VEILED INVESTMENT SCHEMES FOR PRIVATE POOLING - Mr. Rahul Sud and Ms. Aayushi Anand [footnoteRef:1] [1: This article is co-authored by Mr. Rahul Sud (alumni of Law Faculty, National University of Singapore) and Ms. Aayushi Anand (alumni of Symbiosis Law School, Pune) both currently working at SNG & Partners, Delhi. SNG & Partners is a full service law firm and a preferred partner for legal assistance for matters relating to banking finance, private equity and real estate, among others, and advises various banking, financial institutions, multinational and corporate houses. ]

ABSTRACTThis article analyzes the prevalent market practice in India, which has in recent times, witnessed a surging growth in usage of various investment vehicles, at the core of which lies the concept of pooling of funds. The Securities Exchange Board of India (SEBI) aims to regulate private pooling of funds and has introduced various regulations to that effect. In India, unless permitted, the private pooling of funds is prohibited. The concept of limited liability partnerships (LLP) has been introduced in India with the view to ease business operations and provide flexibility to entities. With no specific parameters laid down, sponsors of investment schemes have resorted to luring unsuspecting investors into pooling their funds in violation of the SEBI regulations, using LLP as the preferred investment vehicle. Through this article, an attempt has been made to distinguish genuine LLPs from those used to masquerade private pooling under the guise of an LLP.

I. INTRODUCTIONWith the Securities Laws (Amendment) Bill, 2013[footnoteRef:2] (hereinafter referred to as the Securities Bill) being introduced in the Lok Sabha, the Securities Exchange Board of India (SEBI) shall now vest with the power to regulate any pooling of funds involving a corpus of INR 1,000,000,000 or more, which fall with the ambit of as SEBI Collective Investment Scheme Regulations, 2000 (CIS Regulations). The intent of the Indian government is reflected in the press release issued by the Ministry of Finance on 18th July, 2013, which states: [2: The Securities Bill had previously been promulgated twice as an ordinance and later introduced as a bill in the lower house of the Parliament, which recently lapsed. The Indian government is contemplating re-promulgation of the ordinance in case the Securities Bill cannot be passed in the current session.]

Owing to new and innovative methods of raising funds from investors, such as art funds, time-share funds, emu /goat farming schemes, there has been regulatory gap /overlap regarding types of instruments / fund raising... The Indian government believes that these amendments would give SEBI the legal backing to clamp down on unscrupulous entities that are using newer methods to take gullible investors for a ride. The promulgation of the [Securities Bill] demonstrates the firm commitment and resolve of the Indian government [to ensure that SEBI] acts with speed and alacrity to curb irregularities and frauds in securities market.[footnoteRef:3] [3: http://pib.nic.in/newsite/erelease.aspx?relid=97305 (last visited on January 30, 2014)]

At the core of the CIS Regulations, lies the concept of pooling of funds. This is not the first time that we have seen pooling of funds forming an integral part of regulations which intend to regulate various investment schemes.

Recently, SEBI has released consultation papers on draft SEBI (Real Estate Investment Trust), Regulations, 2013[footnoteRef:4] and Infrastructure Investment Trusts[footnoteRef:5] which would permit pooling of funds for investment in real estate assets and infrastructure sector, respectively. The concept of pooling per se is not new. A historical analysis of the regulatory framework, including the SEBI (Alternative Investment Funds) Regulations, 2012 (AIF Regulations) and SEBI (Mutual Funds) Regulations, 1996, (MF Regulations) governing investment schemes goes to show that the legislature has always sought to regulate pooling of funds by placing entry barriers and investment thresholds, keeping in mind the investment profile of the investors. [4: http://www.sebi.gov.in/cms/sebi_data/attachdocs/1381398382013.pdf (last visited on January 26, 2014)] [5: http://www.sebi.gov.in/cms/sebi_data/attachdocs/1387543144855.pdf (last visited on January 26, 2014)]

In fact, we can also see reference of pooling of funds in regulations adopted by various countries across the globe. Countries such as Singapore[footnoteRef:6], United States of America[footnoteRef:7] and United Kingdom[footnoteRef:8] all stipulate that in order to qualify as a collective investment scheme, contributions of the participants and the profits or income from which payments are to be made to them are required to be pooled. [6: Securities and Futures Act (Chapter 289) (Original Enactment: Act 42 of 2001) Revised Edition 2006 (1st April 2006)] [7: Section 153 of the Investments and Securities Act (ISA) No. 29 of 2007] [8: Section 235 of the Financial Services and Markets Act, 2000]

II. RECENT DEVELOPMENTSWith the view to provide flexibility and ease of business to entities, new concepts, such as increasing the number of members to 200 in a private company, have been introduced by passing of the Companies Act, 2013 in India.

In fact, even the passing of the Limited Liability Partnership Act, 2008 (LLP Act) has encouraged the growth of corporate entities. The LLP Act combines the characteristics of a company and a partnership, thereby making a limited liability partnership (LLP) an ideal choice for incorporation. Under the LLP Act, there is no maximum number of partners prescribed. Further, the LLP, just as in the case of a company, enjoys limited liability and is a separate legal entity.

III. LOOPHOLES IN THE EXISTING FRAMEWORKWhere on one hand, the government intends to promote business opportunities by providing relaxation in formation of a separate legal entity and also relaxing the norms for maximum number of members under such entity, on the other hand, SEBI has been proactively introducing guidelines to curb the menace of dubious schemes in order to protect the interest of the investors.

SEBI primarily intends to regulate the unauthorized pooling of funds, which has been reflected in various regulations, as discussed above. The primary intention of SEBI is that no entity should carry out pooling of funds if it is not registered with SEBI or if does not comply with the regulations of SEBI. In addition to this, SEBI has now been given wide powers including the power to now attach assets in case of non-compliance and entrusting the SEBI chairman with powers to authorize the carrying out of search and seizure operations, as part of efforts to crack down on ponzi schemes[footnoteRef:9]. [9: 18-July, 2013 21:19 IST Ministry of Finance, http://pib.nic.in/newsite/erelease.aspx?relid=97305 (last visited 30th January, 2014)]

The problem arises, when funds are pooled in the guise of a genuinely incorporated separate legal entity. For example, AIF Regulations under regulation 3 (1) stipulate that on and from the commencement of AIF Regulations, no entity or person shall act as an Alternative Investment Fund unless it has obtained a certificate of registration from SEBI. However, if an LLP with a sizable number of partners, undertakes investment of its capital in the real estate sector, which otherwise would have been prohibited by AIF Regulations, it may be then argued that there is no pooling of funds and the contribution by the partners is made towards the capital contribution of the LLP.

A detailed analysis of the extant regulations, coupled with an understanding of the market practices would help us to appreciate this concern better.

With certain exceptions provided under the AIF Regulations, an Alternative Investment Fund[footnoteRef:10] is defined as a fund established or incorporated in India in the form of a trust or a company or an LLP or a body corporate which: [10: Regulation 2(1) (b) of Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012 ]

1. is a privately pooled investment vehicle which collects funds from investors, whether Indian or foreign, for investing it in accordance with a defined investment policy for the benefit of its investors; and

2. is not covered under the Securities and Exchange Board of India (Mutual Funds) Regulations, 1996, Securities and Exchange Board of India (Collective Investment Schemes) Regulations, 1999 or any other regulations of the Board to regulate fund management activities.

As a consequence of these AIF Regulations, unless permitted, any form of private pooling of funds is prohibited. These regulations also stipulate certain entry barriers for the investors, keeping in mind the risk profile of the investors. The intention of the regulator, being very clear is to take on market manipulators and perpetrators of investment frauds. SEBI, like other regulators, does not intent to stifle business or investment. The intention of SEBI is to promote healthy investment and impose such investment restrictions which protect investors, keeping in mind their risk appetite. SEBI has promoted different investment opportunities, for different class of investors, so as to cater to their specific investment requirements and needs. For example, category I AIFs are reserved only for venture capital funds, SME funds, social venture funds, infrastructure funds and the like. Similarly other categories in the AIF Regulations, CIS Regulations and the MF Regulations are aimed at facilitation of investments by different class of investors.

While drafting the AIF Regulations and distinguishing it from the other regulations, SEBI resorted to the concept of private pooling of funds in a more casual way. For example, SEBI issued a Concept Paper on Proposed Alternative Investment Funds Regulation, which was released for public comments on August 01, 2011 (Consultation Paper). This Consultation Paper reflects the intention of the regulator for notifying the AIF Regulations. In this Consultation Paper, SEBI has made a distinction between AIF Regulations and SEBI (Portfolio Managers) Regulations, 1993, (PMS Regulations). The core difference between the AIF Regulations and PMS Regulations, as reflected from the Consultation Paper, is that the portfolio managers registered under with the SEBI would be required to segregate the clients funds and prohibited to pool the fund / securities of clients and all portfolio managers who seek to pool assets such as for investing in unlisted securities should be required to register as an alternative investment fund under the AIF Regulations. Though, no attempt was made to clearly define what would constitute private pooling of funds, an indicative concept was mentioned in the Consultation Paper, which suggested that in case the clients accounts are segregated then that would not be considered as private pooling of funds.

In the recent times, Indian markets have witnessed evolution of new structures, which are being adopted to circumvent the regulations and the prohibition on private pooling of funds imposed by SEBI. By adopting such structures, sponsors have been able to launch schemes, which otherwise would be prohibited or regulated by SEBI.

As discussed above, a very straight forward structure to circumvent SEBI regulations would be masquerade the pooling of funds under the guise of an LLP or a company and the returns are distributed to the partners / shareholders in the form of profits /distributions (assuming all other factors pertaining to taxation remaining neutral). Though, a company can be used effectively to achieve the objective of private pooling of funds, the recent market trends indicate that the limited liability is most preferred vehicle for launching various schemes dues to ease of incorporation and operability. For the purpose of this paper, we shall restrict our discussion to using LLP as a vehicle for private pooling of funds.

IV. USING LLP AS A VEHICLE FOR PRIVATE POOLINGThe SEBI regulations, which prohibit private pooling of funds and the new legislations (including the LLP Act), which intend to promote ease of incorporation and doing business, both run parallel. There are certain salient features of the LLP Act, which provide a favorable foundation to launch schemes for private pooling of funds in the form of a duly incorporated LLP. Some of such features are discussed below:

1. The LLP is a separate legal entity as distinct from its partners. This has been discussed in earlier section of this paper;

2. LLP has combined features of a company, (as formed under the Companies Act, 1956) and that of a partnership (formed under the Partnership Act, 1932). As per Section 22 of the LLP Act, a new partner can be inducted to the LLP, in accordance with the LLP agreement. There is no maximum cap on the number of partners in the LLP. Further, as per Section 23 of the LLP Act, the mutual rights and obligations between the partners shall be governed by the LLP agreement;

3. Section 11 (1)(a) of the LLP Act defines the purpose of incorporating the LLP by two or more persons associated for carrying on a lawful business with a view to profit shall subscribe their names to an incorporation document. The term business is defined to include every trade, profession, service and occupation;

4. The partners of the LLP can designate two or more designate partners, who shall act in accordance with the LLP agreement;

5. The rights of a partner to a share of profit and losses in an LLP and to receive distributions in accordance with the LLP agreement are transferrable in whole or in part, without dissolution or winding up of the LLP;

6. The LLPs are required to comply with certain mandatory fillings with the registrar of companies, which acts more in a capacity of a repository and recording agency, rather than an active regulator of the business activities of the LLP.

The following illustration would further explain how these features of LLPs can be used / misused to privately pool funds and to circumvent the SEBI guidelines.

Illustration: As discussed earlier, the AIF Regulations prohibit any private pooling of funds, unless permitted. The AIF Regulations create certain investment categories and require the funds to register and operate under such categories. SEBI has also stipulated a minimum investment threshold of INR 10,000,000 for investors to invest under alternative investment fund schemes. The intention of SEBI being very clear, that retail investors should not be exposed to the risks associated with the asset class mentioned in the AIF Regulations. Real estate is one such asset class covered under the AIF Regulations. Consequent to the notification of the AIF Regulations, the investment in the real estate sector other high risk asset classes has decreased due stipulation of minimum investment requirement of INR 10,000,000.

In order to continue to attract retail investments in the real estate sector and to circumvent the AIF Regulations, the sponsors adopt various structures. The most common and convenient method is by way of incorporation of an LLP. As discussed above, LLPs provide for a flexible and convenient mode to do business. The sponsors induct the retail investors as partners in the LLP, each of whom make a contribution to the capital of the partnership. There is no minimum threshold for the contribution. The sponsors take on the role on designated partners and look into the day to day activities and business operations of the LLP. The contribution of each partner is then invested into high risk category asset classes, which would have otherwise been prohibited by the AIF Regulations. The partnership deed/ LLP agreement is left open and ambiguous making it easy for investors acting as partners to exit and new investors to come in. Alternatively, the sponsors float multiple LLPs for each investment scheme. Therefore, in the garb of conducting genuine business activities in the form of an LLP, the sponsors float investment schemes and attract retail investors to invest in high risk asset classes.

We can now see how the features of an LLP, which have proven to be a boon to many a business, can be so easily used by sponsors to their advantage. Let us take the features of an LLP and see how the same are actually beneficial for the sponsors intending to circumvent the AIF Regulations. The separate legal entity and the limited liability offered by LLPs are extremely beneficial for the persons who wish to undertake genuine business activity. The LLP Act does not restrict the maximum number of partners and the structure of the LLP is left flexible to be decided by the LLP agreement. Using this to the advantage of the sponsors, the sponsors can induct many investors as partners and the LLP Agreement is structured in a manner such that it facilitates the circumvention of the SEBI regulations. Further, the sponsors, in accordance with the LLP Act, take on the role of designated partners or may appoint some other person to manage the pooled investments and to operate the investments on behalf of the other partners.

V. RISKS OF PROHIBITED PRIVATE POOLINGOblivious of the legal repercussions of subscribing to such veiled investment schemes, retail investors often fall prey to the promising returns offered by the sponsors. What these unsuspecting investors do not realize that they might have signed up for more than what meets the eye.

There is a need to distinguish genuinely incorporated entities, which undertake genuine business activity from the entities which masquerade themselves as genuine business and undertake private pooling of funds in violation of the SEBI regulations.

The question which now arises is how does SEBI crack down upon fraudulent schemes being floated by sponsors in the garb of genuine business transactions which are structurally identical to entities set up with the intent to do genuine business?

Though, certain deterrent provisions are already in place, such as the possibility of lifting of corporate veil and SEBIs powers to investigate and conduct search and seizure of documents relevant to the investigation in the event of non-compliance.[footnoteRef:11] However, the same have not been successful in differentiating genuine business activity from the fraudulent ones. The reason being, that these provisions are provided as a response to non-compliance, rather than curbing the menace at the inception. [11: SEBI (Procedure for Search and Seizure) Regulations, 2014 http://www.sebi.gov.in/cms/sebi_data/attachdocs/1389603402631.pdf (last visited on 29th January, 2014)]

In the absence of clear cut guidelines as to what would constitute private pooling of funds and to establish whether certain activity has been undertaken to privately pool the funds or whether it is a genuine contribution towards the capital of an incorporated entity. There is a risk that these incorporated entities may be exposed to unwarranted investigation by SEBI.

There is a need to define characteristics of private pooling to meet the end objectives, i.e. to provide clarity to the genuinely incorporated entities and to protect them from unwarranted scrutiny of the SEBI and to discourage the dubious schemes taking advantage of separate legal incorporation.

VI. IMPORTANT CHARACTERISTICS OF PRIVATE POOLING The term pooling or pooling of funds has been used broadly in the SEBI regulations. No parameter or yardstick has been laid down to assess what would constitute pooling of funds. The CIS Regulations however, do shed some light on important characteristics of pooling. The CIS Regulation read with Section 11AA of the SEBI Act, 1992 states that in order to constitute a collective investment scheme there should be a) contributions of the investors are pooled; b) contributions are made by investors with a view to receive profits; c) the contribution of the investors is managed on their behalf; and d) the investors do not have day to day control over the management and operation of the scheme or arrangement. Although not exhaustive, the characteristics laid down in the CIS Regulations are indicative of what may constitute pooling. There is a need to establish common characteristics of private pooling across all the SEBI regulations.

Following are some of the salient characteristics of private pooling:

1. Contribution made with a view to receive profits: The contributions made by the investors are solely for the purpose of receiving profits and not to participate in the risks or growth of the investment entity. Contributions are usually made for portfolio diversification purposes and not as the primary source of income of the investors.

2. Contribution separate from the capital of the investment entity: The investment entities have a capital and management of their own which is distinct from the capital of the contributions made by investors to the scheme launched by the investment entity.

3. Contribution not managed by investors: As mentioned earlier, the investors have no interest in the business, except the profits they receive from their contribution. The day to day affairs of the contributions and the scheme launched by the investment entity are managed by fund managers on behalf of the investors.

4. Contribution is bankruptcy remote: Contributions made by the investors is protected even if the investment entity suffers loss or is declared bankrupt.

5. Contribution invested in whole: The contributions made by the investors are invested in whole in accordance with the scheme, less the processing/up-front fee payable to the fund manager. There is no deduction towards expenses of day to day business activity incurred by the investment entity such as advertising/marketing expenses, over-heads and other fixed costs of the investment entity.

6. Disassociation of investors: Typically, the investors are not known or associated with each other. It is worth mentioning here that Section 11 (1)(a) of the LLP Act defines the purpose of incorporating the LLP by two or more persons associated for carrying on a lawful business with a view to profit shall subscribe their names to an incorporation document. Such type of association between the investors is not found in the privately pooled funds.

7. Contributions for a particular scheme cannot be identified against any particular investor: Once the money is transferred into a privately pooled fund, the assets held by the fund cannot be identified against any particular investor and the returns of the privately pooled funds cannot be segregated for specific investors.

VII. BRIDGING THE GAP Having understood the salient characteristics of privately pooled funds and also the manner in which separate legal entities are used as a vehicle to launch schemes which, otherwise would have been prohibited, we see that there is a need to exhaustively define and stipulate salient characteristics of private pooling across various SEBI regulations, which prohibit private pooling of funds. Further, these regulations must also stipulate that irrespective of the fact that funds are pooled under the guise of a separate legal entity, if the entity meets all the salient characteristics of private pooling of funds, such entity must comply with relevant SEBI regulation.

Laying down the salient characteristics of private pooling of funds shall bring more clarity to the extant guidelines and shall also protect the business entities which undertake genuine business activity from unwarranted scrutiny of SEBI. Providing these salient characteristics shall also deter the veiled investment schemes for private pooling, as it shall also shift the onus of compliance with the SEBI regulations on to the sponsors of such veiled investment schemes, even if such schemes are launched under the guise of a genuinely incorporated entity.

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