India’s securities regulator recently amended the law relating to domestic private funds to impose statutory obligations and ‘strict liability’ standards on investment committee members. Whilst the amendment may have been well-intended and was likely rolled out to fix responsibility for investment decision-making, it may have inadvertently unsettled investment management operations in the industry.
A. Background
SEBI recently amended the AIF Regulations[1] to inter alia: (a) codify the roles and liabilities of the investment manager of an alternative investment fund (AIF); and (b) equate the individual liability of the members on the Investment Committee (IC) constituted by an investment manager of an AIF (IM) to that of the IM itself (the Amendment). By way of a separate circular, SEBI has also sought clarity from the federal government on whether the residency of ‘external’ members on the IC should determine whether the AIF is domestically owned and controlled or not (the Circular)[2].
Before we examine the nuances of the Amendment and its far-reaching implications, at the threshold, it is important to understand the role of an IC in the context of India’s private fund industry. Funds raised by seasoned institutional managers with a well-established track record will generally constitute an IC which consists of key personnel of the IM (including, in particular, the investment professionals leading the strategy of the fund) as well as external industry experts. In some cases, large investors are also able to negotiate a position on the IC. With the evolution of the funds industry, ICs have by and large been constituted with one of the following two mandates: (i) guide the board of directors of the IM by offering non-binding recommendatory advice; or (ii) deliberate on all key investment- related matters at length and take final and binding decisions with respect to such matters. A majority of ICs are set up with the latter mandate.
Prior to the Amendment, SEBI had earlier informally required AIF applicants to ensure that all IM related decisions should be taken by the board of the IM, and not by the IC. However, this was inconsistent with global practice and therefore, representations were made to SEBI to permit a similar framework in India. In response, SEBI passed the Amendment, which formally recognises the concept of an IC and sets responsibilities and liability standards for members of the IC.
B. Executive Summary of the Amendment
First, the Amendment provides that the IM shall be responsible for investment decisions of the fund. This is a fairly non-controversial clarification and it is somewhat interesting that the AIF Regulations had not previously codified this elementary responsibility of the IM.
Second, the Amendment permits an IM to constitute an IC (by whatever name called) to ‘approve’ investment decisions of an AIF, subject to the following conditions:
- all members of the IC shall be equally responsible as the IM for the investment decisions of the AIF;
- the IM and the members of the IC shall jointly and individually ensure that investments made by an AIF are in compliance with applicable law (including the AIF Regulations), the placement memorandum, agreements with investors and other fund documents;
- the induction of ‘external’ members to the IC, whose names have not been set out in the PPM or any fund documents at the time of admitting investors, will require the prior approval of at least 75% of investors (by value of their investment).
Third, the Amendment rationalises the experience and qualification conditions for the key investment team of the IM. Earlier, at least one member of the key investment team was required to have at least 5 years’ experience in advising or managing pools of capital or in asset or wealth management or in dealing in securities or other financial assets and was also required to have relevant professional qualification. The Amendment now clarifies that two different persons of the key investment team can jointly fulfil the experience requirement and the relevant professional qualification requirement.[3]
Pursuant to the Circular, SEBI has also clarified that it will not process any AIF applications if any of the external members of the IC constitute with respect to any such AIF are non-residents until it receives clarification from the federal government on the question of whether the residency of IC members should determine whether an AIF is domestically owned and controlled or not.
C. What are the legal and commercial implications of the Amendment on the private funds industry?
- Distorted assumption of IC members’ roles
While SEBI’s objective may have been well- intended from a responsibility allocation perspective, in our view, the Amendment is premised on a distorted understanding of the role and composition of ICs. The Amendment is broadly worded and fixes equal responsibility on all members of the IC without regard to the degree of involvement of individual IC members. For instance, some members of the IC may be roped in to provide domain expertise or guidance on global best practices without having any voting powers in respect of investment decisions. Even where voting powers are conferred upon all IC members, not all members will necessarily perform an executive role and therefore the imposition of equal responsibility for all IC members would appear to be a case of regulatory overreach.
- Strict liability for members of IC Safe harbour for directors of the IM
Under the AIF Regulations and the SEBI Act, 1992, whilst directors of the IM can be held responsible for acts and omissions of the IM or the AIF, non-executive directors and independent directors are provided a safe- harbour exemption. In other words, if a non- executive or independent director can demonstrate that a contravention has been committed by the IM / AIF without any consent / connivance / neglect on her part, then, such director shall not be held liable for the said contravention.
The Amendment seems to dilute this well- accepted principle significantly and imposes a standard of ‘strict liability’ on all IC members irrespective of the actual role played by such member (which could in theory even cover an IC member that dissented with the majority or abstained from a vote). The Amendment, to that extent, seems to place a higher degree of responsibility on non-executive IC members vis- à-vis non-executive directors of the IM. There should be no reason for a safe harbour standard to apply to non-executive directors of the IM but not to non-executive members of the IC. Therefore, whilst the objective of holding an all- powerful IC liable is reasonable, SEBI ought to have had regard to the character, role and involvement of individual members of the IC when setting liability standards.
- Enhanced regulatory scrutiny and penalties
Although there are no explicit penalties prescribed under the AIF Regulations, the SEBI Act, 1992, prescribes extensive penalties for anyone violating the provisions of the Act or the regulations made thereunder, which could extend to imprisonment of up to 10 years and/or a fine extending to INR 25 Crores. Whilst criminal penalties are seldom imposed, the threat of a regulatory action is likely to substantially dissuade persons of repute from joining the IC or at least materially alter the terms on which they are willing to take up IC positions.
- Renunciation of IC membership and investor approval
Due to the risk of enhanced legal exposure, it is possible that some IC members will be minded to resign their positions. Replacing such persons with new members may be challenging for fund managers, particularly in cases where the fund documents have committed to a certain size / composition of the IC. Besides the trouble of identifying suitable replacements, the process of giving effect to such replacements has become burdensome under the Amendment as the induction of new candidates now requires 75% investor approval. Procuring such approval could be problematic (particularly in light of the current economic outlook) as disgruntled investors may opportunistically deny such approval or look to leverage such approval for certain concessions. Moreover, there is a risk that a replacement of an IC member is regarded as a material change.[4] If this is the case, then dissenting investors may have willy-nilly unlocked an exit option for themselves, which could expose fund sponsors to massive financial outflows.
- Fee renegotiation
In consideration of rendering management services, the IM of an AIF is entitled to receive a periodic management fee. The fee is structured to take into account various overheads including the compensation of senior investment professionals in the IC. As the Amendment has enhanced the risk exposure of IC members, it is possible that IC members will seek an adjustment to their compensation to reflect the additional risk. To fund this increase, IMs will either need to squeeze existing overheads or alternatively initiate the unenviable process of renegotiating management fees with investors. In addition, members of the IC may demand insurance cover along the lines of a D&O insurance and / or an iron-clad indemnity from the IM, with the consequent financial impact being eventually passed on to investors.
- Fiduciary duty of individual IC members
The IM stands in the capacity of a fiduciary vis-a- vis the investors and therefore, the IM has a fiduciary duty to act in the best interests of the fund and the investors as a whole. The Amendment provides that members of the IC are equally responsible with the IM in respect of all investment decisions, compliance with the fund documents and compliance with applicable laws. This increased level of responsibility that has been imposed on IC members by way of the amendment could strengthen the case for treating individual IC members as fiduciaries of the fund and its investors and leave such individuals exposed for damages arising from breach of fiduciary duties. This is rather divergent from the global position, where fiduciary duties typically lie with the IM and do not percolate down to the individual members of IC.
- Impact of the Amendment on InvITs and REITs
Whilst the current Amendment has been specifically introduced in the context of AIFs, the IMs of other investment vehicles such as real estate investment trusts (REITs) and infrastructure investment trusts (InvITs) which have constituted formal ICs may also begin to rethink their strategy. For instance, some of these vehicles (especially privately owned InvITs) may have admitted investor nominees into ICs to provide a framework for the exercise of veto rights by investors. Such investor nominees are currently not subject to any statutory or contractual liabilities with respect to their decision making. However, it may not be unreasonable to assume that SEBI could extend the application of the Amendment to other pooled investment vehicles, especially where retail participation is involved.
- IC must ‘approve’ investment decisions
As explained above, the Amendment applies only to those ICs which are constituted by the IM to approve investment decisions of the AIF. The term ‘approve’ holds critical importance. SEBI appears to have drafted the Amendment with the sole objective of regulating ICs which have the power to take final and binding investment decisions. Therefore, an argument can be made that committees which are merely recommendatory in nature or which are involved in pre-screening investment opportunities but which do not ultimately approve investment decisions or which are constituted to review and approve conflicts of interests (such as advisory boards or LPACs) may not fall within the purview of the Amendment.
- Residential status of AIFs
It is not clear why SEBI felt the need to postpone the AIF applications where ICs were proposed to be constituted with an element of foreign, ‘external’ membership. To begin with, this seems rather counter-intuitive since there is no prohibition on foreign owned and controlled AIFs from investing in India. Under the existing foreign exchange rules, if the manager or sponsor of an AIF is either owned and controlled by persons other than resident Indian citizens or owned or controlled by persons resident outside India, then, the only implication is that investments made by such an AIF into an Indian entity is considered as indirect foreign investment. Therefore, stalling all AIF applications pending clarification on the residency status of the AIF seems unnecessary. A more proportional approach would have been to restrict such AIFs from investing in sensitive sectors that are not permitted to avail of foreign investment until the necessary clarifications have been issued by the relevant authorities.
Further, both SEBI and the government should ensure that any clarification introduced should not adversely impact past investments made by AIFs. In other words, all existing investment structures of AIFs should be grandfathered.
D. Conclusion
With the country stumbling under the impact of the Covid-19 pandemic, the Indian economy is projected to contract by 10.3 % in 2020 in stark contrast with the global average of 4.4% as per the International Monetary Fund.[5]Given this, all legislative amendments no matter how well- intended should strike the right balance between regulatory supervision on the one hand and pragmatism and ease of operations on the other hand. It is important to bear in mind that AIFs are not retail products – the minimum ticket size of INR 1 crore under the AIF Regulations ensures that such funds are only accessible to sophisticated investors. As such, there is little reason to further extend the regulatory net.
In light of this, the Amendment seems to have been introduced without a proper understanding of the regime as it exists globally. The private funds industry in India is still at a nascent stage. Deliberations with industry participants and understanding global practices will be key to preserving the growth of this industry.
Endnotes
1] SEBI (Alternative Investment Funds) Regulations, 2012 (the AIF Regulations) were amended pursuant to the amendment dated 19 October 2020.
[2]SEBI Circular (SEBI/HO/IMD/DF6/CIR/P/2020/209) dated 22 October 2020 on “Processing of applications for registration of AIFs and launch of schemes”.
[3] Regulation 4(g) of the AIF Regulations.
[4] See SEBI Circular (CIR/IMD/DF/14/2014) dated 19 July 2014 regarding ‘Guidelines on disclosures, reporting and clarifications under AIF Regulations’ and SEBI Circular (CIR/IMD/DF/16/2014) dated 18 July.
2014 regarding ‘Clarification and extension of deadline with respect to circular on ‘Guidelines on disclosures, reporting and clarifications under AIF Regulations’’.
[5] https://www.imf.org/en/Countries/IND
_________________________________________________________________________________
This material is for general information only and is not intended to provide legal advice.
For further information, please contact:
Ruchir Sinha
Adhitya Srinivasan
Shreyas Bhushan
Pranjal Doshi