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Side Letters and the Caymans: The Latest

dragonA powerful trend in the courts of the Cayman Islands in recent litigation (since 2012) has run against the efficacy of side letters. The best general statement is that those courts have become suspicious of side letters, and that especially if an investor is in the position of having to rely on such a letter in the course of the winding up of a hedge fund, it is going to have to have all of its proverbial ducks in a row.

I’ve written of this trend here before. See here and here. But the matter requires an update because the Cayman Islands Court of Appeals has weighed the subject, In the Matter of Lancelot Fund Inc.  

Not to be confused with the Knight…

Lancelot Investors Fund issued redeemable shares to KBC Investments Ltd. The fund’s confidential information memorand… (CIM) included a lengthy lock-up period. But immediately the plot thickens; KBC had entered into a side letter with the investment manager of Lancelot shortening that period. Note that this agreement was with the IM, Lancelot Investment Management LLC, not with the fund as an entity, Lancelot Investors Fund, viaits board. The IM’s principal, Gregory Bell, acted on behalf of the IM, and according to at least one possible view of the case on behalf of the fund itself, in striking this deal.

In October 2007 Fortis Bank, the custodian of the shares issued to KBC, submitted a redemption request for $29 million in accordance with the terms of the letter. The administrator, Swiss Financial Services (Bahamas) Ltd., made a partial payment, redeeming only those shares that were outside the standard CIM lock-up period.

Still later, at a time when the remaining shares of the redemption request were still unredeemed, this Lancelot’s adventures came to a bad end, defeated by the dragon of insolvency; Lancelot suspended share redemptions and became the subject of an order for winding up.

Fortis Bank submitted a proof of debt for the balance of the attempted October 2007 redemption. The official liquidator rejected the POD, in part because the balance was still subject to the standard CIM lock-up period.

To the Grand Court

KBC (not Fortis) appealed to the Grand Court, which held against the investor on a number of grounds. It said that the remaining shares were still vested in the Custodian, so the Investor, though the beneficial owner of the shares, had no standing to appeal the rejection of the POD. It also indicated the Investor would have lost the claim even if the remaining shares had been transferred to it in the meantime, because the side letter was not binding on the fund, not having been executed with the fund’s authority. Going further, the Grand Court said that even if the side letter had been duly authorized, it still would have amounted to an invalid variation of class rights.

The Investor appealed this decision to the CICA, and it is that court’s decision that represents the latest (April 27, 2015) noteworthy development in this area.

Cayman Islands Court of Appeals

The CICA’s decision has the same bottom line as the Grand Court’s: the side letter was held not to be applicable, so the Liquidator wins the dispute at issue.

The decision, though, was quite different from the multiple-pathways decision of the court below. The CICA didn’t rely on the Privity issue, that is, on the distinction between the Investor and its Custodian, at all. Although it suggests that the relationship between a beneficial shareholder and the registered shareholder needs to be reviewed case by case in such controversies, on the facts of this case it finds that the Investor was entitled to maintain an appeal subject to the joinder of the assignor (Fortis).

The CICA did, though, embrace one of the several arguments against this claim that the Grand Court had urged, and the one was enough. The appeals court found that the investment manager did not have the authority to enter into the side letter. “In these circumstances it does not follow from the fact that Mr. Bell was let loose on the investors … that he or LIM had ostensible authority to bind the Company [Fund] to a variation of the redemption terms.”

Nor did CICA accept the argument that a transaction acknowledgement from the Administrator had effectively ratified the Side Letter, because: “[There] was no evidence that [Swiss Financial Services] knew of the side agreement at the date of acknowledgement, and without such knowledge there can be no ratification.”

Who Speaks for the Board?

The opinion says in essence that the decision to modify the lock-up periods for a particular investor in a side letter is a matter for the board of directors, and that the outside world doesn’t regard an IM as transmitting the decisions of the board, but only considers the IM as one of a number of people who deal with the fund’s affairs. The fact that in this case the IM had “been let loose on the investors” did not enhance his authority in the eyes of the court.

So the takeaway from this decision is (a) that the trend toward more hostile treatment of side letters in the courts of the Caymans continues, and (b) among the other precautions that an investor should take if he/she/it is going to seek a side letter, is ensuring itself that it is dealing directly with the Fund, or those with explicit authority to act on the fund’s behalf.