[Malavika Devaya is an Associate at Poovayya & Co., Bengaluru]
Myre Capital, a fractional ownership platform by Morphogenesis, recently made headlines by raising INR 50 crores for its offering of the integrated township Magarpatta Cybercity. A concept that is fast gaining popularity in India but has been around in developed countries for a while now, fractional ownership is the obvious answer to making an income from extremely highly valued prime commercial real estate with fairly limited resources. The basic idea behind fractional ownership is simple – what an individual cannot afford to purchase, a group of people can pool in money and jointly purchase.
A modern-day fractional ownership platform (FOP) in India is ordinarily a company that identifies suitable high-value properties and invites investors to own a fraction of the same to earn income from the rent generated or the appreciated resale price. Once the property has been identified and investors have been secured, the most common investment route is by incorporating a special purpose vehicle (SPV) to purchase the property. Investors hold securities in the SPV and receive the profits of rent or income as interest or dividends. A new route also seems to be gaining popularity nowadays, wherein sale deeds are registered directly in the names of the purchasers of the property. High tech operators may even use blockchain technology to store and maintain the register of owners securely. The direct deed of ownership method allows the FOP to circumvent even the bare minimum corporate compliances since no SPV is incorporated.
In both cases, after the purchase of the property, the FOP takes on the role of a property manager, allowing the owner-investors to sit back and reap the rewards without having to dirty their hands in the day-to-day management of the property. Exiting a scheme is limited to three options – (i) secondary sale on the platform operated by the FOP; (ii) private sale; or (iii) sale of the underlying property by the SPV, with the consent of majority shareholders.
Since these FOPs operate as real estate agents or brokers before the property is purchased and as property managers thereafter, they would ideally need to register as ‘real estate agents’ under the provisions of the Real Estate (Regulation and Development Act), 2016 (RERA). However, it is unclear whether FOPs actually follow this practice, as the website of only one such FOP discloses that it is ‘RERA Registered’.
While RERA does lay down some obligations of a real estate agent, including maintaining books or accounts, not getting involved in unfair trade practices and facilitating the provision of all information to the allottee at the time of booking, these generic functions do not offer sufficient protection for investors since the context in which they have been introduced is significantly different from the context in which an FOP operates. From an Indian securities market perspective, the Securities and Exchange Board of India (SEBI) has not introduced any specific guidelines or regulations that address the operation and management of FOPs, and as a result, FOPs have so far managed to fly under the radar and avoid having to comply with any major regulations.
Collective Ownership Schemes
Whether or not an FOP would amount to a collective investment scheme, defined under the SEBI Act, 1992 (the SEBI Act) and regulated under the SEBI (Collective Investment Schemes) Regulations, 1999 (CIS Regulations), is an interesting question. The definition of a collective investment scheme set out in section 11AA of the SEBI Act largely mirrors the principles laid down by the US Supreme Court in the case of SEC v. W.J. Howey Co. (popularly known as the ‘Howey Test’), viz. to qualify as a collective scheme, (i) the contributions or payments made by investors must be pooled and utilised for the purposes of the scheme or arrangement; (ii) such contributions by investors must be made with the view to receive profits; (iii) the property or investment forming part of the scheme must be managed on behalf of the investors; and (iv) the investors must not have day-to-day control over the management and operation of the scheme or arrangement.
From a bare reading of section 11AA of the SEBI Act, FOPs arguably do qualify as collective investment schemes and must register as such and comply with the regulatory framework set out in the CIS Regulations. In PGF Limited v. Union of India, the Supreme Court of India (SC) found a similar but very rudimentary form of this concept to fall squarely within the purview of the SEBI Act and the CIS Regulations. PGF Limited operated a scheme wherein they invited individuals to contribute money and purchase portions of agricultural lands, the end goal being to earn an income from the development and management of those lands by PGF Limited. PGF Limited argued that there was no investment scheme as such and the matter would not fall within the scope of securities, but the Supreme Court rejected this view and held that the activity of PGF Limited was nothing but a collective investment scheme in disguise.
While the question of whether they fall within the scope of ‘collective investment schemes’ or not may still be up for debate, assuming arguendo that they do, the existing CIS Regulations would need to undergo certain modifications to be able to regulate FOPs effectively and unambiguously. Such amendments to the CIS Regulations may need to consider, amongst other things, the following:
Inclusion of SPV and direct ownership models
The CIS Regulations presently only contemplate a transaction structure wherein the investment scheme is in the form of a private trust, constituted in terms of a registered trust deed, that holds the securities in trust for the investors (see Chapter IV, CIS Regulations). To regulate FOPs without arresting innovation, the CIS Regulations must be amended to introduce the concepts of (i) collective investment through the incorporation of an SPV and allotment of its securities to investors; as well as (ii) the registration of sale deeds directly in the names of the investors, by-passing the need for an intermediary in the form of a trust or SPV.
Compulsory due diligence and disclosures
Since investors do not interact directly with the property owners and rely upon the offerings of the FOP, it is essential for the FOP to engage reliable and recognised advocates to conduct a thorough title due diligence of the shortlisted property and then make the complete title opinion, including any exceptions or caveats drawn by the advocates, available to the prospective investors to enable them to make an informed decision. Even in the FOP’s role as a property manager post-purchase, it must be required to disclose any disputes, concerns or issues that may arise and provide regular updates. In addition to this, every investor must have unrestricted access to the complete title, revenue and survey documents of the property, along with the documentation executed with tenants or occupants of the property. In case of leased properties, the FOP must undertake a stringent tenant-vetting process and provide all necessary information to the owners.
Under the CIS Regulations, collective investment management companies are permitted to advertise new investment schemes, subject to strict compliance with the guidelines set out therein (see regulation 27). However, in the FOP context, while this may work for the direct ownership model, it may give rise to some confusion in the case of the SPV route, since the Companies Act, 2013 prohibits the advertisement of private placements of securities (see section 42 (7)).
Skin in the game
A popular mechanism that features across most money management and investment schemes, this would require the FOP and/or key management personnel above a certain level to hold a specific percentage of units in the investment scheme (in the form of shares of the SPV or undivided share in the property directly) for a minimum period, before divesting. The current CIS Regulations restrict the collective investment management company from investing in a scheme floated by it unless it adheres to certain conditions (see regulation 13). In contrast, it may be advisable instead to make it compulsory for FOPs to invest in their schemes themselves, as this would ideally increase the FOP’s level of care and due diligence before offering properties for investment by making the stakes more personal.
SEBI has been contemplating introducing the concept of ‘accredited investors’ in the Indian securities market and had earlier released a consultation paper setting out the broad framework, which was recently approved. Some of these principles in the framework could find application in the FOP context as well, for example, FOPs that are only inviting investment from accredited investors being allowed certain regulatory relaxations and those opening to all classes of investors being subjected to more stringent compliances.
A seemingly major reason for the popularity of FOPs today is the absence of rigid, time-consuming and expensive compliances. However, regulation of these FOPs is important to protect investors from being defrauded out of their hard-earned money and have in place safeguards against any unexpected turn of events. FOPs and market regulators need to work together to achieve the bottom-line, which is stimulating economic growth while maintaining investor security.
– Malavika Devaya