[The following post is contributed by Nidhi Ladha, who is a Junior Partner at Vinod Kothari & Co. She can be reached at firstname.lastname@example.org]
SEBI (Alternative Investment Funds) Regulations, 2012 (“AIF Regulations”) were notified by SEBI on May 21, 2012 which thereby replaced the SEBI (Venture Capital Funds) Regulations, 1996. After notification of AIF Regulations, SEBI has granted in principle approval to some 47 AIFs including 10 category III AIFs. However the existing AIF Regulations (like Regulations 18 and 28) have given power to SEBI to issue further operational and reporting guidelines in due course. So after a period of 14 months, SEBI has come up with additional guidelines on operational and prudential norms for category III AIF and reporting norms for all categories of AIF vide its circular CIR/IMD/DF/10/2013 dated July 29, 2013 (“AIF Circular”).
Risk Management and Leverage conditions for Category III AIFs
Category III consists of those funds that employ leverage – that is, apart from investors’ unit capital, these funds may borrow other than for temporary liquidity purposes and may employ leverage including through investment in listed or unlisted derivatives. Accordingly, such hedge funds, real estate funds, funds of funds or such other funds which trade with a view to make short term returns or such other funds which are open ended and for which no specific incentives or concessions are given by the government or any other regulator are to be included in this category. As only a category III AIF is allowed to employ leverage, SEBI is more stringent for such category of AIF and has issued certain norms governing the leverage by the category III AIF. Following are some highlights of the AIF circular in this aspect:
- AIFs to have a comprehensive risk management framework supported by an independent risk management function, appropriate to the size, complexity and risk profile of the fund;
- AIFs to maintain appropriate records of the trades/transactions performed; and
- AIFs to provide full disclosure and transparency about conflicts of interest and policy to manage them. Such conflicts shall be disclosed to the investors in the placement memorandum and by separate correspondences as and when such conflicts may arise.
With regard to leverage, SEBI has directed all Category III AIFs to calculate the leverage as the ratio of the exposure to the Net Asset Value of the AIF and the AIF is to ensure that the leverage shall not exceed 2 times of the NAV of the AIF at all times. In addition, SEBI has also provided the pointers to calculate the NAV of the AIF.
As category III AIFs are more exposed to risks and are allowed to borrow outside funds, stringent conditions for risk mitigation and control should be in place and that is what SEBI has done. By limiting the amount of leverage and putting certain rigorous disclosure requirements on breach of leverage, SEBI has tried to provide a regulatory control over category III AIFs. However, a notable point is that SEBI while granting registration to all 10 AIFs in this category have taken undertakings/affidavits etc and has approved the application subject to these leverage and risk management conditions only. So the only effect of the AIF Circular, so far as it provides additional norms for category III AIF, is that instead of asking for compliances of such conditions applications wise, SEBI has now issued a complete code in form a circular to be adhered by all category III AIFs.
Implications when there is a breach of leverage limits
- AIFs to send a report to the custodian as soon as there is a breach of limits;
- AIFs to send a report to all its clients before 10 a.m. on the next working day stating the reason for breach;
- In addition to actions which SEBI may take, AIFs to bring back the leverage within limit by end of next working day. A confirmation in this regard is to be sent to all the clients by the AIF by end of the day on which the exposure was squared off;
- Custodian to report to SEBI providing name of the fund, the extent of breach and reasons for the same before 10 a.m. on the next working day; and
- Confirmation of squaring off of the excess exposure shall be sent to SEBI by the custodian by end of the day on which the exposure was squared off.
Strict disclosure and reporting requirements for breach of leverage limits have been imposed. However, will it be possible for an AIF to adhere to such strict reporting and compliance requirements to be met within a day? Such requirement of SEBI is a ‘wait and watch’ condition and non-compliances or difficulties in compliances can be known only after practical experience by the AIFs. It is pertinent to note that not only the AIF but also their custodian has been made liable for making appropriate disclosure when there is a breach of leverage limits. Non-compliance with these requirements would not only attract the penal provisions of AIF Regulations but also the provisions of SEBI Act.
Redemption and suspension norms for open ended schemes of category III AIF
The redemption norms as laid down by the AIF Circular are applicable to existing as well as to all new schemes of AIFs. The managers of such AIF have been entrusted with greater responsibility of ensuring adequate and sufficient liquidity and management policies for redemption of any open-ended scheme of the AIF. The redemption can be suspended if so thought appropriate by the manager in the best interest of the investors of the AIF or if so required under the AIF Regulations. The reasons of and planned actions after the suspension are to be intimated to SEBI as well as to the investors. Further, the manager of an AIF whose scheme is suspended is to take all necessary steps in order to resume normal operations as soon as possible having regard to the best interest of investors and such decision of resuming operation of the scheme is to be intimated to SEBI and investors as soon as possible.
Reporting requirements for all categories of AIFs
AIF Regulations were silent on any reporting requirements and power was given to SEBI to issue guidelines in this respect. Accordingly, category I, category II and category III AIFs (which do not undertake leverage) are required to submit a quarterly return (as per the specified format) and category III AIFs employing leverage are to submit the return on monthly basis within 7 calendar days from the end of the quarter/month (however, returns of the quarter ending on June 30, 2013 are to be submitted within 30 days from the date of AIF Circular). Reporting is to be done online however, till such online system is made available, reports are to be sent by email to email@example.com. Further, as a green initiative, SEBI has advised AIFs not to file physical reports.
As per the given formats of reporting, apart from the general information, category I, II and III AIFs (not employing leverage) are required to give cumulative details of funds raised and invested by all schemes under the AIF, details of investments made during the relevant quarter, break up of investments made in associate companies, details of categories of investors, industry sector wise investments details.
Apart from the details as mentioned in the preceding para, category III AIFs employing leverage are additionally required to disclose the details of scheme wise leverage undertaken and details of leverage reported to custodian on daily basis in its monthly return.
After several scams like the recent one in West Bengal by Saradha Group who collected thousands of crores of money from investors illegally in front of all regulators, there comes a law covering the loophole of extant laws. However, there is a need for regulators to keep a watch on money collectors from the very beginning and not when they default. Obviously, so much money is neither raised overnight, nor silently, as there is a massive machinery of agents who do it from the very bottom of the population pyramid. Even though the Saradha Group was regularly submitting its balance sheet with the Registrar of Companies, its huge money collection could only be traced when several investors had already burnt their fingers. In other words, there are several banning/preventing laws prevailing in India and requiring several disclosures and compliances by such companies from time to time; however, the media is replete with several investment scams and similar stories. Likewise, in the case of category III AIFs which have been allowed to employ leverage and borrow from public, the effectiveness of disclosure, operational and prudential requirements of SEBI introduced by the AIF Circular remains to be seen in times to come.
 As on April 22, 2013
 Text of the Circular is available at http://www.sebi.gov.in/cms/sebi_data/attachdocs/1375094611151.pdf