SEBI's Consultation Paper on AIF Winding Up Flexibility: The Inoperative Fund Framework Explained (2026)

On 5 February 2026, the Securities and Exchange Board of India issued a consultation paper titled "Consultation Paper on Flexibility to Alternative Investment Funds (AIFs) in Winding up the Scheme / Surrendering the Registration", inviting public comments until 26 February 2026. The paper addresses one of the most persistent operational frustrations in the AIF industry: funds that have completed their active management lifecycle but remain trapped in a full compliance framework because they cannot achieve the NIL bank balance required to surrender their SEBI registration.

The proposed solution is both pragmatic and structurally significant — the formal introduction of an "Inoperative Fund" classification that allows funds to exist in a rationalised compliance state while managing residual liquidation proceeds, without the burden of full regulatory reporting that makes no sense for a fund with no active management activity.

This blog sets out what the consultation paper proposes, why it matters, and where the framework can be refined further.

The Problem the Consultation Paper Is Solving

How the Current Winding-Up Framework Works

Under the current mandate of Regulation 29(7) of the SEBI (Alternative Investment Funds) Regulations, 2012, the winding-up process for an AIF scheme operates on a strict sequential model:

Liquidate all assets within the one-year "Liquidation Period" following the expiry of scheme tenure
Distribute proceeds to investors after satisfying all liabilities
Achieve a NIL bank balance before applying for surrender of registration

The certificate of registration must be surrendered to SEBI upon winding up — and operational guidelines require a bank statement evidencing a NIL balance as a precondition to that surrender. Distribution must occur only after the full discharge of all liabilities. Even minimal retained balances prevent surrender under the current framework.

The Systemic Bottleneck SEBI Has Identified

SEBI has observed that a meaningful number of AIFs are unable to surrender their registration despite having completed their scheme tenure, because they continue to retain limited funds beyond the permissible fund life. These retention scenarios are not the result of poor management — they are structurally unavoidable:

Pending litigation or tax demands — where a formal demand notice has been received and funds must be held against it
Anticipated litigation or tax demands — where no formal notice exists but prudent retention is warranted
Residual operational expenses — consultant fees, legal costs, RTA charges, PPM audit filings, and compliance expenses that continue to accrue even as management activity winds down
Contingent litigation recoveries — where a fund continues to exist solely in anticipation of a favourable litigation outcome

The consequence under the current framework is operationally absurd: funds with no active investment management, no new capital deployment, and no investor servicing activity must nevertheless continue full regulatory compliance — including PPM audit reports, CTR filings, and quarterly reporting — simply because they hold a residual bank balance.

What SEBI Is Proposing: Three Retention Frameworks and One Structural Reform

Framework 1 — Retention for Pending Litigation or Tax Demands

Where an AIF has received a formal litigation or tax demand notice from a regulatory authority or law enforcement agency, retention of liquidation proceeds beyond the permissible fund life would be permitted. The conditions:

Evidence of the demand notice must be provided
Retained funds must be invested strictly in liquid assets as per Regulation 15(f) — liquid mutual funds, bank deposits, Treasury bills, Triparty Repo Dealing and Settlement, Commercial Papers, Certificates of Deposit, and other high-quality liquid instruments
The AIF may apply for surrender and be tagged as an "Inoperative Fund" pending final resolution
Full surrender will be permitted only once liabilities are discharged and a NIL balance is achieved

This framework eliminates the current situation where a fund with a live demand notice must choose between premature distribution (risking shortfall) and indefinite full compliance.

Framework 2 — Retention for Anticipated Liabilities

SEBI acknowledges that some AIFs retain monies on account of anticipated liabilities — contingent exposures not yet crystallised into a formal demand notice. The proposed framework:

Retention for anticipated liabilities is permitted with prior consent of at least 75% of investors by value
Once consent is obtained, such funds are treated similarly to those facing actual pending litigation
The 75% threshold — replacing an earlier requirement of unanimous consent following deliberations before the Alternative Investment Policy Advisory Committee — strikes a more workable balance between investor protection and operational practicality
SEBI acknowledges the practical challenges of invoking "Investor Giveback" provisions in PPMs and positions this retention framework as a more accessible secondary route

Framework 3 — Retention for Residual Operational Expenses

SEBI recognises that AIFs routinely retain small amounts for residual operational expenses — statutory audit, legal fees, RTA costs, PPM audit filing, and compliance-related expenditure — that continue to arise even after all investments are exited. The proposed framework:

Retention is permitted for fees substantiated by invoices, supporting documents, or prior years' comparable expenses
Operational expense retention is strictly capped at a maximum of three years
Retained funds must be invested in liquid instruments per Regulation 15(f)
The AIF may be tagged as "Inoperative" pending final settlement

The "Inoperative Fund" Classification: The Central Structural Reform

The most significant proposal in the consultation paper is the formal introduction of an "Inoperative Fund" status — a new classification that allows an AIF to continue its legal existence for non-active management purposes while operating under a rationalised compliance regime.

An AIF may be tagged as Inoperative where it:

Has retained funds under any of the three frameworks above; or
Has no retained funds but continues to exist solely in anticipation of contingent litigation recoveries

For Inoperative AIFs, the proposed compliance regime:

Obligation	Status under Inoperative Framework
PPM audit report filing	Discontinued
CTR report filing	Discontinued
Quarterly reporting	Discontinued
Annual status reporting to SEBI and investors	Mandatory
Investment of retained funds in Reg. 15(f) instruments	Mandatory
Launch of new schemes	Prohibited
Charging of management fees	Prohibited
Operational expense retention cap	Three years maximum
Full surrender of registration	Permitted only on NIL balance

This proportionate compliance approach — rationalising obligations to match actual fund activity — is the consultation paper's most consequential reform. It eliminates the regulatory absurdity of full compliance for operationally inactive funds while maintaining appropriate safeguards through annual status reporting and investment restrictions.

The Regulatory Amendment Proposed

The consultation paper proposes amending Regulation 29(7) to state that distribution must occur within the liquidation period "subject to conditions as may be specified by the Board." Detailed operational requirements will be implemented via a subsequent circular rather than through amendments to the detailed regulatory text — a drafting approach that preserves flexibility for SEBI to refine the framework without requiring further regulatory amendments.

Navigate AIF's Comments on the Proposals

On Proposal 1 — Retention of Funds Beyond Permissible Fund Life

We agree with SEBI's proposal to permit retention of funds beyond the permissible fund life across the three identified circumstances. These provisions appropriately balance investor protection with commercial realities that the current framework does not accommodate.

We respectfully suggest two refinements:

Prescribed heads of operational expenses: To avoid interpretational ambiguity during surrender processing, SEBI may consider explicitly prescribing indicative heads of permissible operational expenses. Suggested categories include statutory audit and PPM audit, legal and litigation costs, tax advisory and compliance, Registrar and Transfer Agent charges, custodian and trustee expenses, and secretarial and regulatory filings. Explicit enumeration will bring uniformity across AIFs and reduce discretionary assessments at the point of surrender review.

Flexibility on the three-year cap: While we understand the intent behind limiting retention for operational expenses to three years, certain litigations and regulatory proceedings regularly extend beyond this period — particularly tax disputes that move through appellate forums over many years. We request SEBI to consider providing for case-specific extensions based on demonstrated merit, rather than a hard cap that may create a compliance cliff for funds in extended proceedings.

On Proposal 2 — Investor Consent for Anticipated Liabilities

We support the 75% investor consent threshold by value for retention of funds towards anticipated liabilities. This is a meaningful improvement over the unanimous consent standard previously discussed and strikes a reasonable balance between investor protection and operational practicality.

We also request SEBI to provide procedural guidance on the mode and timelines for obtaining such consent — including whether digital consent mechanisms are permissible, how disputes among investors regarding consent are resolved, and what documentation the AIF must maintain to evidence the consent process. Clear procedural guidance will ensure uniform industry practices and reduce ambiguity at the point of SEBI review.

On Proposal 3 — Inoperative AIF Framework

We strongly support the creation of an Inoperative AIF category with rationalised compliances. The discontinuation of CTR, PPM audit, and quarterly filing requirements for operationally inactive funds — replaced by annual status reporting — is a proportionate and well-designed response to a genuine regulatory gap. The ring-fencing of retained monies in liquid instruments and the prohibition on management fees provide appropriate investor protection within the rationalised framework.

On Proposal 4 — Prohibition on Launch of New Schemes by Inoperative AIFs

While we appreciate SEBI's intent to prevent misuse of Inoperative status, an absolute prohibition on launching new schemes may prove disproportionately restrictive in cases where Inoperative status arises solely due to prolonged litigation or regulatory proceedings — factors that are frequently beyond the control of the AIF manager.

Litigation in India regularly extends over several years, and in some cases over a decade. During this period, the proposed framework would effectively freeze the entire AIF platform — impacting the commercial viability of an otherwise compliant fund manager simply because a single legacy scheme is subject to a pending tax demand or litigation.

We suggest SEBI consider permitting the launch of new schemes at the AIF level (umbrella structure), subject to:

Ring-fencing of the Inoperative scheme from all new schemes
Full regulatory compliance for all new schemes without exception
Appropriate disclosures to new investors regarding the existence of the Inoperative scheme and its status
Continued prohibition on management fees for the Inoperative scheme

This approach preserves investor protection and regulatory transparency while allowing legitimate business continuity for compliant fund managers whose platforms are commercially active but technically constrained by a legacy scheme's legal position.

On Proposal 5 — Reactivation Clarity

We recommend that SEBI explicitly clarify the process for transition from Inoperative to Active status. Specifically, SEBI should confirm the sequential requirements for restoration:

All retained monies distributed to investors
NIL bank balance achieved
Registration either surrendered or formally restored to Active status with full compliance obligations reinstated

Clear reactivation criteria will give fund managers certainty about the pathway back to active status and discourage any ambiguity about whether Inoperative classification is intended to be permanent or transitional.

Why This Reform Matters for the AIF Industry

The timing of this consultation paper is significant. SEBI's Adjudication Order on a Fund — which penalised it for operating beyond its PPM tenure despite investor consent and strong returns — and this consultation paper represent two sides of the same regulatory moment. The adjudication order enforces the current framework strictly. The consultation paper acknowledges that the current framework creates genuine structural hardship that needs a regulatory solution.

Read together, SEBI's message is consistent: operate within the existing rules now, while we build a better framework for the future.

Reducing the Compliance Cost of Doing Nothing

The most underappreciated benefit of the Inoperative Fund framework is the reduction in compliance cost for funds that are genuinely wound down in substance but not in form. Continuing full regulatory reporting for a fund with no investments, no investors being actively served, and a residual bank balance of a few lakhs is a disproportionate burden — both for the fund manager and for SEBI's own supervisory resources. The rationalised compliance framework directs regulatory attention where it actually matters.

A Template for Future Wind-Down Policy

The three-framework structure proposed in the consultation paper — pending litigation, anticipated liabilities, residual operational expenses — provides a replicable policy template for addressing the wind-down challenges that are endemic to closed-ended, finite-tenure fund structures. As the AIF industry continues to mature and an increasing number of early-vintage funds approach their end-of-life, this framework will become progressively more important across the industry.

Conclusion: A Long-Overdue Reform with Refinements Still Needed

SEBI's February 2026 consultation paper addresses a long-standing operational challenge in AIF wind-downs with a thoughtful and structurally sound set of proposals. The introduction of the Inoperative Fund classification, the three-scenario retention framework, and the rationalised compliance regime together represent a meaningful improvement over the current NIL-balance-or-nothing model.

The framework's key strengths:

Three defined retention scenarios covering the full range of circumstances that prevent NIL balance achievement
75% investor consent threshold for anticipated liabilities — workable and protective
Rationalised compliance for Inoperative AIFs — proportionate to actual activity
Liquid investment requirement for retained funds — appropriate investor protection
Annual status reporting — maintains regulatory visibility without disproportionate burden

The refinements that would strengthen it further:

Prescribed operational expense heads to reduce interpretational ambiguity at surrender
Case-specific extensions to the three-year operational expense cap for prolonged proceedings
Procedural guidance on investor consent for anticipated liability retention
Umbrella-level new scheme launches permitted during legacy scheme inoperative status, with ring-fencing and disclosure
Explicit reactivation pathway from Inoperative to Active status

We commend SEBI for addressing these long-standing operational challenges and appreciate the opportunity for industry engagement through the consultation process. With the refinements outlined above, the framework will deliver the regulatory clarity, investor protection, and ease of exit that the AIF industry needs.

This analysis is based on the SEBI Consultation Paper dated 5 February 2026 on flexibility to AIFs in winding up schemes and surrendering registration. It reflects Navigate AIF's comments submitted during the public consultation period and is intended for informational purposes only. It should not be construed as legal or compliance advice. Fund managers should consult their legal advisors regarding the implications of any regulatory amendments that follow from this consultation process.

Managing wind-down compliance for an AIF scheme approaching the end of its tenure? Contact Navigate AIF to understand how our platform supports fund managers through the liquidation period, inoperative fund status, and SEBI surrender processes — from investor communications to regulatory filings.

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