A side letter— also often referred to as a side agreement or side letter arrangement—is an agreement that supplements, amends, or modifies main contractual provisions.
In the private investment arena, the main contractual provisions are the offering documents. The side letter modifies or supplements certain portions of the offering documents, which are typically preferential to the investor who is entering into the side letter. The side letter arrangement is not part of the underlying primary contract (i.e., offering documents). It is an agreement on the “side” between that investor and the fund sponsor that supplements the offering documents.
Side letters are usually limited to a fund’s larger investors. In exchange for investing a significant amount of money or providing an investment at an early stage, an investor may seek to arrange, through a side letter, for beneficial terms which can range from reduced fees to greater investment capacity. The terms of a side letter may widely differ depending upon the agreement between the fund and the investor.
Commonly Used Provisions
Depending on the type of fund, a typical side letter may include certain provisions, including, without limitation:
- Most favored nations (“MFN”);
- Confidentiality;
- Limiting the indemnification obligations;
- Transfer rights;
- Advisory board seats;
- Enhanced reporting requirements;
- Co-investment rights; and/or
- Reduction of management and/or performance fees.
MFN provisions are arguably the most common—and problematic—clauses utilized in side letters. MFN provisions are implemented when investors want to protect themselves from less favorable terms or conditions than those made available to existing or potential investors. An investor can request, via a side letter, that the investment entity manager provide an MFN guarantee that ensures no other investors have been or will be offered superior investment terms, unless those terms are also provided to the investor making the request.
Side Letter Regulatory Issues
Securities and Exchange Commission
In May 2006, the SEC’s Division of Investment Management provided insight to the SEC’s position on side letters. [1]
Specifically, the SEC underscored the fact that liquidity preferences have the potential to cause harm to investors, and are thus a subject of potential concern to the SEC. The hedge fund managers and similar figures should ensure that the rights granted via side letters relating to liquidity preferences establish equitable and fair investment conditions to all investors entering and exiting from the fund and the market.
The SEC also voiced concern on the preferential access to portfolio or performance metrics. The information may allow certain experienced major investors to utilize the data to place the fund, along with its other investors. Accordingly, side letters should remain compliant with both the applicable securities laws and the foundational documents of the underlying investment entity, as well as being written in terms that do not jeopardize the investment vehicle’s exempt status.
Enforceability – Delaware Chancery Court
The Delaware Chancery Court also offered added guidance on the enforceability of a side letter. In ESG Capital Partners II, LP v. Passport Special Opportunities Master Fund, LP. [2], the Chancery Court ruled that, among other things, a side letter was rendered nullified when a subscription agreement entered into the following day included an integration provision that did not include the side letter. Additionally, the court held that a general partner was not authorized to extend preferential rights via a side letter, as such rights would effectively materially and adversely alter the rights of the parties to the original agreement.
The takeaway from ESG Capital Partners is that the fund sponsors should take the following steps in order to increase the chance that side letters are judicially enforceable: (1) refer to the existence of side letters in fund documents; (2) expressly state general partners’ right to extend additional rights via side letter in fund documents without consent from any investors; and (3) ensure the extension of additional rights does not incur a material or adverse effect on associated limited partners, including, those terms that concern the SEC.
Disclosure Requirements
Under the European Union’s Alternative Investment Fund Managers Directive (“AIFMD”), the side letter disclosures are required. Specifically, the sponsor shall provide to investors to
“ensure a fair treatment of investors and, whenever investor obtains a preferential treatment or the right to obtain preferential treatment, a description of that preferential treatment, the type of investors who obtain such preferential treatment and, where relevant, their legal or economic links with the [fund sponsor] or [fund].”
These requirements are implemented by Financial Conduct Authority, a European conduct regulator, under Fund 3.2 Investor Information.
On the other hand, the SEC generally relies on the fiduciary duty rules and antifraud provisions under the securities laws. The SEC opines that the fund sponsor must put the interests of the fund and its investors first, or alternatively, fully disclose the material conflict that arises from the side letter. As commonly known, “materiality” is not a bright line test, but a factual inquiry. When it comes to side letters, “materiality” hinges on how much a conflict or potential impact it may have with the other investors. For example, having preferential liquidity treatment will likely be material information, such that the existing investors would want to know when making their investment decisions. However, when in doubt, it is better to disclose than not, as deficiencies or omission of material fact can lead to enforcement action.
Best Practices for Fund Sponsors
Based on the above, here are some practical considerations and best practices for fund sponsors:
- Check to see if the governing documents permit the sponsor to enter into a side letter agreement;
- If permitted, consult with counsel and disclose to the investors the material terms of the side letter arrangements;
- Keep in mind the fiduciary duty owed to the fund and its investors on the side letter arrangements, and the SEC’s concerns;
- Ensure that the terms of the side letters are incorporated with the main fund documents to avoid dispute; and
- Monitor and keep clear records of the side letter arrangements to avoid any breach of the side letters or provisions within the main fund documents.
Conclusion
Careful attention must be given by fund managers and their legal counsel to ensure side letters do not contradict one another or the underlying investment vehicle’s foundational documents.
[1] Susan Ferris Wyderko, Testimony Before the Submittee on Securities and Investment of the United States Senate Committee on Banking, Housing, and Urban Affairs (May 16, 2006)
[2] ESG Capital Partners II, LP v. Passport Special Opportunities Master Fund, LP., 2015 WL 9060982 (Del. Ch. Dec. 16, 2015).
