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Demystifying SEBI’s Proposed Framework on the issuance of Subordinate Units of InvITs/REITS

[Pratikshya Mohanty and Soumya Sourav Das are 4th year B.A. LL.B. (Hons.) students at National Law University, Odisha]


Introduction


The concepts of Infrastructure Investment Trusts (InvITs) and Real Estate Investment Trusts (REITs) are still at a very nascent stage and undergoing changes time and again with the advent of new regulations and modifications. The Securities and Exchange Board of India (SEBI) has regulated the functioning of InvITs and REITs in India with the SEBI (Infrastructure Investment Trusts) Regulations 2014 (InvIT Regulations) and SEBI (Real Estate Investment Trusts) Regulations 2014 (REIT Regulations) respectively. Regulation 4(2)(h) of the InvIT Regulations and Regulation 4(2)(g) of the REIT Regulations state that no unitholder will be allotted units carrying superior voting rights or any other rights over the others. However, the provisos to the aforementioned regulations say that subordinate units carrying inferior voting rights or any other rights can be issued to the sponsors, sponsor group, associates of sponsors and other related parties to the transaction (sponsor and its associates). While the regulations governing InvITs and REITs have permitted the issuance of subordinate units to the sponsor and its associates, nonetheless there has been no framework regarding the mechanism and terms governing these subordinate units. Hence, to resolve this issue, SEBI formulated a working group named SEBI’s Hybrid Securities Advisory Committee (HySAC) for revamping the InvIT and REIT regulations in the year 2022. The group submitted a comprehensive framework which acted as a bedrock for laying down the proposals in the recent consultation papers dated 9 December 2023 and 10 January 2024.


This post aims to elucidate the concept of subordinate units and the scenarios in which they are issued. It further explains the proposals of the consultation papers along with examining the ramifications of the same on various existing stakeholders.


Subordinate Units – A brief overview


InvITs or REITs typically issue subordinate units exclusively to the sponsor and its associates in circumstances where there exists a valuation gap (Bridge Valuation) of any infrastructural asset/ real estate asset as viewed between the sponsor and InvITs/REITs respectively. To reconcile the Bridge Valuation, equivalent values of subordinate units carrying inferior voting rights are issued to the sponsor and its associates by the InvITs/REITs. Upon the occurrence of a performance benchmark, which is the triggering event, the subordinate units so issued will be converted into ordinary units of such InvITs/REITs.


Expounding the framework


SEBI vide its consultation papers has invited public comments on the proposals pertaining to the creation of a framework for the issuance of subordinate units of InvITs/REITs. A few important proposals of the framework are as follows:


The subordinate units can be issued in the initial or in the subsequent offer after obtaining the approval of 75% of the unit holders by value excluding the votes of the sponsor and its associates or any other parties related to the particular transaction.


The subordinate units will be converted into ordinary units at the entitlement date or after the happening of the entitlement event or both. The entitlement event will include a performance benchmark on the basis of which the conversion of the subordinate units will be decided. Such performance benchmark has to be clearly defined in the placement memorandum/ placement document and has to be quantifiable and objective.


An extension in the entitlement date can be permitted for a period of not exceeding one year subject to the approval of 75% of the unitholders by value provided that such an extension has been duly deliberated upon before the issuance of the subordinate units and the disclosures relating to this have been duly made in the placement document.

In case the performance benchmark has not been met as certified and scrutinized by the statutory auditors, the subordinate units will be extinguished without any payment to its holders.


The subordinate units will be issued with a lock-in period of one year on them, however, the same will not apply to inter-se transfers of such units amongst the sponsor and its associates.

The subordinate units issued will only carry inferior voting rights and/or inferior distribution rights. Additionally, such inferior rights conferred will be similar in their nature and there will be no multiple classes of subordinate units. The regulator has sought public comments on three proposed options with respect to the extent of the inferior rights conferred on the sponsors i.e., whether the subordinate units will carry; (i) zero distribution and voting rights; or (ii) inferior distribution and voting rights to the extent of 10% of the corresponding rights on the ordinary units; or (iii) a combination consisting of an upper and a lower cap on the inferior voting and distribution rights.


A ceiling has been specified for the issuance of subordinate units which can eventually get converted into ordinary units once the performance benchmark has been met with. It specifies that the number of subordinate units issued at a particular time cannot cross the threshold of 10% of the acquisition price of the asset and the total number of outstanding units.


After the subordinate units have been issued, the terms and conditions of such units can only be altered in two situations i.e., where the approval of (i) 75% of the unitholders by value (excluding the sponsor and its associates); and (ii) 100% of the unitholders of subordinate units; has been attained.


The alteration of the terms and conditions of the subordinate units which are initially mutually agreed upon is prohibited post their issuance.


Critical analysis of the proposed framework


In the consultation papers, SEBI has attempted to create a robust investor friendly mechanism where the rights of the individual unitholders will have an extra layer of protection as compared to that of the sponsors.


To prevent the dilution of the holdings of the individual unitholders, a cap has been imposed on the subordinate units that can be issued. Furthermore, in order to bring uniformity, the subordinate units have been conferred with inferior voting rights or inferior distribution rights or both. An embargo on altering the terms and conditions of the placement document pertaining to the issuance of subordinate units post their issuance aims at preventing any disruption that could be caused to any future sale transactions on account of the changes made.


However, there are certain loopholes that have not been addressed yet.


There exists an ambiguity with respect to the legality of the already issued/existing subordinate units. The framework does not clarify the treatment of such subordinate units that already exist and whether or not it will govern the already issued/existing subordinate units.


The framework talks about the conversion of the subordinate units into ordinary units upon the completion of a performance benchmark, the achievement of which shall be scrutinized and certified by a statutory auditor. However, there is no mention of the minimum number of times such checks need to be conducted by the auditor. Additionally, the framework entails that the performance benchmark must be quantifiable and objective. Nonetheless, more light needs to be shed on what qualifies as quantifiable and objective as it might lead to uncertainty.


Inasmuch as the framework has tried to empower the unitholders by establishing a high threshold of approval for the issuance of subordinate units, it has to be understood that the requirement of 75% of approval of the unitholders by value (excluding the sponsor and its associates) is onerous. The approval required for the issuance of any ordinary units in meetings is lenient. It merely needs the votes to be cast in favour of the resolution being more than the votes cast against the resolution. Compared to this, the mandate of 75% of approval for the issuance of subordinate units seems to be very stringent.


Additionally, for the aforementioned provision to take effect, the unitholding of the sponsor and its associates must be less than 25%. However, Regulation 6A of the REIT Regulations allows the sponsor and its associates to hold more than 25% of units. Therefore, the provision of 75% of approval in the new framework needs to be reconciled with the pre-existing regulation in situations where the sponsor and its associates hold more than 25% of units.


The second consultation paper on additional proposals brought in much-needed clarity about the ceiling on the issuance of subordinate units. The ceiling is capped by SEBI at 10% or lesser of the total number of outstanding ordinary units. However, this is also based on the assumption that, typically these valuation gaps will not be too wide. So, the framework does not account for a situation wherein the valuation gap is wide enough to require an issuance of subordinate units of more than the 10% cap.


Lastly, the framework allows for inter-se transfers of subordinate units between the sponsor and its associates. The same can be done only after the depositories release the lock-in period on the said units. However, there is no cap on the number of times these inter-se transfers can take place in a year as it can defeat the purpose of imposing a lock-in period if they are released again and again.


Conclusion


The initiative taken by SEBI in releasing the two consultation papers is highly laudable as it charts out an extensive framework pertaining to the issuance of subordinate units to the sponsor and its associates and has provided the much-needed clarity on the nature of rights to be conferred on the sponsors with respect to the subordinate units.


The proposals have been supported by cogent rationale, which substantiates the framework. On one hand, the consultation papers provide much-needed clarity on a number of regulatory considerations but on the other they make it difficult for some aspects to be implemented. In a situation where these proposals are finally inculcated in the InvIT and REIT regulations through amendments, it will be intriguing to observe how SEBI implements these proposals in the fast-paced infrastructure and real estate market. The detailed framework addressing all possible loopholes is being eagerly anticipated.

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