SEBI Clarifies Pro-Rata And Pari-Passu Rights For AIF Investors
Introduction
The Securities and Exchange Board of India (“SEBI”) recently amended regulations governing Alternative Investment Funds (“AIFs”), focusing on investor rights. These amendments clarify pro-rata and pari-passu rights, outlining exceptions and guidelines for offering differential rights to select investors.[1] The circular provides a framework for AIFs to ensure fair treatment of investors while allowing for flexibility in investment structures.
Understanding the Circular
Pro-Rata Rights of Investors in AIFs
Investor Rights
Investors in an AIF scheme generally have rights proportional to their investment (commitment) in the scheme. This applies to both:
- Participating in each investment of the scheme.
- Receiving a share of the proceeds from those investments (distributions).
Exceptions to Pro-rata Rights
There are two exceptions to the pro-rata rights:
- Investor Exclusion or Default: An investor may be excused or excluded from participating in a specific investment. This could happen for various reasons. An investor who defaults on their contribution for a specific investment will also not have pro-rata rights for that investment.
- Profit Sharing Agreements: Investors can have agreements with the manager or sponsor of the AIF to share profits or returns differently than their pro-rata share. This is typically done through a contribution agreement.
Flexible Investment Options for Certain Entities
Some entities are allowed more flexibility in terms of their investment returns and risk tolerance:
- Manager or sponsor of the AIF
- Multilateral or Bilateral Development Financial Institutions
- State Industrial Development Corporations
- Entities established, owned, or controlled by the government (Central, State, or foreign) including Central Banks and Sovereign Wealth Funds
These entities can invest in junior or subordinate classes of units within the AIF/scheme. These classes may have lower returns or higher losses than pro-rata rights would dictate.
Restrictions on Use of Invested Funds
If the manager or sponsor of an AIF invests in junior/subordinate classes, there’s a restriction on how the AIF/scheme can use the invested funds. The investee company (the company in which an AIF invests) cannot use the funds to repay any obligations to the manager, sponsor, or their associates.
Applicability to Existing AIFs/Schemes
- Priority Distribution Model: SEBI previously directed AIFs with a priority distribution model to restrict new investments and investments in new companies. This restriction continues until SEBI provides further guidance.
- Pre-amendment AIFs/Schemes: AIFs/schemes launched before the regulation update (November 18, 2024)[2] may have non-pro-rata rights that are not exempt by SEBI. SEBI will determine how to handle these on a case-by-case basis.
- Compliance and Investment Limits: Existing AIFs with a priority distribution model (and not exempt) cannot accept new investments or invest in new companies. If this compliance or a previous SEBI circular causes a breach of investment limits, it will not be considered a non-compliance. However, this needs to be documented in the ‘Compliance Test Report’ prepared by the manager.[3]
Pari-passu Rights of Investors in AIFs
General Rule
Investors in AIF schemes[4] generally have equal rights (pari-passu) in all aspects related to the scheme. This includes participation in investments, distribution of proceeds, and decision-making (except for specific committee memberships).
Exceptions to Pari-passu Rights
SEBI regulations allow for differential rights to be offered to certain investors under specific conditions. These differential rights cannot adversely affect the rights of other investors.
Conditions for Offering Differential Rights
- Guiding Principles: Differential rights must comply with the following principles:
- Not cause any investor to bear the liabilities of other investors.
- Not give an investor control over decision-making (except for committee participation as per regulations).
- Not alter the rights of other investors under their agreements with the AIF/manager.
- Be transparently disclosed in the Private Placement Memorandum (“PPM”) of the AIF/scheme.
- Implementation Standards: The Standard Setting Forum for AIFs (“SFA”) will develop a list of specific differential rights that can be offered. This list will be available on the websites of industry associations by January 15, 2025.
Responsibilities of AIFs and Managers
AIFs and their managers must ensure differential rights are offered only in accordance with the SFA standards. The PPM of the AIF/scheme must disclose:
- Eligibility criteria for investors to avail each differential right.
- The right of any investor meeting the criteria to opt for the differential right.
Applicability to Existing AIFs/Schemes
- AIFs are required to disclose in their PPM that any differential rights offered will not harm other investors’ rights.
- AIFs/schemes whose PPMs were filed with SEBI on or after March 1, 2020, need to:
- Report details of differential rights not covered by SFA standards to SEBI by February 28, 2025.[5]
- Immediately terminate differential rights that are found to affect other investors’ rights.
Exemption for Large Value Funds for Accredited Investors (“LVFs”)
LVFs launching their scheme after the issuance of this circular can avail an exemption from maintaining pari-passu rights among investors. This requires:
- Appropriate disclosure in the scheme’s PPM.
- Obtaining a waiver from the accredited investor at the time of onboarding, acknowledging the exemption and potential impact on other investors’ interests.
Existing LVFs can also avail exemption if each investor specifically provides a waiver for this effect.
Compliance Reporting
The trustee/sponsor of the AIF must ensure the ‘Compliance Test Report’ prepared by the manager includes compliance with the provisions of this circular.
Conclusion
The SEBI circular on investor rights within AIFs seeks to strike a balance between protecting investors and giving fund managers the flexibility they need. It reinforces the importance of pro-rata and pari-passu rights, however, at the same time, it also recognizes that exceptions are necessary in certain cases. The provisions for differential rights introduce some customization options, though these will evolve based on SFA standards.
However, AIFs and their managers must take on the responsibility of being transparent and fair, especially when offering differential rights. Strict compliance with the new guidelines will be important to maintain investor trust and preserve the integrity of the AIF ecosystem.
[1] https://www.sebi.gov.in/legal/circulars/dec-2024/pro-rata-and-pari-passu-rights-of-investors-of-aifs_89945.html.
[2] https://www.sebi.gov.in/legal/regulations/nov-2024/securities-and-exchange-board-of-india-alternative-investment-funds-regulations-2012-last-amended-on-november-18-2024-_88648.html
[3]https://www.sebi.gov.in/sebi_data/commondocs/apr-2021/Annexure%20II%20(CTR%20from%20AMC%20to%20SEBI)_p.pdf
[4] See supra pg 2.
[5] https://www.sebi.gov.in/sebi_data/meetingfiles/aug-2019/1565346231044_1.pdf
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