SEBI Fortifies AIF Investment Safeguards: Dematerialization and Custodian Mandate

Detailed Narrative:

The Alternative Investment Funds (AIFs) landscape in India is undergoing a transformative shift as the Securities and Exchange Board of India (SEBI) tightens the regulatory reins. In a landmark circular, the market regulator has unveiled a comprehensive framework governing how AIFs must hold and safeguard their investments, ushering in an era of enhanced transparency and investor protection.

At the heart of this circular lies the pivotal mandate that AIFs must transition to holding their investments in dematerialized (demat) form. This requirement, which comes into effect on October 1, 2024, applies to all new investments made by AIFs, irrespective of whether they are direct investments in companies or acquisitions from other entities.

However, SEBI has granted a grace period for existing investments. AIFs can continue to hold pre-October 2024 investments in physical form, except in two specific scenarios. Firstly, if the investee company is legally obligated to facilitate dematerialization of its securities. Secondly, if the AIF, either independently or in conjunction with other SEBI-registered entities, exercises control over the investee company, as defined by the AIF Regulations.

In such cases, AIFs must ensure that their pre-October 2024 investments are dematerialized by January 31, 2025. This requirement does not apply to AIF schemes with tenures ending on or before January 31, 2025, or those already in their extended tenure as of the circular’s issuance date.

Complementing the dematerialization mandate, SEBI has also made it compulsory for AIFs to appoint registered custodians for safekeeping their securities. This custodian must be in place prior to the scheme’s first investment. Existing Category I and II AIF schemes with a corpus of INR 500 crore or less, and holding at least one investment as of the circular’s date, have until January 31, 2025, to comply with the custodian appointment requirement.

In cases where the custodian is an associate of the AIF’s manager or sponsor, the managers must ensure compliance with the relevant regulations by January 31, 2025.

To streamline reporting and oversight, SEBI has tasked the Standard Setting Forum for AIFs (SFA) with formulating implementation standards for reporting data on AIF investments under custody. These standards will specify the format and modalities for managers to report data to custodians, and subsequently, for custodians to report to SEBI.

AIFs and custodians must adhere to these standards, which will be published on the websites of industry associations within 60 days of the circular’s issuance.

Furthermore, AIF trustees or sponsors must ensure that the manager’s Compliance Test Report includes adherence to the provisions of this circular. The necessary information to ascertain compliance will also be incorporated into the quarterly reporting format on the SEBI Intermediary Portal.

FAQs:

Q1. Why has SEBI introduced these guidelines?

A1. The primary objective is to enhance transparency, investor protection, and oversight in the AIF industry. Dematerialization of investments and appointment of custodians will streamline operations, reduce risks, and improve accountability.

Q2. Are there any exemptions from the dematerialization requirement?

A2. Yes, the requirement does not apply to AIF schemes with tenures ending on or before January 31, 2025, or those already in their extended tenure as of the circular’s issuance date.

Q3. What is the timeline for existing AIFs to appoint custodians?

A3. Existing Category I and II AIF schemes with a corpus of INR 500 crore or less, and holding at least one investment as of the circular’s date, have until January 31, 2025, to appoint a custodian.

Q4. What happens if the custodian is an associate of the AIF’s manager or sponsor?

A4. In such cases, the AIF managers must ensure compliance with the relevant regulations by January 31, 2025, to address potential conflicts of interest.

Q5. How will the reporting of AIF investments under custody be streamlined?A5. The Standard Setting Forum for AIFs (SFA) will formulate implementation standards for reporting data on AIF investments under custody. These standards will specify the format and modalities for reporting by managers to custodians, and subsequently, by custodians to SEBI.

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CIRCULAR

SEBI/HO/AFD/PoD/CIR/2024/5

January 12, 2024

To,

All Alternative Investment Funds

All Depositories

All Custodians

Sir/Madam,

Sub: Guidelines for AIFs with respect to holding their investments in dematerialised form and appointment of custodian

1.SEBI (Alternative Investment Funds) Regulations, 2012 (“AIF Regulations”) have been amended and notified on January 05, 2024, with respect to AIFs holding their investments in dematerialised form and appointment of custodian. Copy of the notification is available at link.

A. Holding investments of AIFs in dematerialised form

2.In terms of Regulation 15(1)(i)of AIF Regulations, AIFs shall hold their investments in dematerialised form, subject to such conditions as may be specified by the Board from time to time. The said requirement does not apply, inter-alia, to such investments by AIFs and such schemes of AIFs as may be specified by the Board from time to time.

3.In this regard, the following is specified:

3.1.Any investment made by an AIF on or after October 01, 2024shall be held in dematerialised form only, irrespective of whether the investment is made directly in the investee company or is acquired from another entity.

3.2.The investments made by an AIF prior to October 01, 2024 are exempted from the requirement of being held in dematerialised form, except in the following cases:

3.2.1.Investee company of the AIF has been mandated under applicable law to facilitate dematerialisation of its securities;

3.2.2.The AIF, on its own, or along with other SEBI registered intermediaries/entities which are mandated to hold their investments in dematerialised form, exercises control over the investee company. For the purpose of the aforesaid clause, the definition of ‘control’ shall be construed with reference to Regulation 2(1)(f) of AIF Regulations.

3.3.The investments made by an AIF prior to October 01, 2024 which are covered under conditions as specified inparas3.2.1 and 3.2.2 above, shall be held in dematerialised form by the AIF on or before January 31, 2025.

3.4.The aforesaid requirement of holding investments in dematerialised form shall not be applicable to:

3.4.1.Scheme of an AIF whose tenure (not including permissible extension of tenure) ends on or before January 31, 2025;

3.4.2.Scheme of an AIF which is in extended tenure as on date of this circular.

B. Appointment of custodian for AIFs

4.In terms of Regulation 20(11) of AIF Regulations, the Sponsor or Manager of the AIF shall appoint a custodian registered with the Board for safekeeping of the securities of the AIF, in the manner as may be specified by the Board from time to time.

5.Further, in terms of Regulation 20(11A) of AIF Regulations, a custodian which is an associate of the Sponsor or Manager of an AIF may act as a custodian for that AIF only when the conditions specified in the said Regulations are met.

6.In this regard, the following is specified:

6.1.The custodian for a scheme of an AIF shall be appointed prior to the date of first investment of the scheme.

6.2.Existing schemes of Category I and II AIFs having corpus less than or equal to INR 500 crore and holding at least one investment as on date of this circular shall appoint custodian on or before January 31, 2025.

6.3.In case of AIFs with custodians that are associates of their manager or sponsor, managers of such AIFs shall ensure compliance with Regulation 20(11A) of AIF Regulations on or before January 31, 2025.

C. Reporting of investments of AIFs under custody

7.In terms of Regulation 20(11) of AIF Regulations, the custodian shall report or disclose such information regarding investments of the AIF in such manner as may be specified by the Board from time to time.

8.In this regard, the following is specified:

8.1.The pilot Standard Setting Forum for AIFs(‘SFA’),in consultation with SEBI, shall formulate implementation standards for reporting data on investments AIFs that are under custody with the custodian. Such standards shall specify the format and modalities of reporting of data by the manager of AIF to the custodian and subsequently, by the custodian to SEBI.

8.2.Managers of AIFs and custodians shall adopt and adhere to such implementation standards, formulated by the SFA in consultation with SEBI. Such standards shall be published on websites of the industry associations which are part of the SFA ,i.e., Indian Venture and Alternate Capital Association (IVCA),PEVCCFOAssociationandTrusteeAssociationofIndia,within60 days of issuance of this circular.

9.The trustee/sponsor of AIF, as the case may be, shall ensure that the ‘Compliance Test Report’ prepared by the manager in terms of para 15.2 of SEBI Master Circular No. SEBI/HO/AFD/PoD1/P/CIR/2023/130dated July 31, 2023,includes compliance with the provisions of this circular.

10.The information necessary to as certain compliance with the provisions of this circular shall be incorporated in the format for quarterly reporting by AIFs in SEBI Intermediary Portal (www.siportal.sebi.gov.in). The manager of AIF shall provide the requisite information accordingly while submitting the quarterly report to SEBI.

11.This circular is issued with the approval of the competent authority.

12.This circular is issued in exercise of powers conferred under Section 11(1) of the Securities and Exchange Board of India Act, 1992 to protect the interests of investors in securities and to promote the development of, and to regulate the securities market.

13.The circular is available on SEBI website at www.sebi.gov.in under the categories “Legal framework -Circulars" and "Info for Alternative Investment Funds”

Yours faithfully,

Sanjay Singh Bhati

Deputy General Manager

Tel no.: +91-22-26449222

ssbhati@sebi.gov.in