Vol 10 (2013) - Issue 2

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Cayman Islands ‘Side Letters’ Judicially Considered?

Introduction
Side letters are agreements between an investor and an open-ended investment fund, or, as they are more colloquially known, hedge fund, specifying terms which are separate and independent from, or additional to, those in the fund’s standard subscription agreement and offering memorandum. Side letters are frequently used by funds domiciled in the Cayman Islands as a way of attracting large or significant investors by offering such investors terms that may be more favourable than those granted to other investors of the fund. This article considers certain topical issues in connection with the enforceability of side letters, highlighted by recent case law in this jurisdiction.

The legal background
The basic principle under Cayman Islands law is that all investors in an exempted limited company holding shares or equity interests in the same class must be treated equally with respect to their class rights. Therefore, a side letter which confers certain rights on an investor may have the effect of creating a new class of shares in the fund in certain circumstances. However, a new class of shares will not ordinarily be deemed to be created if the side letter merely sets out the terms on which the directors agree to exercise their discretion in accordance with the terms of an existing class of shares. It is therefore important that the directors of the fund have the requisite authority in the fund’s offering memorandum and articles of association to be able to offer the preferred terms proposed under the side letter.
Directors must have regard to their fiduciary duties owed to the fund and consider whether it is in the best interest of all investors of the fund for the relevant class to enter into a side letter requiring directors to exercise discretion in a particular way for a prolonged period. Often it will be relatively clear that it is in the best interests of the fund to offer moderately preferential terms to specific large institutional investors who agree to provide seed money or anchor the fund and ensure that its investment objectives may be met.

Recent decisions involving Cayman Islands domiciled hedge funds
Two recent unreported decisions of the Grand Court of the Cayman Islands appear to be the first occasions on which the Court in this jurisdiction has specifically considered side letter terms. Whilst there are certain general observations which emerge, it is suggested that neither of these cases constitutes any sort of attempt by the Court to lay down universal rules or guidelines in terms of how side letters will be construed. Furthermore, each case is quite fact specific and in respect of the Matador case it may well be somewhat of a misnomer to accurately describe it as a side letter case at all.

Re Medley Opportunity Fund
A Cayman Islands exempted limited company – a sophisticated fund of fund professional investor – the 'investor' – invested in Medley Opportunity Fund – 'Medley' – itself a Cayman Islands exempted limited company, in 2007 through a nominee – the 'registered shareholder' (a company incorporated under the laws of Bermuda). The investor was therefore the beneficial owner of the relevant shares and legal title was held by the registered shareholder.