The Delaware Chancery Court recently ruled, in In re El Paso Pipeline Partners, L.P. Derivative Litigation (Apr. 20, 2015), that the general partner of a master limited partnership (MLP) was liable to the MLP for the $171 million by which the court determined that the MLP had overpaid for liquefied natural gas (LNG) assets purchased from its parent company for $1.4 billion in a typical “dropdown” transaction. In a separate memorandum, we have discussed the decision and our view that it will have limited applicability given the unusual factual context. We note that the court’s extremely negative view of the conduct of the conflict committee and its investment banker offers a blueprint for how not to conduct a conflict committee process. We offer the following practice points arising out of the decision.
Please see our separate memorandum (May 7, 2015) discussing the decision: “ Perspec tive on El Paso— Despite Finding of Liability for General Partner, No Increased Scrutiny of Directors and Bankers in MLP Dropdown Situations”.
An MLP conflict committee should:
- Value a dropdown transaction based on all relevant factors—accretion alone is probably not sufficient. This is an important practical point arising from the decision, as it does not relate to the unusual facts of the case and is applicable to all dropdowns. In making a determination whether a dropdown meets the standard for approval set forth in the MLP’s governing documents, concluding that a dropdown will be immediately accretive and that, therefore, the MLP could increase its cash distributions to the MLP’s limited partners, standing alone, probably is not sufficient. A committee should consider all relevant factors, including accretion, fairness of the price, and the potential to add to long-term value. We note that an MLP’s units trade based largely on yield and expectations as to yield growth, and the primary objective for MLPs is to grow cash distributions over time. Thus, a court might not criticize a focus on accretion as the primary factor if (in contrast to the case in El Paso) a committee has considered the extent to which accretion was the most important factor for the MLP as a whole and has considered the other relevant factors. (See the additional discussion in our memorandum about the decision referenced above.)
- Reach a conclusion that meets the standard in the limited partnership agreement. As noted, the committee and its banker should be aware of what the standard is for approval of the transaction under consideration and legal counsel should advise what steps are necessary to meet the committee’s obligations. The committee’s determination, which should track the applicable standard, should be memorialized in the formal record of its deliberations. If the contractual standard is based on the best interests of the MLP as a whole, a committee should not consider just the effect on the limited partners. Contemporaneous emails or other communications that contradict the committee’s determination will affect the credibility of the determination. Committee members should be prepared to explain any changes of view or inconsistencies in the record of their deliberations. The court will find sudden or unexplained changes of view suspect.
- Be engaged. Committee members should be engaged in the process of considering a transaction; should ensure that they have the information needed to make a determination that meets the standard for approval; should ask questions to ensure that they understand the banker’s analyses at some level of detail; and should be in control of the committee’s process, including seeking to ensure that non-committee members are not contacting the committee’s advisors or the parent company.
- Be an advocate for the MLP, not the parent company. A committee must proceed as an advocate for, and consider the interests of, the MLP, not the parent company. Obviously, a committee should not accede to a transaction or to terms simply to facilitate the parent’s wishes. A committee should “say no” and negotiate with the parent company unless it is clear that the standard has been met. In addition, to form a good faith judgment about a transaction (again, unless the determination is clear), the committee probably should engage in some level of negotiation with the parent company.
- Review market reaction to previous transactions for similar assets. A committee should review and understand market and investor reaction to the MLP’s prior dropdowns of similar assets. In El Paso, the court was highly critical of the committee for having ignored the “lessons learned” from the negative market reaction to its own recent prior transactions for interests in the same parent subsidiaries as were being acquired in this dropdown.
- Understand the pricing of the transaction; consider valuing separate components of the transaction separately. Depending on the circumstances, it may be appropriate to value and consider the fairness of the pricing of each component of a deal separately rather than only valuing the unitary transaction and considering the fairness of the aggregate offering price. For example, in the El Paso dropdown, the conflict committee negotiated with the parent company to include additional assets that the committee considered to be beneficial for the MLP. The court noted that a price improvement that had been achieved by the committee with respect to the original assets “was lost” in the course of the negotiations over the “unitary transaction” that then included the additional assets—in the court’s view, an outcome attributable to the committee’s not having analyzed, negotiated for, and priced the two components of the deal separately. Although not addressed in El Paso, we note that, if a parent company rejects selling only the assets that the MLP wants to buy and insists on a unitary transaction that includes assets the MLP does not want, the committee should consider “testing” the parent’s resolve on the issue rather than simply accepting that position.
- Carefully review and understand the work of its investment banker. A committee, advised by legal counsel, should ensure that it is receiving, carefully reviewing, and understanding the work of its investment banker and should understand and consider any potential effects of the fee arrangements with the banker. In El Paso, where the banker’s entire fee was contingent on its delivery of a fairness opinion for the transaction, and the banker’s materials were found by the court to have been deliberately misleading in order to make the transaction appear to be better than it actually was, the court characterized the banker as having done whatever it could to “justify [the transaction], get to closing, and collect its fee,” thereby “undercut[ting] the Committee’s claim to have acted in good faith.”
An investment banker advising a conflict committee should:
- Consider all relevant factors for a valuation. As noted above with respect to the conflict committee practice points, a dropdown should not be valued based on accretion alone. All relevant factors should be considered—such as accretion, fairness of the price, and the potential for adding to the MLP’s long-term value. The banker should advise the conflict committee as to which valuation measures are the most important under the specific circumstances.
- Not utilize a “results-oriented” approach. In El Paso, according to the court, “every one” of the changes made by the banker to its materials relating to the previous El Paso MLP dropdown transaction “made [this] Dropdown look more favorable than it actually was.” Criticizing what the court viewed as the banker’s deliberate omission of certain materials and misleading presentation of other materials, the court concluded that the banker, being “eager for future business,” “manipulated its presentations [to the Committee] in unprincipled ways to justify the deal.” Noting that the banker’s full fee was contingent on its delivering a fairness opinion, the court stated its view that: “[The banker]’s real client was the deal.”
- Exert appropriate effort; have an explanation for changes made to prior materials; and appropriately inform the conflict committee. In El Paso, the court characterized the banker as having exerted “minimal effort” and having approached the project as requiring merely an updating of its analysis of the MLP’s prior dropdown transaction. As MLP dropdowns are frequent and routine transactions that tend to follow the same patterns, the banker’s materials typically are based on prior transactions. That approach in and of itself should not be problematic. However, a banker should:
- update its materials to take into account comparables and other relevant valuation events since the last transaction;
- have an explanation for every change made from prior analyses and presentations and, if it is the case, an explanation for why substantially all of the changes favor the parent;
- make the conflict committee aware of, and explain the reason for, any significant changes made;
- explain its methodology (and choice of inputs for its DCF, WACC and other analyses) to the conflict committee;
- consider whether there are “lessons learned” from previous deals that should be taken into account (such as a negative market reaction to the pricing of a recent past transaction for similar assets);
- not rely on the parent company alone for a determination about the value of the assets being sold; and o discuss its fee arrangement with the conflict committee.
- Note the following specific criticisms the court made relating to misleading information and a failure to explain changes made to prior materials. Specifically, the court criticized the banker for:
- manipulating its precedent transaction analysis to justify the pricing for a majority interest in one of the parent company’s subsidiaries by presenting minority-acquisitions and majority-acquisitions all together without distinction, while in its materials for the prior dropdowns, the banker had separated minority-acquisition precedents and majority- acquisition precedents, depending on whether the MLP was purchasing a majority or a minority interest;
- a slide that created a misimpression with respect to the amount of future revenue that was guaranteed, including deleting material that would have partially corrected the misimpression (and that had been included in the slides used for the other dropdowns the MLP had completed for the same assets);
- manipulating its DCF methodology by changing, without explanation, the cash flow projection periods, the exit multiples to calculate terminal value, and the upper bound of the discount rate from those used with respect to the other dropdowns the MLP had completed for the same assets;
- using the parent company’s cost of capital in its DCF analysis rather than the cost of capital for the subsidiary it was acquiring; and
- manipulating its valuation summary for each of the two businesses being purchased by eliminating valuation methodologies for the business where the summary data would have been inconsistent with the banker’s conclusion.
- Maintain the committee’s independence. In El Paso, the court was critical of the parent company and of the conflict committee’s banker for ongoing contacts between the banker and the CFO of the parent, apparently without the committee’s knowledge (including a first contact with the banker by the parent before the committee had met with the banker). To maintain the independence of a conflict committee, there should be no contacts between the banker and the parent without a member of the conflict committee or its counsel being present, and any contacts should be promptly disclosed to the committee. While not an issue in El Paso, it should be kept in mind that any conflicts of interest or potential conflicts of interest on the part of the banker should be promptly disclosed to the conflict committee.
A general partner/parent company of an MLP should:
- Keep in mind that obtaining the highest possible price for dropdown assets may not be in the general partner/parent’s best interests. The general partner and the parent company are not necessarily benefitted by maximizing the price to be obtained for the assets in a dropdown. As a lower dropdown purchase price paid by the MLP will increase the MLP’s cash flow and earnings on an ongoing basis, the general partner and parent are likely to recapture most or all of the reduction in price through better price performance for the MLP units they hold (particularly important in the case of an MLP that issues equity on a periodic basis) and through the general partner’s incentive distribution rights. Deriving the right price requires a balancing of the parent’s competing objectives.
- Ensure the independence of the conflict committee. In El Paso, the court noted that the three directors who comprised the committee met the NYSE audit committee independence standards. Nonetheless, the court described at length the ties that two of the three had to the parent company. They had been executives of the parent or one of its affiliates and still had a significant portion of their respective net worths tied up in the company. While the court did not find the directors to be unqualified to serve as conflict committee members, the court appeared to be negatively influenced by its view of the close connections of the committee members to the parent. The general partner, when selecting the committee members, should consider the degree of their independence from the parent company. Further, as noted above, the general partner and the parent should maintain the committee’s independence by not having contacts with the committee’s banker, unless a committee member or the committee’s legal counsel is present.