Two recent decisions by the Grand Court of the Caymans concern the scope and enforceability of side letters. Although one has to be careful about sweeping conclusions (each decision was limited to its specific facts), the hedge fund management won both lawsuits, in each case at least in part on privity-of-contract grounds.

The takeaway is that if you are invested in a Caymans domiciled fund, and you want to negotiate an enforceable side letter, you ought to be very careful about its drafting. It may someday be read and construed with a jaundiced eye. I’ll detail the first of these decisions below, and the second in a follow-up.

The Facts

The Hon. Mr. Justice Charles Quin handed down the first of these decisions on June 21.

In Justice Quin’s words, “the chronology, and the facts, are not in dispute.”

On August 24, 2006 Medley Opportunity Fund (‘the Fund”) was incorporated in the Caymans. Its investment manager was Medley Partners LLC, of Delaware. There were Class A and Class B shares in the MOF, redeemable (according to a May 2007 updating of the Confidential Explanatory Memorandum) upon 180 days prior written notice, “subject to staggered redemption fees and a possible gate.”

On August 30, 2007, the first-named defendant, (Fintan Master Fund) entered into a side agreement/letter with the plaintiff, and its manager. In pertinent part, this side letter reads: “All distributions from the Fund to Fintan upon redemption, liquidation or otherwise shall be paid in cash. If it is not possible for a distribution to be paid immediately in cash, securities equal in value to the amount that will otherwise be distributed will be deposited by the Fund into a separate liquidation account on Fintan’s behalf, with the proceeds therefrom to be distributed to Fintan in cash as such securities are liquidated.”

On Sept. 4, the second-named defendant, Nautical Nominees Ltd., as Fintan’s nominee, subscribed for Class A shares. It made additional investments repeatedly in the period ending February 1, 2008. Nautical thus was the legal owner of these shares, though the nominee of Fintan, which was the beneficial owner. Critically: Fintan, not Nautical, was the party to the side letter.

The Lehman Hit the Fan

On November 24, 2008 (two months after the excitement of “Lehman weekend”), Medley Capital wrote to all the members of the plaintiff discussing its liquidity difficulties. It set out two options: One, shareholders could join Class C, a new class of shares, and the next redemption date for class C would be December 31, 2009; Two, they could remain in the fund and receive quarterly cash distributions, out of excess cash rescinding any pending redemption requests.

On December 2, Nautical, on behalf of the Fintan, signed an “Approval of Plan” whereby it elected Option 2 for US $10 million in the value of its shares, and Option 1 as regards the balance, which was close to $39.5 million.

On November 11, 2009, as the redemption date for those Class C shares approached, plaintiff sought the approval of shareholders for a further restructuring. The gist of it was that again there were two options. Class C shareholders were now offered Class D shares, which would have their next redemption date on December 31m 2013. Or they could “maintain existing Class C shares, rescind any pending redemption requests, and participate in an orderly payout … pro-rated quarterly distributions of excess cash by way of a partial redemption of shares as cash…”

In case, in 2008 or in 2009, dissatisfied investors could have refused either option and insisted on their redemption rights, in which case they would have been redeemed in kind, under what is known as a “vertical slice.”

November 19, 2009, Nautical signed, giving its approval to the second option of the new plan. But the quarterly payments proved disappointing, an in December 2011 it submitted a redemption request, for the redemption of all of its shares in cash. Defendants contended that the restructurings had not modified their rights under the side letter to be paid in cash on demand.

The Mighty Quin

That in turn precipitated this action. Plaintiff wanted from Justice Quin a declaration that Nautical does not have rights under the letter agreement into which Fintan had entered with the other defendant. Nautical’s only rights to payout are those defined by the 2008 and 2009 plans respectively.

Fintan argued, and indeed it had to argue, that Fintan and Nautical should be construed as a single entity, on the basis of the practice of the parties. As the court put it (summarizing Fintan’s position): “[The] Plaintiff is using a belated and opportunistic attempt to resile from its previously clearly stated position – that being that the First and the Second Defendants are one and the same.”

Relying on a 1998 decision by the House of Lords, plaintiffs referred to an “estoppel by convention” that precludes a party “from denying the assumed facts or law.”

This, the court rejected. “I do not accept the Defendants’ contention that they are one and the same, nor do I accept the contention that they have single indivisible rights.” Further, there is no estoppel by convention, either. Indeed, “one main purpose of any nominee agreement is to create two distinct and separate legal entities,” so nobody could have been confused about the fact that exactly that had been done.

The judge also with a flourish refers to the policy argument that commercial business must be “conducted sensibly and with the required degree of certainty.” To that end, he finds that the second defendant “bound the ultimate beneficiary” Fintan, “to remain in the Plaintiff Fund and to accept a pro-rated distribution of excess cash on a quarterly basis, which ensured an orderly return of monies to all members.”