Contributed by Yuvraj Sharma

Introduction

In a recent development, the Securities and Exchange Board of India (“SEBI”) has once again taken the financial landscape by storm, unveiling a consultation paper on January 19, 2024 that sheds light on a myriad of instances where regulatory norms are being circumvented. The focus of this paper is on violations related to Foreign Direct Investments (“FDI”) regulations, benefits associated with Indian Overseas Corporate Bodies (“IOCC”) Alternative Investment Funds (AIFs) and the evergreening of loans by regulated lenders, among other concerns.

SEBI proposal limit the Qualified Institute Buyer (“QIB”) benefit to Alternative Investment Funds (“AIF”) held by a single investor group exceeding 50% is noteworthy. This measure has potential to great influence the landscape of AIF investment. Simultaneously, Real Estate Investment Trusts (RE) are being discouraged from using AIFs for evergreening purposes. This proposal brings attention to the well-established rules under the Foreign Exchange Management Act (FEMA) governing IOCC funds, raising questions about their continued relevance.

The consultation paper aims to make AIFs Managers, and key Management Personal responsible for conducting due diligence of their investors and investments. This step is crucial to prevent the facilitation of regulatory circumvention in any financial services sector, aligning with SEBI’s ongoing efforts to uphold market integrity. Notably SEBI has engaged in discussions with the Reserve Bank of India (RBI) on this matter in the past, recognizing that investment norms falling under the RBI’s purview.

Should this proposal come to fruition, it is poised to act as the General Anti Avoidance Rules (“GAAR”) equivalent for AIF regulations. The overarching objectives appears to be two-fold namely, promoting the ease of doing business in the financial sector while concurrently enhancing trust in Alternative investment Funds. As the financial landscape undergoes these potential shifts, it remains to be seen how industry stakeholders and regulatory bodies will respond to this evolving regulatory landscape.

Key Recommendations and Anticipated effects: An Analysis

A. Financial Chess Board: Navigating the Shadow of Ever Greening and AIF Maneuvers

The consultation paper sheds light on the pervasive issue of ever greening loans through the establishment of AIFs by regulated lenders. This practice effectively sidesteps RBI regulations and disclosure mandates related to asset restructuring and the acknowledgment of non-performing assets. Typically, the paper highlights the mechanism by which regulated lenders invest in a junior class of AIF units enabling the AIF to finance the stressed borrowers repay the lender’s loan without any indication of financial stress, as the distressed asset on the lender’s books is substituted with the investment in AIF units.

This intricate financial maneuvering has allowed some regulated lenders to evade classification, provisioning, and other regulatory obligations outlined in the RBI Regulations. Th delayed recognition of the borrower’s deteriorating creditworthiness exacerbates the challenges posed by this practice. In the meanwhile, the RBI has taken specific steps to address ever-greening by proactively preventing the recurrence of such instance in alternative forms. Moreover, the role of AIFs in facilitating these structures needs through examination and resolution.

It is essential to emphasize the delicate balance required between preventing financial malpractices and preserving the space for legitimate investments. Striking this equilibrium demands a nuanced approach that not only addresses the loopholes exploited by regulated lenders but also ensures that genuine investment are not hindered by regulatory measures. Additionally, the evolving landscape of financial innovation should be closely monitored to anticipate and mitigate potential future risk associated with similar practices.

b. AIF Strategies in the World of Foreign Investments

The circumvention of FEMA norms through the strategic use of AIF reflects a sophisticated approach by some foreign investors to exploit regulatory loopholes. The current FEMA NDI Rules 2019 categorised the downstream investment made by AIFs according to the domicile of ownership and control of the manager or sponsor. However, this criterion appears to have unintentionally opened the door for regulatory arbitrage.

One novel aspect to consider is the intentional establishment of AIFs with domestic managers/sponsors to navigate around restriction on Foreign Direct Investment (FDI) in specific sectors. This strategic move allows foreign investors to indirectly access sectors prohibiting for FDI by utilising the flexibility within AIF classification. This not only raises questions about efficacy of the current regulatory framework but also highlights the need for a more nuanced approach that consider the underlying motives of such fund structures.

Furthermore, the setup of AIFs by foreign investors to exceed allow FDI sectoral limits introduces a layer of complexity to the regulatory landscape. By utilising domestic entities as intermediaries, investors can surpass sectoral restrictions potentially undermining the intended controls on foreign investments. This underscores the importance of regulatory framework to adapt to evolving financial strategies.

Another intriguing dimension is the use of AIFs to channel foreign funds into debt and debt securities where tradition foreign investment like Foreign Portfolio Investment (FPI) or External Commercial Borrowings (ECB) are envisioned. This demonstrated the adaptability of investors in navigating through regulatory channels to achieve their financial objectives. Policymakers may need to consider whether the existing distinction between equity and debt investment adequately captures the nuances of contemporary financial practices. 

c. The Veiled tactics: AIF Circumventions and the Shaping of Market Dynamics

This reveals a concerning trend in the circumvention of Qualified Institutional Buyer (QIB) regulations, particularly through the utilisation of AIFs. The primary issue identified is the entry of certain AIFs into Initial Public Offering (IPOs) under the QIB quota, are taking advantages of the benefits accorded to QIBs under SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2018.

One novel aspect is to consider is the observation that these AIFs which typically should represents large and diverse groups of investors, sometimes have only a single or a very limited numbers of investors, often belonging to the same group. The raises questions about intended purpose of QIB regulations and whether AIFs with such narrow and connected investors structures are truly serving the interests of a broad and informed investor base.

The Concern about price discovery manipulation in the public market is highlighted, as these AIFs by availing themselves of QIB status, may influence the IPO process. This influence has a ripple effect, potentially impacting other retail investors participating in the IPO. It underscores the need for regulatory scrutiny to ensure a fair and transparent market, especially when certain entities are leveraging AIF structure to gain undue advantages.

Moreover, the significant level of identified circumventions, amounting to over INR 30,000 Crore out of total investment of approximately INR 3.5 Lakh crore, raises alarms about the scale and potential systematic impact of these practices. The fact that these circumventions were identified through thematic inspections and periodic reports submitted by AIFs highlights the importance of ongoing regulatory vigilance.

Conclusion

Inconclusion, SEBI’s recent consultation paper marks a pivotal moment in the ongoing efforts to regulate and fortify the financial landscape in India. This proposal, with its multifaceted approach to address issues ranging from evergreening of loans to the strategic use of AIFs for circumventing FCI norms, signals a comprehensive attempt to plug regulatory gaps and enhance market integrity.

The proposed restrictions on QIB benefits for AIFs held by a single investor group exceeding 50% and the discouragement of REs from using AIFs for evergreening purposes could reshape the dynamics of AIF investment and strengthen the regulatory framework. These measures may act as the GAAR equivalent for AIF regulations, aligning with SEBI’s objectives of promoting ease of doing business in the financial sector and bolstering trust in AIF.

The paper highlights the delicate balance required to combat financial malpractices without hindering legitimate investments. Striking this equilibrium requires a nuanced approach that considers evolving financial innovations and anticipates potential risks associated with similar practices in the future. The intricate dimensions of AIF strategies in foreign investments reveal the adaptability of investors in navigating regulatory channels to achieve their financial objectives. The veiled tactic employed in the circumvention of QIB regulations through AIFs entering IPOs under the QIB quota raises serious questions about the intended purpose of such regulations. The financial community and regulatory authorities must collaborate, adapt, and implement measures to ensure the resilience and integrity of the Indian financial sector.