Introduction
Banks are increasingly investing into start-up, early-stage ventures, social ventures, small-medium enterprises, infrastructure or other sectors or areas which the government or regulators consider as socially or economically desirable through a Category-I Alternative Investment Fund (“AIF”) which includes venture capital funds, small-medium enterprises funds, social venture funds, infrastructure funds, and such other AIFs. Banks can also invest in private equity funds or debt funds for which no specific incentives or concessions are given by the government or any other regulator through Category-II AIFs which do not undertake leverage or borrowing other than to meet day-to-day operational requirements and as permitted in the Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012 (“AIF Regulations”).[1] Category I and Category II AIFs are required to be close-ended and have a minimum tenure of three years.[2]
It may be noted that usually banks do not make any investment in a Category- III AIFs which represents hedge funds or funds that 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.[3] Investment by a bank’s subsidiary in a Category- III AIFs is restricted to the regulatory minima prescribed by SEBI, as per the Master Direction- Reserve Bank of India (Financial Services provided by Banks) Directions, 2016.[4] Category III AIFs may be open or close-ended.[5]
This article aims to highlight the processes to be undertaken by the banks for the purposes of incorporating and investing into an Alternative Investment Fund. Through the course of this article, insight has been placed on methods to be followed by banks and/or their subsidiaries along with the various approvals required from the regulatory authorities incorporate and invest into an Alternative Investment Fund in India.
Applicable Law:
Regulatory frameworks governing the investment and incorporation of AIFs by banks in India are as follows:
B. Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012 (“AIF Regulations”);
C. Master Direction- Reserve Bank of India (Financial Services provided by Banks) Directions, 2016 (Updated as on September 25, 2017) bearing reference number RBI/DBR/2015-16/25 Master Direction/DBR.FSD.No.101/24.01.041/2015-16 dated May 26, 2017 (“FS Master Direction”);
D. Securities and Exchange Board of India (Merchant Bankers) Regulations,1992 (“Merchant Banking Regulations”); and
E. Master Circular – Para-banking Activities bearing reference number RBI/2015-16/30 DBR.No.FSD.BC.19/24.01.001/2015-16 dated July 1, 2015 (“Para-banking Circular”).
Setting up of AIF and investing into AIF
Banking Regulation Act (“Act”):
Section 6 of the Act permits banks to engage in certain forms of business. Within the realm of the defined business we can include the incorporation or investment into an AIF as provided below in the relevant paragraphs.
“(a) the borrowing, raising, or taking up of money; the lending or advancing of money either upon or without security; the drawing, making, accepting, discounting, buying, selling, collecting and dealing in bills of exchange, hundies, promissory notes, coupons, drafts, bills of lading, railway receipts, warrants, debentures, certificates, scrips and other instruments and securities whether transferable or negotiable or not; the granting and issuing of letters of credit, traveller’s cheques and circular notes; the buying, selling and dealing in bullion and specie; the buying and selling of foreign exchange including foreign bank notes; the acquiring, holding, issuing on commission, underwriting and dealing in stock, funds, shares, debentures, debenture stock, bonds, obligations, securities and investments of all kinds; the purchasing and selling of bonds, scrips or other forms of securities on behalf of constituents or others, the negotiating of loans and advances; the receiving of all kinds of bonds, scrips or valuables on deposit or for safe custody or otherwise; the providing of safe deposit vaults; the collecting and transmitting of money and securities;
(h) undertaking and executing trusts;
(i) undertaking the administration of estates as executor, trustee or otherwise;
(n) doing all such other things as are incidental or conducive to the promotion or advancement of the business of the company……..” (Emphasis supplied)
Further, Section 19 of the Act provides for the incorporation of the subsidiary company to undertake any of the business which is comprised in section 6(1) of the Act:
“A banking company shall not form any subsidiary company except a subsidiary company formed for one or more of the following purposes, namely: – (a) the undertaking of any business which, under clauses (a) to (o) of subsection (1) of section 6, is permissible for a banking company to undertake, or…”(Emphasis supplied)
Therefore it can be inferred that the Act does not prevent banks to set up and invest into an AIF provided they have the necessary RBI approvals as mentioned below.
RBI Directions and Circulars:
From our perusal of the FS Master Directions and the Para-banking Circular we note that banks who are desirous of undertaking the businesses permitted under Section 6(1) of the Act, may, at its option, do so either departmentally or through a separate subsidiary set up for the purpose under the provisions of Section 19(1) of the Act.
Incorporation of an AIF
As per Chapter II, Paragraph 4(b)(v) of the FS Master Directions, no bank is permitted to engage in any financial activity other than that which is stated in Chapter III without prior RBI approval. As per Chapter III, Paragraph 16 of the FS Master Directions, no banks shall undertake the business of Investment Advisory Services (“IAS”) except through a separate subsidiary set up for the purpose (a new subsidiary) or one of its existing subsidiaries, subject to the following conditions: (i) specific prior approval shall be obtained before offering IAS; and (ii) IAS shall be provided only for products and services in which banks are permitted to deal in as per the Act.
As per Paragraph D(2) of the Para-banking Circular banks may form subsidiary under the provisions of Section 19(1) of the Act, for (i) undertaking of any business which is permissible under clauses (a) to (o) of sub-section (1) of Section 6 of the Act; (ii) carrying on the business of banking exclusively outside India; and (iii) for such other business purposes which Reserve Bank of India may, with prior approval of the Central Government, consider to be conducive to the spread of banking in India or to be otherwise useful or necessary in public interest. Prior approval of RBI should be taken by banks for the purpose of setting up of a subsidiary company.
We, therefore, infer that to carry on IAS with respect to the AIF, banks will be required to set up a subsidiary and cannot set up the investment advisory/investment manager role in respect of the AIF departmentally.
Hence, banks have been provided with two alternatives by the FS Master Directions to carry on with the incorporation of the AIF by (a) setting up a new subsidiary; or (b) using an already existing subsidiary.
Method A: In the event, banks are setting up a new subsidiary, as per Para-banking Circular under Paragraph D(2), banks may form subsidiary companies for undertaking any business which is permissible under clauses (a) to (o) of sub-section (1) of Section 6 of the Act with prior approval of the RBI.
Method B: Any already existing subsidiary of bank is not allowed to undertake any new business, or set up any new subsidiary as per Chapter II Paragraph 7(c) of the FS Master Directions without prior approval of the RBI.
Investment into an AIF
As per Chapter II paragraph 5(b)(iii) of the FS Master Directions there is a restriction placed on banks to make an investment of more than 10% of the paid-up capital/unit capital in a Category I/Category II AIF without prior RBI approval.
The applicability of the FS Master Directions does not extend to the subsidiaries of banks; however, the interpretation of the FS Master Directions and the intent of RBI we can infer that what the banks cannot do directly cannot be done indirectly through their subsidiaries. Additionally, as per Chapter II, Paragraph 7 of the FS Master Directions, transactions between a bank and its subsidiary must be kept at arm’s length. Therefore, in the event banks directly or through its subsidiaries invests more than 10% of the paid-up capital/unit capital in a Category I/Category II AIF, we infer that they will be required to receive approval from the RBI for the same.
It is worthwhile to highlight that as per the Para-Banking Circular Paragraph D (3.1)(a) there is a cap on “equity investments that the bank can make into a subsidiary company which shall not exceed 10 per cent of the bank’s paid-up share capital and reserves and the total investments made in all subsidiaries and other entities that are engaged in financial services activities together with equity investments in entities engaged in non-financial services activities should not exceed 20 per cent of the bank’s paid-up share capital and reserves………”.
Therefore, the investment advisory/management entity which banks would generally set up can only receive investment from banks which is within the aforesaid cap.
Additionally, the subsidiary cannot be allowed to engage in any business independently without the direction of banks. As per Chapter II paragraph 7 of the FS Master Directions banks are given the right to review the working of subsidiaries and inspect/audit the books of accounts of the subsidiaries at periodic intervals. Transactions between a bank and its subsidiary shall be at arm’s length. No preferential treatment shall be given to the subsidiary vis-à-vis a counterparty with similar risk characteristics.
Chapter III and III-A of the AIF Regulations provide for certain general investment conditions applicable to all AIFs as well as specific investment conditions applicable to the specific category/sub-category.
AIF Regulations
It may be noted that an application for the registration of an AIF needs to be submitted by virtue of Regulation 3(5) along with Form A of the AIF regulations which states that an AIF can be set up by a sponsor who is (i) an individual; (ii) a company; (iii) limited liability partnership; or (iv) a body corporate.[6]
Hence, to carry on IAS with respect to the AIF, banks will be required to set up a subsidiary and cannot set up the investment advisory/investment manager role in respect of the AIF departmentally. Further, the subsidiary will most likely fall under the category of being either a body corporate as per the definition under section 2(11) of the Companies Act, 2013 or a company as per the definition under section 2(20) of the Companies Act, 2013. Section 2(11) of the Companies Act, 2013 defines body corporate as an inclusive definition, and it is defined to include a company incorporated outside India, but does not include— (i) a co-operative society registered under any law relating to co-operative societies; and (ii) any other body corporate (not being a company as defined in the present act) which the Central Government may, by notification, specify in this behalf. A company means a company incorporated under the present companies act or any previous company law.
Moreover, as per the AIF Regulations a sponsor means any person or persons who set up the Alternative Investment Fund and includes promoter in case of a company and designated partner in case of a limited liability partnership.[7] Further, the sponsor must be a fit and proper person based on the criteria specified in Schedule II of the Securities and Exchange Board of India (Intermediaries) Regulations, 2008 and must have the necessary infrastructure and manpower to effectively discharge its activities.
Sponsoring and Investment into AIF by banks:
Banks are allowed to sponsor an AIF but the investment advisory/management entity would have to be a subsidiary of banks. There is no restriction on banks investing and holding 100% of the paid-up capital/unit capital in a Category I/Category II AIF provided they have received RBI approval for the same.
As we have explained in Paragraph 3 that banks are allowed to make an investment upto 10% of the paid-up capital/unit capital in a Category I/Category II AIF without prior RBI approval. However, if banks go through the subsidiary an investment can be made above 10% of the paid-up capital/unit capital in a Category I/Category II AIF with an approval from the RBI for the same.
The banks may mention that they wish to set up the trust by itself or through the investment manager and contribute monies from time to time, when approaching the RBI for approval to set up an investment manager/advisor subsidiary. While banks could seek approval to contribute more than 10% of the capital, in our view, the RBI would not give a blanket approval and would rather review each scheme and permit the investment limits. It is recommended that the trust set up should also be undertaken by the subsidiary.
Registration Procedure
The following procedure needs to be followed as per the AIF Regulations: [8]
A. The applicant (which is the entity seeking the registration certificate as an AIF) should submit its application to SEBI along with a duly filled Form A and all the necessary documents and once the application is received at SEBI, the applicant will be sent a reply, of acceptance or rejection, within twenty-one (21) working days.
B. A covering letter is to be sent to SEBI by the applicant clearly outlining the following:
a. If it is already registered with the SEBI as a Venture Capital Fund.
b. If the applicant has been undertaking the activities of an AIF prior to such application.
c. If the applicant is applying for a new AIF registration:
C. As an integral part of the registration process, the applicant must submit the duly filled form A along with appropriate application fees in form of a bank draft as per Schedule II of the AIF Regulations, drawn in the name of “The Securities and Exchange Board of India”. The draft must be payable at Mumbai. Once satisfied with the application, SEBI will grant the registration certificate against the charge of registration fees.
Sponsor and Investment Manager of AIF:
Entity through which an AIF will be incorporate is termed as a sponsor as per the AIF Regulations. [9]Further, the definition of manager as provided under the regulation 2(1)(q) of the AIF Regulations states that a manager is any person or entity who is appointed by an AIF to manage its investments by whatever name called and may also be same as the sponsor of the AIF. Therefore, subsidiary setting up the alternative investment fund can act as both the sponsor and an investment manager for the AIF.
However, it may be noted that there must be one person in the key investment team who has 5 (five) years of relevant experience in advising or managing pools of capital or in fund or asset or wealth or portfolio management or in the business of buying, selling and dealing of securities or other financial assets.[10] Also, as per regulation 4 of the AIF Regulations, it must be a fit and proper person based on the criteria specified in Schedule II of the Securities and Exchange Board of India (Intermediaries) Regulations, 2008, and have necessary manpower and infrastructure effectively discharge its activities.
Setting up of AIF in form of a Trust:
Whether Bank can set up a trust for carrying on AIF Business.?
Banks can set up the trust in relation to an AIF. However, normally, the trust is sponsored by the Investment Manager / Advisor, which as we have noted, would need to be a subsidiary of banks and cannot be undertaken departmentally. However, banks can still invest in the AIF.
What will happen in case the Trust is dissolved?
An AIF set up in form of the trust can be wound up in the following circumstances as provided under regulation 29 (1) of the AIF Regulation: (a) when the tenure of the AIF or all schemes launched by the AIF is over; or (b) if it is the opinion of the trustees or the trustee company, that the AIF be wound up in the interests of investors in the units; or (c) if seventy-five percent of the investors by value of their investment in the AIF pass a resolution at a meeting of unit holders that the AIF be wound up; or (d) if the Board so directs in the interests of investors. Further, after the trust is dissolved the following events shall occur chronologically as per regulation 29 of the AIF Regulations. The steps are as follows:
Step 1: The trustees or trustee company or the Board of Directors or designated partners of the AIF, as the case maybe, shall intimate the Board and investors of the circumstances leading to the winding up of the AIF.
Step 2: On and from the date of intimation, no further investments shall be made on behalf of the AIF so wound up.
Step 3: Within one year from the date of intimation, the assets shall be liquidated, and the proceeds accruing to investors in the AIF shall be distributed to them after satisfying all liabilities.
Step 4: Subject to the conditions contained in the placement memorandum or contribution agreement or subscription agreement, distribution of assets of the AIF, shall be made by the AIF, as per the preference of investors, after obtaining approval of at least seventy five percent of the investors by value of their investment in the AIF at any time, including on winding up of the AIF.
Step 5: Upon winding up of the AIF, the certificate of registration shall be surrendered to the Board.
[1] Regulation 3(4) of the Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012.
[2] Regulation 13(2) of the Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012.
[3] Regulation 3(4) of the Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012.
[4] Regulation 5(a)(v)(e) of the Master Direction- Reserve Bank of India (Financial Services provided by Banks) Directions, 2016.
[5] Regulation 13(3) of the Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012.
[6] Regulation 3(5) of the AIF Regulations
[7] Regulation 2(1)(w) of the AIF Regulations.
[8]The registration procedure can be accessed at https://www.sebi.gov.in/sebi_data/attachdocs/1339489217797.pdf
[9] Regulation 2(1)(w) of the AIF Regulations
[10] Regulation 4(g) of the AIF Regulations.
This article has been authored by Abir Lal Dey, Partner at Saraf and Partners, Sakshi Mishra, Associate at L&L Partners, and Mythili Sundar Rajan, former Associate at Saraf and Partners. This blog is a part of RSRR’s Excerpts from Experts Blog Series, initiated to bring forth discussion by experts on contemporary legal issues.