This article explores whether investors in a private capital fund may lawfully refuse to meet capital-call demands based on alleged breaches by the General Partner (GP) of the limited partnership agreement (or equivalent constitutional document) or any investor side letters, referred to collectively in this article as the Fund Documents. This can be a critical issue for lenders of subscription line facilities which rely on the investors funding their uncalled capital to repay the loan facility.
This analysis assumes the relevant constitutional documents and side letters are governed by English law and subject to the jurisdiction of the English courts. English jurisprudence establishes that an investor’s contractual obligation to contribute capital is not automatically discharged by a GP breach. The viability of using a breach of contract as a defence depends on three interrelated factors:
- the precise contractual wording regarding the GP’s obligations under the Fund Documents;
- the specific factual matrix surrounding the alleged breach and its impact on performance of the Fund Documents; and
- the legal classification and nature of the breach of the Fund Documents.
The first and second of the above points are very specific to exact drafting of the Fund Documents and the facts surrounding that breach. This article does not attempt to identify all the possible fact patterns for these two points.
On the third of the above points, the legal classification and nature of the breach, investors may only be excused from capital-call obligations if one of three specific contractual scenarios is satisfied, as follows.
Specific prerequisites: If the Fund Documents expressly stipulate that the GP must fulfil specific prerequisites (e.g., issuing a prescribed draw-down notice, delivering required information, meeting performance metrics) before a capital call becomes enforceable, the investor’s duty does not arise until compliance is achieved.
Conditions: Where a contractual term under the Fund Documents is expressly designated as a “condition,” any breach of that term - regardless of severity - constitutes a repudiatory breach. This entitles the investor to elect termination of the relevant Fund Document, thereby discharging the investor from all future performance obligations.
Frustration: For terms not classified as pre-requisites or conditions, the breach must be sufficiently severe to “go to the root of the contract”, “frustrate its commercial purpose” or deprive the investor of “substantially the whole benefit” of the Fund Documents. This represents a high, fact-sensitive threshold, which if met entitles the investor to terminate its obligations.
Upon identifying a breach that falls within one of the above scenarios, the investor faces a binary election with irrevocable consequences:
Affirmation: The investor may choose to keep the Fund Documents alive, continue meeting capital-call obligations, and preserve the right to claim damages for the GP’s breach. Once affirmed, the election is binding, and the investor remains fully obligated under the Fund Documents.
Acceptance of Repudiation: The investor may treat the breach as repudiatory, terminate the Fund Documents (as they relate to that investor) and be discharged from all future performance under the Fund Documents. This election must be clearly communicated: silence or continued performance constitutes affirmation.
Investors cannot simultaneously rely on a breach to avoid performance while retaining other contractual benefits (e.g., profit distributions). The contract must be either affirmed or terminated.
Side-letters providing investor-specific relief or exemptions are subject to strict limitations. Breaches of side letters can only be invoked by the specific investor party to that side letter, unless the side letter expressly confers third-party rights. In addition, investors must typically disclose internal policy or regulatory constraints in advance of a capital call and may be required to provide a legal opinion confirming the exemption’s applicability. Failure to comply may preclude reliance on side-letter exemption provisions.
If a breach is alleged by an investor, what should the GP do? First, and we would say this of course, contact your lawyers. Second, work with your lawyers through the following steps:
- Clearly identify the alleged breach and scrutinise the Fund Documents to identify whether the breach relates to any pre-requisites or conditions to investor performance.
- If not a breach of a pre-requisite or a condition, determine whether the alleged breach goes to the root of the contract.
- Do fact-finding and fact-checking, and preserve records of relevant dates and communications.
- Consider whether the investor has made a clear election to accept the breach as repudiatory – or has it accepted it and continued to perform, or remained silent.
And if a breach is alleged by an investor, what should the lenders of a subscription line facility do? First, contact your lawyers and with them analyse whether the investors have waived any rights of defence in relation to funding their uncalled capital which is called for the purpose of repaying fund borrowings. It may be the case that although an investor generally has the right to use that breach as a defence to its funding obligations, it may not be able to use that defence in the specific circumstance of funding to repay fund borrowings.
And also consider whether the allegation by an investor that a breach entitles it not to fund its uncalled capital constitutes an exclusion event in relation to that investor under the uncalled capital coverage ratio which will be included in the loan agreement.
Closing Thoughts
So much to think about, in addition to the pure jurisprudence of contract breaches. Note that this article provides a high-level overview of the English legal principles governing investor obligations in the context of GP breaches and is inevitably generic in nature. Remember also that different governing laws or jurisdictions may reach materially different conclusions.