REGULATORY ARBITRAGE THROUGH ALTERNATIVE INVESTMENT FUNDS: REASSESSING INDIA’S INVESTMENT REGIME

This post is authored by Ashar Nezami and Yash Agarwal, 2nd-year B.A. LL.B. (Hons.) students at Dr. Ram Manohar Lohiya National Law University, Lucknow

INTRODUCTION

Alternative Investment Funds (‘AIFs’) refer to a privately pooled investment vehicle that raises funds from domestic or foreign investors for the purposes of investing the funds for the benefit of domestic investors. The recent surge in Indian investments through AIFs highlights a shift in macroeconomic trends, with the Securities and Exchange Board of India (‘SEBI’) raising concerns about regulatory circumvention through AIFs. SEBI has flagged that around 20% of AIF investments may be used to bypass financial regulations. These exploitations range from attempts to bypass the Foreign Exchange Management Act (‘FEMA’) to instances of Foreign Portfolio Investors (‘FPI’) violation. Additionally, concerns like evergreening of loans and possible tax evasion are also flagged through the growing misuse of AIFs. These concerns bring to the forefront the need to examine how AIF investments are classified under the regulatory framework, particularly in relation to foreign versus domestic investment norms.

Due to the scope of ambiguity in the classification of AIF investment as foreign or domestic, key questions concerning the classification of AIF investments arise. This grey area, which will be discussed later, creates a scope for bypassing Foreign Direct Investment (‘FDI’) and FEMA norms. Through the evasion of these regulations, the foreign investor gets a chance to tap sectors outside the scope of foreign investment, in addition to the route to bypass sectoral caps. Before delving into the implications of AIF as a tool for regulatory arbitrage, it is essential to first understand its inherent vulnerabilities to misuse.

AIF’S VULNERABILITY TO MISUSE

Under Rule 23 of the Foreign Exchange Management Non-Debt Instrument (‘NDI’) rules, AIFs are classified differently depending upon the ownership and control of their sponsor or manager. An AIF’s sponsor is the person or people who create it, including the promoter in the case of a business and the designated partner in the case of a limited liability partnership. Moreover, a manager of the AIF is a person or an entity who is appointed to manage its investment activities; therefore, in practice, a sponsor can also assume the role of a manager. When both the sponsor and manager of an AIF have a domestic presence, the fund is considered a resident entity, and its investments are exempt from foreign exchange regulations like pricing guidelines and sectoral caps. However, if either the sponsor or manager of an AIF is not an Indian body, the AIF’s investments are treated as downstream foreign investments and must comply with applicable exchange control rules.

If an Indian entity has over 50% ownership in any corporation, any investment it makes into another Indian company through that enterprise is treated as a downstream investment. The classification of AIFs as foreign or domestic creates an exception where an investment through AIFs, which is sponsored or managed by an Indian entity, is treated as domestic, regardless of the significant foreign investment. Since Indian owned and controlled AIFs do not attract foreign investment regulations, they can be used to gain access to sensitive or capped sectors. Due to this vulnerability, AIFs have been routinely abused as a means of getting around restrictions on foreign investment, allowing entry into delicate industries, skewing fair competition, reducing regulatory oversight, and permitting disproportionate foreign control. Currently, SEBI has already found more than 40 transactions with a cumulative value of approximately INR 30,000 crore, in which 3% breaches are proportioned to FDI sectoral violations. These violations highlight a significant lacuna in the current framework which defies the purpose of the existing investment regime.

IMPLICATIONS OF THE GREY AREAS

Once a foreign investment bypasses the regulatory norms, it gives rise to a host of problems that undermine the integrity of India’s foreign investment regime. Shell-like structures akin to AIF can be misused in similar ways to circumvent regulatory norms. A foreign investor can easily sidestep FDI and FEMA legislations by using AIF as a shell to siphon its funds in the form of domestic investment. Since the domestically controlled AIF would not be subject to foreign regulations, the circumvention becomes a convenient channel for foreign investors to indirectly influence the Indian economy.

For example, in a recent Enforcement Directorate (‘ED’) probe against Myntra, it was alleged that Myntra had misused the relaxed FDI regime by posing as a wholesale business (where 100% FDI is allowed) and routing almost all of its goods through a related party, Vector E-commerce. Since Vector sold these products directly to consumers, the arrangement effectively became retail in disguise, violating the 25% foreign investment cap, which is the maximum limit allowed in a group sale as per the ‘Consolidated FDI policy’.  Similarly, in another case, ED has accused One Sigma Technologies Pvt Ltd, which operates a buy-now-pay-later app SIMPL, for violation of FDI norms. The company received INR 648.87 crore in FDI from the US and issued convertible notes worth INR 246.88 crore under the 100% automatic route. Consequently, it classified its business as “Benefits of Information Technology and other computer service activities.” However, ED’s investigation found out that SIMPL’s business falls under financial activities, which, as per the ‘Reserve Bank of India’s A.P. (DIR Series) Circular No. 8 (2016),’ require prior government approval under the 100 % approval route. By mislabelling its business to evade these requirements, SIMPL allegedly violated the FDI regulations to the tune of INR 913.7 crore.

Now, had Myntra or One Sigma structured its investments through an AIF, bypassing the entire foreign regulatory regime would have been far easier and more seamless. The inherent nature of AIFs could have provided the company with an even smoother route to allegedly sidestep investment restrictions and exploit regulatory gaps. The access to the foreign economy through FDI attracts numerous caps and restrictions to protect the financial integrity of the jurisdiction. Since the degree of direct influence in an economy through foreign investment is limited to an extent to maintain economic sovereignty, direct influence through FDI alone does not put an investor in a position to interfere with the jurisdiction’s financial condition. However, as discussed above, the loophole through an AIF can avoid all these complications. Once an investment gets categorised as domestic, the door for misuse expands significantly. Therefore, suppose, Myntra or One Sigma structured their investments through AIF for the purpose of sidestepping investment restrictions, the process would have been far more convenient and legally unobjectionable for them to do so.

LEGAL RAMIFICATIONS

The hypothesis given in the previous section raises a sharp eye towards the potential misuse of shell structures to sidestep cross-border investment requirements. India’s current foreign investment regime focuses on who owns or controls a company directly. However, it does not account for unchecked foreign control over domestic enterprises through structures such as AIFs.

The assumption regarding the potential misuse of AIF is further strengthened by instances such as the 360 ONE Alternates Asset Management Ltd., In re, where the 360 ONE Group and the Pai Family purchased in API Holdings Limited (a primary healthcare and pharmaceutical platform in India). This was done through compulsorily convertible preference shares (‘CCPS-B’) issued to 360 ONE Large Value Fund (a scheme under a Category II Alternative Investment Fund) and Claypond Capital, a company controlled by the Pai Family. Such an issue of CCPS-B shows that pharma investment routed through an AIF is possible. Since foreign downstream investment by an AIF can be treated as domestic if the AIF is considered Indian-owned and controlled, it creates a regulatory grey area. Such foreign investments can also enter sensitive sectors, like pharma, without scrutiny of foreign exchange regulations.

One more example of such a regulatory framework that has helped foreign entities bypass Indian norms is the case of SAMARA AIF and Amazon’s investment in Witzig Advisory Limited. Witzig Advisory acquired More Retail, a supermarket chain, from Aditya Birla Group. In 2019, Amazon obtained a 49% stake in Witzig Advisory, along with a 51% stake of SAMARA AIF in the same. Foreign investment in multi-brand retail, like More Retail, is capped at 51% through the government route as per the ‘Consolidated FDI Policy’ by the Department for Promotion of Industry and Internal Trade (‘DPIIT’). However, it was alleged by Confederation of All India Traders (‘CAIT’) that Amazon has invested in SAMARA AIF, thus, its total investment surpasses the cap of 51%. This was made possible as foreign investment in SAMARA AIF, being domestically owned and controlled, was considered domestic investment.

Both instances discussed above strengthen the hypothesis that AIF can be misused as a practical circumvention tool. In each case, the AIF structure enabled investors to bypass investment norms, illustrating the ease with which such vehicles can facilitate indirect influence in capped or restricted sectors of the economy. This regulatory lacuna, if left unaddressed, has the potential to open the floodgates to significant compliance and governance challenges in the future.

CONCLUSION AND THE WAY FORWARD

Regulatory reform is required to prevent further bypass of foreign investment rules. SEBI has been involved in scrutinising cases of ‘regulatory arbitrage.’ SEBI has recognized in its ‘Consultation paper on proposal to enhance trust in the Alternative Investment Funds (‘AIF’) ecosystem to facilitate Ease of Doing Business measures’ that some foreign investors have set up AIFs with domestic managers/sponsors to invest in sectors prohibited for FDI, or to invest beyond the allowed FDI sectoral limit. SEBI has also amended SEBI (AIF) Regulations, 2012 (‘AIF Regulations’) to include due diligence requirements to be fulfilled by the Manager or his key management personnel of AIF to prevent facilitation of circumvention of extant regulations administered by any financial sector regulator.

SEBI, through a circular issued on 8 October 2024 titled ‘Specific due diligence of investors and investments of AIFs’ has laid out due diligence requirements primarily for investors who are situated, from, or citizens of a Land Bordering Country, or contributed by the beneficial owners who are situated, from, or citizens of a Land Bordering Country.  However, as there can be a maximum of one thousand investors in a single AIF as per Regulation 10(f) of the AIF Regulations, imposition of such due diligence requirements for AIFs, which have such large numbers of investors, may also increase the burden on managers. Moreover, no penalty or any punitive measure has been prescribed in the circular for such investors. The Circular fails to provide clarity about investors not sharing a land border with India. Such investors can still circumvent other regulations without any due diligence.

The all-encompassing solution lies in amending the NDI Rules, 2019, from where the genesis of the problem lies. There is a need for the government to change the basis of determination of downstream investment with respect to AIF, and that it should be the beneficial interest held by foreign investors rather than ownership and control of the sponsor and manager. Apart from this, a ‘sectoral look-through’ mechanism can be introduced for such transactions. This type of mechanism exists in the USA, where the Committee on Foreign Investment in the United States (‘CFIUS’) reviews certain transactions such as ‘covered control transactions’ or ‘covered investments.’ SEBI can also formulate such a sectoral look-through mechanism in AIF.

SEBI may formulate a look-through mechanism to decipher the real purpose of the transaction, following the doctrine of lifting the corporate veil. The transactions that provide a foreign individual with control of an Indian business, i.e., covered control transactions, should be monitored strictly. After scrutiny, if it appears that the transaction was a result of some ulterior motive, then necessary penalties and punishment must be imposed. Moreover, penalties must also be prescribed for malafide transactions involving non-controlling positions of US businesses that are involved in critical technology, vital infrastructure, or sensitive personal data, which are termed as covered investments. This look- through will prevent malafide transactions aiming to circumvent the existing regulatory framework. Furthermore, the AIF can be mandated to disclose the identities of investors to SEBI, especially the foreign investors, in the case that the AIF is managed and controlled domestically.

Additionally, the government can roll out a review mechanism to monitor the flexible status of AIFs, rather than deciding at a single point in time. This new mechanism will require AIFs to constantly report changes in their ownership or control. Using this data, authorities like SEBI can maintain a better track of foreign-controlled funds. This system would ease the workload for regulatory authorities in keeping track of indirect foreign intervention with the Indian economy, and ensure that India’s investment framework remains efficient, transparent, and aligned with its economic security objectives.