The Legal Documents that Build an AIF

The Legal Documents that Build an AIF

What "legal documentation" actually means here

In the AIF world, legal documentation means the set of legal contracts and documents that:

• define the architecture of the AIF,
• set out the binding roles and performance obligations of every connected party, and
• do so in a way that the outcome of the fund's activity protects the interests of investors and other stakeholders.

The workbook names five principal documents:

Two points the workbook makes about why these documents matter beyond compliance:

1. To attract high quality investors, the fund documents - including the marketing literature and pitch documents prepared by the fund and distributors, and the PPM - must articulate the fund's governance standards. Documentation is part of the fundraising exercise, not paperwork done afterwards.
2. Fund documents make the whole structure bankable from a regulatory, commercial and contractual perspective, so that investors are reassured that their interests are protected.

8.2 The constitutional document - three possible forms

If the AIF is a trust

• It is constituted through a Trust Indenture, executed between the settlor and the trustee, which brings the trust into existence.
• Under the AIF Regulations, the trust deed must be registered.
• A trust does not have a separate legal personality - remember this, it explains a lot of what follows.
• The settlor is the author of the trust. He settles the trust and conveys the initial sum of money to the trustee, setting it up and creating its assets.
• The trust document is also the instrument of trusteeship, vesting trusteeship in the trustees of the AIF.
• It must be drafted carefully to conform to the "determinate" status of its corpus, which is necessary to establish its status and tax treatment with the revenue officials under the Income Tax Act, 1961.

If the AIF is an LLP

• The constitutional document is the LLP agreement, signed initially between the managing partners and thereafter inducting investors into the partnership.
• It defines the relationship between partners and records the commercial understanding contractually.
• The LLP is registered with the Registrar of Companies (ROC), which gives it a legal persona.

If the AIF is a company

• The manager incorporates 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 as a distinct legal entity.

Who gets to see it

The constitution document is the charter document. It is shared with all investors alike, and also shared with SEBI for registering the AIF under the SEBI (AIF) Regulations. Contrast this with the Contribution Agreement, which is not generally shared between investors.

8.3 The Investment Management Agreement

Who signs it: the trustee (on behalf of the AIF) and the investment manager.

What it does: it sets out the terms of fund management, and in effect the trustee delegates all its management powers in respect of investment management to the investment manager, except for certain retained powers identified in the Indenture of Trust.

When it is signed: once for the trust as a whole - it is not signed afresh at the launch of each scheme. This is an easy mark in an exam.

Why almost every Indian AIF is a trust

This is the most important idea in the chapter and it comes from the IMA discussion.

A trust structure permits ring-fencing of the manager's liability - including liability arising from a fiduciary breach or a breach of fund documents - from that of the AIF. Why? Because in a trust the manager is only a counterparty service provider to the AIF. Contrast:

It is for this reason that the majority of AIFs in India are constituted as trusts and not as LLPs.

There is a second reason, given in section 8.4: LLPs and companies have specific, regulated processes for receiving capital - LLP provisions under the Limited Liability Partnership Act, and share allotment and application money under the Companies Act, 2013. AIF arrangements need more flexibility between the investor, the AIF and the manager than a company structure allows. So the trust wins twice - on liability and on flexibility.

Termination and "for cause" removal

Investors have become increasingly cautious about giving managers excessive bandwidth, in the wake of the 2008 financial crisis and several frauds that surfaced in fund management.

• The IMA (or the subscription agreement) may carry a termination clause allowing termination of the manager's services or withdrawal of the investor, where it emerges that the interests of investors and manager are grossly mis-aligned and there is considerable moral hazard in continuing.
• "For cause" removal means premature termination of the manager's services by the investors, owing to events of default - mainly fraud, wilful misconduct and gross negligence.
• The practical difficulty: these facts are subject to interpretation by the courts, so the litigation could be long drawn and vexatious. The mitigant the workbook suggests is suitable dispute resolution provisions through arbitration.

8.4 The Subscription (Contribution) Agreement

Who signs it: each contributor (investor), the trustee and the investment manager.

What it does: it sets out the terms between the AIF and that investor, and it is amenable to amendment from time to time. It contains the conditionalities for an investor to participate in the AIF.

Why it is so detailed: most fund investments are blind pool investing - the investor commits money before knowing which companies it will buy. Because he cannot evaluate the assets, he must be able to evaluate the rules. So the Contribution Agreement covers:

• computation of beneficial interest
• drawdowns
• the distribution waterfall
• commercial aspects of fees and expenses
• the fund governance structure
• powers of the investment committee, and so on

Confidentiality: the Contribution Agreement for each contributor is generally not shared with other contributors, because it contains representations and warranties specific to each contributor.

Dematerialisation: units representing unit capital held by an investor must be issued in dematerialised mode only. The investor then receives unit statements from the depository periodically, showing the balance held and the transactions during the period. This requirement is specified as part of the subscription agreement, and it protects investor interests.

8.4.1 Side letters

Sometimes an investor - usually an institutional or large investor - wants specific arrangements that are not generic to all investors. These are recorded separately in supplementary documentation called a side letter, executed by the specific investor, the AIF and the investment manager.

What side letters typically cover:

• differential terms for charge of management fee
• the working of the distribution waterfall
• participation rights in investment committees
• investor giveback
• a protection right against any other investor being placed in a better position

The MFN clause

An investor may insist on a Most Favoured Nation (MFN) clause, which prevents any other investor from being placed in a better position than himself. The footnote definition is worth memorising: an MFN clause allows an investor to receive side letter entitlements, which can be used to protect himself from less favourable terms or conditions in the PPM compared with the terms offered to other current or future investors.

Three problems with side letters

Problem 1 - enforceability. Side letter enforceability has not been adequately tested in Indian courts, so they carry a certain amount of legal risk for the investors relying on them.

Problem 2 - the manager's fiduciary duty. The investment manager owes a fiduciary duty towards the other investors. Giving differential rights to a few large investors can breach that duty. The common solution: most investment managers create a separate class of units with differential rights, issued to large investors. That converts a private side arrangement into a disclosed class - visible, and therefore defensible.

Problem 3 - the advisor is flying blind. Side letters are bilateral and not disclosed to other investors. So an advisor assessing the fund for his client does not know what preferential rights have already been granted to existing investors. This makes it harder for him to assess risk properly - a point a distributor should raise with the manager directly.

The global practice

Globally, AIFs are set up so that the key constitutional and fund terms sit in the charter documents - executed by all investors along with the fund and the manager - and only certain specific terms for some investors sit in side letters, carefully worded so as not to be construed as prejudicial to others. The principle:

Only those terms which require an individual right of action for an investor against the fund or manager, and which do not impact the general operations of the fund vis-a-vis other investors, belong in a side letter.

8.5 The Private Placement Memorandum - an introduction

The PPM is akin to an Offer Document, detailing all important information about the AIF and its proposed investment activities. It exists so that institutional investors and high net-worth individual investors can analyse the suitability of the investment against their risk-return objective.

For an AIF raising capital commitments, it is the most important and informative document, because it provides information not generally available in the public domain that sophisticated investors need to take informed decisions.

What it contains (the full 15-section template is in the next lesson, but at a high level):

• the parties comprising the fund structure - manager, key investment team, sponsors, trustees, custodians, bankers, auditors, legal advisors
• details of targeted investors
• fees and other expenses to be charged
• tenure of the scheme
• conditions or limits on redemption
• investment strategy
• risk factors and mitigation
• fund governance structure
• conflicts of interest and the procedures to identify and address them
• performance history of the AIF and the manager
• key terms of the investment management services
• details of other service providers
• the process of winding up the scheme

SEBI perceived the need for common disclosure requirements and issued a circular providing templates of PPM for different categories of AIFs.

8.6 The wrapper

Short, and frequently examined because it sounds obscure.

A wrapper is a supplement attached to the PPM of the domestic fund when that PPM is distributed at offshore locations (in the case of a "unified structure"). Its purpose is to achieve compliance with the private placement requirements for the securities of an offshore fund in jurisdictions outside India.

In one line: the PPM is written for Indian law; the wrapper makes it acceptable in the foreign jurisdiction where it is being shown.

8.7 Support services agreements - the cast list

Support services are outsourced functions of the AIF administration and of the investment manager's own offices. The workbook discusses five agreements:

These are covered in detail in the Exam-Ready lesson. For now, hold on to the shape of the structure: one constitutional document creates the fund, one IMA appoints the manager, one contribution agreement per investor brings the money in, one PPM tells everyone what is going on, and a ring of service agreements keeps the machinery running.