Side letter vs Fiduciary Duty: Conflict in Private Equity Firms

[Kaustub N. S. Bhati is a 4th year student at NALSAR University of Law]

A private equity (PE) firm generally consists of two types of partners, limited partners (LPs) and general partners (GPs). As the name suggests, LPs are outside investors (like companies, endowments, foundations, and the like) whose liability is commensurate with the extent of their investment, while the GPs are professional investors who manage the fund. Both LPs and GPs pool funds , which the GPs use to source deals with target companies. The life of a fund is limited, typically to 10 years, and exits are sought after the contractual time limit either by an initial public offering or a sale to a strategic buyer. The motive behind such acquisition of a target company is to increase its value by expert knowledge and investments and sell it at a more attractive price for huge profits, thereby reaping returns.

Within the corporate governance structure of a PE firm exists an agreement called a side-letter. A side letter is an agreement apart from the main agreement (e.g. the limited liability partnership agreement) and is usually an extension or supplement in the sense that it further clarifies certain provisions of the main agreement. In the world of private equity, side-letters are a globally recognised and prevalent practice among many jurisdictions. It is executed as a separate document when an investor wants an arrangement which veers from the main agreement for reasons such as to provide a different fee concession or more active participation in dealing with target companies and differential returns for the investor.[1]

The practice of side letters, as prevalent in the United States currently, allows firms to negotiate agreements which can amend and even go directly against the primary agreement that is common for all the investors. Since these are common place agreements and are also saddled with confidentiality clauses, it creates intra-investor conflict as every investor would indulge in a race-to-the-bottom to ensure maximum individual profits which might not be in the firm’s best interests.[2] It creates a situation similar to that of the prisoner’s dilemma where each party would be better off co-operating to ensure long-term benefits but at the same time have a large incentive to deviate and secure personal gain.

It is a fundamental principle of corporate governance that similarly situated shareholders should be treated equally. This principle has been entrenched to avoid favouritism and diversion of assets to majority shareholders. Side letters as such promote the distinct possibility of partisan behaviour of fund managers towards their favoured investors, violating this basic tenet of corporate governance. This is exacerbated in the US scenario by the lack of statutory safeguards like fiduciary duty of managers to investors like that held by directors of Indian companies to act in the interests of their shareholders.

In India, the SEBI (Alternate Investment Funds) Regulations, 2012 (“AIF Regulations”) provide the framework for PE firms as Category 2 Investments (allowed to invest anywhere but cannot take debts for purchasing securities of Indian companies) and can be set up either as a society or a company or a limited partnership. Side-letters in India are a topic that has received scant attention and there has not yet been case law adjudicating upon the use of side-letters by these firms. It has become a subject of recent controversy in last few months as the Securities and Exchange Board of India (SEBI) is planning to curtail side deals with large investors and bring parity in each class of investors by providing uniform terms. This has been met by resistance from PE companies who claim that such a comparison by SEBI between PEs and mutual funds is unqualified.

The most recent regulation until date regarding side-letters, and that too by way of a constructive interpretation, has been the 2015 SEBI circular regarding chapter 3 and 4 of the AIF Regulations. The circular states that:

b. All managers shall:

…. ii. carry out all the activities of the AIF in accordance with the placement memorandum circulated to all unit holder and as amended from time to time in accordance with AIF Regulations and circulars issued by SEBI.

(emphasis supplied)

The literal interpretation of this circular clearly stipulates the scenario that investment managers cannot indulge in the practice of side letter agreements and have to work according to the general agreement between the managers and all the investors. However, in the same circular, another guideline, the interpretation of which contrasts this above-mentioned guideline, is as follows:

c. The AIF, manager, trustee and sponsors hall:

i. Act in the interest of unitholders of the AIF/scheme and not take any action which is prejudicial to the interest of the unitholders and not place the interest of the sponsor/manager/trustee of the AIF or any of their associates above the interest of the unitholders of the scheme/AIF.

ii. Maintain high standards of integrity and fairness in all their dealings and in the conduct of the business and render at all times high standards of service, exercise due diligence and exercise independent professional judgment.

(emphasis supplied)

This provision exemplifies the fiduciary role of the investment managers to act with “integrity” and “fairness” in its dealings towards all the unitholders. But this also provides for the managers to use their independent professional judgement and due diligence in business conduct. This provision has been interpreted to provide the gateway for side letter agreements if the managers consider them as essential to further the interests of the firm and all the unitholders.

The main question that arises now is whether, in light of how the side letters have been used in the American jurisdiction, i.e., to further partisan investor interests, the same can be applied in India in the absence of well-defined framework and distinctive guidelines. This is essentially a conflict between transparency and customisable rights. On the one hand, it provides investors with the power to maximize their returns and gain an advantage in terms of rights that can be negotiated while, on the other hand, it can be flouted as a concern of discrimination between the investors by the conduct of manager which is exactly the reason behind SEBI recent announcements to curtail these agreements.

These lacunae in the SEBI guidelines can be used to perpetuate unfair and unethical agreements which might undermine the statutorily protected rights of investors in terms of the fiduciary duties owed to them. It is now very much necessary for SEBI to furnish further detailed guidelines in this nuanced but aggressively growing field.

Kaustub N. S. Bhati

[1] William Magnuson, “The Public Cost of Private Equity”, 102 Minn. L. Rev. 1847 (2018).

[2] Id.

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