In In re El Paso Pipeline Partners, L.P. Derivative Litigation, 2015 WL 1815846 (Del. Ch. Apr. 20, 2015), the Delaware Court of Chancery (Vice Chancellor J. Travis Laster) issued a post-trial opinion finding that the general partner of a limited partnership failed to form a subjective good faith belief that a particular transaction was in the best interests of the company, as was required under the limited partnership agreement (the LP agreement). The court found that the general partner’s breach caused the partnership to overpay by some $171 million and awarded that difference to the partnership, to be paid by the general partner.
All of the involved entities are in the oil and gas industry. The partnership, El Paso Pipeline Partners, L.P., was controlled by El Paso Corporation (the parent) through the parent’s ownership of the partnership’s general partner, El Paso Pipeline GP Company, L.L.C. (the GP).The parent also owned 52 percent of the partnership’s common units, with the remaining trading on the NYSE. Most of the GP’s board members were employed directly by the parent.
The transaction in issue was a form of “dropdown,” a transaction common to the industry, which involves a parent disposing of an asset by selling it to a subsidiary for cash or equivalent. In the context of this case, because the company was structured as a partnership − i.e., a pass-through entity − it could distribute cash to investors in a more tax efficient manner than the parent, a corporation, which is taxed at the corporate level and then at the investor level. Thus, the partnership’s cash flows were more highly valued to investors, and it effectively could issue equity at a much lower cost of capital than could the parent. By accomplishing dropdowns in return for cash it had raised at the partnership level, the parent “captured the tax benefit and obtained capital at the lowest possible cost.”
By 2012, the parent and the partnership had completed nine dropdown transactions. In each instance, the parent proposed a sale of assets to the partnership for a mix of cash and assumption of debt. The GP then convened an ad hoc special committee, which hired outside legal and financial advisors to assist in the transaction. After minimal back-and-forth, the special committee recommended the dropdown, which would be completed in short order.
The challenged dropdown
The parent proposed in October 2010 that the partnership purchase 49 percent of the outstanding shares in another of its subsidiaries for $948 million in mixed cash and debt, and included an option for the partnership to purchase 13 percent of the outstanding shares in yet another subsidiary for $325 million, or 2 percent for $50 million in mixed cash and debt in that same company (the additional term and, overall, the proposal). As before, the parent and partnership engaged in minimal back-and-forth. The special committee initially countered at $900 million, which the parent accepted. Following that agreement, the parties settled on removing the option, rendering the additional term part of the deal. The GP eventually agreed to purchase 15 percent of the subsidiary in the additional term. The parent announced the dropdown in November 2010 at $1.412 billion (the challenged dropdown).
The general partner breached the LP agreement because of a weakened and biased deal process
The LP agreement required the GP to form a subjective belief that conflicted transactions, such as the challenged dropdown, are in the best interests of the partnership. That is, it “did not require that the [GP] make a determination about the best interests of the common unitholders as a class or prioritize their interests over other constituencies.” But that is what the special committee, on behalf of the GP, did instead of determining that the dropdown was in the best interests of the Partnership.
The court found, for at least three reasons, that the deal process relating to the challenged dropdown was weak and biased, resulting in the special committee’s failure to form a subjective good faith belief that the transaction was in the best interests of the partnership.
The special committee’s preoccupation with the challenged dropdown’s accretive benefits to parent
The court found that the special committee had “fixated myopically” on the potential accretion to the partnership’s common unit holders. That is, once the transaction closed, the partnership could increase distributions to its investors. The court observed, however, that accretion “says nothing about whether the buyer is paying a fair price,” and therefore whether the purchaser would benefit from the transaction in the long-run. The court found that the special committee had set out to accomplish the deal mostly benefitting the parent.
The special committee member’s actual views and “conscious disregard of lessons learned”
In a previous dropdown, one of the special committee members believed a 51 percent stake in the subsidiary that would become the subject of the challenged dropdown was valued fairly at $725-780 million, with the remaining 49 percent valued at $711-764 million. After countering at $860-870 million, that previous committee approved the purchase of a 51 percent stake at $963 million. Thereafter, one of the members stated that “next time we will have to negotiate harder.”
In addition, the committee members individually expressed reservations in accomplishing future dropdowns that would include same types of assets, in part owing to the deteriorating marketplace for that asset. Nonetheless, the GP approved purchasing the remaining equity in the very same subsidiary as the prior dropdown, with the special committee allowing the prior dropdown’s price to set the bar during negotiations, without ever having challenged the parent effectively on the deal price. The special committee also failed to require its financial advisor to analyze the two major components independently.
Financial advisor’s biased work product and the special committee’s failure identify deficiencies
In short, the court found that the financial advisor’s “actions demonstrated that the firm sought to justify the parent’s asking price and collect its fee”:
- When asked to analyze if the deteriorating marketplace had affected the attractiveness of the assets in the proposal, the financial advisor only asked the parent. In addition, the financial advisor was asked to analyze other recent comparables. The financial advisor pulled press release of other transactions, and performed no further examination.
- As to other aspects of the proposal, the financial advisor had recycled slides from a previous presentation and manipulated the numbers, and in at least one case reducing the information.
- The financial advisor “craft[ed] [ ]a visually pleasing presentation designed to make the [proposal] look as attractive as possible.” For example, it abandoned the majority-minority acquisition groupings it used previously in advising on prior dropdowns, without ever explaining why. In addition, manipulated its DCF analysis by applying the partnership’s cost of capital (thus reflecting the measure of risk in the cash flows of the acquirer, not the asset), adjusting the discount rates to reflect that the proposal lie more in center of the DCF range, and providing a more attractive set of multiples. The financial advisor never explained its adjustments to the special committee.
The special committee never questioned the financial advisor on any of these points. The court concluded from the evidence that “the Committee members went against their better judgment and did what Parent wanted, assisted by a financial advisor that presented each dropdown in the best possible light, regardless of whether the depictions conflicted with the advisor’s work on similar transactions or made sense as a matter of valuation theory.”
Based on the foregoing, the court found that the special committee, and by virtue of that the GP, breached its affirmative duty to form a subjective good faith belief that the challenged dropdown was in the best interests of the partnership. The court determined damages on an expectation damages basis — i.e., the difference between the actual challenged dropdown deal price and what the partnership would have paid had the GP not breached the LP agreement. The court adopted the analysis of the plaintiff’s expert that the partnership overpaid by $171 million.
Two key takeaways
- Independence and process matter. Ultimately, this case is emblematic of the consequences that flow from a weakened deal process and prone subsidiary. Here, a parent-dominated entity failed to maintain an active and robust negotiation process with its parent corporation, and indeed demonstrated that it sought terms that most benefitted the parent. In short, the subsidiary (i) acquired an asset for which it previously had expressed disfavor, (ii) at a price it knew or should have known was inflated beyond the true value of the asset, (iii) without ever having negotiated effectively with a party that it previously had recognized insisted on inflated prices, and (iv) failed to adequately manage and assess its financial advisor’s process and work product. Instead, as the court recognized, the deal closed with the subsidiary having “fixated myopically” on the dividend potentials resulting from the deal. The court’s opinion, and the facts of this case, should serve as a warning to committees tasked with making deal recommendations: independence and process matter.
- It is difficult to understand why the case was tried. If special committee members cannot articulate why a transaction is in the best interests of the company, which was the contractually required standard here, there is no defense. Perhaps the record prevented the special committee from making any attempt to present credible testimony that they acted in the partnership’s best interest, less they be accused of making up their testimony for trial. Lesson learned: competent counsel can help you get it right from the beginning, so that if you cannot avoid being sued, at least you will have a record that will help you win.