CHAPTER 14: REGULATORY FRAMEWORK (PART 7 OF 7)

Specific Due Diligence, Anti-Money Laundering (PMLA) Compliance, Foreign Investment (FEMA) Framework, FATCA/CRS Reporting, and SEBI ICDR Regulations

1. Specific Due Diligence of Investors and Investments of AIFs

To prevent the misuse of Alternative Investment Funds (AIFs) as pass-through structures to bypass regulatory rules, the Securities and Exchange Board of India (SEBI) mandates that AIFs, their Managers, and Key Management Personnel (KMPs) carry out Specific Due Diligence (DD). This requirement applies to both existing and proposed investments, and any compliance failures must be reported directly to the fund's custodian.

I. Due Diligence on Qualified Institutional Buyers (QIBs)

Under SEBI Regulations, AIFs enjoy the status of Qualified Institutional Buyers (QIBs), granting them access to relaxed pricing, allocations, and bid processes in public issues.

• The Circumvention Risk: Investors who do not qualify for QIB status on their own may try to bypass these rules by investing through an AIF.
• The Due Diligence Trigger: If a single investor, or investors belonging to the same group, contributes more than 50 percent of the corpus of an AIF scheme, the manager must conduct specific due diligence before availing of any QIB benefits under the SEBI (ICDR) Regulations, 2018.
• Remediation Policy: If the investment fails to meet the SFA’s implementation standards, the AIF must either refuse to make the investment or exclude that specific investor from the transaction, with clear disclosures in the PPM.

II. Due Diligence on Qualified Buyers (QBs)

AIFs are also designated as Qualified Buyers (QBs) under the SARFAESI Act, 2002, allowing them to subscribe to Security Receipts (SRs) issued by Asset Reconstruction Companies (ARCs).

• The Trigger: Specific due diligence is required for any scheme where a single investor or investor group contributes more than 50 percent of the corpus before purchasing SRs or availing of QB benefits.
• Remediation Policy: If the standards are not met, the manager must refrain from the investment or exclude the ineligible investor from that specific deployment, accompanied by proper PPM disclosures.

III. Due Diligence on RBI-Regulated Lenders (Preventing Stressed Loan Evergreening)

To stop financial institutions from using AIFs to conceal non-performing assets, SEBI and the RBI enforce strict "evergreening" checks. This occurs when a lender invests in an AIF, which then uses those funds to buy or resolve the lender's own stressed assets, effectively hiding bad loans.

• The Due Diligence Trigger: Specific due diligence is mandatory for any AIF scheme where:
  1. The AIF’s Manager or Sponsor is directly regulated by the RBI.
  2. An RBI-regulated investor (such as a bank or NBFC), individually or with its group, contributes more than 25 percent of the scheme's corpus.
  3. An RBI-regulated investor is an associate of the AIF's Manager or Sponsor.
  4. An RBI-regulated investor holds a seat on the AIF's Board of Directors or its Investment Committee (individually or through nominees).
• The Exposure Rule: The AIF Manager must ensure that no investment is made that would result in an RBI-regulated lender acquiring an indirect exposure (through the AIF) to an investee company that the lender is legally barred from holding directly.
• Remediation Policy: If the transaction does not comply, the fund must cancel the investment or exclude the RBI-regulated investor from the transaction.

IV. Due Diligence on Land-Border Sharing Countries (Rule 6 NDI Rules)

Under Rule 6 of the Foreign Exchange Management (Non-Debt Instruments) Rules, 2019, direct investments into Indian companies from countries sharing a land border with India require prior government approval.

• The Due Diligence Trigger: Specific due diligence is required before making an investment if:
  1. 50 percent or more of the scheme’s corpus is contributed by investors who are citizens of, from, or situated in a country that shares a land border with India.
  2. 50 percent or more of the scheme’s corpus is contributed by investors whose Ultimate Beneficial Owners (UBOs) are citizens of, from, or situated in a country sharing a land border with India.
• Mandatory Custodian Reporting: If the due diligence is successful and the investment proceeds, the AIF must report the details to its custodian within 30 days of the investment if the transaction results in the scheme holding 10 percent or more of the equity or equity-linked securities (on a fully-diluted basis) of the investee company.

2. Prevention of Money Laundering Act, 2002 (PMLA) Compliance

India’s status as a full member of the Financial Action Task Force (FATF) requires AIFs to maintain high standards of anti-money laundering (AML) and combating the financing of terrorism (CFT) controls. Under the PMLA, AIFs are classified as reporting entities and must maintain a complete audit trail of their transactions.

I. Mandatory Record-Keeping and Reporting Thresholds

AIFs must record and maintain reports on the following transaction categories:

• High-Value Cash Transactions: All cash transactions valued at more than INR 10 lakh, or its foreign currency equivalent.
• Connected Cash Transactions: Series of cash transactions that are individually below INR 10 lakh but are integrally connected and aggregating to more than INR 10 lakh within a single calendar month.
• Non-Profit Organisation (NPO) Transactions: All transactions involving receipts by an NPO valued at more than INR 10 lakh, or its foreign currency equivalent.
• Cross-Border Wire Transfers: All cross-border wire transfers of a value of more than INR 5 lakh, or its foreign currency equivalent, where either the origin or destination of the funds is in India.
• Counterfeit Currency: All transactions where forged or counterfeit currency notes have been detected.
• Suspicious Transactions: Any transaction, cash or non-cash (including demat account credits/debits), that appears to have no economic rationale, suggests the use of crime proceeds, or is linked to illegal activities.

II. Ultimate Beneficial Owner (UBO) Thresholds

AIFs must identify the natural persons who ultimately own or control the investing entities. The ownership thresholds for UBO identification are defined as:

• For Companies and Trusts: Identified on a controlling ownership or entitlement interest of more than 25 percent.
• For Partnership Firms and Unincorporated Associations: Identified on an ownership or entitlement interest of more than 15 percent.

III. Central KYC Records (CKYCR) and Record Retention

• The 10-Day Filing Rule: AIFs must upload the verified KYC data, scanned address proofs, and identity proofs of their clients onto the CKYCR portal within 10 days of starting a business relationship.
• KYC Identifier: Once uploaded, the unique KYC Identifier issued by CKYCR must be shared with the investor. If an incoming investor already has a KYC Identifier, the AIF can download and use those records for verification.
• Record Retention: Original KYC records and transaction documents must be preserved by the AIF and its custodian for a minimum period of 5 years from the date of cessation of the client relationship.

IV. Appointing a Principal Officer (PO)

• All AIFs must appoint a Principal Officer (PO) to oversee compliance with AML and CFT regulations.
• The PO is responsible for monitoring transactions, generating alerts, filing Suspicious Transaction Reports (STRs), and submitting regular compliance certificates to SEBI.

V. Treatment of Family Trusts under PMLA

• The Non-NPO Exception: A family trust created solely for wealth preservation and the benefit of family members is not required to be registered under the Registration Act, 1908.
• Consequently, a family trust does not fall under the definition of an NPO under PMLA rules. Capital commitments received from family trusts are exempt from NPO reporting requirements unless they trigger suspicious transaction alerts.

VI. Provisional Attachment of Property

• The Director of the Financial Intelligence Unit (FIU-India) has the authority to issue a provisional attachment order to freeze properties or assets suspected to be "proceeds of crime" for a period not exceeding 180 days.

3. Foreign Exchange Management Act, 1999 (FEMA) Framework

FEMA regulates all cross-border capital flows, including foreign investments entering Indian AIFs (inbound) and AIF allocations into overseas markets (outbound).

I. Inbound Foreign Investments in AIFs

• The Automatic Route: Foreign investors, including Foreign Portfolio Investors (FPIs), Non-Resident Indians (NRIs), and Persons of Indian Origin (PIOs), can subscribe to AIF units under the Automatic Route (without prior RBI or government clearance), provided the investee sectors allow automatic inflows.
• The Approval Route: If the underlying target sector or the investor's country requires specific government clearance, the application must be routed through the Foreign Investment Facilitation Portal (FIFP).
• Permissible Settlement Channels: Payments for AIF units must be routed through standard banking channels or financed by debiting the investor's Non-Resident External (NRE), Foreign Currency Non-Resident (FCNR), or Special Non-Resident Rupee (SNRR) accounts.

II. Downstream Investment and "Indirect Foreign Investment" Rules

Downstream investments made by an AIF into Indian companies are subject to specific "Indirect Foreign Investment" classifications:

• The Foreign-Controlled Trigger: A downstream investment by an AIF is classified as an indirect foreign investment if either the Sponsor or the Investment Manager of the AIF is foreign-owned or foreign-controlled.
• Definition of Control: Control is determined by the right to appoint the majority of directors or control policy decisions [12.4.2]. If structured as a trust, control must rest solely with an Indian Sponsor or Manager.
• The Domestic Safe Harbor: If both the Sponsor and the Manager are owned and controlled by resident Indian citizens, the AIF's downstream investments are treated as domestic investments, regardless of the percentage of foreign capital in the AIF's investor pool.

III. FEMA Reporting Compliance Timelines

• InVi Form Filing (30-Day Rule): An AIF that issues units to non-resident investors must file Form InVi with the RBI within 30 days of unit allotment.
• Foreign Liabilities and Assets (FLA) Return: Any AIF with outstanding foreign liabilities or assets must submit an annual FLA Return via the RBI’s FLAIR portal on or before July 15th of each year.
• Single Master Form (SMF): AIFs with foreign investments must register and file details in the SMF on the RBI’s FIRMS portal.

IV. Outbound Overseas Investments by AIFs

• The General Limit: Indian AIFs are permitted to invest in unlisted offshore Venture Capital Undertakings up to an industry-wide cap of USD 1,500 million on a first-come, first-served basis.
• The 6-Month Execution Window: SEBI allocations for overseas investments are valid for 6 months. If the investment is not executed within this window, the allocation lapses and the limit is returned to the pool.
• The 25% Concentration Cap: An AIF scheme cannot invest more than 25 percent of its investable funds in overseas companies.
• Divestment Recycling (3-Day Rule): If an AIF exits or liquidates an overseas investment, it must report the divestment details to SEBI at [email protected] within 3 working days. This allows SEBI to update the industry-wide limit and make the recycled capital available for other AIFs.

4. SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2018

The SEBI (ICDR) Regulations govern how unlisted companies price and issue shares during an Initial Public Offer (IPO), as well as preferential allotments made by listed entities. These rules have a direct impact on how AIFs invest in and exit from investee companies.

I. IPO Lock-in Exemptions for AIFs

Standard SEBI rules require all pre-issue shareholders of a company going public to lock in their shares post-IPO to prevent immediate market dumping. However, Category I and II AIFs are granted significant exemptions:

• The Pre-Issue Lock-in Rule: The entire pre-issue share capital of an unlisted company (excluding the minimum promoter contribution) is locked in for 6 months from the date of allotment in the public issue.
• The Capex Exception: If the IPO proceeds are primarily used to fund the company’s capital expenditure, this lock-in period is extended to 1 year.
• The AIF Exemption Safe-Harbor: Pre-IPO shares held by registered Category I and Category II AIFs (and legacy VCFs) are exempt from these 6-month or 1-year lock-in requirements, provided:
  1. The shares have been held by the AIF for a minimum period of 1 year prior to the date of filing the draft Red Herring Prospectus (DRHP) with SEBI.
  2. The AIF is not classified as a promoter or part of the promoter group.

II. QIP and Preferential Allotments

• Qualified Institutions Placement (QIP): A listed company can raise capital by making preferential issues of securities to Qualified Institutional Buyers (QIBs), including AIFs, on a private placement basis.
• The Preferential Lock-in Rule: Securities issued to AIFs via preferential allotment are subject to a strict lock-in period of 6 months from the date of allotment. If the allotment proceeds are primarily used for capital expenditure, the lock-in period is extended to 1 year.

III. Offer for Sale (OFS) holding period

• The 6-Month OFS Holding Rule: If an AIF wants to exit an investee company by selling its shares to the public through an Offer for Sale (OFS) in an IPO, it must have held those shares for a minimum period of 6 months prior to filing the draft offer document with SEBI.

IV. The Takeover Regulations (5% Disclosure Rule)

• Under Regulation 29(1) of the SEBI (SAST) Regulations, 2011, if an AIF acquires shares or voting rights in a listed company that aggregate to 5 percent or more of the company's total share capital, it must disclose this holding to the stock exchanges within 2 working days of receiving the share allotment.

5. FATCA and CRS Compliance Framework

To prevent offshore tax evasion, India has entered into international tax reporting agreements, including the Foreign Account Tax Compliance Act (FATCA) with the United States and the Common Reporting Standard (CRS) developed by the OECD.

I. Core Definitions under FATCA/CRS

• Reporting Financial Institution (RFI): An Indian financial institution (including registered AIFs) that is legally obligated to collect, verify, and exchange investor tax residency information with tax authorities.
• Global Intermediary Identification Number (GIIN): A unique identification number that all RFIs must obtain by registering with the US Internal Revenue Service (IRS) to facilitate FATCA reporting.

II. Mandatory Investor Information to be Collected

Under Rules 114F to 114H of the Income Tax Rules, 1962, AIFs must obtain a FATCA/CRS Self-Declaration from every subscribing investor. The self-declaration must capture:

• Name and registered Address.
• Place, State, and Country of birth.
• Nationality.
• Gross Annual Income and Occupation.
• Permanent Account Number (PAN).
• Tax Residency Status (whether the investor is a tax resident of any country other than India).
• Tax Identification Number (TIN) or Social Security Number (SSN) issued by the foreign country of residence.

III. Reporting Timelines and Investor Obligations

• Self-Declaration Mandate: Since January 2016, a FATCA self-declaration is compulsory for all Indian and NRI investors subscribing to an AIF.
• The 30-Day Change Intimation Rule: Investors must inform the AIF or its Manager of any changes to their tax residency status or FATCA/CRS information within 30 days of the change.
• The Right to Reject or Force Redeem: If an investor fails to provide the required tax declarations or documents, the AIF has the legal authority to reject their application or force-redeem their existing units, in addition to reporting the account as "recalcitrant" to the tax authorities.

6. Practical Scenarios & Worked Case Studies

Scenario A: The RBI Evergreening Block

• The Situation: Alpha Capital Bank (regulated by the RBI) holds a 28% corpus share in Apex Debt Fund (a Category II AIF). The bank has a stressed loan of INR 50 crore outstanding from Zenith Textiles. The fund manager of Apex Debt Fund proposes to purchase the stressed loan from the bank at a discount using the fund's pooled capital.
• The Regulatory Verdict: This transaction will be blocked during the specific due diligence phase. Under SEBI and SFA standards, since an RBI-regulated lender (Alpha Capital Bank) contributes more than 25% of the AIF's corpus, the fund manager must conduct specific due diligence to prevent the evergreening of stressed assets. The bank cannot use the AIF to indirectly remove a stressed asset from its balance sheet while holding an equity position in the fund. The investment must be cancelled, or the bank must be excluded from this transaction.

Scenario B: The Delayed FATCA Update Penalty

• The Situation: Siddharth Mehta, an NRI investor in Matrix Venture Fund, moves from Dubai to New York on October 1st and becomes a US tax resident. Busy with the relocation, he sends his updated tax status and FATCA self-declaration containing his US Social Security Number (SSN) to the fund manager on December 15th.
• The Regulatory Verdict: Siddharth has violated the 30-day change intimation rule. Under FATCA regulations, investors must report any change in their tax residency details within 30 days of the change (which would have been by October 31st). The fund manager must flag this account, and if the delay leads to reporting errors, the fund may face regulatory audits or be forced to redeem Siddharth’s units.

7. Key Takeaways & Exam-Relevant Terms

• Qualified Institutional Buyer (QIB) Check: Mandatory specific due diligence for any AIF scheme where a single investor or group contributes more than 50% of the corpus.
• The 25% RBI Lender Rule: Triggers mandatory evergreening checks if an RBI-regulated entity holds more than a 25% stake in the AIF scheme.
• Land-Border Sharing Check: Triggers specific due diligence if 50% or more of the fund's corpus is sourced from countries sharing a land border with India.
• Ownership Entitlement for UBOs: Fixed at more than 25% for companies/trusts and more than 15% for partnerships under PMLA rules.
• The InVi Form Timeline: Must be filed with the RBI within 30 days of unit allotment to foreign investors.
• Overseas Limit Validity: SEBI allocations for outbound investments are valid for 6 months.
• 3-Day Divestment Rule: Outbound divestments must be reported to SEBI within 3 working days to recycle the industry-wide limit.
• OFS Holding Period: A seller must hold shares for a minimum of 6 months to participate in an Offer for Sale in an IPO.
• 30-Day FATCA Rule: Investors must report any change in their foreign tax residency status to the AIF within 30 days.

Summary of Chapter 14 regulatory timelines (Part 1 - Part 7):

• 10 Days: Timeline to upload KYC records to CKYCR after onboarding a client.
• 21 Days: Timeline for an AIF to resolve investor complaints or submit an Action Taken Report (ATR) on SCORES [10.5.8].
• 30 Days: Timeline to file Form InVi with the RBI after allocating units to foreign investors.
• 30 Days: Timeline for the Investment Manager to draft and submit the Compliance Test Report (CTR) to the Sponsor and Trustee after the close of the financial year [12.2.5].
• 30 Days: Timeline for investors to intimate any changes to their FATCA/CRS tax status to the fund manager.
• 30 Days: Timeline to report overseas divestments to SEBI (reduced to 3 working days to recycle limits).
• 180 Days: Timeline for Category I and II AIFs to distribute their detailed annual reports to investors [12.2.2].
• 12 Months: Maximum timeline to declare the First Close of a scheme from the date SEBI takes the PPM on record [14.5.2].