Ring-fencing of schemes

One AIF can run several schemes. Each scheme has its own investors, its own portfolio and its own life.

So each scheme must also have its own fence. Ring-fencing means Scheme A's money cannot be used for Scheme B's obligations, and Scheme B's loss cannot reach Scheme A's investors.

The duty is stated in four parts, and the last two are the practical ones. Assets must be segregated. Liabilities must be segregated. Bank accounts must be segregated. Securities accounts must be segregated.

The reason is that investors bought one scheme, not a house. A person who committed to a long-only equity scheme did not agree to fund a derivatives scheme's margin call.

One warning comes with it. The workbook requires the fund to tell investors that this segregation may not hold up against a third party's suit or a regulator's action. The fence is a regulatory duty, not a guarantee.

Where it sits. Chapter 13, section 13.2 (Regulatory Framework for Fund Monitoring and Reporting), as the fifth of the specific responsibilities under Regulation 20 of the SEBI (AIF) Regulations. The obligation is placed jointly on the Investment Manager and either the trustee or the trustee company or the Board of Directors or designated partners of the AIF, who must ensure that:

• the assets and liabilities of each scheme of the AIF are segregated and ring-fenced from other schemes of the AIF; and
• the bank accounts and securities accounts of each scheme are segregated and ring-fenced.

How it is put into practice elsewhere in the paper.

The disclosure that admits the limit. The workbook's template of risk factors at fund and investor level (Annexure 7.1) lists, among the general risk factors, the risk of segregation of assets between funds, schemes or trustees not being available in third-party suits or regulatory actions with respect to the Fund. So the PPM both promises the fence and warns that it may not be honoured by a court or a regulator acting against the Fund.

No figure attached. The ring-fencing obligation in Regulation 20 carries no percentage, no rupee threshold and no time limit. It is absolute in form and qualitative in expression. The only number in its immediate neighbourhood is the Compliance Officer's 7 working days for reporting a deviation, and that is a reporting clock, not a tolerance.

Do not confuse it with the other ring-fence in this paper. Chapter 9 says a trust structure permits ring fencing of the manager's liability — including from a fiduciary or breach-of-fund-documents perspective — from that of the AIF, because the manager is only a counterparty service provider rather than a director or designated partner. The workbook adds that this is why the majority of AIFs in India are constituted as trusts and not as LLPs. Same phrase, entirely different fence: that one separates the manager from the fund; this one separates scheme from scheme.

The fund and amounts are illustrative; the four-part obligation, the custodian rule and the risk-factor warning are the workbook's.

Meridian Alternatives manages three schemes under one AIF:

Each scheme has its own bank account and its own securities account. Scheme III uses a different custodian, which the workbook expressly allows in order to segregate that scheme's assets and liabilities.

The Tuesday problem. Scheme II faces a Rs 12 crore margin call at 11 a.m. Its own bank account holds Rs 3 crore. Scheme I's account holds Rs 90 crore of undeployed cash.

Moving Rs 9 crore from Scheme I to Scheme II — overnight, at market rates, repaid on Thursday — breaches the ring-fence. It does not matter that the money comes back, that interest is paid, or that both schemes have the same manager and the same custodian. Bank accounts of each scheme are to be segregated and ring-fenced. Scheme II must fund the call from its own resources, or cut the position.

If it happened anyway, the Compliance Officer must report the deviation to SEBI forthwith within 7 working days.

The other direction. Scheme II's derivatives book loses Rs 40 crore, exceeding its own assets net of the loss. A Scheme I investor is not called on for a rupee of it. The fence is what makes Scheme I's Rs 600 crore unavailable to Scheme II's counterparties in the ordinary course.

And the honest caveat. Meridian's PPM discloses the general risk factor that this segregation may not be available in third-party suits or regulatory actions against the Fund. If a claim is brought against the AIF itself rather than against Scheme II, the Scheme I investor's protection is the disclosure they signed, not an unbreakable wall.

Chapter 13, section 13.2, lists the Regulation 20 responsibilities as nine numbered items, and ring-fencing is item 5 — one of the most quotable lines in the chapter. Chapter 9 supplies the custodian and PPM support, and Chapter 7's Annexure 7.1 supplies the risk factor that qualifies it.

Expect: who must ensure it (the Investment Manager and the trustee, trustee company, Board or designated partners — not the manager alone), and what exactly must be segregated — a four-item list where candidates remember assets and liabilities and forget bank accounts and securities accounts. A harder question pairs it with the Annexure 7.1 risk factor and asks what the PPM must warn investors about.

• Four things, not two. Assets, liabilities, bank accounts and securities accounts. The account limbs are the ones dropped in answers.
• The duty is joint. It falls on the Investment Manager and the trustee or trustee company or Board of Directors or designated partners, as the case may be.
• A different custodian per scheme is permitted, not required. The workbook says each scheme can have a different custodian in order to segregate assets and liabilities; appointing a custodian at all is what is mandatory.
• The fence may fail against third parties. Annexure 7.1 lists the risk that segregation is not available in third-party suits or regulatory actions. A page that presents ring-fencing as absolute protection is wrong on the paper's own terms.
• Two ring-fences in one workbook. Chapter 13's ring-fence separates scheme from scheme. Chapter 9's separates the manager's liability from the AIF's, and is the reason most Indian AIFs are trusts rather than LLPs.
• This is not a mutual fund's segregated portfolio. Segregated portfolio, or side pocketing, is a mutual fund response to a credit event within one scheme, written from another paper. Ring-fencing here is a permanent structural duty between schemes.
• No threshold to breach. There is no de minimis inter-scheme transfer. The obligation carries no figure at all.