U.K. Hedge Fund Group Provides Guidance on Side Letter Disclosures
Beginning this week, U.K.-based hedge fund managers will be providing their fund investors with new disclosures about side letter arrangements.
Back in March 2006, the U.K. Financial Services Authority, in its "Feedback Statement 06/2," stated that it would "expect acceptable market practice to be for managers to ensure that all investors are informed when a side letter is granted and any conflicts that may arise are adequately managed." However, the FSA offered little guidance on what, when, or how such side letter disclosures should be made.
Enter the U.K. Alternative Investment Management Association, a trade group representing the U.K. hedge fund industry. Following a series of "constructive meetings" with the FSA, the AIMA issued two guidance statements that put some meat on the bones of the FSA disclosure requirement:
A September 27 "Industry Guidance Note on Side Letters"; and
An October 24 "Supplement No. 1."
The two guidance statements are simply that: guidance. They aren’t mandatory, nor do they represent official FSA policy. However, according to the AIMA, the FSA has reviewed the statements and "confirmed that it will take it into account when exercising its regulatory functions."
Why should U.S.-based managers care about what’s going on in the U.K.? Technically speaking, the FSA’s disclosure requirement (and, by extension, the AIMA guidance) applies only to FSA-regulated advisers. In recent months, however, the SEC has taken a strong interest in side letter agreements. Examiners have been reviewing them, looking at the conflicts of interest they may present and the extent to which they have been disclosed to other investors. To that end, the AIMA statements may provide helpful guidance for U.S. advisers wondering whether and how to disclose the existence of side letters.
In addition, Debevoise & Plimpton partner Ken Berman pointed to the increased consultation and cooperation between the staffs of the FSA and the SEC. "We know that the SEC and the FSA sometimes consult with each other on how to deal with issues of mutual interest," said Berman. "To the extent that this guidance may in some sense reflect what is satisfactory to the FSA, then it is of interest to [hedge fund] sponsors in the U.S."
Here’s a quick overview of the AIMA guidance:
Who has to make the disclosure? The FSA’s disclosure requirement applies only to FSA-regulated hedge fund managers. However, there are a number of exceptions to that general rule. For example, U.K. fund of hedge fund managers are not subject to the requirement to disclose side letters. (For more details about the various exceptions, see AIMA’s October 24 Supplement).
What has to be disclosed? Firms must disclose the existence of side letters that contain "material terms," and the nature of such terms. Side letters that contain no material terms do not need to be disclosed.
What is a material term? The guidance defines a "material term" as "[a]ny term the effect of which might reasonably be expected to provide an investor with more favorable treatment than other holders of the same class of share or interest, which enhances that investor’s ability either (i) to redeem shares or interests of that class or (ii) to make a determination as to whether to redeem shares or interests of that class, and which in either case might, therefore, reasonably be expected to put other holders of shares or interests of that class who are in the same position at a material disadvantage in connection with the exercise of their redemption rights."
Examples of material terms include:
an agreement to accept a shorter notice period for redemptions and other preferential redemption rights;
key man provisions;
redemption gate waivers; and
portfolio transparency rights.
Fee rebates and most favored nation clauses would not be considered material.
Interestingly, a side letter term that on its face is material may not, in practice, be material if the fund actually provides the same favorable treatment to other like investors. "For example," said the guidance, "where a side letter contains a term granting a shorter notice period for redemptions, but the fund undertakes to accept an identical notice period in respect of all other investors in the same share class, the term would be ‘cured’ of its materiality."
How must the disclosures be made? The guidance suggests that firms should give only a brief description of the side letter agreements: "[W]e have entered into side letters with investors, which contain material terms [that] (a) grant preferential redemption rights; (b) contain a ‘key man’ provision; (c) etc."
The guidance states that firms are not expected to disclose the number of side letters, their dates, or the names of the parties to the agreements. If side letters with material terms have been entered into with investors who, individually or in the aggregate, own a significant portion of the fund ("i.e., in excess of 10 percent"), the guidance suggests that firms "consider highlighting this fact."
When must the disclosures be made? By October 31, firms are expected to have made initial disclosure of all material terms contained in side letters entered into prior to that date. However, the FSA has taken the position that this initial disclosure requirement will be satisfied where firms make the disclosure in reports or newsletters sent out in early November 2006.
On an ongoing basis, firms will be expected to keep the disclosure "reasonably up-to-date" and to make "reasonably timely" disclosure where a new side letter containing a material term of a category not included in the firm’s previous disclosures is entered into.
Who must receive the disclosures? Existing and prospective investors. Disclosure need not be made to investors who have previously redeemed their shares or interests.
How often must the disclosures be made? "Firms are at liberty to select the method by which they make disclosure," said the guidance. "It is anticipated that many firms will choose to do so in their monthly, quarterly, or half-yearly investor reports/newsletters."
What does the Managed Funds Association have to say about side letters? The MFA’s 2005 Sound Practices for Hedge Fund Managers contains only a passing reference to side letters: "Appropriate disclosures should be made about any agreement between a Hedge Fund and Hedge Fund investors that varies the material terms of the arrangements with certain Hedge Fund investors, for example through use of ‘side letters,’ unless the ability to vary such terms is disclosed to Hedge Fund investors in connection with their investment in the Hedge Fund."