Author name: CBCL

Unravelling the Impact: RBI’s Stringent Investment Measures Shake Up India’s AIF Landscape

Leave a Comment / Contemporary Issues /

[By Sibasish Panda & Disha Bandyopadhyay] The authors are students of National Law University Odisha.   Introduction India’s economy stands as one of the fastest-growing major economies worldwide. The growth in the investment market has been impeccable especially with the Alternative Investment Funds (AIFs) now surpassing the mutual funds (MFs) in terms of growth rate. With transparent structures, a diversified portfolio, and a promise of superior returns the industry has attracted investment from a wider spectrum of investors encompassing High Net individuals (HNIs) and Ultra High Net Individuals (UHNIs). AIFs have experienced a remarkable Compound Annual Growth Rate (CAGR) of 26%, resulting in impressive assets under management (AUM) of ₹13.74 lakh crore as of June FY24. SEBI as of June 2023 reported the total commitment by the AIF industry to stand at Rs 8.44 trillion. The Security Exchange Board of India (SEBI), and the Reserve Bank of India (RBI) are working hand in hand to make the market more investor-friendly by curbing shoddy practices such as “Evergreening of loans” through AIFs. SEBI was reported to investigate such cases involving Rs15,000 crores to Rs 20,000 crores. In November 2022 it also banned the priority distribution (PD) model of the AIFs and now the RBI has come up with a circular directing lenders investing in alternative investment funds to liquidate their holdings if the funds invest in a debtor firm.  The authors in this blog try and analyse the impact of the RBI guidelines on the players involved in the industry. Background  RBI noticed a practice whereby banks or Non-Banking Finance Companies (NBFCs) when they find that a borrower is unable to repay, float an AIF, invest funds in that AIF, and lend the money to the stressed company so that it can repay the bank or the NBFC. Now since AIFs redeem themselves after six or seven years the borrower company has enough time to turn A naround. This practice of extending new loans to a borrower to pay the existing loans thereby concealing the status of non-performing assets is known as the Evergreening of loans. In May 2023 SEBI floated a consultation paper highlighting the regulatory arbitrage of “priority distribution (PD)” among AIFs. It envisages that AIFs maintain the pro-rata rights of the investors since they are privately pooled investment vehicles. Now in a PD model an investor who subscribes to a junior tranche suffers loss more than the one who subscribes to a senior tranche thus disrupting the pro-rata harmony.  This arrangement is used by regulated lenders to offload the bad loans to the AIFs and to mitigate the initial impact on their books.    The regulated lenders subscribe to the junior class of investors and their investment is equivalent to a loss on the loan portfolio given to the borrower. The AIF then onboards other investors to its senior class and subscribes to the Non-convertible Debentures (NCDs) of the borrower company. This investment, representing the expected loss or haircut on the loan portfolio, is shown at par with senior class units in the lender’s books. This structure potentially helps regulated lenders avoid compliance requirements related to defaulting loans, while also deferring the recognition of the deteriorating creditworthiness of the investee company. Now the junior class of AIFs is structured to absorb losses hence by subscribing to the junior class the lender also ensures that in case of any further default by the borrower, the risk is proportionately distributed among the whole class of investors of the AIF and bad loan is not reflected in the books of the lender.   Although the borrower may still default on the AIF, the AIF can hold defaulted debt for extended periods, waiting for potential recovery. The risk is somewhat concealed as the NBFC’s exposure to the AIF doesn’t immediately reflect the default, and the AIF can take several years before declaring the debt as unrecoverable. This process allows the NBFC to maintain the appearance of a healthy portfolio by avoiding the immediate recognition of bad loans and creating a situation commonly known as “evergreening,” where the default is obscured over time.  RBI’s Stringent Measures: Impact on Regulated Entities, Market Disruptions, and Investor Confidence  To prevent this regulatory arbitrage, the RBI in the recently released circular takes a restrictive stance. It has directed investor Regulated Entities (REs) and NBFCs not to invest in any AIFs that have a downstream investment in debtor companies that have loans or investment exposures from the same REs in the preceding 12 months. It further directs the REs to liquidate their investment in the AIFs within 30 days of the AIF’s investment in the debtor company. This timeline applies to both investments as of the issuance of the circular and also in case of any future investments. This short timeline would trigger panic selling among the investors and they would rush to comply with the directive. Such abrupt liquidation of investments and mis-selling in such a short period can cause market disruptions and negatively impact asset prices. The 30-day timeline would be inadequate to carry out thorough due diligence. This raises the risk of undervaluation of assets and diminished return as a result of forced selling.  Another flagged issue is the circular’s broad application to all REs would inadvertently impact Development Financial Institutions (DFIs) such as SIDBI, NABARD, NHB, NIIF, etc. These DFIs often have a developmental mandate to channel capital into specific sectors for economic growth. Unlike entities engaging in evergreening practices, DFIs may not have the intent of concealing non-performing assets. However, the circular, by applying uniformly to all REs, including DFIs, may unintentionally subject them to the same regulatory provisions. This could be counterintuitive to the primary purpose of DFIs, potentially hindering their ability to fulfill their developmental objectives by imposing restrictions meant to address issues unrelated to their specific operations.  In case of failure of the REs to comply with the above direction within the stipulated timeframe, RBI has mandated them to make 100% provision on their investments in AIFs. Now to make a

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Client Poaching using Geo-fencing Technology – A Potential Antitrust Concern

Leave a Comment / Competition Law /

[By Anmol Aggarwal & Ria Bansal] The authors are students of Rajiv Gandhi National University of Law.   Introduction  The advent of Artificial Intelligence (‘AI’) technology has opened the gates to many potential methods of abuse of dominance that would not have the potential to exist on a large scale without AI technology. Geo-fencing is one of those methods, which, if used by a dominant firm to cause market rupturing, can lead to antitrust concerns. Geo-fencing refers to a technology used to mark a digital geographical boundary using tools like Global Positioning System (‘GPS’) around a specific determined territorial area or, in simple words, create a geo-fence around that specific area. Although primarily used for healthy market advertisement practices, this technology can become a leading concern in the antitrust regime.   Although the illegitimate use of geo-fencing is regulated by various technology acts like the Digital Personal Data Protection Act, 2023, and Information Technology Act, 2000, among others, this piece will argue on how dominant firms indulging in client-poaching using geo-fencing can lead to an anti-competitive practice and calls for the need of investigative tools and regulation of the existing Competition Law Authorities in India. The authors also propose a risk-assessment model for the potential abuse of the dominant position using geo-fencing technology.  Client-Poaching Vis-à-vis Geo-fencing  Geo-fencing is often used as a market penetration technique used by firms to steal the potential or existing clients of a rival firm. This poaching takes place through extensive digital marketing practices (such as advertisements) that a firm indulges in, which helps it offer comparatively better prices for its products than its rivals offer. Although it can be regarded as a healthy practice for new firms trying to penetrate the market, geo-fencing can lead to greater evil than good if not regulated by the competition authorities. As stated above, the usage is beneficial if deployed by a new market entrant as it can help it gain market power and, in turn, maintain healthy competition in the market. The specific laws pertaining to geo-fencing are capable enough to identify the illegitimate use of geo-fencing. However, the issue arises when a new market entrant and a dominant firm both deploy geo-fencing techniques to gain market power. The inability of specific laws to draw a line between the acts of these two types of firms calls for competition law authorities to interfere and prevent the foreclosure of competition in such a case. The same will be better understood through this illustration showcasing two different situations -   Situation 1 - A firm ‘A’ trying to make its place in the relevant market of ‘house brokerage’ deploys a geo-fencing technique to poach clients from its rival firm ‘B’ in the same relevant market. It deploys a geo-fence around the offices of firm ‘B’ and bombards the potential clients of ‘B’ with advertisements showing better house prices. With the help of this technology, ‘A’ was able to break the entry barrier and make its place in the market, which led to the entrance of a new market player and the promotion of healthy competition in the market.  Situation 2 - A dominant firm, ‘X,’ with considerable market power and a market share of 90% in the relevant market of ‘house brokerage’ deploys a geo-fencing technique to poach clients from its rival firm, ‘Y,’ which is the second largest player in the market, by providing its potential clients with advertisements of better prices for the houses. This leads to ‘Y’ losing its clients and eventually eliminating firm ‘Y’ from the relevant market, leaving ‘X’ with a monopoly position with no rival.  Now, in both of the situations mentioned above, the technique of geo-fencing was deployed by the firms. When we see it through the lens of specific laws, there is no technical illegality in the action of the firms in both cases, as advertising using geo-fencing is a practice that firms indulge in day-to-day life, and there is nothing against the law in digital advertising of better prices to the potential customers.  However, when the same is seen from the eyes of Antitrust Law, we will find that in ‘situation 2’, there is a foreclosure of competition in the relevant market of ‘house brokerage’. However, to determine the same, the Competition Commission of India (‘CCI’) uses investigative tools to determine factors like relevant market and market power, among others, and ultimately finds out whether a firm is abusing its dominant position. The same kind of investigation is impossible if done through the lens of specific laws as they lack the requisite tools and powers to identify whether market foreclosure is taking place.  Solutions  The existing solutions, like the doctrine of special responsibility for the dominant firms, are capable of curbing this problem. The doctrine of special responsibility, as stated by the court in the EU case law of Michelin v. Commission, refers to the responsibility of a dominant firm to take special care of its actions so that its conduct does not impair competition in the market.  However, the authors believes that additional methods, beyond the existing antitrust principles are required to curb this problem in the future and, therefore, proposes a model similar to the recent risk assessment model of the proposed global AI regulatory framework. Under this model suggested by the authors, the firms can be divided into parts according to their market powers in respective relevant markets. Now, these parts can be categorized ranging from high risk to moderate, low and negligible risks according to the extent to which geo-fencing technology could harm the competition in the market.  CCI or a new separate regulatory body under CCI’s control can regularly check the firms falling in the high-risk and moderate-risk brackets. This will help curb this futuristic problem of the abuse of dominance using geo-fencing technology, even before the firm indulges in it. A constant check by the regulatory body will help prevent market distortion practices by dominant firms who plan to use geo-fencing technology for client-poaching from their rivals.  Conclusion   The problem of client-poaching using

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Anatomising (Mis)utilization of Client’s Securities by (Professional) Clearing Members

Leave a Comment / Capital Markets and Securities Law /

[By Aniket Panchal & Shubhankar Sharan] The authors are students of Gujarat National Law University.   Introduction An interesting chain of events transpired centered on Edelweiss (a registered Professional Clearing Member (“PCM”), against whom appeals were filed in response to directives from the Member and Core Settlement Guarantee Fund Committee (“Committee”) of NSE Clearing Ltd (“NCL”). These directives ordered Edelweiss to reinstate securities that were disposed of in violation of the Securities and Exchange Board of India (“SEBI”) Circular and NCL Regulations. The contentious issue arose when Edelweiss, providing clearing and settlement services, sold collateral worth Rs. 460 Crore from broker and trading member Anugrah to fulfill clearing obligations.   The central issue here was that the PCM liquidated the securities of the Trading Member’s clients to offset the trading member’s debit balance. The Committee found Edelweiss on the wrong side, underlining a failure to ensure that clients’ securities were used solely for meeting their obligations, thus violating NCL Rules. Similarly, accusations regarding the misuse of client securities emerged in appeals involving other Clearing Members, including Yes Bank and SMC Global.   The Edelweiss order sheds light on the pressing issue of intermediary misconduct in handling client funds.  In light of this, the authors examine SEBI’s previous initiatives in curbing such malpractices and then discuss the roles of clearing members and the ambit of powers vested with NCL.   Past to Present: SEBI’s strides in countering misuse of client funds  Throughout the course of its existence, SEBI has actively tried to curb the menace of misuse of clients’ funds by Stock Brokers (“SB”) and Clearing Members (“CM”). A string of circulars has been released to further the objective. The premise was set by its 1993 circular, which prescribed maintenance of separate accounts of Member Brokers and their clients. It set the course for future actions against misuse. A brief leap in time necessitated SEBI to release another set of circulars in this regard. More importantly, all of them have been laid out prima facie to combat misuse of funds and client collaterals. Several actions in the form of alerting and monitoring mechanisms and enhanced supervision over SBs have been devised by SEBI. Not to mention, SEBI has been proactive in not only outlining the measures but also prescribing guidelines for implementing those measures. A look at some of the circulars, as mentioned in the SAT Order, underscores the principle highlighted in the 1993 Circular.   Precisely, the Circular dated 20 June 2019 proscribes the usage of clients’ funds by SBs for themselves or any other client (as provided in Securities Contracts (Regulation) Act 1956 (“SCRA”) and Securities Contracts Regulation Rules, 1957 (“SCRR”). Lastly, some of the immediate circulars dated 11 November 2022 and 12 December 2023 fortify SEBI’s position on misuse of clients’ funds. The former deals with handling clients’ securities by Trading Members (“TMs”)/CMs, while the latter lists the criteria for receipt/payment of funds by SB and CMs from/to clients. An essential requirement that stands out is establishing clear time frames for completing the transactions with clients.  Stock Exchanges, too, have been on the heels of SEBI. NSE circulars, for instance, reproduce the intent of the SEBI circulars. A case in point can be that of its June 2023 circular, wherein it established detailed guidelines for immediate actions against misuse of clients’ funds. “Enhanced Supervision” principles form the bedrock of implementing those administrative guidelines. The administrative actions referred to in the circular are in addition to pre-defined measures against Trading Members, as existing in the NSE circular no. 82/2022.   Several cases have been reported on misutilization of clients’ funds, of which the case of Karvy Group takes most of the light. The concerned company was involved in creating a labyrinth of transactions in order to misuse clients’ securities. Subsequently, it was expelled by the NSE and deregistered by SEBI on account of misutilizing clients’ funds and securities.  Analysis PCM and CM – Cut from the same cloth?   On this count, the main contention of Edelweiss was that based on the bye-laws of NCL, a PCM cannot be considered as a CM; therefore, circulars issued by SEBI/NSE/NCL will hold no applicability on the PCM. As a corollary, it was argued that the word “constituent” under NCL bye-laws can only encompass trading members with which a PCM has an agreement and not the end clients of the trading member. Based on this, it was contended that a PCM has no duty of care to a TM’s clients. Edelweiss urged that the clients of trading members do not have any legal or beneficial ownership over their shares once the trading members transfer the same to a PCM.  To rebut Edelweiss’s contention that a PCM is not the same as a CM, the tribunal referenced two provisions of the Futures & Options (“F&O”) Regulations. Firstly, the definition of F&O CM defines it as a member of the Clearing Corporation and includes all categories of clearing members. Secondly, a PCM is defined as a clearing member admitted by the relevant authority. Based on this, the tribunal noted that a PCM is nothing but a type of CM.   In any case, the whole discussion, at best, was academic since the tribunal found Edelweiss was registered as a CM and not as a PCM. As stated in the Order too, it is by virtue of the recent amendment to the Securities and Exchange Board of India (Stock Brokers) Regulations, 1992, that a PCM got defined under Section 2(ca). the reason being that, as per the Schedule appended to the Regulations PCM requires higher net worth than other sub-categories of CM. Otherwise, any member having clearing and settlement rights is a CM.   Interestingly, Edelweiss drew parallels between a PCM and a Senior Counsel to further its contention that PCM bears no liability to the trading member’s client. The analogy rested on the premise that Senior Counsel’s accountability lies only with the instructing advocate and not the end client. Likewise, PCM shall be answerable only to trading members (its client) and

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​​​Performance Validation Agency: SEBI’s Fresh Step Towards Investor Protection

Leave a Comment / Capital Markets and Securities Law /

[By Srishti Multani & Aryan Birewar] The authors are students of Symbiosis Law School, Pune.   Introduction   The Securities and Exchange Board of India (‘SEBI’) on 31st August 2023, issued a Consultation Paper to propose a Performance Validation Agency (‘PVA’). The objective of such an institution is to validate performance claims of SEBI-registered intermediaries. Such validation will enable the entities to catapult their customer-base in the securities market. There was a pressing need ​for transparency and authenticity in the claims made to attract investors. In this article, the authors examine the rationale behind a PVA, stress-points of the consultation paper, and critically analyze the benefits and challenges posed by the establishment of a PVA. Furthermore, they suggest certain solutions to address the forthcoming said challenges.   Need & Rationale   The urging requirement of credibility in the securities market pushed the regulator to produce this proposal. All the SEBI-registered intermediaries seek to increase their customer-base, which requires them to build investor trust. Such validation by the PVA will allow the intermediaries to attract investor clients in the market by highlighting their performance claims. An independent body like the PVA will facilitate the trust-building process ​between market intermediaries and investor entities.   Presently, SEBI has imposed differential restrictions on the market intermediaries in making performance claims to expand their service-base to more investor clients.   ​​​Claims of Asset Management Companies (‘AMC’) and Portfolio Managers are self-verified. There is absence of any independent body to validate their claims.   Claims of Investment Advisers (‘IA’) and Research Analysts (‘RA’) cannot be made in reference to their past performance. As per the existing SEBI Advertising Code, any ‘buy/sell/hold’ recommendation by these intermediaries cannot be made in reference to past performance and by usage of any superlative terms. For example, ‘best’, ‘top’, ‘leading’, etc.   Claims of Stockbrokers pertaining to past or future returns ensuing from algorithmic trading is not permissible.   The regulator recognized the need for intermediaries like IA’s, RA’s, Stockbrokers, etc. to showcase their performance claims to increase their clients. The same must be predated with an independent and impartial performance claim validation agency to ensure accuracy and correctness of claims floated in the securities market.   The functioning of such an agency will preclude eventualities of false, misleading, and inflated performance claims floated to attract investors. It will ensure that all participating intermediaries resort to fair and correct practices to expand their services to the investor clients. It is important to recognize that relying on verification from just one brokerage company can be misleading for investors, as it does not offer a comprehensive view of trading performance across all accounts. This makes the existence of a PVA all the more important.   Proposal by SEBI  The following proposals encapsulate the major highlights in SEBI’s Consultation Paper:  Criteria for Grant of Recognition   SEBI has mandated the PVA’s to be subsidiary entities of Market Infrastructure Institutions (‘MII’s). The rationale provided by them is that MII’s are the sole components of the securities market, which deal with ​a large​​ amount of investor data daily. As per the Bimal Jalan Panel (2010), they defined MII’s to be inclusive of Stock Exchanges, Depositories, Clearing Corporations, etc.   PVA’s are thus mandated to be wholly-owner or jointly-owner subsidiary entities of MII’s.   PVA’s will be recognized by SEBI only, when their parent MII fulfill the eligibility criteria prescribed by SEBI.   Obligations of a PVA  The paper prescribes the task of claim validation to be based on the parameters of risk, return, volatility, or any other parameter deemed suitable by SEBI. It is PVA’ duty to ensure that all information shared to them by the investors or intermediaries is kept confidential. Since, the major function is validation of investor data, SEBI permits ​PVA to partner with credit rating agencies for the purpose of validation, who aid in evaluating credit worthiness of debt securities and their issuers. Notably, the PVA can charge a reasonable fee for the validation of performance claims.   Categories of Claims validated by PVA.   Actual Profit – The PVA validates the actual profit minted by the investor basis the advice rendered by the SEBI-registered intermediary.   Algorithm – The recommendation rendered by PVA is derived from a certain algorithm. PVA undertakes performance evaluation of such algorithms over a prospective reasonable test period.   Stock/Portfolio – In order to evaluate recommendation of a stock/portfolio, the PVA must ​furnish​​ the recommendation on the day of recommendation and period of holding by the SEBI-registered intermediary.   Display of Recommendations   ​​​Exclusive Access– The validation of such recommendations is required to be published on their websites with access exclusively with clients.  Public Recommendations – Once the intermediaries publish the recommendations they can be accessed on the websites of the intermediaries and PVA both.  Specific Recommendation – When the intermediaries seek validation of a specific portfolio recommendation, then it shall be published on the websites of the intermediary and PVA in the format prescribed by the industry practice.  The unique attribute in these proposals is the “No Cherry-Picking” principle. As per this principle, the PVA cannot arbitrarily select clients, results, or events to their favor. Any validation of a performance claim must be done for all clients to prevent ​biases in the results. Furthermore, all such claims must be verified from third-party independent sources excluding the entity making the claim.  Analysis of the Proposals   The principal reason for this proposal was the pressing need ​for transparency​​ ​and investor reliance. By virtue of ​being an​​ independent verification body, it benefits both the investor and registered intermediaries – eliminating inflated performance claims and permitting marketing of successful investment advice, respectively.   For the investors, they place reliance on the stock and portfolio recommendations furnished by the SEBI-registered intermediaries to reap good returns. It becomes vital that an independent, third-party evaluator validates these recommendations. Especially, in cases of claims made by Asset Management Companies and Portfolio Managers, they are self-verified sans being subject to any external system of checks.  For the SEBI-registered intermediaries, they pressed the regulator for such an initiative as they want to increase their service-base to maximum investors. By

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RBI’s Regulatory Landscape: Decoding Guidelines for REs’ Investments in AIFs

Leave a Comment / Banking Law /

[By Lavanya Chetwani] The author is a student of National Law University Odisha.   INTRODUCTION  Recently, the Reserve Bank of India (‘RBI’) vide its circular dated December 19 has issued guidelines to prevent all Regulated Entities (‘RE’) from holding units of Alternative Investment Funds (‘AIF’) which have invested in a debtor company of the RE. AIFs are currently regulated by the Securities and Exchange Board of India (‘SEBI’)  under the SEBI (AIF) Regulations, 2012 (‘The Regulation’) and  SEBI Master Circular For AIFs, 2023 (‘MC-AIF’).  The guidelines issued by the RBI is motivated by a consultation paper issued by SEBI on 19 May 2023. SEBI had identified in its consultation paper certain structures which could be used for “evergreening” of loans by regulated entities. However, the guidelines might have an impact beyond the stated intent.   UNDERSTANDING THE GUIDELINES  AIFs have been defined by SEBI in paragraph 2(1)(b) of the Regulation as any fund established or incorporated in India which is a privately pooled investment vehicle which collects funds from sophisticated investors, whether Indian or foreign, for investing it in accordance with a defined investment policy for the benefit of its investors. As per paragraph 3(4) of the regulations, there are three categories of AIFs. Category I include infrastructure funds, angel funds, venture capital funds etc. Category II include funds like private equity funds, debt funds etc. and Category III includes funds which give returns under a short period of time like hedge funds.  The latest guidelines by the RBI bring the following changes:  1. Investment Restriction   The guidelines prohibit REs from investing in any scheme of the AIFs which has downstream investments in a ‘debtor company of the RE’. Downstream investments, though not defined in these guidelines, have been defined under Rule 23 Explanation (g) of the Foreign Exchange Management (Non-Debt Instrument) Rules, 2019 as investment made by an Indian entity which has total foreign investment in it, or an Investment Vehicle in the capital instruments or the capital, as the case may be, of another Indian entity. The circular is unfavourable for REs with genuine investments in these AIFs, and due to strict timelines, there is a high probability that these REs will struggle to liquidate their investments.    2. Liquidation time  Moreover, if in case, the RE has already invested in an AIF scheme and that AIF later makes a downstream investment in the debtor company of the RE then the RE has to liquidate its investments in such AIF scheme within 30 days. Additionally, should the RE already have invested in an AIF scheme, the 30-day timeframe will start on the date of issuance of circular i.e. 19 December 2023. The guidelines also lay out that the REs have to make 100 percent provision on such investments if they are unable to comply with the stipulated timelines. These regulations strengthen transparency and compliance through clear definitions and timeframes, but also raises concerns about administrative burden, exit challenges, and potential unintended consequences like decreased RE participation and concentration risk.  3. Priority Distribution Model  The directions also provide that investment by REs in the subordinated units of any AIF scheme with a ‘priority distribution model’ will be subject to a full deduction from RE’s capital funds. The explanation of this clause provides that ‘priority distribution model’ shall have the same meaning as in the circular issued by SEBI. According to paragraph 3 of the circular it means AIF schemes that use a waterfall distribution model suffer a share loss relative to other investor classes or unit holders that is greater than pro rata to their investment in the AIF because the latter has priority in distribution over the former.   While transparency and risk mitigation improve, REs face limited options and AIFs with these models may struggle to attract investors.  EVERGREENING OF LOANS   The RBI in its circular mentioned that the guidelines have been issued in order to deal with the problem of REs ‘evergreening’ loans through the AIF route. The similar issue was highlighted and informed by the SEBI to the RBI last year. In simple words, evergreen loans mean loans that never end. Evergreening of loans imply instances when REs provide the borrower another loan through AIF as an investment vehicle in order to repay the previous in default debt. Then, in order to demonstrate a low percentage of non-performing assets on their books, REs turn to these loans. The REs do so because once classified as such, they will have to provide for losses, which will in turn reduce profits. It has the  potential to mislead about the profitability and asset quality of banks and to postpone the identification and resolution of stressed assets.   However, the circular is unclear about whether AIFs in the Debtor Companies are pursuing this evergreening through fresh debt or equity infusion. Consequently, the circular refers to “investments” without making a distinction between debt and equity infusion.    DECIPHERING THE GUIDELINES: UNVEILING KEY CONCERNS    It is pertinent to highlight that SEBI, through paragraph 11 of the MC-AIF, has already imposed a restriction on arrangements incorporating priority distributions. Consequently, this broad prohibition by the RBI has the potential to negatively affect REs’ capacity to engage with AIFs that provide risk-adjusted returns for diverse groups of investors via various unit classes.   Additionally, the RBI Circular appears to be at odds with the inherent characteristics of AIFs. AIFs (Category I and Category II) are legally structured as privately pooled blind investment vehicles, characterized by a close-ended nature. AIF investors typically lack visibility into the AIFs’ investments and lack the right to freely redeem their units due to the highly illiquid nature of the AIF’s investments. Moreover, any transfer of AIF units necessitates explicit consent from the investment manager of the AIFs. In contrast, the RBI Circular mandates regulated entities to liquidate their investments in AIFs with downstream investments in debtor companies within 30 days. Assuming consent from the investment manager for the transfer, regulated entities may encounter challenges in finding buyers in the market, given

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Navigating M&A Transactions Amidst the Digital Personal Data Protection Act

Leave a Comment / Mergers & Acquisitions /

[By Rahil Arora & Vidushi Sehgal] The authors are students of Jindal Global Law School.   Introduction The realm of M&A transactions and investments today is dominated by parties sharing a potpourri of crucial data with one another and their advisors. This collaborative process involves the target company, the sellers, and the potential buyers sharing and disclosing vast amounts of information to undertake a meticulous assessment of the risks associated with a particular transaction. Through the course of this information sharing, Personal Data protection concerns are often overlooked, especially with the weakly enforced SPDI Rules. However, such an approach is unsustainable under the imminent Digital Personal Data Protection Act, 2023 (“DPDP Act” or “the Act”), and its rigorous penalty framework.  A Brief Overview of the Act  The DPDP Act is a comprehensive Personal Data protection legislation that finds its roots in Puttaswamy wherein the Supreme Court not only recognized the right to privacy as a fundamental right under Article 21 but also emphasized the need for such a legislation. Many of the Act’s provisions draw inspiration from the European Union’s General Data Protection Regulation (“GDPR”), albeit with certain modifications tailored to the Indian context. To simplify matters, the DPDP Act does not differentiate between different forms of Personal Data based on sensitivity. Any data in digital form about an individual who is identifiable by or in relation to such data, is classified as Personal Data.  Furthermore, the data ecosystem under the Act encompasses three primary stakeholders. First, the Data Principal or the individual to whom the data relates. Second, the Data Fiduciary, who determines the purpose and means of processing such data and is subject to various compliances, and penalties. Lastly, the Data Processor, upon whom no liability has been placed given that they are agents or service providers to the Fiduciary. “Processing” of Personal Data has been given a very wide definition under the Act and such processing by the Data Fiduciary must be for a lawful purpose and limited to the consent-notice framework or for legitimate uses as laid down under Section 4. Therefore, data processing should not only occur with the consent of the Data Principal and for specified purposes but also be accompanied or preceded by a notice in accordance with the provisions of Section 5. However, an exception may be made from this consent-notice framework when the same is for a legitimate use as specified under Section 7.  Personal Data in an M&A Transaction  Through the course of an M&A transaction, parties and their advisors such as legal representatives and financial auditors, share bucketloads of data concerning the target company. This exchange of information, generally facilitated through virtual data rooms, kickstarts the due diligence process and also involves the sharing of Personal Data such as supplier or vendor contracts, employment contracts, and personal details of employees, customers, directors, etc. All such information shared between the parties to the transaction amounts to “processing” under the scope of the Act.   What Role Does Each Party Play?  Given the processing of Personal Data that takes place through the course of the transaction, the inquiry that emerges pertains to the role assumed by each data processing party in such instances—whether they function as a Data Fiduciary or a Data Processor. Drawing this distinction is crucial as obligations are placed on Data Fiduciaries for their actions, as well as those of the Data Processors.  As the target or the seller furnishes Personal Data to the bidder or acquirer, it unmistakably operates as a Data Fiduciary. Importantly, this action also prompts the acquirer to similarly adopt the role of a Data Fiduciary. This is because it may process the Personal Data according to its purpose and means to ascertain the feasibility of the transaction. Thus, in such a case both the target and the acquirer will be responsible for compliance with the Act in their individual capacity. Nevertheless, this classification is not rigid and is contingent on the actions of the parties involved. Therefore, it is advisable for the parties to explicitly define their individual responsibilities and the purpose of data sharing in their pre-merger documentation. Moreover, advisors of either party reviewing documentation and Personal Data to offer professional opinions would be categorized as Data Processors under the Act.  The Grounds for Processing  Under the GDPR, processing of Personal Data for the “legitimate interests of the data controller” (same as a Data Fiduciary) is permissible. Thus, if parties to an M&A transaction can balance their interests against those of the Data Principal, they may process Personal Data without any external considerations or taking fresh consent. Interestingly, the 2022 Data Protection Bill also permitted processing of Personal Data for mergers, acquisitions, or other corporate restructuring transactions as a legitimate use thus, allowing for an exception to the consent-notice framework.   However, under the current iteration of the Act, Section 17(1)(e) exempts the application of certain provisions of the Act, including the grounds for processing under Section 4, only when the processing is pursuant to court or tribunal approved corporate actions like compromise, arrangement, merger, amalgamation, reconstruction, or transfer of undertaking between companies. Therefore, any other non-court-approved transaction such as a share sale or an asset sale would have to conform with the Act, including the consent and notice requirements prior to sharing Personal Data with a third party.   Actions To Consider  The DPDP Act envisages an extremely high penal regime in case of a Personal Data breach with penalties upon Data Fiduciaries reaching up to INR 250 Crores. Given the same, Data Fiduciaries must meet their obligations under the Act at all stages. The first step would involve determining whether the purpose for which the Personal Data is being processed is within the specified purpose for which consent was earlier obtained from the Data Principal. If beyond the specified purpose, fresh consent must be obtained from the Data Principals along with meeting the notice requirements before processing such data. In cases where fresh or prior consent proves difficult to obtain, the target

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Revisiting CBIRC-II: A Call for a Group Company Insolvency Regime

Leave a Comment / Insolvency Law /

[By Isha Khurana] The author is a student of Jindal Global Law School.   Introduction   The NCLAT in a January 2023 decision, reiterated the need to lift the corporate veil in matters of group company insolvencies. In doing so, it followed the path laid down in the 2021 CBIRC-II (hereinafter, “CBIRC-II Report”). This subject has been long debated in India and has found itself at the center of various working groups and committee reports. The 2019 working group report was the beginning of India’s recognition of the growing need to incorporate a provision for group company insolvencies, noting the shared control and economic interdependence of corporates. This, at the time, was deemed a win since the only preceding authority was the 2018 report of the insolvency law committee, which placed limitations on the growth of the group insolvency process. The 2018 report limited the scope of group insolvencies in India, by observing that since the insolvency code was only introduced in 2016, it may be “too soon” to introduce such a group company complexity in the statute.    Nevertheless, both the 2019 working group report and the 2021 CBIRC-II report have altered the course for group company insolvencies in India. While previous articles have addressed the nuances of group company insolvency, it is essential to consider the pivotal role played by reports such as the 2019 working group report and the 2021 CBIRC-II report. This article aims to revisit the discussion through the lens of the CBIRC-II decision and the January 2023 decision, to delve into the future of group company insolvencies in India. It attempts to incorporate the family-dominated business environment of India in this discussion, to stress the increased need for a group insolvency procedure. Through this, the article flows into an evaluation of whether the alleged conflict between group insolvencies and the separate legal entity doctrine could hamper the adoption of a group insolvency regime.   Contextualizing Group Companies in India   The 2021 CBIRC-II report fared well in establishing jurisprudence on which corporate groups could be deemed as group companies in India and what factors must exist for the same. A perusal of the committee’s deliberations on the definition of a “group” highlights the importance of shared control, common shareholding, and interdependence among members of a corporate group, for them to be termed as a group company structure. It thus becomes clear that an inclusive definition of “group” must be included in India’s insolvency regime and reliance may be placed on either control or ownership to establish the existence of a group company structure.   It is argued here that the business environment in India will be complemented by this definition. India is known to be home to several family-run businesses, both in the public and private sectors. The existence of such family-run businesses opens the doors for situations wherein holding companies exercise control over their subsidiaries (essentially, a vertical relation) and also for members of the same corporate group (a horizontal or lateral relation) to impact one another, through economic dependence. Thus, the insolvency regime needs to address the same, for promoting equity and fairness, and ensuring the protection of creditors.    The focus on control and ownership factors in the leading elements in establishing group company structures in the Indian context. Owing to the fact that it is commonly observed for common shareholding to be present with corporates exercising control over one another’s activities. Additionally, the deliberations of the working group coupled with the decision in Videocon, also open up the possibility of establishing a group company structure through the presence of common assets, pooling of recourses, interlinked financing, and so on. Thus, judicial decisions and committee reports work well with one another to account for a broad range of scenarios wherein a group company structure may be present.   As India’s corporate environment is dominated by family businesses (arguably, more than any other jurisdiction), it becomes all the more important that an efficient group company insolvency and recovery regime is in place. The same stems from the increased likelihood of corporations exercising control over each other’s operations and decisions. Further, given the operation of businesses in India, where significant control and decision-making power are shared, it becomes easier to pierce the corporate veil, and to allow for the institution of insolvency proceedings against a group of companies that are acting together. However, some may be apprehensive about initiating proceedings against a group of companies, as it may violate the separate legal entity principle, by treating different corporate entities as akin to one another. Thus, an analysis of whether the process of lifting the corporate veil for group insolvencies would contradict the separate legal entity principle must be undertaken, through the lens of judicial decisions.    A Judicial Lens to Piercing the Corporate Veil  Scholars and committee reports have repeatedly noted that insolvency laws are based on the principle of corporations being separate legal entities, following the jurisprudence laid down in Saloman v Saloman. The principle in insolvency law has come to be viewed as one that also distinguishes companies from their subsidiaries or holding companies, advancing from the view that a company is distinct from its members. Thus, binding corporate bodies belonging to the same group of companies was thought of as going against the basic tenets of corporate law.   However, jurisprudence which allows courts to lift/pierce the corporate veil has found its place in insolvency law as well. Practice now allows for the veil to be lifted in situations where associated companies are connected in a manner that they come to be treated as a single concern. The CBIRC-II sheds light on when companies may be treated as a single concern or rather, what links must be present for the same. The most commonly observed would be situations where companies have linked operations or finances when they own shared assets, and engage in related party transactions. In such scenarios, carrying out individual insolvency proceedings for one entity would be fruitless as a creditor would not be able to

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Lifting Or Piercing The Corporate Veil: Clarifying The Two-Step Examination

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[By Arunoday Rai] The author is a student of National Law School of India University.   Introduction The doctrine of lifting or piercing the corporate veil is fundamental to the company law. This doctrine acts as an exception to the concept of a company being a separate juristic entity. It allows the court to treat the rights and liabilities of the corporation as the rights and liabilities of its shareholders. The courts in India have recently tried to expand the horizon of this doctrine to pay regard to the new economic realities behind the evolving corporate structure in the modern era.  This article contends that such an expansion of this doctrine has been on a misplaced understanding of Supreme Court (SC) precedents. The courts in India have failed to provide a sound legal basis to expand the contours of this doctrine and have failed to differentiate between various attitudes with which SC has lifted the veil in different cases. It argues that SC has used this doctrine in two types of situations: the first type involves peeping behind/lifting the veil, whereas the second type of cases involves penetrating/piercing the veil. The author sheds light on the confusion caused by the interpretation of the doctrine by the courts due to their lack of understanding of the above-mentioned two-step examination.  The Two-Prong Test   It is essential to understand what is meant when the courts lift the veil of the company. The doctrine is generally been used to impose liability on the shareholders or alter ego of the company by lifting the veil. However, the two-stage analysis in this post highlights that such a view of the doctrine is incomplete. The act of lifting the veil is not always detrimental to the shareholders/alter ego of the company but can be beneficial at times.   Peeping Behind/Lifting the Veil  The first stage in the analysis involves the least discussed act taken by the court, where it merely lifts the veil of the company. At this stage, the court lifts the veil of the company to gather information such as shareholding patterns, shareholders, control, etc. It pulls down the veil once such information is gathered and the company is treated as per the information gathered during the inquiry done by the court at this stage. For instance, the statutory lifting of the veil provided in Sections 2(46) and 2(87) of the Companies Act, 2013 is a classic example of this stage.   The SC in the case of Renusagar had to adjudicate on the issue whether Renusagar was a power plant owned by Hindalco. If both these entities were considered to have no separate existence, then Hindalco would be entitled to certain exemptions on electricity duty by the State government. The SC lifted the veil to hold that both industries had no independent existence and were inextricably linked up together. The judgment by the SC eventually benefitted the Petitioner’s company as the veil was lifted only to investigate the relationship between both entities involved in this petition.  SC has also provided certain prerequisites that need to be fulfilled before the veil is lifted or peeped into. The apex court in LIC v. Escorts had held that a veil can be lifted in various situations such as fraud or improper conduct, evasion of taxing or a beneficent statute, public interest, effect on parties, etc. It did not provide a straight jacket formula but listed broad illustrative situations where the veil could be lifted. However, it went ahead to say that in the present case, no such lifting of the veil is necessitated beyond the governing statutes involved as it is not necessary to the case.  Therefore, it should be noted that this stage only involves the court lifting the veil and is a condition precedent to the next stage of penetrating the veil where a court after gathering information may make an order against the company imposing liability on them or refrain from imposing any liability.   Penetrating/Piercing the Veil  This stage involves the imposition of liability upon the shareholders for the company’s acts through the piercing of the veil. Such liability can be seen through Section 36 of the Companies Act, 2013 where a person who knowingly or recklessly induces persons to invest money can be held liable for action under Section 447 of the Act. This provision is an example of the statutory piercing of the corporate veil where liability is imposed on a person for committing a prohibitive act.  The standard for piercing the corporate veil has been subject to contradictory judgments in India. While some courts have held that fraud is a sine qua non for piercing the veil, other courts have held to the contrary. This article supports the former view by underscoring the importance of demonstrating impropriety or evasion of legal obligations as a prerequisite for piercing the veil.  It has upheld such a view by recognizing that the law does not allow for imposing liability on mere commonality or interlocking shareholding or common directorships. The requirement of fraud or evasion of a legal obligation is essential to protect the fundamental precept that every company is a distinct legal entity. However, various courts have agreed to the latter view as they have conflated the standards to be used during the two-stage analysis while applying this doctrine.  The Confusion  Several courts in India have held that the contours of this doctrine cannot be restricted to the requirement of fraud/sham/façade and could be extended to situations where justice, equity, public interest, and convenience so required. The courts that have taken this view have tended to rely on judgments of the SC in LIC v. Escorts and Renusagar which has been interpreted to enlarge the standard of piercing the corporate veil.   For instance, the Bombay High Court in Bhatia International has held that the doctrine is no longer restricted to the cases of tax evasion but also pertains to cases that are opposed to justice and convenience. It goes ahead to state that once the court

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Municipal Bankruptcy: India’s Chapter 9 Moment?

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[By Bhaskar Vishwajeet] The author is a student of Jindal Global Law School.   Introduction  Municipal bonds have gathered steam in India. As of when this piece was written, the country has 29 active municipal bonds on the NSE’s IBMX index for municipal bonds. Municipal debt instruments are a great alternative to raising capital for public infrastructure/service works. That said, assuming that the debt obligation is watertight may not be prudent because the issuer is a sovereign. There may be issues with revenue generation and projects being delayed. However, a far more significant threat is the municipal corporation’s bankruptcy.  This article aims to contextualize municipal bonds within India’s bankruptcy regime and assess whether these debt instruments and investors are secured through regulation in case of possible bankruptcy. We shall also refer to the United States to see how the sovereign’s promise of “faith and credit” to back the bond’s health is not always guaranteed.  What are Municipal Bonds?  Municipal bonds are government debt instruments financing public projects and utilities. They attract investors by allowing them to lend money to local government institutions in return for regular interest payments and the return of their principal when the bond matures. The potential tax benefits, such as income tax exemptions on interest income, make municipal bonds appealing, especially to investors in higher tax brackets.  Municipal bonds are of two types: General Obligation (GO) bonds, supporting general development works through revenue from property tax and revenue cess, and Revenue Bonds, funding specific projects like schools and water filtration plants through project-generated revenue. Backed by the respective government’s reliability in repaying debts, municipal bonds receive ‘investment-grade’ ratings from agencies, exemplified by AA+ ratings for New Delhi Municipal Council and Navi Mumbai bonds.  Municipal Bond Health  Municipal Bonds are generally considered safer than other investments in the market for two primary reasons. First, municipal corporations are state instrumentalities. A sovereign pledge supports the bond’s health, and there is a sense of assurance that the state will make good on the interest income and any default whatsoever.  Second, to reinforce investor confidence in the value and health of the bonds, regulators require  municipal issuers to meet certain eligibility requirements. The SEBI (Issue and Listing of Municipal Debt Securities) Regulations 2015 stipulates eligibility requirements in regulation 4 and requires the issuing local government authority or ULB to, inter alia, not have a history of defaulting on debt repayments in the past 365 days of the issuance of a municipal bond and to have at least an investment grade credit rating (BBB- or above) by a SEBI-registered credit rating agency.  The Detroit Case Study and Chapter 9 Protections  Despite their perceived safety, municipal bonds face financial distress, as evidenced by the City of Detroit’s bankruptcy in 2013. Detroit’s case illustrates how legislative protections, such as Chapter 9 of the U.S. Bankruptcy Code (Adjustment of Debts of Municipalities), facilitated a resolution.  Detroit had issued various bonds before its bankruptcy, including GO bonds backed by taxing power and Revenue bonds secured by specific project revenues. Financial problems, stemming from issues like population decline and rising pension costs, led to a severe budget deficit, prompting the city to file for Chapter 9 bankruptcy protection in July 2013. Chapter 9 allows municipalities to restructure debts without asset liquidation, enabling negotiations with creditors under court supervision. This ensures a fair repayment plan while maintaining essential services. Detroit emerged from bankruptcy in 2014 after a federal judge approved a financial restructuring plan.  Does India’s Bankruptcy Regime Protect Municipal Issues?  India’s Insolvency and Bankruptcy Code (IBC) lacks provisions akin to Chapter 9 in the U.S., raising concerns about the protection of municipal bondholders during bankruptcy. Even SEBI offers no guidance on municipal bankruptcies or defaults. Regulators seem to have complete faith in the sovereign pledge of these municipalities and the principle of not interfering with the state’s powers. This logic is akin to the history behind Chapter 9 in the United States, wherein the original municipal bankruptcy legislation from 1934 was held unconstitutional for violating the sovereignty of states. The United States Congress later revised the Act in 1937, which was constitutionally affirmed in United States v. Bekins, and subsequently retained as Chapter 9 through the 1978 Bankruptcy Reform Act.  Chapter 9 is unique because it is tailored for municipal bankruptcies. It includes an automatic stay on any associated claims or litigation against the debtor. The provisions include restrictions on the court’s interference with the municipal debtor’s powers, such as not interfering with the municipality’s borrowing powers and converting the proceeding into a liquidation proceeding. These restrictions are necessary to preserve the constitutional status of Chapter 9 (as the borrower is a sovereign). As a corollary, the municipal debtor must propose a plan to adjust its debt since creditors cannot file plans under Chapter 9. The entire process provides space to negotiate and restructure a debt repayment plan for municipal debt. Indian law does not guarantee such a position.  The problem worsens with the incompatibility of general bankruptcy laws as List I (Central) subjects with List II municipalities. As local governments, municipalities are state subjects in Entry 5 of List II. Multiple states have statutory municipal corporation acts (“Acts”), enabling municipal corporations to raise money by issuing debentures or other instruments (see Section 114A of the Uttar Pradesh Municipalities Act 1916). Almost every Act stipulates the security interests that may be created in a bondholder’s name. These range from municipal taxes, borrowed funds from public financial institutions and even, rarely, immovable property vested in the Corporation. Most municipal corporations/councils must maintain a municipal/sinking fund to ensure an adequate corpus to return the borrowings on debentures/loans. However, many Acts are unclear on whether the sinking fund can be used for other forms of issues, i.e., if the municipality chooses to issue, say – non-debt securities.  There is some guidance concerning the order of payments. Section 151 of the erstwhile Municipal Corporation Act 2000 (Jammu and Kashmir) stated that interest income and loan repayments will be paramount. However, this instance is too remote for broad application. In isolation, these provisions

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