Lancelot: Investor Side Letters

Still a gap in Cayman between legality and reality

Originally published in the May 2015 issue

In 2012 and 2013 first instance decisions of the Cayman Islands Grand Court [1] restricted the efficacy of side letters which may be routinely entered into between investors and investment managers of the fund they are investing in, seeking to vary rights attached to their issued shares. The Cayman Islands Court of Appeal (CICA) has now given its first judgment on the topic. [2]

In the Matter of Lancelot Investors Fund, Ltd, the beneficial owner of shares in a fund had sought to agree a shorter lock-up period for redemptions with the investment manager. At first instance, the Grand Court found that the side letter was not enforceable for want of authority or standing on both sides of the side letter:

  1. Side letters attaching rights to shares could only be enforced if entered into by the registered owner – the beneficial owner could not directly enforce its rights; and
  2. There was a lack of authority for the investment manager to bind the fund.

In its judgment, the CICA has narrowed the gap to enforceability – accepting that in certain circumstances the beneficial owner could directly enforce a side letter attaching rights to its beneficially owned shares, although holding that the particular side letter in question still failed because the investment manager did not have actual or ostensible authority to sign it on behalf of the fund.

Whilst the appeal was unsuccessful, the CICA’s purposive reasoning strengthens the position of a beneficial owner in pursuing recovery of its investment. Although the CICA expressly explained its reasoning in the context of a liquidation, it could also be logically extended to the situation of a company on the brink of insolvency and form the basis for arguments in cases where beneficial owners may otherwise be restricted from presenting a winding up petition – such as where a beneficial owner is forced to change its custodian, which is then unable to present a winding up petition for six months from the date of registration.

The ruling also gives an indication of how the gap to enforcement can be further reduced. The CICA considered that, based on the documents and the “world’s view” of investment managers, the investment manager did not have actual authority to bind the fund or transmit the decisions of its directors. The CICA’s narrow view of the role of the investment manager was correct on the basis of that fund’s documents, but may surprise many in the investment community, who view an investment manager as their primary point of contact and capable of negotiating binding commitments on behalf of the fund it manages.

An investment manager must therefore have actual authority (which could be contained in the fund’s investment management agreement or a separate board resolution regarding a particular transaction) or have the agreement ratified by the directors after the fact – a transaction acknowledgement by the administrator in response to a redemption request was held by the CICA not to be sufficient ratification.

The background to the Lancelot case
From 2005 to 2007 KBC Investments Limited (the investor) invested periodically in redeemable shares issued by Lancelot Investors Fund, Ltd (the fund, and the shares). The shares were subject to a lengthy lock-up period stated in the fund’s Confidential Information Memorandum (the CIM). The investor sought to vary the lock-up period by entering into a side letter directly with the investment manager of the fund. The shares were registered in the name of Fortis Bank (Cayman) Ltd as custodian for the investor.

In October 2007 the custodian submitted a redemption request for $29 million in accordance with the terms of the side letter. The administrator of the fund confirmed a partial redemption of the shares effective as of the nextquarter date. The administrator then made a partial payment in respect of the redemption request, having redeemed those shares which were outside of the standard CIM lock-up period, but indicated that the balance of the redemption request could not be satisfied, as the remaining shares held by the custodian were subject to the standard CIM lock-up period, and so could not be redeemed. The administrator accordingly revised the transaction acknowledgement. The remaining shares were not redeemed and the balance was not paid by the time the fund suspended share redemptions. The fund subsequently became the subject of an order for winding up, whereupon an official liquidator (OL) was appointed.

The custodian duly submitted a proof of debt (POD) for the balance. The OL gave notice of rejection of the POD on various grounds, including that the redemption request was correctly refused in relation to the remaining shares and the balance were still subject to the standard CIM lock-up period, because the amended lock-up period set out in the side letter was ineffective in respect of the remaining shares.

The investor, not the custodian, appealed to the Grand Court against the rejection of the POD. The judge at first instance held that:

  1. The remaining shares still vested in the custodian, and unless and until the remaining shares were transferred to the investor, the investor had no standing to appeal the rejection of the POD;
  2. In any event, the side letter was not binding on the fund: it was not executed with the fund’s authority and had not been ratified by the custodian; and even if duly authorised, amounted to an invalid variation of class rights; and
  3. The redemption request did not amount to a request to redeem at the first available date, and once it had failed, no longer stood effective.

The investor appealed to the CICA. The judgment of the CICA was written by Justice of Appeal Martin (Martin JA) and supported by the rest of the CICA.

The beneficial/registered owner issue
Martin JA concluded that it was no bar to enforcement that the investor was the signatory to the side letter:

  1. Whilst in general only a registered shareholder may bring proceedings to vindicate shareholder rights, once a company goes into liquidation, all provable claims against the company rank for dividend, which may be assigned by virtue of CWR 18, r9(1);
  2.  If the custodian had validly assigned the benefit of the POD to the investor, then the investor would have been entitled to appeal its rejection as creditor;
  3. The agreement between the custodian and the investor was such that the custodian was a bare trustee, but once the custodian became a proving creditor then there was no obstacle to the investor maintaining an action as equitable assignee, even while the custodian agreement continued in effect, but once it came to an end, the provisions of the agreement contained a separate equitable assignment (which would include the benefit of the POD);
  4. Accordingly, the investor was an equitable assignee with the benefit of the POD, and so was entitled to be regarded as a creditor for the purpose of CWR O.16, r17 and as such entitled to maintain an appeal, subject to joinder of the assignor – the evidence being such that there was no good reason to refuse permission for its joinder; and
  5. Under the circumstances the side letter could only be construed as made on the custodian’s behalf, and the custodian’s redemption request and proof of debt were explicable only on the basis that it had the benefit of the side letter, which it had accordingly ratified by its conduct.

The CICA’s approach strengthens the position of a beneficial owner seeking to recover in a liquidation, raising the prospect that otherwise unenforceable contracts may be ratified by the conduct of the beneficial owner’s custodian/nominee. Although the CICA did stress that “there is no doubt that in ordinary circumstances the rights attaching to shares may only be pursued by the registered shareholder”, there are not many steps between the logic adopted by the CICA in this situation and a situation whereby a beneficial owner needs to secure the winding up of a company, but is prevented from doing so because of some procedural irregularity.

One stark situation is the blanket provision in the Companies Law preventing any shareholder from presenting a winding up petition if it has not held some or all of its shares for at least the six months immediately preceding the presentation of the winding up petition [3] – which catches administrative transfers from custodians back to long-standing beneficial owners or changes of custodian necessitated by circumstances beyond the beneficial owner’s control (such as the insolvency of the custodian) which are made in the period prior to a winding up petition being presented. Investors in such a position should be in a stronger position to enforce their rights prior to insolvency, and may now be emboldened to present petitions with some expectation that the Grand Court of the Cayman Islands will take a similarly pragmatic approach.

Authority of the investment manager
Martin JA went on to conclude that the side letter was not binding on the fund because:

  1. Whilst the CIM expressly contemplated a variation of lock-up periods, the investment manager did not have actual authority to make such an arrangement;
  2. None of the documents or actions of the fund gave any ostensible evidence of the investment manager having such authority;
  3. The outside world would not generally regard an investment manager as having authority to transmit decisions of the board of directors, and any investor would be aware that the investment manager was merely one of a number of persons dealing with the fund’s affairs – the fact that the investment manager had “been let loose on the investors” did not in the circumstances give it ostensible authority to make representations as to the fund’s decisions about share redemption; and
  4. A transaction acknowledgment from the administrator could not amount to a ratification of the side letter by the fund, because the administrator was similarly not authorised to transmit the decisions of the board.

Those looking to enter into side letters should ensure that they are negotiating with those who have the authority to agree the compromise sought, the safest solution being to contract directly with the fund. Martin JA’s comment about the “outside world’s” view of the general authority of investment managers to bind an investment fund is an interesting proposition. It suggests that, when contracting with an investment manager, authority to bind the fund should be explicit in the fund’s documentation.

However, Martin JA’s comments do not reflect the practical reality of the alternative investment industry: in our experience, the majority of fund promoters and onshore counsel will expect investment managers to have the requisite authority to enter into binding side letters. The CICA’s findings suggest that this practicality is not reflected in legality. For this practice to continue, investment managers should build authority into their investment management agreements or seek director resolutions appointing the investment manager or delegating authority to agree side letters (and reflect this in the offering documentation so that the authority is apparent to the contracting counterparties).

Those seeking to enforce side agreements already entered into by an investment manager should seek confirmatory evidence of that authority or obtain express ratification of the agreement by the directors of the fund. Those who have yet to rely on their side letters should seek assurance that they have been entered into with the appropriate authority, the best solution being to seek ratification by the board of the relevant fund.

The question as to whether the side letter was invalid as an unlawful variation of class rights did not fall to be determined by the CICA, so the thorny issue of class right variations still remains to be tackled by the higher courts.


1. Namely ‘Medley Opportunity Fund Ltd v Fintan Master Fund Ltd & Nautical Nominees Limited’ 2012 (1) CILR 360; ‘Lansdowne Limited & Silex Trust Company Limited v Matador Investments Limited (In Liquidation) & Ors.’ 2012 (2) CILR 81; ‘Swiss-Asia Genghis Hedge Fund v Maoming Fund’ (24 July 2013, unreported); and ‘KBC Investments Limited v Geoffrey Varga’ (12 August 2012, unreported).
2. In the matter of ‘Lancelot Investors Fund, Ltd (in official liquidation)’, ‘KBC Investments Limited v Geoffrey Varga’, 27 April 2015 (unreported).
3. s94(3) Companies Law (2013 Revision).