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Avishek Mehrotra and Renuka Mishra†
By way of an amendment brought to the SEBI (Alternative Investment Funds) Regulations 2012 (AIF Regulations) on August 3, 2021, the concept of “Accredited Investors” (AI) as a separate class of investors has been introduced in India. In furtherance of the same, a Circular titled “Modalities for implementation of the framework for Accredited Investors” (the Circular) was issued by the Securities Exchange Board of India (SEBI) on August 26, 2021. The Circular prescribed various intricacies for the said class of investors, which inter alia included their eligibility, procedure for accreditation, and procedure for availing benefits linked to such accreditation. The changes have been welcomed by industry experts owing to the positive bearing it would have on the investor sentiment attracting both domestic and foreign investors to AIFs, thus expanding the pool of investors.
The concept of AIs was inculcated under the AIF Regulations to value the investors which have shown significant financial ability and an appetite towards taking higher risks in their investments. The purpose of demarcating such a class of investors was to increase the capital infused in AIFs, which are inherently riskier investment options. AIs with their financial understanding and capability are perceived to make informed decisions while infusing capital in such investments and would have the ability to suffer losses incurred. However, in the opinion of the authors, the criteria laid down for being designated as AI might not necessarily result in the fulfillment of these purposes.
The literature available on the topic advocates the inclusion of financial acumen as an eligibility requirement for AIs. The global perception of an AI, besides financial sufficiency also considers their ability to identify potential and underlying risks in the concerned investment. The same also finds backing in the Report of the Alternative Investment Policy Advisory Committee, wherein the reference to qualitative factors like financial knowledge was recommended. The adverse impact of the absence of financial acumen as a criterion to become AIs has surfaced in the past, wherein wealthy investors have lost their fortunes due to the lack of financial knowledge. Several jurisdictions have recognized the need for inclusion of financial knowledge as a criterion. For instance, departing from its reliance on merely factors like income and net worth, the USA has amended its regulations governing eligibility of AIs to include experience and knowledge of natural persons investing in securities within its ambit. Moreover, a Bill titled “Equal Opportunity for All Investors Act of 2021”, has proposed an exam to be conducted for determining the financial knowledge of prospective AIs. Similarly, UK has adopted a hybrid test of qualitative as well as qualitative factors to determine eligibility as Elective Professional Clients (corresponds to AI in India). The authors second the inclusion of financial acumen as an eligibility criterion for being designated as an AI.
However, what has escaped the glances of the legal scholarship and requires scrutiny is the efficacy of parameters laid for determining the financial capability of AIs. To address this gap, the authors first appraise the eligibility criteria as has been laid down under the AIF Regulations for different categories of persons. The authors then point out that the existing criteria of annual income and net worth as determinants of financial capacity might not necessarily result in increasing the pool of investors. The fallacy of considering a proportional relation between the said determinants and the risk-taking ability of a person has also been highlighted. Besides highlighting the issues in the existing criteria, the authors have enumerated alternative criteria, which can better serve the aim of the regulators. Lastly, the authors have provided their concluding remarks on the topic.
Who Are Accredited Investors?
The definition of AI has been included under Regulation 2(1)(ab) of the AIF Regulations. It defines AI as any person who is granted such accreditation from an accreditation agency. It further provides for specific eligibility criteria for the various categories of persons (See Table).
Category of Persons | Eligibility Criteria |
Individual, Hindu Undivided Family, Family Trust or Sole Proprietorship | ▪ Minimum annual income of Rs 2 Crores, or ▪ Minimum net worth of Rs 7.5 Crore wherein a minimum of Rs 3.75 Crore are financial assets, or ▪ Minimum annual income of Rs 1 Crore and net worth of Rs 5 Crore wherein a minimum of Rs 2.50 Crore are financial assets. |
Body Corporate | Minimum net worth of Rs 50 Crores |
Trust apart from Family Trust | Minimum net worth of Rs 50 Crores |
Partnership Firm formed under the Indian Partnership Act, 1932 | Each partner of the firm is required to meet the criteria provided above. |
Besides these, there are also certain deemed AIs, however the same is not relevant to the aim of the present article.
An illusionary increase in the pool of investors?
For being designated as an AI, a person has to meet the criteria for minimum income or that of the minimum net worth of which 50% have to be in financial assets. As discussed above, the introduction of the concept of AI was supported as it was expected to increase the existing pool of investors and attract more capital. However, with the existing criteria of annual income and net worth as determinants of financial capacity, the reality might be contrary to this perception. This apprehension of the authors arises from two-fold factors.
Firstly, annual income which has been used as an eligibility criterion in the case of individuals, HUF, family trust, sole proprietorship, and partnership firm does not take into account their liabilities. This is concerning because the liabilities of the aforementioned class of persons in a year have the potential to exceed their annual income, which means that the person might not have enough money at his/her disposal to invest in the capital market. Furthermore, as per the Income Tax Return Statistics 2018-2019, there were less than one lakh individuals in India declaring income of more than 1 crore, meaning the number is much lesser for those with an annual income of more than 2 crores. This shows that a meagre number of persons meet the eligibility criteria and within this small number, the ones actually having the ability to invest is even lesser as the present eligibility criteria for AIs do not take into account their annual liabilities.
While the authors acknowledge that the targeted group for being designated as AI was a class of persons who have the ability to bear substantial financial loss. This is done keeping in mind the fact that investments in AIFs are inherently risky. However, the authors have reservations regarding the use of annual income as a criterion for measuring the loss suffering ability of a person. For instance, A, a married individual with 3 children having an annual income of more than Rs. 2 crores, has annual liabilities exceeding 2 crores, while B, an unmarried individual has an annual income of Rs. 1.5 crores with liabilities of Rs. 50 Lakhs. Here, B would have much more income left at his disposal for making investments and have better risk suffering ability as compared to that of A. Thus, B despite having lesser income would be better suited to suffer risks. Accordingly, the authors opine that discretionary income i.e., the income of a person after the deduction of taxes, expenditures, and other liabilities, rather than annual income is a better determinant of the ability of an individual to infuse capital as well as bear the risk suffered.
Secondly, the high threshold for net worth, comprising 50% in the form of financial assets, may completely oust small investors from being direct owners of the security. This is owed to the fact that having a net worth exceeding Rs. 3.75 crores or 2.5 crores, as the case may be (see table), that too in the form of easily liquefiable assets acts as a barrier for investors such as retail investors. Restricting retail investors from investing in AIFs, despite the growing trends of retail investors becoming active participants in the security market, not only limits the number of potential investors but also denies such investors an opportunity to further diversify their investments. The regulators aim to protect the interests of investors by safeguarding them against risky investments. . However, this is resulting in a situation in which even investors with sufficient discretionary income and investment knowledge are denied the opportunity to profit.
In the opinion of the authors, the net worth of a person may not be a correct parameter to decide if the person can be an AI or not. This is owed to the fact that it may completely oust certain persons with high discretionary income and financial acumen from extracting the benefits linked to designation as an AI.
Concluding Remarks
The purpose of incorporating the concept of AIs was to increase capital infusion by the inclusion of a pool of investors with a higher ability to bear the risks suffered. However, with the existing criteria, the said objective may not be adequately satisfied. While there might only be a marginal increase in the number of investors, there would be no surety that they actually have the capability to suffer risk due to the reasons discussed above. Taking into account these factors, there is an ardent need for a change in the present criteria to enable the fulfillment of the objective of the regulators in its true sense.
†Avishek Mehrotra and Renuka Mishra are penultimate year students at Symbiosis Law School, Pune.