SEBI – Vinod Kothari Consultants

Some relief in RBI stance on lenders’ round tripping investments in AIFs

March 28, 2024/0 Comments/in Financial Services, NBFCs, RBI /by Team Finserv

– Team Finserv | finserv@vinodkothari.com

The Reserve Bank of India on 19th December 2023 issued a notification^[1] imposing a bar on all regulated entities^[2] (REs) with respect to their investments in AIFs. We had covered the same in our earlier write-up. The Circular has already created some bloodshed as several banks took a hit in their Q3 results. Though late, yet welcome, the RBI has now come with some relief by a March 27 2023 circular. The following Highlights are based on the original circular, as amended by the March 27th circular :-

What has the RBI done?

Prohibited all regulated entities (REs), including banks, cooperative banks, NBFCs and All India Financial Institutions from making investments in Alternative Investment funds (AIFs), if the AIF has made any investment in a “debtor company”, other than by way of equity shares of the debtor company. Hence, if the AIF has made investment by way of bonds, structured capital instruments, etc., issued by a debtor company, the bar as above will apply.
Debtor company means a company in which the RE currently has or previously had a loan or investment exposure anytime during the preceding 12 months
The bar applies immediately, that is, effective 19th Dec 2023. No further investments to be made.
If investments already exist, the RE shall exit within 30 days, that is, by 18th Jan., 2024. Hindsight clearly shows that for most regulated entities, there was no way to cause exit, as AIF investments are evidently illiquid. Hence, most regulated entities took a hit on their P/L.
Further, if an RE has made an investment in an AIF, and the AIF invests in a debtor company, the RE shall make an exit within 30 days.
Investment by REs in the subordinated units of any AIF scheme with a ‘priority distribution model’ subject to full deduction from RE’s capital funds. See further discussion on priority distribution model below.

What was the intent?

Since several REs have affiliated AIFs, routing the money through AIFs to borrowers might have led to ever greening. That is, the AIF would invest the money into a debtor company, and consequently, the debtor company would keep its account as a performing asset. In essence, the AIF was acting as a stopover in the process of round tripping of the money back to a debtor company, from where it will be used to pay off the lender.

What will be the impact of the Circular?

Most of the larger REs have affiliated AIFs. Flow of funds to them from the RE would stop completely.
The sweep of the circular is wide and non-discriminatory. Not only affiliated AIFs, but any AIF in general will be dried of funding from REs. While the bar is only for those AIFs which have invested in “debtor companies”, it will be practically tough for REs to avoid overlapping investments. Given the severe implications of a breach, compliance-sensitive REs will avoid investing in AIFs.
There is an immediate disinvestment pressure on AIFs, as there may be overlapped investments. AIFs’ assets are mostly illiquid – ensuring exit to RE investors may be tough. In many cases, there are lock-in restrictions as well.
Not only has the RBI expressed concerns, SEBI also issued a consultation paper for enhancement of trust in the AIF ecosystem, citing use of AIFs for regulatory arbitrage. See our write up on the SEBI proposals.

Direct or indirect investments:

As the Circular is driven by concerns of round-tripping, widening the circuit by creating more stop-overs does not help. For example, if a lender invests in an AIF, which invests in an intermediate entity, which in turn invests in a debtor entity, the trail of the money is clear. Likewise, the lender may be making an indirect investment in an AIF.
However, where there is no round-tripping of the money to a “debtor company”, there should be no concern. For example, if a lender makes a loan to an entity, where an AIF of the group has also made investments, there is no flow of money from the lender to the AIF, for the purpose of the downstream investment by the AIF into the debtor company.

Investments through mutual funds and FOFs exempt:

The 27th March circular exempts instances where investments are made by lenders into mutual funds or FoFs, and those in turn have some exposure in either an AIF or in a debtor entity.

Priority distribution model or structured AIFs

In addition to the concerns on downstream investments by AIFs in debtor companies, the RBI also had concerns on the so-called structured AIFs or AIFs with a distribution waterfall. Whether AIFs can at all have a priority distribution waterfall is currently under SEBI examination and SEBI has stopped AIFs from using structured distribution schemes (by way of accepting fresh commitment or making investment in a new investee company) . However, several existing schemes have such models.
If a lender makes an investment in the subordinated units of a structured AIF scheme such investments will get deducted from the regulatory capital of the lender. The March 27 circular now clarifies that the deduction will be equally from Tier 1 and Tier 2 capital. Further, it also clarifies that the subordinated exposures in the AIF schemes could be in the form of subordinated exposures, including investment in the nature of sponsor units.

Concern areas

Ideally, the bar should have been limited to affiliated AIFs. Affiliated AIFs could have been defined appropriately – for example, a related party, or where the investment manager, or sponsor is a related party of the RE. Extending the bar to all AIFs is quite far from the intent of the circular – which is, admittedly, to curb evergreening. It is difficult to see how unrelated AIFs can be used by an RE to evergreen, as investment decisions of these AIFs are not exercised by the investors.
Ideally, the bar should have been limited only to Cat 1 and Cat 2 AIFs. Cat 3 AIFs, widely known as hedge funds, typically play in equity long/short strategies, or do other leveraged trades. REs find such investment a useful way to diversify their funds into hedge funds. Hedge fund investments are common by institutional investors all over the world; an outright curb on these investments by REs is, once again, beyond the stated intent. Notably, given the wide range of investments that Cat 3 AIFs make, avoiding an overlap with the RE’s borrowers will be quite impractical.
Practical implementation of this circular, if at all a RE invests in an AIF, will be quite tough. AIFs will have to share their potential investment list, which will be against any investment manager’s choice. Assuming there is an overlapped investment, the RE will have to exit within 30 days, which will create liquidity issues for AIFs, in addition to challenging the lock-in restrictions.
Most of the regulated entities took a provision in the 3rd quarter. The 27th March circular of the RBI gives some relief by saying that the provision will be required only to the extent of the downstream investment in a debtor entity.

In our view, there is a need to review the regulatory mechanism for AIFs, as currently, AIFs are being used as instruments of regulatory arbitrage.

^[1] https://rbi.org.in/Scripts/NotificationUser.aspx?Id=12572&Mode=0

^[2] Commercial Banks (including Small Finance Banks, Local Area Banks and Regional Rural Banks), Primary (Urban) Co-operative Banks/State Co-operative Banks/ Central Co-operative Banks, All-India Financial Institutions, Non-Banking Financial Companies (including Housing Finance Companies)

SEBI approves uniform approach for market rumour verification, eases on-going compliance requirement for listed companies, eases norms for IPO/ fund raising, AIFs, relaxes requirement for FPI & extends timeline for HVDLE on March 15, 2024

March 17, 2024/0 Comments/in Corporate Laws, IPOs and listing, LODR, SEBI /by Team Corplaw

-Avinash Shetty and Manisha Ghosh | corplaw@vinodkothari.com

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The Promise of Predictability: Regulation and Taxation of Future Flow Securitization

March 4, 2024/0 Comments/in Financial Services, RBI, Securitisation /by Staff

Dayita Kanodia | Executive | finserv@vinodkothari.com

The most reliable way to predict the future is to create it
– Abraham Lincoln

Surely, Lincoln did not have either securitisation or predictability in mind when he wrote this motivational piece; however, there is an interesting and creative use of securitisation methodology, to raise funding based on cashflows which have some degree of predictability. In many businesses, once an initial framework has been created, cashflows trickle over time without much performance over time. These situations become ideal to use securitisation, by pledging this stream of cashflows to raise funding upfront. Surely, traditional methods of on-balance-sheet funding fail here, as there is very little assets on the balance sheet.

Securing the Beat: Tuning into Music Royalty Securitization

February 26, 2024/0 Comments/in Financial Services, RBI, Securitisation, Taxation /by executive

Dayita Kanodia | finserv@vinodkothari.com

“Music can change the world”

–Ludwig van Beethoven

This quote by Beethoven remains relevant today, not only within the music industry but also in the realm of finance. In the continually evolving landscape of finance, innovative strategies emerge to monetize various assets. One such groundbreaking concept gaining traction in recent years is music royalty securitization. This financial mechanism offers investors a unique opportunity to access the lucrative world of music royalties while providing artists and rights holders with upfront capital.

The roots of this innovative financing technique can be traced back to the 1990s when musician David Bowie made history by becoming the first artist to securitize his future earnings through what became known as ‘Bowie Bonds’. This move not only garnered attention but also paved the way for other artists to follow suit. Bowie Bonds marked a significant shift in how music royalties are bought, sold, and traded.

As per the S&P Global Ratings^[1], the issuance of securities backed by music royalties totaled nearly $3 billion over the two-year span 2021-22. The graph below shows a recent surge in issuance of securities backed by music royalties.

Data showing the growth of Music Royalty Securitization

This article discusses music royalty securitization, its mechanics, benefits, challenges along with implications for the music industry.

Understanding Music Royalties:

Before exploring music royalty securitization, it’s essential to understand the concept of music royalties. In the music industry, artists and rights holders earn royalties whenever their music is played, streamed, downloaded, or licensed for use. These royalties are generated through various channels, including digital platforms, radio, TV broadcasts, live performances, and synchronization licenses for commercials, movies, and TV shows. However, it’s important to note that artists only earn royalties when their music is utilized, whether through sales, streaming, broadcasting, or live performances.

As a result, the cash flows from these royalties being uncertain are received over time and continue to be received for an extended period. Consequently, artists experience a delay in receiving substantial amounts from these royalties, sometimes waiting for several years before seeing significant income.

The Birth of Music Royalty Securitization:

Securitization involves pooling and repackaging financial assets into securities, which are then sold to investors. The idea is to transform illiquid assets, such as mortgage loans or in our case, music royalties, into tradable securities. Music royalty securitization follows a similar principle, where the future income generated from music royalties is bundled together and sold to investors in the form of bonds or other financial instruments.

Future Flows Securitization:

Music royalty securitization is a constituent of future flows securitization and therefore before discussing the constituent, it is important to discuss the broader concept of future flows securitization.

Future flows securitization involves the securitization of future cash flows derived from specific revenue-generating assets or income streams. These assets can encompass a wide range of future revenue sources, including export receivables, toll revenues, franchise fees, and other contractual payments, even future sales. By bundling these future cash flows into tradable securities, issuers can raise capital upfront, effectively monetizing their future income. Future flows securitization differs from the traditional asset backed securitization by their very nature as while the latter relates to assets that exist, the former relates to assets that are expected to exist. There is a source, a business or infrastructure which already exists and which will have to be worked upon to generate the income. Thus, in future flows securitization the income has not been originated at the time of securitization. The same can be summed up as: In future flow securitization, the asset being transferred by the originator is not an existing claim against existing obligors, but a future claim against future obligors.

Mechanics of Music Royalty Securitization:

Music royalty securitization involves packaging the future income streams generated by music royalties into tradable financial instruments. The process begins with the identification of income-generating assets, which are then bundled into a special purpose vehicle (SPV). The SPV issues securities backed by these assets, which are sold to investors. The revenue generated from the underlying music royalties serves as collateral for the securities, providing investors with a stream of income over a specified period.

The process of music royalty securitization typically involves several key steps:

Asset Identification: Rights holders, such as artists, record labels, or music publishers, identify their future royalty streams eligible for securitization.

Valuation: A valuation is conducted to estimate the present value of the anticipated royalty income streams. Factors such as historical performance, market trends, and artist popularity are taken into account.

Selling the future flows: The future flows from royalties are then sold off to the Special Purpose Vehicle (SPV) to make them bankruptcy remote. The sale entitles the trust to all the revenues that are generated by the assets throughout the term of the transaction, thus protecting against credit risk and sovereign risk as discussed later in this article.

Structuring the Securities: These future cash flows are then structured into securities. This may involve creating different tranches with varying levels of risk and return.

Issuance: The securities are then issued and sold to investors through public offerings or private placements. The proceeds from the sale provide upfront capital to the rights holders.

Revenue Collection and Distribution: The entity responsible for managing the securitized royalties collects the revenue from various sources which is then distributed to the investors according to the terms of the securities.

Importance of Over-collateralization:

Over-collateralization is an important element in music royalty securitization. In music royalty securitization and in all future flows transactions in general, the extent of over-collateralization as compared to asset backed transactions is much higher. The same is to protect the investors against performance risk, that is the risk of not generating sufficient royalty incomes. Over-collateralization becomes even more important since subordination structures generally do not work for future flow securitizations. This is because the rating here will generally be capped at the entity rating of the originator.

Why go for securitization ?

Now the question may arise as to why an artist or a right holder of a royalty has to go for securitization of his music royalties in order to secure funding. Why cant he simply opt for a traditional source of funding ? The answer to this question is two folds:

Firstly, the originator in the present case generally has no collateral to leverage and hardly there will be a lender willing to advance a loan based on assets that are yet to exist.

Secondly even if they are able to obtain funding it will be at a very high cost due to high risk the lender perceives with the lending.

Music royalty securitization, could be his chance to borrow at a lower cost. The cost of borrowing is related to the risks associated with the transaction, that is, the risk the lender takes on the borrower. Now, this risk includes performance risk, that is the risk that the work of the originator does not generate enough cash flows. While this risk holds good in case of securitization as well, it however takes away two major risks – credit risk and sovereign risk.

Credit risk, as divested from the performance risk would basically mean that the originator has sufficient cash flows but does not pay it to the lender. This risk can be removed in case of a securitization by giving the SPV a legal right over the cash flow.

Sovereign risk on the other hand emanates only in case of cross-border lending. This risk arises when an external lender gives a loan to a borrower whose sovereign later on in the event of an exchange crises either imposes a moratorium on payments to external lenders or may redirect foreign exchange earnings. This problem is again solved by giving the SPV a legal right over the cash flows from the royalties arising in countries other than the originator’s, therefore trapping cash flow before it comes under the control of the sovereign.

The lack of these two types of risks might reduce the cost of borrowing for the originator; thus making music royalty securitization a lucrative option.

Accounting Treatment:

As discussed, there is no existing asset in a music royalty transaction. In terms Ind AS 39, an entity may derecognize an asset only when either the contractual rights to the cash flows from the financial asset have expired or if it transfers the financial asset. However, here asset means an existing asset and a future right to receive does not qualify as an asset in terms of the definition under Ind AS 32.

Accordingly, the funding obtained through the securitization of music royalties should be shown as a liability in books as the same cannot qualify as an off-balance sheet funding.

Regulatory Framework in India:

It is crucial to discuss the applicable regulatory framework on securitization currently prevalent in India and whether music royalty securitization would fall under any of these:

Master Direction – Reserve Bank of India (Securitization of Standard Assets) Directions, 2021(‘SSA Master Directions)
SEBI (Issue and Listing of Securitised Debt Instruments and Security Receipts) Regulations, 2008 (SDI Framework)
Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002

While the SSA Master Directions primarily pertain to financial sector entities, and will not directly apply to this domain; however, there exists a possibility that the securitization of music royalties could fall under the purview of SEBI’s SDI Framework.

The same has been discussed in detail in the artcile- The Promise of Predictability: Regulation and Taxation of Future Flow Securitization

Benefits of Music Royalty Securitization:

Music royalty securitization offers a range of benefits for both investors and rights holders:

Diversification: Investors gain exposure to a diversified portfolio of music royalties, potentially reducing risk compared to investing in individual songs or artists.

Steady Income Stream: Music royalties often provide a stable and predictable income stream, making them attractive to income-oriented investors, such as pension funds and insurance companies.

Liquidity: By securitizing music royalties, rights holders can access immediate capital without having to wait for future royalty payments, providing liquidity for new projects or business expansion.

Risk Mitigation: Securitization allows rights holders to transfer the risk of fluctuating royalty income to investors, providing a hedge against market uncertainties and industry disruptions.

Challenges and Considerations:

While music royalty securitization presents compelling opportunities, it also poses certain challenges and considerations:

Market Volatility: The music industry is subject to shifts in consumer preferences, technological disruptions, and regulatory changes, which can impact the value of music royalties.

Due Diligence: Thorough due diligence is essential to assess the quality and value of music assets, including considerations such as copyright ownership, market demand, and revenue potential.

Potential Risks:

Market Risk: Changes in consumer behavior, technological advancements, or regulatory developments could impact the value of music royalties.
Legal Risk: Disputes over ownership rights, copyright infringement, or licensing agreements could lead to litigation and financial losses.
Concentration Risk: Investing in a single music catalog or genre exposes investors to concentration risk if the popularity of that catalog or genre declines.
Cash Flow Variability: While music royalties can provide steady income, fluctuations in streaming revenues or changes in licensing agreements may affect cash flow stability.
Reputation Risk: The success of music royalty securitization depends on the ongoing popularity and commercial success of the underlying music assets. Negative publicity, controversies, or declining relevance can adversely affect investor confidence and returns.

Implications for the Music Industry:

While music royalty securitization presents exciting opportunities, it also raises certain considerations for the music industry:

Artist Empowerment: Securitization can empower artists by providing them with alternative financing options and greater control over their financial destiny.

Industry Evolution: The emergence of music royalty securitization could reshape the traditional music business model, fostering innovation and collaboration between artists, labels, and investors.

Way Forward

Music royalty securitization offers a compelling investment opportunity for investors seeking exposure to the lucrative music industry. By securitizing future royalty streams, music rights owners can unlock liquidity while providing investors with access to a diversified portfolio of music assets.

As the music industry continues to evolve, music royalty securitization is likely to play an increasingly prominent role in the financial landscape, providing new avenues for capital deployment and revenue generation. It has the potential to transform the rhythm of creativity into the melody of investment opportunity.

AIFs ail SEBI: Cannot be used for regulatory breach

January 31, 2024/0 Comments/in Corporate Laws, SEBI /by Vinod Kothari

Vinod Kothari | corplaw@vinodkothari.com

The alternative investment management industry in India works in the form alternative investment funds (AIFs), a SEBI-regulated vehicle. Most of the PE, VC funds, and hedge funds in India work in this mode.

AIFs have recently been at the receiving end of regulatory flak. RBI had expressed concerns on use of AIFs by regulated lenders for evergreening, and prohibited regulated entities from making any investment in such AIFs as have investments in their borrowers.

Now, SEBI, vide a Consultation Paper dated 19th January heaped a bunch of similar concerns, and required AIFs to affirm that the AIF or investments therein are not being used for regulatory breaches. These concerns, SEBI says, are a result of an ongoing thematic check on the AIF industry, and SEBI says it has already detected at least 40 cases, involving AUM over Rs 30000 crores, where the structure was used to create dents in existing financial regulations.

Based on Data relating to activities of Alternative Investment Funds (AIFs)

The AIF industry has demonstrated steady growth in recent years. As of September 2023, the assets under management (AUM) of AIFs have surged to 3.88 lakh crores, a substantial increase from the 13,000 crores recorded in September 2015. [See Graph above].

LEAP to listing: India permits direct listing of shares overseas through IFSC

January 25, 2024/0 Comments/in Corporate Laws, FEMA, IFSC, MCA /by Team Corplaw

MCA & MOF notify rules for the same

– Vinita Nair & Prapti Kanakia | corplaw@vinodkothari.com

Indian companies were permitted to raise funds from overseas either pursuant to issue of depository receipts listed overseas or having the non-residents subscribe to issuances made in India or by way of borrowing overseas. As an initiative to provide an avenue to access global capital markets, GoI had announced the decision to ease raising of foreign funds in order to boost foreign investment inflows, unlock growth opportunities and offer flexibility to Indian companies to raise funds. Consequently, an enabling provision for direct listing of prescribed class of securities on permitted stock exchanges in permissible foreign jurisdictions was inserted vide Companies (Amendment) Act, 2020 in Section 23 of Companies Act, 2013 (‘CA, 2013’), that deals with permissible modes of issue of securities, vide notification dated September 28, 2020 and made effective from October 30, 2023. Thereafter, the Ministry of Corporate Affairs (‘MCA’) notified Companies (Listing of equity shares in permissible jurisdictions) Rules, 2024 (‘LEAP Rules’) effective from January 24, 2024. As listing of shares abroad will result in raising funds from persons resident outside India, Ministry of Finance (‘MoF’) notified FEMA (Non-Debt Instruments) Amendment Rules, 2024 amending FEMA (Non-Debt Instruments) Rules, 2019 (‘NDI Rules’) with effect from January 24, 2024. SEBI is also expected to roll out the operational guidelines for listed companies to list their equity shares on permitted stock exchanges.^[1]

Additionally, FAQs on direct listing scheme (FAQs) have also been rolled out on January 24, 2024. Further, two of the key recommendations of the working group report on Direct Listing of Listed Indian Companies on IFSC Exchanges submitted in December 2023 was to notify the rules under Section 23 (3) and (4) of CA, 2013 and notify necessary amendments in NDI Rules to permit cross-jurisdiction issuance and trading of equity shares of Indian companies on IFSC exchanges.

Presently, both the LEAP Rules as well as NDI Rules have notified International Financial Services Centre in India (‘Gift City’) as the permissible jurisdiction and India International Exchange and NSE International Exchange as the permissible stock exchange. International Financial Services Centres Authority (‘IFSCA’) had issued the IFSCA (Issuance and Listing of Securities) Regulations, 2021 effective July 19, 2021 (‘IFSC Regulations’) however, in the absence of enabling provision under CA, 2013 and NDI Rules, Indian companies were unable to undertake listing of securities abroad.

In this article we provide an overview of the regulatory regime and deal with the procedural aspect.

Corporate Governance: Miles Travelled and Miles to go

January 16, 2024/0 Comments/in corporate governance, Corporate Laws, Publications /by Team Corplaw

Register to our premium section to access the e-book

Book released on January 24, 2024

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Inviting you to delve into a sweeping 700-pager book that unfolds the intricate tapestry of Corporate Governance as concept, providing a comprehensive and enlightening treatise on its evolution across diverse areas. Some of the salient features of this book are

Runs over 700 pages of text, divided into 9 parts, consisting of 25 chapters.
Coverage of the complete ecosystem of corporate governance including the board and its committees, independent directors, auditors, proxy advisors, and shareholders.
Extensive coverage of conflicts of interest which forms the major area of concern in corporate governance with detailed analysis of regulations on related party transactions.
Covers information symmetry and corporate transparency as one of the key targets of effective corporate governance, with substantial coverage on insider trading and ensuring confidentiality and the flow of information from companies to the stock exchanges.
Several chapters are supported by extensive,well-classified FAQs.
Global coverage with an Indian focus, to allow readers to put the regulations into a wider context and understand international best practices.
Sustainability and business responsibility covering detailed analysis of obligations relating to ESG, climate change and directors’ liability for the same, sustainability financing, and CSR.
Use of technology in corporate governance like the use of AI in boardroom decisions.

In addition to the contents, the book has been designed in an e-book format to provide additional benefits to readers such as –

Hyperlinked text allowing access to the net resources
Eco-friendly, as we save paper and print
Cost effective -note that the subscription charges to our premium section are nominal, and not for this book but for all the materials/text that we put in the premium section
Reader’s ease of access – you may refer to the book using your handheld device, laptop, and at any point or place
Ease of searching and referencing – text search, string search capabilities of PDF versions may be deployed
Timely updations – we may, at intervals that we determine, update the text – therefore, you will be reading the last updated version, whereas print publications take long time to be revised. Notably, in the dynamic space of corporate governance, regulatory information itself may change frequently enough