SEBI'S Due Diligence Framework for AIF: Addressing Regulatory Arbitrage and Investment Transparency
- Administrator
- Mar 24
- 7 min read
Yash Arjariya*
INTRODUCTION: REGULATORY ARBITRAGE IN THE GUISE OF AIF
Investments made by Alternative Investment Funds[1] ("AIF") with domestically owned and controlled Sponsor[2] and Manager[3] are not classified as downstream investments[4] or indirect foreign investment. Instead, they are treated as investments by persons resident in India. However, investments made by AIF on a fully diluted basis (equity shares, mandatorily convertible preference shares, mandatorily convertible debentures) are classified as downstream investments if either or both Sponsor or Manager is/are not Indian. Consequently, exchange control norms apply to these investments, such as pricing guidelines and sectoral restrictions. The rationale of allowing AIF with Indian owned and controlled Sponsor and Manager was to facilitate such AIF in raising investments from a large number of investors without being restricted by the exchange norms and attendant conditions. The classification is rooted in the AIF's domicile. AIF with an Indian Sponsor and Manager means that the domicile is based in India, as investment decisions are effectively made by them.
However, the Securities and Exchange Board of India ("SEBI") has been mulling over the cases of refers as 'regulatory arbitrage'. This can be traced back to SEBI's consultation paper in January 2024 titled "Consultation paper on a proposal to enhance trust in the Alternative Investment Funds ('AIF') ecosystem to facilitate Ease of Doing Business measures," where SEBI inter alia highlighted the attempts of exchange norm circumvention through AIF. For example, as SEBI explained, AIF has been set up with an Indian-owned and controlled Sponsor/Manager to aid foreign investors in investing in restricted sectors or beyond the prescribed limits. The investment made by such AIF is not characterised as a downstream investment. As a result, foreign exchange norms will not be attracted. Furthermore, AIF enables certain investors to route their investment in the investee companies—or up to a specific limit—where direct investment would otherwise not be permissible.
Perhaps this change was long anticipated, with Reserve Bank of India ("RBI") already recommending the government to change the basis of determination of downstream investment with respect to AIF and that it should be the beneficial interest held by foreign investors rather than ownership and control of Sponsor and Manager. However, the recommendations have not yet been adopted in the form of an amendment to Foreign Exchange Management (Non-Debt Instruments) Rules, 2019 ("NDI Rules"). Similarly, RBI had barred regulated entities from investing in AIF that had invested in the debtor companies, as it amounted to the evergreening of loans, i.e., the money being channelled through AIF to debtor companies to keep themselves alive. This problem also led to twin problems: firstly, it prevented the proper classification of such debtor companies in the books of the regulated entities, and secondly, it prevented adequate classification, and thus, the debtor's creditworthiness remained unaffected. Therefore, debtors who were otherwise ineligible to receive capital from regulated entities (owing to non-payment of previous loans, etc.) were receiving money from regulated entities channelled through AIF and using the newly received funds to repay earlier loans. Accordingly, the debtors successfully evaded being classified as non-performing assets in the books of the regulated entities.
SEBI, through a circular titled, "Specific due diligence of investors and investments of AIFs' ("Circular"), has laid down due diligence ("DD") requirements to be carried out by the AIF, its Manager, and their Key Management Personnel ("KMP"). This article analyses the DD requirements laid down by the Circular regarding the investment from land bordering countries with India ("LBC") through AIF. This analysis delves into the specific DD requirements imposed by the Circular, examining the operational challenges AIF faces in implementation, including the complexities of outsourcing these obligations while maintaining regulatory accountability. A key focus is the interplay between the framework laid by the Circular and the existing restrictions on capital from LBC investors. The article argues that SEBI's emphasis on disclosure signals a proactive intent to monitor and potentially address risks associated with LBC capital, creating uncertainty about future regulatory actions. Ultimately, this article explores the implications of this evolving regulatory landscape for AIF, highlighting the need for greater clarity on penalties and the RBI's potential role in shaping future cross-border investment flows.
DUE DILIGENCE STANDARDS AND REPORTING DUTIES
On 25 April 2024, SEBI issued Securities and Exchange Board of India (Alternative Investment Funds) (Second Amendment) Regulations, 2024, which inter alia amended the SEBI AIF Regulations, 2012 to introduce an additional obligation incumbent upon an AIF, Manager, and KMP of the AIF to exercise DD with respect to their investors and investments to prevent the facilitation of circumvention of laws. Pursuant to this, SEBI has released the Circular delineating the DD requirements required to be carried out by AIF, the Manager of AIF and their KMP. Following are the specific DD requirements to be carried by the fund, the Manager of the funds and its KMP where the fund is raising capital commitment from LBC or has already raised capital from LBC before the date of the Circular:
1. For Proposed Investment:
If in a scheme of an AIF, a citizen of an LBC or an investor whose beneficial owners are citizens of LBC contributes 50% or more to the corpus, necessary DD as per the implementation standards formulated by Standard Setting Forum for AIF needs to be carried out prior to making any investment. Post such DD, the details of the investment need to be reported if the scheme holds 10% or more of equity/equity-linked securities (on a fully diluted basis) issued by the investee company.
2. For Existing Investment:
If the scheme(s) of AIF meet the corpus threshold (50% or more contribution by the investor from LBC) and the scheme holds 10% more of equity/equity-linked securities (on a fully diluted basis) issued by the investee company, then it must report the same to their custodians by 7 April 2025.
OUTSOURCING DUE DILIGENCE BY AIF: BALANCING OPERATIONAL EFFICIENCY WITH REGULATORY ACCOUNTABILITY
The DD obligations incumbent upon AIF, its manager, and its KMPs are continuing. As per the Circular, the data compilation needs to be done on a monthly basis. Thus, any indirect acquisition of beneficial interest by foreign investors from LBC from the last date of disclosure ought also to be reported. Therefore, it adds to the operational burden of the AIF. AIF may outsource the DD work to third parties to discharge such a burden. This outsourcing needs to be assessed on the cornerstone of the incumbent obligations on the AIF.
Regulation 20(20) of the AIF regulations read with the Circular mandate the DD requirement. Though the responsibility of carrying out DD is cast upon AIF, its manager and their KMPs, they may want to outsource it to ensure operational efficiency and reduce the burden. Perhaps outsourcing DD obligations is a tenable and reasonable option; however, it is unequivocal that the burden solely remains on AIF, its manager and their KMP, and their responsibility for ensuring compliance cannot be evaded. Since SEBI has neither in the AIF Regulations nor in the Circular prescribed any penalty for the failure to perform DD, clarity on penalty provision is awaited.
However, the AIF outsourcing the work may want to sign an indemnity agreement with the third party in case of any inconsistency or default in the DD. So, it is outsourced, and a penalty is levied by SEBI. It is anticipated that AIF will outsource the DD requirements, and therefore, robust indemnification agreements will help maintain operational efficiency through outsourcing and indemnity against potential action by the regulator.
PN3 CONUNDRUM
Investments in units of investment vehicles such as AIF are governed by Schedule VIII of the NDI Rules. Schedule VIII, however, does not incorporate the Press Note 3 ("PN3") restrictions but allows investment in units of investment vehicles by non-residents other than citizens of Pakistan and Bangladesh or entities incorporated in such nations. On the other hand, PN3 restrictions relate to Schedule I investments, which govern the purchase or sale of equity instruments of an Indian company by non-residents. It needs to be emphasised that the ambit of PN3 restriction is much wider than any restriction in Schedule VIII in the sense that investments from an entity of an LBC, or when the beneficial owner of any such investment is a citizen of LBC, the investments will need government approval.
Therefore, technically, PN3 restrictions do not apply to investments in units of AIF, absent any such restriction in Schedule VIII of NDI Rules. However, the funds have been hesitant to take this position and accept investments from entities from LBC due to much regulatory antagonism against investments flowing from LBC and fear of any regulatory action that may follow.
With respect to this Circular, SEBI has not outlawed the investment in AIF units from LBC entities but has merely sought disclosure. It may be the case that SEBI may forward the collated data to the RBI, which may then deem it fit to warrant any regulatory action in some instances concerning such investment from LBC countries. However, as submitted above, technically, PN3 restrictions do not apply to AIF units; thus, SEBI has merely sought disclosure and not crammed down on such investments.
CONCLUSION
While the PN3 restrictions technically do not apply to AIF investments, the emphasis on disclosure highlights SEBI's intent to monitor and potentially address risks associated with investments from LBC. The mandatory reporting could lead to heightened scrutiny, regulatory interventions, or even de facto deterrence of capital inflow from LBC. Looking ahead, greater regulatory clarity—particularly regarding penalties and RBI's role in overseeing such investments—will be crucial in shaping cross-border capital flows. Without clear guidelines, AIF may struggle to anticipate future restrictions, impacting investment strategies and risk assessments. As SEBI continues refining its oversight, stakeholders must remain agile, ensuring they align with both formal regulations and emerging enforcement trends.
[1] As per reg 2(1)(b) of the Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012 ("AIF Regulations"), AIF is a privately pooled investment vehicle which collects funds from investors, whether Indian or foreign, for investing it in accordance with a defined investment policy for the benefit of its investors.
[2] As per reg 2(1)(w) of the AIF Regulations, Sponsor means any person or persons who set up the Alternative Investment Fund.
[3] As per reg 2(1)(q) of the AIF Regulations, Manager means any person or entity who is appointed by the Alternative Investment Fund to manage its investments.
[4] As per rule 23 of the Foreign Exchange Management (Non-debt Instruments) Rules, 2019, downstream investment means an investment made by the foreign owned and/or controlled entity into an Indian investee entity.
(*) Yash is a fourth-year law student at Hidayatullah National Law University, Raipur, with internship work experience in M&A, PE-VC, and Investment Funds. He can be contacted at yasharjariya.hnlu@gmail.com for any discussion related to the article. The views expressed are personal and do not bear affiliation to any institution/organisation that the author is currently associated with or may be associated with in the future.
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