Side letters, i.e secret agreements aiming at clarifying or amending issues that a primary contract does not cover, have a bad reputation. This being stated, the general validity of a side letter between the parties to a contract seems clear regardless of the applicable system. It is then possible to determine legal aspects regarding side letters that should be avoided (Part I) and others that could be recommended (Part II).
Don'ts of Side Letters
Some don'ts apply to all agreements (I), others only relate to specific ones (II).
I. General don'ts
As any contract, concerning its substance, a side letter particularly requires a lawful object and a non-fraudulent intention of the parties. Therefore, a side letter should not intend to defraud third parties or to bypass mandatory statutory provisions. Fraudulent side letters can lead tax authorities to convict companies. In 2003, the Dutch authorities conducted an investigation in the company Ahold and looked particularly at some of its side letters which allowed the wrongful consolidation of joint ventures in order to improve its financial statements. A settlement was first reached with the Dutch authorities and the company was fined 8 million euros. Later, Ahold was convicted for fraud by the SEC. Side letters should also comply with imperative rules and international public order to be valid and enforceable.
Concerning the form, in most situations a side letter is based on consensualism. Even though, in principle, side letters can be concluded orally, parties may want to ensure a solid proof. Legal formalism will even be required for some transactions. An illustration is provided by the German civil code (the BGB), which states that the purchase of a house must be concluded in front of the notary (Article 311b I 1 BGB), or failing that, will be considered as invalid (Article 125 BGB). This paragraph also applies to side letters which will be considered invalid if they do not comply with this formal requirement. It could affect the entire contract making it invalid (Article 139 BGB).
II. Special don'ts
Three situations regarding the use of side letters can be highlighted as a hurdle to their validity or efficiency.
First, it is prohibited to use side letters to change the price in some real estate transaction. As a part of the total price would be in the side letter it would permit to declare a lower price in the primary contract, reducing the tax base. In this situation, the side letter would not be valid, and would moreover expose to sanctions the parties to the side letter as well as the professional drafter.
Second, in most European countries, side letters do not affect the rights of third parties, who may nevertheless enforce a side letter they are aware of, if it advantages them. An illustration of this rule can be found in a case in which the French Supreme Court ruled that rightful heirs may ask for the reduction of a hidden donation contained in a side letter signed by their author.
Third, by modifying terms of the primary contract the side letter might change the qualification of the whole agreement. For instance in France, some management lease contracts are concluded by parties to hide in the side letter the real qualification of a contract i.e. the purchase of the business.
Do's of Side Letters
Recommendations can be given as to the content (I) and the secrecy (II) of side letters.
I. Content of side letters
Even if a primary contract and a side letter are two independent agreements, the content of the primary contract may have effects on the side letter. Once the validity of both contracts is separately verified, the consistency of both documents need to be examined.
In the primary contract, particular attention must be given to the choice of law provision and the entire agreement clause. The choice of law provision may have various consequences impacting the side letter. These consequences can arise from the application of domestic international public order policy, national overriding mandatory rules, or domestic rules. When an entire agreement clause is in the primary contract, the side letter shall be concluded after the primary contract. To make the day and/or the hour of conclusion of the two documents apparent will then facilitate proof.
In the side letter, it may be useful to modify terms defined in the primary contract. In the case International Milling Co v. Hachmeister Inc., the parties to a purchase agreement used a side letter in order to modify the quality requirements for the product delivered to make them more restrictive than the terms contained in the primary contract. The preamble and the confidentiality clause of a side letter are also essential terms.
The preamble of the side letter will permit both to determine the intent of the parties and to justify itself if it becomes publicly available. Because of the secrecy surrounding side letters, the confidentiality clause will also be a key element, permitting to determine which degree of (non-)disclosure is desired.
II. Secrecy of side letters
The need to keep side letters secret can be illustrated in various legal areas.
In share purchase agreements, side letters are sometimes added to representations and warranties to deal with subjects such as tax liabilities or social issues that parties to the contract do not want public authorities to be aware of.
In sport contracts, it is possible to officially postpone a contract by concluding officially a promise as a primary contract; simultaneously, a side letter allows the party to secretly exercise the option to contract earlier. This is what happened between the FC Barcelona and the PSG soccer club for the transfer of the player Neymar Jr.
To increase secrecy, the parties to a side letter sometimes choose to keep it in escrow. In this later situation, parties need to draft carefully the instructions they want to give to the escrow agent and may decide to hire attorneys as escrow agent in order to take advantage of the legal privilege attached to this profession.
Nevertheless in some situations it is necessary to disclose side letters for transparency reasons. It might be the case for example regarding investors, or even third parties.
In the United Kingdom, the FSA (Financial Services Authority in the UK) recommended to make the security of the market prevail on the core principle of side letters; confidentiality. This position was then indirectly codified under the European AIFM Directive in article 23. Thus, the manager of an alternative investment fund (AIF) must disclose information regarding the AIF such as side letter terms to investors before they make their investment.
Side letters might have to be disclosed to third parties when modifying the terms of a primary contract. For example in lease agreements, concessions such as a shorter lease period or a consent to sublease are often granted by the landlord to the tenant by means of a side letter. In our example, the prospective purchaser will have to be informed of the different concessions granted.
Side letters remain valuable tools to keep secret or to bypass contractual provisions. If they do not deserve their dark reputation, they certainly deserve special attention.