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Hedge Fund Side Letters: Recent Case Illustrates Potential Pitfalls

March 4, 2009

On February 18, 2009, in Umbach v. Carrington Inv. Partners, the U.S. District Court for the District of Connecticut issued an important decision declining to dismiss claims made by an investor arising from a fund’s imposition of a new lock-up period and rescission of previously made withdrawal requests.1 The investor had executed a side letter with the fund concerning his redemption rights. The decision underscores, among other things, the possibility that a court may admit evidence of oral understandings to interpret the terms of an executed side letter where the investor alleges that he or she was misled by the manager.

Joseph Umbach, an investor in Carrington Investment Partners (US), LP, sued the fund and its general partner for securities fraud, common law fraud, negligent misrepresentation, breach of fiduciary duty, breach of contract and a declaratory judgment in connection with the fund’s refusal to permit him to withdraw his investment. The plaintiff alleged that, after receiving the fund’s private placement memorandum, he initially decided not to invest because of a one-year lock-up period provided in the fund’s partnership agreement. The GP then allegedly gave verbal assurances that the plaintiff would be exempt from the lock-up period and that his investments would always be redeemable on 30 days’ notice. The parties then executed a side letter on May 27, 2005, which provided that the fund had “agreed to exempt [the plaintiff] from the ‘lock-up’ period as described in Section 3.9.1” of the partnership agreement. In July 2007, the plaintiff sought the withdrawal of his entire investment, as of September 30, 2007. On August 30, 2007, however, the GP proposed an amendment to the partnership agreement, imposing a new one-year lock-up period applicable to all investors, and at the same time rescinding any pending withdrawal requests. The GP allegedly represented that it had proposed the amendment at the request of a majority of investors, and that more than the required majority in interest supported the amendment. The fund obtained the approval of the necessary percentage of investors and announced that the amendment had passed.

Denying the defendants’ motion to dismiss the securities fraud claim, the court first held that the plaintiff had made sufficient allegations of misstatements by the defendants, namely by failing to disclose that the fund could amend its partnership agreement to impose a new lock-up period, applicable to the plaintiff, which would restrict future withdrawals. The defendants argued that as a sophisticated investor, the plaintiff’s reliance on the alleged misrepresentation was unreasonable, given that the parties’ executed side letter only explicitly exempted the plaintiff from the lock-up period referred to in Section 3.9.1 of the partnership agreement. The court agreed that the plaintiff was a sophisticated investor, but rejected the defendants’ reasonable reliance argument because the side letter controlled “notwithstanding any provisions to the contrary in the agreement.” The court thus held that the “defendants could well have misrepresented the effect of the Side Letter as precluding any future lock-up period.” In the court’s view, the side letter was ambiguous as to whether the exemption from the one-year lock-up meant only the lock-up period in the partnership agreement, or any future lock-ups that might be imposed by amendment. The court rejected the defendants’ arguments based upon “merger clauses” within the partnership agreement — common provisions stating that there are no terms other than those in the agreement. The court reasoned that the plaintiff could have relied upon the agreement as modified by the side letter, which suffered from ambiguity, and which was further complicated by defendants’ representations concerning the side letter. The court held that the plaintiff stated claims for fraud and negligent misrepresentation on essentially the same grounds.

The court also rejected the defendants’ argument that the plaintiff had not adequately alleged scienter — the intent to deceive. The defendants asserted that an intent to defraud could not be inferred solely from the GP’s motive to receive compensation through continued investment in the fund, citing well-established precedent rejecting similar allegations of scienter levied against the officers and directors of corporations. The court disagreed: “This case is different. Plaintiff’s allegations involve fraud by the General Partner of a hedge fund rather than outside directors. Furthermore, in managing a hedge fund, defendants allegedly had a much stronger stake in keeping money in the fund than the outside directors” named as defendants in corporate securities fraud cases.

The court also held that the plaintiff stated a claim for breach of fiduciary duty by alleging that the GP falsely represented that a majority of investors favored the proffered amendment to the partnership agreement imposing a new lock-up period. The court concluded that causing investors to vote for reasons other than the merits of the amendment might constitute a breach of fiduciary obligations to investors. The court also held that the GP’s attempt to secure the amendment by consent without a meeting, on 20 days’ notice, may have breached the partnership agreement even though the procedure technically complied with the terms of the agreement, citing case law holding that “inequitable action does not become permissible simply because it is legally possible.”

The court further held that the plaintiff stated a claim for breach of contract, reasoning that, if the plaintiff’s allegations about the defendants promising exemption from all future lock-up periods were true, the defendants’ actions amounted to breach.

Finally, the court declined to assert its discretionary jurisdiction over the plaintiff’s declaratory judgment claim. The plaintiff sought a ruling that he was entitled to withdraw his investment from the fund, and that the amendment to the partnership agreement was void. The court noted that the declaratory judgment requested would amount to a finding of liability as to the underlying fraud, negligent misrepresentation, breach of contract and breach of fiduciary duty claims. Since the court was permitting those claims to proceed, and because those claims afforded a more effective or efficient means of relief, the court dismissed the plaintiff’s declaratory judgment claim.

The District Court’s decision is not binding authority in any jurisdiction. The decision nonetheless suggests: (i) a court may admit evidence of oral understandings to interpret the terms of an executed side letter where the investor alleges he or she was misled by the manager; (ii) short-form side letters may give rise to claims for failure to disclose the continuing operation of the partnership agreement as it may impact the terms of the side letter; and (iii) funds engaging in side letters with investors must take extraordinary care to clearly and unequivocally document the terms of the side agreement, including affirmative representations by the investor that there are no other terms of the agreement apart from those contained in the letter.

For assistance, please contact the following lawyers in the Securities Area. 

Michael D. Blanchard, Partner, Securities Litigation 
michael.blanchard@bingham.com, 860.240.2945

Jordan D. Hershman, Co-chair, Securities Litigation
jordan.hershman@bingham.com, 617.951.8455

Roger P. Joseph, Practice Group Leader, Investment Management; Co-chair, Securities Area
roger.joseph@bingham.com, 617.951.8247


1 3:08CV484(EBB), 2009 WL 413346 (D. Conn. Feb. 18, 2009).

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