In the current competitive hedge fund marketplace the use of side letters between investors and funds has become commonplace. Side letters are used by funds and fund managers to draw in investors who jockey for the most favourable terms possible.
Seed investors, institutional investors, strategic investors and investors who are subject to certain governmental regulations are most often the beneficiaries of such agreements. However, certain funds may also offer special terms to employees, friends and family.
Side letters are additional agreements that set out terms that supplement or modify the terms of the offering memorandum, subscription agreement or constitutional documents of the fund. Such agreements generally provide preferential treatment with respect to matters such as redemption terms, fees, access to information and “most favoured nation” (MFN) status.
Potential problems and hazards
Before negotiating side letters all parties to the agreement should be aware of potential problems and hazards, which may include:
|(iv)||regulatory issues and|
Some side letters address discrete terms that can be negotiated quickly and efficiently. Examples of such terms include agreements by the manager to waive fees, or the fund to waive a “lock up period” for redemptions.
However, large institutional investors who often have requests for material concessions may require substantial bespoke side letters fraught with extensive details and complexity. Negotiating these agreements may result in a delayed launch of the fund and significant legal costs may be incurred in the drafting and review of the terms of the proposed agreement.
A fund must also be prepared to accommodate the administrative burdens that may arise as a result of the variation of terms created by the side letter. The fund and its service providers will have to ensure that such varied provisions are monitored and observed. Also, to the extent that MFN protection has been extended to more than one investor, the fund will need to ensure that communications are made to those multiple investors with MFN rights as appropriate.
In an era where transparency is becoming more important to investors and investors are keeping a closer eye on the proper governance of funds, funds and fund managers must pay particular attention to the disclosure that they provide to investors in the fund’s offering documents, including its private placement memorandum.
Historically, it may not have been common place to disclose the use of side letters as a risk factor, however, given the increase in their use, most fund documents should carefully and fully disclose the fact that such arrangements may create an uneven playing field on which investors participate. Without proper disclosure investors could potentially bring an action against the fund asserting that their investment would not have been made had they been privy to full disclosure on the use of side letters by the fund with other investors.
Such litigation, or the mere threat of litigation, can result in not only a distraction from the primary duties of the fund’s directors and investment manager, but may also result in substantial legal and other costs associated with a dispute with an investor.
As the fund industry as a whole becomes increasing regulated the scope of regulation continues to vary from jurisdiction to jurisdiction. Both the Securities and Exchange Commission in the United States (SEC) and the Financial Services Authority in the United Kingdom (FSA) have raised concerns over the use of side letters. However, it remains to be seen whether the SEC will prescribe any regulation around side letters in the future. In 2006 the FSA established rules requiring that the existence of side letters containing material terms must be disclosed by way of a brief summary of the nature of those terms.
The Cayman Islands Monetary Authority (CIMA) which regulates the Islands’ funds industry has currently not published formal guidelines with respect to the use of side letters. The position of regulators appears to be consistent with that of industry groups such as the Alternate Investment Fund Managers Association (AIMA), which reiterate concerns over their use, but suggest that a possible resolution may be to enhance disclosure of such terms to enable other investors to assess the impact of such rights on their own investment.
The debate over use of side letters and whether regulations should come into play also considers equitable and fiduciary obligations of the fund to operate in the best interests of the fund as a whole and not to inappropriately favour one investor over another. Fund directors therefore must carefully balance these issues and be satisfied that the participation of a certain investor on such favourable terms nonetheless is beneficial to the fund as a whole.
With respect to enforceability, the Cayman Islands court recently delivered a judgment in a dispute concerning the effectiveness of side letters and whether a fund’s restructuring agreements limited an investor’s redemption rights under the fund’s articles of association.
In summary, the side letter had been signed by the investor rather than by its nominee, which was the party that was the shareholder in the fund. The court was robust in holding that the two parties were separate entities and that the side letter was not binding on the fund as the investor was not a shareholder in the fund. This decision highlights a simple yet critical issue with respect to the enforceability of side letters; side letters must be signed by the entity that in fact holds the shares.
Further, all parties who are to be bound by the terms of the side letter must execute the side letter and be parties thereto. It is also important to note that under current Cayman Islands law, only parties to a contract may enforce it.
In addition to the enforceability issues raised above, one must also use caution to ensure that the directors of the fund do in fact have the power (discretionary or otherwise) under the fund’s articles of association to grant the terms contained in side letters to investors, either with or without creating a new share class. These enforceability issues may require consultation with the fund’s legal counsel to ensure that the desired outcomes are attainable or whether it is necessary to seek alternative methods of achieving the same objectives.
In order to avoid pitfalls that may result in unwanted side effects from side letters the following practices should be observed:
- Consult with legal counsel regarding appropriate disclosure in the fund’s offering documents. Proper disclosure and well drafted articles of association are a must if a fund wants to have the flexibility to offer preferential terms to certain investors. Also, it is imperative to make proper disclosure to avoid possible litigious claims from investors arguing that they have been prejudiced by material terms that were not disclosed to them at the time of making their investment.
- Avoid inadvertent agreements that purport to supplement or alter the terms of the fund’s offering documents or constitutional documents. E-mails and verbal agreements are not advised to be used. Formal side letter agreements that have been reviewed by all parties’ respective counsel are preferable to informal agreements.
It is critical that the correct parties enter into the side letter, especially if the investor acts through a custodian or nominee. Also, the power, capacity and authority of those signing the side letter must be confirmed. If a side letter is to be entered into on behalf of the fund by its investment manager, than specific authority must be granted to the investment manager. This authority may be contained in the investment management agreement or by a separate power of attorney.
As side letters become more prevalent and complex in the fund industry, it will become increasingly important that side letters are properly drafted, executed and monitored while taking into account appropriate corporate governance considerations.
A failure to have regard to these issues may lead to unintended, unwanted and costly consequences for a fund, its manager and its investors.