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HEDGE
FUNDS AND SIDE LETTERS
Side letters are
a common phenomenon encountered by hedge fund managers today.
These letters are often used to secure better fees for key
investors and to give preferential or improved access to
information about underlying investments and liquidity. They also
provide what are commonly referred to as most favoured nation
provisions, meaning that if the fund offers better terms to
another investor, the early-stage investors will also be able to
take those new or better terms. It is increasingly common these
days for institutional investors to require a side letter prior to
making an investment in a hedge fund.
Because of this
trend, side letters have begun to attract the attention of
regulators in some developed jurisdictions. Hedge fund managers
and the boards of directors of hedge funds need to be mindful when
entering into side letters as to whether, for example, the
provisions in the side letters are consistent with the fund’s
constitutive documents (e.g. articles of association, partnership
agreement), the holders of interests in each class are being
treated fairly and whether the hedge fund managers or the boards
are breaching any of their duties to investors by entering into
these side letter arrangements?
Conflict with
Constitutive Documents
The first pitfall is that certain terms of side letters may be
contrary to or inconsistent with the constitutive documents of the
fund and may not be enforceable at all. Such terms should be
rejected by the manager or directors of the fund, or alternatively
an amendment of the fund documents (which in all likelihood would
require the consent of the other investors of the fund) should be
undertaken. Where managers or directors enter into side letters
containing such conflicting terms, in addition to such terms being
unenforceable, they open themselves up to potential actions for
breach of duties.
New Share
Class Required?
Even where side letter terms are permissible under the
constitutive documents, one needs to consider whether a separate
class of shares in the fund needs to be created. This follows from
the fundamental principle that holders of interests in each class
of a fund must be treated fairly. Hence, even if the fund has
authority to grant special terms to a specific investor under its
constitutive documents, one needs to consider whether such terms
operate unfairly against other investors – in which case, a
separate class of shares or units may be needed to justify why
such investors are being treated differently. In this regard, some
thought needs to be given to the fact that the directors of a fund
have a fiduciary duty to act in the best interests of the fund as
a whole, and not just a certain investor. Any side letter should
be examined to see if this principle is being offended.
Note that
investors in the fund must be treated “fairly” as opposed to
“equally”. It may sometimes be possible to treat investors
unequally but still be able to argue that it is fair. For example,
where a manager gives a rebate of management or performance fees
to a key investor because of the size of his investment, other
investors are not being treated equally in terms of the rate of
fees. However, it can be argued that such treatment is fair in
light of the size of this key investor’s investment in the fund.
It is also “fair” in the sense that these fees are payable to
the manager and not the fund, hence the fund and other investors
suffer no detriment as a result of this rebate. On the other hand,
certain terms in side letters may be unfair and operate to the
detriment of other investors, for example provisions where key
investors are given additional / better information or liquidity
than other investors plus in some cases, the ability to redeem out
of the fund on shortened notice. In these cases, a separate class
of shares or units should be set up for such investors so as not
to prejudice other investors in the same class.
Where the terms
of the side letter do not contravene the fund’s constitutive
documents and do not prejudice other investors in the fund (e.g. a
rebate of management or performance fees), it may not be necessary
to create a special share class to cater for these investors.
Practical
Considerations
Apart from the legal considerations above, there are practical
problems associated with side letters. One problem is keeping
track of the side letters and ensuring that the terms therein are
complied with, particularly if a fund has numerous side letters
with different terms and conditions.
The second
problem is managing conflicting side letters. This problem is
exacerbated where the side letters have a “most favoured
nation” (MFN) clause. A MFN clause is one where the manager or
the fund agrees with an investor that it will not enter into any
agreement with another party that gives such party rights or
benefits which are more favourable in any material respect that
those extended to the investor in question without first offering
the investor those preferential terms.
From a legal and
regulatory view point such clauses are not of particular concern.
However, from a practical view point, they can be problematic,
particularly if there are several side letters with such a term.
With such a term present, every time a new side letter is entered
into, one has to ensure that the MFN clause in previous side
letters has not been breached. This essentially requires all
concessions given in each side letter to be as good as the best!
If the manager is not actively monitoring these letters on an
on-going basis, the more side letters that are entered into, the
greater the likelihood that certain terms are going to conflict
and the manager or the fund is going to be in breach of its MFN
obligations.
Disclosure in
Offering Document
Even if all the above considerations have been dealt with, proper
disclosure of the concessions given must be made in the fund’s
offering document. There is a growing view in the industry that
offering documents ought to go further than they have in the past
and expressly disclose the existence (not the contents) of side
letters which are entered into by the fund. The disclosure should
include brief and general details of the type of concessions
granted.
This view has
been endorsed by recent developments in the United Kingdom. In a
recent discussion paper by the UK Financial Services Authority
(“FSA”), side letters were identified as an area of concern
where a market failure may be present, thus potentially requiring
regulatory intervention. The FSA stated their view that failure by
UK based hedge fund managers to disclose the existence of side
letters is potentially in breach of Principle 1 of the FSA’s
Principles of Business (i.e. “a firm must conduct its business
with integrity”). The end result has been that the FSA now
requires managers to ensure that all investors are informed when a
side letter containing “material terms” is granted (the
existence of these side letters, and not the nature of the
individual agreements, must be disclosed) and any conflicts that
may arise must be adequately managed.
While the above
applies only to UK based managers, it is probably a good
indication of the stand that regulators in other jurisdictions may
take in the future. In any event, disclosure in the terms
mentioned above is a matter of good practice for managers in other
jurisdictions.
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SFC
LICENSING FAQs
The Hong Kong
Securities and Futures Commission (SFC) has recently updated its
Licensing Related Frequently Asked Questions (FAQs) on its website
regarding Topic 2 - Competence and Topic 6 - Licensing Conditions.
In relation to
Competence, the updated FAQs focus on under what circumstances the
SFC would consider granting an exemption from the local regulatory
framework examination requirement to compliance officers and
existing responsible officers who will be responsible officers of
another type of regulated activity. The SFC has reiterated in the
FAQs that if a licensed individual is granted a conditional
exemption from the local regulatory framework examination
requirement, the additional CPT hours (in addition to the annual
requirement) that the individual is required to complete must be
in local regulatory knowledge in the relevant regulated activity.
If an existing licensed representative wishes to apply for
approval to become a responsible officer for the same regulated
activity and a conditional exemption from the local regulatory
framework examination requirement on the basis that he has an
extra 3 years of relevant industry experience, the SFC requires
the extra experience must be gained in Hong Kong and must be
recent and relevant in order to qualify.
The SFC also
emphasised that responsible officers are expected to occupy
full-time positions in order to properly discharge their
supervisory functions. The SFC is of the view that itinerant
professionals should not be responsible officers except under very
extraordinary circumstances.
As for the
Licensing Conditions, the updated FAQ states that if an existing
responsible officer resigns and takes up the role as a responsible
officer of the same regulated activity for another licensed
corporation, the SFC will assess the applicant's fitness and
properness, his competency and whether he will have sufficient
authority within the new principal. It may then impose various
licensing conditions on the applicant accordingly. The updated FAQ
lists some common licensing conditions for different regulated
activities that may be imposed on a responsible officer for the
transfer of accreditation application. For example, for Type 1
regulated activity, the licensee shall only perform a distribution
function for collective investment schemes. For Type 9 regulated
activity, the licensee:
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shall not
provide a service of managing a portfolio of futures contracts
for another person unless it is for hedging purpose only.
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shall only
provide services to professional investors (as defined in Part
1 of Schedule 1 to the Securities and Futures Ordinance).
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shall not
conduct business involving the discretionary management of any
collective investment scheme (as defined in the Securities and
Futures Ordinance).
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CHINA
RESTRICTS FOREIGN INVESTMENT IN REAL ESTATE MARKET
On 11 July 2006,
six Chinese ministries (Ministry of Construction, Ministry of
Commerce, National Development and Reform Commission, The
People’s Bank of China, State Administration for Industry and
Commerce and State Administration of Foreign Exchange) jointly
issued a circular “Opinions on Regulating the Entry into and the
Administration of Foreign Investment in the Real Estate Market”
Jianzhufang [2006] Circular No.171, which sets out administrative
measures aiming to tighten and regulate foreign investment in the
deemed overheated real estate market.
Circular 171
restricts foreign investors (both corporate entities and
individuals) from using offshore companies to purchase and to hold
real estate properties in China that are developed for any
purposes other than for self-use. Foreign investors investing in
Chinese real estate properties must now set up onshore real estate
investment companies, which may be wholly foreign owned or joint
ventures, with approvals from the relevant authorities. The
registered capital of such an onshore foreign invested company
must not be less than 50% of the total investment amount if such
amount exceeds US$10 million. The measures also prohibit an
onshore property development company from obtaining any financing
(either domestic or foreign) until its registered capital has been
fully paid up, it has obtained the relevant land use right
certificate or at least 35% of the total project development
amount has been funded.
There are tax
implications for bringing foreign property investments onshore.
Such an onshore company would be subject to a corporate tax rate
of 33%, whereas before for an offshore investor a 10% withholding
tax is payable. For those real estate investment trusts (REITs)
which invest in Chinese properties, this would impact on their
potential dividend distributions and there will be added costs in
setting up onshore property holding companies under the new
measures.
Separately, for
foreign companies with branches or representative offices in China
and foreign individuals, they may now only purchase real estate
properties (office premises or residential) for self-use. Foreign
individuals must prove that they will work or study for more than
one year, though this restriction does not apply to individuals
from Hong Kong, Macau and Taiwan.
On 1 September
2006, the State Administration of Foreign Exchange and the
Ministry of Construction jointly issued a circular “Notice on
Regulating the Administration of Foreign Exchange in Real Estate
Market” Huifa [2006] Circular 47, which sets out the
administrative measures, procedures and documentation requirements
relating to foreign exchange matters for the implementation of
Circular 171. As a result of Circular 171, more detailed
implementation rules are expected to be issued by the local city
and provincial governments.
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CONSULTATION
CONCLUSIONS ON THE GUIDELINES ON MARKETING MATERIALS FOR LISTED
STRUCTURED PRODUCTS
In September
2006, the Securities and Futures Commission (SFC) released the
Consultation Conclusions on the draft guidelines on marketing
materials for listed structured products (Guidelines). The
Guidelines, to be published under section 399 of the SFO, will
replace the current guidelines, which take the form of a letter to
warrant issuers. The Stock Exchange of Hong Kong will continue to
require compliance with the revised Guidelines as a condition to
the listing of structured products.
The Guidelines
have been amended to clarify the scope of their application. For
example, a paragraph has been added confirming that the Guidelines
apply to issuers of structured products as well as all entities
responsible for issuing marketing materials promoting listed
structured products. In addition, a question-and-answer section
was enclosed with the Consultation Conclusions. The Q&A
section helps to clarify that the Guidelines are not intended to
capture listing documents and prospectuses, or marketing materials
which are designed purely for professional investors.
Under the
previous version of the Guidelines, an issuer is required to
disclose to the SFC any commercial or business relationship it has
with a person who appears on any audio or audiovisual programme,
seminar or lecture, or writes to promote particular listed
structured products, where their relationship with the person is
such that his objectivity or independence may be called into
question. In light of the practical difficulties in implementation
and enforcement, this requirement has been removed from the
revised Guidelines.
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PROFITS
TAX EXEMPTION FOR OFFSHORE FUNDS - PRACTICE NOTE ISSUED
Following the
amendments to the Inland Revenue Ordinance earlier this year, the
Inland Revenue Department (IRD) issued its Departmental
Interpretation and Practice Notes (DIPN) No. 43 on 6 September
2006. A Deacons Client Alert on DIPN 43 is available for download
at
http://www.deacons.com.hk/eng/knowledge/knowledge_272.htm.
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DEACONS
WINS 3RD HONG KONG LAW FIRM OF THE YEAR AWARD FOR 2006
On Friday, 22
September 2006, Deacons was named the Asian Legal Business (ALB)
Hong Kong Law Firm of the Year at an awards ceremony at the Conrad
Hotel. Our Financial Services Practice Group also won, for the
third consecutive year, the Investment Funds Law Firm of the Year.
Winning the ALB
Hong Kong Law Firm of the Year makes it a hat trick for the firm
in 2006. In March, Deacons was named IFLR Hong Kong Law Firm of
the Year and Asian Legal Business China Hong Kong Law Firm of the
Year.
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