UK: Side Letters and the FSA 

September, 2006 -

In the recent Feedback Statement (FS06/2) from the UK's Financial Services Authority (FSA) to its Discussion Paper entitled "Hedge funds: A discussion of risk and regulatory engagement", the FSA identified the use of side letters as an area of concern where a market failure may be present, thus potentially requiring regulatory intervention by the FSA. Side letters are agreements or arrangements entered into between hedge funds and/or their managers with key investors which provide such investors with more information and preferential (early) redemption and other terms compared with other investors in the same share class (who may be unaware that the side letters exist and who will be denied these terms). The FSA pointed out that this may be to the detriment of other investors in the same share class in the fund who should be aware that side letters can affect the risk profile of their investment. The FSA believes that failure by UK based hedge fund managers to disclose the existence of these side letters maybe, amongst other potential breaches, in breach of Principle 1 of the FSA's Principles of Business ("a firm must conduct its business with integrity"). FS06/2 states that, as a minimum, the FSA would expect acceptable market practice to be for managers to ensure that all investors are informed when a side letter is granted (i.e. the existence of these side letters, and not the nature of the individual agreements, must be disclosed) and any conflicts that may arise to be adequately managed. The FSA also intends to undertake a review of a sample of firms’ practices in this area later this year. This will inform their policy thinking and enable them to take action against firms and management if appropriate. At a recent meeting between the UK chapter of AIMA and the FSA in relation to FS06/02 and the use and disclosure of side letters, the following were noted: (i) AIMA and FSA will continue their dialogue and a fuller note of the outcome of these discussions will be circulated; (ii) the FSA will not be commencing its thematic review of side letter disclosure practices before October 2006; (iii) the FSA expects fund managers to have written - by 30 September - to all underlying investors in the funds which they manage disclosing the existence of any side letters (AIMA will continue to discuss with the FSA the nature of the disclosure which managers will be expected to make).



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