Contributed by Shubham Singh

Introduction

The Indian financial system grapples with stressed loans, necessitating substantial capital infusion in banks and financial institutions. In response, SEBI explores Alternative Investment Funds (AIFs) as a risk capital source, complementing Asset Reconstruction Companies (ARCs) efforts. In December 2021, SEBI approved Special Situation Funds (SSFs) as a Category I AIF sub-category designed for stressed loans. SSFs can acquire stressed loans per Clause 58 of RBI Master Directions, pending their inclusion in the Annex. AIF Regulations were amended in January 2022 to permit SSFs to invest in stressed loans, clarified by a SEBI circular on January 27, 2022.

For the inclusion of SSF in the Annex of the Master Circular, RBI communicated a few requirements to SEBI. On November 28, 2023, SEBI released a consultation paper discussing the requirements and their implementation, while also soliciting public comments.

In this article, we will critically analyze the consultation paper, examining its impact if suggestions of SEBI are implemented. However, before delving into the analysis, let’s first understand what is SSFs and Clause 58 of RBI Master Direction.

Special Situation Funds and Clause 58

SSFs are a type of AIF, specifically designed for investing in special situation assets, encompassing distressed assets like stressed loans, NPAs, and undervalued or underperforming real estate assets. Clause 58 of the RBI Master Directions outlines the conditions for transferring stressed loans, permitting such transfers to entities listed in the Annex. The Annex is updated by the RBI as per regulatory permissions. To enable SSFs to acquire stressed loans, the RBI has requested SEBI to fulfil six prerequisites for their inclusion in the Annex of the RBI Master Directions.

These six requirements are –

• Definition of ‘special situation assets’ (SSA).

• Eligibility of investors in SSFs in terms of Section 29A of the Insolvency and Bankruptcy Code, 2016 (IBC).
• Restrictions concerning investment in connected entities.
• Minimum holding period and subsequent transfer of loans.
• Monitoring of SSFs.
• Supervision of SSFs.

Analysing Requirements and its Proposal by SEBI

Definition of SSA

Regarding the definition of SSA, as per Regulation 19I of AIF Regulations, ‘Special Situation Assets‘ include securities of investee companies with stressed loans ‘available for acquisition’ under Clause 58 of the RBI Master Directions. SEBI proposes changing the term ‘available for acquisition‘ to ‘are acquired’ for clarity. The issue stems from stressed loans under Clause 58 not being considered ‘available‘ until lenders agree to the borrower’s resolution plan, contradicting the assumption tied to the term ‘available for acquisition’. This proposed change provides a clearer definition. The proposed change also considers the potential issue wherein it could have restricted SSFs from acquiring stressed loans available known from companies in which they have already invested as the term ‘available acquisition’ is removed changing the dynamic of the definition. The proposal to permit SSFs to acquire these loans resolves this conundrum.

Eligibility of investors in SSFs in terms of Section 29A of the IBC

As per SEBI, AIF Regulations should be updated to prevent SSFs from investing in or acquiring special situation assets if any of their investors are disqualified under Section 29A of IBC concerning those assets.

Section 29A of IBC was introduced in 2017 to prevent individuals and entities with a history of misconduct or mismanagement from acquiring stressed assets and potentially perpetuating the same problems that led to the financial distress of those assets.

SEBI, in this regard, wants to bring SSF investors under the purview of Section 29A due to the broad spectrum of investors in SSFs. As observed, when selling stressed loans, lenders must ensure that the buyer is not disqualified under Section 29A of the IBC; however, there is no requirement to check if the buyer’s investors are also disqualified. This is a commendable step to prevent stressed assets from falling into the hands of investors with poor credit behaviour and to curb the possibility of round-tripping. (Round-tripping is a financial manoeuvre that involves buying and selling an asset quickly to create false demand or inflate its price. It can mislead investors and manipulate markets.)

If implemented, this measure would significantly reduce the risk of investments by individuals or entities with a history of misconduct or mismanagement in SFFs.

Restrictions concerning investment in connected entities

Let’s first understand why the connected entity restriction is important. For example, an SSF manager or sponsor establishes an associate company and invests the SSF’s funds into the company’s stressed loans. The associate company utilizes these proceeds to acquire overvalued assets, artificially inflating its financial standing. Subsequently, the SSF offloads the associate company’s stressed loans to a third party at a profit.

Understanding the bad implications of this practice, AIF regulations have restricted investment into an ‘Associate’. An associate refers to any company, limited liability partnership, or body corporate in which a director, trustee, partner, sponsor, or manager of the AIF, or a director or partner of the manager or sponsor, holds more than fifteen per cent of its paid-up equity share capital or partnership interest, as applicable.

SEBI proposed, that to ensure ethical investment practices and mitigate potential conflicts of interest, the AIF Regulations should be modified to restrict SSFs from investing in entities that are considered their “Associate”. The definition of “Associate” should align with the Companies Act, 2013 definition of “related party“.

The Companies Act’s definition of “related party” casts a wider net than the AIF Regulations’ definition of “Associate”. This broader definition is also employed in other SEBI regulations. Consequently, adopting the Companies Act’s definition would effectively mitigate concerns regarding potential conflicts of interest and more control over roundtripping.

Minimum holding period and subsequent transfer of loans

SEBI proposed that the AIF Regulations should be modified to mandate that SSFs can only transfer or sell stressed loans acquired under Clause 58 of the RBI Master Directions to entities specifically listed in the Annex of the RBI Master Directions.

This is a favourable step for the SSFs as there is a lock-in period of 6 months as per RBI master direction. This means the SSFs have to wait for six months before they sell the SSA.

The measure of the lock-in period was implemented to curb round-tripping, artificial inflation of asset values, and other market manipulations. It helps to prevent disruptions caused by short-term speculative trading and promotes a more orderly and transparent market for stressed loans. However, it raises concerns for SSFs, as it limits their ability to capitalize on favourable market conditions within six months, even in genuine cases where there is no manipulative intent. Nonetheless, given the potential for manipulation, this proposal strikes a balance between maximizing profits and maintaining market oversight as the entities to which SSF can sell will be chosen by the regulatory body.

Monitoring of SSFs & Supervision of SSFs

To enhance transparency and oversight, SEBI proposes Special Situation Funds SSFs should report information about stressed loan acquisitions and investor details to a designated trade reporting platform under RBI purview. Additionally, SSFs should submit any supplementary information requested by SEBI or RBI. Furthermore, a dedicated supervisory framework tailored for SSFs should be established within the AIF Regulations, incorporating specific parameters considered by RBI for supervising entities dealing in stressed loans. This dedicated framework should apply to SSFs acquiring stressed loans under Clause 58 of the RBI Master Directions.

Enhancing transparency and oversight of SSFs would promote market efficiency by enabling informed investment decisions, curb the misuse of stressed assets, protect investor interests, enhance financial stability, and promote responsible debt resolution.

Conclusion

SEBI’s proposals appear to be well-considered and comprehensive in addressing the concerns surrounding SSFs. While some may argue that the definition of connected entities has been overly broad, this expansion is essential to encompass all potential avenues for conflict of interest and ensure the integrity of SSF operations. The proposals strike a judicious balance between the regulatory requirements of the RBI, the operational needs of SSFs, and the overarching goal of safeguarding market stability and investor interests.