Monday, October 15, 2012

AIF Regulations: Meaning of Ownership Interests and Investor Interests in a Company – Part I

[The following is the first in a series of posts contributed by Vinod Kothari and Soma Bagaria. The authors can be reached at and respectively]

1.          BACKGROUND

There has been a speculation and confusion regarding the extent of applicability of the SEBI (Alternative Investment Fund) Regulations, 2012 (“AIF Regulations”), particularly in the case of alternative investment funds (“AIFs”) set up as companies. It is notable that the AIF Regulations permit an AIF to be organised either as a company, a limited liability partnership (“LLP”), or a trust. In case of the SEBI (Venture Capital Funds) Regulations, 1996, the options of organising a fund as a company, trust or a body corporate were available. However, most venture capital funds were actually orgnaised as trusts.

The difficulty arises from a reading of the definition of an AIF, and is further compounded by the definition of “units”. Regulation 2(1)(b) of the AIF Regulations defines the term an AIF to mean, subject to the exceptions set out therein, any fund established or incorporated in India in the form of a trust or a company or an LLP or a body corporate which:

(a)        is a privately pooled investment vehicle which collects funds from investors, whether Indian or foreign, for investing it in accordance with a defined investment policy for the benefit of its investors; and

(b)        is not covered under the Securities and Exchange Board of India (Mutual Funds) Regulations, 1996, Securities and Exchange Board of India (Collective Investment Schemes) Regulations, 1999 or any other regulations of the Board to regulate fund management activities.

The AIF Regulations do not define the word “investor”. However, the definition of the term “unit” includes shares, and therefore, every shareholder becomes a unitholder, and by extension, an investor. If, therefore, every shareholder of a company is taken to be an investor, then every company, other than a listed public company, irrespective of what business the company carries on, is a privately pooled vehicle which collects money from its sareholders to be used in a particular manner. The question that, therefore, arises, and in relation to which no clarification has been issued by SEBI, is whether all privately pooled capital, such as contribution of ownership capital to a company, would fall within the purview of the AIF Regulations.

If any application of funds by a company is taken to be covered by the expression “investing it in accordance with a defined investment policy”, then every company becomes an AIF. And if the expression “investing it in accordance with a defined investment policy” is taken to mean investments as commonly understood, then every investment company becomes an AIF. There are thousands of investment companies registered with the Reserve Bank of India (“RBI”) and yet other  thousands which are not registered. Obviously, the idea of AIF Regulations could not have been to bring all such investment companies, currently under RBI’s non banking finance company regime, also under AIF Regulations. If the idea of the AIF Regulations was to include only such funds as companies gather and manage other than shareholders’ money, then that meaning is not at all clear from the extant definition of either AIF or units.

2.          WHAT IS REGULATED?

SEBI intends to regulate a pooling vehicle which essentially pools capital from various investors and investing such capital in accordance with defined investment policy. The idea is to ensure benefit to the investors.

Who are investors? The Black’s Law Dictionary (9th Edition) defines an investor as a buyer of a security or other property who seeks to profit from it without exhausting the principal, i.e. a person who spends money with an expectation of earning profit. Under common parlance, investors are outsiders who are neither the owners of the pooling vehicle, nor are they the managers. Therefore, it makes good sense to have excluded owners and managers.

2.1       Meaning of investment

The Blacks’ Law Dictionary (9th Edition) defines investment to mean expenditure to acquire property or assets to produce revenue, a capital outlay. Furthermore, P Ramanatha Aiyar’s, The Law Lexicon, (3rd edition) has also similarly defined the term investment to signify the laying out of money in such a manner that it may produce a revenue, whether the particular method be a loan or the purchase of stocks, securities, or other property.[1]

The term investment is defined in the Accounting Standard AS 13 as assets held by an enterprise for earning income by way of dividends, interest and rentals, for capital appreciation, or for other benefits to the investing enterprise and assets held as stock-in-trade are not investments.

It is true that behind every outlay of capital the ultimate purpose is to earning revenue. However, there is a difference in the intentions and purposes while outlaying capital (a) by way of an ownership capital and (b) solely with the purpose of earning profit.

To our understanding where two or more persons come together with a common objective and work together to pursue that common objective, it cannot be said to constitute an AIF. There is an element of control is present in an ownership interest.

2.2       Key determinants of an AIF

The key deciding factors, as set out in the definition, are:

(a)        a privately pooled investment vehicle;

(b)        collection of funds from investors;

(c)        investment made in accordance with a well defined investment policy; and

(d)        investments are made for the benefit of the investors.

Therefore, funds are collected from investors on a private placement basis which are invested in accordance with an investment policy is drawn with an idea to earn returns in form of dividends, etc., for the benefit of the investors.

In an ownership capital scenario, the primary benefit is attributable to the entity (the company or a LLP, for instance) and the purpose is the growth of such entity. Furthermore, unlike an AIF, there are no third party funds involved.

(to be continued)

- Vinod Kothari & Soma Bagaria

[1] In case of Surat Peoples’ Co-Operative Bank v. CIT, 1958 33 ITR 396 Bom, it was stated that the word “investment” in itself literally means nothing more or less than to lay out money; and, therefore, where a person purchase securities whether as his stock-in-trade or by way of capital investment, he is in either case investing in securities.


Anonymous said...

With due respect to SEBI, as usual this is a half-backed regulation, drafted without applying any mind.

The SEBI (CIS) Regulations, are actually good enough to bring within its purview, what is intended to be achieved through AIF regulations.

But it seems, for SEBI, CIS regulations is only restricted to plantation companies or at the most art fund and nothing beyong, which actually is incorrect.

Anyways, we are where we are.

Anonymous said...

brilliant writing like always mr. kothari. esp the point on how by sebi's logic every co will be a fund!