Side letters: caveat scriptor

legal

A hedge fund that secures a significant part of its funding from a major investor, and as a consequence, enhanced marketability, may be prepared to grant such an investor preferential rights to such an investor.

Such rights are typically in the form of fee-rebate arrangements, rights to early redemption without penalty, or the right to more information than other investors who hold, ostensibly at least, shares of the same class. These arrangements are commonly entered into by the investment manager on behalf of the hedge fund under delegated authority of the board of directors of the company.

A matter of principle

In its feedback document titled Hedge Funds: A Discussion of Risk and Regulatory Engagement,1 the UK Financial Services Authority (FSA), addresses the failure by some UK hedge fund managers to disclose the existence of side letters, which the FSA regards as a breach of the statement of principle that "a firm must conduct its business with integrity."

The paper equates this practice with violation abuses, and promises robust action.

We would expect the Bermuda Monetary Authority to adopt the same approach with respect to any similar breaches by any entity which is subject to regulation under either, or both of the Trust (Regulation of Trust Business) Act 2001 or the Investment Business Act 2003, which replicate the UK statements of principles.

If the hedge fund is structured as a mutual fund company, it will be governed by the provisions of the Bermuda's Companies Act 1981 (the Act), its memorandum of association, its bye-laws, its prospectus (the foregoing constituting the constitutional documents of such an entity), and the Bermuda Monetary Authority (Collective Investment Scheme Classification) Regulations 1998 (unless it is classified as an Exempted Scheme).

The Act2 permits a company to make provision in its bye-laws, if appropriate, to regulate (among other things):

'...the voting rights and restrictions relating to any class of shares in companies limited by shares, or other company having a share capital, and the voting rights and restriction of members of companies limited by guarantee including material companies...'

An investor that successfully negotiates a side letter with preferential rights must ensure the shares being issued under the terms of the side letter are duly authorised to be, and are issued validly by the company in that manner.

Obtaining a legal opinion in this regard is recommended.

It is not advisable to derive comfort solely on the basis of the usual authority given to the board of directors of a Bermuda company to issue shares on "such terms as the board of directors thinks fit." Where the side letter is offering preferential terms that, in effect, vary the rights of other shareholders of the same class of share, then unless the bye-laws of the company otherwise provide, the Act requires such a variation to be approved in writing by 75% of shareholders of the affected class, or by a majority of such shareholders in a general meeting.

In any event, even where the consent of the relevant class is obtained in accordance with the bye-laws or the memorandum of association, the Act3 permits holders of at least 10% of the shares of the affected class to apply to the court to have the variation cancelled, provided that such an application is made within 28 days of the shareholder consent.

Ruling minority

In such circumstances, any side letter whose effect is to vary shareholder rights will be ineffective unless, and until, it is confirmed by the court. The court may refuse to uphold the variation if it is satisfied that having regard to all the circumstances of the case, the variation would unfairly prejudice the shareholders of the class represented by the applicant.

Such a successful challenge to the validity of the issue by the board of directors of a side letter is potentially very serious and might possibly expose the board of directors to legal action for breach of its duty to properly supervise the activities of the investment manager (to whom powers to enter into a side letter might have been delegated).

Each of the directors may be personally liable under the Act4 for breach of statutory duty to act honestly and in good faith with a view to the best interests of the company and a failure to exercise the care, diligence and skill that a reasonable prudent person would exercise in comparable circumstances.

in whose best interest?

It must be emphasised that as a matter of Bermuda law, such an action would be founded on the basis of the director having breached a duty to the company and not the shareholder.

This is because under Bermuda law, the primary duty of the directors is to act in the interest of the company, rather than the shareholder.

Bermuda law also requires the fund prospectus to contain a description of the rights attached to the shares being offered. The prospectus must be published and filed where there is an offer to the public (unless an exemption applies). Any material changes to the prospectus must be published by filing a supplementary prospectus.

Disclosure in the fund's prospectus (or a supplement if the side letter is issued after the original prospectus is filed) that the fund's board of directors may, from time to time, issue side letters that may provide preferential rights to other shareholders of the same class would not in my view, be sufficient to discharge the requisite standards of fiduciary duty in circumstances where shareholders consent is required.

play straight on the side

Disclosure may facilitate shareholder consent once the arrangements are submitted for the approval of shareholders because previous disclosure in fund documentation may at least eliminate the element of surprise to other investors.

Therefore, investors who have been issued side letters but are uncertain about their position should obtain legal advice on the validity or otherwise of the side letters and the shares issued under them.

If it is established that the shares have been issued in breach of the bye-laws of the company, then the investor must, at the very least, seek to obtain shareholder ratification of the side letter and the issuance of shares in relation thereto, and hope that there is no block of members carrying more than 10% who might succeed in an application made under section 47(1) of the Act.

KEY POINTS

Where side letters offer preferential terms to some varying rights of other investors Bermuda law typically requires approval in writing by 75% of shareholders of the affected class

Investors issued side letters should seek legal advice on their validity

Footnotes

1 FS 06/07 March 2006.

2 Section 13 (3) (xv).

3 Section 47(1) of the Companies Act 1981.

4 Section 97 of the Companies Act 1981