Why SEBI’s move to enhance liability of AIF investment committees is excessive
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The Securities and Exchange Board of India (SEBI) has notified key amendments to its Alternative Investment Funds Regulations, 2012, detailing liabilities and obligations of members of investment committees (ICs) of AIFs and temporarily putting on hold applications for registration of new AIFs which have non-resident Indians on their ICs.

Moreover, SEBI has required that external IC members whose names are not disclosed in the placement memorandum or the agreement made with the investors or any other fund documents at the time of on-boarding investors shall be appointed to the IC only with the consent of at least 75% of the investors by value of their investment in the AIF.

Background and extent of liability of IC members

ICs are typically set up by fund managers of AIFs to review and approve investment proposals before they can be implemented. It is common for managers to appoint independent or expert members to the ICs to enhance the governance standard for their funds.

In some cases investors prefer appointing nominees to the AIF’s IC in order to have clearer visibility of the AIF’s investment decisions and ensure independent evaluation of the manager’s proposals. The significance of ICs in ensuring good governance and having a robust investment process for funds cannot be overstated.

SEBI had in the past few months clarified to various AIF applicants that ICs of AIFs should not have decision making powers, and their role should be restricted to providing non-binding recommendations to the manager.

In view of the consistent feedback from fund managers as regards the globally accepted model of IC having powers to review and approve decisions for funds, SEBI has now explicitly permitted managers to set up ICs to approve investment decisions of the AIF.

However, the amendments provide that the members of ICs will be ‘equally responsible as the manager’ for investment decisions of AIFs. The amendments also provide that the manager and members of the IC shall ‘jointly and severally ensure’ that the investments of the AIF are in compliance with the provisions of the AIF Regulations, the terms of the placement memorandum, agreement made with the investor, any other fund documents and any other applicable law.

Impact of the amendments

Members of ICs are viewed as having a fiduciary responsibility towards the fund as a whole while undertaking an independent assessment of the manager’s investment proposals. But the amendments raise critical questions as regards the extent of liability of IC members vis-à-vis their role and function.

In a typical construct, IC members would merely review and approve investment proposals which are sourced and evaluated by managers. IC members do not generally source investment opportunities themselves, and also lack powers to execute investment decisions for the fund.

In other words, despite the independent assessment of investment proposals by the IC, the overall managerial control over the fund’s investments rests with its manager. Thus, making IC members equally responsible as the manager seems excessive.

Additionally, IC members could find it difficult to discharge the regulatory obligation to ensure that the AIF’s investments are in line with the requirements of applicable laws, and the agreements executed with investors which could be confidential and their terms may not be known to the IC members.

The amendments could deter certain investor nominees and independent members from accepting IC appointments. This could, in turn, dilute the governance standard for AIFs.

Further, it is fairly common for funds managed by financial services groups to appoint expert members, who are associated with an affiliate entity of the manager (but not employee, directors or partners of the manager as the amendments provide for), to the IC for the overall benefit of the fund. Seeking investor consent for such appointments each time could be administratively cumbersome.

What IC members could do to mitigate liability

The amendments may prompt fund managers to adopt a construct where the IC would only provide non-binding recommendation to managers and refrain from taking investment decisions. In this construct, investor nominees on the IC may retain additional contractual rights to dissociate themselves from the fund or to suspend their funding obligations in case of major disagreements with the manager. IC members may also require fund managers to provide indemnity protections, and procure liability insurance for IC members wherever feasible.

It will become all the more important to review IC minutes and ensure that any recommendations and reservations made by individual IC members are appropriately recorded therein. The same could go a long way in demonstrating bona fides of IC members, if the need arises.

Temporary freezing of AIF applications

In a separate development, SEBI said in a circular dated October 22 that it had written to the government and the Reserve Bank of India seeking clarity on the applicability of foreign exchange regulations to investment made by an AIF whose IC approves investment decisions and consists of external members who are not ‘resident Indian citizens’.

The circular also specifies that until clarity has been obtained, SEBI would refrain from processing applications from funds for registration as AIFs whose IC constitutes external members who are not ‘resident Indian citizens’.

This development comes in the backdrop of a flexible and beneficial foreign exchange regime permitting foreign investments into AIFs. Taking advantage of such flexibility, various curated investment platforms have been set up domestically as AIFs leading the pooling of domestic and foreign capital in India itself.

Indian foreign exchange regulations do not prohibit foreign investors seeking to appoint their nominees to ICs of AIFs who may not be Indian resident citizens.

Moreover, in case an AIF is controlled by non-resident investors, among other things through IC nominations, as per the current regulatory framework, the downstream investments of such AIFs in equity-linked instruments of Indian portfolio companies could be treated as ‘indirect foreign investments’.

In view of such flexible foreign exchange regulatory regime, refraining from processing registration applications from AIF aspirants whose IC constitutes external members who are not ‘resident Indian citizens’ could be viewed as a speed-bump in an otherwise successful stint of AIFs as a regulatory platform.

Conclusions

The amendments have brought ICs into the centre stage while evaluating legal structures for AIFs. Individual members may consider their enhanced liabilities prior to accepting IC nominations and may require managers to provide additional protections to shield them from a personal liability through indemnification agreements.

Curated investment platforms with investors wanting to appoint IC members who are not resident Indian citizens may experience a longer set-up time in view of SEBI’s decision to not process their registration applications pending clarity from the government and the Reserve Bank of India.

Vivaik Sharma and Rohan Priyadarshi are Partner and Associate, respectively, at AZB & Partners. Views are personal.

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