CHAPTER 4 (PART 4): AIF REGULATORY FRAMEWORK

General Obligations, Code of Conduct, and FEMA Regulations, 1999

1. Introduction to General Obligations, Conduct, and FEMA Regulations

The operational integrity of an Alternative Investment Fund (AIF) is maintained through a combination of strict reporting duties, structured codes of conduct, and compliance with cross-border capital regulations. Under the SEBI (AIF) Regulations, 2012, managers and trustees are bound by fiduciary obligations to protect investor interests and prevent regulatory circumvention. Furthermore, as India continues to be a major destination for global private capital, the Foreign Exchange Management Act (FEMA), 1999 and the Non-Debt Instruments (NDI) Rules govern how foreign capital enters Indian AIFs and how Indian AIFs deploy capital overseas.

2. 4.1.14 General Obligations and Responsibilities of Category I and II AIFs

SEBI mandates ongoing governance, operational transparency, and systemic safeguards to ensure AIFs operate in an orderly manner.

A. Regulatory Approvals & Changes in Key Personnel

• Prior SEBI Approval for Control Changes: An AIF must secure prior written approval from SEBI in the event of any change in the Sponsor or Manager, or any change in control of the Sponsor or Manager.
• Intimation of Material Changes: All Category I and II AIFs must inform SEBI of any material changes to the information previously provided to the Board.
• Placement Memorandum (PPM) Amendment Reporting: Any changes or amendments to the terms of the PPM or other fund documents must be consolidated and intimated to both investors and SEBI within one (1) month of the end of each financial year. The filing must clearly highlight the changes made along with the relevant pages of the revised clauses.
• Filing Routes: PPM amendments must be filed through a registered merchant banker, accompanied by a due diligence certificate. However, SEBI provides relaxation by allowing changes in a few specified terms of the PPM to be filed directly with SEBI.

B. Policies, Audit, and Compliance Framework

• Detailed Policies and Procedures: Every AIF must establish comprehensive, written internal policies and procedures approved jointly by the Manager and the Trustee (or designated partners/directors). These policies ensure that all operations comply with SEBI Regulations, terms of the PPM, and the contribution agreements.
• Periodic Policy Review: These policies and procedures must be reviewed on a regular basis to ensure their continued appropriateness.
• Annual Statutory Audit: The books of accounts of Category I and II AIFs must undergo a mandatory annual audit by a qualified auditor.
• Appointment of Key Officers:
  1. Compliance Officer: The Manager must appoint a dedicated Compliance Officer responsible for monitoring compliance with SEBI regulations and circulars.
  2. Custodian: The Sponsor or Manager must appoint a SEBI-registered Custodian for the safekeeping of the fund’s securities.
• Advisory Restrictions: The Manager is prohibited from offering separate investment advisory services to any investor—other than clients of a registered Co-investment Portfolio Manager—regarding securities of the investee companies where the AIF makes investments.

C. Investor Due Diligence and Rights

• Prevention of Law Circumvention: AIFs, their Managers, and their Key Management Personnel (KMPs) must conduct specific investor and investment due diligence to prevent the facilitation of circumvention of laws specified by SEBI.
• Pro-Rata Rights Rule: Investors in an AIF scheme hold rights pro-rata to their capital commitments in each investment and in the distribution of its proceeds. Pre-existing schemes launched prior to November 18, 2024, with non-pro-rata rights, are subject to specific SEBI transition rules.
• Differential Rights Allowance: Differential commercial terms (such as side letters) may be offered to select investors, provided they do not adversely affect the interests of other investors in the scheme.
• LVF Exemption: The strict pari-passu right of investors does not apply to Large Value Funds (LVFs) for Accredited Investors.

3. 4.1.15 Code of Conduct for AIF Stakeholders

The Fourth Schedule of the SEBI AIF Regulations prescribes a binding Code of Conduct for AIFs, Managers, Key Management Personnel, Trustees, and Investment Committee members.

A. Key Management Personnel (KMP) Definition

Under SEBI guidelines, "Key Management Personnel" is defined as:

1. Members of the key investment team of the Manager, as disclosed in the fund's PPM.
2. Employees involved in executive decision-making on behalf of the AIF (including senior management at the level of Managing Director, Chief Executive Officer, Chief Investment Officer, Whole Time Directors, or equivalent roles).
3. Any other person declared as a KMP by the AIF or its Manager.

Exam Rule: The names of all KMPs of the AIF and the Investment Manager must be disclosed in the PPM, and any subsequent changes in KMP status must be promptly intimated to investors and SEBI.

B. Section I: Code of Conduct for the AIF

Every registered AIF must:

• Invest strictly in accordance with the objectives disclosed in the PPM and other fund documents.
• Be operated and managed in the interest of all investors, rather than only in the interest of a select class of investors.
• Provide adequate, accurate, explicit, and timely disclosures to all investors, including periodic performance and financial data.
• Maintain robust risk management systems and internal control frameworks.
• Establish procedures to identify, monitor, and appropriately mitigate conflicts of interest.
• Avoid making any misleading or inaccurate statements, whether written or oral, regarding fund operations or achievements.
• Record in writing all investment, divestment, and other key operational decisions, along with their detailed justifications.
• Formulate and implement strict policies to ensure compliance with anti-money laundering (AML) and combating the financing of terrorism (CFT) laws.

C. Section II: Code of Conduct for Managers and KMPs

The Investment Manager and KMPs must:

• Abide by the SEBI Act, Rules, Regulations, Guidelines, and Circulars at all times.
• Maintain the highest standards of professional integrity, ethical conduct, and fairness in all dealings.
• Exercise proper care, due diligence, and independent professional judgment in all investment decisions.
• Act in a strict fiduciary capacity toward the fund's investors.
• Provide appropriate, well-considered, and non-misleading inputs to the appointed Valuer for portfolio valuation.
• Document all key deal correspondences and understandings with counterparties in writing.
• Maintain absolute confidentiality regarding information received from investee companies or prospective investee companies, unless a formal waiver is signed.
• Avoid offering or accepting any form of inducement in connection with fund affairs.

D. Section III: Code of Conduct for Investment Committee, Trustees, and Directors

Members of the Investment Committee, Trustees, and Directors must:

• Maintain high standards of integrity and ethical behavior.
• Disclose any personal, pecuniary, or professional conflicts of interest immediately to the Manager, and recuse themselves from the decision-making process for that transaction.
• Maintain confidentiality of information concerning the AIF, its investors, and investee companies.
• Avoid indulging in any unethical practices, professional misconduct, gross negligence, or fraud.

4. 4.1.16 Exemption from Enforcement (Regulatory Sandbox)

To encourage financial innovation, SEBI may grant a Category I or Category II AIF (or a class of persons) a temporary exemption from the enforcement of any or all provisions of the AIF Regulations:

• Maximum Period: The exemption is granted for a period not exceeding twelve (12) months.
• Objective: Aimed at testing new products, processes, services, or business models in a live, controlled environment under the SEBI Regulatory Sandbox framework.
• Sandbox Definition: A live testing environment where new financial innovations are deployed on a limited set of eligible customers for a specified time period.

5. 4.2 General Provisions of the Foreign Exchange Management Act, 1999 (FEMA)

FEMA provides the legal foundation for managing cross-border capital flows, foreign inbound investments, and outbound investments by Indian pooling vehicles.

A. 4.2.1 FDI and its Economic Significance

• Historical Context: Prior to 1999, foreign exchange was regulated under the restrictive Foreign Exchange Regulation Act (FERA), 1973, which contained stringent criminal provisions and focused on conservation.
• Shift to FEMA: In 1999, the Foreign Exchange Management Act (FEMA) was enacted to facilitate orderly international trade and payments, shifting the regulatory focus from "regulation/restriction" to "management".
• PMLA Bifurcation: Serious economic offences such as money laundering, terror financing, and round-tripping were separated from administrative exchange issues and are regulated under the Prevention of Money Laundering Act (PMLA), 2002.

B. 4.2.2 & 4.2.4 The Concept of "Residence" under FEMA

FEMA distinguishes between domestic and foreign investors based on their residential status. This status is evaluated separately from the Income Tax Act, 1961:

FEMA Residential Status Evaluation != Income Tax Residential Status Evaluation

• FEMA Criterion (Intention of Stay): Focuses heavily on the purpose and intention of stay rather than mere physical days.
• Income Tax Criterion (Physical Stay): Evaluates residency strictly based on the number of physical days spent in India.

Defining a "Person Resident in India" under FEMA (Section 2(v))

1. The 182-Day Preceding Year Rule: An individual who resides in India for more than 182 days during the course of the preceding financial year.
   • Exclusion: It does NOT include individuals who have gone out of India, or who stay outside India, for employment, for carrying on a business/vocation outside India, or for any other purpose indicating an intention to stay abroad for an uncertain period.
   • Inclusion: It does NOT include individuals who come to or stay in India, otherwise than to take up employment, carry on a business/vocation, or for any other purpose indicating an intention to stay in India for an uncertain period.
2. Corporate Entity Rule: Any person or body corporate registered or incorporated in India.
3. Office/Branch (Inbound Control): An office, branch, or agency in India owned or controlled by a person resident outside India.
4. Office/Branch (Outbound Control): An office, branch, or agency outside India owned or controlled by a person resident in India.

C. 4.2.3 Non-Resident Indians (NRIs) and Persons of Indian Origin (PIOs)

• Non-Resident Indian (NRI): An individual resident outside India who is a citizen of India or holds an Overseas Citizen of India (OCI) Cardholder status.
• Person of Indian Origin (PIO): An individual resident outside India who is a citizen of any country other than Bangladesh, Pakistan, Afghanistan, China, Iran, Bhutan, Sri Lanka, and Nepal, provided they meet any of the following:
  1. Held an Indian passport at any time.
  2. Had parents, grandparents, or great-grandparents who were citizens of India by virtue of the Constitution or the Citizenship Act, 1955.
  3. Is the spouse of an Indian citizen or a person of Indian origin.

D. 4.2.6 Inbound Foreign Investment Routes in India

Apart from AIF routing, foreign capital enters India through three primary channels:

1. Foreign Direct Investment (FDI) Route: Used for strategic, long-term investments. Governed by Foreign Exchange Management (Non-Debt Instrument) Rules ("NDI Rules") and overseen by the Department for Promotion of Industry and Internal Trade (DPIIT). Strategic non-resident investments that represent 10% or more of the post-investment fully diluted paid-up capital of a listed company fall under the FDI route.
2. Foreign Portfolio Investment (FPI) Route: Used by registered foreign investors for secondary market trading. Investment from an FPI must be less than 10% of the post-investment paid-up capital of a listed company.
3. Foreign Venture Capital Investor (FVCI) Route: Available to registered offshore venture capital funds targeting eligible unlisted sectors (e.g., biotechnology, infrastructure) or startups. FVCIs register with SEBI, and their transaction pricing is unregulated (negotiated mutually between buyer and seller).

6. 4.2.7 Foreign Investments in AIFs (NDI Rules, Schedule VIII)

Under the NDI Rules, a registered AIF is classified as an Investment Vehicle.

A. Acquisition of Units and Swap Options

• Schedule VIII Permittance: Non-residents can purchase, hold, sell, or transfer units of an Investment Vehicle (such as an AIF) under the automatic route without prior regulatory approvals, subject to standard sector-specific conditions.
• Payment Sources: Subscriptions must be routed via normal banking channels, debited from Non-Resident External (NRE) accounts, Foreign Currency Non-Resident (FCNR) accounts, or Special Non-Resident Rupee (SNRR) accounts.
• Equity-to-Unit Swap Option: Foreign investors are permitted to acquire units of an AIF against the swap of equity instruments of the Special Purpose Vehicle (SPV) that the AIF proposes to acquire.

B. Downstream Investments and "Indirect Foreign Investment"

• Definition: A downstream investment is an investment made by an Indian Investment Vehicle (AIF) into a domestic investee company.
• Classification as "Indirect Foreign Investment": If more than 51% of the corpus of the AIF is contributed by foreign/non-resident investors, any downstream investment made by that AIF is legally deemed to be Indirect Foreign Investment.
• Compliance with Sectoral Caps: AIFs classified as making indirect foreign investments must strictly conform to the sectoral caps, pricing guidelines, and conditions applicable to the target investee company under the FDI policy.

The Sponsorship "Control" Exception: The actual percentage of foreign investment in the AIF's corpus will not classify the downstream investment as foreign, provided that:

1. The "control" of the AIF rests entirely in the hands of the Sponsor and Investment Manager.
2. The Sponsor and Manager are resident Indian citizens (or entities owned and controlled by resident Indians). Under this structure, the downstream investments of the AIF are treated as domestic investments, regardless of whether the fund's corpus is 100% foreign-funded.

Sponsor/Manager Control = Indian Citizen => Downstream Investment = Domestic (Corpus Nationality Irrelevant)

C. Reporting and Compliance Portal

• Annual Foreign Liabilities and Assets (FLA) Return: Any AIF that has received foreign investment or made overseas investments must file an annual return on Foreign Liabilities and Assets (FLA) on the FLAIR portal on or before July 15th of each year.
• Single Master Form (SMF): AIFs with foreign investments must register and file details under the SMF on the RBI's FIRMS portal.
• Form DI Filing: When an AIF makes a downstream investment that is classified as indirect foreign investment, it must file Form DI with the RBI within thirty (30) days from the date of allotment of the equity instruments.

7. 4.2.8 Overseas Investments by AIFs

To facilitate geographic diversification, SEBI and the RBI permit domestic AIFs to invest in securities of companies incorporated outside India, subject to strict limits.

A. Key Conditions and Limits for Outbound Investing

1. Offshore Target Instruments: AIFs can invest in equity and equity-linked instruments only of offshore venture capital undertakings that are not listed on a recognized stock exchange in India or abroad.
2. Industry-Wide Cap: Outbound investments are subject to a cumulative industry-wide cap of USD 1500 million (increased from USD 750 million) for all AIFs combined, allocated on a first-come-first-served basis.
3. Filing and Validity: AIFs must submit their proposal to SEBI for prior approval. Once SEBI grants approval, it is valid for four (4) months, after which any unutilized limit lapses and is reallocated.
4. Scheme-Wise Concentration Cap: Outbound investments by an individual AIF scheme must not exceed 25% of its investable funds (capital).
5. Regulator Compatibility: The overseas investee company must be incorporated in a country whose securities market regulator is a signatory to the IOSCO Multilateral MoU or a bilateral MoU with SEBI.
6. FATF Sanction Exclusion: AIFs are strictly prohibited from investing in companies incorporated in countries identified in the public statement of the Financial Action Task Force (FATF) as having strategic AML/CFT deficiencies to which counter-measures apply.
7. The 50% NBFC Single Contributor Rule: If more than 50% of the funds of the AIF are contributed by a single Non-Banking Financial Company (NBFC), the AIF must comply with all RBI guidelines regarding NBFCs opening branches/subsidiaries or undertaking investments abroad.
8. Outbound Secondary Sales: An AIF can transfer or sell its overseas investments only to entities that are themselves eligible to make overseas investments under FEMA, 1999.

Important Terms & Exam Definitions

1. Merchant Banker Route: The mandatory compliance process requiring AIF managers to file draft PPMs and subsequent amendments through a SEBI-registered merchant banker.
2. Key Management Personnel (KMP): Key individuals (investment team, MD, CEO, CIO) who are legally responsible for fund decision-making and must abide by the Fourth Schedule Code of Conduct.
3. Indirect Foreign Investment: Downstream investment made by an Indian AIF into an investee company where more than 51% of the AIF's corpus is foreign-funded, unless controlled by an Indian resident manager.
4. FDI vs. FPI Route: Strategic non-resident investment representing >=10% of post-investment company capital (FDI) versus secondary portfolio trading representing <10% (FPI).
5. FLAIR Portal: The RBI's Foreign Liabilities and Assets Information Reporting portal where AIFs with foreign capital must file annual FLA returns by July 15th.
6. IOSCO Multilateral MoU: International regulatory agreement that overseas investee country regulators must sign for Indian AIFs to be allowed to invest in them.