Trust Structures In Floating Alternative Investment Funds: The Arbitration Conundrum

A critical examination of why trust remain the preferred structure for floating AIFs in India, and why disputes arising out of them cannot be arbitrated under current law.

Key Takeaways:

• Preferred Route: Trust structures dominate Indian AIFs due to tax pass-through efficiency, operational flexibility, minimal compliance burdens, and the ability to create multiple schemes with ring-fenced assets under a single framework.
• Categorical Non-Arbitrability: The Supreme Court's decision in Shri Vimal Kishor Shah v. Jayesh Dinesh Shah 2016 SCC OnLine SC 825 (decided on August 17, 2016) limits arbitration of disputes arising out of the trusts and the Indian Trust Act, 1882 as beneficiaries are non-signatories to the trust deeds. The Indian Trust Act, 1882 confers exclusive jurisdiction to the civil courts over fiduciary matters.
• Contractual Mitigation Limits: While contribution agreements try to create arbitrable commercial disputes, courts may reinterpret operational claims as breaches of fiduciary duties.
• SEBI's Solution: Regulation 25 of SEBI (AIF) Regulations, 2012 and the ODR Portal offer quasi-arbitral resolutions for regulatory compliance disputes within SEBI's oversight.
• The Reform Imperative: As India seeks global capital, the legal framework must change to distinguish sophisticated commercial AIFs from traditional family trusts. It should also balance tax efficiency with modern expectations for resolving disputes.

The Trust Imperative: Fiscal Necessity Over Choice

Alternative Investment Funds (AIFs) in India, largely continue to prefer the trust structure even though there are corporate options available under the SEBI (AIF) Regulations, 2012 (AIF Regulations). This preference reflects a convergence of fiscal, operational, and structural advantages that make trusts commercially indispensable.

One of the decisive factors is tax pass-through efficiency. Under Section 115UB of the Income Tax Act, 1961, Category I and II AIFs structured as trusts enjoy pass-through status (except on business income), ensuring income keeps its character when it reaches investors. Capital gains, dividends, and interest are taxed directly in investors' hands at applicable rates, preserving treaty benefits and exemptions.

Beyond taxation, trusts offer unmatched flexibility, confidentiality and customization. A single trust can establish multiple schemes with ring-fenced assets and liabilities under the AIF Regulations, enabling sponsors to launch distinct investment strategies within one regulatory framework.

Further, the operational advantages reinforce this preference. Trusts can be constituted through execution of a trust deed under the Indian Trusts Act, 1882 (Trust Act), making formation simpler, quicker, and less compliance-heavy than incorporation under the Companies Act, 2013 or LLP Act, 2008. Unlike its corporate alternatives, trusts impose minimal compliance, reporting, and disclosure requirements thus reducing administrative overhead. The winding-up process upon tenure expiry is contractual rather than statutory thereby ensuring faster exits with lower costs.

The Arbitration Barrier: When Equity Trumps Contract

This structural choice leads to a key vulnerability: disputes arising out of the trust deeds are generally not arbitrable. Importantly, arbitrability is not determined by a straitjacket formula but requires a nuanced and fact-specific analysis.

The Framework of Arbitrability

To understand why disputes arising out of the trusts cannot be arbitrated, it is essential to first understand what makes a dispute arbitrable. In Booz Allen & Hamilton Inc. v. SBI Home Finance Ltd (2011) 5 SCC 532 (decided on April 15, 2021), the Hon'ble Supreme Court framed three questions to determine arbitrability:

1. Whether the disputes having regard to their nature could be resolved by a private forum chosen by the parties (Arbitral Tribunal) or whether such disputes exclusively fall within the domain of Public Fora (Courts);
2. Whether the disputes are covered by the arbitration agreement; and
3. Whether the parties have referred the disputes to arbitrator?

The Court further observed that every dispute, either contractual or non-contractual, which can be decided by a court, is in principle capable of being adjudicated and resolved by arbitration unless the jurisdiction of arbitral tribunals is excluded either expressly or by necessary implication. The decision also drew a critical distinction between actions in personam and actions in rem. Actions in personam refer to actions determining the rights and interests of the parties themselves in the subject matter of the case, whereas actions in rem refer to actions determining the title to property and the rights of the parties, not merely among themselves but also against all persons at any time claiming an interest in that property. Generally, and traditionally all disputes relating to rights in personam are considered to be amenable to arbitration; and all disputes relating to rights in rem are required to be adjudicated by courts and public tribunals, being unsuited for private arbitration. This distinction becomes crucial in understanding why trust disputes, which often have in rem characteristics affecting all beneficiaries, may not be amenable to arbitration.

However, the Court itself in Booz Allen (Supra) observed that the difference between actions in personam and actions in rem is not however a rigid or inflexible rule. The distinction is not determined by a straitjacket formula, and determination of arbitrability solely based on these expressions may not be correct because of the interplay between these terms. Disputes relating to sub-ordinate rights in personam arising from rights in rem have always been considered to be arbitrable. This determination requires careful case-by-case assessment rather than rigid categorization based on a mechanical approach

Trust Disputes: The Categorical Bar to Arbitration

The Hon'ble Supreme Court's decision in Shri Vimal Kishor Shah v. Jayesh Dinesh Shah 2016 SCC OnLine SC 825 (decided on August 17, 2016) framed the question as whether the disputes relating to affairs and management of the Trust including the disputes arising inter se trustees, beneficiaries in relation to their appointment, powers, duties, obligations, removal etc. are capable of being settled through arbitration by taking recourse to the provisions of the Arbitration and Conciliation Act, 1996 (A&C Act), if there is a Clause in the Trust Deed to that effect or such disputes have to be decided under the Trust Act.

The Court held that disputes relating to trust, trustees and beneficiaries arising out of the Trust Deed and the Trust Act are not capable of being decided by the arbitrator despite existence of arbitration agreement to that effect between the parties.

The Court's dual rationale was:

1. Non-Signatory Problem: Trust deeds are made between the settlor and the trustee; the beneficiaries do not sign these deeds. In the absence of a direct consent indicated by a signature, the arbitration clauses cannot bind the beneficiaries under Section 7 of the A&C Act.
2. Implied Statutory Bar: The Trust Act serves as a complete code, giving civil courts full jurisdiction over fiduciary relationships. The Court held that since the Trust Act in explicit terms confers the civil courts with the power of supervising and enforcing fiduciary duties, thereby implicitly excluding arbitral tribunals from this jurisdiction.

Exclusion by Necessary Implication

The principle of exclusion by necessary implication was further reinforced in Vidya Drolia v. Durga Trading Corporation (2019) 20 SCC 406 (decided on February 28, 2019) where the Hon'ble Supreme Court observed that disputes arising out of the Trust Act, are not arbitrable as this was excluded by necessary implication. The Court noted that the Trust Act, in fact, provides an excellent instance of how arbitration is excluded by necessary implication, emphasizing that for arbitration to be excluded by necessary implication, the entire statute must be read as a whole, and such examination must necessarily lead to the conclusion that disputes arising under that statute cannot be the subject matter of arbitration.

The Hon'ble Supreme Court further in Vidya Drolia and Ors. v. Durga Trading Corporation and Ors. (2021) 2 SCC 1 (decided on December 14, 2020) observed that arbitration is not suitable in the situations where the rights and liabilities of persons who have not consented to arbitration are affected or the collective resolution of the disputes by including non-parties is required. The Court propounded the four-fold test for determining when the subject matter of a dispute in an arbitration agreement is not arbitrable:

1. When cause of action and subject matter of the dispute relates to actions in rem, that do not pertain to subordinate rights in personam that arise from rights in rem;
2. When cause of action and subject matter of the dispute affects third party rights and have erga omnes effect, i.e., it affects the rights and liabilities of persons who are not bound by the arbitration agreement and require centralized adjudication;
3. When cause of action and subject matter of the dispute relates to inalienable sovereign and public interest functions of the State and hence mutual adjudication would be unenforceable; and
4. When the subject-matter of the dispute is expressly or by necessary implication non-arbitrable as per mandatory statute(s).

These tests are not watertight compartments; they dovetail and overlap, albeit when applied holistically will help and assist in determining and ascertaining with great degree of certainty when as per law in India, a dispute or subject matter is non-arbitrable. Only when the answer is affirmative that the subject matter of the dispute would be non-arbitrable.

Practical consequences

When investors claim a breach of fiduciary duty, seek to remove trustees, or challenge investment decisions as trust violations, arbitration clauses in trust deeds are generally not enforceable as per the decision in Vimal Kishor Shah (Supra). Such matters typically must proceed through civil courts, resulting in protracted timelines and public court proceedings that expose confidential fund strategies and proprietary information. Further, disputes that involve structural remedies such as the appointment or removal of trustees or the amendment of trust deeds that affect all unit holders have in rem features, affecting the rights not merely among the immediate parties but against all beneficiaries. Such conflicts remain fundamentally unsuitable for arbitration, as they require the court's supervision to ensure that the interests of all beneficiaries are protected.

Nevertheless, for sophisticated institutional investors who prioritize speed in financial matters, being pushed into proacted litigation presents a significant governance risk, which goes against international fund management standards.

Contractual Workarounds: Partial and Fragile

A potential pathway for investment managers lies in strategically structuring contribution agreements as bilateral contracts with individual investors. Since investors become signatories to these agreements unlike the trust deed, the agreements could satisfy the requirements under Section 7 of A&C Act for constituting a valid arbitration agreement. These agreements should be meticulously drafted to carve out a distinct contractual sphere encompassing purely commercial disputes such as fee calculations, capital call timing, distribution methods, and breaches of specific representations through arbitration. This approach aims to establish a clear contractual boundary separating disputes that do not implicate the trustee's primary fiduciary duties under the trust deed.

The strategic drafting serves a critical purpose: isolating disputes concerning subordinate rights in personam i.e. those rights arising from purely commercial relationships between the manager and individual investors from disputes involving rights in rem that affect the trust structure and all beneficiaries collectively. Where this bifurcation succeeds, such commercial disputes would theoretically satisfy the arbitrability test laid down in Vidya Drolia (Supra) and remain amenable to arbitration, offering investors a viable enforcement mechanism without triggering the non-arbitrability bar applicable to trust disputes proper.

SEBI's Regulatory Response: The ODR Framework

As a regulatory response, SEBI amended Regulation 25 of AIF Regulations effective from July 04, 2023 requiring all claims, differences or disputes between investors and AIFs or manager shall be submitted to the SEBI's ODR Framework.

Key features:

• SEBI ODR Portal: A dedicated platform for investor complaints, allowing escalation of unresolved issues through internal processes.
• Quasi-Arbitral Forum: Operating under SEBI's supervisory authority, it offers dispute resolution mechanism through arbitration, mediation and conciliation.
• Scope Constraints: Cannot address key fiduciary disputes such as trustee removals, investment mandate challenges, or alleged fiduciary duty breaches.

This partially addresses the arbitration gap without challenging the Trusts Act framework, but it provides only limited relief.

The Unresolved Conundrum & Way Forward

The song remains the same: trust structures are favoured for efficiency and operational advantages but don't align with modern dispute resolution expectations for sophisticated commercial investors. The moot question is whether arbitration should be permitted for disputes arising in AIFs structured as trusts or not?

Should the law treat AIFs floated through trust differently from traditional family trusts? The law laid down in Vidya Drolia (Supra) provides analytical tools for such differentiation. Institutional investors negotiating billion-rupee commitments differ materially from beneficiaries for whom the Trust Act was designed to protect. Does non-arbitrability of disputes arising out of trust deed and Trust Act as remain justified for sophisticated and commercial relationships?

The interplay between rights in rem and rights in personam in commercial fund structures suggests that not all AIF disputes necessarily implicate the public policy concerns underlying the Vimal Kishor Shah (Supra) decision. Where a dispute arising out of trust deed concerns purely commercial matters and does not affect third-party rights, such disputes may not be expressly barred by the Trust Act and such disputes may be arbitrable under a holistic application of Vidya Drolia (Supra).

However, this determination requires intensive factual and legal inquiry in each case. The absence of clear precedential guidance on where precisely the line falls between arbitrable commercial disputes and non-arbitrable fiduciary governance matters creates substantial uncertainty for fund managers and investors alike.

As India prepares to attract global capital, this issue demands urgent attention. Until the Hon'ble Supreme Court creates such distinction or Parliament amends the framework including the Trust Act for funds including AIF's, managers and investors must accept this governance cost as the price of the comprehensive advantages that trust offer.

SEBI's ODR mechanism, is a practical and welcoming regulatory innovation, is an important first step to address the underlying fiduciary-commercial divide in sophisticated investment vehicles. As the framework develops and is applied in practice, there remains scope for further evolution to address the range of governance challenges inherent in trust structures.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.