Side Letters: Guidelines from Cayman Court on Who Should be the Parties to Them
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An analysis of a fund's side letters and guidelines to the parties that should be involved. The Grand Court of the Cayman Islands recently ruled on the enforceability of side letters in the case of Medley Opportunity Fund Ltd. v. Fintan Master Fund Ltd & Nautical Nominees Ltd (21 June 2012) and in so doing has emphasized a number of points to bear in mind when entering into side letters.
Case Background
The background to the case was that Medley Opportunity Fund Ltd., a hedge fund established in the Cayman Islands (the "Fund") had been receiving a large volume of redemption requests during 2008 and 2009 at the height of the global financial crisis and sought to stay in business by developing restructuring arrangements with its investors. The restructuring arrangements involved offering investors the ability to choose between two options for restructuring the Fund. Option A involved investors redeeming their shares, and subscribing for a new class of shares, which would make new investments, but with modified redemption rights and fee arrangements.
Option B involved investors staying in the relevant share class in consideration for rescinding any earlier redemption requests and having redemption rights limited to quarterly pro rata distributions during the course of an orderly run-off of the Fund’s assets by way of partial redemption of shares as cash was generated from existing assets. Investors who chose not to take up Option A or Option B and who insisted on redeeming in full were to be paid in-kind in accordance with the Fund's Articles of Association.
Fintan Master Fund Ltd (“Fintan”) was an investor in the Fund but it held its shares through its nominee, Nautical Nominees Limited (“Nautical”). At the time of investing in the Fund in 2007, Fintan had entered into a side letter (the “Side Letter”) with the Fund and its investment manager which entitled Fintan to be paid all redemptions in cash, and not in-kind. Nautical, being the shareholder of record in the Fund was not a party to the Side Letter.
In 2008 and 2009 when the restructuring arrangements were put into place by the Fund with its shareholders in accordance with its Articles of Association, Nautical, being the shareholder of record, chose Option B.
In 2011, Fintan became unhappy with the pace of the orderly run-off and Nautical, apparently at Fintan's direction, submitted a redemption request, arguing that the restructuring arrangements had not validly modified their redemption rights, including Fintan’s right under the Side Letter to be paid in cash. The Fund disagreed with this argument and sought declarations from the Cayman Islands Court as to the true position.
The Judge held that the Side Letter was not binding, because Nautical, as the shareholder of record, was not a party to it.
Analysis
The Judge rejected the argument that the Court should treat Nautical, the nominee and Fintan, the beneficial shareholder as being "one and the same" for this purpose. Instead, the Judge pointed out that Nautical and Fintan were “both entirely different legal entities incorporated in two different jurisdictions.”
This view of the Court re-emphasizes the general principle of privity of contract under Cayman Islands law (i.e. the principle that only the parties to a contract can enforce it in Court). There are currently proposals before the Cayman Islands legislature for the privity of contract principle to be reformed. The Contracts (Rights of Third Parties) Bill, 2012, if it becomes law, will enable parties to contracts to extend the right to rely upon and sue under that contract to non-parties.
The second thing to say about the case is that it emphasizes that the Cayman Courts will always regard custodians or nominees as the shareholder for legal purposes, and therefore ideally, they ought to be parties to all agreements concerning the investment, including side letters. Notwithstanding this however the case should be viewed on its own facts. For example, the Side Letter appeared to have focused solely on Fintan’s rights as underlying beneficiary without mentioning its nominee. It stated (words underlined for emphasis): “All distributions from the Fund to Fintan upon redemption, liquidation or otherwise shall be paid in cash.” Accordingly the scope of the Side Letter was not drafted sufficiently wide to cover redemptions by Fintan’s nominees, custodians and/or affiliates. In all likelihood, if the Side Letter had been drafted in such a way, Fintan might have been able to enforce the terms of the Side Letter against the Fund in favour of its nominee, Nautical, even though Nautical was not a party to the Side Letter.
The other point to note about the case is that the Court wanted to ensure that shareholders were treated equitably and fairly in respect of the restructuring arrangements. The Court was not inclined to allow one shareholder, Nautical, to steal a march on the other shareholders by relying on the Side Letter which its ultimately beneficiary (Fintan) had entered into, in order to get out of the restructuring arrangements Nautical had agreed to. The view being taken that Nautical had signed up to the restructuring arrangements and was therefore bound by them. The Judge stated it as follows:
“If commercial business is to be conducted sensibly and with the required degree of certainty, I find that, by entering into these agreements,[Nautical] bound the ultimate beneficiary [Fintan] to remain in the Plaintiff Fund and to accept a pro-rated distribution of excess cash on a quarterly basis, which ensured an orderly return of monies to all members. It would cause great confusion and make no sensible commercial business sense if members such as [Nautical] were allowed to enter into these agreements only to then try and redeem and enforce a redemption right by a different route.”
ABOUT THE AUTHOR: Gary Smith, Senior Associate
Gary's practice includes establishment of investment funds, fund re-organisations, fund related deals, and ongoing advice in relation to fund structures, corporate finance, mergers and acquisitions, disposals and joint ventures. Gary was admitted as an attorney-at-law in the Cayman Islands in 2009 and was admitted as a solicitor in England and Wales (but does not practice as an English solicitor) in 2000.
Copyright Stuarts Walker Hersant, Attorneys at Law
More information about Stuarts Walker Hersant, Attorneys at Law
Disclaimer: While every effort has been made to ensure the accuracy of this publication, it is not intended to provide legal advice as individual situations will differ and should be discussed with an expert and/or lawyer. For specific technical or legal advice on the information provided and related topics, please contact the author.
The background to the case was that Medley Opportunity Fund Ltd., a hedge fund established in the Cayman Islands (the "Fund") had been receiving a large volume of redemption requests during 2008 and 2009 at the height of the global financial crisis and sought to stay in business by developing restructuring arrangements with its investors. The restructuring arrangements involved offering investors the ability to choose between two options for restructuring the Fund. Option A involved investors redeeming their shares, and subscribing for a new class of shares, which would make new investments, but with modified redemption rights and fee arrangements.
Option B involved investors staying in the relevant share class in consideration for rescinding any earlier redemption requests and having redemption rights limited to quarterly pro rata distributions during the course of an orderly run-off of the Fund’s assets by way of partial redemption of shares as cash was generated from existing assets. Investors who chose not to take up Option A or Option B and who insisted on redeeming in full were to be paid in-kind in accordance with the Fund's Articles of Association.
Fintan Master Fund Ltd (“Fintan”) was an investor in the Fund but it held its shares through its nominee, Nautical Nominees Limited (“Nautical”). At the time of investing in the Fund in 2007, Fintan had entered into a side letter (the “Side Letter”) with the Fund and its investment manager which entitled Fintan to be paid all redemptions in cash, and not in-kind. Nautical, being the shareholder of record in the Fund was not a party to the Side Letter.
In 2008 and 2009 when the restructuring arrangements were put into place by the Fund with its shareholders in accordance with its Articles of Association, Nautical, being the shareholder of record, chose Option B.
In 2011, Fintan became unhappy with the pace of the orderly run-off and Nautical, apparently at Fintan's direction, submitted a redemption request, arguing that the restructuring arrangements had not validly modified their redemption rights, including Fintan’s right under the Side Letter to be paid in cash. The Fund disagreed with this argument and sought declarations from the Cayman Islands Court as to the true position.
The Judge held that the Side Letter was not binding, because Nautical, as the shareholder of record, was not a party to it.
Analysis
The Judge rejected the argument that the Court should treat Nautical, the nominee and Fintan, the beneficial shareholder as being "one and the same" for this purpose. Instead, the Judge pointed out that Nautical and Fintan were “both entirely different legal entities incorporated in two different jurisdictions.”
This view of the Court re-emphasizes the general principle of privity of contract under Cayman Islands law (i.e. the principle that only the parties to a contract can enforce it in Court). There are currently proposals before the Cayman Islands legislature for the privity of contract principle to be reformed. The Contracts (Rights of Third Parties) Bill, 2012, if it becomes law, will enable parties to contracts to extend the right to rely upon and sue under that contract to non-parties.
The second thing to say about the case is that it emphasizes that the Cayman Courts will always regard custodians or nominees as the shareholder for legal purposes, and therefore ideally, they ought to be parties to all agreements concerning the investment, including side letters. Notwithstanding this however the case should be viewed on its own facts. For example, the Side Letter appeared to have focused solely on Fintan’s rights as underlying beneficiary without mentioning its nominee. It stated (words underlined for emphasis): “All distributions from the Fund to Fintan upon redemption, liquidation or otherwise shall be paid in cash.” Accordingly the scope of the Side Letter was not drafted sufficiently wide to cover redemptions by Fintan’s nominees, custodians and/or affiliates. In all likelihood, if the Side Letter had been drafted in such a way, Fintan might have been able to enforce the terms of the Side Letter against the Fund in favour of its nominee, Nautical, even though Nautical was not a party to the Side Letter.
The other point to note about the case is that the Court wanted to ensure that shareholders were treated equitably and fairly in respect of the restructuring arrangements. The Court was not inclined to allow one shareholder, Nautical, to steal a march on the other shareholders by relying on the Side Letter which its ultimately beneficiary (Fintan) had entered into, in order to get out of the restructuring arrangements Nautical had agreed to. The view being taken that Nautical had signed up to the restructuring arrangements and was therefore bound by them. The Judge stated it as follows:
“If commercial business is to be conducted sensibly and with the required degree of certainty, I find that, by entering into these agreements,[Nautical] bound the ultimate beneficiary [Fintan] to remain in the Plaintiff Fund and to accept a pro-rated distribution of excess cash on a quarterly basis, which ensured an orderly return of monies to all members. It would cause great confusion and make no sensible commercial business sense if members such as [Nautical] were allowed to enter into these agreements only to then try and redeem and enforce a redemption right by a different route.”
ABOUT THE AUTHOR: Gary Smith, Senior Associate
Gary's practice includes establishment of investment funds, fund re-organisations, fund related deals, and ongoing advice in relation to fund structures, corporate finance, mergers and acquisitions, disposals and joint ventures. Gary was admitted as an attorney-at-law in the Cayman Islands in 2009 and was admitted as a solicitor in England and Wales (but does not practice as an English solicitor) in 2000.
Copyright Stuarts Walker Hersant, Attorneys at Law
More information about Stuarts Walker Hersant, Attorneys at Law
View all articles published by Stuarts Walker Hersant, Attorneys at Law
Disclaimer: While every effort has been made to ensure the accuracy of this publication, it is not intended to provide legal advice as individual situations will differ and should be discussed with an expert and/or lawyer. For specific technical or legal advice on the information provided and related topics, please contact the author.
