Don’t let your side letter be a wipe out

Side letters have long been in use in the private equity market, helping to interpret, supplement, modify and establish the terms contained in fund agreements and related documents.

A notable memorandum opinion of the Delaware Court of Chancery, ESG Capital Partners II LP v. Passport Special Opportunities Master Fund LP, serves as a timely reminder that while side letters are negotiated and entered into with increasing frequency, their enforceability and the preferential terms contained in them cannot be taken for granted.

What you need to know

  • When entering into a side letter, it is imperative to ensure that there is language to the effect that no one agreement supersedes and nullifies another.
  • A side letter can only be binding to the extent the GP is authorized under the terms of the fund documents to enter into and agree to the provisions in such side letter.
  • A side letter cannot be used to unilaterally amend the fund agreement. If the proposed terms in the side letter would alter the rights of other investors in the fund without their consent, then those provisions should be incorporated into the fund agreement.

Background: ESG Capital, Facebook shares & Passport’s side letter

ESG Capital Partners II LP was formed as a Delaware limited partnership by Timothy Burns to raise money from investors to buy shares in Facebook prior to its IPO. Once Facebook went public, the fund would distribute to its investors the Facebook shares or their cash value. The fund raised about US$14 million from 44 investors and purchased 452,515 Facebook shares.

The fund entered into standard documentation with its investors—a partnership agreement, subscription agreements and with one investor, Passport Special Opportunities Master Fund LP, a side letter. The partnership agreement granted equity stakes represented by units in the fund to the investors and made it clear that any distributions would be made to all partners in proportion to their respective “percentage interests.”

After Facebook completed its IPO, Burns misappropriated cash, Facebook shares and other property for which he was indicted and convicted. Before his wrongdoing was discovered, Burns also caused the fund to make preferential transfers of the remaining Facebook shares to certain investors. The favoured LPs received one Facebook share for each unit held in the fund, while other LPs either did not receive any shares or received less than one share for each unit held, all without regard to the percentage interests.

Once Burns’ wrongdoing was discovered, certain LPs demanded the removal of him and the original GP and elected a successor unaffiliated with Burns as the fund’s GP. Rather than all LPs suffering proportionately—the result that would have occurred had the transfers been made in compliance with the partnership agreement—only the disfavoured LPs bore the cost of Burns’ wrongdoing.

The disfavoured LPs, the successor GP and the fund successfully sued the favoured LPs for breach of the partnership agreement, wrongful conversion of property and unjust enrichment.

Passport’s side letter

As noted above, one investor, Passport, entered into a side letter with the fund seeking to secure preferential terms for itself, including that Passport held both a fixed number of Facebook shares and a specific and fixed percentage interest in the Fund (22.11 percent) and that no action could be taken by the fund or the GP that would have the effect of diluting its shares.

The side letter was entered into by Passport and the fund and Passport’s subscription agreement was executed a day later. The other LPs were unaware and did not consent to its terms. Passport was a favoured LP and sought to rely on the preferential terms in its side letter as part of its defense in the action by the disfavoured LPs.

The court weighs in

Without even considering its terms, the court declared that the integration clause in the subscription agreement (which was entered into one day after the side letter) had the legal effect of rendering the side letter a nullity.

In the words of Vice Chancellor Laster, the integration clause “wiped out” the side letter. The integration clause provided that the subscription agreement “constitutes the entire understanding among the parties with respect to the subject matter hereof, and supersedes any prior understanding and/or written or oral agreements among them.”

Accordingly, the side letter was a “prior agreement” relating to the subject matter of the subscription agreement, and so was superseded by the terms of such subsequent agreement.

The court found that even if the side letter had remained in effect, many of the rights purported to be given in it were invalid due to the GP’s lack of authority to grant them. Specifically, the court stated that the GP could not grant Passport a fixed percentage interest in the fund in light of the definition contained in the partnership agreement.

The court explained that the provisions in the partnership agreement which provided that distributions were to be proportionate to each investor’s percentage interest were mandatory and inured to the benefit of the fund and all of its partners and that the partnership agreement did not authorize the GP to waive those provisions or grant rights that ran contrary to them in any separate agreement with an investor.

As the court stated, “[c]ontrary to what the side letter envisioned, a limited partner’s capital account was not an escrow account in which the General Partner could park shares tagged for a preferential transfer. It was a set of accounting entries used to track the limited partner’s net investment in the Partnership.”

Further, the court, applying ordinary principles of agency law, explained that Passport knew that the partnership agreement imposed limitations on the GP’s authority as agent of the fund to bind it and that Passport could therefore not rely on the side letter as a defense.


As noted at the outset, side letters are routinely entered into in the PE market to interpret, supplement, modify and establish the terms contained in fund agreements and related documents.

It is important that when a fund is entering into a side letter with an investor, that proper authorization is provided for under the governing documents (most commonly the partnership agreement) of the fund (via a representation from the fund’s GP).

The case also illustrates the importance of reviewing integration clauses in fund documents (partnership, subscription and other fund-related documents) to ensure that such clauses do not override any side letters that have been entered into. Such clauses are often viewed as standard boiler-plate language of little consequence, but this case highlights that investors and sponsors should be turning their minds to such provisions to ensure that their side letters will be effective in granting the rights they have negotiated.

Emma Brady is a corporate law associate with a specialization in investment funds and private equity at Torys LLP. She co-wrote this article with her Torys’ colleague Sarah Carter, a corporate law associate focused on private equity and fund formation. The article was reviewed by Amy Johnson-Spina and Shannon Gotfrit, both partners at Torys.

Photo courtesy ©iStock/BrianAJackson