With the tightening investment regime in India by the market watchdog, SEBI, the appointment of a custodian is not an optional operational choice anymore for an Alternative Investment Fund. The regulatory framework establishes a clear and proactive mandate, ensuring that an independent entity is integrated into the fund’s structure from the day the fund is established. However, it is important to understand what or who a custodian is, how far their role extends, and what should a fund keep in mind while appointing a custodian.
Regulatory Mandate
The foundational requirement is enshrined in Regulation 20(11) of the SEBI (AIF) Regulations, 2012. The said regulation states that the Sponsor / Manager of the AIF shall appoint a custodian registered with SEBI for safekeeping of the securities of the AIF. This provision makes the appointment of a SEBI-registered custodian a non-negotiable condition of operation.
The operational specifics and timelines for this mandate are further detailed in the SEBI Master Circular for AIFs, dated May 07, 2024 (“Master Circular”). Chapter 13 of this circular clarifies the precise timing and scope of the appointment. Paragraph 13.2.1 of the Master Circular stipulates that the custodian for a scheme of an AIF shall be appointed prior to the date of first investment of the scheme. This provision ensures that from the very first transaction, an independent entity is responsible for holding and tracking the fund’s assets.
Role of Custodian
The fundamental responsibilities of a custodian, have been detailed both in the AIF Regulations as well as SEBI (Custodian) Regulations, 1996. The role of a custodian extends significantly beyond passive safekeeping into active asset administration. The precise scope of these functions must be formally documented in a legally binding agreement between the custodian and the AIF as required under Regulation 17 of the Custodian Regulations.
Regulation 2(e) of the SEBI (Custodian) Regulations, 1996, defines “custodial services” comprehensively. This definition includes not just the safekeeping of securities, but also a suite of incidental administrative services that are critical to the fund’s operations:
Maintaining accounts of securities for each client:
- Collecting benefits or rights accruing to the client, such as dividends, interest payments, or rights entitlements.
- Keeping the client informed of corporate actions initiated by the issuer of securities that may impact the client’s rights or benefits.
- Maintaining and reconciling all records related to these services.
Beyond its duties to the AIF, the custodian has explicit, non-discretionary obligations to monitor specific activities and report directly to the regulator. This enhanced role is most clearly articulated in the Master Circular. Several provisions mandate a direct reporting line from the custodian to SEBI, bypassing the AIF Manager and ensuring the regulator receives timely, independent, and verified information.
- Reporting of General Investment Data: Paragraph 15.4 of the Master Circular states that the custodian shall report information regarding the AIF’s investments to SEBI. Paragraph 15.4.1 further directs the pilot Standard Setting Forum for AIFs (SFA) to formulate implementation standards for this reporting, formalizing the data chain from the AIF Manager to the Custodian and ultimately to SEBI.
- Monitoring Leverage in Category III AIFs: For high-risk Category III AIFs, the custodian’s role as a watchdog is explicit. Paragraphs 5.2.13 and 5.2.14 of the Master Circular create a clear and immediate reporting cascade for leverage breaches. If a Category III AIF exceeds its permitted leverage limit, it must report this to the custodian by the end of the same day. The custodian is then independently obligated under Paragraph 5.2.14 to report the breach to SEBI before 10 a.m. on the next working day, providing the fund’s name, the extent of the breach, and the reasons for it.
- Oversight of Complex Instruments: Chapter 9 of the Master Circular, which governs AIF participation in Credit Default Swaps (“CDS”), places reporting duties on the custodian. Paragraph 9.3.1 requires AIFs to report all CDS transactions to their custodian by the next working day. More critically, Paragraph 9.3.4(c) mandates that if an AIF sells CDS and fails to rectify a shortfall in the required earmarked collateral, the custodian shall report details of the breach to SEBI, on the next working day.
Eligibility of Custodian
The principle of independence is the bedrock of the custodian’s role. A conflict of interest, particularly where the custodian is an “associate” of the AIF’s Sponsor or Manager, poses a significant threat to this independence. SEBI’s regulations address this risk not with a blanket prohibition, but with a higher scrutiny allowing for such arrangements only under exceptionally stringent conditions.
An “associate” is defined in Regulation 2(1)(c) of the AIF Regulations as an entity where the AIF’s Sponsor, Manager, or their directors/partners hold more than a 15% stake. The inherent conflict is clear: an associated custodian may face pressure to overlook irregularities or act in the interest of the Manager rather than the AIF’s investors.
To mitigate this, Regulation 20(11A) of the AIF Regulations establishes a set of high barriers that must all be cleared for an associate to act as a custodian. The key conditions include:
- A minimum net worth of at least INR 20,000 crore for the Sponsor or Manager.
- A requirement that 50% or more of the directors on the custodian’s board do not represent the interests of the Sponsor or Manager.
- A structural separation, ensuring the custodian and the Sponsor/Manager are not subsidiaries of each other.
- A complete separation at the board level, with no common directors between the custodian and the Sponsor/Manager.
The high net worth threshold of INR 20,000 crore effectively limits this exception to the largest and most systemically significant financial institutions, which are presumed to have more robust internal controls and a greater reputation stake in maintaining market integrity. The conditions regarding board composition and the absence of common directors are designed to create a functional, if not entirely structural, separation of power and decision-making.
Conclusion
The role of the custodian within the Alternative Investment Fund framework has evolved significantly from that of a mere safe-keeper of assets. The regulatory architecture established by SEBI has strategically molded the custodian into a multi-dimensional guardian of investor interests and a vital component of the market’s supervisory mechanism.
Most importantly, the modern framework has elevated the custodian to the position of a quasi-regulator. With direct, non-discretionary reporting obligations to SEBI on matters of systemic importance such as leverage breaches and exposure to complex derivatives, the custodian serves as the regulator’s eyes and ears on the ground. This provides a layer of independent, verified data that is crucial for effective market supervision. By weaving these duties into the fabric of AIF operations, SEBI has made the custodian an indispensable element for ensuring accountability, transparency, and the long-term stability of India’s alternative investment industry.