Side Stepping Side Letters?
This article was published in AsianInvestor.
In a market where fundraising has been challenging, side letters providing tailored investment terms to investors can be a helpful tool to attract capital.
Although advisors will commonly highlight issues arising with 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 the terms investors have sought to include in side letters have become more sophisticated. There is an emerging trend towards requests for specific information (which may include details of portfolio composition), increased liquidity, and the inclusion of provisions which limit the fund's ability to make, or excuse investors from, certain kinds of investments. Agreeing to 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 many 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 which 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. As well as confirming that side letters cannot validly confer redemption rights inconsistent with the fund's articles of association, the Court 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 which are 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 the persons who may wish to enforce its terms.