Foundation — The constitutional document, the IMA, the contribution agreement and side letters

9.1 What "legal documentation" means

The term 'legal documentation' in the context of an AIF refers to the set of legal contracts and documents that define the AIF architecture and set out the binding roles and performance obligations of the connected parties in such a way that the outcome of the fund activity protects the interests of the investors and other stakeholders.

The principal documents to be mentioned in this regard are:

1. the constitutional document of the AIF
2. the contractual document governing the investment management
3. the contractual document governing the investors' relationship with the AIF
4. the Private Placement Memorandum or the PPM
5. the various service agreements that define the roles and responsibilities of other stakeholders such as trustees, investment advisors etc. and service providers such as distributors

Learn those five as a set. Each has a chapter section of its own, and the exam builds questions by asking which document does what.

Why documents matter for fundraising:

To attract high quality investors, it is essential that the fund documents (including marketing literature prepared by the Fund and the distributors such as the 'Pitch documents' and the PPM) include an articulation on the fund's governance standards. Fund documents are an important aspect of the fundraising exercise.

Fund documents also serve the very important purpose of making the whole fund structure bankable from a regulatory, commercial and contractual perspective so that investors are reassured of the protection of their interests.

Note that word bankable — from three perspectives, regulatory, commercial and contractual. Documents are not a formality performed after the money is raised. They are part of how the money gets raised.

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9.2 The constitutional document

If the AIF is a trust

When the AIF is constituted as a trust, it is necessary to constitute it through a 'Trust Indenture' which is a document that is executed between the settlor and the trustee to bring the trust into existence. Further as provided under the AIF Regulations, the trust deed is required to be registered.

Note who signs: the settlor and the trustee. Not the investors, who come later.

It is also noteworthy that a trust does not have a separate legal personality.

That single line explains a great deal, and it links straight back to Chapter 5's rule that the trust... does not have the ability to sue or be sued like other legal entities. It is represented by its trustee.

The settlor of the trust who is the author of the trust, settles the trust and conveys the initial sum of money to the trustee towards setting up the trust and creating its assets. The sponsor may act as the settlor of the trust.

Three roles in one sentence: the settlor is the author of the trust, he conveys the initial sum of money to the trustee, and the sponsor may act as the settlor.

The trust document is also the instrument of trusteeship which is vested in the trustees of the AIF. The trust document has to be drafted carefully to conform to the 'determinate' status of its corpus and is necessary to establish its status and tax treatment with the revenue officials under the Income Tax Act, 1961.

Determinacy again — exactly as Chapter 5 required. And here you see why it is drafted so carefully: to establish its status and tax treatment with the revenue officials under the Income Tax Act, 1961. Get the trust deed wrong and the tax neutrality the whole structure depends on falls away.

If the AIF is an LLP

In the case of an LLP structure, the constitutional document would be the LLP agreement signed between the managing partners initially and thereafter it would induct the investors into the partnership. It would define the relationship between the partners and all commercial understanding between them contractually. The LLP is registered with the Registrar of Companies (ROC) to provide it with a legal persona.

Note the two-stage sequence — signed between the managing partners initially and thereafter it would induct the investors — and that registration is with the ROC, which is why, as Chapter 5 warned, details of investors come under public domain.

If the AIF is a company

If the AIF is constituted as a company, the manager would incorporate it with initial shareholders as subscribers to the Memorandum. The memorandum and articles of association are registered with the ROC and the company takes birth with a distinct legal entity.

Who gets to see it

The constitution document of the AIF is shared with all investors of the AIF alike, being the charter document, and also shared with SEBI for registering the AIF under the AIF Regulations.

All investors alike — remember that phrase. It contrasts sharply with the contribution agreement and side letters, which are not shared.

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9.3 The Investment Management Agreement

The Investment Management Agreement (IMA) is required to be entered into by and between the trustee (on behalf of the AIF) and the investment manager.

Note the parties: the trustee, on behalf of the AIF, and the investment manager. Not the investors.

This agreement not only sets out the terms of fund management by the manager but in effect, the trustee delegates all its management powers in respect of investment management to the investment manager.

Delegates all its management powers — that is the legal work the IMA does. Without it, the trustee would have to make every investment decision itself.

The ring-fencing point — and why Indian AIFs are trusts

This is the most important paragraph in the section and a very likely exam question:

A trust structure permits ring fencing of the manager's liability (including from a fiduciary, breach of fund documents perspective) from that of the AIF's, because the manager is only a counterparty service provider to the AIF, unlike also being on the board of directors of an AIF which could be a company, or being a designated partner of an LLP. It is due to this reason why majority AIFs in India are constituted as trusts and not as LLPs.

Follow the argument carefully:

• In a trust, the manager is only a counterparty service provider — an outsider contracting with the fund. His liability is ring-fenced from the fund's.
• In a company, the manager's people would sit on the board of directors — insiders, with directors' duties and directors' liabilities.
• In an LLP, the manager would be a designated partner — again an insider, and you know from Chapter 5 that designated partners are responsible for the conduct and compliances of the LLP.

Chapter 5 gave you commercial reasons for preferring the trust (tax neutrality, investor privacy, cheaper compliance, self-written governance). This chapter adds a liability reason, and states it as the decisive one: It is due to this reason why majority AIFs in India are constituted as trusts and not as LLPs.

Termination and "for cause" removal

Nowadays, investors are becoming increasingly cautious about providing excessive bandwidth to managers in terms of their functioning or commercial interests in the wake of the financial crisis in 2008 and several frauds that surfaced in fund management.

There can also be a termination clause in the investment management agreement with the fund / subscription agreement that may provide for termination of services of the manager or withdrawal of the investor in the event if it has come to light that the interests of the investors and manager are grossly mis-aligned and there is a considerable moral hazard in continuance. These aspects need to be looked into carefully in drafting the agreement and provisions made therein for termination of management services.

Note the two possible remedies — termination of services of the manager or withdrawal of the investor.

'For cause' removal typically refers to the premature termination of the manager's services to the fund by the investors, owing to events of default – mainly fraud, wilful misconduct, and gross negligence.

Three grounds, and only three: fraud, wilful misconduct, and gross negligence. Poor performance is not on the list. A manager who loses money honestly and competently cannot be removed for cause.

Since these facts are subject to interpretation by the courts, such litigation could be long drawn and vexatious. Suitable dispute resolution provisions through arbitration could mitigate this risk to some extent.

The practical warning matters. "Gross negligence" sounds precise but is not — it is subject to interpretation by the courts, and proving it takes years. Which is why the workbook recommends arbitration.

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9.4 The Subscription (Investor Contribution) Agreement

The Contribution Agreement is to be entered into by and between each contributor (i.e. investor), the trustee and the investment manager.

Three parties: the investor, the trustee and the investment manager. Compare the IMA, which has only two.

This agreement sets out the terms between the AIF and the investor and is amenable for amendments as may be required from time to time. The Contribution Agreement sets out the conditionalities for an investor to participate in the AIF.

Why it must be comprehensive:

Considering that most fund investments are about blind pool investing, the subscription agreements includes all aspects relating to fund investing such as computation of beneficial interest, drawdowns, distribution waterfall, commercial aspects of fees and expenses, fund governance structure and so on.

The phrase blind pool investing is doing real work. An investor in a listed company can see what he owns. An investor in a blind pool is handing money to someone who has not yet decided what to buy. Everything he can rely on must therefore be written down in advance — which is why the contribution agreement covers beneficial interest, drawdowns, distribution waterfall, fees and expenses, and governance.

Confidentiality — a favourite exam point

The Contribution Agreement for each Contributor is generally not shared with other Contributors, as it contains representations and warranties which may be specific to each Contributor.

Contrast this squarely with section 9.2: The constitution document of the AIF is shared with all investors of the AIF alike. The charter document is common; the contribution agreement is private.

No unit certificates, but a statement of account

In the trust structure, issue of unit certificates representing the unit capital held by an investor is not required but a statement of account needs to be furnished to the investors to show their determinate share in the trust. Such requirement would be specified as part of the subscription agreement. This compliance requirement protects investor interests.

No certificate; a statement of account instead — and note that the requirement is written into the subscription agreement, not left to practice.

Why not an LLP or a company

LLPs and companies have specific processes to receive contributions towards capital from their partners, shareholders. LLP provisions are contained in the Limited Liability Partnership Act. In case of a company, share allotment / application money, etc. are regulated concepts, which require compliance with the Companies Act, 2013. Since AIF investment arrangements require more flexibility between the terms governing the investors, AIF and the investment manager, a company structure will pose difficulties to set up an AIF. Hence, a trust structure has become the most popular to constitute an AIF and enter into subscription agreement for investor contributions.

The theme of the chapter is now unmistakable. The trust wins on liability ring-fencing (9.3) and on flexibility of contribution terms (9.4), just as it won in Chapter 5 on tax, privacy, compliance cost and self-written governance.

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9.4.1 Side letters

In many instances, investors may seek specific investment arrangements with respect to their participation in the fund. Since these may not be generic to all investors but may be available only to a few institutional or large investors, they are recorded separately in supplementary documentation known as the side letter(s). These are executed by the specific investor, the AIF and the investment manager.

Three signatories again: the specific investor, the AIF and the investment manager.

What they typically contain:

Most of the time, side letters relate to differential terms for charge of management fee, working of the distribution waterfall, participation rights in investment committees, investor giveback, etc.

Five items: management fee, distribution waterfall, participation rights in investment committees, investor giveback, and protective rights.

Sometimes, investors may also insist on including a protection right that would protect them from the risk of any other investor being placed in a better position than them... An investor may also insist on including a 'Most Favoured Nation' (MFN) clause to prevent any other investor being placed in a better position than itself.

The MFN footnote is examinable: MFN Clause allows an investor to receive side letter entitlements, which can be used to protect themselves from less favourable terms or conditions in the PPM, as compared to the terms or conditions offered to other current or future investors.

Note current or future. An MFN reaches forward in time — if the manager gives a better deal to an investor who comes in at the final close two years later, the MFN holder catches it too.

The legal risk

Side letter enforceability has not been tested adequately in Indian courts and they do have certain amount of legal risk for such investors.

A frank admission, and a very likely exam point. A side letter is a contract, but enforceability has not been tested adequately in Indian courts.

The fiduciary problem and the market's answer

However, it is important to note that the investment manager has a fiduciary duty towards other investors in the fund. Hence, the investment manager should ensure that they are not in breach of such fiduciary duty, in an attempt to provide differential rights to some large investors. To avoid such a breach of fiduciary duty, most investment managers create a separate class of units with differential rights, issued to large investors.

This is the practical solution and you should remember it: a separate class of units with differential rights. Instead of a private promise that might breach the fiduciary duty owed to everyone else, the manager creates a transparent, disclosed class of units — visible in the PPM, available to anyone who meets the criteria.

Recall from Chapter 4 that this is permitted: Differential rights may be offered to select investors in the AIF scheme, without affecting the interest of other investors of the scheme.

Global practice — what goes where

In global practice, AIFs may be set up in such a way that the key constitutional and fund terms are included in the charter documents, and only certain specific terms for some investors (which are carefully worded so as not be construed as prejudicial to other investors) are included in side letters.

Such charter documents are executed by all investors to the fund, along with the fund and the manager while the side letters are not disclosed to the other investors since they are bilateral between AIF / investment manager and the specific investors.

And the dividing line: Therefore, only those terms which would only require individual right of action for an investor against the fund or the manager, and not impact the general operations of the fund vis-à-vis other investors, are contained in the side letter(s).

Learn that test. A side letter may contain a term that gives one investor a personal right of action. It may not contain a term that impacts the general operations of the fund as against everybody else.

The distributor's problem

Having side letters would generally make the job of an Advisor difficult to assess the risk for his investors, since he is unaware about the preferential rights already granted to the existing investors.

Feel the force of this. A distributor recommending a scheme cannot see what has been promised to the anchor investors. If an earlier investor has a preferential waterfall position, the client's economics are worse than the PPM suggests — and neither the distributor nor the client can find out. This is a real, structural limitation on the diligence work of Chapter 8, and it is the honest reason an MFN clause is worth asking for.