The Real Estate (Regulation & Development) Act, 2016 (act), the most significant reform of India’s real estate sector in modern times, came into effect in 2017. The act established a Real Estate Regulatory Authority (RERA) in each state. Each RERA is tasked with regulating the real estate sector and protecting the interests of the sector’s consumers in that state. The act has proven to be a double-edged sword for private equity (PE) investors.
The act has introduced a plethora of reforms in the sector. Among other measures, it imposes checks, balances and obligations upon the promoter of the project, and gives consumers certain rights to safeguard their interests. This has increased consumer confidence and accelerated sales, making the real estate sector more attractive to, and, potentially, more lucrative for PE investors.
Certain other provisions of the act work in favour of PE investors. The promoter of a real estate project is required to register with the RERA. This entails the submission of project-related and legal documents to the RERA as evidence that the project complies with the requirements at law. Registration with the RERA demonstrates the first step of due diligence, and can, therefore, be made a precondition to PE investors agreeing to invest in a project. The existence of the RERA as a sectoral regulator is a deterrent to the violation of legal and compliance requirements by promoters, and enhances transparency. This safeguards the interests of the consumers and investors whose investments could be jeopardised by breaches of law or contract.
Despite the added transparency, certain provisions of the act could deter PE investors from investing in the real estate sector. Under the act, a promoter includes a person who causes the construction of the real estate project. This definition is ambiguous and could be interpreted as referring to the PE investor, the target company or special purpose vehicle or entity, or the founder shareholders who are actually responsible for the construction and management of the project, that is the management shareholders. If considered promoters, PE investors will need to comply with promoters’ obligations under the act.
Another concern for PE investors is the prohibition on a promoter transferring majority rights and liabilities in respect of the real estate project to a third party without the prior written consent from two-thirds of the allottees and the prior written approval of the RERA. Although the definitive documents often enable a PE investor, in the event of a material breach, to exit and drag along the target company’s principal shareholders, this may be difficult where the target company is engaged in the real estate business. Under the definitive documents, a material breach invariably includes a violation of the act by the company’s principal shareholders. However, where the provisions of the act have been breached, the allottees and the RERA may be reluctant to approve the transfer of the majority interest.
Even if a PE investor is not deemed to be a promoter, the actions that the RERA can take against a non-compliant promoter may deter investment. Breach of the provisions of the act or the terms of approval granted by any authority for developing the project may lead to the revocation of the promoter’s registration under the act. As registration is a precondition for advertising, marketing and selling of any real estate project, any default by the promoter could adversely affect the PE investor’s return on investment.
To safeguard against the risk of being classified as promoters, it is imperative that PE investors do not take part in the operation, supervision and management of the real estate project, and that this is reflected in the definitive documents. It is advisable to identify the company’s principal shareholders as the promoters for the purposes of the act in the definitive documents. PE investors should require indemnities from the company’s principal shareholders for themselves and the entity should loss or damage be caused through violation of the act by them. PE investors should remember they may not be in a position to exercise a drag along option as this requires the consent of the RERA and two-thirds of the allottees.
Vandana Pai is a partner and head of the investment funds practice, and Subham Chatterjee is a senior associate at Bharucha & Partners.
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