In re El Paso Pipeline Partners, L.P. Derivative Litigation: A Cautionary Tale for MLPs and Yieldcos
The Delaware Court of Chancery, in In re: El Paso Pipeline Partners, L.P. Derivative Litigation, C.A. No. 7141–VCL, 2015 WL 1815846 (Del. Ch. Apr. 20, 2015), found that a master limited partnership ("MLP") overpaid its parent corporation by $171 million for certain "dropdown" assets because the Conflicts Committee of its general partner failed to form a subjective belief that the dropdown was in the best interests of the MLP.
This decision could bolster the power of activist investors and should serve as a cautionary tale for MLPs and Yieldcos alike.
The Transactions at Issue
El Paso Corp. ("Parent") formed El Paso Pipeline Partners, L.P. ("El Paso MLP") to maximize the amount of capital it could raise and to lower the cost of that capital by transferring to El Paso MLP assets generating stable cash flows. Parent controlled El Paso MLP through its ownership of El Paso Pipeline GP Company, L.L.C. ("General Partner"), a subsidiary of Parent that served as El Paso MLP's sole general partner.
In March 2010, Parent dropped down to El Paso MLP a 51 percent interest in Southern LNG Company, L.L.C. and Elba Express, L.L.C. (together, "Elba") for $963 million (the "Spring Dropdown"). Several months later, Parent dropped down its remaining 49 percent interest in Elba and a 15 percent interest in Southern Natural Gas, L.L.C. ("Southern") for $1.412 billion (the "Fall Dropdown"). An El Paso MLP limited partner brought a derivative suit claiming that El Paso MLP had been harmed by the overvaluation of these assets. The court granted summary judgment to the defendants as to the Spring Dropdown. However, it found the General Partner liable for breach of El Paso MLP's Limited Partnership Agreement ("LP Agreement") in the Fall Dropdown, in no small part because it determined, based on a comparison of the terms and negotiations of the Fall Dropdown with those of the Spring Dropdown, that the Conflicts Committee had affirmatively ignored certain lessons learned and acknowledged in the earlier transaction. In doing so, according to the court, the Committee had caved in to pressure from Parent regarding the price of the Fall Dropdown assets.
The LP Agreement permissibly waived the common law fiduciary duties that the General Partner would have otherwise owed El Paso MLP's limited partners under Delaware law and replaced them with contractual standards relating to the governance of El Paso MLP. In relevant part, the LP Agreement permitted approval of related-party transactions such as those between Parent and El Paso MLP, despite the inherent conflict of interest, as long as one of several conditions was met. Among these was "Special Approval," i.e., "approval by a majority of the members of the Conflicts Committee [of the General Partner's board of directors] acting in good faith." For the Conflicts Committee to act in good faith, the LP Agreement required only that its members subjectively "believe that the determinations or other action is in the best interests of the Partnership."
Deficiencies of the Fall Dropdown
The court identified a variety of problems with the Conflicts Committee's consideration of the Fall Dropdown. Ultimately, the decision paints a picture of the Conflicts Committee as one that simply "went through the motions" and whose judgment was subordinated to the twin goals of increasing distributions to common unitholders and raising inexpensive capital for its Parent. The court noted that while it expected the Committee and its financial advisor(the "FA") to "provide a credible account" of how they evaluated and negotiated the Fall Dropdown and determined that it was in the best interests of the MLP, it instead concluded that they lacked explanation of such details. Whether because they did not learn the relevant information, disregarded information they did learn, or were overruled by Parent, the court found that the Committee "did not subjectively believe that approving the Fall Dropdown was in the best interests of [El Paso MLP]." In reaching this determination, the court considered the Conflicts Committee's disregard for lessons learned in the Spring Dropdown, its preoccupation with "accretion" over value add, and the failing of the FA.
The Conflicts Committee's Conscious Disregard of Lessons Learned. In both the Spring and Fall Dropdowns, El Paso MLP acquired a share of Parent's Elba assets. During the several months between the two transactions, the Conflicts Committee members appear to have decided that it would not be "in the best interests of [El Paso MLP] to have too much of its assets tied up in the LNG trade" because of a negative outlook and limited growth prospects for LNG generally. Moreover, the Conflicts Committee members became convinced that El Paso MLP had paid too much in the Spring Dropdown because the markets reacted negatively and because an unrelated LNG facility transaction closed at a comparatively lower valuation. For these reasons, the Conflicts Committee resolved to negotiate harder with Parent for the next dropdown.
Despite these intentions expressed by the Conflicts Committee in contemporaneous email communications among its members, the court outlined the ways in which the Conflicts Committee did not act in accordance with its actual views and "consciously disregarded" the lessons it learned in the Spring Dropdown. As an initial matter, the court found that the Conflicts Committee "accommodated" Parent by agreeing to acquire its remaining interest in Elba. With respect to valuation for the Fall Dropdown, the court found that the Committee "did more than simply negotiate poorly." According to the court, they allowed the Spring Dropdown price to anchor the Fall Dropdown negotiations, ignored what evidence they had regarding a fair value for the Elba assets, and did not use Parent's Spring Dropdown valuation arguments to push back against its proposed Fall Dropdown valuation. Although the Conflicts Committee successfully argued for the inclusion of the Southern assets in the Fall Dropdown in exchange for agreeing to acquire the remaining Elba assets, the court found that they did not stand firm on their own stated interest in separate valuations for the two. This allowed Parent to increase the price El Paso MLP paid for the Elba assets above the agreed-upon valuation without the Committee realizing it.
The Preoccupation with Accretion. The court also found that rather than determining that the Fall Dropdown was in the best interests of El Paso MLP, the Conflicts Committee appears to have, by focusing on whether the transaction would be accretive to the holders of El Paso common units, failed to acknowledge or understand that "accretion" is not a part of valuation. The court found that the Committee "fixated myopically on accretion" despite the fact that accretion would not add value—the fundamental feature of a sound acquisition according to the court.
The Failings of the Financial Advisor. The court's decision portrays the Conflicts Committee's FA as ineffective at best, and misleading or manipulative at worst. The court implies that the FA acted as if Parent, rather than the Conflicts Committee, was its client, noting that each dropdown began with a diligence session performed with Parent and that Parent "back channeled" throughout the Fall Dropdown with the FA. With respect to the Fall Dropdown, the court found that the FA viewed it as an "update" on its work on the Spring Dropdown and noted that the FA failed to perform any new analyses notwithstanding that it was specifically requested to do so by the Conflicts Committee. Furthermore, the court noted that the FA's valuation methodology changed between the Spring and Fall Dropdowns, but that the FA failed to explain these changes to the Conflicts Committee.
In fact, the court pointed out that the FA, the Conflicts Committee, and Parent all produced a number of inconsistent justifications for the valuation work that was performed for the Fall Dropdown. The court also noted specifically that the FA worked on a contingent fee basis and would not get paid until and unless the deal closed, concluding that the FA specialized in producing "visually pleasing presentation[s] designed to make the dropdown look as attractive as possible," but was not aggressive about seeking out information that would help it produce a fair valuation. The court concluded that to ensure that the deal would go through, the FA was not entirely truthful with Conflicts Committee members and manipulated its valuation analyses (e.g., shifting the meaning and purported value of majority and minority stakes, carefully selecting precedent transactions to show that the Fall Dropdown valuation had a comparably favorable EBITDA multiple, and using misleading or erroneous inputs (cost of capital, discount rate, terminal value) for its discounted cash flow analysis). The court also rejected the FA's fall-back argument—that the FA had exercised its "judgment"—on the grounds that the FA's "judgment" routinely benefitted Parent instead of El Paso MLP. In short, the court concluded that the FA "failed to perform the real work of an advisor to a committee" and "[r]ather than helping the Committee bolster its claim to have acted in good faith, [the FA] undercut it."
Ultimately, the court found that El Paso MLP overpaid for the Fall Dropdown assets by $171 million and imposed damages against the general partner in that amount. In so finding, the court emphasized that ritualistic, nonsubstantive dropdowns to MLPs (and, by analogy, to Yieldcos) can pose a danger if not handled carefully. Indeed, the court's extensive opinion may provide a road map to activists intent on derivative litigation second-guessing business decisions and demonstrates that the elimination of board fiduciary duties in constituent documents is not sufficient to shield against such suits. MLPs, Yieldcos, and financial advisory firms should take note and handle such intercompany dropdown transactions with due care.