Hong Kong: Hedge Funds and Side Letters
Side letters are a common phenomenon encountered by hedge fund managers today. These letters are often used to secure better fees for key investors and to give preferential or improved access to information about underlying investments and liquidity. They also provide what are commonly referred to as most favoured nation provisions, meaning that if the fund offers better terms to another investor, the early-stage investors will also be able to take those new or better terms. It is increasingly common these days for institutional investors to require a side letter prior to making an investment in a hedge fund. Because of this trend, side letters have begun to attract the attention of regulators in some developed jurisdictions. Hedge fund managers and the boards of directors of hedge funds need to be mindful when entering into side letters as to whether, for example, the provisions in the side letters are consistent with the fund’s constitutive documents (e.g. articles of association, partnership agreement), the holders of interests in each class are being treated fairly and whether the hedge fund managers or the boards are breaching any of their duties to investors by entering into these side letter arrangements? Conflict with Constitutive Documents The first pitfall is that certain terms of side letters may be contrary to or inconsistent with the constitutive documents of the fund and may not be enforceable at all. Such terms should be rejected by the manager or directors of the fund, or alternatively an amendment of the fund documents (which in all likelihood would require the consent of the other investors of the fund) should be undertaken. Where managers or directors enter into side letters containing such conflicting terms, in addition to such terms being unenforceable, they open themselves up to potential actions for breach of duties. New Share Class Required? Even where side letter terms are permissible under the constitutive documents, one needs to consider whether a separate class of shares in the fund needs to be created. This follows from the fundamental principle that holders of interests in each class of a fund must be treated fairly. Hence, even if the fund has authority to grant special terms to a specific investor under its constitutive documents, one needs to consider whether such terms operate unfairly against other investors – in which case, a separate class of shares or units may be needed to justify why such investors are being treated differently. In this regard, some thought needs to be given to the fact that the directors of a fund have a fiduciary duty to act in the best interests of the fund as a whole, and not just a certain investor. Any side letter should be examined to see if this principle is being offended. Note that investors in the fund must be treated “fairly” as opposed to “equally”. It may sometimes be possible to treat investors unequally but still be able to argue that it is fair. For example, where a manager gives a rebate of management or performance fees to a key investor because of the size of his investment, other investors are not being treated equally in terms of the rate of fees. However, it can be argued that such treatment is fair in light of the size of this key investor’s investment in the fund. It is also “fair” in the sense that these fees are payable to the manager and not the fund, hence the fund and other investors suffer no detriment as a result of this rebate. On the other hand, certain terms in side letters may be unfair and operate to the detriment of other investors, for example provisions where key investors are given additional / better information or liquidity than other investors plus in some cases, the ability to redeem out of the fund on shortened notice. In these cases, a separate class of shares or units should be set up for such investors so as not to prejudice other investors in the same class. Where the terms of the side letter do not contravene the fund’s constitutive documents and do not prejudice other investors in the fund (e.g. a rebate of management or performance fees), it may not be necessary to create a special share class to cater for these investors. Practical Considerations Apart from the legal considerations above, there are practical problems associated with side letters. One problem is keeping track of the side letters and ensuring that the terms therein are complied with, particularly if a fund has numerous side letters with different terms and conditions. The second problem is managing conflicting side letters. This problem is exacerbated where the side letters have a “most favoured nation” (MFN) clause. A MFN clause is one where the manager or the fund agrees with an investor that it will not enter into any agreement with another party that gives such party rights or benefits which are more favourable in any material respect that those extended to the investor in question without first offering the investor those preferential terms. From a legal and regulatory view point such clauses are not of particular concern. However, from a practical view point, they can be problematic, particularly if there are several side letters with such a term. With such a term present, every time a new side letter is entered into, one has to ensure that the MFN clause in previous side letters has not been breached. This essentially requires all concessions given in each side letter to be as good as the best! If the manager is not actively monitoring these letters on an on-going basis, the more side letters that are entered into, the greater the likelihood that certain terms are going to conflict and the manager or the fund is going to be in breach of its MFN obligations. Disclosure in Offering Document Even if all the above considerations have been dealt with, proper disclosure of the concessions given must be made in the fund’s offering document. There is a growing view in the industry that offering documents ought to go further than they have in the past and expressly disclose the existence (not the contents) of side letters which are entered into by the fund. The disclosure should include brief and general details of the type of concessions granted. This view has been endorsed by recent developments in the United Kingdom. In a recent discussion paper by the UK Financial Services Authority (“FSA”), side letters were identified as an area of concern where a market failure may be present, thus potentially requiring regulatory intervention. The FSA stated their view that failure by UK based hedge fund managers to disclose the existence of side letters is potentially in breach of Principle 1 of the FSA’s Principles of Business (i.e. “a firm must conduct its business with integrity”). The end result has been that the FSA now requires managers to ensure that all investors are informed when a side letter containing “material terms” is granted (the existence of these side letters, and not the nature of the individual agreements, must be disclosed) and any conflicts that may arise must be adequately managed. While the above applies only to UK based managers, it is probably a good indication of the stand that regulators in other jurisdictions may take in the future. In any event, disclosure in the terms mentioned above is a matter of good practice for managers in other jurisdictions.