[Vidisha Tanna and Sonali Nagariya are 5th-year BLS LLB students at SVKM’s Pravin Gandhi College of Law, Mumbai]
In the ever-evolving landscape of Indian financial markets, the move towards dematerialisation of units of alternative investment funds (“AIFs”) marks a significant regulatory stride. The SEBI (Alternative Investment Funds) Regulations, 2012 have heralded a new era where AIFs, an integral part of the investment ecosystem, are transitioning from traditional physical certificates to a more secure, electronic form.
The concept of dematerialisation in India is not new, tracing its origins to the establishment of the National Securities Depository Limited (“NSDL”) and the Central Depository Services (India) Limited (“CDSL”). Over the years, there has been a gradual yet steady transition towards electronic holding of securities, primarily driven by the need to curb the risks associated with physical certificates. Traditionally, AIFs in India have issued units in physical form, conforming to the definitions under the Securities Contracts (Regulation) Act, 1956. However, the application of this concept to AIF units required a nuanced understanding of the unique nature of these investment vehicles.
SEBI’s Consultation Paper, Circular and FAQs
SEBI’s consultation paper issued in February 2023 emerged as a pivotal document in shaping the transition towards the dematerialisation of AIF units. This consultation paper was crucial in initiating a dialogue among stakeholders and identifying the reluctance of AIFs to transition from physical certificates. The hesitancy stemmed from concerns such as limited investor participation, a preference for private transactions, and perceived administrative complexities, especially affecting foreign investors and small fund managers. The paper was instrumental in highlighting these industry apprehensions and stressed the need for a structured regulatory response.
In addressing the challenges and reservations brought forward by the consultation paper, SEBI took decisive action by issuing a comprehensive approach that laid out a clear pathway for dematerialisation. This approach, detailed in a SEBI circular SEBI circular dated June 21, 2023, mandated the dematerialisation of AIF units and introduced a phased timeline based on the corpus of the AIFs. This timeline was carefully crafted to allow a gradual and manageable transition, aimed at causing minimal disruption within the market.
For AIFs with a corpus greater than INR 500 Crore, the deadline for dematerialisation was set at October 31, 2023, while those with a corpus less than INR 500 Crore were given until April 30, 2024. This staggered approach demonstrated SEBI’s commitment to bringing Indian financial markets in line with global standards, while also taking into account the unique challenges faced by the domestic market.
Further, the approach delineated specific roles and responsibilities for market participants. It emphasized the necessity for AIF managers to maintain accurate records, including KYC details, and comply strictly with the new regulations. Depositories such as CDSL and NSDL were also recognized as key players in facilitating this shift, requiring changes to their rules and regulations to support this significant transition.
SEBI further refined its approach with a circular a circular dated December 11, 2023. This circular introduces the “Aggregate Escrow Demat Account” for managing units not immediately claimed or dematerialised by investors. This account will be established by AIFs solely for the purpose of holding demat units on behalf of these investors.
When investors provide their demat account details to AIFs, their units held in the Aggregate Escrow Demat Account will be transferred to their respective demat accounts within five working days. No transfer of units from or within the Aggregate Escrow Demat Account will be allowed except for this purpose. Units held in the Aggregate Escrow Demat Account can be redeemed, and the proceeds will be distributed to the respective investors’ bank accounts with a full audit trail. This ensures transparency and accountability in the redemption process.
To supplement the approach and address the various queries arising from the shift, NSDL released a set of FAQs. These FAQs clarified numerous aspects of the dematerialisation process, the vital role of custodians, and the detailed responsibilities of AIF managers and investors.
India and UK: Parallel Paths in AIF Regulation
In the United Kingdom (“UK”), the issuance of AIFs presents notable parallels with the recent developments in India, particularly in aspects like dematerialization and regulatory compliance. Governed by the Financial Conduct Authority (“FCA”), which plays a role akin to SEBI in India, AIFs in the UK adhere to regulations that emphasize investor protection, transparency, and market conduct. The UK market, much like India’s recent initiatives, has widely adopted the practice of holding securities, including AIF units, in electronic form. This approach mitigates risks associated with physical certificates and aligns with the global trend towards digital record-keeping.
For authorization and operation, AIFs in the UK are required to register with the FCA, entailing rigorous disclosure and compliance standards similar to those imposed by SEBI in India. The focus is largely on qualified or institutional investors, mirroring India’s approach in targeting investors who possess the necessary expertise and financial resilience. A key component of the AIF framework in both jurisdictions is the provision of a comprehensive prospectus or offering document that outlines critical information about the fund, including investment objectives, risks, and management details.
Furthermore, the operational structure of AIFs in the UK, involving the appointment of custodians for asset safekeeping and administrators for day-to-day operations, shares similarities with Indian practices. This structure ensures efficient fund management and adherence to regulatory standards. Both in the UK and India, AIFs are subject to ongoing reporting obligations to their respective regulatory bodies, reinforcing a commitment to transparency and regular oversight.
Rationale Behind the Mandate
The rationale behind SEBI’s mandate for the dematerialisation of AIF units is multifaceted and aimed at enhancing the overall functioning of the Indian financial markets. At its core, this initiative prioritizes investor protection by minimizing risks associated with physical securities, such as loss, theft, or fraud. It simplifies the administrative process, making it more efficient and error-free, which is especially crucial given the sophisticated nature of AIFs. Dematerialisation also facilitates easier and faster transfer and transmission of securities, thereby enhancing liquidity and operational convenience.
Additionally, this transition significantly reduces the administrative burden, cutting down on paperwork and streamlining various processes associated with the management of investments. From a regulatory perspective, dematerialisation allows for more efficient oversight and easier compliance monitoring, as it centralizes and simplifies the access to investment data. Aligning with global financial practices, this move positions the Indian market on par with international standards, enhancing its appeal to global investors.
Furthermore, this initiative is in line with the Digital India campaign, reflecting the country’s commitment to embracing digital solutions across various sectors, including financial services. It instills greater confidence among investors, assuring them of the safety and modern handling of their investments. Overall, the shift towards dematerialisation is a strategic step towards a more secure, transparent, and efficient investment environment, addressing both operational challenges and regulatory compliance needs.
However, implementing SEBI’s directive poses substantial issues that need to be carefully navigated. One of the primary challenges lies in the technological upgrade required for a seamless transition. This is particularly significant for smaller AIFs, which may have limited infrastructural support and resources to adapt to these changes. Overcoming this technological barrier is crucial for ensuring that all market participants can comply with the new mandate without undue burden.
Furthermore, there is a critical need for educating investors about the benefits and the process of dematerialisation. This involves widespread awareness campaigns to ensure that investors are well-informed and comfortable with the transition, thereby facilitating smoother acceptance and adaptation to the new system. The successful implementation of this transition largely depends on investor understanding and cooperation.
An additional crucial aspect is the functionality of the Aggregate Escrow Demat Account, introduced by SEBI to manage unclaimed units effectively. This account plays a pivotal role in ensuring that units not immediately claimed or dematerialised by investors are securely managed and accounted for. The management of this account requires meticulous oversight to prevent potential misuse or operational inefficiencies, ensuring that the transition to dematerialisation maintains its integrity and serves its intended purpose of enhancing market efficiency and security.
The mandatory dematerialisation of AIF units represents a significant step towards digitalisation in India’s financial sector. This move not only aligns with global best practices but also enhances the overall efficiency, security, and transparency of the investment process. As the market adapts to this new regime, it paves the way for more innovative and investor-friendly reforms in the future.
– Vidisha Tanna & Sonali Nagariya