Side Letters

An idea whose time has passed?

Martin Harty

Investment funds are essentially off the peg investments. As Stanley Fink, CEO of Man Group was recently reported as saying "If you want different terms for some clients, you really need different accounts."1 Butsuch accounts do not make for investment or operational efficiency and cornerstone investors in a new hedge fund may demand preferential terms. Side letters have become a well established feature of the industry, offering terms such as reduced or rebated fees, levels of enhanced transparency at the level of fund holdings, and enhanced liquidity. The object is to customise some terms for some investors at the same time as preserving the funds structure. But do they work?

FSA has now expressed highly significant views on the use of side letters. These are considered below. But there has been an increasing recognition more generally that the use of side letters may be problematic. The International Bar Association Private Investment Funds Conference in February this year included a Workshop on "Side Letters: Best Practices." Although this covered the use of side letters in both private equity funds and hedge funds, a tendency among participants was to regard their use in the hedge funds area as giving rise to greater problems. Issues addressed included – the potential for a side letter to be an impermissible amendment to the fund agreement, the use of "most favoured nation clauses" and the language to be included in funds agreements to permit the use of side letters.2

The problem is really this. Any indirect investment has to be through an investment vehicle. Whatever the nature of that vehicle, investors are offered the right to participate in it on terms contained in its constitutive documents (e.g. memorandum, articles and prospectus). The participation will be by way of purchase of units whose characteristics are set out in those documents. Subject to any express provisions to the contrary, each unit of each class will be entitled to equal treatment. That will generally follow from the law of the jurisdiction under which the vehicle has been established and the terms of the constitutive documents. If the vehicle is listed, listing rules will almost certainly re-inforce this requirement.

So if the starting point is equality of treatment for investors within each class, the scope for the use of side letters might seem to be limited. The response of the hedge funds and their advisers has been to include language in the prospectus which appears to reserve the right to offer different terms on certain points to certain investors. There has been little adverse comment on the use of such provisions in relation to the rebate of management fees where this has been (as is usually the case) expressly provided for in the prospectus. Some investors, whether because of the size of their investment, long term time horizon, prestige or time at which they invest, will be more significant than others to a particular fund and it does not seem inherently unfair or inappropriate to rebate management fees in these cases. It does not in itself cause any loss or disadvantage to the other investors.

Concerns begin to arise when some investors are offered terms which provide them with material advantages which may result in loss or disadvantage to other holders of the same class of interest. Obvious examples here are enhanced reporting of underlying fund positions and advantageous terms on liquidity. A hedge fund prospectus will usually contain detailed restrictions limiting redemption rights and the percentage of the fund that may be redeemed at any one time. It is also likely to reserve very general powers on the directors to vary these terms. To what extent, if at all, can general powers such as these be relied on to justify making exceptions in favour of a limited number of investors? The answer is likely to depend on the particular jurisdiction of the vehicle, the precise wording of the relevant power, the context and the jurisdiction in which any issues or disputes arise. The exercise of general powers to benefit a favoured sub class of investors in these circumstances may not necessarily be immune to challenge.

Would the position be any better if hedgefunds adopt express language permitting, at the absolute discretion of the board, enhanced disclosure and liquidity to selected investors? Even if that is possible, it leads on to two difficulties (1) is it right for fiduciaries and professional investment advisers to make an investment into a fund which reserves the right to grant beneficial terms to other investors which may have an adverse impact on their client? Is it really possible to discharge an obligation to perform due diligence in those circumstances? (2) how appropriate is it for investors with the benefit of enhanced disclosure and liquidity to take advantage of these terms to the detriment of the rest of the investors. (Those with knowledge that a fund is in difficulties, where this is not known to all the investors in that class, may gain a benefit if they redeem before the others have the opportunity).

Depending on the fund vehicle used, whether it is listed and if so where, and the nature of the underlying investments, there might possibly be insider dealing and/or market abuse issues for the fund and its directors, the investment managers, and the "privileged access" investors to consider. At the very least, there may be some reputational risk in taking advantage of restricted information to head for the exit early and leaving others with what might be regarded as more than their fair share of any loss.

Interestingly, Stanley Fink (same article) of Man is quoted as saying that "We do not make extensive use of side letters. Their enforceability is questionable." The point is really not that there are clear answers to all the points raised above, but rather that with the passage of time and the greatly increased size of the industry, issues such as these may arise. Most industries and professions tend to think of themselves as special cases. But when issues arise, they are decided by courts and regulators applying general legal and regulatory principles which may not always co-incide with the understandings of those in the particular industry in question.

In these circumstances, it is not surprising that the FSA has something to say on the issue of side letters in its Feedback Statement 0602: Hedge Funds: A discussion of risk and regulatory engagement (Feedback on DP0504) March 2006. FSA adopts a risk based approach to regulation. It analyses issues in terms of the risks, controls and mitigants and has developed a powerful methodology to push this approach down to the level of specific industry issues. It is not afraid to debate issues and withdraw proposals which do not appear to be proportionate. It also seeks to work with industry associations to develop industry driven solutions.

A feature of this style of regulation is that it evolves. As the risks inherent in the different areas of the financial services industry become better understood, FSA tends to lead the debate towards what it sees as proportionate, risk based regulation. To that extent, it may well be more prudent to regard the current FSA stance on side letters as simply that. It by no means follows that FSA will not return to the issue with more rigorous requirements if events so demand. If, for example, there were to be significant litigation over the enforceability of contentious terms in side letters, that might be seen as a systemic issue requiring a more intensive regulatory response.

For the time being at least, FSA is concentrating on the transparency and managing conflicts of interest aspects of side letters. UK based managers will be expected to ensure that all investors are informed when a side letter is granted, and adequately manage any conflicts of interest that may arise. As the hedge funds themselves are not regulated by FSA, the obligations are imposed on the manager: "…playing some active role in relation to their [side letters] negotiation…" Since this will usually be the case, most UK based managers will be affected. Failing to disclose the existence of side letters to potential investors is, in FSA's view, a potential breach (amongst other unspecified breaches) of Principles for Business, Principle 1 (Integrity). FSA also raises the possibility of criminal liability of the manager under section 397 of FSMA 2000 on the grounds of dishonest concealment of such side letters. FSA will be reviewing a sample of firms' practices later in the year.

What should UK based hedge fund managers do? Firstly they will need to have a policy on side letters. The easiest policy would obviously be not to have them but that may be completely impractical for many managers, especially those with large US institutional and foundation investors (attitudes of such investors are hardly likely to change overnight). Rather unusually, funds of funds may have more of a problem than funds since they will usually want side letters from the funds they invest in and be requested to provide them to their own investors. Funds of funds offer access to/capacity in underlying funds, initial and continuing due diligence and portfolio construction. The continuing due diligence aspect could be affected by any decision of underlying funds to discontinue or restrict the use of side letters.

Having decided a policy on side letters, it will then be necessary to decide how to deal with the requisite disclosures and to identify and manage any conflicts of interest. It is widely thought that there will be a degree of M&A activity in this area. Due diligence on any fund which is an acquisition target should clearly include a review of side letters and practices. Any fund manager thinking of selling any time soon would be well advised to pay particular attention to this area.

Conclusion

FSA has played a leading role in examining the issues arising from the growth of the alternative investments industry. It has been broadly supportive and taken great effort to understand the area. Having identified the issues, FSA really had little alternative but to start the process of regularising as far as possible the use of side letters. Requirements that UK based hedge fund managers disclose the existence or grant of side letters (but not the terms of individual letters) to investors, and adequately manage any resulting conflicts of interest seem well founded. But they give rise to greater difficulties for UK based managers than may seem immediately apparent. Firstly, investor demands for side letters will not fall away overnight. Overseas jurisdictions may lag behind FSA in imposing comparable requirements on managers in their jurisdictions, thereby putting UK based managers at a competitive disadvantage. It is possible that there could be confidentiality issues in disclosing even the existence of some side letters.

No doubt the industry will develop further best practice guidelines in this area. But this can take time and will impose demands on the organisational infrastructure of managers. There is likely to be a degree of uncertainty over what constitutes adequate compliance in the meantime. The greatest need at present is arguably for co-ordinated industry debate (not just in the UK) at the most senior levels on whether side letters really are appropriate in the context of an increasingly mainstream business. Perhaps, as the title to this article suggests, side letters really are an idea whose time has passed.

Martin Harty is Senior Consultant, Financial Services, at Crowell & Moring. He advises on financial services and regulatory issues, including the design, review and implementation of compliance programs as well as transactional matters in alternative investments.

References

  1. Quoted in FT Wednesday 29 March 2006 page 20. Source; Bloomberg
  2. International Bar Association: 7th Annual International Conference on Private Investment Funds. London February 2006 Workshop 3.