Side Letters

Martin Kelly, IMS Consulting
Originally published in the November 2006 issue

About now, hedge fund managers will be starting to realise the problems caused by the new AIMA “Guidance” on the disclosure of Side Letters, as thousands of investors who were previously unaware of side letters or who never particularly thought about the matter, begin to demand the same treatment and investment terms as those “favoured” investors large enough or canny enough to have negotiated favoured terms.

These problems could perhaps have been avoided with more understanding, consideration and consultation on Side Letters. Instead, and somewhat contrary to the FSA’s more usual regulatory approach, Side Letters, which have never before been a concern of the FSA, took on an unexplained urgency and were railroaded, in the most unusual manner, into regulatory policy in the space of a few short months. The resulting document is not universally popular with AIMA taking much of the flack.

The Guidance is perhaps both fairly and unfairly attributed to AIMA: fairly, in that it was indeed drafted by AIMA and its advisers but unfairly in that the content is therefore seen to reflect AIMA’s views on disclosure. The facts are that AIMA parachuted in to help draft the document but had to work within strict content and time parameters laid down by FSA which did not provide much in the way of drafting latitude or industry consultation. It was also AIMA, and/or its advisers, who quickly fought for immediate supplemental guidance when it became apparent that further clarification was necessary. So let us not pretend the Guidance is anything other than an FSA rule by another name.

The FSA provided the bricks and AIMA built the best house possible in the time permitted. The FSA insisted on review and approval of the document and, further, has made it quite clear that it requires compliance with the Guidance as the minimum standard of compliance with Principle 1 (conducting business with integrity).

So what happens now?

You get a call tomorrow from an irate investor demanding the same level of portfolio transparency or the same liquidity terms as those with whom the manager has in place Side Letter agreements.

Do you have to comply with their requests?

After all, implicit in the FSA’s insistence on disclosure of material terms is the fact that such terms may act to the advantage of some investors and, consequently, to the disadvantage of others. If this was not the case, there would clearly be no need to make any disclosure. The disclosure serves to better inform investors of the actual or potential conflicts which may exist.

I think it is perhaps dangerous to assume that a manager’s obligations to its investors stops at disclosure. Rather, I expect the FSA’s requirement to disclose material terms rather than offer those terms to all investors reflects the view that material terms do not necessarily result in actual conflicts.

But what if they do?

It is a basic regulatory principle to treat all Customers fairly and to the extent a manager’s side letter arrangements may act to the detriment of other investors, various complications arise, whether under the FSA rules, at common law or even at the level of the relevant listing requirements or any applicable laws or regulations in the jurisdiction in which the fund is domiciled.

“The FSA is probably thankful it does not operate in as litigious an environment as the SEC does”

However, it is the very definition of who is the Customer, and of whom, that gives rise to this problem. The investor with whom Side Letters are agreed will often only have an investment contract with the Fund in which they are invested. These funds are normally outside the UK they are therefore outside the FSA’s regulatory jurisdiction. So in effect, the FSA, via the AIMA guidance, is requiring UK based investment managers to disclose terms of agreements to which the regulated firm may not even be party. And this disclosure is required to be made to investors in funds which the firm manages, but with whom they may have no other agreement.

The FSA is probably thankful that it does not operate in as litigious an environment as the SEC does, bearing in mind the public humiliation the SEC encountered when it redefined the term Customer to meet its own ends in its efforts to regulate hedge funds. In a show of cooperation it would appear that AIMA on behalf of the industry is trying to make sense of FSA’s intent. In simple terms, the effect of the Guidance is that managers now have to decide not only which of its Side Letter terms are material and therefore disclosable but also whether it must offer the same terms to other investors because, to fail to do so, may breach one or more rules or regulations in one or more jurisdictions. Even absent a regulatory or moral obligation to offer the same terms, managers could face serious investor relations problems justifying why it is not offering a level investment playing field. Rather than increase their reporting burden, which in certain cases could have a serious impact on a fund, managers may find they have to withdraw the privilege of side letters rather than offer that privilege more widely.

There are other solutions of course, such as to establish different share classes with differential terms, but such solutions may be expensive or otherwise impractical. In time, therefore, the solution may well be a drastic reduction in the use of Side Letters altogether.

And was there any need for the new Guidance?

Well, despite being an avid proponent of regulation, I cannot see the need in this case. At a time when we are moving towards a more principle based regulatory regime under MiFID, it seems odd that the FSA should be focusing on such prescription.

The use of side letters is adequately caught within various of the FSA’s principles, not least the principles of integrity, fair treatment and proper management of conflicts of interest. All the Guidance really achieves is to focus hedge fund managers on these principles as they relate to Side Letters. This could surely have been done more gently and by providing managers with latitude on how to deal with the issue, as it does in so many other areas of the rules, rather than by the hasty issuance of new rules, packaged as independent industry guidance, which is likely to cause much unnecessary angst in coming months and which, somewhat unfairly, may not reflect well on AIMA, which has served the hedge fund industry so well to date.