SEC Guidance on Side Letters
Date: July 12, 2006
Side letters are sometimes used by hedge funds, and at times in private equity investment contexts, to grant preferred investors terms that are different, and in many cases more favorable, than those described in the hedge fund's or other investment vehicle's standard offering documents. The absence of public SEC pronouncements in the past concerning the use of side letters has led to some confusion regarding the SEC's position.
The most recent guidance regarding the SEC's position with respect to side letters has been provided by Susan Ferris Wyderko, the former Acting Director of the SEC's Division of Investment Management, in her May 16, 2006 testimony before the Subcommittee on Securities and Investment of the United States Senate Committee on Banking, Housing, and Urban Affairs. Ms. Wyderko, in expressing the concerns of the SEC Staff regarding side letters, highlighted several issues as to which the Staff had some concern, and described other issues as to which the Staff had lesser concern.
Issues that Create Greater Regulatory Concern for the SEC
Liquidity preferences can potentially create conflicts among investors, and are therefore of some concern to the SEC Staff. Hedge fund managers and others in similar situations should be sure to confirm that the rights they confer via side letters regarding liquidity preferences create a fair environment for all investors to enter and exit without undue bias or difficulty.
Also, preferential access to portfolio or performance information may become troublesome, particularly in cases where sophisticated investors that have significant market presence may use such information to put the fund, and its other investors, at risk.
Side letters should always conform not only to applicable law and the basic organizational documents of the hedge fund or other investment vehicle, but should also be drafted so as not to put the entity's exempt status in jeopardy. Further, it was suggested by Ms. Wyderko that the basic organizational documents of a hedge fund or other investment vehicle be drafted in as flexible a manner as practicable so that future side letter arrangements do not extend rights not disclosed to the fund's other investors as permissible or possible. In addition, disclosure documents should be expansive enough to convey to all investors the effect to them of side letter understandings.
Issues of Lesser Regulatory Concern
Issues of lesser regulatory concern include management fees and performance compensation reductions, "most favored nation" clauses, and the ability to make additional investments. However, while of lesser concern, this does not indicate that a decrease in disclosure is warranted. To the contrary, the Staff encourages ample and full disclosure as a means of addressing possible side letter inequities.
Ms. Wyderko's testimony did not specify whether managers should disclose all detailed aspects of each side letter issued. This may not be necessary, but disclosure should be sufficiently broad and should at least include the outline of terms that managers may include in side letters.
Conclusions and Suggestions for SEC Compliance
Generally, hedge fund managers and other investment vehicles using side letter arrangements should (1) carefully consider the appropriateness of all preferential rights that they confer, (2) follow up with sufficient disclosure, (3) be in a position to provide the SEC with all outstanding side letters and relevant terms and (4) be sensitive to their fiduciary duties as managers to all investors in the hedge fund or investment vehicle.