CHAPTER 14: REGULATORY FRAMEWORK (PART 6 OF 7)

General Obligations, Fiduciary Responsibilities, SEBI Code of Conduct, Market Surveillance, Inspection Framework, and Periodic Disclosures/Reporting

1. General Obligations and Responsibilities of AIF Constituents

The operational integrity, transparency, and accountability of an Alternative Investment Fund (AIF) are maintained through general obligations imposed on its core constituents: the Sponsor, Investment Manager, and Trustee [14.11.3].

I. Appointment of Key Intermediaries

1. SEBI-Registered Custodian:
   • The Sponsor or Investment Manager must compulsorily appoint a SEBI-registered custodian for the safekeeping of the scheme's securities and physical assets [14.11.3].
   • For Category III AIFs, the custodian must also keep custody of securities and goods received in delivery against the physical settlement of commodity derivatives [14.11.3].
   • Timeline for Appointment: The custodian for a scheme must be appointed prior to the date of the first investment of that scheme [14.11.3].
   • Related Party Restriction: The appointed custodian cannot be a related party to the Sponsor, Investment Manager, or designated partners of the AIF unless specific conditions (such as independent directors, structural arm's-length separation, and disclosures) are satisfied [14.11.3].
2. Registrar and Transfer Agent (RTA):
   • The appointment of an RTA registered under the SEBI (Registrars to an Issue and Share Transfer Agents) Regulations, 1993 is compulsory [14.11.3].
   • The RTA acts as the mandatory collecting agent to collect and deposit applicable stamp duty on the issuance, transfer, and sale of AIF units [14.11.3].

II. Review of Policies and Procedures

• The Sponsor or Investment Manager is obligated to establish, implement, and review the policies and procedures of the AIF on an ongoing and regular basis to ensure continuing compliance with regulatory changes and business developments [14.11.3].

III. Annual Auditing of Financials

• The books of accounts of the AIF must be audited at least once every financial year by a qualified, independent statutory auditor [14.11.3].

IV. Strict Record Maintenance Norms

Under Regulation 27, the Investment Manager or Sponsor must maintain key operational records for a minimum period of 5 years after the complete winding up of the fund [14.11.3]:

• Detailed assets under the scheme.
• Valuation policies, methodologies, and historical practices.
• Documented investment strategies and asset allocation plans.
• Full registries of investors, including their capital contributions and drawdowns.
• Detailed written rationales for every investment and divestment decision [14.11.3].

2. Fiduciary Responsibilities and Conflict of Interest Policy

The Sponsor, Investment Manager, and Trustee of an AIF have a strict fiduciary duty to act in the best interests of the unitholders [10.5]. They must prevent, manage, and disclose all potential conflicts of interest that may arise during the fund's lifecycle [10.5].

I. Core Fiduciary Principles

• The interests of the investors must be prioritized above those of the Sponsor, Manager, employees, or intermediaries [10.5].
• The fund must establish and enforce a robust written Conflict of Interest Policy approved by its governing board [10.5]. This policy must outline:
  1. The nature of potential conflicts of interest at various levels of the fund's operations [10.5].
  2. The specific methodologies and systems adopted by the Manager to mitigate these conflicts [10.5].
  3. A transparent disclosure mechanism to inform investors of these risks and secure their formal acknowledgment [10.5].

II. Levels of Potential Conflicts of Interest

The Conflict of Interest Policy must address risks across multiple operational tiers [10.5]:

III. Mitigating Conflict through Human Capital Controls

To minimize conflict risk, the Investment Manager must implement operational controls, including [10.5.8, 10.6]:

• Establishing "Chinese Walls" to protect price-sensitive, non-public information.
• Providing regular training and upskilling to the investment team on compliance and market conduct.
• Exercising due skill and care when outsourcing administrative or accounting tasks.
• Directly aligning team compensation with the long-term performance of the fund (e.g., clawback clauses and deferred carried interest structures).
• Refraining from co-investing in deals that generate direct conflicts, unless prior disclosure is made and a written waiver is obtained from the investors.

3. SEBI Code of Conduct (Fourth Schedule)

SEBI enforces a strict statutory Code of Conduct under the Fourth Schedule of the AIF Regulations [14.12]. This code applies to the AIF as an entity, the Investment Manager, Sponsor, Trustees, and members of the Investment Committee [14.12].

I. Code of Conduct for the AIF as an Entity

The AIF must comply with these core principles [14.12]:

• Conduct all activities and investments in strict accordance with the registered objectives declared in the PPM and other fund documents.
• Ensure the fund is managed and operated in the interest of all investors, rather than for the exclusive benefit of the Sponsor, Manager, directors, or a select class of investors.
• Disseminate adequate, accurate, explicit, and timely information to all unitholders.
• Maintain a robust, documented risk management process and internal control systems.
• Maintain written policies and procedures to ensure strict compliance with Anti-Money Laundering (AML) laws.
• Never employ unethical or coercive means to market, sell, or induce investors to purchase units.

II. Code of Conduct for Investment Managers and Key Management Personnel (KMPs)

The Investment Manager and their KMPs (including Chief Executive Officers, Chief Investment Officers, Managing Directors, Whole-Time Directors, and members of the key investment team) must adhere to these standards [10.8]:

1. Regulatory Abidance: Maintain absolute compliance with the SEBI Act, Rules, Regulations, and circulars at all times.
2. Professional Diligence: Exercise independent professional judgment, high ethical standards, and proper care in all investment evaluations.
3. Written Rationales: Record in writing every investment, divestment, and key operational decision, along with its detailed justification.
4. Accurate Valuation Inputs: Provide well-considered, accurate, and non-misleading inputs to the independent registered valuer.
5. No Collusive Trading: Refrain from entering into buy or sell arrangements for securities where there is no effective change in beneficial interest, or where trades are executed via collusion or concert to manipulate valuations.
6. Inducement Ban: Never offer or accept any inducement, bribe, rebate, or illegal commission in connection with managing investor funds.
7. Confidentiality: Protect all non-public information received from investors, target entities, and portfolio companies.

III. Code of Conduct for Trustees and Investment Committee Members

Trustees, directors of trustee companies, designated partners, and members of the Investment Committee must [10.8]:

• Maintain the highest standard of professional integrity.
• Disclose any personal conflict of interest in any proposed transaction immediately to the Manager, and recuse themselves from the decision-making and voting process.
• Refrain from any unethical practice, professional misconduct, gross negligence, or fraudulent omission.

4. Market Surveillance and Information Integrity

To protect capital markets from manipulation, SEBI enforces strict guidelines regarding information sharing, rumors, and digital communications [14.13]:

• Circulation of Rumors: Employees, temporary staff, and voluntary workers are strictly prohibited from circulating unverified rumors or unverified market information obtained from clients, chat forums, or other external sources.
• Communication Platform Restrictions: Access to online blogs, chat forums, and public messenger sites must be restricted or placed under active compliance supervision.
• Log Retention: Full system logs of any permitted usage of blogs, chat forums, or messenger platforms must be maintained as official records.
• The Pre-Approval Rule: Any market-related news or report received by an employee (on official mail, personal mail, or blogs) must be forwarded to the Compliance Officer for approval before being circulated. If an employee circulates unapproved market information, both the employee and the Compliance Officer can be held liable for a breach of regulatory duty.

5. SEBI’s Inspection and Investigation Framework

SEBI has the statutory authority to appoint an Inspecting Authority to inspect and investigate the books of accounts, records, and documents of any AIF, Sponsor, or Manager [14.11].

I. Grounds for Ordering an Inspection

SEBI can initiate an inspection for several reasons [14.11]:

• To verify that books of accounts, records, and compliance documents are being maintained in the specified manner.
• To investigate complaints received from investors, clients, or other participants regarding the activities of the AIF.
• To determine whether the provisions of the SEBI Act and AIF Regulations are being complied with.
• To conduct suo motu (independent) inspections in the broader interest of the securities market or to protect investor interests.

II. Notice and Cooperation Requirements

• The 10-Day Notice Rule: Under normal circumstances, SEBI must provide a minimum of 10 days' written notice to the AIF before commencing an inspection [14.11].
• Emergency Exception: If SEBI is satisfied that giving notice would compromise the investigation or harm investor interests, it can order an immediate inspection without notice [14.11].
• Mandatory Cooperation: The Sponsor, Manager, Trustees, and all officers are legally obligated to co-operate with the Inspecting Authority, provide access to physical/digital offices, and produce all requested records [14.11].

III. Enforcement Directions and Penalties Post-Inspection

Following the evaluation of the Inspection Report, SEBI can issue binding enforcement directions to protect the market [14.11]:

• Fundraising Restraints: Prohibit the AIF from launching new schemes or raising fresh capital from investors for a specified period.
• Asset Disposal Prohibitions: Bar concerned parties from selling or disposing of properties or assets acquired in violation of the regulations.
• Mandatory Orderly Liquidation: Require the fund to divest or liquidate its assets in a specified manner.
• Refund with Interest: Order the AIF or its Manager to refund capital or assets to affected investors along with requisite interest.
• Capital Market Ban: Prohibit the Sponsor, Manager, or key personnel from accessing or operating in the capital markets for a specified period.

6. Periodic Disclosures and Transparency Reports to Investors

Under Regulation 22, AIFs must provide regular, transparent disclosures to their unitholders to ensure they can track performance, costs, and risks [12.2.2].

I. General Disclosure Items

An AIF must disclose the following information to its investors [12.2.2]:

• Complete financial, operational, portfolio, and transaction-level details of the fund's investments.
• Detailed breakdown of all fees paid to the Investment Manager or Sponsor, and any fees charged to the AIF or investee companies by associates.
• Any regulatory inquiries, audits, or legal actions initiated by regulatory bodies in any jurisdiction, disclosed as and when they occur.
• Any material liabilities arising during the scheme's tenure, disclosed as and when they occur.
• Any material breach of the PPM, contribution agreements, or other fund documents, disclosed as and when they occur.
• Any change in control of the Sponsor, Investment Manager, or portfolio investee companies.
• Any significant change in the key investment team.

II. Annual Reporting Timelines

• The 180-Day Rule: Close-ended Category I and Category II AIFs must compile and distribute their detailed annual reports to investors within 180 days from the end of the financial year (i.e., by September 27th for the financial year ending March 31st) [12.2.2].

III. Mandatory Disclosures in the Annual Report

The annual report sent to Category I and II investors must include detailed assessments of [12.2.2]:

1. Investee Financials: Financial statements and operational performance of each portfolio company.
2. Concentration Risks: Exposure limits and concentration levels at the fund level.
3. Foreign Exchange Risks: Currency exposures and hedging strategies.
4. Leverage Risks: Borrowing levels and debt-to-equity ratios at both the fund and investee levels.
5. Realisation Risks: Changes in the exit environment, IPO timelines, and market liquidity.
6. Strategy Risks: Any divergence by portfolio companies from their approved business plans.
7. Reputation Risks: Operational or governance issues at portfolio companies.
8. ESG/Extra-Financial Risks: Environmental, social, and corporate governance exposures at both the fund and investee levels.

7. Portfolio Valuation Regulations and Independent Valuers

To ensure that performance metrics and Net Asset Values (NAVs) are calculated fairly, SEBI enforces strict valuation guidelines under Regulation 23 [11.11].

I. Core Valuation Standards

• Listed Securities: Must be valued using the closing prices on recognized stock exchanges as prescribed under the SEBI (Mutual Funds) Regulations, 1996 [11.11].
• Unlisted and Thinly Traded Securities: Valuation must be carried out in accordance with the valuation guidelines endorsed by an AIF industry association (such as the SFA) representing at least 33% of registered AIFs [11.11]. These guidelines are formulated based on the recommendations of SEBI's Alternative Investment Policy Advisory Committee (AIPAC) and typically align with International Private Equity and Venture Capital (IPEV) guidelines [11.11].

II. Frequency of Valuation

• The Six-Month Rule: Category I and Category II AIFs must conduct a valuation of their portfolio investments at least once every 6 months [11.11].
• Extension Exception: This frequency can be reduced to once a year, provided the manager obtains the formal approval of at least 75 percent of the investors by value of their investment in the AIF [11.11].
• Category III Frequency: Category III AIFs must calculate and disclose their NAV quarterly for close-ended schemes and monthly for open-ended schemes [12.2.2].

III. Criteria for Appointing an Independent Valuer

All portfolio valuations for Category I and II AIFs must be conducted by an appointed Independent registered valuer who meets these criteria [11.12]:

• The valuer cannot be an associate of the Sponsor, Investment Manager, or Trustee of the AIF.
• The valuer must have at least 3 years of experience in valuing unlisted securities.
• The valuer must be registered with the Insolvency and Bankruptcy Board of India (IBBI).
• The valuer must hold a valid membership with ICAI, ICSI, ICMAI, or hold a CFA Charter from the CFA Institute.

IV. Valuation Deviations and Manager Responsibility

• Manager Accountability: The Investment Manager remains primarily responsible for ensuring a true and fair valuation of the fund's assets [11.12]. If standard valuation policies fail to reflect fair value, the manager must deviate from them, document the detailed rationale for the deviation, and inform investors [11.12].
• The 20% Material Deviation Trigger: If there is a valuation deviation of more than 20% at the asset level between two consecutive valuation runs, or a deviation of more than 33% in the overall valuation of the scheme's portfolio, the Investment Manager must:
  1. Provide a detailed explanation of the causes of the deviation to the Trustee or Board of Directors.
  2. Disclose the deviation and its underlying rationale directly to all investors in the scheme.

8. Regulatory Reporting to SEBI

Registered AIFs must submit periodic regulatory reports to SEBI to facilitate market surveillance and systemic risk monitoring [12.2.4].

I. Quarterly Reporting to SEBI

• Every AIF must file its regulatory activity report on a quarterly basis [12.2.4].
• The 10-Day Rule: The quarterly report must be submitted online through the SEBI Intermediary Portal within 10 calendar days from the end of each quarter [12.2.4].

II. Annual Reporting of PPM Changes

• Any changes made to the terms of the PPM or other fund documents must be consolidated and reported to SEBI within 1 month of the end of each financial year (i.e., by April 30th) [12.2.4].
• This filing must be routed through a SEBI-registered Merchant Banker and accompanied by a formal Due Diligence Certificate [12.2.4].

III. The Compliance Test Report (CTR) Framework

To ensure continuous compliance, the Investment Manager must prepare and execute a Compliance Test Report (CTR) at the end of each financial year [12.2.5].

• Timeline to Submit: The Investment Manager must submit the draft CTR to the Sponsor and Trustee within 30 days from the end of the financial year [12.2.5].
• Sponsor/Trustee Review: The Sponsor or Trustee must review the CTR and return their formal comments or observations to the Manager within 30 days of receipt [12.2.5].
• Manager Incorporation: The Manager must incorporate necessary changes and address the observations within 15 days of receiving the comments [12.2.5].
• Mandatory Violation Reporting: Any regulatory or compliance violation identified by the Sponsor or Trustee during this review must be reported to SEBI immediately [12.2.5].

9. The Stewardship Code

All registered AIFs must adhere to SEBI's mandatory Stewardship Code in relation to their investments in listed equity securities [12.2.1]. The code consists of six guiding principles designed to protect client wealth and enhance corporate governance in investee companies [12.2.1]:

• Principle 1 (Stewardship Policy): Formulate a comprehensive, written policy on how the AIF discharges its stewardship responsibilities. This policy must be reviewed periodically and publicly disclosed on the fund’s website [12.2.1].
• Principle 2 (Managing Conflict): Establish a clear policy to identify and manage conflicts of interest while fulfilling stewardship duties, ensuring the client’s interest is prioritized over the fund’s commercial interest [12.2.1].
• Principle 3 (Monitoring Investees): Continuously monitor investee companies regarding financial performance, strategy, corporate governance, board structure, and ESG factors, while strictly complying with insider trading regulations [12.2.1].
• Principle 4 (Intervention and Collaboration): Maintain a clear policy on when and how to actively intervene in investee companies (e.g., meeting with management, collaborating with other institutional investors, or voting against board proposals) [12.2.1].
• Principle 5 (Clear Voting Policy): Formulate a comprehensive voting policy. The AIF must take its own independent voting decisions based on in-depth analysis rather than blindly supporting management, and disclose its voting activity [12.2.1].
• Principle 6 (Periodical Reporting): Report periodically to investors and beneficiaries on how stewardship responsibilities have been fulfilled, maintaining website disclosures of these activities [12.2.1].

10. Investor Charter and Grievance Redressal

To protect investor rights, SEBI mandates the publishing of an Investor Charter and enforces a structured grievance redressal framework [12.2.2].

I. The Investor Charter

Every AIF must bring the Investor Charter to the notice of its unitholders by publishing it on its website or incorporating it into the PPM [12.2.2]. The Charter outlines:

• The fund's vision, mission, and services provided during onboarding, consent collection, and financial reporting [12.2.2].
• Explicit timelines for services, such as distributing valuations and resolving complaints [12.2.2].
• The responsibilities of investors, including timely KYC updates, abiding by contribution agreements, and maintaining confidentiality [12.2.2].

II. Grievance Redressal Timelines (The 21-Day Rule)

• The Investment Manager must redress all investor grievances within 21 calendar days from the date of receipt of the complaint [10.5.8].
• Investors can lodge complaints digitally on SEBI's web-based centralized portal, SEBI Complaint Redress System (SCORES) [10.5.8].
• Once a complaint is lodged on SCORES, the AIF must submit an Action Taken Report (ATR) within 21 days [10.5.8].

III. The Two-Tier SCORES Review Mechanism

1. First Review: If the investor is unsatisfied with the ATR or if the AIF fails to respond, the investor can request a review within 15 calendar days of receiving the ATR [10.5.8]. A SEBI-appointed Designated Body will review the case, establish deadlines for a revised ATR, and upload its findings on SCORES within 10 days [10.5.8].
2. Second Review: If the investor remains unsatisfied, they can request a second review within 15 calendar days of the revised ATR [10.5.8]. SEBI will take direct cognizance of the dispute, intervene with the stakeholders, and determine the final resolution [10.5.8].
3. Online Dispute Resolution (ODR) Route: AIFs must also provide investors with access to SEBI's ODR portal for alternative conciliation and arbitration [10.5.8].
4. Trust Structure Expense Limitation: If the AIF is structured as a trust, no loss, damage, or legal expense incurred by the Manager or their officers in resolving investor claims or disputes shall be met out of the trust property [10.5.8].

11. Practical Scenarios & Worked Case Studies

Scenario A: The Late Custodian Appointment

• The Situation: Orion Growth Fund (a Category II AIF) declared its First Close on April 1st. On May 1st, they entered into a Share Subscription Agreement to acquire a 12% stake in a logistics startup and transferred the investment cash on May 10th. The manager formally appointed and signed the agreement with a registered custodian on May 12th.
• The Regulatory Verdict: This is a clear compliance violation. Under SEBI regulations, the custodian for an AIF scheme must be appointed prior to the date of the first investment of the scheme. By executing the investment on May 10th before appointing the custodian on May 12th, Orion violated Regulation 20. This breach must be flagged in the annual PPM audit and reported in the Compliance Test Report.

Scenario B: The Delayed Annual Report

• The Situation: Apex Venture Fund (a Category I AIF) has a financial year ending on March 31, 2025. Due to delays in obtaining audited financials from two underlying start-ups, the manager compiles and emails the annual report (including investee financials and risk assessments) to the unitholders on October 15, 2025.
• The Regulatory Verdict: This represents a delayed disclosure violation. Category I and II AIFs are required to provide their annual reports to investors within 180 days from the end of the financial year (which falls on September 27th for a March 31st close). Apex missed this deadline by 18 days, which constitutes a regulatory infraction that must be reported to SEBI via the next compliance filing.

12. Key Takeaways & Exam-Relevant Terms

• Fiduciary Duty: The legal obligation of the Sponsor, Manager, and Trustee to act solely in the best interests of the unitholders.
• 10-Day Notice Rule: The standard notice period SEBI must give an AIF before ordering a routine regulatory inspection.
• Stewardship Code: A set of six mandatory principles governing how AIFs monitor, engage, and vote in listed equity investments.
• 180-Day Rule: The maximum timeline for Category I and II AIFs to distribute annual reports to investors following the close of the financial year.
• 21-Day SCORES Rule: The mandatory timeframe within which an AIF must resolve investor complaints and upload an Action Taken Report (ATR) on the SCORES portal.
• Aggregate Escrow Demat Account: Used to temporarily hold demat units for investors who have not provided personal depository details.
• Compliance Test Report (CTR): An annual internal audit report prepared by the Manager within 30 days of FY close, reviewed by the Trustee/Sponsor, and used to verify continuous compliance.