Investment Restrictions and Prohibitions

A mutual fund pools the savings of strangers and entrusts them to a fund manager who will never meet most of the people whose money he deploys. The single greatest danger in that arrangement is concentration — the temptation to bet too much of the pool on one issuer, one group, or one risky stratagem. The Securities and Exchange Board of India answers that danger not with exhortation but with hard numerical ceilings. Regulation 44 of the SEBI (Mutual Funds) Regulations, 1996 binds every investment to the limits in the Seventh Schedule, and the SEBI (Alternative Investment Funds) Regulations, 2012 impose a parallel discipline on the more sophisticated AIF universe. This chapter maps those restrictions and prohibitions, the prudential logic behind them, and the litigation — above all the Franklin Templeton debt-fund collapse — that has tested their edges.

Why the Law Caps a Fund Manager's Discretion

A mutual fund is a creature of trust law dressed in the language of securities regulation. The unitholder hands over money on the faith that it will be spread across many securities so that the failure of any one issuer does not sink the scheme. Left to commercial instinct alone, a fund manager chasing yield might load a debt scheme with the paper of a single high-coupon borrower, or an equity manager might concentrate in the sponsor's own group. SEBI's response is structural: it converts the prudential ideal of diversification into mandatory arithmetic. As explained in our chapter on the SEBI (Mutual Funds) Regulations, 1996, the whole edifice rests on a three-tier structure — sponsor, trustee and asset management company — and the investment restrictions are the substantive content that this structure is meant to police.

The constitutional and statutory legitimacy of this command-and-control approach is no longer open to doubt. In the second Franklin Templeton Trustee Services (P) Ltd. v. Amruta Garg, 2021 SCC OnLine SC 464 (decided 14 July 2021), the Supreme Court held that SEBI possesses plenary power to regulate every phase of a scheme's life, including its winding up, precisely to protect investors against decisions of trustees and the AMC that may be detrimental to unitholders. The investment-restriction regime is the front-end of that same protective philosophy: it tries to prevent the concentration that makes a forced winding up necessary in the first place.

Regulation 44: The Gateway Provision

Regulation 43 sets out the permissible universe — a mutual fund may invest the monies collected under any scheme only in securities, money market instruments, privately placed debentures, securitised debt and such other instruments as SEBI may specify, and gold or gold-related instruments for a gold ETF. Regulation 44 then clamps the constraint onto that universe: any investment made under Regulation 43 "shall be invested subject to the investment restriction specified in the Seventh Schedule."

Regulation 44 carries three further commands of its own. First, borrowing is tightly leashed — a mutual fund shall not borrow except to meet temporary liquidity needs for repurchase, redemption of units, or payment of interest or dividend to unitholders, and shall not borrow more than twenty per cent of the net asset of the scheme, for a period not exceeding six months. Second, a fund holding an aggregate of securities worth ten crore rupees or more as on the latest balance-sheet date must settle transactions only through dematerialised securities. Third, the entire Seventh Schedule, save clause 14, is disapplied to gold and silver exchange-traded fund schemes, whose underlying is bullion rather than corporate paper. These carve-outs are the seams through which most examination problems and most real-world disputes pass.

The Single-Company Equity Limit and the Voting-Rights Cap

The cornerstone of the Seventh Schedule is the single-company restriction. A scheme shall not invest more than ten per cent of its net asset value in the equity shares or equity-related instruments of any single company. For an index fund or a sector/thematic ETF the limit yields to the weight of the constituent in the underlying index, since slavishly replicating the index is the very mandate of such a scheme — a sensible exception, because a passive fund cannot meaningfully diversify away from its benchmark.

Running alongside the NAV cap is a control cap operating at the level of the fund family rather than the individual scheme: a mutual fund under all its schemes taken together shall not own more than ten per cent of any company's paid-up capital carrying voting rights. This is the prohibition that keeps a large AMC from quietly accumulating a controlling block in a portfolio company and crossing the line from passive investor to corporate raider. The two limits work in tandem — one polices concentration of risk within a scheme, the other polices concentration of influence across the house. The conduct standards that backstop these caps are examined in our chapter on the asset management company.

Exposure to Sponsor Group Companies

The most politically sensitive restriction targets self-dealing. A mutual fund scheme shall not invest in the listed securities of group companies of the sponsor in excess of twenty-five per cent of the net assets. The mischief is obvious: a sponsor could otherwise use the trust corpus as a captive source of finance for its own affiliates, converting public savings into related-party funding and exposing unitholders to the sponsor's group risk. The restriction sits beside the broader conduct prohibitions discussed in our chapter on restrictions on AMC business activities, which together prevent the AMC from turning the fund into an instrument of group convenience.

The SEBI (Mutual Funds) (Amendment) Regulations, 2024 introduced a calibrated relaxation to clause 9 of the Seventh Schedule, permitting equity-oriented exchange-traded funds and index funds to exceed the twenty-five per cent group ceiling subject to conditions specified by the Board. The logic mirrors the index-fund carve-out elsewhere: a passive fund that must track an index cannot be faulted for holding sponsor-group stocks in their index weight. The relaxation is therefore narrow and conditional, not a general loosening of the anti-self-dealing rule.

Debt and Money-Market Single-Issuer Caps

For debt schemes — where the binary risk of default makes concentration especially lethal — SEBI layers issuer-level and group-level ceilings. A scheme may not invest more than ten per cent of its NAV in debt and money-market instruments rated investment grade and issued by a single issuer; that limit may be extended to twelve per cent of NAV, but only with the prior approval of the board of the AMC and the board of trustees. The two-percentage-point headroom is a governance valve: it forces the very organs responsible for the fund's prudence to put their names to any concentration beyond the default ceiling.

By a circular dated 1 October 2019, SEBI further capped a debt scheme's exposure to debt and money-market instruments of group companies — of both the sponsor and the AMC — at ten per cent of net assets, extendable to fifteen per cent with trustee approval. SEBI subsequently moved to a credit-risk-based architecture through its circular of November 2022, tightening single-issuer limits by rating band so that a scheme's appetite for any one borrower shrinks as that borrower's credit quality falls. The progression — from a flat ten per cent to a rating-sensitive grid — reflects lessons learnt the hard way, as the next section explains.

A parallel sectoral discipline operates above the issuer level. A debt scheme's exposure to any single sector is capped at a prescribed percentage of net assets, with an additional headroom for the housing-finance sub-sector subject to conditions. The purpose is to prevent a scheme from being diversified across issuers on paper while remaining dangerously concentrated in one industry — a fund spread across ten non-banking finance companies is no safer than a fund holding one if the entire sector seizes up at once. Concentration risk, SEBI recognised, hides at the sectoral as well as the issuer level, and the restrictions are layered accordingly.

The Franklin Templeton Collapse and Its Regulatory Aftermath

The most instructive failure of the modern Indian debt-fund market is the abrupt winding up, in April 2020, of six yield-oriented debt schemes managed by Franklin Templeton. The schemes had reached aggressively for return by holding illiquid, lower-rated and structured paper; when the pandemic froze the corporate-bond market, redemptions could not be met and the trustees invoked the winding-up machinery of Regulation 39.

The litigation produced two foundational rulings. In Franklin Templeton Trustee Services (P) Ltd. v. Amruta Garg, 2021 SCC OnLine SC 88 (decided 12 February 2021), the Supreme Court, per S. Abdul Nazeer and Sanjiv Khanna, JJ., held that the "consent" of unitholders required by Regulation 18(15)(c) before a scheme is wound up means the consent of a simple majority of the unitholders present and voting, not the consent of a majority of all unitholders — and that such consent must be sought after publication of the notice disclosing the reasons for winding up. In the sequel, Franklin Templeton Trustee Services (P) Ltd. v. Amruta Garg, 2021 SCC OnLine SC 464 (decided 14 July 2021), the Court upheld the validity of the Regulations, affirmed SEBI's power to inquire whether the trustees had discharged their fiduciary duty under Regulation 39(2)(a), and candidly described Regulation 53 — on the treatment of redemption requests received before the winding-up notice — as a "grey area."

The episode vindicated the prudential restrictions discussed above. SEBI's post-crisis reforms — the credit-risk-based single-issuer grid, tighter liquidity-buffer norms, and potential-risk-class disclosure for debt schemes — were a direct response to the concentration and illiquidity that the existing caps had not fully contained. The fiduciary obligations of the trustees, tested in this very matter, are the human counterpart to the numerical restrictions: the limits set the floor, and the trustees must police it.

Restrictions on Unlisted and Illiquid Securities

Liquidity is the lifeblood of an open-ended scheme, which must stand ready to redeem units at NAV on demand. The Seventh Schedule therefore restrains investment in instruments that cannot be readily sold. An open-ended scheme may not invest more than a prescribed slice of its NAV in unlisted equity shares or equity-related instruments — historically five per cent — while a close-ended scheme, which is not exposed to daily redemption, is permitted a somewhat larger allowance. The point is structural: the redemption promise dictates the liquidity profile of the permissible portfolio.

The same instinct underlies the limits on illiquid debt. SEBI has separately capped a scheme's holding of unlisted non-convertible debentures and has tightened exposure to debt instruments with so-called special features — perpetual bonds and AT-1 instruments whose maturity and loss-absorption characteristics make them treacherous in a liquidity crunch. Each of these prohibitions is a refinement of the same theme: an open-ended scheme must be able to honour redemptions without fire-selling its book, and the law will not let a fund manager pledge liquidity it cannot deliver.

The Franklin Templeton episode threw this principle into sharp relief. The six wound-up schemes had reached for yield by holding precisely the kind of low-rated, unlisted and structured paper that the liquidity restrictions are designed to limit; when redemptions surged and the secondary market for such paper evaporated, the schemes could neither sell nor borrow their way to solvency. The post-crisis introduction of a mandatory liquidity buffer — a minimum slice of every open-ended debt scheme held in cash, government securities and other readily realisable assets — was SEBI's structural answer, converting the lesson of illiquidity into a standing prudential floor rather than a matter left to the manager's judgment.

Inter-Scheme Transfers and the Borrowing Leash

Two further prohibitions guard against the temptation to manage one scheme's distress at another scheme's expense. First, inter-scheme transfers of securities are permitted only at the prevailing market price for quoted instruments, only where the security transferred is in conformity with the investment objective of the receiving scheme, and only subject to disclosure and the conditions SEBI has progressively tightened. The danger averted is the dumping of an illiquid or souring security from a scheme facing redemptions onto a captive sibling scheme — a manoeuvre that would convert one set of unitholders into the involuntary rescuers of another.

Second, the borrowing leash in Regulation 44 — twenty per cent of net assets, six months maximum, and only for temporary liquidity to meet redemptions or distributions — prevents a scheme from levering up to chase return or to paper over a liquidity gap. Borrowing must rest on a policy approved by the boards of the AMC and the trustees. Together these rules embody a simple prohibition: a mutual fund is a vehicle for collective investment, not a leveraged trading desk, and it may not borrow its way out of imprudent illiquidity.

Investment Conditions Under the AIF Regulations, 2012

Alternative Investment Funds serve a more sophisticated, higher-net-worth clientele, and the SEBI (Alternative Investment Funds) Regulations, 2012 calibrate their restrictions accordingly — lighter than the retail mutual-fund regime, but still anchored in concentration control. Regulation 15 prescribes the general investment conditions for all three categories. A Category I or Category II AIF may invest not more than twenty-five per cent of its investable funds in a single investee company, whether directly or through investment in the units of other AIFs. A Category III AIF, which pursues complex and leveraged strategies, is held to a tighter ten per cent ceiling per investee company.

Regulation 15 also addresses idle capital: the un-invested portion of the investable funds may be parked in liquid mutual funds, bank deposits, or other high-quality liquid assets such as treasury bills, certificates of deposit and commercial paper pending deployment in accordance with the investment objective. The graduated single-investee limits — twenty-five per cent for Category I and II, ten per cent for the riskier Category III — mirror the mutual-fund logic that the more aggressive the strategy, the tighter the leash on concentration.

Leverage and Category-Specific Prohibitions for AIFs

The sharpest line within the AIF regime concerns leverage. Category I and Category II AIFs are prohibited from borrowing or otherwise employing leverage, save for meeting temporary funding requirements for a short period and within prescribed limits — a restriction that keeps these closed-ended, longer-horizon funds from amplifying risk against the interests of their investors and the financial system. Category III AIFs alone may employ leverage, including through investment in listed or unlisted derivatives, but only subject to the maximum limits, disclosure and consent conditions that SEBI specifies; the leverage of a Category III fund is reported to and monitored by SEBI precisely because of its systemic potential.

Layered on top are conduct prohibitions familiar from the mutual-fund world: an AIF and its manager must avoid conflicts of interest in dealings with associates, related-party transactions are circumscribed, and a large-value fund for accredited investors enjoys relaxed concentration limits in recognition of the sophistication of its investors — a Category III large-value fund, for instance, may invest up to twenty per cent rather than ten per cent in a single investee company. The architecture is consistent across both regimes: the more sophisticated the investor and the more controlled the disclosure, the more discretion the law is willing to return to the manager.

Two further AIF-specific prohibitions deserve note. First, an AIF may not invest in its associates except with the approval of seventy-five per cent of investors by value of their investment, a supermajority safeguard against the manager routing money to entities it controls. Second, the manager or sponsor must maintain a continuing interest in the fund — a "skin in the game" contribution of a prescribed percentage of the corpus — so that the persons making investment decisions stand to lose alongside the investors whose money they deploy. These conditions are prophylactic prohibitions in the same family as the mutual-fund group-exposure cap: each tries, by a different mechanism, to align the incentives of the manager with the interests of the investors and to neutralise the structural temptation to self-deal.

Enforcement: Consequences of Breaching the Limits

A breach of the investment restrictions is not a mere technicality; it engages the full enforcement apparatus of the SEBI Act, 1992. Section 11B empowers SEBI to issue directions, Section 11(4) to pass interim measures, and Chapter VIA to impose monetary penalties for contraventions of the Regulations. Passive breaches — where a limit is crossed because of market movement rather than a deliberate purchase — are ordinarily treated leniently and must be rebalanced within a prescribed cure period; active breaches, by contrast, invite the full weight of regulatory action.

The judicial backdrop confirms that SEBI's writ over the mutual-fund and pooled-investment universe is expansive. In Sahara India Real Estate Corpn. Ltd. v. SEBI, (2013) 1 SCC 1, the Supreme Court affirmed SEBI's jurisdiction over unregulated mass fund-raising even by unlisted entities, emphasising the systemic risk of pooling public savings without regulatory oversight. While Sahara concerned optionally convertible debentures rather than a registered mutual fund, its reasoning — that the legislature entrusted SEBI with preventive control over collective fund-raising to protect investors — is the doctrinal soil in which the investment-restriction regime grows. Coupled with the Franklin Templeton rulings, it establishes that the numerical caps of the Seventh Schedule are backed by a regulator whose protective jurisdiction the courts have construed generously.

Synthesis for the Examination Hall

For judiciary and CLAT-PG purposes the topic resolves into a small set of high-yield propositions. Regulation 44 is the gateway: it subjects all permissible Regulation 43 investments to the Seventh Schedule, caps borrowing at twenty per cent of net assets for six months, and exempts gold and silver ETFs from the Schedule save clause 14. The Seventh Schedule's headline numbers — ten per cent of NAV in a single company's equity, ten per cent of paid-up voting capital across all schemes, twenty-five per cent of net assets in sponsor-group listed securities, and ten per cent (extendable to twelve per cent with dual board approval) in a single debt issuer — should be memorised cold.

On the AIF side, fix the contrast: twenty-five per cent single-investee limit for Categories I and II, ten per cent for Category III, with leverage forbidden to Categories I and II and permitted only to Category III. For case law, Franklin Templeton is indispensable — 2021 SCC OnLine SC 88 on the meaning of unitholder consent, and 2021 SCC OnLine SC 464 affirming SEBI's regulatory power and labelling Regulation 53 a "grey area." Sahara supplies the broader jurisdictional principle. Begin your revision with the SEBI Mutual Funds and AIF notes hub and the chapter on the 1996 Regulations to see how these restrictions sit within the larger regulatory scheme.