related party identification for fund – Vinod Kothari Consultants

– Sikha Bansal, Senior Partner and Payal Agarwal, Partner | corplaw@vinodkothari.com

Corporate relationships and hierarchies are prone to misuse and hence, there are regulatory prescriptions to ascertain and address the areas of conflict. This is usually done through identification of control and/or significant influence, if any, existing between the parties. If there is an element of control /significant influence, the parties may be required to follow a host of protocols – including but not limited to being identified as a promoter, to put in place related party controls, to disclose their transactions and even go for consolidation of accounts, etc.

While in simple structures, it is still possible to objectively conclude the existence of control/significant influence (or the absence of it); in certain complex structures, particularly where unincorporated entities are involved, the determination can be quite subjective and dependent on multiple factors. For instance, in the case of pooled investment schemes (called “funds” henceforth) like mutual funds, AIFs, ReITs, InVITs, etc., the entity would often be formed as a trust which would hold the common hotchpot of funds contributed by investors. Besides investors, there would be multiple parties involved, viz., the fund sponsor, fund manager, and the trustee. Mostly, the fund may not be a legal entity^[1]; however, it is segregated from the funds of either the manager or trustees. If there is any element of control or even significant influence on the funds, by any of these investors/parties, it would necessitate treatment of such funds in accordance with regulatory protocols as discussed above. Further, at the next level, if there is any element of control by such funds on other entities, then there would be concerns around indirect control of investors/parties on such other entities as well, percolating through the fund. Therefore, whether the fund is being controlled or significantly influenced by any person, becomes a pertinent question.

In this article, we attempt to analyze the same and try to frame some guiding principles for ascertaining circumstances in which a fund would be said to be controlled or significantly influenced.

Meaning of control

Depending on the specific nature and characteristics, pooled investment funds in India are governed by distinct SEBI regulations, such as, SEBI (Alternative Investment Funds) Regulations 2012, SEBI (Infrastructure Investment Trusts) Regulations 2014, SEBI (Mutual Funds) Regulations 1996, etc. These regulations define the terms “control” or “change in control” in the context of either the sponsor or the manager or both, but not in the context of the fund. Hence, one will have to look towards accounting standards – namely IFRS 10 which sets out guidelines for the assessment of control in the hands of a fund manager. In India, Ind AS 110 replicates the guidance provided under IFRS 10. Detailed discussion on the principles discussed under IndAS 110 is as below.

Components of control

Ind AS 110 refers to three cumulative components of control, viz.,

Power over the investee,
Exposure or rights to variable returns from its involvement with the investee, and
The ability to use its power over the investee to affect the amount of the investor’s returns.

As evident, the Standard assumes a relationship of investor and investee. In case of funds, while there would be investors; however, the asset manager too, may be required to hold a certain percentage in the fund as skin-in-the-game, pursuant to applicable regulations. Therefore, in the case of funds, the asset manager is also in the position of an investor, besides being in the position of a manager.

Here, it is significant to note that the “existence of power” or “exposure to returns” individually does not indicate an existence of control, unless there is a link between power and returns, that is, the power can be used to direct the relevant activities, which would affect the returns of the investee.

Component of control	Test for existence
Existence of power over the fund	Ability to direct the relevant activities, i.e., activities that significantly affect the investee’s returns.
Exposure to or rights over variable returns	Potential to vary investor’s returns through its involvement as a result of investee’s performance
Link between power and returns	Ability to use its powers (of directing relevant activities) to affect the investor’s returns from its involvement with the investee, i.e., the investor shall hold decision-making rights as a principal. Also, note that what matters is “ability”, whether there is actual use of such power or not, becomes irrelevant.

As power arises from rights, the investor must have existing rights that give the investor the current ability to direct the relevant activities [para B14]. Such rights have been briefly discussed in the later part of this write-up.

Power to direct relevant activities of the Fund

In the context of a fund, the relevant activity would be the management of the asset portfolio of the fund. The said function is primarily performed by the fund manager, albeit, the same may be in the capacity of an agent to the unitholders. Hence, Para 18 of Ind AS 110 requires a decision-maker to determine whether it is a principal or an agent for the fund, since a delegated power cannot signify control.

Fund manager – a principal or an agent

IndAS requires that an investor with decision-making rights (called as “decision maker”), when assessing whether it controls the investee, shall determine whether it is a principal or an agent. An investor shall also determine whether another entity with decision-making rights is acting as an agent for the investor [para B58]. The investor shall treat the decision-making rights delegated to its agent as held by the investor directly [para B59].

Thus, in cases where the fund manager is acting as a mere agent of the investor (that is, the fund manager is under the control of the investor), the decision-making rights of the fund manager are treated as that of the investor itself, and control is assessed accordingly. Therefore, to say that an investor has control over the fund, it is important to establish that the investor has control over the fund manager, who in turn, is acting as an agent of the investor. Here, whether the fund manager itself is able to control the fund or not also becomes a pertinent point for determination.

Para B60 of Ind AS 110 specifies the factors that need to be considered in order to determine whether the fund manager in its capacity of a decision maker, is merely an agent to the principal (other investors) or exercises its decision-making rights in the capacity of a principal to the fund.

The primary factor, holding the highest weightage, in making such determination – is the kick-out rights available with other investors. However, where the same does not conclude fund manager as an agent, various other factors require consideration.

Determination of fund manager as a principal v/s agent

Determining ‘control’ of the investor

Various tests are relevant for determining the control of the investor over the Fund. A summary view of the same is given below:

The table below shows a detailed analysis of each relevant test for assessing the existence of control:

Sl. No.	Test of control	Assessment Remarks
Power to direct relevant activities
1.	Nature of rights	The nature of rights shall be substantive, i.e., providing an ability to direct relevant activities and not merely protective. Protective rights apply only to protect an investor from fundamental changes in the funds’ activities or in exceptional circumstances and do not imply power over the fund.
2.	Majority voting rights	An investor holding more than 50% of voting rights in the fund would generally be considered to have power over the fund, unless such voting rights do not signify substantive decision-making rights. Mention is also made of the SEBI Circular dated 8th October, 2024 that requires conducting due diligence for every scheme of AIFs where an investor, or investors belonging to the same group, contribute(s) 50% or more to the corpus of the scheme.
3.	Ability to influence other investors into collective decision-making	Where a right is required to be exercised by more than one party, whether the investor has the practical ability to influence other rights holders into collective decision-making is relevant in assessment of control of the said investor over the fund.
4.	Contractual arrangements with other investors	Voting rights as well as other decision-making rights may arise out of contractual arrangements giving an investor sufficient rights to have power over the fund.
5.	Size of an investor’s holding relative to size of holding of other parties	Significantly high voting rights held by one investor, and Small fragmented holdings by other parties, and Large number of parties required to outvote one investor An investor holding substantially higher stake, where other investors are holding fragmented holdings, such that a large number of parties are required to outvote the investor, will give the first investor power over the other investors, even in the absence of majority voting rights.
6.	Exercise of voting rights by other investors	Absolute size of one investor’s holding is higher than the relative holdings of other investors, and Other investors are passive and do not actively participate in decision-making Where the stake held by an investor is relatively higher from other investors but not significantly higher to indicate existence of power, however, the other investors do not actively participate in the meetings – the same indicates the unilateral ability of the first investor to direct the relevant activities.
Exposure to, or right over variable returns
7.	Dividend and distributable profits proportionate to holdings	This is directly proportional to the holding of an investor in a fund. Where the holdings of an investor does not comprise a sizable portion of the fund, the same does not indicate a significant exposure to variable returns earned by the fund.
8.	Remuneration for servicing the assets and liabilities of the fund	In the context of a fund, the fund manager provides services w.r.t. the management of its assets and liabilities. The remuneration may contain a fixed as well as a variable component, generally, a percentage based fees based on performance of the fund. However, the same does not indicate an existence of control, if the following elements are present: Remuneration is commensurate with services provided, and Terms and conditions are on arm’s length as per customary arrangements for similar services
9.	Returns in other forms	In addition, there might be returns available in other forms providing a right over variable returns of the Fund.

Analysis of examples contained in Ind AS 110

Below, we discuss the examples explained under Ind AS 110 in the context of funds:

Illustration	Facts	Analysis
13	Defined parameters for investment decisions within which fund manager has discretion to invest Fund manager’s stake in Fund – 10% Market based fee for services – 1% of NAV of Fund Assumption that fees are commensurate to services provided No obligation to fund losses No independent board in the fund No substantive rights held by other investors	Current ability to direct relevant activities rest with fund manager since no other investor has substantive rights to affect the fund manager’s decision-making authority Variability of returns pursuant to fees and investment does not create significant exposure to classify fund manager as principal Fund manager is an agent, so question of holding control does not arise
14	Fund manager has decision-making discretion in the best interest of investors and in accordance with governing documents Market based fee for services – 1% of NAV of Fund Profit sharing upon achieving a specified level of profit – 20% of the Fund’s profits Assumption that fees are commensurate to services provided	Current ability to direct relevant activities rest with fund manager Variability of returns pursuant to fees and investment does not create significant exposure to classify fund manager as principal Fund manager is an agent, so question of holding control does not arise
14A	Fund manager has decision-making discretion in the best interest of investors and in accordance with governing documents Market based fee for services – 1% of NAV of Fund Profit sharing upon achieving a specified level of profit – 20% of the Fund’s profits Assumption that fees are commensurate to services provided Fund manager’s stake in Fund – 2% No obligation to fund losses Removal of fund manager – through simple majority vote of investors, but only for breach of contract	Current ability to direct relevant activities rest with fund manager Variability of returns pursuant to fees and investment does not create significant exposure to classify fund manager as principal Removal rights with other investors are in the nature of protective rights, hence, not substantive Fund manager is an agent, so question of holding control does not arise
14B	Fund manager has decision-making discretion in the best interest of investors and in accordance with governing documents Market based fee for services – 1% of NAV of Fund Profit sharing upon achieving a specified level of profit – 20% of the Fund’s profits Assumption that fees are commensurate to services provided Fund manager’s stake in Fund – 20% No obligation to fund losses Removal of fund manager – through simple majority vote of investors, but only for breach of contract	Current ability to direct relevant activities rest with fund manager Variability of returns pursuant to fees and investment are substantial for the fund manager to consider personal economic interests in making decisions for the Fund Removal rights with other investors are in the nature of protective rights, hence, not substantive Decision-making rights are exercised by the fund manager in the capacity of principal. Variability of returns appears significant to conclude an existence of control.
14C	Fund manager has decision-making discretion in the best interest of investors and in accordance with governing documents Market based fee for services – 1% of NAV of Fund Profit sharing upon achieving a specified level of profit – 20% of the Fund’s profits Assumption that fees are commensurate to services provided Fund manager’s stake in Fund – 20% No obligation to fund losses Independent board in fund Appointment of fund manager – annually through the independent board	Current ability to direct relevant activities rest with fund manager Variability of returns pursuant to fees and investment are substantial for the fund manager to consider personal economic interests in making decisions for the Fund Removal rights with other investors are substantive, since fund manager’s appointment is subject to annual approval of independent board, and can be terminated without cause While variability of returns appears significant to indicate control with the fund manager, more weightage is given on substantive removal rights held by other investors. Hence, the fund manager is considered as an agent, and does not control the fund.
15	Investments in fund through both debt and equity instruments First loss protection to debt investors Residual returns to equity investors Assets funded through equity instrument – 10% of the value of the assets purchased Fund manager decision-making within parameters set out in prospectus Market based fee for services – 1% of NAV of Fund Profit sharing upon achieving a specified level of profit – 10% of the Fund’s profits Assumption that fees are commensurate to services provided Fund manager’s stake in Fund – 35% of equity Other investors for remaining equity and debt – large no. of widely dispersed unrelated investors Removal of fund manager – without cause, by simple majority	Current ability to direct relevant activities rest with fund manager Variability of returns pursuant to fees and investment, as well as significant exposure to losses on account of equity investments being subordinate to debt investments are substantial for the fund manager to consider personal economic interests in making decisions for the Fund. Removal rights with other investors are without cause, still, not considered substantive, on account of the large number of investors required to exercise such rights. Considering the significant level of exposure to variability of returns, the fund manager is considered principal and controls the fund.
16	Sponsor establishes a multi-seller conduit Establishes terms of conduit Manages conduit for market based fees (commensurate with services provided) Approves the sellers/ transferors and the assets to be purchased and makes decisions (in best interest of investors) Entitled to residual return Provides credit enhancement (upto 5% of all conduit’s assets, after risk absorption by transferors) Liquidity facilities provided (except against defaulted assets) Transferors sell high quality medium term assets to the conduit Manages receivables on market based service fees Provides first loss protection through over-collateralisation Conduit Issues short term debt instruments to unrelated investors by a conduit Marketed as highly rated medium term asset with minimum exposure to credit risk Investors Do not hold substantive decision-making rights	Current ability to direct relevant activities of the conduit Exposure to variability of returns through right to residual returns of the conduit and provision of credit enhancement and liquidity facilities Considering the significant level of exposure to variability of returns, the sponsor is considered principal and controls the fund. The obligation to act in the best interests of the investors is not significant.

The “trust” angle

Funds are usually constituted in the form of a trust, where there is an independent trustee. Further, the investment manager is under an obligation to act in a fiduciary capacity towards the investors of AIF, in the best interest of all investors and manage all potential conflicts of interest [Reg 20(1) of AIF Regulations r/w the Fourth Schedule]. In such a scenario, can it be argued that there can be no element of control over a fund, irrespective of who the contributor is?

In SREI Infrastructure Finance Limited vs Shri Ashish Chhawchharia, the NCLAT, in view of the specific facts and circumstances of the case, held the existence of control of the contributor of the AIF over the investee company of the AIF through the AIF. The matter pertained to identification of the appellant as a related party of the corporate debtor in the context of IBC. The surrounding facts and circumstances are briefly put forth as under:

Therefore, in a given set of facts and circumstances, it might be possible to contend that the fund is being controlled by an investor/group of investors.

Conclusion

In questions involving conflict of interest, control, and relationships, Courts have often adopted purposive interpretation in such cases rather than literal interpretation. As held in Phoenix Arc Private Limited v. Spade Financial Services Limited, AIRONLINE 2021 SC 36, albeit in the context of section 21(2) of IBC would still be relevant. Referring to an authoritative commentary by Justice G.P. Singh which states that the terms may not be interpreted in their literal context, if the same leads to absurdity of law, the Supreme Court held: “The true test for determining whether the exclusion in the first proviso to Section 21(2) applies must be formulated in a manner which would advance the object and purpose of the statute and not lead to its provisions being defeated by disingenuous strategies.” Therefore, whether the fund is being controlled by any person/entity is to be seen in the light of all facts and circumstances, and there can be no straight-jacket formula to arrive at a conclusion.

Other resources on AIFs:

^[1] For example, it may be a trust. However, it is possible to envisage funds held in LLP or company format, in which case the fund becomes a separate entity. This article does not envisage a fund formed as a body corporate.

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