SEBI Introduces Major Reforms for Alternative Investment Funds

Significant Changes in AIF Regulations

The Securities and Exchange Board of India (SEBI) has announced a comprehensive update to the regulatory framework for Alternative Investment Funds (AIFs). This reform aims to provide fund managers with enhanced flexibility during the winding-up phase and introduces a new category known as the 'Inoperative Fund.' These modifications arise from amendments to the SEBI (Alternative Investment Funds) Regulations, which were officially notified on April 18. The goal is to assist investment vehicles in addressing unresolved tax, legal, and regulatory issues prior to formally relinquishing their registrations. The revised framework is anticipated to transform how AIFs handle liquidation proceeds at the conclusion of their operational lifespan.

One of the key updates allows AIFs to retain a portion of liquidation proceeds even after the end of a scheme's allowable duration. This provision is applicable when a fund has received official notifications regarding existing or potential tax, legal, or regulatory obligations that may arise in the future. Notably, SEBI has clarified that this allowance is not limited to confirmed liabilities; it also encompasses expected claims stemming from ongoing disputes, investigations, reassessment actions, or regulatory reviews where a final demand has yet to be issued.

Communications that could justify the retention of proceeds include notices, summons, show-cause notices, reassessment orders, correspondence related to investigations, and claims initiated by regulators, tax authorities, law enforcement, courts, investors, or counterparties. SEBI has explicitly included litigation-related communications as part of the eligible liabilities.

Investor Approval Provides Additional Protection

The updated framework also offers fund managers an alternative method to retain proceeds. AIFs can withhold funds for anticipated litigation or tax obligations if at least 75% of investors by value consent to the proposal. To enhance transparency, managers must disclose the amount they wish to retain and the expected duration for which the funds will be set aside.

Furthermore, SEBI has allowed retained proceeds to cover residual expenses associated with winding up a scheme, provided these costs are substantiated by invoices or other documentation of similar expenditures incurred previously. If retention is solely for operational expenses, the duration cannot exceed three years from the end of the fund's permissible life.

Introduction of the 'Inoperative Fund' Category

A notable aspect of the reforms is the establishment of the 'Inoperative Fund' classification. Funds that have divested all investments but remain active due to retained proceeds or unresolved litigation can apply for this status while completing closure procedures. Although Inoperative Funds are barred from making new investments, launching new schemes, or charging management fees, they will enjoy significant compliance relaxations. SEBI has exempted these funds from various reporting and disclosure requirements, including quarterly and annual activity reports, compliance test reports, performance benchmarking disclosures, and audits related to private placement memorandum (PPM) terms.

Any retained proceeds under this classification can only be invested in instruments permitted by existing AIF regulations.

Enhanced Reporting and Broader Applicability

To maintain oversight, AIFs operating as Inoperative Funds due to retained funds for anticipated liabilities must submit annual status reports to both SEBI and investors. These reports will outline the amount retained and the nature of outstanding liabilities. SEBI has also assigned the Standard Setting Forum for AIFs (SFA) the task of developing implementation standards and creating uniform guidelines for eligible operational expense categories in collaboration with the regulator.

Once all liabilities are resolved and the remaining proceeds are distributed to investors, the relevant scheme will be wound up in accordance with applicable regulations. The regulator has extended similar benefits to Venture Capital Funds registered under the previous SEBI (Venture Capital Funds) Regulations. These funds may also retain proceeds beyond their permissible life and apply for Inoperative Fund status, provided they comply with the conditions set for AIFs. Additionally, schemes that have not retained funds but continue to face unresolved litigation can seek Inoperative Fund status, although they will still be subject to restrictions on launching new schemes and charging management fees while operating under this classification.