Background.
Infrastructure Investment Trusts (InvITs) are investment vehicles designed to collect funds from public and institutional investors and invest them into long-term infrastructure projects. Considering the quantum of funds and assets handled by InvITs, they are structured in a manner where multiple entities, such as trustees, Investment Managers (IMs), and Project Managers (PMs) are involved in decision-making as well as day-to-day activities.
A similar working model is seen in case of Real estate Investment Trusts (ReITs) as well.
Introduction.
Considering the scale of investor funds and number of entities involved in functioning of INVIT, it is essential to have some eligibility standard for entities or individuals involved in management of INVIT in order to ensure safe keeping of funds and assets, and for smooth conduct of business. SEBI has introduced such basic eligibility standard for InvITs and parties to InvIT in the form of “fit and proper person criteria (criteria)” as prescribed under SEBI intermediaries’ regulations 2008.
In this article we shall make an effort to understand these criteria and its implications in the context of InvITs and/or ReiTs.
About Fit and proper person criteria.
The “fit & proper person criteria” is one of the basic regulatory gateways that SEBI has created to ensure the basic competency of market intermediaries and persons in control of such intermediaries. The criteria originally formed part of ‘SEBI criteria for fit and proper persons regulations 2004’. However, these regulations were latter repealed and the criteria now forms part of Schedule II of Intermediaries regulations 2008.
the following criteria, as applicable to, both entities and individuals, can broadly be classified into 2 types.
- Principle-based:
Principle-based criteria relate to personal attributes such as integrity, honesty, reputation, and character. These factors are subjective in nature and do not have fixed parameters for determination. they primarily apply to individuals rather than entities.
- Rule-based:
Rule-based criteria are triggered by the occurrence of specific events, such as convictions, regulatory actions, or issues relating to financial integrity. Upon the occurrence of such events, the concerned person is deemed not to be “fit and proper. Unlike principle-based criteria, these apply to both, entities and individuals.
Applicability of criteria to INVITs
The fit and proper criteria become applicable to InvITs under Regulation 4(2)(k) of the InvIT Regulations. This provision requires that both the InvIT and all its parties comply with the criteria at all times.
as per definition under reg 2(1) (ZK) of InvIT regulations, Parties to the InvIT include:
- Sponsor(s)/sponsor group
- Investment Manager (IM)
- Project Manager (PM)
- Trustee
Since regulation 4(2)(k) says that InvIT and its parties should be fit and proper persons as per the criteria prescribed under schedule II of Intermediaries regulations, reference also must be made to clause II of schedule II which prescribes the entities who are required to comply with the criteria. As per clause II of Schedule II, in addition to InvITs and its parties, the criteria also apply to:
- Directors and key managerial personnel of parties to InvIT,
- Principal officers of InvIT and parties to InvIT and
- the persons holding controlling interest or persons exercising control, directly or indirectly over InvIT or parties to InvIT.
An exact same provision as reg 4(2)(k) of InvIT regulations, is found in regulation 4(2)(j) of ReIT regulations as well. Hence by virtue of ReIT regulations, the criteria is applicable to ReIT its parties and individules like directors, KMPs, principal officers and persons in control of ReIT and its parties, just like InvITs.
It is to be specifically noted here that, as per schedule II of intermediary’s regulations the criteria apply to all directors, whether executive or non-executive. Therefore, the criteria have to be complied with by all directors including non-executive directors and independent directors. Basically, the criteria apply to persons who occupy responsible positions in InvIT/ReIT or their parties or those who are in a position to significantly influence the decision making process of the InvIT/ReIT.
Compliance requirement under the criteria
The criteria do not prescribe any specific compliance action like form filing or submission of declaration etc., to be undertaken as compliance. Instead, they prescribe the following requirements,
- Integrity, reputation, soundness of mind and good character to be possessed by individuals and
- Absence of convictions and restrain orders etc. in case of all entities including individuals.
- Person being solvent and non-initiation of recovery proceedings, or passing of winding up order etc.
Although there is no specific compliance action required, the conditions listed in the criteria have to be satisfied on continuous basis .
Compliance stages.
As per regulation 4 of the InvIT Regulations and ReIT regulations, compliance with the criteria by the InvIT/ReITs and all its associated parties on continuous basis is a pre-condition for registration as well as continuation as an InvIT. Accordingly, compliance can broadly be divided into two stages:
- compliance at the time of registration, and
- compliance on a continuous basis post-registration.
(a) Compliance at the time of registration
Since compliance with the criteria is a pre-condition for registration of InVIT, all parties to the proposed InvIT — including the sponsor, trustee, Investment Manager (IM), project manager (PM), their principal officers, directors, KMPs and persons in control are required to satisfy the criteria at the time of registration. That means, if any party or individual falls under any disqualification listed in the criteria prior to applying for registration, then he/it will be considered as not satisfying the criteria at the time of registration.
(b) Compliance on continuous basis post registration
Once the InvIT is registered, both the InvIT and all its associated parties are required to comply with the criteria on a continuous basis. If at any point in time, an entity or individual falls within any of the disqualifications, such person or entity will be considered as not satisfying the criteria from the very movement he/it incures the disqualification.
Consequences of non-compliance.
As mentioned earlier, the criteria have to be complied with by all parties at all times. The non-compliance by a single entity/person can result in to serious consequences for whole structure of InVIT. The clauses 4 to 7 of schedule II of Intermediaries regulations (the criteria) prescribe for such consequences.
As per these clauses, if an InvIT fails to satisfy the prescribed criteria, it is not entitled to obtain or retain registration. Further, if at any time it is found that any director/KMP/principal officer of the InvIT or its parties does not meet the criteria, such individual must be replaced within 30 days from the date of non-compliance. Similarly, if any person in control fails to satisfy the criteria, they are required to divest their holdings in the InvIT or its parties within 6 months from the date of disqualification. If InVIT does not replace the disqualified person within 30 days of disqualification, or the person in control does not divest his stake, then the InVIT itself will be held not a fit and proper person, which may result in to cancelation of registration.
Example of such situation can be seen in the case of Sahara Mutual Funds, wherein SEBI had cancelled registration of Sahara Mutual fund and its Asset Management Company (AMC), for the reason that, the person in control of sponsor and AMC of the said mutual fund failed to satisfy the criteria and no action was taken against him. An analogous situation was also seen in case of 1 Real estate Investment Trust (REIT) wherein the CEO of the IM of Reit failed to satisfy the criteria and hence SEBI sent show cause notice to the Reit. However, on receipt of SCN from SEBI, the IM of ReIT replaced the CEO and hence no further action was taken.
Responsibility to ensure compliance.
Given the serious consequences of non-compliance, it is essential that the InvIT, its parties, and all individuals involved in their management comply with the criteria at all times. However, neither the InvIT Regulations nor Schedule II of the Intermediaries Regulations assign this responsibility to any specific person. In the absence of a clear provision, the question of who is responsible for ensuring such compliance becomes significant, especially considering the number of entities and individuals involved and the implications of non-compliance.
Even though there is no express provision, reference may be made to Regulation 10(25) of the InvIT Regulations, which requires the Investment Manager to appoint a compliance officer responsible for ensuring compliance with the InvIT Regulations and reporting any non-compliance to its board. Since compliance with the criteria forms part of regulatory compliance, it may be said that it is the primary responsibility of the IM to oversee the compliance with the criteria by InvIT and all its parties. The latest amendment to schedule II of Intermediaries regulations strengthens this view. The amendment has inserted a new clause 3A requiring the intermediary (InvIT in our case), to inform SEBI within 15 working days about non-compliance with the criteria by any person covered in clause II of schedule II, that is by any person who is required to satisfy the criteria. Since InvIT functions through IM, it becomes duty of IM to oversee the compliance and report its non-compliance if any to SEBI
This view is also supported by the fact that, whenever SEBI observes or suspects non-compliance with the criteria, it requires the IM to check and verify the compliance.
However, looking at the number of separate entities required to comply with the criteria and the serious consequence of non-compliance, it would not be appropriate to hold any one individual or entity alone, responsible to ensure compliance. Hence InvIT regulation assigns certain responsibility to trustee as well.
if we refer to regulation 9(20) of InvIT regulations, it is also the duty of trustee of InvIT to ensure compliance with the provisions of trust deed and InvIT regulations and inform the SEBI in case of non-compliance. Hence it can be said that trustee also has a supervisory duty to check whether the criteria is complied by all parties or not.
This view is also substantiated by SEBI in its orders. One of such orders is in the matter of Sahara Mutual fund, wherein it has stated that trustee was supposed to inform the SEBI about non-compliance of criteria by person in control of sponsor.
Another such order is in the matter of Axis trustee services ltd. In this order SEBI highlighted that the trustee has a regulatory responsibility to independently analyse the compliance with the criteria without relying on the analysis done by IM.
Hence it can be said that, primarily IM is expected to ensure compliance with the criteria along with the supervisory duty on trustee to oversee the compliance.
Practical challenges in ensuring compliance.
Although the compliance officer of the InvIT and the board of the IM may be primarily responsible for ensuring compliance with the criteria, with supervisory oversight by the trustee, there is a practical difficulty in doing so. The criteria apply to multiple entities and individuals, including the sponsor, trustee, PM and other parties to the InvIT, all of whom are separate legal entities. Therefore, it may not be practically possible for the compliance officer to track their compliance at all times. Hence, a feasible oversight mechanism is required to ensure continuous compliance by all parties and to promptly inform the compliance officer of any non-compliance for necessary action.
One such possible solution can be that all the entities who are parties to InvIT, should themselves ensure the compliance with the criteria on their own part as well as on the part of their directors, KMPs and persons in control. They may also give a periodic declaration in this regard to the compliance officer of InvIT. If in case, there takes place any disqualification due to which the entity itself or any of the individuals connected with it, fails to comply with the criteria, that also may be notified to the compliance officer by such entity and the compliance officer in turn would notify the board of IM about said non-compliance.
However, point of caution in this regard is the newly inserted clause 3A of the criteria. As discussed above, the IM is required to disclose to the SEBI within 15 working days about non-compliance with the criteria by any person. Therefore, when any party to InvIT updates the compliance officer of InvIT about non-compliance, care should be taken that whole process of intimating the compliance officer, he informing the board of IM and then IM intimating the SEBI should be completed within 15 working days.
Guidance from NBFC master directions
It is a general practice that, when one law is silent about any particular aspect, reference is made to other laws having similar provisions or purposes. Since InvIT regulations are silent on the aspect of responsibility to ensure compliance with the criteria, reference may be made to other SEBI regulations like REIT regulations or Mutual Fund regulations. However, all these regulations as well are silent in this regard. They require the entities to comply with the criteria but do not fasten the responsibility to ensure compliance on any specific person/entity.hence reference has to be made to RBI master directions to NBFCs.
These master directions require the directors of NBFCs to comply with the fit and proper criteria as prescribed by each NBFC’s policy on fit and proper criteria. The directions also provide a basic list of points to be covered in the criteria and mechanism for overview of compliance with these criteria.
Para 96 of the master directions says that the Nomination and Remuneration committee of NBFC shall formulate the policy on fit and proper criteria to be satisfied by the directors at the time of appointment and at all times thereafter. as per point 5 of annexure XXIII of master directions the NRC is required to scrutinise the compliance of the criteria by the directors at the time of appointment/re-appointment. also, at the end of each year (at 31st March), the directors are required to give a simple declaration to NBFC stating that they comply with the criteria and there is no change in information already provided and where there is any change, requisite details are furnished by them forthwith. Further, as per Para 96(4), the managing director of the NBFC is required to give a quarterly declaration to the RBI stating that the criteria are being complied with by all directors.
These provisions make it clear that, as per NBFC master directions, the directors are required to give a declaration to the NBFC that they satisfy the criteria and are also required to notify the NBFC in case of any change in status. Also the provisions make it adequately clear that it is the responsibility of NRC and the managing director to oversee the compliance of criteria by directors. In addition to this, the RBI also retains the right to inspect the fit and proper criteria related parameters for any director in public interest.
Guidance to InVITs
The guidance that can be taken by InVITs from these provisions of NBFC master directions relates to that of, taking declarations from parties to INVIT and related individuals, and making NRC responsible to oversee compliance with the criteria by all eligible entities and individuals.
Just like NBFCs, the InVITs can take periodic declarations from all the parties to INVIT and the individuals stating that they comply with the criteria and that they would inform the INVIT in case of any change in status (occurrence of disqualification). Also, with respect to NRC, the IM of INVIT is required to constitute a NRC as per regulation 19 of SEBI LODR regulations. The same NRC may be assigned the task of scrutinising the declarations received and overseeing the compliance with the criteria by all entities/individuals.Since InvITs and ReITs share a same working model, the ReITs may also implement the same compliance mechanism as discussed above in context of InvITs.
Conclusion
The key challenge in complying with the fit and proper criteria is not, understanding the consequences of non-compliances, but ensuring continuous monitoring across multiple entities and individuals involved in the InvIT/ReIT structure. In the absence of a prescribed oversight framework, InvITs/ReITs may benefit from adopting structured internal mechanisms, such as periodic declarations and defined reporting processes, to ensure timely identification and rectification of non-compliance.
This article is published on Taxmann at the link below.
https://www.taxmann.com/research/company-and-sebi/top-story/105010000000028672/fit-and-proper-criteria-in-invits-continuous-compliance-and-oversight-opinion