Establishing a Robust Mechanism
The framework is divided primarily into three parts. The first part recommends establishing a regulatory body that will be responsible for regulating the SIFs primarily. It will set rules and regulations governing the flow of funds inside India with socially beneficial standards and disclosure. The second part recommends establishing a whole new transaction channel, just like FCRA, for the inflow and outflow of Funds for Impact Investing. The third part recommends complying with SFDR regulations to align with International Taxonomy. The framework will enhance the attractiveness of impact investing in India.
Part 1: Establishing a regulatory body
In order to effectively regulate SIF investments, a dedicated regulatory body is of utmost importance. This body could be a newly established body or SEBI itself. The regulatory body will oversee SIFs, foreign investors and social enterprises in order to ensure transparency and accountability. The regulatory body will list down all the required disclosures and set standards in order to prevent the illegal flow of money and the optimum utilisation of funds by developing rules and regulations.
This regulatory framework can rely on the Global Reporting Initiative (“GRI”) framework in order to promote sustainable growth. The GRI standards emphasise materiality, urging organisations to report on issues most significant to their stakeholders and business operations. Furthermore, the regulatory body can rely upon the Sustainability Accounting Standards Board (“SASB”) standards to set financial and accounting criteria for SIFs and social enterprises. These decisions are formed in order to merge the existing financial reporting system with decision-useful information that is in line with Environmental, Social, and Governance principles (“ESG”) (Refer here to get an in-depth understanding of ESG principles). By establishing a robust regulatory mechanism and adhering to these guidelines, the foreign funds will be utilised in the most impactful manner.
Part 2- Establishing a separate banking channel
The second part of the proposed framework emphasises creating a separate banking channel, just like FCRA contributions, which have to flow only through the State Bank of India (“SBI”) branch in Delhi. In a similar manner, SIFs must be compulsorily registered in a prescribed banking channel and all the funds for SIF investment must flow through that channel in order to ensure proper financial disclosures. This approach will bring all the transactions into the purview of a regulated banking channel to prevent money laundering and tax evasion.
It must also be noted that this will not create much burden on foreign investors as they will have just to make the investments through the prescribed channel and make disclosure about the source of their income. The primary responsibility will lie with the SIFs to comply with these regulations, thus not deterring foreign investments in social enterprises. This system will increase the integrity of foreign investments in the Indian impact sector.
Part 3- Complying with SFDR regulations
The third part of the framework emphasises aligning SIFs with Sustainable Finance Disclosure Regulation (“SFDR”) standards. SFDR aims to reorient capital flow toward sustainable finance. Investment managers must adhere to the principles of honesty and professionalism and shall act in the interest of honest investors. Sustainability tests must be adhered to, which requires fund managers to invest in those financial tools which are in the client’s favour. But they shall ensure that the funds are invested for social welfare and not for the personal welfare of a person. Making investments in the related companies of the investors without the permission of the regulatory authority shall be prohibited in order to prevent the illegal transfer of funds in favour of the investors.
Additionally, investment firms must engage in stewardship activities in line with their broader investment duties, as mandated by the Shareholder Rights Directive II (“SRD II”). They shall be made subject to various disclosure requirements and auditing requirements and include obligations on ESG risks and adverse impacts under the SFDR. Penalties must also be imposed on fund managers and funds in case of violation of the rules, improper disclosure, assisting illegal flow of funds in the country, and illegitimate use of funds.
Cost Benefit Analysis
There might be an argument that the proposed framework for regulating SIFs will hinder investment attraction from foreign investors due to the regulatory requirements. The authors certainly deny this argument and use a cost-benefit analysis to contend how the proposed approach will be able to attract more foreign investments. This analysis is an economic tool used for evaluating the net output of a decision (Refer here to get an in-depth understanding of Cost-Benefit Analysis).
The cost of adopting this framework includes the possibility that some funds might not be invested due to the single transaction channel and the requirement for income source disclosure. However, the benefits are substantial. The framework ensures the optimal use of funds through established standards, attracts more funds for sustainable development in India by easing FCRA regulations, and reduces the likelihood of tax evasion and money laundering. The benefits outweigh the costs in this scenario, making it advantageous to attract foreign investments.
Without such a framework, exempting SIFs from FCRA without a regulatory framework will just open ways for people to tax evasion, money laundering and an influx of illegal funds in the country. In that scenario, the costs will outweigh the benefits by a big, which will affect the national integrity significantly. Thus, the framework suggested by the authors offers a balanced approach for increasing impact funding with reasonable restrictions.
The Way Ahead
The Social Impact Fund, as discussed above, is an important part of impact investing, where investors can have more secured financial returns with fewer risk factors. The recent amendments in the AIF Regulations are definitely a welcoming step, however, there are still certain significant challenges which the SIFs face in our country. There is a need for an increase in SIFs within our country so as to ensure that the social sector gets more benefits, thereby ultimately expanding the economy.
The recent amendments indicate the inclination of the regulatory body to increase the market traction of the SIFs. However, the regulatory body can take several steps in order to create a conducive environment for SIFs. One of the foremost steps that the SEBI can take is to grant tax exemptions against the investment in SIFs under section 80G of the Income Tax Act, 1961. Such relaxation will grant investors a sigh of relief and will even encourage individual investors to invest in such SIFs, thereby having an overall benefit for all the parties involved.
Another step that the regulatory body may pursue is that it can allow the SIFs to provide loans to different small social enterprises or, rather Micro, Small and Medium Enterprises (“MSMEs”). Currently, the SEBI Regulations disallow the AIFs to grant loans, as evident from the FAQs on AIF regulations. However, if we carefully analyse this aspect, then the MSMEs are the most important sector which requires credit and investment, as it will directly help in the growth of the country’s economy. It is pertinent to note that the investors of SIFs are highly sophisticated and have enough credit with them to bridge the critical gap of credit that lies between the MSMEs and investors. Also, if we critically analyse the situation of credit-linked investments in the sector of small enterprises within our country, then it is very minimal as compared to the other sectors of the economy.
According to an April 2023 report by Avendus, the MSME sector of India is facing a monumental credit gap of about $530 Billion, which shows how vulnerable is our country’s MSME sector. The loan process for MSMEs is multi-layered where the banks or NBFCs provide them with the loans, thereby increasing the rate of interest and lowering returns.
However, if SIFs are allowed to grant loans directly to the MSMEs, then it can surely help them in solving their credit gap because the SIFs have enough resources to analyse and do due diligence on any MSME, which will then be used to grant those loans easily. In Germany, AIFs are allowed to grant loans but are subjected to certain restrictions so as to prevent misuse of the fund. A similar kind of framework can be promoted in India as well so as to promote the overall sustainable development of the economy.
Further, the legislature or SEBI can even allow the Companies to directly invest in SIFs as part of their mandatory Corporate Social Responsibility (“CSR”). As per Section 135 of the Companies Act 2013, companies with a certain threshold are required to, mandatorily in every financial year, spend at least two per cent of their average profits during the preceding three years. If these companies are allowed to directly invest in the SIFs as part of their CSR, then it would lead to an infusion of much more share capital in the SIFs. This kind of direct investment will help the SIFs with a ready pool of capital, which they can invest in the furtherance of their prescribed social standards. As CSR is mandatory for every such applicable company, if such CSR is allowed to be directly infused in the SIFs, then it will lead to a rise in enhancement in the number of SIFs, as more and more such funds will be created due to easy availability of funds and lesser threshold.
However, there are chances that the companies in the garb of investing in SIFs, invest in their subsidiary or backed funds, thereby just laundering the money within themselves and not doing real investment in SIFs. Therefore, SEBI must ensure that the companies remain accountable to them and should present the records of such investments annually. It is necessary to make sure that there is a certain threshold for the investment in SIF as a part of CSR because if companies start investing all of their mandated CSR money into SIFs, then the whole purpose of CSR, which was to promote the facilities related to education, healthcare, social welfare etc will be hampered. Therefore, SEBI should create a certain maximum threshold, maybe 0.5 % of the total two percent, beyond which the companies could not invest in SIFs.
In conclusion, enhancing the SIF framework in India requires aligning SEBI and FCRA regulations, establishing robust regulatory mechanisms, and creating dedicated transaction channels. By integrating sustainability standards and proposing practical measures like tax exemptions and allowing CSR investments in SIFs, the framework can attract substantial foreign investments while ensuring transparency and accountability. These reforms will bolster social impact initiatives and contribute significantly to the country’s socio-economic development, balancing financial returns with societal benefits.
This article is authored by Arihant Sethia and Siddhant Singhi, 4th year law students at Gujarat National Law University. For Part I
