United States private equity funds have long considered Delaware the “gold standard” jurisdiction for formation of domestic pooled investment vehicles. Delaware entities provide ease of formation and amendment, superior quality of jurisprudence with respect to matters of business, and clarity and ease of interpretation of law for practitioners. As the world market shrinks, private equity funds increasingly invest in portfolio companies outside of the United States. To maintain tax efficiency for limited partners, many funds invest in non–U.S. companies through entities formed in tax “flow-through” jurisdictions. The Cayman Islands jurisdiction has long been favored due to the well-established legal, banking, and government business services there.
Although both Cayman Islands and Delaware partnership laws trace their roots to the British Partnership Act of 1890, which was fundamentally premised on the right of contract between parties, they differ significantly in some respects. For example, the Delaware Limited Partnership Law (DRULPA) often thoroughly enumerates the rights and remedies associated with its provisions, while the Cayman Islands Exempted Limited Partnership Law (EPL) presumes that, where the statute is silent, the agreement will control. This article seeks to highlight differences in some of the more important provisions of DRULPA and the EPL that may create unanticipated results for the investor.
Side letters and ancillary agreements
Delaware and Cayman Islands common law both recognize the integration of ancillary agreements to a partnership agreement. Many limited partners in Delaware partnerships enter into side letter agreements to address regulatory, policy, tax, and other matters. Side letter provisions may affect the economic relationship between an individual investor and the partnership by, for example, reducing the management fee, extending enhanced information rights, or granting the limited partner an advisory committee seat in exchange for its commitment. Cayman Islands common law, however, does not permit ancillary agreements to change the material terms of an agreement without the consent of all partners. Accordingly, an ancillary agreement (such as a side letter) may not change the “material” terms of a Cayman Islands limited partnership agreement.
To combat this restriction in the EPL, one option we’ve increasingly seen in the marketplace is the use of New York– or Delaware-governed side letter agreements by partners in Cayman Islands limited partnerships that would allow limited partners to obtain material changes from the partnership agreement.
Freedom of Information Act
Subject to a limited partner’s reasonable demand for any purpose reasonably related to it as a limited partner, DRULPA has historically provided for a limited partner’s right to receive information concerning the partnership. In recent years, however, media and other organizations have used public entity limited partners to obtain information about private equity funds through state Freedom of Information acts (FOIAs). Public disclosure of information about the portfolio companies of such funds can be damaging to the funds and their portfolio investments.
The fund sponsors’ response was to dramatically limit the breadth and scope of information disclosed to limited partners. Delaware legislators subsequently codified the enforceability of such provisions under DRULPA; however Cayman Islands legislators did not react similarly. DRULPA now gives general partners the right to keep trade secrets, disclosures not in the best interest of the partnership, and disclosures required by law or contract confidential from limited partners. Limited partners in Delaware limited partnerships frequently use side letters to provide for enhanced information rights. To avoid discomfort as to the enforceability of a side letter governed by Cayman Islands law as discussed above, limited partners in Cayman Islands limited partnerships may wish to negotiate specific terms enabling them to receive the information they require in the partnership agreement itself (with details of how the information may be provided in a side letter) or enter into side letter agreements governed by New York or Delaware law, as mentioned above.
DRULPA allows a limited partner to bring a cause of action on behalf of the limited partnership when the general partner refuses to do so, or if an effort to force the general partner to do so is unlikely to succeed. The limited partner must show why the general partner wrongfully refused to bring the action or why demanding that the general partner bring the action would be futile. Conversely, for a limited partner in a Cayman Islands limited partnership to bring a derivative action, it is necessary to demonstrate that the general partner failed to bring such action without good cause, a more difficult standard to establish than “unlikely to succeed.” This distinction is important where it is possible that the general partner has not pursued a remedy on behalf of the partnership because of collusion, self-dealing, or other issues not reflecting the best interests of the partnership. Given the higher EPL burden of proof, limited partners of EPL-governed entities may wish to negotiate for a lower threshold voting requirement to remove the general partner, so that the obstructing general partner may be replaced with a person who will pursue appropriate remedies on behalf of the partnership.
Assignment of limited partner interests
DRULPA allows a limited partner to assign its interest in a limited partnership without any reference to the authority of the general partner. Thus, restrictions contained in Delaware partnership agreements are frequently modified through side letters, establishing in advance the right to transfer to affiliates or others. Conversely, the EPL dictates that any assignment of partnership interests requires the consent of the general partner in its sole discretion, and consents to transfer may not be waived by the partnership agreement. Because, under Cayman Islands common law, ancillary agreements cannot change the material terms of partnership agreements, the consent requirement cannot be changed through side letters.
DRULPA permits a partnership agreement to provide for virtually any specified penalty or consequence (including forfeiture of the limited partner’s interest) in the event of a limited partner’s default (e.g., failure to make a capital call), despite any punitive characteristics. In contrast, under the Cayman Islands common laws of equity and public policy, default provisions must reflect a reasonable pre-estimate of damages, rather than a penalty or amount not tied to such analysis. As such, penalties not tied to making the injured party whole may be found unenforceable in the Cayman Islands.
Under DRULPA, parties have complete and ultimate authority to define the terms of indemnification provisions (other than with respect to a breach of the implied covenant of good faith and fair dealing) in the limited partnership agreement. The EPL, however, is silent with respect to indemnification. Because indemnification rights are not addressed under the EPL, a limited partnership may not be able to indemnify a partner absent an express provision in the partnership agreement.
Moreover, litigation of indemnification provisions contained in the limited partnership agreement in the Cayman Islands may be more narrowly construed than the same provision might be construed in Delaware. Thus, we would recommend that potential investors in partnerships governed by the EPL negotiate and draft indemnification provisions with care and specificity.
Although DRULPA explicitly recognizes the rights of third-party beneficiaries, the EPL does not recognize the rights of a person not a party to the limited partnership agreement. Rights of third-party beneficiaries may affect the return to the partnership of excess distributions of carried interest made to the general partner, indemnification, confidentiality provisions, and the indemnification of representatives serving on an advisory committee. The general partner (through a “clawback” provision in the partnership agreement) generally has an obligation to return to the partnership distributions made to it in excess of the carried interest to which it is entitled. Because the general partner is typically an entity with no assets of its own, the fund must look to the principals to return such excess distributions. As a result, the partnership is often a third-party beneficiary of the principals of the general partner to return any over-distribution. In contrast, in the event that the principals have not executed a guarantee or otherwise established a contractual basis for their obligation to return distributions to the partnership, the limited partners of an entity formed under the EPL may have no recourse if the general partner becomes insolvent. Under the EPL, it is not clear that persons not a party to the limited partnership agreement are covered by the indemnification provisions therein, no matter how carefully the indemnification provisions are drafted. This issue is also relevant for individuals representing investors on a partnership’s limited partner’s advisory committee. Such individuals may wish to enter into an indemnity to ensure proper coverage by the fund.
In conclusion, both Delaware and the Cayman Islands provide an excellent legal framework for the formation of a pooled investment vehicle. Nonetheless, it is important to be aware of the sometimes-subtle differences between the laws of the two jurisdictions. With this knowledge, wise negotiating positions can be taken early on, before litigation leads to unexpected results for the parties.