Changing Investor Terms
This article was published in The Alternative Investment Management Association Journal, Quarter 3, 2012.
At some stage in their lives, many Cayman Islands funds consider changing investor terms, i.e. the terms on which investors initially subscribed for their shares in the fund.
This may be as a result of changing macro-economic conditions, specific investment opportunities, changing investor demand or simply the whim of the fund's operator.
The question then arises as to what steps must be taken in order to amend such terms. Unfortunately, there is no 'one size fits all' answer to this question. The advice given will depend on individual circumstances and will require an analysis of, amongst other factors, the nature of the proposed amendment and, if the fund is regulated, the laws and regulations of the jurisdiction in which such regulation occurs.
This article highlights some of the key Cayman Islands legal issues for investment managers to consider when seeking to amend investor terms, as well as providing some practical advice on how a fund may be structured in order to retain flexibility for a later restructuring.
HOW CAN THE OFFERING MEMORANDUM BE AMENDED?
In practice, an amendment to investor terms will inevitably entail an amendment to the fund's offering memorandum. In order to determine how an offering memorandum may be amended, it is first necessary to consider the status of the offering memorandum. Clearly it is a marketing tool, although often the offering memorandum also serves as the basis of the legal agreement between the fund and its investors, as the subscription agreement will typically refer to an investor's subscription being made on the terms of the offering memorandum.
Proposed amendments to offering memoranda generally fall into three categories:
1. Changes to simple disclosure information — If the proposed amendment will amend simple disclosure information, for example, information relating to the fund's service providers; an update to the risk factors; or an update to statutory references, the fund's operator will generally be free to make such amendment without any specific investor action being required;
2. Changes to class rights — If the proposed amendment will amend the class rights attaching to a particular class of shares which are in issue, for example, the ability of holders of such class to vote, the procedures in the fund's constitutional documents governing amendments to class rights will need to be followed; or
3. Changes to investment terms – By far the most common category of amendment relates to a change which, if made, would not amend the class rights attaching to the shares but which would change the contractual terms on which an investor has subscribed for his shares in the fund, a so called "change to investment terms". Changes to the fund's investment objective, policies and/or restrictions, or increases in the fees that are payable to the investment manager, administrator, custodian or other service providers, provide just a few examples of changes which are likely to fall into this category. In such cases, some level of investor input will generally be required.
Occasionally investment terms will be incorporated into a fund's constitutional documents. If this is the case, it will be necessary to amend the fund's constitution (following the procedure contained in the fund's constitutional documents) in order to give effect to a change of investment terms.
In the majority of cases, investment terms will not be hard-wired into the fund's constitution. In such cases, in order to amend investment terms, and in the absence of a pre-agreed adjustment mechanism, the consent of all affected investors will be required, in accordance with general contractual principles.
However, obtaining the consent of all investors in the fund may not be possible if there are a large number of investors in the fund. In such circumstances, the fund's operator sometimes decides to take a pragmatic approach and simply provide investors with a reasonable period of notice of the proposed change, before proceeding to implement the change without investor consent. In such circumstances, the notice provided to investors should be sufficient to give investors the opportunity to redeem out of the fund before the change is implemented.
Providing investors with a redemption opportunity does not, in legal terms, equate to obtaining the necessary investor consent.1 It remains the case that, in the absence of a pre-agreed adjustment mechanism, investment terms cannot be varied unilaterally without the consent of investors. Nevertheless, providing a redemption opportunity may provide some comfort to the fund's operator as it enables any investors who disagree with the proposed change to exit the fund before the change is implemented.2
WHAT PRACTICAL STEPS CAN BE TAKEN AT THE TIME OF LAUNCH TO INCREASE FLEXIBILITY?
One practical way in which a fund's operator may increase flexibility and avoid the need to seek investors' consent when changing investment terms is to build flexibility for later changes into the offering memorandum at the time of launch through the inclusion of an adjustment mechanism in the fund's offering memorandum (an "Adjustment Mechanism").
This can be achieved by, for example:
• Including in the fee disclosure relating to a service provider a statement which provides, "or such other fee as may be agreed between the Fund and the [administrator/custodian/investment manager] from time to time"; or
• Including a statement in the offering memorandum which states that the fund's investment objective, policies and/or restrictions may be amended by the investment manager providing not less than one month's notice is provided to investors.
So long as the Adjustment Mechanism is clearly disclosed in the fund's offering memorandum, the Adjustment Mechanism forms a term of the investor's subscription.
Should an amendment later be made to investment terms in accordance with the Adjustment Mechanism, an investor could not later claim that the amendment breaches the terms on which he has subscribed for his shares; as it was always a term of his subscription that these terms could be amended in accordance with such procedure. Of course, for the more drastic proposed amendments to investment terms, the fund's operator may nonetheless wish to obtain some level of investor consent before proceeding with such change, if only for good shareholder relationship reasons.
It is important to ensure that any Adjustment Mechanism is clearly and precisely drafted which should help to avoid later challenges that a proposed amendment is beyond the scope of the Adjustment Mechanism.
At the time of launch of a fund, amending investment terms is perhaps the last item on the mind of most fund operators. However, being alive to the issues which can later be raised by changes to investment terms, and using appropriate structuring at the outset may not only avoid later headaches, but ensure that the fund operator has a sufficiently flexible vehicle that is able to respond to changing market conditions.
1. It would be open to a fund operator to argue that an investor who does not redeem and instead remains in the fund has, by his conduct, implicitly accepted the amendment. However, in order to successfully make out this argument a number of hurdles must be overcome and the argument is far from certain of success.
2. Cleary there are conceptual difficulties with extending this analysis to cover closed-ended funds where it is not possible to offer investors a redemption opportunity. Also note, if the fund has in place either a "hard" or "soft" lock- up period, consideration should be given to waiving such lock-ups during the proposed redemption period.
This article is not intended to constitute legal advice. In the case of any specific advice required you should contact either the author or your usual legal adviser.