Chapter 15: Regulatory Framework of Alternative Investment Funds (AIFs) — Comprehensive Short Notes (Part 4 of 5)

15.11 General Obligations and Responsibilities of AIFs

15.11.1 Pro-rata and Pari-passu Rights of Investors

To maintain capital market integrity and prevent unequal treatment of sophisticated investors, SEBI mandates strict guidelines regarding the allocation of investment exposures and the distribution of fund proceeds.

A. Pro-rata Rights of Investors

• The Pro-rata Mandate: Investors in an Alternative Investment Fund (AIF) scheme must hold rights that are strictly pro-rata to their committed capital in the scheme. This equal-treatment principle applies directly to:
  1. The scheme's participation in each portfolio investment.
  2. The distribution of proceeds generated from such investments.
• Treatment of Historical Schemes: Any scheme launched prior to November 18, 2024, which features non-pro-rata rights that have not been specifically exempted, must be dealt with strictly in accordance with SEBI-prescribed transition guidelines.
• Permissible Exceptions to the Pro-rata Rule: The requirement to maintain pro-rata investment participation and distribution rights is not applicable under three specific conditions:
  1. Excuse or Exclusion: When an individual investor has been formally excused or excluded from participating in a specific portfolio investment under the designated regulatory criteria.
  2. Investor Default: When an investor fails to honor a capital drawdown notice, resulting in a default on their pro-rata contribution.
  3. Manager Performance Share (Carry): When profits or returns on investments are shared with the Investment Manager in the form of Performance Fees or Carried Interest in accordance with the terms of the Contribution Agreement.

B. Junior or Subordinate Classes of Units

To enhance fundraising flexibility from investors with varying risk appetites, AIF schemes may issue a junior or subordinate class of units. These units may accept lesser returns or absorb higher losses compared to their standard pro-rata share.

• Eligible Subscribers for Subordinate/Junior Units: Only the following designated entities are permitted to subscribe to a junior or subordinate class of units in an AIF scheme:
  • The Manager or Sponsor of the AIF.
  • Multilateral or Bilateral Development Financial Institutions.
  • State Industrial Development Corporations.
  • Entities owned, established, or controlled by the Central Government, a State Government, or the Government of a foreign country (including Sovereign Wealth Funds and Central Banks).

C. Prohibition on the "Evergreening" of Liabilities

• If the Manager or Sponsor of an AIF subscribes to a junior/subordinate class of units, the Investment Manager must implement strict internal controls.
• The Non-Repayment Rule: The capital deployed by the AIF scheme into any investee company must not be utilized, directly or indirectly, to repay any outstanding obligations or liabilities owed to the Sponsor, the Manager, or their associates. Any such capital routing constitutes evergreening of loans/liabilities, which is strictly prohibited and classified as unethical.

D. Restrictions on Existing Priority Distribution Models

• AIF schemes that adopted a priority distribution model (where one class of investors absorbs disproportionate losses or receives preferential distribution over others) and issued such differential rights prior to November 18, 2024, are subject to a strict investment freeze.
• The Freeze Mandate: These schemes shall not accept any fresh capital commitments or make any new investments in any investee companies, directly or indirectly.
• Reporting: Any breach of investment limits resulting from this transitional freeze must be recorded in the fund's annual Compliance Test Report (CTR) compiled by the Investment Manager.

15.11.2 Pari-passu and Differential Rights of Investors

While AIFs are pooled vehicles, managers may offer differential rights to specific investors (often through side letters or distinct unit classes) subject to strict guiding principles.

A. Core Guiding Principles for Offering Differential Rights

Any differential right offered to a select group of investors must comply with the following four regulatory benchmarks:

1. No Inter-Investor Liability: The differential rights must not result in any investor accruing or assuming a liability to other investors within the same AIF scheme.
2. No Control Over Decision-making: Non-monetary or non-commercial differential rights must not provide control to an investor over the decision-making process of the AIF scheme, unless that investor is a designated member of the scheme's Investment Committee.
3. No Alteration of Existing Rights: The differential rights must not alter, dilute, or adversely affect the pre-existing economic or non-monetary rights of any other investors in the scheme.
4. Transparent Disclosure: All differential rights, and the specific eligibility criteria to avail of them, must be fully and transparently disclosed in the Private Placement Memorandum (PPM) of the AIF scheme.

B. Alignment with SFA Implementation Standards

• SFA Standards Compliance: AIF Managers and their Key Managerial Personnel (KMPs) must ensure that any differential rights provided to select investors are executed exclusively in accordance with the implementation standards formulated by the Standard Setting Forum for AIFs (SFA).
• Disclosures: The PPM must clearly disclose the objective eligibility criteria to avail of each differential right and the exact process through which an eligible investor can opt for it.
• Reporting of Non-SFA Rights: If a manager offers a differential right that does not fall within the SFA's pre-approved implementation standards, they must:
  1. File the details in the prescribed format with SEBI.
  2. Report the same via email to [email protected] within the specified timeline.
• Termination Clause: If any reported differential right is subsequently ascertained by SEBI or the SFA to have an adverse impact on the rights of other investors, the Investment Manager must immediately terminate those differential rights.

C. Exemptions for Large Value Funds (LVFs)

• The requirement to maintain strict pari-passu rights among investors does not apply to Large Value Funds for Accredited Investors (LVFs).
• New LVFs: For new LVFs whose PPMs are filed with SEBI after December 13, 2024, the exemption from pari-passu requirements is permitted provided the manager:
  1. Makes explicit disclosures regarding the differential rights in the PPM.
  2. Obtains a signed, mandatory undertaking from each Accredited Investor at the time of on-boarding, containing the following statutory clause:

     "The prospective investor is aware that LVFs may avail exemption from the requirement of maintaining pari-passu rights among investors and therefore, may offer differential rights to select investors which might affect interest of other investors of the LVF."

• Existing LVFs: Existing schemes can avail of this exemption only if every single investor in the scheme provides a written waiver containing the exact waiver clause. All such compliances must be disclosed by the Trustee or Sponsor in the annual Compliance Test Report (CTR) submitted to SEBI.

15.12 Inspection

To ensure regulatory compliance and protect market stability, SEBI retains the statutory power to conduct inspections of an AIF's operations.

15.12.1 Purpose and Grounds for SEBI Inspections

SEBI may appoint one or more persons as an Inspecting Authority to inspect the books of account, records, and relevant documents of an AIF for the following reasons:

• To verify whether the books, records, and statutory documents are being maintained by the AIF in the prescribed manner.
• To investigate formal complaints received from investors, clients, or any other person on matters having a direct bearing on the AIF's activities.
• To independently ascertain whether the provisions of the SEBI Act and the AIF Regulations are being complied with in spirit and letter.
• To conduct suo motu inspections in the interest of the securities market or to safeguard investor protection.

15.12.2 Notice Timelines and Co-operation Mandate

• Standard Notice Period: Under normal circumstances, SEBI must provide a 10-day notice to the AIF before ordering an inspection.
• The "No-Notice" Exception: If SEBI is satisfied that it is in the interest of the investors or the securities market, it may direct that the inspection be taken up without any prior notice. This decision must be recorded through a formal order in writing.
• Mandatory Co-operation: Sponsors, Managers, Trustees, and all officers of the AIF are legally required to co-operate fully with SEBI and the Inspecting Authority. They must produce all books, accounts, transaction logs, and relevant records upon demand.

15.12.3 Post-Inspection Directions and Enforcement Actions

After evaluating the formal Inspection Report, SEBI is empowered to issue binding directions to the AIF, including:

1. Fundraising Debarment: Requiring the AIF not to launch any new schemes or accept fresh capital commitments from investors for a specified period.
2. Asset Disposal Ban: Prohibiting the AIF or its managers from disposing of any of the assets or properties of the fund or scheme that were acquired in violation of AIF Regulations.
3. Mandatory Asset Liquidation: Requiring the concerned person to dispose of the underlying assets of the fund or scheme in a specified, compliant manner.
4. Compulsory Refund Order: Requiring the concerned person to refund the capital or assets to the affected investors, along with prescribed interest.
5. Market Debarment: Debarring or prohibiting the concerned individuals or entities from operating in or accessing the capital markets for a specified period.

15.13 Code of Conduct for AIFs

All registered Alternative Investment Funds must strictly abide by the comprehensive Code of Conduct specified in the Fourth Schedule of the SEBI (Alternative Investment Funds) Regulations, 2012. This framework establishes the fiduciary standards for funds, managers, trustees, and their key personnel.

15.13.1 General Fiduciary Obligations of the Fund

• Investment Alignment: The AIF must carry out all its business activities and asset deployments in strict accordance with the investment objectives disclosed in the PPM and other constitutional fund documents.
• Collective Interest Priority: The AIF must be operated and managed solely in the interest of all its unit holders. It must not operate to prioritize the personal interests of the Sponsor, Manager, Trustees, directors, or any select class of investors.
• Information Dissemination: The fund must ensure the dissemination of adequate, accurate, explicit, and timely information to all its unit holders in compliance with AIF Regulations and any separate covenants agreed upon with investors.
• Risk and Control Systems: The fund must implement and maintain an active risk management framework and robust internal controls.
• Conflict of Interest Mitigation: AIFs must have written, board-approved policies to actively identify, monitor, and mitigate potential conflicts of interest throughout their operations.
• Ethical Marketing: AIFs must not use any unethical, misleading, or deceptive means to market, sell, or induce any investor to subscribe to their units.
• Anti-Money Laundering (AML): AIFs must maintain active, written policies and procedures to ensure strict compliance with anti-money laundering laws and KYC guidelines.

15.13.2 Key Ethical Conduct Standards for Investment Managers

Under the Code of Conduct, Investment Managers must adhere to the following professional and ethical constraints:

• Written Record of Decisions: Managers must record every investment, divestment, and key portfolio decision in writing, accompanied by a detailed, objective justification.
• Valuation Integrity: Managers must provide comprehensive, well-considered, and completely accurate inputs to the appointed third-party valuer. They are strictly prohibited from providing misleading data to manipulate the NAV.
• Prohibition of Collusive Trades: Managers shall not enter into any transaction for the purchase or sale of securities where there is no effective change in beneficial interest, or where the transfer is executed between parties acting in concert or collusion (unless executed for a documented, bona fide, and legally valid reason).
• Investor Confidentiality: Managers must abide by all confidentiality agreements and are strictly barred from making improper use of the details of personal investments or any non-public information obtained from investors.
• No Inducements: Managers must never offer or accept any form of financial or non-financial inducement in connection with the business of managing investor funds.

15.14 Market Surveillance by AIFs

To maintain market integrity and prevent the spread of speculative rumors that distort stock prices, SEBI enforces strict guidelines regarding how AIFs and their employees handle market information.

15.14.1 Managing Unverified Information and Market Rumors

• Verification Duty: AIFs and their managers are strictly prohibited from circulating or acting upon unverified market rumors or information obtained from unauthorized sources.
• Restriction on Blogs and Chat Forums: Employee access to financial blogs, chat forums, messenger sites, and speculative online groups (irrespective of nomenclature) must either be heavily restricted under direct compliance supervision or completely disallowed.
• Usage Logs as Auditable Records: AIFs must maintain comprehensive electronic logs of any permitted usage of blogs, chat forums, or messenger sites. These logs are classified as official records and must be preserved for SEBI's inspection in accordance with AIF Regulations.
• Employee Reporting Mandate: Employees must be formally directed that any market-related news or stock tips received by them (whether on official email, personal email, personal blogs, or messaging apps) must be immediately forwarded to the fund's Compliance Officer for verification and recording.

15.15 Exemption from Enforcement in Special Cases

Recognizing the need to foster financial innovation without compromising investor protection, SEBI provides a structured framework for regulatory exemptions.

15.15.1 The Regulatory Sandbox Mechanism

• Purpose: SEBI may grant specific, time-bound exemptions from the strict enforcement of AIF Regulations to entities operating within the SEBI Regulatory Sandbox.
• Scope: This live testing environment allows sandbox participants to test innovative financial products, technological services, and business models on a limited, pre-approved set of eligible customers.
• Exemption Conditions: Any such regulatory exemptions are subject to the applicant satisfying specific conditions and maintaining compliance on a continuous, real-time basis.

15.16 Periodic Disclosures and Reporting

Transparency is a fundamental tenet of the AIF framework. All registered Category III AIFs must adhere to a rigorous, periodic disclosure mandate to ensure that both investors and SEBI can monitor risk exposures.

15.16.1 Consolidated Disclosure Mandates

The Investment Manager must provide comprehensive disclosures to all unit holders regarding the following operational and financial parameters:

• Detailed financial, risk management, operational, and transactional information regarding the fund's underlying investments.
• Periodic disclosure of the exact fee structure, including any fees charged directly to the AIF or its investee companies by associates of the Manager or Sponsor.
• Full disclosures of any ongoing or past inquiries and legal actions initiated by regulatory or legal bodies in any jurisdiction.
• Details of any material liability arising during the fund's tenure.
• Immediate notification of any breach of the provisions of the PPM, Contribution Agreement, or other constitutional fund documents.
• Disclosures regarding any change of control at the Sponsor, Manager, or investee company level, alongside any significant change in the key investment team.
• Systemic Risk Reporting: All Category III AIFs must provide detailed, structured reports to SEBI on a quarterly basis to identify and mitigate systemic risk factors.

15.17 Specific Due Diligence of Investors and Investments of AIFs

To prevent AIFs from being utilized as conduit vehicles to circumvent primary securities laws, SEBI and the Reserve Bank of India (RBI) enforce specific Due Diligence (DD) check protocols. These checks are mandatory for both existing assets and proposed investments, and are conducted in accordance with SFA implementation standards.

15.17.1 Qualified Institutional Buyer (QIB) & Qualified Buyer (QB) Circumvention Checks

Under SEBI ICDR and SARFAESI Act regulations, certain investment relaxations and benefits are granted to designated QIBs and QBs. To prevent ineligible retail or non-institutional investors from indirectly obtaining these benefits through an AIF, the following checks are mandatory:

The 50% Group Corpus Rule

• This rule is triggered for any AIF scheme where a single investor, or investors belonging to the same group, contribute more than 50 percent of the total corpus of the scheme.
• Mandatory SFA Checks: Before the scheme can make investments in Security Receipts (SRs) issued by an Asset Reconstruction Company (ARC), avail of SARFAESI QB benefits, or subscribe to QIB-allocated issues, the manager must conduct rigorous due diligence aligned with SFA standards.
• Exclusion Mandate: If the proposed investment does not satisfy the SFA's strict due diligence parameters, the Investment Manager shall either not make the investment, or must completely exclude the non-compliant investor/investor group from the transaction, accompanied by detailed disclosures in the PPM.

15.17.2 Prevention of Evergreening of Stressed Loans (RBI-Regulated Lenders)

To prevent commercial banks and Non-Banking Financial Companies (NBFCs) from utilizing AIFs to evergreen their stressed loan portfolios (avoiding mandatory provisioning and asset classification downgrades), the following strict due diligence rules apply:

• Trigger for Mandatory DD: SFA-aligned due diligence is compulsory prior to making any investment if:
  1. The Manager or Sponsor of the AIF is regulated by the RBI.
  2. The AIF's investors include RBI-regulated lenders who, individually or along with their group, contribute more than 25 percent of the total scheme corpus.
  3. RBI-regulated lenders hold veto or majority voting power in the Investment Management Committee setup by the AIF scheme.
• Evergreening Prohibition: If a proposed investment fails these due diligence checks, the AIF must not execute the transaction. Under no circumstances can AIF capital be deployed to acquire securities of an investee company that intends to use the funds to repay outstanding loans or obligations to the RBI-regulated lender.

15.17.3 Foreign Investment Controls (Land Border Sharing Countries)

Under Rule 6(a) of the FEMA Non-Debt Instruments (NDI) Rules, 2019, any entity or beneficial owner from a country sharing a land border with India is strictly prohibited from investing in Indian securities without prior, explicit Government approval.

• Trigger for SFA Due Diligence: The Investment Manager must execute rigorous, SFA-standard due diligence if:
  1. 50 percent or more of the corpus of the AIF scheme is contributed by investors who are citizens of, or situated in, a country sharing a land border with India.
  2. 50 percent or more of the corpus is contributed by investors whose underlying beneficial owners are citizens or residents of such border-sharing nations.
• The 30-Day Custodial Reporting Rule: Upon reviewing existing portfolio investments, if the manager discovers any asset or investor that violates these land-border compliance parameters, they must report the complete details of such investments to the Custodian of the AIF within 30 days of such discovery.

15.18 Summary Table of Timelines and Thresholds in Part 4

15.19 Key Exam-Relevant Terms and Definitions

• Pari-passu Rights: A regulatory standard requiring that all units within a particular class of an AIF scheme share identical economic and non-monetary rights, without any investor receiving preferential treatment that prejudices other unit holders.
• Evergreening of Loans: An unethical and prohibited practice where fresh capital (often routed through a junior tranche of an AIF) is deployed to a distressed investee company solely to enable them to pay off their existing debt obligations to the fund's sponsor, manager, or allied lenders.
• Inspecting Authority: A designated officer or team appointed by SEBI to formally investigate, review, and audit an AIF's books, files, and compliance records, either under a 10-day notice or on an unannounced suo motu basis.
• Standard Setting Forum for AIFs (SFA): An industry-led regulatory forum that, in consultation with SEBI, formulates standardized implementation and due diligence guidelines to streamline compliance across the AIF ecosystem.
• Qualified Institutional Buyer (QIB): A category of sophisticated, institutional market participants (e.g., mutual funds, insurance companies, AIFs) recognized under SEBI ICDR Regulations as having the financial capacity to participate in specialized primary issuances.

15.20 Key Takeaways for Alternative Investment Managers

• Pari-passu Exceptions must be SFA-vetted: Managers cannot draft arbitrary side letters or offer custom liquidity windows to large institutional investors. Any differential right must strictly align with the SFA standards, and any non-standard right must be proactively reported to SEBI and terminated if flagged.
• Audit Trail for Market Rumors is Compulsory: Category III managers must ensure that their trading desks do not act on WhatsApp or Telegram rumors. Compulsory compliance logs for any permitted blog or chat platform usage must be maintained as auditable records, as SEBI inspectors can demand these logs without prior notice.
• Due Diligence is Continuous, Not Point-in-Time: Managers must actively monitor their investor register. If secondary unit transfers or changes in ultimate beneficial ownership (UBO) push a land-border country investor group above 50% of the corpus, SFA-level due diligence must be triggered immediately, and any compliance failure must be reported to the custodian within 30 days.
• Evergreening Debarment has Personal Liability: If an AIF's junior tranche is used to evergreen stressed assets, both the KMPs and the Manager face serious SEBI enforcement actions, including capital market debarment, asset freezes, and personal debarment from fund-raising.