India: SEBI's Consultation Paper On Special Situation Funds: Key Takeaways

1. INTRODUCTION

The Securities and Exchange Board of India ("SEBI") recently introduced a consultation paper ("Consultation Paper") to amend the extant regulatory framework governing Special Situation Funds ("SSFs"). Pursuant to the Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012 ("AIF Regulations"), SSFs are a separate category of Alternative Investment Funds ("AIF") which are permitted to invest exclusively in 'special situation assets' which, presently, include inter alia stressed loans available for acquisition as described under Clause 58 of the Reserve Bank of India (Transfer of Loan Exposures) Directions, 2021 ("RBI Master Directions"). Interestingly, such stressed loans can only be transferred to entities listed in the Annex to the RBI Master Directions, which currently do not include SSFs.

2. KEY CHANGES PROPOSED BY THE CONSULTATION PAPER

In order to address the aforesaid regulatory loophole, the Consultation Paper aims to further streamline the framework governing SSFs and take measures to broaden the scope of capital infusion in stressed assets by including SSFs as a distinct investor class within this market segment. Key takeaways of the Consultation Paper have been set out below:

2.1. Changes to the definition of Special Situation Assets

Presently, SSFs are permitted to invest in stressed loans available for acquisitions as well as securities of companies which have stressed loans that are available for acquisition under the RBI Master Directions or as a part of a resolution plan under the Insolvency and Bankruptcy Code ("IBC") or under any resolution framework stipulated by the RBI. The Consultation Paper states that such loans being 'available for acquisition' implies the existence of such assets and their visibility to SSFs even before the approval of the resolution plan/framework. Accordingly, the Consultation Paper proposes to replace the term 'available for acquisition' with assets which 'are acquired' for the purpose of investments by SSFs.

However, the suggested proposal may act to the detriment of SSFs which may consider acquiring such a stressed account from creditors during the resolution plan/process. Whilst the legal clarity on the ability of SSFs to acquire such loans under the IBC regime is awaited, the framework governing SSFs must be broadened to include situations where such funds are permitted to acquire the stressed accounts both during the resolution process as well as instances where the resolution plan has already been adopted. Accordingly, the definition of special situation assets should include stressed loans, both that "have been acquired" or "are available for acquisition".

2.2. Investor Eligibility for SSFs under Section 29A of the IBC:

In order to harmonise the applicability criteria under Section 29 of the IBC to the asset reconstruction companies ("ARCs") and SSFs, the Consultation Paper seeks to apply the aforesaid eligibility not just to the SSF, but also to its underlying investors. Note that this additional criterion stipulated on the SSFs has been suggested on account of a wider investor pool that is typically made available to an AIF, unlike an ARC or any other regulated financial institution authorised to acquire such assets.

2.3. Definition of related party:

Currently, AIF Regulations restrict SSFs from investing in associate companies, which constitute any body corporate wherein a director/trustee/partner/sponsor or manager of an AIF holds more than 15% (fifteen percent) of its paid-up equity shares or partnership interest. The Consultation Paper proposes amending the AIF Regulations to expressly prohibit SSFs from investing in their 'related parties,' as defined under the Companies Act, 2013; as the term 'associate' does not include several constituents which would otherwise be designated as a 'related party'. However, it is imperative to note that the Consultation Paper does not clarify whether the 'related party' threshold is applicable to only the fund manager of the SSF, or would it even extend to the sponsors/investors of the fund, and therefore may hamper operational flexibility.

2.4. Minimum Holding Period

SSFs are currently subject to a six-month minimum holding period for stressed loans acquired under Clause 58 of RBI Master Directions. To address concerns of fund round tripping, the Consultation Paper further suggests mandating SSFs to transfer such loans only to entities specified in the Annex of RBI Master Directions. While such a measure would isolate the stressed asset pool from any investor base outside the Annex of RBI Master Directions, stipulating a mandatory investment criterion on the SSFs could ensure credit discipline as well as a regulatory harmonisation with ARCs where such companies are required to maintain a minimum 15% (fifteen percent) investment in the security receipts ("SRs") of each class issued by them in every scheme until the redemption of such SRs.

2.5. Enhanced Reporting

The Consultation Paper further prescribed enhanced reporting wherein SSFs would be required to submit information in respect of all investments in stressed loans to a trade reporting platform notified by RBI. This information would typically include details of units issued, details of investors' subsequent changes in unit holdings, resolution strategies implemented, and recoveries effected and therefore ensure a seamless information symmetry between the regulators.

3. INDUSLAW VIEW

The Consultation Paper marks a positive step, integrating SSFs into RBI Master Directions, fostering regulatory alignment between RBI and SEBI for enhanced liquidity and resilience in secondary debt markets.

Whilst SEBI's latest initiative in the growth of the distressed asset segment may be a step in the right direction thus far, it could definitely have gone a step further. For instance, currently, SSFs are only permitted to invest in stressed loans, including non-performing assets ("NPA") and special mention accounts ("SMAs"), resulting in limited cash flow certainty as well as providing limited recovery incentives for SSFs. Expanding the stressed loan portfolio to include below investment grade assets including non-NPA or SMA assets would enhance market liquidity as well as encourage the initiation of an active market for investments that are considered 'junk' or basically investments below a 'BBB'-rating like other jurisdictions. Needless to mention, other regulatory arbitrage including rights under the IBC, stamp duty exemptions, etc., would also need to be extended to make SSFs a lucrative alternative to a market which has been predominantly driven by ARCs and other regulated financial institutions.

With the aforesaid concerns being adequately addressed, the suggested measures are likely to see more active participation from foreign investors. This is especially since special situations are subject to lesser stringent capital adequacy requirements as compared to other regulated entities in this sector. Consequently, the suggested initiative is likely to provide the much required impetus for the creation of a larger pool of distressed capital.

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