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

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 II

Real Estate Investment Trusts (REITs)

With a view to facilitate growth of real estate investment trusts (REITs), the SEBI has approved the following key changes to the REITs regime in its Board Meeting:

• Permitting REITS to acquire at least 50% stake in the Holding Company (Holdco)/ Special Purpose Vehicle (SPV) and the Holdco to acquire at least 50% in the SPVs

As per the REITs Regulations 2014 (Regulations), a REIT must hold at least 51% of the equity share capital or interest in the Holdco and the REITs or Holdco must hold at least 51% of the equity share capital or interest in the SPV. Further, as per Regulation 18(3A)(a) of the REITs Regulations, REITs investing in properties through Holdco must ensure that it has an ultimate holding interest of at least 26% in the underlying SPV.

The SEBI has now reduced the minimum holding requirement from the existing 51% to 50%. A REIT is now required to invest a minimum of 50% of the equity share capital or interest in the Holdcos or SPVs and the Holdco is required to invest a minimum of 50% of the equity share capital or interest in the SPV, subject to meeting the following conditions:

• the REIT shall continue to have an ultimate holding interest of at least 26% in the underlying SPV;
• the REIT manager, in consultation with the trustee, must appoint directors on the board of the Holdco and/or SPV in proportion to the shareholding or interest in the Holdco and/or SPV; and
• the provisions of the REITs Regulations will prevail in case of any inconsistency between the obligations applicable to the REIT under the REITs Regulations and the provisions of any shareholders' agreement or partnership agreement entered in that regard.

Comment: SEBI has introduced this change to bolster 50:50 joint venture arrangements in respect of Holdcos and SPVs, which was not possible under the earlier regime as it required a minimum holding of 51% by the REITs or the Holdcos.

• Permitting REITS to Invest in Unlisted Shares under the 20% Limit in respect of Investments in Assets other than Completed and Rent Generating Projects

As per Regulation 18(4) of the REITs Regulations, REITS are required to invest a minimum of 80% of their asset value in assets in completed and rent generating projects. As per Regulation 18(5), not more than 20% of their asset value may be invested in assets such as certain under-construction properties, developmental properties, listed or unlisted corporate debt, government securities and cash equivalents etc. To widen the scope of investment opportunities for REITs, the SEBI has now permitted REITs to invest in unlisted shares in accordance Regulation 18(5) of the REITS Regulations.

• Rationalising the definition of Sponsor Group in case of REITs

SEBI had issued a consultation paper dated 18 July 2016[1] (REITs Consultation Paper) which recommended the introduction of the concept of 'sponsor group' comprising of multiple schemes or fund or affiliates who are under common control. In line with the REITs Consultation Paper, SEBI had amended the REITs Regulation to introduce the definition of 'sponsor group' which included the body corporate that acts as the sponsor, entities controlled by the sponsor, and downstream entities controlled by its subsidiaries. The entire sponsor group is required to meet the eligibility criteria stipulated on a sponsor under the REITs Regulations, which inter alia include net worth criteria, relevant experience requirements etc.

As per the text of the Board Meeting, we understand that SEBI has now sought to further rationalise the definition of sponsor group.

Comment: The exact nature of the change has not been specified and we await the final text of the amendments. In any event, SEBI should consider relaxing the definition of the sponsor group whereby it should be sufficient for any one member of the group to meet the prescribed eligibility requirements, as opposed to requiring all the members to meet such requirements.

It is also pertinent to note that the SEBI, in a prior board meeting on 18 September 2017, had proposed various changes to the REITs regime, to harmonise the provisions of the REITs Regulations with that of the SEBI (Infrastructure Investment Trusts) Regulations 2014. These changes include: (i) introduction of the concept of strategic investor; (ii) permitting the issue of debt securities by REITS and InvITs; (iii) permitting single asset REITs etc. By way of the SEBI (REITs) (Amendment) Regulations 2017 and SEBI (InvITs) (Amendment) Regulations 2017, dated 15 December 2017, SEBI has notified the changes to these regulations. Our newsflash dated 4 January 2018 analyses these amendments.

Investment Advisors

SEBI had issued 2 Consultation Papers dated 7 October 2016[2] (2016 IA Consultation Paper) and 22 June 2017[3] (2017 IA Consultation Paper) to seek views from the public vis-à-vis amendments and clarifications to SEBI (Investment Advisers) Regulations 2013 (IA Regulations).

• Compulsory Registration for Mutual Fund Distributors (MFDs) who provide Investment Advisory Services on Mutual Fund Products

Currently, under Regulation 4(d) of the IA Regulations, mutual fund distributors (MFDs) who are members of a self-regulatory organisation recognised by SEBI or are registered with association of asset management companies (AMCs) of mutual funds, who provide investment advisory services to clients which are incidental to its primary activity, are exempt from registration under the IA Regulations. Accordingly, under the current framework, MFDs are engaged in the primary activity of distribution of mutual fund products and also provide incidental investment advice and execution services regarding the same. Consequently, MFDs are receiving commission from AMCs and also charging execution and/ or advisory fees to the client.

The 2016 IA Consultation Paper and the 2017 IA Consultation Paper proposed that MFDs should not provide incidental advisory services on mutual fund products without registering under the IA Regulations. Further, MFDs shall be permitted to provide incidental investment advice in respect of mutual fund products only to the extent of describing specification of the products which are appropriate to the risk profile of the investors.

• Investment Advisory Services to be provided by a Separate Subsidiary

Presently under the IA Regulations, IAs which are banks or NBFCs providing distribution and/or execution services to their clients are required to segregate their investment advisory services (from its other activities) through a subsidiary or a separately identifiable department or division (SIDD) within the same entity. Similarly, body corporates are also required to segregate their investment advisory services (from its other activities) through a SIDD within the same entity. The 2016 IA Consultation Paper and the 2017 IA Consultation Paper, with a view to bring uniformity across intermediaries and to address the issues arising on account of conflicts of interest, proposed to permit banks, NBFCs and body corporates to offer investment advisory services through a separate subsidiary only, instead of providing the same through a SIDD. In this regard, the 2017 IA Consultation Paper sought to provide a 6 month timeline for the above-mentioned entities to ensure that investment advisory services are being provided through a separate subsidiary. Additionally, the 2017 IA Consultation Paper has suggested that an entity engaged 'solely' in the business of advising on investment products should not be permitted to sell any products by itself.

Recognising the need for further stake-holder consultation, SEBI has issued another Consultation Paper on 2 January 2018[4] (2018 IA Consultation Paper) clarifying that individuals who intend to be registered as IAs cannot provide any distribution services in financial products and vice-versa, either directly or through any immediate relatives. Immediate relatives shall mean a person's spouse, parent, brother, sister or child or the child's spouse as defined in the SEBI (Substantial Acquisition of Shares and Takeover) Regulations, 2011. Similarly, banks, NBFCs, body corporates, LLPs and firms intending to seek registration as an IA cannot provide any distribution services in any financial products and vice-versa, either directly or through any holding or associate or subsidiary company. In this regards, associate company shall mean a body corporate in which the entity or its director or partner holds, either individually or collectively, more than fifteen percent of its paid-up equity share capital or partnership interest, as the case may be.

Further, the 2018 IA Consultation Paper proposes that existing persons who are registered IAs and offer distribution services and distributors offering advisory services, directly or indirectly, must elect between providing investment advise or distribution services before 31 March 2019. Therefore, from 1 April 2019 any person, including their immediate relatives or holding/subsidiary/associate entity, shall offer either investment advice or distribution services. Additionally, MFDs must disclose to the client the list of mutual funds they are associated with and are permitted to describe the specification vis-à-vis only these mutual fund products and they must inform the client that he/she may consider other products not distributed by the MFDs. MFDs must also abide by the principle of 'appropriateness' while recommending products which entails selling only those products which are identified as best suited for that client.

Comment: While the intention of SEBI to address the conflicts of interest must be appreciated, considering that it is difficult to separate the distribution and incidental investment advice function of MFDs, the impact study on the mutual fund sector and cost-benefit analysis of requiring them to compulsorily elect between acting as distributors or investment advisors must be undertaken. The 2018 IA Consultation Paper has far reaching impact as group companies must now evaluate whether the entities in their group should provide either investment advise or distribution services. Further, the client must be provided the autonomy to determine if they would like to avail of the execution services recommended by the IAs, after disclosure of any conflict in respect of the same by the IAs. The 2018 IA Consultation Paper also leaves open the issue of commissions which may be received by the IAs from the entity providing execution services in relation to the Client. Further, SEBI should also consider the issue of soft dollar arrangements between the IAs and the broker-dealer.

Security Receipts of Asset Reconstruction Companies (ARCs)

• Listing of Security Receipts

To complement the wave of changes brought about by the Insolvency and Bankruptcy Code 2016, and in line with the 2017-18 Union Budget Speech, SEBI proposes to lay down the roadmap for the listing of security receipts (SRs) issued by ARCs. We understand that a separate chapter will be incorporated in the SEBI (Public Offer and Listing of Securitised Debt Instruments) Regulations 2008 to provide for this framework.

Comment: This change is in line with the Government's efforts to transform over the counter SRs into exchange traded instruments. The fact that FPIs, AIFs and mutual funds can now trade in SRs on the floor of the exchanges, is expected to translate into greater liquidity, effective price discovery, and enhanced capital flows for SRs.

Mutual Funds (MFs)

• Limits to Cross Holdings and Board Representation in Multiple AMCs/ Trustees

In order to boost governance and prevent to potential conflicts of interest situations in the mutual fund industry, the SEBI proposes to limit cross holdings to 10% and prohibit board representation in AMCs or trustee companies of multiple mutual funds. More specifically, SEBI provides that: (i) the sponsor of a mutual fund; (ii) its associate and/or its group company; and (iii) its AMC through the schemes, or otherwise collectively, may not be permitted to hold more than 10% of the stake or have board representation in the AMC or the trustee company of any other mutual fund. Similar limitations have been imposed on shareholders against holding more than 10% stake or having board representation in the AMCs or trustee companies of multiple mutual funds.

The SEBI has also declared that any existing non-conformity should be resolved within reasonable time, which the SEBI chairman has prompted to mean a period of 1 year.

Comment: The decision comes in the backdrop of the RBI impelling banks to liquidate their holdings in multiple AMCs to 10% or less in light of them having their own AMCs along with having significant shareholdings in other AMCs. A good example would be the case of UTI Asset Management Company (UTI AMC) where several banking conglomerates such as Bank of Baroda, Life Insurance Corporation of India, Punjab National Bank and State Bank of India have holdings of more than 10% each. Each of these entities run their own fund houses, and therefore will be required to dilute their individual holdings in UTI AMC to less than 10%.

• 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