In a recent opinion, In Re: El Paso Pipeline Partners, L.P. Derivative Litigation, the Delaware Court of Chancery (Vice Chancellor Laster) found after a trial that a special committee of the board of the general partner did not actually believe that a dropdown transaction was in the best interests of the MLP, but nevertheless approved the transaction, violating the requirements in the partnership agreement.
El Paso Pipeline GP Company LLC was the general partner (the General Partner) of El Paso Pipeline Partners LP (the Company) and a party to its limited partnership agreement (the LPA). The General Partner was controlled by El Paso Corporation (Parent). In 2010, the Parent sold two of its subsidiaries to the Company in separate dropdown sales, the first occurring in March 2010 (the Spring Sale) and the second occurring in November 2010 (the Fall Sale). The LPA permitted the General Partner to engage in a transaction involving a conflict of interest (each of the Spring Sale and the Fall Sale involved such a conflict of interest), if the transaction received approval from a conflicts committee (the Committee) comprised of qualified members of the board of directors of the General Partner. The LPA required that the determination by the members of the Committee be based on their belief in good faith that the transaction was in the best interests of the Company.
Plaintiffs challenged both the Spring Sale and the Fall Sale. The Court granted defendants’ summary judgment as to the Spring Sale, but partially denied defendants’ motion for summary judgment as to the Fall Sale, requiring a trial as to the state of mind of the members of the Committee in approving the Fall Sale.
Conflict of Interest
Parent had created the Company to maximize the market value of certain of its assets. Because the Company was a pass-through entity for tax purposes, it could distribute cash to investors on a cost-effective basis. Parent had done several dropdowns into the Company to take advantage of this tax benefit. In addition, the sale of assets to the Company was an inexpensive way for the Parent to raise capital. Naturally, in this type of transaction, the higher the price paid for the asset by the buyer (here the Company), the better it would be for the seller (in this case, Parent, the controlling affiliate) and the worse for the buyer.
The Court held that the Committee was required to evaluate a transaction raising a conflict of interest and determine that, despite the conflict, the transaction was in the best interests of the Company. The Committee could not simply approve a transaction because it was best for its controlling affiliate. The Court determined that the Committee did not follow the standards set forth in the LPA to protect the Company and in essence acquiesced to the desires of the Parent.
Because the Court found that the Committee members failed to form the subjective belief that the Fall Sale was in the best interests of the Company, the Court found that the General Partner breached the LPA and ordered the General Partner to pay $171 Million to the Company (which was the amount that the Court determined the Company had overpaid in the Fall Sale). There was no secondary liability for any of the directors or other defendants.
In making this determination, the Court explained that it had expected that at trial the defendants “would provide a credible account of how they evaluated the Fall [Sale], negotiated with Parent and ultimately determined that the transaction was in the best interests of [the Company].” The Court observed that “the evidence at trial ultimately convinced me that when approving the Fall [Sale], 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.”
Failures of the Committee Process
The Committee was comprised of three members of the board of directors of the General Partner. Although they each met the independence standards to serve on an audit committee of a NYSE-listed company, at least 2 of them had significant ties to the Parent. By the time of the Spring Sale, the Company had already consummated several significant acquisitions from the Parent (and, in fact, had not acquired any assets from any other seller).
The Court reviewed the process in detail and identified a variety of deficiencies in the process that collectively resulted in a finding that the Committee had not subjectively determined that the Fall Sale was in the best interests of the Company. These defects, none of which alone was fatal, in combination resulted in a conclusion that the Committee had ignored its duties under the Agreement. The defects are instructive for all special committees charged with evaluating controlling person transactions. Here is a summary of the key defects:
- Engagement of Same Financial Advisor for Multiple Transactions. A routine had been established with respect to the dropdown acquisitions and they proceeded somewhat mechanically. Each time, the Committee would engage the same financial advisor (the Advisor) to render an opinion as to the fairness of the transaction. The Advisor was new to the advisory business when it was first engaged by the Committee. The Advisor’s fee was to be paid on a contingency basis—i.e., the Advisor would only receive payment if it rendered an opinion. The Advisor was motivated to present data in a way that supported a favorable fairness opinion, so that it would be hired for the next engagement. Thus, the Committee was relying on an expert which had a motivation to find that each succeeding transaction was fair to continue its stream of income from what turned out to be a steady flow of transactions from the Company. Although there are efficiencies involved in a Committee using one financial advisor for a series of similar transactions, the Committee could have engaged a different financial advisor for some of the transactions, thus focusing the advisor in each transaction on the job at hand without creating an expectation of further employment.
- Inadequate Record of Committee Evaluation. The Court explained that the Committee was not able to provide a credible account of its evaluation of the transaction at question or negotiations with the Parent to secure the best terms for the assets being purchased. In fact, in most instances, “the Committee members and their financial advisor had no explanation for what they did. The few explanations they had were conclusory or contradicted by contemporaneous documents.” Of course, a well-functioning special committee is aided by a contemporaneous record of its deliberations and evaluation.
- Failure to Notice Differences in Presentation of Data And Make Inquiries. In this case, because this same Advisor had given the Committee several similar opinions in the past, the Committee could have realized that the presentation of data for the Fall Sale was somewhat different and asked questions about the data the Advisor was presenting. In fact, the Advisor had manipulated the data (changing parameters of comparable sales, presentation of relevant metrics, relevance of acquiring a controlling interest, etc.) to provide the outcome it needed to support the fairness opinion. If the Committee had pursued this questioning the Advisor might have shown its bias. The Court observed, “one would expect a financial advisor to have reasoned explanations for its changes, and it would be surprising if every one of the changes moved the analysis in the same direction.” The Committee would have been well-served by a request to the Advisor to highlight changes from its prior presentations, and a discussion focused on the reasonableness of the changes in light of the market evidence regarding the prior deal. The Court conducted a lengthy review of the Advisor’s work, concluding that the “unifying theme for [the] changes was making Parent’s asking price look better” and that “. . . [Advisor] practiced a different kind of art: the crafting of a visually pleasing presentation designed to make the dropdown of the moment look as attractive as possible. This was a case in which ‘the financial advisor, eager for future business…compromises its professional valuation standards to achieve the controller’s unfair objective.’”
- Failure of the Financial Advisor to Seek Alternatives, or Assist in Negotiation of Best Price. In addition, the Court observed the failure of the financial advisor to help develop alternatives, identify arguments and help negotiate the best price it can. The Court observed that, “[r]ather than helping the Committee bolster its claim to have acted in good faith, [the Advisor] undercut it.”
- Failure to Consider Evidence from Prior Transaction to Evaluate Current Transaction. The trading price of the Company units went down after the consummation of the Spring Sale. This was evidence that the market did not believe that the acquisition was advantageous for the Company. At that time, one of the Committee members indicated that they did not think that the Company should acquire any more liquefied natural gas assets as the sector had become less favorable. Despite its experience in the Spring Sale, the Committee did not use the lessons learned in that negotiation against Parent in the Fall Sale. Further, although the Committee members knew about recent arm’s-length acquisitions of similar assets, the Committee did not obtain or use this information in price negotiations with Parent. Moreover, when the Advisor presented data about the multiples used in recent sales, it relied heavily on the Spring Sale, despite the contrary market evidence of value post-transaction. The Court observed, “[a]fter receiving market evidence that the Company had paid too much [for the assets purchased in the Spring Sale], and after deciding they would have to do better the next time, the Committee disregarded these expensive lessons.”
- Failure to Consider Valuation of Separate Assets to Determine Impact on Aggregate Purchase Price. After negotiations setting a price with respect to one asset in connection with the Fall Sale, resulting in a downward adjustment in the price favorable to the Company, the Parent offered the Company an additional asset. In the revised offer, Parent did not provide separate prices for the two assets, but rather proposed an aggregate purchase price. The Committee’s advisor did not present information to the Committee about the value of the two assets separately. The Committee failed to assess how much was being paid for the two assets and the combination thus masked an increase in the price of the first asset from the previously negotiated price. The Court found that the Committee thereby gave up what little price improvement they had negotiated by disregarding their prior determination that they should evaluate the components separately.
Ultimately the Court held that, notwithstanding the formal documentation to the contrary, the Committee did not decide that the Fall Sale was in the best interests of the Company and in fact “never learned enough about the price to make that determination.” The court observed that the composite picture was “one in which the Committee members went through the motions.”
The Court explained that it was an accretion of points here that created a picture. The Court noted that this Fall Sale “was the fifth since [the Company]’s IPO, and the participants had established a comfortable pattern. Everyone understood the routine and expected the transaction to go through with a tweak to the asking price. No one thought the Committee might bargain vigorously or actually say no.” The evidence demonstrated to the Court that the Committee and its Advisor simply went through the motions, and that the Committee approved the Fall Sale despite their better judgment, and relied upon work product of the Advisor that showed that the process the Committee was undertaking was simply an exercise to paper the transaction, and not an effort to form a subjective view that the proposed transaction was indeed in the best interests of the Company. In reviewing this record, the Court concluded that the Committee had disregarded their known duty to determine the Fall Sale was in the best interests of the Company, and therefore did not act in good faith.
Members of special committees evaluating controlling person transactions can take valuable lessons from the process defects identified by Vice Chancellor Laster in determining their process and complying with their duties. The lessons here are particularly applicable to committees engaged in a series of transactions with controlling persons. This decision reminds directors that in a conflict of interest transaction, it is important for the committee reviewing the conflicted transaction to demonstrate that the committee is acting in the best interests of stockholders, with a contemporaneous record of its deliberations to provide a court with evidence of its deliberations.