India: SEBI's Year End Bonanza To Investors And Fund Managers – Volume I

Reeling under the after-effects of the demonetisation policy introduced in late 2016, India had entered 2017 with the aim to maintain strong macro-economic fundamentals, restore historic growth levels and tackle the surmounting stressed assets problem. As 2018 approaches, the Indian economy is displaying signs of recovery from the temporary slowdown caused by the introduction of the GST regime, has an improved ease of doing business score, and is gradually restoring the euphoric levels of foreign investment inflows amidst a bull market frenzy. Against this backdrop, the final board meeting of the Securities and Exchange Board of India (SEBI) in 2017, with its intensive reform agenda conceptualised to enhance corporate governance and further improve the ease of doing business standards, projects the tone for 2018 and paves the way for several changes to the securities market regulatory framework in respect of the investment funds industry.

In this newsletter, we analyse the key regulatory changes approved by SEBI in their board meeting held on 28 December 2017 (Board Meeting). For ease of reference, we have divided this newsletter into 2 volumes.

Volume I of this newsletter will focus on updates to the following regulatory regime:

  • Foreign Portfolio Investors (FPI)

Volume II of this newsletter will focus on updates to the following regulatory regimes:

  • Real Estate Investment Trusts (REITs)
  • Investment Advisors (IA)
  • Security Receipts of Asset Reconstruction Companies (ARCs)
  • Mutual Funds (MFs)

VOLUME I

Foreign Portfolio Investors

SEBI issued a 'Consultation Paper on Ease of Access Norms for Investments by FPIs' on 28 June 2017[1] (FPI Consultation Paper) with the objective of easing registration and compliance norms for FPIs, by suggesting amendments to the SEBI (Foreign Portfolio Investors) Regulations 2014 (FPI Regulations) and the SEBI Frequently Asked Questions on the FPI regime[2] (FPI FAQs). The proposals of the FPI Consultation Paper, approved by SEBI in their Board Meeting, are as follows:

  •    Rationalisation of Eligibility Conditions for Category I and II FPIs

The FPI Regulations require an FPI applicant to fulfil the 'fit and proper' criteria along with the following additional conditions (Additional Conditions):

  • the applicant should be legally permitted to invest in securities outside the country of its incorporation or establishment or place of business;
  • the applicant should be authorized by its memorandum of association and articles of association or equivalent document(s) or the agreement to invest on its own account or on behalf of its clients;
  • the applicant should have sufficient experience, good track record, be professionally competent, financially sound and should have a generally good reputation of fairness and integrity; and
  • the grant of certificate to the applicant should be in the interest of the development of the securities market.

Considering that the 'fit and proper' criteria is very wide and broadly covers the aforesaid conditions, and that Category I and II FPIs are typically government bodies and regulated entities, the FPI Consultation Paper proposed that such applicants need not be subject to the Additional Conditions and requisite documentation thereunder.

Further, the FPI Consultation Paper proposed to insert the 'fit and proper' criteria as a part of Chapter V on 'General Obligations and Responsibilities' of FPIs under the FPI Regulations. This would ensure that obligation is cast not only on the Designated Depository Participants (DDPs), but also on the applicant itself to meet this eligibility criteria. Notably, Category III FPIs shall continue to be subject to the above Additional Conditions.

Comment: This decision to waive off the Additional Conditions for entities seeking Category I and II FPI registration are expected to iron out duplication in eligibility norms and would add efficiency to the registration process. This change is a pragmatic one and should aid in inflow of credible institutional capital in India.

  •        Simplification of the Broad-Based Criteria

Currently, a fund seeking registration with SEBI as a Category II FPI is required to meet the 'broad-based' criteria which requires it to have at least 20 investors, with no single investor holding more than 49% of the shares or units of the fund. Considering that in certain situations (such as redemptions, portfolio rebalancing etc.) the number of investors in the fund may go below 20, SEBI had provided a clarification that FPI applicants that have banks as underlying investors shall be 'deemed to be broad based'. The FPI Consultation Paper extends this deemed broad-based status to FPI applicants that have other institutional investors viz.; sovereign wealth funds, insurance/ reinsurance companies, pension funds and exchange traded funds; subject to the condition that such underlying investors jointly or individually hold majority stake in the applicant fund, at all times.

Secondly, the FPI Consultation Paper also clarified that in case a fund loses its broad-based status due to the exit of an offshore global investor, then it may not immediately lose its Category II FPI status, provided that it regains its broad-based status within a period of 3 months.

Thirdly, the FPI Consultation Paper proposed to extend the facility of conditional registration to existing funds. As per Clause 2.5 of the Operational Guidelines for DDPs issued by SEBI on 8 January 2014, conditional registration facility was only available to newly established India dedicated funds seeking FPI registration, subject to inter alia, subject to it meeting the broad-based criteria within 180 days of receiving such conditional registration.

Comment: The expansion of the list of the underlying investors to include sovereign wealth funds, insurance / reinsurance companies, pension funds, exchange traded funds is a pragmatic move by SEBI and is bound to reduce compliance obligations for FPIs. Such entities inherently represent interests of a number of ultimate beneficiaries and are hence worthy of being viewed as automatically fulfilling the broad-based test, provided that they hold a majority stake in the investor-applicant.

Having said that, it is noteworthy that the FPI Consultation Paper does not propose to extend the same benefit to university related endowments seeking to register as FPIs afresh. Currently, only such university related endowments which were registered with SEBI as Foreign Institutional Investors (FIIs) or as sub-accounts (under the erstwhile SEBI (Foreign Institutional Investors) Regulations 1995 (SEBI FII Regulations)) are considered for Category  II FPI registration and the balance endowment funds are treated as eligible for Category III FPI registration. Given that endowments related to universities are credible investors and could extend benefits to a larger section of the public or society, SEBI should consider making them eligible for granting Category II FPI registration, irrespective of their registration status under the erstwhile SEBI FII Regulations.

  • Expansion of the List of Entities considered as Appropriately Regulated

The FPI Regulations state that Category II FPI applicants should be 'appropriately regulated persons'. For this purpose, the term 'appropriately regulated persons' refers to banks, asset management companies, investment managers/advisors, portfolio managers.

The FPI Consultation Paper proposed to broaden the aforesaid definition vide the FPI FAQs to include broker-dealer, swap dealer etc. regulated by an 'appropriate regulator', provided that such applicant entity agreed to disclose the beneficial ownership details of their clients to SEBI or other enforcement agencies, as and when required.

Comment: The FPI Regulations inter alia require Category II FPIs applicants to be 'appropriately regulated'. The above change, which is a clarification in furtherance of this requirement, affirms that the list of entities specifically mentioned in the FPI Regulations may not be exhaustive, and may include additional entities such as broker-dealer, swap dealer etc. that are regulated by an 'appropriate regulator'.

  • Rationalisation of Protected Cell Company or Multi-Class Vehicle Declarations and Undertakings and Investor Grouping Requirements at time of continuance of Registration

At the time of seeking continuance of registration, FPIs are required to re-submit declarations and undertakings (D&Us) to the effect that it is not a protected cell company (PCC) or a Multi-Class Vehicle (MCV) along with: (i) information regarding FPI investor group; and (ii) confirmation that there is no change in structure or intimation of any change as and when required.

Considering that the PCC and MCV related D&Us and information related to investor group (i.e. point (i) above) are provided at the time of FPI registration and that the details thereof are recorded in National Securities Depository Limited (NSDL) portal, the FPI Consultation Paper proposes to do away with the requirement to re-submit these details at the time of seeking continuance of registration, provided that there is no change in the information already submitted.

Comment: This decision will iron out duplication and add efficiency to the re-registration process. It seems that upon this proposal coming into force, DDPs may require a separate declaration regarding 'no change in information', by FPIs seeking continuance of registration.

  • Simplification of Process for Addition of Share Class

Previously, in case of an addition of share classes, FPIs were required to obtain prior approval from SEBI/ DDP. SEBI has acknowledged that this requirement potentially impedes the launch of new share class of the FPI, thus impacting the fund and its investors. The FPI Consultation Paper proposed that in a fund where common portfolio was maintained across all the share classes and the broad-based criteria is fulfilled at the portfolio level, prior approval for creation of an additional share class may not be required. Nevertheless, the FPI will be required to notify the DDP of the change in structure due to the addition of a share class.

Further, in case segregated portfolios are maintained, FPIs are required to obtain prior approval of DDP for creating an additional share class. The DDP should obtain a D&U with respect to the PCC and MCV status of the applicant. The FPI Consultation Paper further proposes that for the addition of a share class that is not broad-based, the DDP may obtain an undertaking from the FPI that all the newly added share classes shall attain broad-based status, within 180 days from the date of approval issued by the DDP.

Comment: Doing away with the requirement of obtaining prior approval of the DDP for issuances of a new class of shares for funds where: (i) common portfolio is maintained across all share classes; and (ii) broad based criteria is fulfilled at the portfolio level; is justified and pragmatic given that the same does not breach the broad-based requirement for the share classes. This would help ease compliance obligations for funds seeking to issue additional classes of their shares in the ordinary course of their business.

  • Ease of Process of Change of Custodian

Currently, FPIs seeking to change their custodian (i.e. DDP) are required to obtain prior approval of the SEBI. Additionally, at the time of change of DDP, the new DDP is required to carry out due diligence to ascertain the eligibility of the FPI.

To ease the process of change of DDP, the FPI Consultation Paper proposed that either the FPI or its global custodian (authorised by the FPI in this regard) may request for a change of the FPI's DDP by forwarding a request for change to the new DDP, without requiring prior approval from SEBI. The change is effected once the new DDP obtains a no-objection certificate from the prior DDP and the new DDP is required to intimate SEBI of this change. Further, to ease the process of transition of the FPI from one DDP to another, the new DDP may rely on the registration granted by the previous DDP. However, the new DDP will be required to carry out the adequate due diligence of the FPI at the point when the FPI applies for the continuance of its registration.

Comment: Doing away with the requirement of obtaining prior approval of SEBI for a change of the DDP by FPIs is another step in the process of de-cluttering the provisions of the FPI Regulations. This decision is also expected to create level playing field for service providers and may boost the standards of custody services in India given the increased ease of transition of the FPI account from one service provider to another.

  • Specific Relaxations for Multi-Manager Structures

Vide the FPI Consultation Paper, the SEBI has proposed the following specific relaxations for multi-manager structures.

  • No requirement of SEBI approval for free of cost transfer of assets: Presently, free of cost transfer of assets (FOC transfers) by FPIs are permitted where the transferor and transferee FPIs have the same beneficial owner. DDPs are required to forward the application for such FOC transfers to SEBI.

The FPI Consultation Paper proposed that the application for FOC transfers by FPIs registered under the 'Multiple Investment Manager' (MIM) structure should be processed by the DDP, without requiring specific SEBI approval. However, for non-MIM FPIs, DDPs should continue forwarding requests for FOC transfers to SEBI.

  • Appointing multiple custodians: Under the current regime, FPIs with MIM structures are permitted to obtain multiple FPI registrations, but are required to appoint the same local custodian (i.e. DDP). The rationale for having a single DDP was to ensure smooth monitoring of investments limits (i.e. 10% of the issued share capital of the entity, referred to as "Investment Limits") for FPIs registered under multiple registrations.

However, the feedback received from FPIs was that by appointing a single entity as the DDP, they were exposed to a higher counter-party risk. Further, given that investor group information was required to be disclosed to the DDP and that depositories were now in charge of monitoring Investment Limits, the restriction of having a single DDP was no longer necessary. In light of the above, the FPI Consultation Paper proposed to permit FPIs operating under MIM structures to appoint multiple DDPs.

In relation to the above, it may be pertinent to note that as per the amended foreign investment regulatory framework, any investments by an FPI or its investor group in an entity in excess of the Investment Limits shall be regarded as foreign direct investment, as opposed to foreign portfolio investment.

  • Permitting FPIs holding FVCI Registration to appoint Multiple Custodians

Under the extant regulatory framework, an applicant is permitted to obtain registration both as an FPI and a Foreign Venture Capital Fund (FVCI) under the SEBI (Foreign Venture Capital Funds) Regulations 2000. SEBI had previously advised that an applicant holding both FPI and FVCI registrations should have a single custodian (i.e. DDP).

For reasons similar to those noted in point g(ii) above (i.e. permitting FPIs with MIM structures to appoint multiple DDPs), the FPI Consultation Paper proposed to permit applicants holding both FPI and FVCI licenses to also appoint separate DDPs for the FPI and the FVCI registrations of the same entity.

The existing mechanism of monitoring of investments by NSDL ensures that the aggregate holding by the FPI and FVCI entities that form part of the same investor group is below the Investment Limits stipulated under the FPI Regulations. It is therefore proposed that, FPIs should report the details of all FVCI accounts that share 50% or more of common beneficial ownership to their DDP, at the time of seeking registration. Subsequently, this information on group accounts may be passed on to NSDL by the DDP. Similarly, FVCI applicants will be required to provide details of 'group' FPI accounts to SEBI at the time of their registration application and this information can be further shared with NSDL by SEBI for monitoring purposes. Additionally, DDPs will be required to provide daily, the details of physical securities held by FVCI accounts that are part of any investor group to NSDL for the purpose of monitoring the Investment Limits.

  • Permitting Private Banks or Merchant Banks to invest on behalf of their Clients

Currently, private banks and merchant banks that are regulated by an 'appropriate regulator' may be classified as Category II FPIs. However, such entities are only permitted to undertake proprietary investments.

The FPI Consultation Paper proposed that private banks or merchant banks should be permitted to undertake investments on behalf of their investors provided the private bank or merchant banks submit a declaration that:

  • the details of the beneficial owners are available and will be provided as and when required by the regulators; and
  • the banks do not have any secrecy arrangement with the investors and secrecy laws do not apply to the jurisdictions in which such private bank or merchant bank is regulated.
  • Rationalisation of Requirement for Equity Shares to be Free from Encumbrances

The FPI Regulations stipulate a requirement on the DDPs to ensure that equity shares held by FPIs are free from all encumbrances. The FPI Consultation Paper observed that lien or set-off on FPIs investments were required for regulatory reasons such as irrevocable payment commitment (IPC), payment of clearing and settlement obligations, custody fees, administrative fees or charges. Accordingly, it proposed that the FPI Regulations should be amended to provide that obligations created to meet statutory and regulatory requirements should not be considered as creating encumbrance for this purpose of this requirement.

  • Khaitan & Co Funds Team

Footnotes

The content of this document do not necessarily reflect the views/position of Khaitan & Co but remain solely those of the author(s). For any further queries or follow up please contact Khaitan & Co at legalalerts@khaitanco.com

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