SEBI’s New “Inoperative Fund” Framework: Reforms In Winding-up Rules For Alternative Investment Funds (AIFs)

Over the years, Securities and Exchange Board of India (“SEBI”) has introduced a series of reforms to refine the winding-up framework governing Alternative Investment Funds (“AIFs”). Through these changes, SEBI has sought to make the winding-up process more practical and comprehensive, addressing the various issues that arise at the end of a fund’s tenure and improving the overall framework for closure of AIFs.

As per Regulation 29 of the SEBI (Alternative Investment Funds) Regulations, 2012, the scheme must liquidate every asset, settle every liability, distribute every rupee to investors and bring the fund’s bank balance down to NIL - all within a fixed “permissible fund life.” In practice, however, this rarely matched reality. Pending litigation, anticipated tax demands, regulatory notices, and residual winding-up expenses routinely kept small amounts of money trapped in AIF bank accounts long after investment activity had ended - leaving fully economically inactive funds subject to the same compliance obligations as actively investing AIFs.  

The AIF Regulations, 2012 have undergone several amendments over the years, reflecting SEBI’s continuous efforts to refine and strengthen the regulatory framework.

The 2023 Reforms

SEBI amended the AIFs Regulations to introduce Regulation 29A and issued a Circular No. SEBI/HO/AFD/PoD-I/P/CIR/2023/098 dated on 21 June 2023 setting out two principal mechanisms for dealing with unliquidated investments: -

1. Creation of a Liquidation Scheme, whereby the remaining unsold investments could be transferred to a separate scheme and investors in the original scheme would receive proportionate units in the Liquidation Scheme while the residual funds continued to be managed separately.
2. In-specie distribution, under which unliquidated investments could be distributed directly to investors in-specie instead of being monetised.

Either route required approval of at least 75% of investors by value. The 2023 Circular also introduced several safeguards to protect investors. AIFs were required to arrange bids for at least 25% of the value of the unliquidated investment portfolio and obtain valuations from two independent valuers. Dissenting investors were provided an exit opportunity through the bid mechanism, and failure to arrange the prescribed bid resulted in the investments being recorded at one rupee for the manager’s track record and for performance benchmarking. Where consent could not be mustered at all, in-specie distribution became mandatory, at the same nominal value, with a write-off for any investor unwilling to accept.

However, the schemes addressed only the problem of investments that could not be liquidated. They did not address an equally significant issue that increasingly confronted fund managers once all investments had, in fact, been liquidated. Pending tax reassessments, regulatory investigations, contractual indemnities, ongoing litigation and residual winding-up expenses frequently required managers to retain a portion of the liquidation proceeds until the relevant contingencies had been resolved. Consequently, although the investment portfolio had ceased to exist, the fund remained trapped within the regulatory framework solely because it could not satisfy the requirement of achieving a nil bank balance.

The 2026 Reforms

Throughout 2026, SEBI has moved decisively to fix the above issue. SEBI opened the reform process with a Consultation Paper dated 5 February 2026, titled “Flexibility to Alternative Investment Funds (AIFs) in Winding up the Scheme / Surrendering the Registration.” The paper sought to address the practical challenges faced by AIFs in surrendering their registration by proposing a clearer, more predictable and operationally efficient exit framework.

Following the consultation, SEBI notified the Securities and Exchange Board of India (Alternative Investment Funds) (Amendment) Regulations, 2026 dated on 16 April 2026. This amendment introduced the legal changes in Regulation 29(7) by inserting the phrase “subject to conditions as may be specified by the Board from time to time”, enabling SEBI to prescribe conditions under which liquidation proceeds may be retained through circulars.

SEBI issued the subsequent implementing Circular No. HO/19/34/11(2)2026-AFD-POD1/I/13764/2026, dated 16 June 2026. Effective immediately, the circular operationalises the amendments introduced under Regulation 29 by permitting AIFs to retain liquidation proceeds beyond expiry of their permissible fund life where the AIFs or the scheme satisfies at least one of three conditions:-

1. First, where the fund has received an official communication including a litigation notice or demand indicating a potential tax, regulatory or legal liability. The Circular adopts a broad approach by covering show-cause notices, reassessment notices and investigation summons and similar claims.
2. Secondly, the circular also recognises situations involving anticipated liabilities arising from potential litigation or tax demands, subject to the approval of at least 75% of the investors by value, with the manager being required to disclose both the amount proposed to be retained and the expected duration of such retention.
3. Thirdly, AIFs may retain proceeds to meet residual winding-up related operational expenses including legal, audit and administrative costs, provided such expenses must be substantiated through invoices or comparable historical records. However, such retention may not exceed three years from the end of permissible fund life.

Prior to the 2026 amendments, AIFs that had liquidated all their investments but retained cash to meet pending liabilities occupied a regulatory grey area. The old framework assumed that a fund’s operational life would conclude simultaneously with its legal and financial obligations. These economically inactive funds remained unable to surrender their registration while continuing to be subject to the regulatory framework despite having ceased all investment activities.

The Inoperative Fund Framework  

The Amendment also introduced a new Regulation 29(10A), which provides the statutory basis for the “Inoperative Fund” category, addressing a long-standing regulatory gap in the winding-up framework for AIFs. The framework addresses the issue of such economically inactive funds by creating a formal regulatory status. Such funds may apply to SEBI to be designated as an Inoperative Fund. Under Inoperative status, the funds are prohibited from making fresh investments, launching new schemes or charging management fees. Any retained monies must be invested only in the temporary investment instruments permitted under Regulation 15(1)(f) of the AIF Regulations, thereby ensuring that the funds remain liquid while pending liabilities are resolved. In exchange for the status, the Inoperative Funds are exempt from several routine regulatory requirements, including quarterly and annual activity reports, compliance test reports, performance benchmarking submissions, PPM audit reports and certain key personnel certification requirements. These obligations are replaced with a simplified annual status report to be submitted to both SEBI and the investors, disclosing the retained funds, outstanding liabilities and the status of their resolution, within 30 calendar days of the end of March each year.
Importantly, the framework is not restricted to funds retaining liquidation proceeds. Consistent with the proposals contained in the Consultation Paper, the circular extends eligibility to AIFs that hold no retained monies but continue to remain registered solely because of pending litigation, such as where the fund is awaiting the outcome of legal proceedings that may result in a future recovery. Such funds may also apply for Inoperative Fund status and will remain subject to the same restrictions on undertaking fresh investment activities and charging management fees. The benefits of the framework have also been extended to Venture Capital Funds registered under the erstwhile SEBI (Venture Capital Funds) Regulations, 1996, thereby ensuring regulatory consistency across legacy investment vehicles.

Once all outstanding liabilities have been discharged and the retained proceeds have been fully distributed, resulting in a nil bank balance, the scheme may complete its winding-up in accordance with the AIF Regulations and proceed with the surrender of its certificate of registration.

Recognising that certain aspects of the framework require further operational guidance, SEBI has directed the Standard Setting Forum for AIFs (“SFA”), in consultation with the regulator, to formulate implementation standards, including standardising the categories of eligible operational expenses. This indicates that while the circular establishes the overarching regulatory framework, certain procedural and operational aspects will continue to evolve through industry-led standards.

Impact Of The 2026 Reforms

The introduction of the Inoperative Fund framework represents a significant advancement in SEBI’s evolving approach to the winding-up of Alternative Investment Funds. While the 2023 reforms sought to address the practical difficulties associated with unliquidated investments through the introduction of Liquidation Schemes and in-specie distributions, the 2026 reforms complete the regulatory framework by addressing an equally important issue – the retention of liquidation proceeds to meet outstanding and contingent liabilities. Read together, these measures provide a structured and sequential pathway for fund managers from the liquidation of investments to the eventual surrender of registration, thereby bringing greater certainty and practicality to the winding-up process.

From a regulatory and operational perspective, the framework introduces a more proportionate compliance regime for economically inactive funds. Rather than requiring schemes that have effectively ceased investment activities to continue complying with the full range of regulatory obligations applicable to active funds, the Inoperative Fund mechanism recognises their limited operational role while preserving appropriate safeguards through investor consent, disclosure requirements and annual reporting obligations. This strikes a careful balance between providing fund managers with the flexibility necessary to manage unresolved liabilities and ensuring that investor interests remain adequately protected.

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