[Palash and Arihant are students at Institute of Law, Nirma University, and Gujarat National Law University, respectively.]
The alternative investment funds (AIFs) sector has experienced a significant spike over the recent years. AIFs are privately pooled investment vehicles that gather funds from investors for deployment according to a specified investment policy. AIFs offer certain benefits like diversification, high-return potential, and access to specialized investment opportunities like investing in a startup. While there are certain notable benefits of investing through the route of AIFs, this potential route is being misused to circumvent various financial sector regulations. Therefore, recently, Securities and Exchange Board of India (SEBI) released a consultation paper that proposes to enhance trust in the AIFs ecosystem. This article delves into the consultation paper, highlighting the need to regulate AIFs, exploring the international perspectives, navigating the current regulatory framework in India while suggesting changes, and providing a critical analysis of SEBI’s recent strides towards regulating the AIFs framework in India.
What is the Need to Enhance Trust in the AIF Ecosystem?
Regulating AIFs has become imperative due to instances where these funds are structured to exploit gaps in financial sector regulations. Despite the robust growth of the AIF industry, concerns have arisen about the erosion of trust in the financial system due to the misuse of AIF structures.
The AIF industry, connecting sophisticated investors with enterprises in need of risk capital, has seen consistent growth, with investments reaching INR 3,53,352 crore as of 30 September 2023. Unlike other SEBI-registered investment channels, AIFs operate under a relatively light-touch regulatory regime. However, recently, more than 40 instances involving over INR 30,000 crore, constituting almost 9% of the total investments reveal that some AIFs have been structured to circumvent existing financial sector regulations.
Various modus operandi have been identified by SEBI in the consultation paper, including the ever-greening of loans by regulated lenders. In this scenario, AIFs are set up to facilitate the restructuring of stressed loans of regulated lenders, allowing them to avoid regulatory requirements. Another concern is the circumvention of Foreign Exchange Management Act 1999 (FEMA) norms, where AIFs are established to exploit regulatory arbitrage, enabling foreign investors to invest in sectors or instruments beyond the limits set by foreign investment regulations.
Additionally, certain AIFs, designated as qualified institutional buyers (QIBs), have been found to have a single or very few investors, often from the same group, influencing the price discovery process in the public market. This circumvents the intended purpose of QIB regulations. These identified circumventions have led to significant investments and have raised serious questions about the trust and integrity of the AIF ecosystem.
International Perspective
The global regulatory landscape for private equity and AIFs is undergoing significant shifts, with developments in the United States and the United Kingdom leading the way. In September 2023, International Organization of Securities Commissions released a thematic analysis report titled "Emerging Risks in Private Finance." This report addresses the inherent opacity of private finance markets, emphasizing the challenges for regulators and market participants in understanding the scale of risks. The report recognises the economic benefits of private financing but highlights the need for increased transparency and understanding of risks associated with private equity and private credit activities.
Further, in the United States of America, the Securities and Exchange Commission (SEC) has adopted new rules and amendments to enhance the regulation of private fund advisers. The rules, effective 12 to 18 months after the final publication, mandate increased transparency, competition, and efficiency in private fund markets. Private fund advisers must provide detailed quarterly statements, obtain annual audits, avoid preferential treatment for investors, and adhere to restricted activities. The SEC's reforms address concerns about fairness, disclosure, and conflicts of interest in private funds.
In the United Kingdom, the Financial Conduct Authority (FCA) is taking proactive steps to update and improve the regulatory regime for private finance. The FCA chair recently outlined strategic objectives, including making the AIF manager regime more proportionate, updating the regulatory framework for retail funds, and supporting technological innovation, particularly the tokenization of funds.
While the regulatory developments may vary across jurisdictions, the common themes of transparency, fairness, and risk management underscore the international community's commitment to fostering a resilient and accountable private finance sector.
Current Regulatory Approach in India
Over the past few years, SEBI has been actively amending the SEBI (Alternative Investment Funds) Regulations 2012 (AIF Regulations) to bolster the governance of AIFs and foster greater transparency and accountability for market participants. The recent revisions focus on investor protection and adherence to existing laws governing AIF Regulations. SEBI has undertaken this initiative by publishing consultation papers, and inviting public and stakeholder comments on various proposals.
The latest consultation paper released by SEBI last month, proposes measures to enhance trust in the AIF ecosystem and streamline the ease of doing business. The proposal recommends introducing a requirement for AIFs, managers, and key management personnel to ensure non-facilitation of such circumvention. In addition to this, the paper also discusses SEBI’s aim to facilitate the establishment of Standards Forum for AIFs (SFA) aiming to restore trust and facilitate regulatory comfort for other ease of doing business proposals under consideration. The SFA would be instrumental in formulating specific standards, guided by SEBI's principles, to achieve the proposed regulatory objectives.
Another key consultation paper, titled “Consultation Paper on the Proposal to Review Qualified Institutional Buyer Status of Alternative Investment Funds, Venture Capital Funds and Foreign Venture Capital Investors”, raises concerns about certain AIFs with very few investors, often from the same family or group, exploiting the QIB status to invest in initial public offering. As of 31 March 2023, it notes that 318 AIF schemes had 5 or fewer investors, with 210 having one or two investors. To address this issue, the proposal suggests that entities with 50% or more contributions from a single investor or investors belonging to the same group would not qualify as QIBs. The term "same group" includes relatives and related parties as defined in the Companies Act 2013.
Is SEBI Working in the Right Direction?
SEBI's commendable initiatives to enhance trust within AIFs deserve recognition; however, it is essential to underscore the significance of addressing prevailing regulatory gaps. In our thorough analysis, we have examined and highlighted specific loopholes in SEBI's current approach. The proposed SFA is a positive move. However, the guidelines lack clear specifics for effective execution. Though self-regulation is good in principle, enforceability concerns persist. Concrete, enforceable rules guiding acceptable versus prohibited conduct are needed, rather than broad obligations without specifics that lend themselves to subjective analyses. More importantly, the suggested provision barring regulatory circumvention seems inadequate without clear penalties for the violation of the regulations, as the proposed provision fails to provide penal actions for the same.
Further, if we apply cost-benefit analysis to fund managers in case of following these regulations, it becomes apparent that the manager of an AIF may find it advantageous to deviate from these guidelines. Managers motivated by profit commissions tied to successful investments may prioritize financial gains over strict adherence to regulatory guidelines. So, in the absence of a robust regulatory framework with clear consequences for non-compliance, the proposed general obligation may fall short of providing meaningful oversight and accountability.
Furthermore, the QIB consultation paper highlights the absence of a specification for the minimum number of investors in a scheme of an AIF. This oversight allows AIFs with a single or a few connected investors to qualify as QIBs, potentially undermining the intended purpose of QIB designation. The proposal fails to address this fundamental gap in the regulatory framework. Moreover, the paper notes the absence of an outer timeline specified in AIF Regulations for AIFs to drawdown funds out of commitments for investments. This lack of clarity may lead to a prolonged holding of funds without investment, potentially affecting market dynamics. The consultation paper does not propose a solution or timeline specification to address this concern.
The Way Forward
To bolster oversight, SEBI should refine proposals through precise guidelines shaped in further consultation with industry experts and the RBI. The SFA necessitates clear, actionable measures outlining compliance expectations, not just broad prohibitions against regulatory circumvention devoid of violation criteria.
The definition of "circumvention" within the general obligation must be clarified to eliminate ambiguity. SEBI should consider incorporating precise criteria for ensuring a more objective interpretation. Additionally, the regulatory framework should include stringent penalties for non-compliance to strengthen deterrence for managers. This may involve monetary fines, suspension of operations, or other punitive measures, creating a robust deterrent against potential deviations by managers.
Additionally, SEBI can strengthen supervision through systematic audits and evaluations to promote AIF accountability, supplemented by whistleblower policies to encourage reporting of non-compliance. SEBI has also made it mandatory for AIFs to report their quarterly statements, which is likely to bring more transparency.
SEBI can implement fund tokenisation for AIFs by establishing clear regulatory frameworks governing the issuance and trading of digital tokens representing fund ownership. It can collaborate with industry stakeholders to develop secure distributed ledger technology platforms for tokenised funds. Periodic reviews and updates to these regulations will be essential to accommodate technological advancements and maintain investor confidence in this innovative investment approach within the AIF space.
While SEBI's commendable efforts to strengthen governance and trust within the AIFs sector are evident, the aforementioned critical suggestions are imperative for ensuring the efficacy of the proposed regulatory measures. The need for precise guidelines, clear definitions, stringent penalties, systematic audits, and periodic updates underscores the importance of refining the regulatory framework to address the existing gaps and bolster oversight.
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