New York (HedgeCo.Net) – Guest post by Tony Heaver-Wren, Counsel at Appleby (Cayman) Ltd – Side letters have become a common feature in the landscape of hedge fund investment but with them has come considerable debate and uncertainty about their practical effect, particularly in the milieu and aftermath of the Global Financial Crisis.  The prevailing economic conditions have created a tension between investors seeking to rely upon the terms of side letters and hedge funds needing to enter into restructuring arrangements with investors which impinge on the favourable terms often enshrined in investor side letters.

Until recently there had been no judicial consideration of side letters to assist in the navigation of these choppy waters.  In recent months, however, the Cayman Islands Grand Court has handed down two judgments relating to side letters:

• (Medley Opportunity Fund Ltd. v. Fintan Master Fund Ltd & Nautical Nominees Ltd (21 June 2012) (the “Medley case”); and
• Lansdowne Limited & Silex Trust Company Limited v. Matador Investments Limited (In Liquidation) & Ors (23 August 2012) (the “Matador case”).

The facts, findings and practical significance of each case are addressed below.

The Medley case

Facts: Fintan Master Fund Limited (“Fintan”) acting through its nominee Nautical Nominees Ltd (“Nautical”) invested $45M in the Medley Opportunity Fund (the “Fund”) in late 2007.  Prior to its investment in the Fund, Fintan had entered into a side letter with the Fund which had granted Fintan certain terms that were more favourable than those granted to other investors of the Fund.  Nautical was not a party to the side letter.

The side letter included a term that, when Fintan requested a redemption of its investment, the Fund would pay Fintan the redemption proceeds immediately in cash, so far as it was possible, and to the extent that the Fund could not satisfy the redemption sum in cash, securities would be deposited into a separate liquidation account, with proceeds of realisations of those securities to be paid to Fintan as they occurred.

In the fallout of the Global Financial Crisis, the Fund offered 2 successive restructuring options to investors, the practical effect of which was to place certain limits on investor redemption rights; existing redemption requests were cancelled and quarterly distributions of excess cash on a pro rata basis.  In each instance, Nautical, accepted the restructuring proposal on Fintan’s behalf.

Despite Nautical’s acceptance of the restructuring proposals, in December 2011 it submitted a redemption request, seeking a cash redemption in accordance with the Fund’s articles and the terms of the side letter.

In the ensuing litigation, the Fund claimed that Fintan had waived its redemption rights under the articles and side letter by reason of Nautical’s acceptance of the restructuring proposals.

Findings: Fintan failed to reach first base; the Court found that although Fintan had signed the side letter, it was not the registered shareholder in the Fund and accordingly the side letter could not be enforced by Fintan.  Justice Quin ruled that for a side letter to be enforceable it must be entered into by the parties intending to be bound by the agreement – that is, the fund and the investor of record.  It is not sufficient for a side letter to be signed by some other party such as the beneficial owner of the shares.

Justice Quin further found that the side letter was superceded by Nautical’s agreement with the Fund in relation to the restructuring terms, as the restructuring agreements constituted variations to the investors’ redemption rights.

Although the restructuring agreements did not address future redemption requests expressly, the Cayman Court readily found (applying the English Supreme Court decision of Rainy Sky SA v Kookmin Bank [2011] UKSC 50) that commercial common sense dictated that the Fund’s investors could not agree to a restructuring plan which exchanged their redemption rights for periodic cash distributions and then later seek to revert to the pre-restructuring agreement redemption entitlements.

Practical significance

The Medley case underlines the importance of the correct parties entering into the side letter, particularly where the investor acts through a custodian or nominee.  If the side letter is between a fund and the investor without the custodian as a party, the investor should, ideally, novate the side letter to the custodian or, as a minimum, ensure that it has a limited power of attorney from the custodian to allow the investor to enter into side letters on behalf of the custodian.  Failure to attend to this requirement is likely to lead to the favourable concessions made in the side letter being unenforceable and therefore unavailable to the investor.

Further, while the Court has demonstrated in the Medley case that restructuring agreements will be sensibly interpreted in accordance with the commercial realities, it would be advisable to ensure that restructuring agreements clearly state whether they are varying or replacing redemption rights and in what terms, so as to remove any uncertainties and minimise the risk of litigation in relation to entitlements set out in side letters.

The Matador case

Facts: Justice Quin gave further consideration to issues pertaining to side letters in the Matador case. The Court was there required to consider the enforceability of an alleged oral agreement (characterised as an ‘oral side letter’) which was alleged to have been made in a discussion between a person beneficially entitled to shares in the Matador fund and another a representative of the investment manager of the Matador fund.  The alleged side letter purported to disapply the gating and suspension provisions in the Articles of Association to redemption requests by those investors.

The Articles of Association empowered the directors of the Matador fund to gate and suspend redemptions but did not empower them to treat investors in the same class differently.

Findings: Because the alleged agreement was said to have occurred in a discussion between parties who were not, respectively, the investors of record and (an authorised representative of) the Matador fund, Justice Quin held that the alleged ‘oral side letter’ was not enforceable against the Matador fund, and hence was not binding on the liquidator of the Matador fund.

The Court found that, even if it could be said that there was an ‘oral side letter’ between the Matador fund and the investors concerned, the agreement would have been inconsistent with the Articles and would not have been effective in changing the prescribed redemption and suspension process for those investors.

For an ‘oral side letter’, or indeed any side letter in the same terms, to be valid and enforceable, firstly, the Articles must permit the fund to relax the gating and suspension provisions set out therein, and, secondly, such relaxations must be set out in an agreement specifically between the fund and the investors.  Neither of these requirements was satisfied in the Matador case.

The terms and manner of redemption from a fund must be ‘sufficiently’ set out in the company’s Articles.  It is sufficient, for this purpose, for a fund’s Articles to set out the general gating and suspension powers and to specifically cross-refer to another document (most commonly, the PPM) which lays out the mechanics of how the directors intend to exercise those powers.

Practical significance

Justice Quin in the Matador case emphasised the importance of providing to investors (actual and prospective) transparency in relation to key investment terms.  In particular, to the extent that investors in a fund receive preferred treatment, that position needs to be ascertainable by both new and existing investors.  This does not mean that the specific details of side letters are required to be disclosed in to all investors and potential investors.  However, new investors must be aware, from a plain reading of the Articles of Association and offering documents, that the fund is entitled, for example, to give certain investors enhanced liquidity entitlements which will not be available to all investors.  Even if those entitlements themselves are not disclosed, the new investor is nonetheless able to undertake a risk analysis and make an informed decision whether or not to invest.

The findings in the Matador case with regards to the requirement for transparency are consistent with statements made by onshore regulators and industry bodies, such as the Financial Services Authority, the Securities Exchange Commission and AIMA, each of which has stressed the need for appropriate disclosures to made, given the terms of side letters entered by the fund concerned.

A further lesson from the Matador case is that the parties entering into the side letter must each have the power, capacity and authority to do so if the side letter is to be enforceable by the investor.  Where an investor enters into a side letter prior to investment and the investment is made through a custodian, the side letter should be novated to the custodian.  Where a side letter is entered after an investment has been made, the side letter should ideally be a tripartite agreement between the fund, the custodian and the investor.

It is also clear that, depending upon the terms of the side letter (for instance preferential liquidity terms to those offered to investors holding the same class of shares), consideration should be given as to whether or not the terms are such that a new class of shares may need to be issued so as to avoid the side letter being unenforceable by reason of the uneven treatment of the same class of investor.

Taken together, the Medley case and Matador case provide useful points of reference for participants in the funds industry in relation to the use of side letters.  The cases confirm some basic pre-requisites and guidelines that must be observed if the side letters are to have their intended effect and cast light on traps that might otherwise prove costly for those relying upon the terms of side agreements with the fund concerned.

Tony Heaver-Wren, Counsel at Appleby

Tony Heaver-Wren is Counsel to the firm and a member of the Cayman Litigation & Insolvency department. He qualified in 1994 and joined Appleby in 2007, having been a senior associate at leading firms in England and Australia for over eight years.

Tony practises in the Insolvency & Restructuring team and the Fund Disputes team. He works primarily in the areas of solvent and insolvent liquidations and insolvent corporate restructurings, shareholder and director disputes and insolvency litigation. Tony also provides advice on a range of funds, insurance and cross-jurisdictional matters and works closely with the firm’s Funds and Corporate teams on risk management and related advice in a non-contentious context.

Tony has over fifteen years experience in advising and representing major lenders, liquidators, administrators, receivers and boards of private and publicly listed companies on all aspects of corporate governance, contentious and non-contentious insolvency and corporate restructuring. He has provided insolvency advice and representation to key participants in the finance, aviation, shipping, retail, tourism, manufacturing and automobile industries. Tony has also provided extensive advice on enforcement options and strategies to banks and other lenders and has recently provided advice to a number of clients in the firm’s Hong Kong office.

Tony has published and presented extensively and is the author of the Cayman chapter of Cross Border Insolvency. He was a committee member of the Association of Business Recovery Professionals in England and of the Insolvency Professionals’ Network in Australia.