Investment is a complex activity that involves investee who promises to make the investment more profitable and an investor who invests money in the investment. Investments usually works by the way of a trust created as per the Indian Trust Act, 1882. The trust is usually taken care by a manager and the manager is the investee here. Companies in India like ICICI Capital, Unit Trust of India, Axis Capital are managers who take care of the trust. The main question that comes in our mind is what the trust comprises of?

The trust usually comprises of the pool of money that is invested in the trust by the investors and this pool of money is again invested by these managers in different stocks in the country and abroad. This investment of the pool of money in stocks makes the money grow and the profit is again redistributed between the investors who invested in the pool initially as per the ratio they have agreed to.

The whole process is legally effective by the way of a contract called the Private Placement Memorandum (hereinafter, PPM), which is a general document for all the investors making investment. The parties agree to all terms and condition of the trust pool of investment by the way of the PPM. The PPM usually contains clauses like, what should be the investment amount the investor is supposed to invest; the lock-in period of the investment etc. PPM is not a public document and is usually given to an investor who is willing to invest in the trust pool hence, there is confidentiality.

The problem in a private placement and hedge funds start when some of the investors want extra favours from the trust manager and when they don’t want to be treated as ordinary investors but want special privileges as an investor. These special investors ask this as a right from the investee because of heavy investment of theirs, than other investors. By analysing this situation, we can conclude that it is absolutely right when an investor asks for special rights if he invests more in the pool and most of the time the asked privileges are given to the investor, but it also triggers a problem in the contract.

If a manager of a trust pool gives special privileges to only few investors, he/she does it by not disclosing the same to the other ordinary general investors and it is done by the way of a Side Letter. The investee by law is not bound to disclose the terms because if the investee discloses the terms of the Side Letters to the ordinary investors then it will trigger the ‘confidentiality clauses’ and it will harm those special investors with whom the Side Letters and PPM have been entered with. There is also a problem of ‘Most Favoured Nation’, i.e. treatment of each investor in the same way possible and if one investor is getting special privilege then other must also get the same treatment. If an investee considered giving MFN treatment also, then it will harm the interest of the special investors again, because these special investors usually pool in more amount of money in the trust than ordinary investors.

In India, Side Letters are not a most talked subject but the Financial Services Authority (hereinafter, FSA) has written extensively about Side Letters usage by the fund managers in UK. The FSA in their papers write that the fund managers must ensure that they follow the imbibed and followed Principles of Business in UK and must ensure there in integrity[1] in the business when the manager and investor in a Side Letter agreement. The FSA has also not come up with any solution to solve the issues of disclosures regarding to disclosures; MFN and confidentiality. Similarly, the Securities Exchange Commission (hereinafter, SEC) of the United States[2] is also silent in its papers, though they have considered that there is a problem with Side Letters.

In India Securities and Exchange Board of India (Alternative Investment Funds), 2012 lays down the laws and regulations regarding investments in India, but it has no where addressed concerns with respect to the problems of Side Letters in its regulations. It is required now for SEBI to come out with guidelines on the usage of Side Letters since there is still a concern with respect to usage of Side Letters in investment.

[1] Principle 1, Principles of Business of UK.

[2] Hedge Funds Side Letters, also available at http://hedgefundlawblog.com/hedge-fund-side-letters.html.

Author: Saurav Das, Content Writer at Legal Desire