Unfortunate experiences from the past decades has compelled the Securities and Exchange Board of India (SEBI) to adopt the "foot in the game" approach while regulating the Indian capital markets. This approach requires promoters, persons in control and comparable persons to hold a minimum number of securities/ units in an entity for a certain period of time post listing. For instance, a company proposing an initial public offering of equity shares is required to lock-in the promoter holding, of atleast 20% of the equity shares for a period of three years and the residual holding for a period of one year. Similarly, the SEBI (Real Estate Investment Trusts) Regulations, 2014 (REIT Regulations) require the sponsor and sponsor group, collectively, to hold a minimum 25% of the REIT units, post the initial public offer for a period of three years, along with other lock-in requirements. While the sponsor and the sponsor group, as a concept, are not comparable to promoters of a company - the former are, in essence, settlors of a trust - the 'foot in the game' approach has rightly been extended to such entities as they are, typically, the primary beneficiaries of the REIT's distributable cashflows and also, in many ways, exercise indirect control over its operations.

Expanding the universe to permit REIT Unit Encumbrance:

Borrowed funds are essential to the growth of any organization and REIT units are valuable property, which can be encumbered as security for debt. SEBI already permits promoters of a company to encumber lock-in securities, subject to a number of conditions. As an evolving framework, SEBI has now permitted the sponsor and sponsor group to encumber locked-in units held by them in a REIT, again subject to a number of conditions. Such permission was granted through its circular issued on 23 March 2020 (the Circular), which this newsletter critically analyses.

The regulator usually does not hinder commercial growth of companies, once it has ensured investor protection. What are such conditions envisaged to protect investors?

The sponsor and sponsor group of a REIT are required to lock-in, on a collective basis, (a) 25% of their unitholding in the REIT for a period of three years, and (b) 75% of their unitholding in the REIT for a period of one year, from the date of listing of the units. The sponsor and sponsor group are also, collectively, required to hold at all times, (a) 15% of all outstanding units of a REIT and (b) each sponsor is obligated to hold 5% of all outstanding units. However, a real estate business is capital intensive, a fact which SEBI clearly appreciates and therefore, has allowed sponsors and sponsor group to encumber1 such locked-in units, subject to the following conditions:

  1. Conditions for creation and invocation of such encumbrance shall be included in the agreement executed for the purpose of creation of such encumbrance,
  2. Such encumbrance shall not be invoked unless the lender gets itself or its nominee to be re-designated as a sponsor, in accordance with applicable law. This condition shall not be applicable if the lender is a member of the sponsor group,
  3. Such re-designated sponsor shall be obligated to perform all duties and have all liabilities of a sponsor, specified by applicable law.

What the Circular does not address and can we aid such interpretation?

Some ambiguities remain – for instance, the Circular does not lay down conditions on purpose of the debt raised for which sponsor's REIT units can be encumbered2. One can assume, in absence of conditions, that sponsor and sponsor group entities can raise debt for any purpose, including in their personal capacity (in case of individuals) and encumber locked-in REIT units. The safeguard seems to be that in case of default and subsequent invocation of encumbrance, the lender is alerted ab initio (as a written condition in the debt documents) that it risks being named as a sponsor. If you think about it, this beats the "foot in the game" approach that SEBI has so successfully adopted in recent years – by allowing sponsors and sponsor groups to exit a REIT during the lock-in period, through passing of the baton to the lender.

Further, the Circular requires a lender to be re-designated as a sponsor if it invokes the encumbrance during the lock-in periods. Mathematically, a REIT can comply with lock-in conditions if one sponsor holds 5% of the units at all times and the balance 10% of the units being held through sponsor group entities. Therefore, if a lender invokes the pledge on the units held by the sponsor group, during the lock-in period, logically it should not be re-designated as a sponsor. However, the nomenclature of the Circular is ambiguous – literal reading and interpretative reading alchemises different answers. Nonetheless, we would favour the logical interpretation of the provision, i.e. only if the encumbrance on REIT units pledged by the sponsor (and not the sponsor group) is invoked, the lender would be re-designated as a sponsor.

The Circular also instructs the sponsor and sponsor group to follow certain procedural formalities while creating encumbrance on REIT units held by them. Such formalities include a requirement to formally intimate the investment manager as well as the stock exchanges within two working days from the date of creation of the encumbrance.

All things considered, the circular is a welcome move, allowing sponsors to raise debt with greater ease. Listed units are valuable assets, with underlying income generating commercial properties and the Circular is another step in the right direction by SEBI in order to promote the REIT product.

Footnotes

1 Encumbrance shall include pledge, lien, negative lien, non-disposal undertaking etc. or any other covenant, transaction, condition or arrangement in the nature of encumbrance.

2 In the case of equity shares, shares can only be encumbered for specified purposes, which are disclosed in the offering documents

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