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A New Year’s wish: may all your side letters be enforceable
A little over a year ago, the Delaware Court of Chancery issued a forceful reminder that not all side letter agreements are enforceable. In ESG Capital Partners II, LP v. Passport Special Opportunities Master Fund, L.P. C.A. No. 11053-VCL (Del. Ch. Dec. 16, 2015) (the ESG Capital Partners Case), the court found that a side letter agreement issued to a limited partner investor in a Delaware limited partnership private fund entity (the Fund) was nullified and rendered useless by the fact that the side letter was entered into one day prior to the limited partner’s entering into the subscription agreement to acquire interests in the Fund, and the “entire agreement” clause included in the subscription agreement did not reference or otherwise contemplate the existence of any side letter agreement. More importantly, the court also found that, even assuming that the side letter agreement had not otherwise been nullified, the preferential rights granted under the terms of the side letter agreement purported to confer a “super-limited-partner status” upon the limited partner investor in a way that materially and adversely affected the other limited partners in the Fund. As such, the side letter agreement amounted to a unilateral amendment of the Fund’s limited partnership agreement (LPA) in clear violation of the amendment provisions of the LPA that require a majority in interest approval of all limited partners of the Fund in connection with any such amendment and was therefore unenforceable.
While the facts of the ESG Capital Partners Case are somewhat unusual (involving a general partner who misappropriated assets from the Fund and then later sought to make preferential (and disproportionate) distributions to a “favored limited partner” (the Favored LP) in reliance on the side letter agreement in question), the court’s findings have universal application for private equity fund investors, sponsors and their respective advisors when side letter agreements will be issued by the general partner on behalf of a fund. An important aspect of the ESG Capital Partners Case was that the Fund’s LPA did not reference or otherwise contemplate that the general partner may enter into side letter agreements with one or more limited partner investors, and the court found that the supplemental rights purportedly granted to the Favored LP in its side letter agreement were unenforceable absent a duly authorized amendment to the Fund’s LPA.
Key Takeaways
The ESG Capital Partners Case serves as an important reminder that to ensure the enforceability of side letter agreements, private fund managers, investors and practitioners should always consider the following points:
1. Integration Clauses (also known as “entire agreement” clauses)—make sure that each of the governing agreements of the fund includes an integration clause that specifically references the fact that the side letter agreement will be a part of the entire agreement of the parties;
2. Subscription Agreement Provisions—in addition to the integration clause, the subscription agreement should also make clear that each applicable investor has received a copy of its side letter agreement (together with all other fund documentation) and is making its investment in the fund in reliance on the terms of all such agreements;
3. LPA Provisions—make sure that the Fund’s LPA specifically references the existence of side letter agreements, and specifically authorizes the general partner to enter into side letter agreements that supplement or alter the terms of the limited partnership agreement. Limited partner investors need to confirm this point as part of their legal diligence processes, and not simply assume that a fund manager has this authority. This language would be in addition to the typical “most favored nations” provision included in each investor’s side letter agreement, and it serves to further evidence the fact that all investors were made aware that certain supplemental and preferential terms may be granted to some but not all investors in the fund;

4. PPM Provisions—make sure that the fund’s private placement memorandum references the fact that the fund may issue side letter agreements, and that it includes a risk factor that highlights the risk that such side letters may be issued to certain limited partners and not others, and that their terms may supplement or alter the terms otherwise provided in the fund’s LPA; and
5. Preferential Rights—make sure that any supplemental rights granted to a limited partner in a side letter agreement do not materially or adversely affect the other limited partners in a way that would require an amendment to the fund’s LPA. In cases where this is unclear, investors or sponsors should seek out advice of counsel.

Note: this article is a summary for general informational and discussion purposes only, and should not be considered as legal advice. This article discusses the enforceability of a side letter agreement under Delaware law. Courts in other jurisdictions may determine the enforceability of side letter agreements differently.


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