The Securities and Exchange Board of India’s (SEBI’s) decision to allow merchant bankers, custodians and debenture trustees to undertake unregulated activities without hiving them off into separate entities may open doors to regulatory arbitrage, conflicts, mis-selling and oversight evasion, said experts.

The SEBI board, in its December meeting, had mandated a hive-off of such activities into separate entities. After putting the rule on hold in the March board meeting, the regulator has recently reversed it to allow fee-based, unregulated financial services to be carried out within the same firm.

“At the heart of this issue lies the fundamental principle of ring-fencing regulated activities from unregulated ones to prevent conflicts of interest, ensure operational integrity and maintain regulatory oversight,” said Gaurav Sahay, Partner at Arthashastra Legal.

Regulatory arbitrage

While this rollback reduces compliance burdens, it also risks muddying the waters of accountability and supervision. “When regulated and unregulated activities co-exist in the same entity the legality may cover for regulatory evasion or unauthorised business,” said Prachi Shrivastava, founder of Lawfinity Solutions.

For example, a registered NBFC outsourcing loan underwriting or customer profiling to an unregulated tech affiliate without supervision may violate RBI’s digital lending norms, or a Healthtech platform offering AI-based diagnostics via an unregulated arm, but using EMR data obtained via a HIPAA-compliant regulated partner may breach patient consent frameworks.

“If there is an occurrence of a dispute or a regulatory breach, it would be difficult to disentangle responsibilities and attribute liability when both regulated and unregulated activities are conducted under the same roof,” Sahay said.

Pranav Bhaskar, Senior Partner at SKV Law Offices, agreed that if decisions or advice provided under SEBI-regulated functions are influenced by an unregulated or differently regulated activity, conflicts may arise. “Clients and investors could be exposed to higher risks, less transparency and fewer avenues for grievance redressal if things go wrong in these unregulated activities,” he said.

Reputational risks

A structural management overlap can trigger enforcement issues, such as insider access, misuse of client data. It may lead to a possibility of mis-selling, co-mingling of funds, reputational spillover risks and undue advantage being taken of confidential or non-public information obtained through the regulated business. It could go as far as structuring to bypass KYC norms, capital adequacy rules or limitations on fee models, legal experts said.

“But, even if it is all legally watertight, there are major reputation risk signals here…if the firm is seen as deliberately dodging regulation through structuring, even within legal limits, it starts to resemble evasion,” Shrivastava said.

If a client, regulator or media outlet can’t easily understand who is responsible for what, it signals opacity. Venture capitalists or institutional investors often see opaque hybrid models as governance red flags, especially if disclosures are vague or if brand names are shared between arms, she said.

More clarity

“Like every right which can be abused, this also can be misused,” said Archana Balasubramanian, Partner at Agama Law Associates, adding that clarity on execution is still missing for many intermediaries.

As issues crop up, the regulator may have to introduce tighter definitions or retrospective scrutiny, triggering trust collapse in similar business models.

Experts suggest that SEBI must now follow through with enforceable guardrails, such as mandatory internal separation, regular audits, independent compliance officers and client disclosures, as this model risks creating regulatory blind spots.

Published on June 28, 2025