On October 8, 2024, the Securities and Exchange Board of India (SEBI) introduced new compliance guidelines for Alternative Investment Funds (AIFs). These updated rules are designed to improve transparency, prevent any misuse of regulations, and ensure that AIFs and their investors strictly adhere to the established legal requirements.

The new regulations are effective immediately and place a stronger emphasis on conducting detailed due diligence on AIFs, their managers, and investors to ensure that all operations are in line with the law and to protect the interests of all parties involved.

Purpose of the Circular

The primary goal of the circular is to enforce due diligence in the AIF industry, ensuring that all parties involved comply with various legal regulations. These include:

• ICDR Regulations (Issue of Capital and Disclosure Requirements): The ICDR Regulations play a crucial role in overseeing the issuance of securities by AIFs and ensuring that the disclosure requirements are met. These rules are designed to promote transparency and fairness in the market by making sure that AIFs provide accurate and comprehensive information about their securities to investors and the public. The goal is to protect investors from misleading or insufficient information that could impact their investment decisions
• SARFAESI Act (Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act): This act provides a legal framework for the enforcement of security interests and addresses the issue of recovery of loans. Under the SARFAESI Act, AIFs can engage in transactions such as subscribing to Security Receipts (SRs) issued by Asset Reconstruction Companies (ARCs). However, SEBI’s circular requires due diligence when AIFs engage in such transactions to ensure that only eligible investors, such as Qualified Buyers (QBs), are able to benefit from these provisions.
• RBI Norms (Reserve Bank of India Regulations): The RBI regulates financial institutions and the banking sector in India. SEBI’s new compliance guidelines emphasize the importance of AIFs adhering to these RBI norms to ensure that their operations do not conflict with the rules governing financial institutions, particularly when RBI-regulated entities are involved. AIFs are required to carry out due diligence to ensure that they are not facilitating actions like “ever-greening” of stressed loans, which could violate RBI’s regulations.
• NDI Rules (Foreign Exchange Management Act – Non-Debt Instruments Rules): The NDI Rules are designed to regulate foreign investments, particularly those from countries sharing land borders with India. Under these rules, investments from such countries must receive approval from the government of India before they can be accepted. The SEBI circular mandates that AIFs conduct thorough due diligence if more than 50% of the corpus of a scheme is contributed by investors from these countries. This is to prevent any undue influence from foreign investments that may pose security risks or conflict with national interests. SEBI aims to ensure that these investments are in line with India’s foreign investment policies, thus maintaining both economic and national security.

Key Due Diligence Requirements

SEBI’s new compliance guidelines for Alternative Investment Funds (AIFs) introduce several key due diligence requirements to ensure transparency, accountability, and regulatory compliance.

1. Due Diligence for Qualified Institutional Buyers (QIBs): AIFs are recognized as Qualified Institutional Buyers (QIBs) under SEBI regulations, which provide certain benefits. However, if 50% or more of an AIF’s corpus is contributed by a small number of investors, SEBI mandates that due diligence must be conducted to ensure that these investors meet the eligibility criteria for QIBs.
2. Due Diligence for Qualified Buyers (QBs) under SARFAESI Act: Under the SARFAESI Act, AIFs have the ability to subscribe to Security Receipts (SRs) issued by Asset Reconstruction Companies (ARCs). If 50% or more of an AIF’s corpus is contributed by investors seeking to avail of QB benefits, the AIF is required to perform due diligence on those investors. This is necessary to ensure that only eligible investors can take advantage of the benefits under the SARFAESI Act before any investment is made.
3. Preventing Ever-greening of Stressed Loans: SEBI is focused on preventing the use of AIFs for “ever-greening” of stressed loans by RBI-regulated lenders. If an AIF involves an RBI-regulated entity or has investors regulated by RBI contributing 25% or more of the corpus, due diligence is required to ensure compliance with RBI regulations. “The term “ever-greening” of stressed loans refers to the practice where lenders, including those regulated by the Reserve Bank of India (RBI), extend additional loans or restructure existing loans to borrowers who are already struggling to repay their current debts. This is done to avoid classifying the loan as a non-performing asset (NPA) or a bad loan.”
4. Investments from Countries Sharing Land Borders with India: AIFs must be especially cautious when accepting investments from countries that share land borders with India. As per the Foreign Exchange Management Act (FEMA), investments from these countries require government approval. If investors from such countries contribute 50% or more of an AIF’s corpus, detailed due diligence must be conducted. Additionally, if the AIF holds 10% or more of the equity or equity-linked securities of an investee company, the AIF must report this investment to the custodian within 30 days. This ensures that the investments comply with national security and foreign investment regulations.
5. Action on Existing Investments: AIFs must conduct due diligence on existing investments in their schemes. Any investments that do not meet the required standards must be excluded or restricted. AIFs must inform their custodian about these changes by April 7, 2025.
6. Role of Custodians: Custodians are tasked with submitting comprehensive reports to SEBI regarding the AIFs’ due diligence practices, especially in relation to existing investments and investments from land-border countries. These reports must be submitted to SEBI by May 7, 2025, providing SEBI with an overview of how AIFs are adhering to the regulatory framework and maintaining compliance with the new guidelines.
7. Compliance and Reporting: The trustee or sponsor of an AIF must ensure that the “Compliance Test Report” confirms adherence to the new provisions. This report will be part of the SEBI Master Circular. This report will serve as an official confirmation that the AIF has followed the necessary due diligence procedures and is in compliance with SEBI regulations.
8. Implementation Standards: SEBI has tasked the Standard Setting Forum for AIFs (SFA) to develop specific standards for implementing due diligence measures. These standards will be published by industry associations, such as the Indian Venture and Alternate Capital Association (IVCA), and other relevant bodies. AIFs, along with their managers and key personnel, will be expected to adopt these standards in their operations. By adhering to these implementation standards, AIFs can ensure that they are meeting SEBI’s due diligence requirements and maintaining transparency and accountability in their investment processes.

Conclusion

The new guidelines by SEBI aim to enhance the transparency and integrity of the AIF industry. By enforcing strict due diligence and reporting requirements, SEBI is ensuring that AIFs follow legal frameworks and protect investor interests. AIFs and custodians must ensure full compliance with these guidelines to avoid penalties and maintain a transparent investment process. Failure to comply could lead to severe consequences, making it crucial for AIFs and their managers to act swiftly to meet these new standards.

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CS Isha Deshwal