Side Letters – Who has Agreed to What?
The Cayman Islands Grand Court's recent decision in Re Medley Opportunity Fund Ltd (Grand Court, 21 June 2012) is a useful reminder of the importance of both being careful what you agree to as an investor, and of bearing in mind the legal distinction between beneficial shareholders and investors of record.
Like many funds at the time, the Medley Opportunity Fund (the "Fund") had been subject to a run on redemptions during 2008 and 2009 – and like many funds, it had sought to restructure. Essentially those restructurings involved offering investors a choice between two options. Option 1 involved investors redeeming their shares, and subscribing for a new class of shares, which would make new investments, but with modified redemption rights and fee arrangements. Option 2 involved investors staying in the class, but on the basis that they would rescind any earlier redemption requests and participate in an "orderly payout" by agreeing to accept pro-rated quarterly distributions of excess cash by way of partial redemption of shares as cash was generated from existing assets. Any investors who did not take either option and who insisted on redeeming would be paid in kind, by way of a "vertical slice" of the assets - which was permissible under the fund's Articles of Association.
In commercial terms, Fintan was an investor in the Fund. However, Fintan held its shares through its nominee, Nautical. Prior to its initial investment restructurings Fintan (but not Nautical) had signed a pre-investment side letter with the Fund which entitled it to be paid all redemptions in cash, and not in kind.
When the restructuring plans were implemented, Nautical had elected for Option 2.
Fintan was not happy with the progress of the wind down – and in late 2011 Nautical, apparently at Fintan's direction, submitted a redemption request. They argued that the restructuring had not validly modified their redemption rights, including its right under the side letter to be paid in cash. The Fund, not surprisingly, disagreed, and sought declarations from the Cayman Islands Court as to the true position.
Two principal issues arose for determination: (a) could Fintan and Nautical rely on the side letter, despite Nautical not being a party to it; and (b) to the extent the side letter was binding, did Nautical's agreement to Option 2 amount to a waiver of rights under the side letter?
Was the side letter binding?
The Judge held that the side letter was not binding, because Nautical, as the member of record, was not a party to it. Quin J accepted that Nautical was Fintan's 'nominee', but as the nominee agreement was not before the Court, he could not determine the precise nature of the relationship. His Lordship emphatically rejected Fintan's argument that the Court should treat the nominee and the beneficial shareholder as being "one and the same" for this purpose. To the contrary, he noted, Nautical and Fintan were separate legal entities, incorporated in different jurisdictions, and that "one main purpose of any nominee agreement is to create two distinct and separate legal entities".
Certainly, this finding is a useful reminder that custodians or nominees are the shareholder for legal purposes, and that, ideally, they ought to be parties to all agreements concerning the investment, including side letters. That said, it would be going too far to suggest that this judgment means a side letter will be unenforceable unless it is signed by the shareholder of record. There is nothing especially controversial or new about the principles that emerge from this judgment. In particular, we note:
(a) The decision makes it clear that (a) privity of contract – i.e., the principle that only the parties to a contract may enforce it in Court – is alive and well in the Cayman Islands. This is true for the moment at least, albeit it may shortly be modified by pending statutory reforms, mentioned below; and (b) Cayman Courts will generally not treat a custodian shareholder of record and the underlying beneficial owner as being "one and the same" when it comes to enforcing their legal rights. Both of those principles are well established.
(b) Like any decision, the Medley judgment must be viewed in its factual context. In that case, on its face the side letter purported to modify Fintan's (and, it seems, only Fintan's) rights in connection with redemptions. The result may well have been different if the side letter had been drafted so as to apply also to investments made by Fintan's nominees, custodians and/or affiliates – even if Nautical had not then signed it. Although Nautical still could not have enforced the side letter itself, Fintan likely could have enforced it against the Fund in favour of Nautical.
(c) The Fintan/Medley side letter was assumed to be governed by Cayman Islands law. Where side letters are governed by other countries' legal systems, the analysis may be affected - including as to whether, on their proper construction, the signatory's nominees can enforce or rely upon them.
(d) The Court rejected Fintan's argument that Fintan and Nautical should be viewed as a single entity through an estoppel by convention. However, there appeared to be very little evidence before the Court supporting that argument. That does not mean estoppel will never be available, and where there is evidence that the parties have conducted themselves so as to make it inequitable for the fund to deny that the side letter extends to the nominee, the outcome may again be different.
(e) Finally, the position is likely shortly to change under Cayman Islands law, as a result of impending statutory reforms. The Contracts (Rights of Third Parties) Bill, 2012, if enacted, will enable parties to contracts to extend to non parties the right to rely upon and sue under that contract. Note though, that in its current form, this law would apply only to contracts that come into existence after the law is enacted.
Did the 2008/2009 restructurings modify the investor's redemption rights?
Quin J went on to hold that, even if the side letter had been valid, the restructuring plans modified Nautical's redemption rights.
There was no real doubt as to the validity of the restructurings. In particular, the Fund's Articles contained provisions permitting bilateral agreements with shareholders varying the terms of their investment - which facilitated the modifications through the investor elections and Nautical had elected Option 2.
Applying general principles of contractual interpretation (and in particular the recent English Supreme Court's decision in Rainy Sky SA v Kookomin Bank  1 WLR 2900), Quin J held that when construing the restructuring plan, the Court ought to favour a commercially sensible construction. This in turn is more likely to give effect to the objective intention of the parties. Quin J held "the plain commercial intention of Option 2 ... was to require [Nautical] to exchange its existing redemption rights for periodic cash distributions effected pro-rata with all other investors accepting this Option. This allowed [the Fund] to have the advantage of minimising a liquidity squeeze and avoiding a fire sale of assets. The benefit to [Nautical] and all the members as to allow [Nautical] to benefit from the expected recovery of asset provides, to avoid a disorderly scramble for assets under liquidation, and to be treated equally and fairly, with the other members".
By electing Option 2, Nautical bound itself and Fintan to remain in the Fund on those terms.
Fintan and Nautical could not later change their minds and seek to revert to their original redemption rights (including under the side letter, had it been binding), as these were necessarily inconsistent with Option 2.