Anuja Chatterjee & Sahil Singh
Introduction: The Exit Problem in India’s Growing AIF Market
The growth of Alternative Investment Fund (AIF) in India has been remarkable since the introduction of AIF Regulations in 2012 by the Securities and Exchange Board of India (SEBI). By FY 202425, the industry will have more than 1,300 registered funds and commitments of ₹10 lakh crore. But this growth has also revealed a regulatory blind spot i.e. the money that has technically gone through their investment cycle but are still in operation because of litigation that has not been resolved, or leftover liabilities or contingent claims. These funds that can hardly be wound up effectively are well termed as zombie funds.
In response to this, SEBI’s Consultation Paper from February 5, 2026, suggests that fund retention beyond the liquidation period should be allowed for three specific periods. This article says that the mechanism that allows retention for expected liabilities with 75% investor consent goes against the main principles of protecting investors. The article proposes also certain safeguards that would maintain the operational objective of the Consultation paper without reducing the fairness of the flexible exit structure.
The February 5, 2026 Consultation Paper: SEBI’s Three Proposals
Through its Consultation paper, SEBI lists three factual situations and explains how each should be handled by the rules.
Proposal 1 is concerned with actual litigation or tax demands. A fund can hold the appropriate amount without the consent of the investors, where a notice is issued by a regulator, such as a tax authority. Proposal 2 addresses anticipated liabilities where no notice has yet been received. AIPAC originally demanded unanimous approval by investors due to the speculative nature of the trigger, but industry resistance reduced this requirement to 75% of investors by value, and no minority safeguards were put in place, and, most importantly, no time limit on retention. Proposal 3 allows the retention of residual operation costs, but these must be supported by invoices or comparable prior-year figures, limited to three years.
All three proposals boil down to the same outcome, i.e., the fund is declared inoperative, compliance is cut to one annual status report, and formal surrender follows once the balance hits zero. A fourth group of funds having no retained money at all but waiting for a favourable result in litigation is also prudently brought into the framework.
Tyranny of the Majority – The 75% Consent Rule
Proposal 2 reveals a structural concern. Where investors representing 75% of the fund’s value approve the retention of capital for anticipated liabilities, the remaining 25% are effectively left without recourse. They are neither able to exit through redemption nor challenge such retention before an independent forum. Further, in the absence of any prescribed time limit unlike the three-year cap applicable to operational expenses their capital risks being indefinitely locked in. The minority shareholder suffers actual economic harm i.e., loss of returns, loss of deployment, and possibly, a distribution quota to downstream beneficiaries, at the whim of a majority whose interests can be diametrically opposed to theirs.
A. The Subjectivity Problem
The major problem is that “anticipated” is doing a lot of work and yet has no clear definition. The Consultation Paper itself admits that these liabilities are on the basis of assumptions. What a given investor would see as a real tax risk, another would see as far-fetched. This is because the 75% rule permits the perception of risk by the majority to prevail over the liquidity requirement of the minority, with no independent scrutiny of whether the expectation is feasible or not. A fund manager who has reasons of his own to keep the fund alive, who runs a parallel claim, retains optionality on a contested valuation, has every reason to describe general contingencies as anticipated liabilities. With a majority of 75% of institutional investors, the fund would live forever under the reduced-compliance inoperative status.
B. The Missing Safeguard: Company Law Comparison
This is not new in Indian company law; it has long been understood that the power of the majority can be easily abused. Under Section 230 of the Companies Act, 2013, schemes that impact shareholders have to be approved by a court, i.e. NCLT, which is an independent judge of fairness. Dissenting shareholders can be heard. It is obligatory to have class meetings in which other groups are impacted differently. The Supreme Court in Dale & Carrington Invt. (P) Ltd. v. P.K. Prathapan (2005) held that majority power cannot be exercised oppressively against the minority. The AIF structure, as suggested, offers none of these checks, no other scrutiny, no consideration of the classes, and no redress to the dissenters. The trust structure contributes to the gap. AIF investors are not shareholders; they are beneficiaries. Fiduciary duties are owed to all beneficiaries by the trustee equally under the Indian Trusts Act, 1882, and that includes a duty of impartiality. Allowing 75% of investors to bind 25% on speculative matters without any trustee-level check does not easily fit with that duty.
C. The Inoperative Tag and the Giveback Fallacy
To the minority investors who are stuck under Proposal 2, to be people who are labeled inoperative is no protection but an epitome of their fix. Annual status report only makes them aware of what they own, but there is no means of challenging the decision on this status report and reclaiming the investment. Giveback is however, proposed as a possible alternative under the Consultation Paper.
Essentially, in case of distributions and subsequent liabilities, the cash of the investors can be recovered through the claw back conducted by the fund according to the conditions in the PPM. AIPAC has realized that these are real challenges, which are hard to control. Giveback clauses can be effective in special cases, like lesser amounts amongst domestic investors with continuing associations. They however cannot effectively cope with big liabilities such as tax claims that only emerge with years till the money has been dissipated or inherited. When giveback is treated as an alternative, it thus gives an oversized estimate of its practical usefulness.
Comparative Analysis: Minority Protection in Investment Funds
Other jurisdictions have faced such problems. An overview of their regulatory structures indicates that minority shareholder safeguarding when it comes to fund winding is anything but inconceivable and the idea of developing such a practice is longstanding.
The Delaware Revised Uniform Limited Partnership Act (DRULPA), which underlies fiduciary obligations of general partners to all limited partners in Delaware, is enforceable before the Delaware Court of Chancery. The protections against investors cannot be wiped out in the majority consent even in a contractarian regime.
In the UK, the Financial Conduct Authority under its Sourcebook on Collective investment Schemes, employs a graduated system of consent whereby various decisions are made that necessitate varying degrees of investor consent. It is important to note that a move to change investor rights, regardless of whether the change is material or not, cannot be imposed by a majority of investors and must be supervised by the FCA. This demonstrates that regulation strengthens governance is not a substitute of fund governance.
In Singapore, segregated sub-funds that have separate asset-liability pools are permitted under the Variable Capital Companies Act 2018, and some restructurings require court permission. The main point is that due to their difference in risk profile, not all investors can be uniformly bound by the majority rule.
Own Precedents of India: AIF vs. InvIT/REIT
With the domestic regulatory framework of India in consideration, the difference in the proposed AIF framework and the current InvIT/REIT rules is quite understandable.
To begin with, InvIT/REIT regulations provide a more organized system of unitholder meetings, annual and special, whereas the AIF proposal is based on an ad hoc consent, without procedural safeguards. Second, InvIT/REIT regulations provide differentiated classrooms in which investors have different rights and none of such are considered under the AIF framework. Third, trustees of InvIT/REIT have well-established oversight and certification and for the AIF proposal the standard seen is general fiduciary standard. Lastly, the InvIT/REIT regulations entail active SEBI involvement such as express consent to make major decisions whereas the AIF proposal only involves provision of annual status report.
AIF structure does not seem to provide much cover to minority investors a loophole which SEBI has already sewed. This is in compliance with what the International Organization of Securities Commissions Principles of the Collective Investment Schemes say; that investor protection and fair treatment holds paramount importance.
Balance Restoration: A Reform Blueprint
A. Mandatory Opt-Out Right for Dissenting Investors
Amongst all solutions suggested, this is the most critical one. When 75 percent of the investors are present at a meeting to retain the funds to cover future liabilities, those who vote against it must be allowed by law to pull out after 30 days and their units redeemed in fair value created after an independent valuation is done. The corpus which is retained must pay out first and any deficit must be filled in proportion by the supporters of retention. This ensures that the ability of the majority to make plans in case of contingencies is maintained, and the minority investors have a real exit strategy.
B. Objective Definition of “Anticipated” Liability with a Mandatory Time Cap
SEBI ought to establish what actually constitutes as expected liability. Eligibility to retention needs to necessitate either a written legal opinion of independent outside counsel, which points out the character, ground and approximate amount of the possible assertion, or the documentation that indicates a real and definite exposure. The vaguity of the managerial worry is not enough to tie up the capital of the minority investors. This is to be supported by a firm maximum retention limit of five years after which all the sums which have been retained should be allocated whether or not the liability has materialised. The PPM giveback provisions of the fund would apply in case it does that later on. This offers one solution to the subjectivity problem and lockup problem that is not definite.
C. Independent Valuation to Cap Retained Amounts
The quantum retained should not be left to the fund manager’s discretion. It should be certified by an independent valuer as being reasonable and proportionate to the maximum exposure that is likely to be incurred by the intended claim. Retention of much more than the realistic worst-case liability is prejudicial in itself against the minority and should be prevented structurally. This is a reflection of the current need to have independent valuation of unlisted targets under the AIF framework, and thus a natural, and not novel, extension.
D. Compulsory Trustee certifications that have the veto power.
In the event of any retention under Proposal 2 occurring, the trustee who holds assets trustee to all the beneficiaries, notwithstanding any difference of opinion, on an equality basis under Indian Trusts Act, 1882 should first be required to independently certify that the retention is in the best interest of all investors not merely the consenting majority. A clear power should be provided to a trustee to cancel a retention resolution which it finds to be unfairly prejudicial to the minority. This adds a check within the existing system of institutional governance of the fund, without necessitating any external litigation or the creation of a new regulatory agency, and is directly in line with the fiduciary duties of the existing trustee.
E. Mandatory Class Rights and Separate Voting
The existing structure considers all investors as one homogeneous group without considering that a decision to retain could have different effects on various types of investors in fundamentally different ways. A large institutional investor might not be concerned with a delay, whereas a family office with a final distribution awaiting could be severely liquidity-constrained. In response to this, SEBI ought to require the class to vote in favor of any retention under Proposal 2. The investors are to be separated into different classes depending on objectively determinable factors like the fact whether their capital is fully drawn and awaiting distribution, and the retention has to be sanctioned by a majority (e.g. 75 per cent. by value) of that particular class, not by the entire fund as a whole. This is already reflected in the Companies Act, 2013 and in the framework of REITs/InvITs of SEBI, which can ensure that fairness is not compromised for the convenience of the arithmetic majority.
Conclusion: Balancing Flexibility and Fairness
The Consultation Paper of February 5, 2026, by SEBI is an attempt to tackle a long-standing operational issue, and it succeeds, in most aspects, in doing so conscientiously. The point of weakness is Proposal 2. It is not a fissure; it is a structural imbalance which clearly has to be corrected. The four corrections recommended in the current paper are streamlined, proportional, and are in line with the existing regulatory framework of SEBI. An able exit structure can never be complete without a just one, and it is in this paper that SEBI will be requested to make sure that when it takes up the matter of zombie funds, it does not inadvertently create a new breed of trapped investors.
Anuja Chatterjee & Sahil Singh are fourth year students at the Chanakya National Law University (CNLU), Patna.