On 25 April 2024, the Securities and Exchange Board of India (“SEBI”) made certain amendments to the regulatory regime governing Alternative Investment Funds (“AIFs”) through the SEBI (Alternative Investment Funds) (Second Amendment) Regulations, 2024 (the “Amendment Regulations”). One of the key changes introduced by the Amendment Regulations to the SEBI (Alternative Investment Funds) Regulations, 2012 (“AIF Regulations”) is the permission for Category I AIFs and Category II AIFs to create encumbrances over the equity of an investee company in the infrastructure sector. Curiously, this permission formalizes a restriction on creation of encumbrances over shares of investee companies in other sectors, which was first expressed by SEBI in an order passed in 2023 but was previously perceived as not being restricted.

Background
Regulations 16(1)(c) and 17(c) of the AIF Regulations prohibit Category I and Category II AIFs respectively, from borrowing either directly or indirectly or engaging in any leverage except for meeting temporary funding requirements. “Leverage” was generally understood to cover borrowings and guarantees, but not third-party security over shares of investee companies, where the borrowing was by the investee company (particularly given that a pledge over the shares of the borrower is a common requirement imposed by lenders and does not by itself impose a payment obligation on the pledgor). However, in an order dated 31 May 2023 in the matter of India Infrastructure Fund II (a Category I AIF), SEBI had held that the use of the expression ‘directly or indirectly’ in Regulation 16(1)(c) of the AIF Regulations, prohibits a Category I AIF from being party to any borrowing either directly or indirectly and that pledging of securities of companies by an AIF, for loans availed of by such companies, falls within the meaning of indirect borrowing. SEBI further held that the use of the expression “any leverage” in the aforementioned Regulation is not confined to leverage availed of by the Category I AIF itself. It prohibits a Category I AIF from being party to any leverage availed of either by itself or by any other entity.

Amendment to AIF Regulations
The Amendment Regulations have now incorporated provisos to Regulations 16(1)(c) and 17(c) stipulating that Category I and Category II AIFs respectively, may create encumbrance on the equity of an investee company, which is in the business of development, operation, or management of projects in any of the infrastructure sub-sectors listed in the Harmonised Master List of Infrastructure issued by the Central Government (“Infrastructure Investee Company”). Encumbrance, which has been defined with reference to the meaning assigned to the term in the SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 2011 (“Takeover Regulations”), may only be created for the purpose of borrowing by such investee company and will be subject to such conditions as may be specified by SEBI from time to time.

SEBI has, pursuant to a circular dated 26 April 2024 on the Framework for Category I and II Alternative Investment Funds (AIFs) to create encumbrance on their holding of equity of investee companies (“SEBI Circular”), specified certain conditions in this regard, which are set out below:

1. Creation of new encumbrance – existing schemes of Category I or Category II AIFs who have not on-boarded any investors prior to 25 April 2024, may create encumbrance on the equity of an Infrastructure Investee Company for the purpose of borrowing by that company, provided explicit disclosures are made regarding the creation of encumbrance and the associated risks, in the Private Placement Memorandum (“PPM”).
2. Existing encumbrance created after explicit disclosure in PPM – any existing encumbrances created prior to 25 April 2024 on the securities of an investee company, for the purpose of borrowing by such investee company, may continue if such encumbrances were created after making an explicit disclosure to this effect in the PPM of the scheme. Note that this permission to continue an existing encumbrance is not limited to encumbrances created over securities of an Infrastructure Investee Company.
3. Existing encumbrance created without explicit disclosure in PPM – in the case of existing encumbrances created prior to 25 April 2024 without making an explicit disclosure in the PPM:
   (a) if the encumbrances were created on the securities of an Infrastructure Investee Company, and consent of all investors in the scheme of the AIF is obtained by 24 October 2024, such encumbrances may be continued. If the consent of all investors is not obtained within this time, the encumbrances are required to be removed by 24 January 2025.
   (b) if the encumbrances were created on securities of an investee company which is not an Infrastructure Investee Company, such encumbrances need to be removed by 24 October 2024.
4. End use of borrowings – Category I and II AIFs are required to ensure that borrowings made by the investee company against the equity investments encumbered by the AIFs are not used for investing in another company or for any purpose other than development, operation or management of the investee company.
5. Tenure of encumbrance – the duration of encumbrance cannot exceed the residual tenure of the scheme of the Category I or Category II AIF.
6. Pledges by foreign owned or controlled AIFs – for creation of pledges over the equity of an Infrastructure Investee Company, a Category I or Category II AIF with more than 50% foreign investment or with foreign sponsor or manager or with persons other than resident Indian citizens as external members in its investment committee which is set up to approve its decisions, is required to ensure compliance with the FEMA provisions governing pledges by a person resident outside India.
7. No encumbrance on shares of foreign investees – Category I and II AIFs are not permitted to create encumbrances over foreign investee companies.
8. No additional liability – Category I and II AIFs are required to ensure that, in case of default by the borrower investee company, the fund or its investors are not subject to any liability over and above the equity of the borrower investee company encumbered by the AIF.
9. No Guarantee – Schemes of Category I or II AIFs cannot extend any form of guarantee for an investee company.

Implications and issues for consideration

1. Issues for borrowing by non-infrastructure investee companies – Given that a pledge of the borrowing company’s shares is a fairly common requirement for lenders across sectors, the ability of AIFs to provide such a pledge only for Infrastructure Investee Companies places AIF owned companies in other sectors at a distinct disadvantage as compared with investee companies owned by non-AIF entities. This may lead market participants to reconsider seeking investments through an AIF structure where borrowing is contemplated.
2. Status of NDUs and other contractual restrictions – The definition of “encumbrance” in the Takeover Regulations has a very wide ambit and includes negative liens, non-disposal undertakings and “any covenant, transaction, condition or arrangement in the nature of encumbrance, by whatever name called, whether executed directly or indirectly”, and the objective of such a wide definition is to ensure disclosure of such arrangements. As mentioned earlier, “encumbrance” has been defined in the AIF Regulations (pursuant to the Amendment Regulations) with reference to the definition in the Takeover Regulations. In light of this and given the interpretation by SEBI of “indirect borrowing” and “leverage” in the India Infrastructure Fund II matter referred to above, a Category I or II AIF may be able to provide NDUs, negative liens, etc. in connection with a financing for an investee company only if such investee company is an Infrastructure Investee Company. As such, the AIF Regulations now effectively prevent the creation of encumbrances on shares held by an AIF, other than in relation to an Infrastructure Investee Company. This may create further constraints when it comes to borrowings by investee companies in other sectors.With respect to existing negative liens, non-disposal undertakings and other such restrictions which were created prior to 25 April 2024, the instructions on existing encumbrances in the SEBI Circular listed in paragraphs (2) and (3) above, will be applicable.
3. Whether pledge of the AIF units amounts to an indirect encumbrance – Under the Takeover Regulations, encumbrance includes indirect encumbrance and a pledge of the equity of the holding company amounts to an encumbrance of the underlying shares. Given that the same definition of encumbrance applies, the question arises whether a pledge or encumbrance over the units of a Category I or II AIF would amount to an encumbrance of the investments made by the AIF. While it remains to be seen how widely “encumbrance” is construed in the context of the AIF Regulations, it needs to be borne in mind that the consequences of categorisation as an “encumbrance” under the Takeover Regulations is significantly different from that of the AIF Regulations. Under the Takeover Regulations encumbrances are required to be disclosed, while under the AIF Regulations, encumbrances by a Category I or II AIFs are not permitted other than for the borrowing of an Infrastructure Investee Company. It is noteworthy that the FEMA provisions governing pledges envisage pledges created over the units of an AIF and does not exclude pledges over units of Category I and Category II AIFs.
4. Creation of new encumbrance by existing schemes of Category I or II AIFs with on-boarded investors – while the SEBI Circular sets out the mechanics of creation of encumbrance by existing schemes of Category I and Category II AIFs who have not on-boarded any investors prior to 25 April 2024, it is silent on creation of encumbrances in case of schemes with existing investors. The SEBI Consultation Paper on creation of encumbrances by Category I and II AIFs had proposed that for schemes of Category I and II AIFs who have already on-boarded investors, encumbrance may be created with either (a) the consent of all investors; or (b) the consent of 75% of the investors by value. SEBI had sought public comments on which of the two options should be made applicable. However, in the circular finally issued by SEBI, this matter is not addressed. As such, it is unclear whether SEBI intends to permit creation of encumbrances in such cases and if so, what procedure is required to be followed.