Ananya SonthaliaPartner
Key Developments
Proposed amendments to the regulatory framework for Special Situation Funds to facilitate the acquisition of special situation assets, including stressed loans
To attract the participation of Special Situation Funds (SSF) as a potential source of risk capital in addition to asset reconstruction companies (ARC), the Securities and Exchange Board of India (SEBI) is looking to revamp the regulatory framework governing SSFs by facilitating SSFs to acquire special situation assets, including stressed loans. To this end, SEBI released a consultation paper on 28 November 2023 proposing amendments to the SEBI (Alternative Investment Funds) Regulations, 2012 (AIF Regulations) in consensus with the Reserve Bank of India (Transfer of Loan Exposures) Directions, 2021 (RBI Master Directions).
The key proposals, along with the issues they aim to alleviate, and their impact are:
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Definition of 'special situation assets'
Issue: In terms of Regulation 19I(2)(c)(i) of the AIF Regulations, the definition of 'special situation assets' includes securities of investee companies, whose stressed loans are 'available for acquisition'. This definition relies on assumptions relating to a future point in time when the stressed loans will be available to the SSFs for acquisition. Whereas a stressed loan under clause 58 of the RBI Master Directions cannot be said to be 'available' for acquisition since visibility of the stressed loan for acquisition occurs only after the committee of creditors gives its approval to the circulation of a resolution plan by the corporate debtor as per the Insolvency and Bankruptcy Board of India (Insolvency Resolution Process for Corporate Persons) Regulations, 2016.
Proposal: The definition of 'special situation assets' be amended to include securities of investee companies whose stressed loans are acquired in terms of clause 58 of the RBI Master Directions.
SSFs having prior investment in securities of stressed companies will not be disqualified/barred from acquiring stressed loans of the said companies.
Impact: The proposed change under 19I(2)(c)(i) of the AIF Regulations from 'available for acquisition' to 'are acquired' provides much-needed clarity regarding the stage at which an SSF can acquire a stressed loan. Additionally, allowing SSFs to acquire stressed loans of companies in which they have an existing investment provides guidance on the 'eligibility' of companies whose stressed assets may be acquired by SSFs.
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Eligibility of investors in Special Situation Funds
Issue: Chapter 6 of the Master Circular for AIFs (dated 31 July 2023) already states that SSFs acquiring stressed loans are required to comply with the same initial and continuous due diligence requirements for its investors, as those mandated by RBI for investors of an ARC (i.e., monitor for disqualification in terms of Section 29A of the Insolvency and Bankruptcy Code, 2016 (IBC)). However, as per Regulation 19I(2) of the AIF Regulations, 'stressed loans' are only one type of the assets falling under 'special situation assets' that can be acquired by SSFs and the due diligence requirements in compliance with RBI mandated norms should exist for SSFs investing in all types of special situation assets, and not be limited to SSFs acquiring stressed loans.
Proposal: SSFs will not be allowed to invest in or acquire a special situation asset if any of their investors are disqualified in terms of Section 29A of IBC (i.e., not eligible to be a resolution applicant) in relation to such a special situation asset.
Impact: The responsibility of verifying for disqualification of the transferee in terms of Section 29A of IBC prevents circumvention of Section 29A through misuse of SSFs.
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Restrictions on investment in connected entities
Issue: As per Regulation 19M(1) of the AIF Regulations, SSFs are prohibited from investing in their 'associates', which has a restricted scope and does not sufficiently address the concern of round-tripping of funds, whereas the definition of 'related party' as provided under the Companies Act, 2013 (Companies Act), is wider in scope and may help bridge the gap around round-tripping concerns better.
Proposal: Regulation 19M(1) be amended to prescribe that an SSF cannot invest in its 'related parties', with related party having the same meaning as given in the Companies Act.
Impact: The proposed change from 'associates' in Regulation 19M(1) of the AIF Regulations to 'related party' is a step towards imposing a precise limitation on the kind of entities in which investments can be undertaken by SSFs thereby moving towards a more refined mechanism to prevent round-tripping. However, owing to the predominance of family-owned businesses in India with complex legal structures which usually form a part of large corporate groups, the proposal may obstruct SSFs from accessing a large portion of stressed debt in the Indian financial system.
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Minimum lock-in period and subsequent transfer of loans
Issue: While Chapter 6 of the Master Circular for AIFs mandates a lock-in period of six months on stressed loans acquired by SSFs (in terms of clause 58 of the RBI Master Directions), the subsequent transfer of loans needs to be restricted to certain entities only so as to address the concerns on round-tripping and credit discipline.
Proposal: AIF Regulations be suitably amended to permit SSFs to transfer or sell stressed loans, acquired in terms of clause 58 of the RBI Master Directions, only to the entities listed in the annex of RBI Master Directions, once the lock-in period is over.
Impact: The specification that SSFs can only sell the stressed loans to entities permitted in the annex of RBI Master Directions will lend credibility to the divestments made by SSFs, assuage investor concerns, and incentivise market participation.
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Monitoring of Special Situation Funds
Issue: While SSFs are governed by SEBI, given the nature of investments undertaken by SSFs, it is only appropriate that RBI has the power to call for information directly from SSFs, if required. Additionally, a suitable arrangement for data sharing between SEBI and RBI is imperative. According to the RBI Master Directions, all RBI-regulated transferors are required to report each loan transfer transaction undertaken to an RBI-notified trade reporting platform. Similarly, it has been proposed that SSFs should also report the details of (i) issuances, (ii) investors (including subsequent change in unit holdings), (iii) resolution strategies implemented, (iv) recoveries effected, etc., to RBI through its trade reporting platform.
Proposal: Introduce enabling clauses requiring SSFs to submit any information as may be specified by SEBI in consultation with RBI from time to time. SSFs will also be required to submit to RBI any information as may be required by RBI from time to time.
Additionally, since SSFs will be transferring units to investors, they will be required to submit the following information to the RBI on the aforesaid trade reporting platform, similar to how RBI-regulated transferors are required to report each loan transfer transaction undertaken by them:
- details of units issued;
- details of investors;
- subsequent change in unit holdings, if any;
- resolution strategies implemented;
- recoveries effected; and
- any other information as may be specified by SEBI.
Impact: While the proposition will help in data sharing between the two regulators along with RBI having the power to call for information directly from SSFs, it will also impose a duplicated administrative and compliance burden on SSFs, which may disincentivise market participants.
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Supervision of Special Situation Funds
Issue: Given that SSFs are designed to be governed by two regulatory bodies, RBI and SEBI, the incorporation of specific parameters that RBI takes into consideration with regard to supervision of its regulated entities that transact in stressed loans, should be built into the regulatory framework being designed for SSFs by SEBI.
Proposal: SSFs that have acquired stressed loans in terms of clause 58 of RBI Master Directions be subject to a dedicated supervisory framework as may be specified by SEBI, in consultation with RBI, from time to time.
Impact: A streamlined regulatory framework dedicated for SSFs will facilitate a seamless supervisory structure that aims for transparency and ease of compliance. The supervisory powers granted to each body in the streamlined framework should take into account that different aspects of an SSF can be regulated by each entity respectively and overlaps should be avoided. An overlap may increase compliance burdens and expenses on the SSFs and consequently impact their investors.
While the proposed amendments are aimed at encouraging participation of entities in the stressed loans market through SSFs, the implementation of these norms may pose challenges in terms of increased regulatory compliances and narrowed scope of investments. According to the Financial Stability Report released by RBI in 2022, banks are increasingly writing off loans, contributing to an economic slowdown. In this backdrop, the proposed regulatory regime for SSFs has the potential to revitalise investments in stressed loans, provided that the framework introduced is not cumbersome in terms of compliance and avoids duplication vis-à-vis the compliance requirements of RBI and SEBI.
