In this sixth article in the KB Associates’ series on investment fund governance we examine the use of side letters by asset managers.
What are side letters?
Side letters are agreements that supplement or modify the terms of a fund’s offering memorandum, subscription agreement or constitutional documents. They are often granted to large or important investors prior to investment and provide preferential treatment and typically, for example will cover agreements by the manager to waive or reduce fees, grant enhanced transparency, or allow preferential liquidity provisions to that particular investor. Other uses of side letters may be to affect the investment policy of the fund in some way or to ensure subsequent investors are not afforded more beneficial rights.
There are cases where a side letter would not be acceptable, for example if it has no legitimate purpose or is contrary to what the hedge fund or hedge fund manager is doing in practice. In most circumstances, however, there is no clear answer as to what constitutes an acceptable side letter term. The side letter can be used to facilitate a large investment that attracts other strategic investors, which could benefit the fund and the execution of its investment strategy. However, side letters generally raise various fiduciary and other concerns that must be addressed.
The use of side letters is becoming a common theme amongst investors and managers but there are many practical issues to be considered.
Transparency is becoming more important to investors, managers and regulators and care must be taken to disclose in the fund’s offering memorandum that side letters may be entered into and that other investors may be given preferential investment terms. Particular attention needs to be paid to side letters that seek to provide enhanced liquidity for certain investors or those that provide increased or earlier access to information on the underlying portfolio of the fund. Side letters offering these terms will need to be disclosed in the fund’s offering documents so that other investors may assess the impact of these terms on their own holdings in the fund.
These terms may allow a particular investor to mitigate or avoid losses where other investors are not able to do so. This was highlighted in June 2012 when the Securities and Exchange Commission indicted hedge fund manager Philip Falcone of Harbinger Capital Partners for fraud and a breach of Falcone and Harbinger’s fiduciary duties to their clients. It was alleged that while soliciting required investor approval to restrict withdrawals from another Harbinger fund, Falcone and Harbinger exempted large strategically important investors from soon-to-be imposed liquidity restrictions – provided those investors voted to approve restrictions that would temporarily stabilise the decline in Harbinger’s assets under management. Falcone and Harbinger allegedly permitted these investors who were connected to certain favored institutional investors to withdraw a total of approximately $169 million. Harbinger concealed these quid pro quo arrangements from the independent directors and from fund investors.
Failure to disclose the use or potential use of side letters may cause the side letter to be unenforceable and possibly open the fund to legal proceedings from other investors. They may claim that they would not have invested had they been made aware of the use of side letters by the fund with other investors. This may result in substantial legal and other costs associated with a dispute with an investor.
The effectiveness of side letters and their enforceability was judged upon by the Grand Court in The Cayman Islands in 2012. In the case of Medley Opportunity Fund Ltd v Fintan Master Fund Limited & Nautical Nominees (Medley) it was confirmed that 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 held 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 critical issue with respect to the enforceability of side letters, namely that they must be signed by the entity that holds the shares
Regulatory impact on the use of side letters
Regulators have raised concern over the use of side letters. The Cayman Islands Monetary Authority (CIMA) which regulates the Island’s funds industry has not as yet published formal guidelines on the use of side letters. This contrasts with the position taken by the Financial Services Authority (FSA) in the UK, predecessor of the Financial Conduct Authority (FCA). In 2006, the FSA issued rules requiring disclosure of the use of side letters and that a description of the material terms must also be disclosed. The Alternative Investment Fund Managers Association (AIMA) has also had concerns over their use but advises enhanced disclosure of such terms to enable all investors to evaluate the impact of such rights on their own investment
More recent regulatory impact on the use of side letters by hedge funds includes a requirement under The Dodd Frank Act to require an investment advisor (such as a hedge fund adviser) to maintain records relating to the “side arrangements or side letters” of a private fund.
Given that most large investors will request a side letter, the administrative burden imposed by agreeing to multiple side letters can be onerous and can substantially increase costs for a manager. Letters that require certain periodic information disclosures force the fund to maintain the necessary information and ensure its appropriate distribution. As the number of side letters grows, hedge fund managers may incur significant cost to meet all the special requirements specified in the letters. Following the Madoff scandal, the portfolio and related fund information that must be reported by managers has increased substantially and many of the new reports are included in side letter terms. As a result, many firms have hired additional compliance and investor relations staff to respond to the increase in customised reporting requests.
“Most Favored Nation” (“MFN”) provisions are a common side letter provision which allows an existing investor with an MFN clause to benefit from more advantageous terms negotiated by subsequent investors. MFN provisions can cause considerable operational difficulties for managers. When faced with a situation where the manager thought just one investor would be invoking their side letter provision, in reality there can be multiple parties invoking the same provision.
The use of side letters raises fiduciary considerations of the fund to act in the best interests of all investors. One investor must not be given excessively favorable terms over those of other investors and directors need to be satisfied that such terms are beneficial to the fund as a whole. Directors must be especially cautious of terms which seek to restrict their discretion, for example, to make distributions in kind, to effect a compulsory redemption of shares or arrangements that affect liquidity rights or provide for variations to gating or lock up provisions.
The fund’s legal counsel should always review the proposed side letter and it must be approved by a directors’ resolution. Its scope must fall within the side letter disclosure provisions in the offering memorandum and it must not modify existing share rights. The directors’ resolution should explain why a subscription on the side letter’s terms is in the fund’s best interests.
If the terms of a side letter favor one investor at the expense of another, its effect on fiduciary obligations should be reviewed. If the provisions of the side letter raise concerns in connection with the fiduciary duties owed to other investors, an alternative is to create a separately managed account for the investor who is requesting terms different to those offered by the fund.
Side letters present difficult management issues and must be considered carefully. While the entry into a side letter does not, of itself, expose the directors to claims of breach of duty, directors must not just accept the investment manager’s recommendations to enter into a side letter without making an independent judgment on the issue. Directors must make enquiries into the nature and impact of a side letter and satisfy themselves that it is in the best interests of the fund.
The use of side letters is a common practice but careful consideration needs to be given to how they are structured. Often used as a means to secure investment from a key investor, they can present operational, legal and fiduciary challenges in their negotiation and execution. Whilst there is little in the way of defined regulation concerning their use, best practice is to follow a policy of full disclosure and transparency about their content. Fund directors have to pay particular attention to the use of side letters and to ensure their fiduciary responsibility to act in the best interest of the fund and its shareholders is maintained. Extensive use of side letters may also become an operational burden on the manager as strict compliance with a variety of side letter requirements is monitored.