Introduction

Since the promulgation of SEBI (Alternative Investment Funds) Regulations, 2012 (“AIF Regulations”), Securities and Exchange Board of India ("SEBI"), India’s securities market regulator, for the first time was confronted with a matter which required critical analysis and interpretation of the AIF Regulations. This article analyses adjudication order dated November 29, 2017 issued by SEBI in the matter of SREI Multiple Asset Investment Trust, a Category II Alternative Investment Fund (“AIF Fund”).

The article deals with SEBI’s views concerning investment conditions, requirement of maintaining continuing interest by the sponsor of an AIF, objective and strategy of an AIF and its deviation from the offering document in light of the applicable provisions under the AIF Regulations. SEBI initiated adjudication proceedings against the AIF Fund, its investment manager and sponsor. In its detailed order, SEBI held that the AIF Fund, investment manager and sponsor had violated certain provisions of the AIF Regulations and imposed a penalty of ₹ 30 Lakhs on them. The SEBI order throws light on few important aspects concerning the functioning of AIF industry which has been summarized in the form of Q&A in the following paras.

Can AIF give loans?

In the given context, SEBI, had to examine if AIF Fund had violated the provisions of AIF Regulations by giving loans to various companies. SEBI, for the said issue, examined relevant provisions of the AIF Regulations to arrive at a conclusion that an AIF shall invest as per the defined ‘investment policy’ set out in its offering document. SEBI took a positive stand on allowing AIF to offer plain vanilla loans if the offering documents of fund stipulates such form of financing.

Interestingly, if an AIF is allowed to give plain vanilla loan, it could tantamount to a ‘NBFC’ activity, which falls squarely under the domain of Reserve Bank of India (“RBI”). This may lead to a situation where same activity is being regulated by two different regulators i.e., RBI and SEBI concurrently. Further, allowing an AIF to give loans may have unintended consequence as one may then instead of registering as NBFC which involves cumbersome compliances and strict supervision of RBI, form a Category II AIF and offer loans / finance portfolio companies thereby defeating the very purpose of NBFC regulations. Strangely, SEBI’s own FAQs on AIF Regulations suggests that 'in case of a debt fund' being an Alternative Investment Fund and a privately pooled investment vehicle, the amount contributed by the investors shall not be utilized for purpose of giving loans…….”  Thus SEBI’s order in the present case of AIF Fund, seems to have contradicted its own stand and remains open for interpretation.

Whether AIF Fund had invested more than 25% of its total investible funds in an investee company?

SEBI, in another issue had to examine whether the AIF Fund had violated regulation 15(1)(c) of AIF Regulations by investing more than 25% of the total investible funds in an investee company. Investible fund refers to corpus available for investment by the AIF Fund. SEBI, for the said issue, relied upon the admission of the AIF Fund that the investment threshold of 25% of the investible fund under regulation 15(1)(c) of the AIF Regulations was breached with respect to two investments i.e. Loop Mobile Holding (₹299 Cr) and Essar Projects India Ltd. (₹222 Cr). As the quantum of investible fund reduced from ₹1260 crore to ₹855 crore due to distributions made to the contributors, the percentage of such investment in terms of investible funds increased to 35% and 26% respectively. Consequently, SEBI held that the AIF Fund had contravened the relevant provisions of AIF Regulations.

The above interpretation of ‘investible fund’ by both the AIF Fund as well as SEBI appears to be erroneous. It is clear from the AIF Regulations that ‘investible funds’ definition is linked to ‘corpus’ of the fund which in turn is linked to capital commitments given by the contributors to an AIF, i.e. amounts agreed by the contributors to be contributed to the Fund over a period of time as and when the drawdown are made by the investment manager.

Thus, in order to ascertain whether an investment in an investee company will be in excess of 25% of the investible funds or not, the quantum of capital commitments made to an AIF needs to factored as base. As the quantum of capital commitments made to an AIF remains intact even if there is any interim distribution being made to the contributors, the threshold of 25% which is in a way linked to capital commitments, too shall remain constant. Therefore, in the above case, even post interim distributions made to the contributors, amount of ₹1260 crore should have been considered instead of ₹855 crore as ‘investible funds’. Furthermore, investment conditions pertaining to the threshold of 25% is to be met at the time of making investment and thus any subsequent change in the quantum of investible fund, due to any reason whatsoever, should not be treated as breach. Thus, the view taken by SEBI on this aspect is open for interpretation and may be a subject matter of future litigation.

Whether the AIF Fund violated SEBI norms by not following the investment strategy as specified in its offering document?

One issue which SEBI had to examine related to the ‘investment strategy’ of the AIF Fund. SEBI in its order observed that the loans of ₹299 crores to Loop Mobile Holdings India Limited and ₹222 crores to Essar Projects India Limited were not in accordance with the investment limits of ₹50 crores to ₹200 crores as specified in the offering document of the AIF Fund. Therefore, SEBI held that the AIF Fund had failed to comply with the relevant SEBI norms which mandates all AIF/ investment managers to carry out all the activities of the AIF in accordance with the offering document circulated to the investors.

Regulation 9(1) of the AIF Regulations mandates that an AIF shall state investment strategy, investment purpose and its investment methodology in its offering document. Further, Regulation 9(2) of the AIF Regulations mandates that an AIF shall not make any material alteration to the fund strategy without the consent of at least two-thirds of its unit holders.

Taking into consideration the above legal provisions, the view taken by SEBI that the investment strategy as specified in the offering document is not indicative in nature and must be strictly followed by the AIF, seems to be correct but only to a limited extent. A moot question still remains as to what shall constitute a ‘material alteration’ of fund strategy in terms of Regulation 9(2) of the AIF Regulations, as only a ‘material alteration’ of fund strategy without the consent of at least two-thirds of its unit holders shall amount to breach of AIF Regulations. Thus, the view taken by SEBI on this aspect is open for interpretation and may be a subject matter of future litigation.

Whether the Sponsor failed to maintain specified continuing interest in the Fund?

SEBI, in one of the issues, interpreted regulation 10(d) of AIF Regulations relating to sponsor’s requirement of maintaining specified continuing interest. SEBI, upon perusal of the facts of the present case, observed that sponsor’s initial contribution was ₹5 crore. However, after distribution of ₹1.87 crores to the Sponsor as repayment of capital, it was reduced to ₹3.13 crore. Basis the said observation and rejecting sponsor’s submission that being an investor, it was entitled to receive pro-rata distribution, SEBI concluded that the sponsor had failed to have a minimum required continuing interest in the AIF and thereby had violated regulation 10 (d) of AIF Regulations.

It is pertinent to note that SEBI, vide its circular dated June 19, 2014, had clarified that for the purpose of maintaining continuing interest under Regulation 10(d) of the AIF Regulations, such interest may be maintained pro-rata to the amount of funds raised (net) from other investors in the AIF. However, no clarification was issued by SEBI concerning the modus operandi of returning the funds so raised from sponsors. The said conclusion of SEBI appears to be contradictory to the fund industry practice as sponsor is usually entitled to receive pro-rata distributions on its contribution in the fund. One possible view which may be inferred from SEBI order is that in case of Category II AIF where the total funds raised is more than ₹200 Crores, the sponsors will be required to maintain its interest of at least ₹5 crore till the time the aggregate funds raised do not fall below ₹200 Crores. Thereafter, pro-rata distributions may be made to the sponsors.

Conclusion

There is no doubt in the fact that in this order, SEBI has provided much needed insight regarding its approach towards addressing the violation of provisions under AIF Regulations. However, concurrently, SEBI should also be prepared to face challenges relating to implementation aspects of this Order. Few of them being - how it is proposing to allow or disallow AIF to give loans?  How it proposes to address the concerns of the AIF industry on the interpretation of investment condition of 25% threshold and requirement of sponsor to maintain continuing interest. It will be interesting to see how SEBI deals with these challenges going forward as it will define the basis on which AIF industry will practice.