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Side letters

The side letter is an animal increasingly seen in the hedge fund jungle. It is a species that can be unpredictable, even dangerous. The attitude that any arrangement outside the principal contractual documents can simply be put into a side letter is foolhardy.

Investors considering a hedge fund may require amendments to the offering memorandum's terms as a condition of their investment. Such amendments are typically implemented using a side letter (a species of collateral contract), the consideration for which is the investor's entry into the principal contractual documentation and the investment. Often the approach to side letters has been casual and parties have not checked, first, that the fund's documentation accommodates the creation of side-letter arrangements and, secondly, that the preparation and approval of the side letter is consistent with the fund's documentation. Failure to do this might render the side letter unenforceable and expose the fund to complaints and legal proceedings by other investors, on the basis that the side-letter investor was given unfair and improper preference that was not disclosed adequately in the offering memorandum.

In practice, side letters range from simple side letters between the investors and the investment manager that provide for arrangements completely outside the fund structure (for example, a rebate of management fees to a shareholder) to complex arrangements with seed investors that amend the fund's principal documentation, thus becoming integral to the fund's structure. The most common type of side letter is an agreement between the fund, the investment manager and the investor on more favourable terms than those in the offering memorandum. In this briefing, we assume the fund is a standalone Cayman exempted company. The following matters should be considered when preparing a side letter of this kind:

  1. What is required in order to give the side letter binding contractual effect?
  2. Are there provisions in the fund's documentation that permit a side letter?
  3. What considerations apply to a side letter whose purpose is to vary rights attached to shares, or the commercial and economic terms of the particular investment?
  4. Have the required actions been taken to approve and implement the terms of the side letter?

As with any contract, to be enforceable, a side letter arrangement must either be supported by consideration or be made by deed. Any side letter arrangement entered into after the investor's entry into the initial principal contractual documentation will generally require consideration other than the initial investment or the entry into the principal documentation, as such consideration will be past. The arrangement must also comply with other essential requirements (such as certainty of terms) for contractual effect.

The offering memorandum, the subscription agreement, and the memorandum and articles of association govern the relationship between the investor and the fund. A side-letter investor is seeking to subscribe for shares on the terms of the offering memorandum and subscription agreement, as modified by the side letter. A side letter should not modify the provisions of the memorandum and articles of association that bind an investor once the shares are registered in the fund's register of members.

To accommodate the creation of side letters, the fund must include provisions in its offering memorandum that disclose the possibility of side letters, alerting investors that others could be given preferential offering terms. The disclosure should clearly distinguish between two issues: modification of class rights and variation of offering terms. This distinction lies at the core of proper side-letter implementation.

Modification of class rights

Rights carried by shares prima facie rank pari passu, that is, shareholders benefit from membership equally. It is only when a company divides its share capital into different classes with different rights that share equality is displaced. A separate class of shares is constituted when the rights carried by those shares differ from those attached to other shares, even if there is no express wording to that effect. The principal rights that a share may carry are:

  • the right to dividends;
  • the right to vote at meetings of members; and
  • the right, in the winding up of the company, after the payment of the debts, to receive a proportionate part of the capital or otherwise to participate in the distribution of the company's assets.

When defining share rights, the capital clause in the memorandum of association us usually kept simple, and the rights of the different classes are defined in the articles.

However, differentiation between rights could itself create a different class of shares. If the articles give specific rights to certain members only, these members become a class of members and their shares constitute a class of shares, even though the shares qua shares enjoy no special rights. But there is no class right if the shares are the same and the rights of the shareholders qua shareholders are the same.

It is important that a side letter's terms do not give rights to the side-letter investor that inadvertently create a separate class of shares, requiring the existing shareholders' approval for such modification. Without such consent, the issue of shares to the side-letter investor might be invalid.

Variation of offering terms

The expression offering terms means the terms of the commercial and economic contract between the fund and the investor. These terms include the fund's investment objective and strategies, the identity of the investment manager, the fees charged by service providers and other material economic and commercial terms.

This distinction between share rights and offering terms is really a distinction between two separate contracts – the contract represented by the articles of association, and the economic contract represented by the offering memorandum and the subscription agreement. A side letter should only purport to vary the economic contract, never the provisions of the memorandum or articles of association. To accommodate side-letter arrangements, the articles of association should make clear that such arrangements will only affect the former.

Modification of class rights provisions should also state that any such variation does not constitute a modification of share rights. And if any term of the side letter relates to a provision in the articles (for example, a lock-up period), the provision should be one the application or exercise of which is left to a broad discretion given to the directors by the articles, to be exercised solely and absolutely, either generally or in any particular case.

A good rule of thumb for directors when considering whether the provisions of a side letter will affect the economic contract of existing shareholders, is to ask whether existing shareholders would be affected if the side-letter investor invested or did not invest. If the position of existing investors would remain neutral regardless, then the answer is generally that its economic contract will not be affected. If it will, then the directors should only approve the side letter if the extent to which the existing investors are affected falls within the disclosure in the offering memorandum at the time they invested.

A side letter should always be reviewed by the fund's legal counsel and approved by a directors' resolution. Its scope must fall within the side-letter disclosure provisions of the offering memorandum and it must not modify existing share rights. The directors' resolution should recite in full the provisions in the offering memorandum and the articles that permit the creation of side letters, and explain why a subscription on the side letter's terms is in the fund's best interests.

Side letters can be a useful tool in the hedge fund world. But appropriate structuring steps and legal advice must be taken so that the negotiated terms are implemented without unintended adverse consequences for the fund or any of its existing shareholders, and so that each party has all the benefit of the negotiated terms with no unforeseen adverse consequences to either.

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