UK: Side Letters – Are Funds Hedging Their Bets?

Hedge fund managers often provide certain investors in hedge funds with separately negotiated ‘side letters’ granting terms that are different from the fund’s standard offering documents. Regulators in the UK and the US have voiced concern at the potential problems presented by the use by hedge funds of such letters. Side letters have also been the subject of recent guidance from AIMA. This article looks at some of the practical problems and considers some legal issues associated with these documents.

BACKGROUND

Side letters have long been a facet of the hedge fund industry. Their prevalence is a function of the relative economic bargaining power of the prospective investor and the fund. Typically, early stage hedge funds, which are eager to gather assets, are more receptive to entering into side letter arrangements. Conversely, hedge funds that have established track records and ample investor demand are less willing to entertain the prospect of entering into side letters. Institutional investors may require side letters as a condition of their participation in a fund.

In a recent survey of hedge funds, 40 per cent of hedge funds said that they used side letters, of which 63 per cent did not disclose the side letters to all investors, choosing only to communicate the existence of the side letter to those who benefited from the terms of the side letter.¹ As we will see later, these percentages may change as the market attitude towards side letters – and therefore whether they should be disclosed – starts to shift.

COMMON TERMS OF SIDE LETTERS

Side letters may cover a wide range of matters. For example:

• Reducing the management fees and/or performance-based compensation to which the investor will be subject.

• Assuring that the terms applicable to the investor will be the best terms offered to any other investor (or offered to any other investor investing a comparable amount of capital), commonly referred to as a ‘Most Favoured Nations’ (‘MFN’) clause.

• Permitting the investor to invest additional capital with the manager in the future.

• Limiting the right of the manager to force an investor to withdraw from the fund.

• Permitting the investor to transfer hedge fund interests to affiliates of the investor

• transfers the manager would otherwise have broad discretion to prohibit.

• Prohibiting the manager from settling the investor’s subsequent withdrawal from the fund with in-kind payments from the fund’s portfolio, rather than in cash (at least without the investor’s consent).

• Providing the investor with superior liquidity terms, including more frequent withdrawal dates, shorter notice periods for redemptions of shares in the fund (and other preferential redemption terms), or waivers of gates or lock-up provisions.

• Providing the investor with enhanced and/or early information about the fund manager (eg notification of particular changes in the personnel or structure of the manager) and the fund (eg some side letters provide the investor with daily or weekly net asset values for the fund and information on levels of leverage and risk).

• Providing the investor with further representations and warranties.

• Providing different procedures for calculating net asset values for different investors.

INCREASED INTEREST FROM REGULATORS

The FSA has taken greater interest in side letters in the last few years, in part due to a perception of inherent ‘unfairness’. It has stated that ‘the failure by hedge fund managers to disclose that side letters have been granted to certain clients may result in some investors receiving more information and preferential treatment, than other investors in the same share class’. Th e FSA’s original guidance was that hedge fund managers should ensure that all investors are informed when a side letter is granted (as opposed to disclosure of the nature or content of side letters) and that any conflicts that might arise should be adequately managed. Th e FSA opined that it might even be possible, depending on the circumstances, for a hedge fund manager to commit a criminal offence under s 397 of the Financial Services and Markets Act 2000 if it dishonestly concealed the existence of a side letter.²

The FSA also made clear that failure by a UK-based hedge fund manager to disclose the existence of a side letter is potentially in breach of Principle 1 of the FSA’s Principles of Business – ‘a firm must conduct its business with integrity’ – and that non-disclosure of a side letter that gives preferential liquidity or transparency would amount to a breach of Principle 1.³

The FSA’s stringent position has been tempered by the publication on 27 September 2006 of an AIMA guidance note on side letters (the ‘Industry Guidance’), discussing when UK hedge fund managers should disclose the existence and nature of such documents. Th e FSA supports the publication of the Industry Guidance and it has confirmed that it will take it into account when exercising its regulatory functions. Th e FSA has commented that ‘this is a good example of Industry Guidance being used to refine the FSA’s approach to make it more proportionate and appropriate’.⁴ In summary, firms (ie FSA regulated fund managers) will be required to disclose (to both existing and prospective investors) the existence of side letters which contain ‘material terms’, and the nature of such terms, where the firm is a party to the side letters or is aware that a fund of which the firm or an affiliated entity is the fund manager is a party to them.

A ‘material term’ is defined by AIMA as:

‘Any term the effect of which might reasonably be expected to be to provide an investor with more favourable treatment than other holders of the same class of share or interest which enhances that investor’s ability either:

• to redeem shares or interests of that class, or

• to make a determination as to whether to redeem shares or interests of that class,

and which in either case might, therefore, reasonably be expected to put other holders of shares or interests of that class who are in the same position at a material disadvantage in connection with the exercise of their redemption rights.’

In other words, a material term is one which enables the side letter recipient to make a profit or avoid a loss in circumstances where other fund investors, who do not receive the information promised by the material term, might not be able to do so.

AIMA clarifies that material terms would include preferential redemption rights, rights to more detailed portfolio information, redemption ‘gate’ waivers and ‘key man’ provisions (eg notification and redemption rights if the designated portfolio manager ceases to be responsible for the fund), but would not include fee rebates or MFN clauses.

The Industry Guidance also makes it clear that a term which would otherwise be regarded as material may not be objectionable if it does not, in practice, provide one investor with more favourable treatment. Th is could be achieved by granting all of the other investors of the same class the same rights granted by the material term – this would have the effect of ‘curing’ the materiality of a clause.

In the US there is no specific guidance relating to side letters. However, in testimony covering various topics before the US Senate, Susan Ferris Wyderko, former Acting Director of the Securities Exchange Commission's (‘SEC’s) Division of Investment Management, stated that hedge fund side letters are indeed a concern of the SEC staff .⁵ She also provided an insight into which terms in side letters are considered to raise more issues than others:

Terms of little regulatory concern:

• the ability to make additional investments;

• MFN clauses; and

• management fee and performance compensation reductions.

Terms the SEC staff find ‘troubling’:

• liquidity preferences;

• preferential access to portfolio information.

The SEC considers preferential liquidity terms to be particularly problematic because they can enable certain investors to exit a fund ahead of others. At times when the fund is not performing well, or where an event, such as the death, disability or departure of a key member of the manager’s investment team raises concerns regarding the future viability of the fund, permitting certain investors to pull their capital out ahead of the rest of the fund’s investors is likely to be viewed as unfair (particularly as the preferential early exit of one investor may in itself reduce portfolio liquidity, which might make withdrawals unavailable to other investors). Similarly, the provision to certain investors of enhanced transparency into the fund or its manager can create an unlevel playing field that the better informed investor can use not only to its benefit, but also to the detriment of others in the fund. In all cases, consideration should be given to whether the nature and scope of the rights are consistent with treating all investors fairly, albeit not equally.

While a number of the issues covered by side letters should not be problematic, those that benefit the recipient of the letter at the expense of other investors in the fund may be viewed by regulators in the US as violating the fund manager’s fiduciary duties to the fund.

PRACTICAL ISSUES – MANAGEMENT AND COMPLIANCE

Keeping track of side letters and ensuring that the terms therein are complied with becomes particularly problematic if the hedge fund has entered into numerous side letters with different terms and conditions.

Practical administrative and compliance issues are particularly exacerbated if the fund manager enters into side letters without approval of the board of the hedge fund company and/or without copying the letter to the administrator and the hedge fund company.⁶ Questions are raised of the ostensible/actual authority of the fund manager to bind the fund in the absence of explicit approval of the fund company board and/or other partners in the LLP, and keeping track of the various side letters agreed by the fund manager becomes extremely difficult. As a result, fund administrators may not be afforded the opportunity to check whether each side letter is enforceable, and whether the fund is complying with its terms. It is therefore imperative that guidelines are laid down for fund managers, setting out the scope of their authority with regard to side letters.

Managing conflicting side letters is also a difficult area. In particular, MFN clauses present problems. An MFN clause is one where the manager of the fund agrees with an investor that it will not enter into any agreement with another party that gives such party rights or benefits which are more favourable in any material respect than those extended to the investor in question without first offering the investor those preferential terms. Many investors have required MFN clauses as a condition of their participation

However, with such a term present, every time a new side letter is agreed, the fund has to ensure that any MFN clauses in previous side letters have not been breached. If the manager is not actively monitoring side letters on an ongoing basis, the more side letters that are entered into, the greater the likelihood that certain terms are going to conflict and the manager of the fund is going to breach the various MFN clauses that bind the fund.

Moreover, the acceptance of requests for MFN clauses can potentially expand the legitimate requirements of one investor contained in its side letter across a large number of the fund’s other investors, for whom the purported benefit derived from the MFN clause may be far less relevant/valuable, leading to increased costs with little accompanying value to the MFN clause recipients.

If there is a breach of an MFN clause, the investor with the benefit of the MFN clause may be able to apply to the courts for specific performance of the MFN clause. The investor may not have knowledge of the terms of other side letters in the fund and may not therefore be able to assess how he has suffered loss vis-à-vis the other investors. However, if he is able to obtain disclosure (either pre-action or during the course of litigation) of the other side letter(s), he may be able to quantify the loss, depending on the nature of the term(s) in question.

LEGAL ISSUES

Th e practicalities surrounding MFN clauses highlight other pertinent side letter issues. Ideally, managers need to consider early on what future side letter provisions might be given by a particular fund to avoid later investors being given special rights not disclosed in offering documents provided to earlier investors. Also, in some jurisdictions (eg in Cayman), shareholders in each share class must be treated identically, so the fund must be created with the flexibility to create and issue new share classes.⁷ In addition, once a fund has been formed, managers should ensure that new side letters do not conflict with applicable law or any prior fund agreements, including the fund’s organisational documents, offering documents and previous side letters (aside from being an invitation to litigation, side letter terms that conflict with the fund’s organisational documents might be unenforceable in some jurisdictions). Side letters should also be reviewed to ensure that they do not change the regulatory status of the fund (eg in the US the registration requirement under the Investment Advisers Act of 1940 may be triggered).

The side letter issue has a number of wider implications. For example, it affects corporate activities such as due diligence. In short, if the terms are not disclosed to potential investors, then proper due diligence has not taken place. If an investor enters the hedge fund on a false belief that side letters/certain terms do not exist, then this may give rise to an action for misrepresentation. This highlights the importance of disclosure, which in such instances would have to be above and beyond that required by the regulatory guidance.

In terms of such disclosure, there is a potential for conflict between commercial considerations (which would dictate that the side letters/terms of certain side letters are not disclosed) and legal responsibility (which would lead to the opposite conclusion).

Once FSA/AIMA guidance leads to side letter terms being generally disclosed to investors, including existing side letters that have not previously been disclosed,⁸ certain side letters – or at least the more objectionable terms within them – may be the subject of legal action, mainly by the other investors in the fund who feel that they are at a disadvantage compared with the investor(s) with the benefit of certain side letter terms. Given the off shore domicile of many funds, and the incorporation of off shore exclusive jurisdiction clauses in fund documentation, these matters may well be subject to the law of an off shore jurisdiction. However, assuming for the moment that English law applies, an overview of potential causes of action under English law is set out below:

• Enforcement of contractual agreement by specific performance/declaration – by the investor with the purported benefit of the side letter (to ensure compliance with the terms of the side letter).

• Possible causes of action by the other investors in the fund include:

• Conflict of interest/breach of fiduciary duty on the part of the hedge fund manager/director (as regards the fund as a whole rather than particular investors). It is unlikely under English law that managers of a hedge fund will owe fiduciary duties to investors to disclose those side letters issued to only some investors.
• Misrepresentation – this is most likely to apply where the hedge fund manager has represented that there are no side letters/misrepresented the terms of side letters offered to other investors. Th e traditional view under English law is that mere non-disclosure does not amount to a misrepresentation. However, if failure to disclose some fact distorts a positive representation or a partial non-disclosure is made, then a claim for misrepresentation may be available.
• Section 459 Companies Act 1985 action (from 1 October 2007 an action under s 994 of the Companies Act 2006) to remedy unfair prejudice to a minority shareholder. Note that such an action requires the investors without the benefit of side letters to be in the minority. This is unlikely to be the case, and so the s 459 action may be of limited impact in practice.
• Restitutionary claims, claims in conspiracy or knowing assistance claims. Such claims are likely to be difficult to make out, and so again may have only limited impact.

CONCLUSIONS

Alternative Investment News has recently reported that ‘in-house counsel at investment management firms said they are continuing to see a decline in use of … side letters’.⁹ It would be logical to suggest that this pattern has, at least in part, been precipitated by hedge fund managers’ increasing awareness of the interest of regulators in this area, and fear of litigation against the fund manager by disaffected investors.

Of course, fund managers who have already entered into side letters will have to play a waiting game to find out the effects of future regulation and/or litigation (with those who attempt to revoke the side letters they have issued risking actions for breach of contract).

What is clear is that side letters – both in terms of practical management and potential liability – are laden with problems for hedge fund managers, directors of hedge fund companies (particularly non-executive directors) and fund administrators alike. Given the increasingly demanding nature of institutional investors, and regulatory encouragement towards disclosing side letters, these problems may worsen. Hedge fund managers are therefore best advised to offer side letters only when the terms can be effectively implemented and where they are not likely to work to the detriment of the other investors in the fund. Investors should expect clear guidelines from fund managers as to the circumstances in which the fund would consider entering into a side letter.

Footnotes

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.