[By Raj Shekhar & Krati Gupta]
Raj Shekhar is a student at NUSRL, Ranchi and Krati Gupta is a student at NLU, Jodhpur.
The Securities and Exchange Board of India (SEBI, hereinafter) has recently released the SEBI (Alternative Investment Funds) (Third Amendment) Regulations, 2021 on August 03, 2021. The amendment seeks to introduce a new category of investors in an Alternative Investment Fund (AIF, hereinafter) called Accredited Investors (AIs, hereinafter). This move can be seen as a successor to the initial SEBI consultation paper on AIs, released in February 2021. The aim of the consultation paper was to seek comments from industry experts that were largely positive. The experts considered the introduction of AIs as a powerful tool to distinguish sophisticated investors who are capable of independently managing risk without the need to adhere to strict regulatory prescriptions, thereby making Indian regulations more aligned with capital market regulations in more mature markets. In one of its recent board meetings, SEBI which has been deliberating on the concept of AIs for quite a while now has accepted the proposal. In furtherance of the same, it has released an amendment regulation that tries to introduce AIs as a completely new category of investors. In light of this recent notification, the article seeks to elucidate upon the concept of AIs in the Indian securities market, its advantages and disadvantages through a global comparative study.
Accredited Investors: The “Experienced” Players
AIs are based on the concept of a class of investors who, due to their prior experiences and other allied factors, have an understanding of various financial products and the risks- returns associated with investments that they make in the market. Thus, they are able to make an informed choice regarding their investments, unlike other investors in the market. This concept of ‘experienced’ or ‘professional’ investors is recognized by many securities and financial market regulators around the globe who have their own names for such categories of investors like Qualified Investors, Accredited Investors or Professional Investors. This class of investors is seen as one that has the capacity to deal in relatively riskier investment products due to their stable financial status and ability to bear financial losses which may be incurred. The majority of the time, investments made by such players are closely monitored by fund managers who have financial acumen or are directly overseen by the AI who is well aware of the risks involved, owing to his experience of the market. Thus, AIs are those investors who are presumed capable of making risky investments with minimal regulatory protection.
The Accredited Investor Tag: Why it Matters?
When we look at the functioning of SEBI or any international market regulator, we find that their function is not just limited to the smooth functioning of the market. Their other prime duty is to provide necessary protection by introducing regulatory requirements that help investors in making a more informed choice. While the idea behind disclosure requirements, filing of offer document/ prospectus, flexibility in respect of investor reporting, etc. is to ensure a safe and conducive investing environment, these are time-consuming at the same time. Further, the main aim of such stringent requirements is generally to ensure that the investors are making an informed choice. So, for experienced investors, such requirements are redundant for they are already well acquainted with the risks/prospects of their investments.
The concept of AI, as per SEBI, envisages that such accreditation can lead to identifying a class of sophisticated investors who have the ability and willingness to invest in the securities market, particularly in investment products that are relatively riskier and have minimal regulatory oversight. What adds to the benefit is that the redundant restrictive practices are relaxed for this class of investors. However, the advantage that the AI tag offers is exactly the same element that forms the core of its disadvantage. The minimal intervention by the regulator means that the chances of financial losses are much higher in spite of the fact that AIs have a better understanding of investments. Thus, we can rightfully assert that the tag of AI enables the holder to enter into a trade-off between investment security and ease of investing.
Accredited Investors Around the World: A Global Comparative Analysis
As discussed above, the idea of AI is not new and has been operational in various global jurisdictions. The following discussion provides a brief understanding of how the concept of AIs differs in these jurisdictions from that in India.
United States of America
An AI in US is an investor who satisfies one or more of the conditions that the US Securities Commission has laid down. Some of them include the condition that a potential AI should have an annual income that exceeds $200,000 in each of the two most recent years (or $300,000 in joint income with a person’s spouse) and who reasonably expects to reach the same income level in the current year. Further, his net worth should exceed $1 million and other allied requirements.
Singapore
In Singapore, an individual whose net personal assets exceed Singaporean $2 million; an individual whose income in the preceding 12 months exceeds Singaporean $300,000; or corporations with assets exceeding S$10 million can apply for accreditation and become an AI. The problem till 2018 in Singapore was that anyone with above-stated requirements was made an AI without the need for an explicit request. This led to a lot of controversies where investors complained that they were unaware of the risks involved as an AI in the market. This led to the introduction of the opt-in requirements where an investor can only become an AI once he has explicitly made an application in writing.
European Union
EU similar to the USA has tried to include the essence of experience, but unlike the USA which has kept such a requirement as an alternative path, EU has made it mandatory. For an individual to get accredited as a ‘Profession Investor’, he needs to have carried out transactions of significant size on the relevant market at an average frequency of 10 per quarter over the previous four quarters and further needs to have a financial portfolio exceeding EUR 500,000. Along with this, he needs to work or should have worked in the financial sector for at least one year.
Accredited Investors in India: Is the Framework Robust?
In India, individuals, HUFs, family trusts and sole proprietorships, that have an annual income of INR 2 Crore and more; or have a net worth of INR 7.5 Crore or more, out of which at least INR 3.75 Crore is in the form of financial assets; or have an annual income greater than or equal to INR 1 Crore with a net worth of INR 5 Crore or more, out of which at least INR 2.5 crore is in the form of financial assets; are eligible for accreditation.
When we analyze the requirements for AI tag in India, we find that a huge emphasis has been supplied to individual wealth and the entire requirement of a prior experience has been negated. Historically, individual investors who do not meet specific income or net worth tests, regardless of their financial sophistication, were denied access to invest in multifaceted and vast private markets. However, the regulators soon figured out that apart from economic stability, the experience of an investor was also a key factor in determining his capability to be a designated AI.
As a result of this realization, the USA introduced a parallel route based on experience to allow certain investors, who failed to meet minimum income requirements for AI, to get accredited solely on the basis of their diverse experience in investments. The introduction of experience requirements as a parameter, by the USA, improved the mechanism to effectively identify institutional and individual investors that have the knowledge and expertise to participate in these markets. EU has been a leader in this development too, owing to their strict experience requirement as a prerequisite to be classified as a professional investor. In light of these mature jurisdictions adopting experience as a major criterion, the absence of the same in Indian AI classification seems to be a worrying concern.
Conclusion and The Way Forward
Before any concrete statements could be made regarding the SEBI-introduced AI regime, we need to understand the risks involved with a non-experience-based AI accreditation system. As discussed above, security regulators in the case of AIs presume that they have an understanding of the functioning of the market and risks. However, it is quite contrary to what has been introduced by SEBI for AIs in India. The major question that arises here – “Is wealth/income/net worth equitable to experience?” While it cannot be denied that such parameters could indeed justify the “ability to bear any financial losses” part of AI rationale, it in no way equates to “has information with regards to risks involved”. This could be seen as a major oversight on part of SEBI which failed to take lessons from the Singapore fiasco.
In Singapore, before the 2018 amendments, the AI tag was allotted to anyone who met the financial criteria without a requirement of an active application. This meant that people who were ‘wealthy’, and not necessarily experience, were made AIs. In many cases, these AIs were not even aware of the risks involved which eventually led to many losses. One central point to blame was the inexperience of such AIs. As a result, in 2018 an opt-in mechanism was introduced which made it mandatory to allot AI tags to only such investors who requested it by an active application. The central point of the entire argument in this article is that in absence of such experience requirements for AIs that have been introduced globally, India seems to be lagging behind. Thus, it is the need to the hour for SEBI to look into this area of concern and if deemed fit, introduce experience requirements for the AI regime in India.