In this article, Faraz Salat pursuing Diploma in Entrepreneurship Administration and Business Laws from NUJS, Kolkata, discusses Hedge fund regulation in India.
STRUCTURE AND TRENDS
The Securities and Exchange Board of India (Alternative Investment Funds) Regulations 2012 (AIF Regulations) are regulations which were issued in May 2012 by the SEBI and they govern the establishment as well as the operation of various types of alternative funds in India. The AIF Regulations were introduced, among others, category III AIFs which are essentially hedge funds. These are funds traded only to make returns within a short term. These regulations allow the category III funds to be either open-ended funds or close-ended funds. Prior to the Regulations, laws that governed such types of open-ended funds and any business of a similar nature were absent and were carried out by portfolio managers. These were covered under the SEBI (Portfolio Managers) Regulations issued in 1993.
As of 30 June 2016, 33 these alternative funds have been registered as category III AIFs from the beginning of the AIF Regulations. A total of about INR62.4 billion worth of commitments from 30 June 2016 have been received by registered category of these funds.
LEGISLATION
SEBI (Alternative Investment Funds) Regulations 2012 (AIF Regulations)
REGULATOR
Securities and Exchange Board of India
The category III funds (AIFs) are subject to a necessary requirement to disclose risk management tools so that the investors are placed in the memorandum. Additionally, all category III funds are also required to provide disclosure as regards to the risks and how they will be managed:
- The risk at the funding level.
- Risk of foreign exchange at the funding level.
- Leveraging the risk at the funding and the investee levels.
- The change in environment at the exit stage relative to funding and the investee levels.
- The change in or divergence from business relative to funding and the investee levels.
- The risk of the investee’s reputation
- Political, Environmental, Social and Technological changes
PRICING
Category III funds must ensure that calculation of the net asset value (NAV) is not dependent and is regardless of the fund management of the alternative funds and such NAV has to be disclosed to the investors quarterly. Such disclosures for investors are to released quarterly for both open ended funds and close ended funds.
INSIDER TRADING AND MARKET ABUSE
Financial intermediaries, mutual funds, hedge funds are all subject to regulations namely –
- SEBI (Prohibition of Insider Trading) Regulations 2015.
- SEBI (Prohibition of Fraudulent and Unfair Trade Practices relating to Securities Market) Regulations 2003.
OPERATIONAL TRANSPARENCY
SEBI Regulations require these alternative funds disclose the several of the information to the investors to ensure transparency, which are listed as the following –
- Financial, risk management, operational, portfolio, and transactional information relative to the investment funds and therefore they are to be disclosed in a periodical way to the investors.
- As far as fees are ascribed to the manager or any fees, which are charged to the alternative funds or any such investees by associate, manager or such persons, are now critical to the investor and must be disclosed to the investors.
- With regards to inquiries or any legal actions by legal or regulatory concerns, as and when they occurred relative to any jurisdiction.
- Liability of any material kind arising during the alternative funds’ tenure are to be disclosed, as and when they occurred.
- A breach of such provision of the placement memorandum, or such agreement with the investor or any other fund agreements, if any, as and when they occur.
- Change in the control, manager, sponsor of the investee company.
ANTI MONEY LAUNDERING
There is a legislation, which governs money laundering in India by the Prevention of Money Laundering Act 2002.
SHORT SALE
There isn’t a regulation particularly governing the short sale of securities, the SEBI has notified through its circulars relative to the short selling of securities in lending and borrowing. Further, the provisions of the following laws are also applicable in few specific circumstances:
- SEBI (Prohibition of Insider Trading) Regulations 2015.
- SEBI (Prohibition of Fraudulent and Unfair Trade Practices relating to Securities Market) Regulations 2003.
THE SALESMAN (MARKETING)
Under the aforesaid legislations, the funds have to be marketed by a private placement. There is a person who is characterized as investment advisor, and thus such a person is registered. These are provisions of SEBI and the managers of these funds are also exempt from the registration requirements under the aforesaid regulations.
Restriction per se is not specifically mentioned under Indian laws on the investors who are subject to these alternative funds. These funds can be marketed to such sophisticated investors like institutions and high net individuals. However, foreign hedge funds cannot be marketed in India.
RESTRICTIONS
In the local investors’ scenario investing in a hedge fund, there are no restrictions on local investments that are to invest in an alternative investment fund (AIF). However, such funds are not targeted at retail investors. Accordingly, these regulations require an investor to invest at least INR10 million in the AIF. Moreover, employees and directors of investment managers to the alternative funds have to invest at least INR2.5 million in the AIF. However, for any performance fees, the employees and directors of the investment managers are exempted from the investment in the AIF.
PORTFOLIO
These regulations need that a custodian’s appointment is made by the sponsor or manager of such category of funds. This must maintain the portfolio of assets and of such category of funds. This custodian is governed by the SEBI (Custodian of Securities) Regulations 1996.
CONSIDERING THE REQUIREMENTS
The key disclosure in the filing requirements, which must completed by the hedge fund are
Disclosure: All alternative funds have to issue a placement memorandum. This should contain all the material information about:
- The fund and the manager
- The background of the team and the manager
- Targeted investors.
- Expenses and related costs to be charged.
- Tenure of the fund
- Conditions or limitations on redemption.
- The strategy.
- Risk management
- Service providers.
- Conflicts of interest and procedures to address them
- Disciplinary actions and history.
- The terms and conditions
- Its affiliations with other intermediaries.
- Winding up procedure
- Other information deemed necessary
Filings: The Regulations require such category to submit a report to the Regulator on a quarterly basis in a form prescribed by the Regulator themselves. Further, the manager of an alternative fund is supposed to submit a compliance report at the end of each financial year. The managers of such category funds are exempted from registration under the Regulation. Such a foreign manager may manage a category of alternative fund in India. Nevertheless, foreign exchange regulations in India are subject to certain restrictions on the investments. This can be made by an alternative fund which is controlled by a foreign manager or a manager in the country, which is accordingly owned or controlled by expatriates.
LEGALITY OF THE FUND VEHICLE AND THE STRUCTURE
The Regulations provide for a category of such funds to be established as a trust, company, partnership or any such corporation. Such categories of these alternative funds are established as trust, and they have a limited partnership. The interest of the participants is best represented by unit or partnership interest. The Indian Trusts Act 1882 governs a trust. These laws let the settlor to draft their own constitution as compared to other bodies corporate. There are no restrictions on the beneficiaries that a trust can have and moreover there are no restrictions on the redemption of units. Further, there are also no restrictions on the distribution and there is no dividend tax payable. Beside the main and one of the concerning main advantages of a trust structure for investors and are that taxation is only in the hands of the investors with no restrictions on the quantum. We also note that the trust also doesn’t serve the purpose of taking an escape from the corporate veil. These trust structure could also substantially be of disadvantages.
Let us now look at a variant of secondary market, which is the forward market. Here, the securities are traded for future delivery and payment. Further, Pure forward is not inside the formal market. Moreover, these versions of forward in formal market are futures and options. Accordingly, in the futures market, there is also a standardized securities and are therefore traded for future delivery and settlement. We must also note that these futures can be on a basket with a range of securities such as index or security. Moreover, in case of options, securities are traded for future delivery conditionally.
Therefore, we note that there is no standard meaning of hedge fund. These funds are broadly to be private investment partnerships, funds or pools that may invest and trade in different markets. Certain characteristics of these funds are to be identified. The following are the few categories of the funds –
- Private investment partnerships or offshore corporations;
- Trading strategies in a range of markets;
- Trading techniques and instruments, such as short selling, derivatives and leverage;
- Performance fees; and
- Investor base comprising with high net income.
