Plug loopholes in alternative investment funds regulations: RBI to Sebi

Illustration by Ajay Mohanty
The Reserve Bank of India (RBI) wrote to the Securities and Exchange Board of India (Sebi) to plug loopholes in alternative investment funds (AIFs) regulations that are being exploited by the funds to give corporate loans.


According to sources, the banking regulator is concerned about the risks posed by such practices and fears the route could also be used for money laundering.


It is worthwhile to note that all the lending businesses in India are regulated by the RBI.


The issue came to light during the market regulator’s investigation against Srei Alternatives, a category-II AIF.


In 2015, the fund had given out loans to seven entities, including Essar Steel, Essar Shipping and Loop Telecom. Sebi’s adjudication investigated four violations at Srei Alternatives.


The regulator had not imposed any penalty on Srei AIF for issuing loans as there was a regulatory loophole.


“The current verbatim of the AIF regulations leaves the areas such as loans open to interpretation. The issue of AIFs giving corporate loans, however, was a serious regulatory gap. It potentially provided a regulatory arbitrage,” said a source, adding the RBI prompted Sebi to consider reviewing framework.


According to 2(1)(i) of Sebi AIF regulations, a debt AIF could invest “primarily in debt or debt securities of listed or unlisted investee companies  according to the stated objectives of the fund”.


This means a debt AIF could invest in any type of debt as long as the same is mentioned in their offer document. This provision is in direct conflict with question number seven of Sebi’s frequently asked questions on AIFs, which says an AIF could not dole out loans.


Sebi could not impose any penalty on Srei for giving out loans as the fund had mentioned the same in its offer document. However, Sebi found Srei guilty on the other three charges and imposed a penalty of Rs 3 million.


Legal experts say the lenient language of the current AIF rules could be prone to misuse as the funds can structure any investment to be a debt security and invest in it.


“AIFs can invest in any debt instruments as long as the mode of investment is specified in their offer document. For instance, a fund could even buy a land if it is structured in form of a security. As far as Sebi’s order against Srei is concerned they can always review it if there are any obvious errors,” said Sandeep Parekh, founder, Finsec Law Advisors.


AIFs enjoy the most lenient regulatory regime compared to mutual funds (MFs) or any other pooling vehicles. The rules has been deliberately kept lighter as only sophisticated investors, who are aware of the risks, are allowed to invest through these funds. The minimum ticket size to participate in an AIF is Rs 10 million compared with Rs 1 million for portfolio management services.


AIFs are pooled funds just like MFs, but are allowed to invest even in the unlisted space. There are three categories of AIFs according to Sebi rules. Category-I are investors that fund socially important sectors such as infrastructure and small and medium enterprises. Category-II comprises private equity and venture capital funds who invest in equity and debt instruments in the unlisted space. Category-III AIFs are hedge funds who invest only in listed securities, including equity and commodities.

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