April 20, 2016

DELAWARE INSIDER: ESG Capital Partners II, LP v. Passport Special Opportunities Master Fund, LP – Delaware Court of Chancery Addresses Investment Fund Side Letter

In a recent opinion, the Delaware Court of Chancery considered, among other things, the impact of an integration clause contained in a subscription agreement for interests in a Delaware limited partnership on a side letter between the limited partnership and an investor, as well as the authority of a general partner to cause the limited partnership to enter into such a side letter. On the facts of this case, the court found that the subscription agreement’s integration clause rendered the side letter a nullity and that the general partner did not have the authority to grant certain rights purported to be provided in the side letter.

ESG Capital Partners II, LP v. Passport Special Opportunities Master Fund, LP, C.A. No. 11053-VCL (Del. Ch. Dec. 16, 2015), involved a Delaware limited partnership formed by Timothy Burns for the limited purpose of raising money from investors to purchase shares of Facebook stock before its anticipated IPO. Following the IPO, it was anticipated that the partnership would then distribute to its investors the Facebook shares or their equivalent cash value, as stipulated in the partnership’s partnership agreement. The partnership agreement gave each investor an equity stake in the partnership and provided that any distribution was to be made to all investors in proportion to their respective percentage interests in the partnership. Following Facebook’s IPO, Mr. Burns wrongfully diverted cash, shares, and other partnership property and, before his wrongdoing was discovered, made preferential transfers of Facebook stock to certain limited partners of the partnership (the favored LPs) instead of complying with the distribution provisions set out in the partnership agreement. The favored LPs received one Facebook share for each of their partnership units without regard to their actual percentage interests in the partnership. As a result of Mr. Burns’s wrongful actions, the other limited partners of the partnership (the disfavored LPs) either did not receive any Facebook shares or received less than one Facebook share for each of their partnership units. Mr. Burns was subsequently indicted criminally and convicted for his misconduct. The disfavored LPs sued the favored LPs, asserting that the favored LPs had breached the partnership agreement by receiving the excess Facebook shares, had wrongfully converted property, and were unjustly enriched.

While the court addressed several aspects of Delaware law in its analysis, of particular interest to investment fund sponsors and their investors and counsel who deal with side letters is the court’s examination and analysis of a side letter that was entered into between the partnership and one of the favored LPs. The side letter purported to provide a favored LP with certain preferential rights not provided to other limited partners, including an indirect ownership interest in a specific number of Facebook shares notwithstanding such favored LP’s actual percentage interest in the Partnership, the terms of the partnership agreement, or Section 17-701 of the Delaware Revised Uniform Limited Partnership Act (the LP Act). The disfavored LPs were negatively impacted by certain of the side letter provisions.

The court rejected the argument that the preferential transfer of Facebook shares to the favored LP was protected because of the specific rights provided under the side letter. First, the court held that the side letter was rendered a nullity because of the integration clause in the applicable favored LP’s subscription agreement that was entered into after the favored LP entered into the side letter. The integration clause provided that the subscription agreement constituted the entire understanding among the parties thereto with respect to the subject matter thereof and superseded any prior understanding and/or agreement among such parties. The court held that the side letter was a prior agreement covered by the integration clause and therefore was superseded by the subscription agreement.

The court further concluded that even if the side letter remained in effect notwithstanding the integration clause contained in the subscription agreement, the side letter rights at issue were not valid and did not bind the partnership. First, the court relied on principles of agency law, holding that because the applicable favored LP knew about the limitations in the partnership’s partnership agreement on the ability of the partnership to grant many of the rights contained in the side letter, such favored LP could not rely on the side letter as a defense. The court also held that where the applicable favored LP could not secure many of the rights contained in the side letter without an amendment to the partnership’s partnership agreement, the side letter could not be used as a means to amend the partnership agreement without complying with the partnership agreement’s amendment provisions.

In the world of investment funds, side letters are regularly used as a means of interpreting, establishing rights under, altering or supplementing the terms contained in partnership agreements, subscription agreements and other fund-related documents. Practitioners, sponsors, and investors who deal with side letters should give careful consideration to the court’s side letter analysis, in particular with respect to whether side letters being entered into in particular transactions are permitted to grant certain rights under the applicable governing documents. While ESG Capital highlights the inability of partnerships to grant certain rights to an investor in a side letter where the partnership agreement lacks the appropriate authorization, implicit in the court’s analysis are the benefits that a strong side letter authorization provision in a partnership agreement can provide.

As stressed by the court, however, authorization to enter into a side letter does not end the analysis, and special consideration should be given to the particular integration clauses contained in partnership agreements (including amended and restated partnership agreements entered into subsequent to the adoption of side letters), subscription agreements, and other fund-related documents to ensure that they do not have the unintended consequence of nullifying side letters. With proper integration clauses and a side letter authorization provision, funds should be permitted to continue to use side letters as a means to grant certain rights and provide other provisions to their investors.

In addition to its analysis of the side letter, the court turned to various other provisions of Delaware law in denying the favored LPs’ motion to dismiss. The court denied the favored LPs’ primary defense that they held an ownership interest in the partnership’s Facebook shares and therefore did not breach the distribution provisions of the partnership agreement because they were entitled to receive a number of Facebook shares equal to the number of units they held in the partnership. The court struck down this argument, finding that it was contrary to (i) the LP Act, which provides that a partnership is a separate legal entity and the individual partners of a partnership do not have any rights in specific partnership property but instead have an interest in the profits and losses of the partnership; and (ii) the plain language of the partnership agreement, which contemplated distributions being made to all the partners as a class in accordance with their respective percentage interests in the partnership and not as one-off preferential transfers to certain limited partners.

Moreover, the court further disagreed with the favored LPs’ proposition that the sole means for challenging any partnership distribution was through Section 17-607(b) of the LP Act, and because the disfavored LPs did not use this means, their claim should be dismissed. The court held that what occurred was not a distribution, but was in fact a preferential transfer to the favored LPs. Additionally, the court held that Section 17-607(b) of the LP Act is not the exclusive means of challenging a distribution, as such provision does not contain any text implying exclusivity. The court concluded that while Section 17-607 of the LP Act does impose a limitation on distributions, it is not the exclusive limitation, and here it was not an applicable limitation with respect to the preferential transfer made to the favored LPs.

Additional Resources 

For other materials on this topic, please refer to the following. 

Business Law Section Program Library 

Annual LLC Case Law Update (PDF)
Presented by: LLCs, Partnerships and Unincorporated Entities
Location: 2016 Spring Meeting