While advisers highlight issues arising from side letters, including the risks of breach of fiduciary duties or inconsistency with constituent documents, two recent cases in the Cayman Islands have highlighted a more fundamental issue: whether the side letter actually works.
In the past, side letters commonly included provisions such as a reduction in fees, approval of transfers to parties related to the investor and undertakings to use best efforts not to pay redemption proceeds in kind. A ‘most favoured nation’ provision was also a typical feature. The legal issues raised by such provisions could generally be managed.
However, recently investors have sought to include more sophisticated terms in side letters. There is an emerging trend towards requests for specific information (which may include details of portfolio composition), increased liquidity and the inclusion of provisions limiting the fund’s ability to make, or excuse investors from, certain kinds of assets.
Agreeing such things with particular investors can pose a variety of legal and practical issues for the fund and the manager, including breaches of fiduciary duty, breaches of the fund’s constitutional documents or breaching the terms of the relevant offering documents.
Depending on the terms of the fund’s governing documents and the precise terms of the side letter, there are often practical ways to deal with potentially dangerous side-letter provisions. Solutions can be as simple as enhanced disclosure ensuring the benefits of certain terms are received by all investors, creating separate classes of interests or including carve-outs in the side letter that can be invoked in specific situations.
However, in the recent Cayman Islands Grand Court decision of Medley v Fintan, the court found that a side letter could not be enforced at all by the relevant investor. This was because the side letter had been entered into by the beneficial owner of shares in the relevant fund, but not by the shareholder of record of the shares, who was a nominee of the beneficial owner.
As the shareholder of record was not a party to the side letter, it could not enforce the agreement by the fund to have the relevant shares redeemed in accordance with the arrangement set out in the side letter. And the beneficial owner of the shares could not enforce that agreement, as it was not the legal holder of the shares.
The dangers of not correctly establishing who is who in respect of a side letter were highlighted again in Landsdowne v Matador. The court confirmed that side letters cannot validly confer redemption rights inconsistent with the fund’s articles of association. It also found that the side letter was not an agreement to which the investors of record or the fund itself were parties such that they could enforce its benefit. Rather, the relevant side letter was an agreement between a director of the fund and the beneficial owner of one of the investors.
Both the Fintan and Matador decisions turned on the facts of the cases, the terms of the side letters and documents governing the relevant funds. However, these cases serve as a cautionary tale, highlighting what seems to be a common issue with side letters agreed in a hurry in order to attract capital; the parties to the letters are not necessarily the parties who owe the obligations, or who will ultimately seek to enforce them.
When considering a side letter, as well as considering the typical issues that side letters raise, investors, funds and managers should remember the legal distinction between the parties signing the side letter and those who may wish to enforce its terms.
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About the author
James Gaden has experience across a spectrum of legal issues affecting the investment funds industry. He specialises in private equity and hedge fund formation, as well as advising both hedge fund and private equity fund service providers, and investors.
Gaden joined Maples and Calder in 2010. He previously worked for Sidley Austin in Hong Kong and before that Gilbert & Tobin in Sydney.