In Re Lancelot Investors Fund, KBC Investments Ltd v Varga (Unreported, Civil Appeal 27/2013, April 27 2015) the Cayman Islands Court of Appeal has ruled on an appeal from the Grand Court concerning the impact of side letters on the constitutional arrangements of Cayman funds. The judgment highlights key issues that are relevant to investors engaging with such funds.
The two critical questions raised in Re Lancelot Investors Fund were:
- whether a side letter (collateral agreement) 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
- whether a side letter was enforceable when made between the investment manager of a fund and an individual institutional investor in that fund, where the investment manager had no 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 in relation to the main offering (ie, the private placement memoranda and articles of association),(1) Re Lancelot Investors Fund expressly recognised that the counterparty's status as a mere beneficial owner does not preclude the enforceability of a side letter operating in tandem with the fund's core provisions.
The court held that where a beneficial owner seeks to rely on ancillary terms contained within the side letter, creating new rights or modifying existing rights, the side letter may be enforced notwithstanding that the custodian or nominee which is the registered shareholder of the beneficial owner's shares is not party to it. However, the court did not discuss stratified beneficial ownership and the effect that this would have on the validity of a side letter – which could prove fertile ground for future litigation.
The court noted that a company, even when acting as an investment vehicle, is not required to take into account any custodian/nominee arrangements (including beneficial ownership rights) other than those of the registered shareholder.(2) This decision reflects the widespread use of non-recognition of trusts clauses in many of the articles of association regulating Cayman Islands funds.
The decision turned predominantly on the application of agency and contract law principles and held that on the facts, the investment manager in question did not have the 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 court held that only the company's directors had that authority and capacity.
The recent proliferation of side letter agreements has further complicated matters for both funds and potential and existing investors. Aside from the risk of side letter arrangements being held void from the beginning, grounds for challenge from other shareholders may exist if a side letter creates enhanced class rights that are detrimental to their own shareholdings. The scope for litigation in the event of a dispute is also widened by the existence of a side letter – especially if it contains a choice of law clause conferring exclusive jurisdiction on a non-Cayman court.
As a matter of good practice, the following conditions are crucial for the drafting of side letters:
- A side letter should:
- satisfy the relevant requirements and formalities needed for any contractual agreement to be binding; and
- be drafted so as to be governed by the same law as the memorandum and articles of association.
- A thorough review of the actual terms of a custodian/nominee agreement should be conducted in order to ensure that an agreement between the beneficial owner and the fund does not conflict with the original subscription agreement and the articles of association (such that would render it ineffective).
Further, the decision in Re Lancelot Investors Fund is a useful reminder to investors and their counsel to conduct appropriate due diligence on the counterparties' rights, duties and powers in order to ensure that:
- they have the necessary authority to enter into binding agreements;(3)
- a side letter cannot conflict with the main contract (the memorandum and articles of association of the company); and
- the memorandum and the articles effectively determine the validity and legal effect of any side letter.(4)
A postscript attached to the judgment expressly leaves open the issue of 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 unenforceable due to its failure to observe mandatory requirements that cannot be opted out of or altered by private agreement.(5) However, the issue was not decided and may resurface.
The dispute in Re Lancelot Investors Fund arose before the Contracts (Rights of Third Parties) Law 2014 came into force. This 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 (or its representative), the beneficial owner and the registered shareholder. The advent of the Contracts (Rights of Third Parties) Law is expected to regularise these relationships by conferring statutory protection on third parties who may benefit from the side letter but may not be parties to it.
The Cayman Islands has rejected proposals to implement a standalone 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 Contracts (Rights of Third Parties) Law, strengthens their position.
For further information on this topic please contact David Butler at Harney Westwood & Riegels' Grand Cayman office by telephone (+1 284 494 2233) or email (firstname.lastname@example.org). Alternatively contact Sean Scott at Harney Westwood & Riegels' London office by telephone (+44 207 842 6085) or email (email@example.com). The Harney Westwood & Riegels website can be accessed at www.harneys.com.
(1) See the Cayman Islands case of Medley Opportunity Fund Ltd v Fintan Master Fund Ltd (2012 (1) CILR 360) and the English Court of Appeal decision in Barbudev v Eurocom Cable Management Bulgaria Eood (2012 EWCA Civ 548).
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