The Securities and Exchange Board of India (Sebi) Act, 1992, just got amended by a Presidential Ordinance. While most of the amendments are quite logical, rational, and are excellent in furthering the objective of making the regulatory system more effective, in one emotive area of law-making, the new law opens up scope for creating ambiguity in the future, with the fear that more questions may arise than get answered by the amendment.
There are two critical amendments relating to collective investment schemes (CIS) - one that gives Sebi full freedom to decide what constitutes a CIS, and the other that creates a deeming fiction that any arrangement despite not fitting any description of a CIS would be regarded as a CIS if its size is of above Rs 100 crore.
Section 11AA(2) of the Sebi Act lays down the conditions under which any scheme or arrangement would be regarded as a CIS. Essentially, if payments from various persons are pooled in a profit-oriented arrangement, and the property so collected is managed on behalf of the contributors without the contributors being involved in day-to-day management and control, the scheme would be a CIS.
Now, under a new Section 11AA(2A), Sebi may make regulations that could provide for schemes not entailing the features of this fundamental character too to be regarded as a collective investment scheme. For example, even if investors do have day-to-day control over management of the assets, Sebi could regard their coming together as constituting a CIS, regardless of the number of contributors involved. The other amendment to the Sebi Act is to provide a deeming legal fiction that could render any collective activity involving a bunch of persons coming together as a CIS, which would in turn, necessitate registration with Sebi as a CIS.
The provision granting Sebi absolute discretion to effectively expand the Sebi Act without going back to Parliament is exposed to the risk of a constitutional challenge as excessive and arbitrary delegation. However, one should rightly assume that Sebi would not deviate from the essential common-sense meaning of a CIS when using its powers to widen the scope of CIS coverage. Besides, a court would look at the context in which the expansion was made, and would generally lean towards upholding constitutional validity rather than rush to outlaw a regulation. Only recently, before the recent Presidential Ordinance, the Calcutta High Court ruled that Section 11AA of the Sebi Act was constitutionally valid.
However, it is the deeming fiction of rendering any collective activity of above Rs 100 crore as a CIS that would cause enormous problems. The only safeguard from this provision is that arrangements and contracts (listed in Section 11AA(3) as falling within the jurisdiction of other specific regulators) would not constitute CIS.
Not too long ago, Sebi passed an order adopting an interpretation of CIS that was so expansive that it could hold that all unit-linked insurance plans were not really contracts of insurance but were CIS.
It was an interesting mixed question of fact and law. Sebi was confident of proving that despite being labelled as "insurance", the products were in fact CIS masquerading as insurance products, and therefore not excluded from Sebi's coverage. Another Ordinance had then been introduced to pre-empt that debate and the issue got buried. A constitutional challenge to that amendment could revive the issue and the new amendments could support such a challenge.
Real-life examples will make this complexity easier to grasp. For instance, if a bunch of residents of an old building come together to get a redeveloper to break-down and rebuild their property and a few more apartments to share profits with the redeveloper, they would be creating a CIS if the cumulative value of the property is Rs 100 crore (one can easily have just 10-12 apartments in a building add up to this value in Mumbai). Likewise, individual projects and transactions that are privately syndicated to a small number of "big boys" would be exposed to illegality.
Arguably, if a private limited company that is not covered by the regulated activity listed in Regulation 11AA(3) were to make a private placement among just five private equity investors, so long as the collective investment size exceeds Rs 100 crore, the arrangement would be a CIS in the eyes of law. Even if Sebi were to find a reason not to be bothered with such transactions, a court hearing a public interest litigation from someone who believes he is saving the nation from sleepy regulators colluding with private businesses, would not have much choice but to direct that such arrangements get registered as CIS with Sebi.
Now, the issue is not just about being reluctant to register as a CIS. The CIS Regulations made pursuant to Section 11AA were never conceptualised taking such transactions into account - they were aimed, and rightly so, at regulating and preventing those accessing the general public to raise public funds from being able to mislead, or cheat the public. The CIS Regulations were therefore made with the objective of ensuring that there is no real registered CIS activity, which it has well achieved - there is no real CIS running effectively with a registration.
Indeed, there is a crying need for regulatory intervention with those that cheat the public. Yet, it is important to remember that it is in trying circumstances that the policymaker's clarity of thought and commitment to a predictable rule of law is truly tested. Just throwing in a provision with a single numerical value-based jurisdiction (Rs 100 crore) is fraught with risk - how to compute it, whether no other factor is relevant, when the number would run out of meaning quickly, are but some of the issues that needed careful consideration.
The examples discussed above can never get registered as mutual funds, or alternate investment funds, or as CIS, and therefore, run the risk of being rendered illegal overnight, although not a penny of public money may get solicited or invested.
There are two critical amendments relating to collective investment schemes (CIS) - one that gives Sebi full freedom to decide what constitutes a CIS, and the other that creates a deeming fiction that any arrangement despite not fitting any description of a CIS would be regarded as a CIS if its size is of above Rs 100 crore.
Section 11AA(2) of the Sebi Act lays down the conditions under which any scheme or arrangement would be regarded as a CIS. Essentially, if payments from various persons are pooled in a profit-oriented arrangement, and the property so collected is managed on behalf of the contributors without the contributors being involved in day-to-day management and control, the scheme would be a CIS.
Now, under a new Section 11AA(2A), Sebi may make regulations that could provide for schemes not entailing the features of this fundamental character too to be regarded as a collective investment scheme. For example, even if investors do have day-to-day control over management of the assets, Sebi could regard their coming together as constituting a CIS, regardless of the number of contributors involved. The other amendment to the Sebi Act is to provide a deeming legal fiction that could render any collective activity involving a bunch of persons coming together as a CIS, which would in turn, necessitate registration with Sebi as a CIS.
The provision granting Sebi absolute discretion to effectively expand the Sebi Act without going back to Parliament is exposed to the risk of a constitutional challenge as excessive and arbitrary delegation. However, one should rightly assume that Sebi would not deviate from the essential common-sense meaning of a CIS when using its powers to widen the scope of CIS coverage. Besides, a court would look at the context in which the expansion was made, and would generally lean towards upholding constitutional validity rather than rush to outlaw a regulation. Only recently, before the recent Presidential Ordinance, the Calcutta High Court ruled that Section 11AA of the Sebi Act was constitutionally valid.
However, it is the deeming fiction of rendering any collective activity of above Rs 100 crore as a CIS that would cause enormous problems. The only safeguard from this provision is that arrangements and contracts (listed in Section 11AA(3) as falling within the jurisdiction of other specific regulators) would not constitute CIS.
Not too long ago, Sebi passed an order adopting an interpretation of CIS that was so expansive that it could hold that all unit-linked insurance plans were not really contracts of insurance but were CIS.
It was an interesting mixed question of fact and law. Sebi was confident of proving that despite being labelled as "insurance", the products were in fact CIS masquerading as insurance products, and therefore not excluded from Sebi's coverage. Another Ordinance had then been introduced to pre-empt that debate and the issue got buried. A constitutional challenge to that amendment could revive the issue and the new amendments could support such a challenge.
Real-life examples will make this complexity easier to grasp. For instance, if a bunch of residents of an old building come together to get a redeveloper to break-down and rebuild their property and a few more apartments to share profits with the redeveloper, they would be creating a CIS if the cumulative value of the property is Rs 100 crore (one can easily have just 10-12 apartments in a building add up to this value in Mumbai). Likewise, individual projects and transactions that are privately syndicated to a small number of "big boys" would be exposed to illegality.
Arguably, if a private limited company that is not covered by the regulated activity listed in Regulation 11AA(3) were to make a private placement among just five private equity investors, so long as the collective investment size exceeds Rs 100 crore, the arrangement would be a CIS in the eyes of law. Even if Sebi were to find a reason not to be bothered with such transactions, a court hearing a public interest litigation from someone who believes he is saving the nation from sleepy regulators colluding with private businesses, would not have much choice but to direct that such arrangements get registered as CIS with Sebi.
Now, the issue is not just about being reluctant to register as a CIS. The CIS Regulations made pursuant to Section 11AA were never conceptualised taking such transactions into account - they were aimed, and rightly so, at regulating and preventing those accessing the general public to raise public funds from being able to mislead, or cheat the public. The CIS Regulations were therefore made with the objective of ensuring that there is no real registered CIS activity, which it has well achieved - there is no real CIS running effectively with a registration.
Indeed, there is a crying need for regulatory intervention with those that cheat the public. Yet, it is important to remember that it is in trying circumstances that the policymaker's clarity of thought and commitment to a predictable rule of law is truly tested. Just throwing in a provision with a single numerical value-based jurisdiction (Rs 100 crore) is fraught with risk - how to compute it, whether no other factor is relevant, when the number would run out of meaning quickly, are but some of the issues that needed careful consideration.
The examples discussed above can never get registered as mutual funds, or alternate investment funds, or as CIS, and therefore, run the risk of being rendered illegal overnight, although not a penny of public money may get solicited or invested.
(The author is a partner of JSA, Advocates & Solicitors. The views expressed herein are his own) somasekhar@jsalaw.com