The impact of side letters on the constitutional provisions of Cayman Islands funds

In Re Lancelot Investors Fund, KBC Investments Ltd v Varga (Unreported, Civil Appeal 27 of 2013, 27 April 2015) the Cayman Islands Court of Appeal (CICA) has delivered its judgment on an appeal from the Grand Court concerning the impact of side letters on the constitutional arrangements of Cayman funds. The judgment highlights some interesting and novel issues to be borne in mind by investors when engaging with funds.

The two critical questions raised were:

  1. Whether a collateral agreement (a side letter) between the beneficial owner of shares in a hedge fund structured as a Cayman Islands exempted company, and the investment manager of that fund, was enforceable against the fund itself (raising questions of common law privity and standing); and
  2. Whether the side letter was enforceable when made between the investment manager and an individual institutional investor without the investment manager having either actual or ostensible authority to make it (raising issues of agency and contractual capacity).

Contrary to previous decisions which contested the compatibility of side letters as enforceable agreements vis-à-vis the main offering private placement memoranda and articles of association (see the Cayman Islands case of Medley Opportunity Fund Ltd v Fintan Master Fund Ltd & Nautical Nominees Ltd [2012] (1) CILR 360) and the decision of the English Court of Appeal in Barbudev v Eurocom Cable Management Bulgaria Eood & Ors [2012] EWCA Civ 548), Re Lancelot Investors Fund expressly recognises that the counterparty’s status as a mere beneficial owner does not in and of itself preclude the enforceability of a side letter operating in tandem with the fund’s core constitutional provisions. The judgment holds that where a beneficial owner seeks to rely on ancillary terms contained within the side letter, creating new rights or modifying any existing rights, it may be enforced notwithstanding that the custodian/nominee who is the registered shareholder of the beneficial owner’s shares is not party to it. The court did not however discuss stratified beneficial ownership and the effect this would have on the validity of a side letter, which could prove fertile ground for future litigation where there is a breakdown in investor relations coupled with stratified share ownership.

The CICA noted that a company, even when acting as an investment vehicle, is not required to take into account any custodian/nominee arrangements (and by extension any beneficial ownership rights) other than that of the registered shareholder, reflecting the wide-scale use of Non-Recognition of Trusts clauses incorporated in many of the Articles of Association regulating Cayman Islands funds (confirming Schultz v Reynolds [1992-93] CILR 59). The recent proliferation of side letter agreements has made matters even more complicated, both for funds and for any potential or existing investor. The risks are not only limited to the side letter arrangements being held void ab initio, but also extend to possible grounds for challenge from other shareholders if a side letter creates enhanced class rights detrimental to their own shareholdings. The scope for litigation in the event of a dispute is also widened, especially if there is a choice of law clause in the side letter conferring exclusive jurisdiction on an overseas, ie non-Cayman, court. As a matter of good practice, it is crucial that any side letter be drafted so as to be governed by the same law as the Memorandum and Articles of Association, and a thorough review of the actual terms of any custodian/nominee agreement be conducted to ensure that any agreement between the beneficial owner and the fund does not conflict with the original subscription agreement and the Articles of Association, which may render it ineffective. Any side letter should also satisfy the relevant requirements and formalities needed for any contractual agreement to be binding.

The judgment in Re Lancelot Investors Fund turned predominantly on application of agency and contract law principles and held that on its specific factual matrix, the investment manager in question did not have the requisite legal authority to create legal relations between the investor and the fund in order to effect an accelerated two-year redemption lock-up period. The CICA held that it was the company’s directors alone who had that authority and capacity, and the decision is a useful reminder to investors and their counsel to conduct appropriate due diligence on the counterparties’ rights, duties and powers to ensure that they have the necessary authority to enter into binding agreements (see also the decision in Lansdowne Limited & Silex Trust Company Limited v Matador Investments (In liquidation) & Ors [2012] (2) CILR 81) that a side-letter cannot conflict with the main contract (the Memorandum and Articles of Association of the company) and that it is the provisions of the Memorandum and Articles that effectively determine the validity and legal effect of any side-letter: see also Swiss-Asia Genghis Hedge Fund v Maoming Fund (FSD 12 of 2013).

A post script attached to the judgment expressly leaves open the issue whether a side letter capable of varying subsisting class rights could also be binding on the fund as a whole. A side letter purporting to vary or modify the rights attaching to a particular class without having first obtained shareholder authorisation as prescribed in the Articles of Association is likely to be held to be unenforceable for failure to observe mandatory requirements that cannot be opted out of or altered by private agreement (Russell v Northern Development Bank [1992] BCLC 431). The issue was not however decided and may again resurface.

The dispute arose before the Cayman Islands’ Contracts (Rights of Third Parties) Law 2014 (the Law) came into force. The Law adjusts the common law doctrine of privity of contract and confers rights on third parties where the contract purports to confer a benefit on them. The Law has a potentially interesting impact in the context of side letters and in custodian/nominee arrangements where both the fund and the custodian/nominee are parties. The decision in Re Lancelot Investors Fund offers useful guidance in the case of a triangulated relationship between the fund and/or its representative, the beneficial owner and the registered shareholder and it is expected that the advent of the Law will regularise these relationships by conferring statutory protection on third parties who may derive a benefit from the side letter but who may not be parties to it.

The Cayman Islands has rejected proposals to implement a stand-alone beneficial ownership register which could have offered a platform for beneficial owners to act on the legal rights vested in their custodians and nominees. Nevertheless this decision, together with the advent of the Law, strengthens their position.