Use Caution When Entering Into Side Letters With Investors
Side letter agreements have long been used in private equity fund investments to supplement or interpret the terms of a partnership agreement and related documents. But as one notable decision from the Delaware Court of Chancery illustrates, the enforceability of these agreements cannot be take for granted.
ESG Capital Partners was formed to purchase shares of Facebook stock before the company’s initial public offering. The idea was that once Facebook completed its IPO, the partnership would distribute to investors either the Facebook shares themselves or their case value and then dissolve.
The fund entered into a partnership agreement with its investors, which granted equity stakes represented by units in the fund to the investors and stated that any distributions would be made to all partners in proportion to their respective “percentage interests.” But ESG Capital’s founder made preferential transfers to certain limited partners.
The favored LPs received one Facebook share for each of their units, while the disfavored LPs either did not receive any Facebook shares or received less than one share for each of their units, all without regard to their actual percentage interests. The latter group sued, claiming the favored LPs breached the partnership agreement and were unjustly enriched.
The Passport fund, one of the favored LPs, defended its preferential treatment by pointing to a side letter with the partnership that provided it with the right to a specific number of Facebook shares, among other things. The court rejected that argument on two grounds.
As an initial matter, the court said the side letter was rendered null by the integration clause in the subscription agreement. The integrated clause stated that the subscription agreement “constitutes the entire understanding among the parties with respect to the subject matter hereof, and supersedes any prior understanding and/or written or oral agreements among them.” Because the side letter had been entered into a day before the subscription agreement was signed, the court said the side letter was a “prior agreement” and therefore was superseded and nullified.
Even had the side letter remained in effect, the court said the preferential rights it granted were invalid because the partnership agreement didn’t provide the general partner with the authority to grant preferential rights that would “materially and adversely change the specifically enumerated rights” of other LPs. While Passport argued there was no detrimental effect, the court disagreed, saying that the side letter tried to shift Passport's share of any losses onto the other investors.
While the facts in the ESG Capital case are unusual, the court’s findings have broad application to private fund managers, investors and advisors. Here are a couple of important points to keep in mind when entering into a side letter:
Integration Clauses and Subscription Agreement Provisions. The fund’s governing documents should include an integration clause that states a side letter will part of the agreement. The subscription agreement should also make clear that investors have received a copy of the side letter and are making their investment in reliance on the terms of all such agreements.
LPA, PPM Provisions and Preferential Rights. The fund’s limited partnership agreement (LPA) must reference the existence of a side letter and authorize the general partner to enter into an agreement that supplements or alters the terms of the LPA. The fund’s private placement memorandum (PPM) should similarly indicate that the fund can enter side letters and that these agreements can be issued to some LPs but not others. Side letters should also not contain any terms that would harm other investors in the fund unless the granting of such rights is specifically provided for in the fund documents.