On March 20, 2017, the Delaware Supreme Court announced that it had “change[d] course” from earlier precedent by reversing in large part the Chancery Court’s dismissal of a master limited partnership (“MLP”) investor lawsuit for failure to plead that the challenged transaction was the product of “bad faith.” The Court held that it would not hold the plaintiff to an exceptionally high pleading standard analogous to that for “waste,” and remanded the case for re-evaluation under a somewhat less demanding pleading based on a “more traditional definition of bad faith utilized in Delaware entity law.”
The Supreme Court’s decision in Brinckerhoff v. Enbridge Energy Company, Inc., et al. (No. 273, 2016 (Del. Mar. 20, 2017)), is the latest reminder of the difficulty dealmakers and courts encounter drafting and interpreting limited partnership agreements (“LPAs”) and, in particular, provisions that address perceived conflicts that otherwise may arise from transactions involving MLPs and their general partners or other related parties. In key respects, this case is typical of the MLP disputes that Delaware’s highest court acknowledged at the outset it has “frequently been called upon” to referee. As discussed below, however, the relevant LPA provisions in question are largely not found in more recent LPAs and so, with one exception, its importance to more recent MLPs is probably limited.
The plaintiff and his trust are long-term investors in Enbridge Energy Partners, L.P. (“EEP”), a Delaware MLP organized under an LPA that eliminates common law fiduciary and other duties in favor of contractual ones. Plaintiff challenged a transaction between EEP and Enbridge, Inc. (“Enbridge”), the ultimate parent that controls EEP’s general partner (“EEP GP”), whereby EEP repurchased EEP GP’s majority interest in a pipeline project joint venture established several years before under terms that had been approved by a Special Committee but that plaintiff nonetheless alleged had unfairly benefited Enbridge at the expense of EEP and its unitholders.1
The Chancery Court dismissed the lawsuit, ruling that plaintiff failed to sufficiently allege that the defendants violated the LPA’s specific requirement that affiliated transactions be consummated on terms that are “fair and reasonable” to the MLP. The Chancery Court reasoned that defendants’ specific “fair and reasonable” obligations were effectively subordinated to other provisions of the LPA, including broad exculpation against claims for money damages based on actions undertaken in “good faith,” and that dismissal was necessary because plaintiff had failed to allege bad faith in the first instance.
The Supreme Court, however, reversed, ruling that the “fair and reasonable” provision that was specific to affiliated transactions was not displaced by more general provisions, specifically rejecting defendants’ theory that “EEP GP and its affiliates were free to breach any of the LPA’s specific requirements, so long as they did so in good faith.” The Court also clarified that, for purposes of the LPA, “bad faith is sufficiently alleged ... if the plaintiff pleads facts supporting an inference that [the GP] did not reasonably believe it was acting in the best interest of the partnership.” In so doing, the Court embraced the “traditional definition” applied in entity litigation, and rejected defendants’ argument that the standard was still higher for this LPA (a standard that the Court analogized to one for waste, i.e., the requirement that plaintiff “plead facts that ruled out all legitimate explanations” for the transaction other than bad faith”).
The broader market impact of the Supreme Court’s decision will be limited to a great extent by the passage of time. Most of the LPA provisions that the Court ruled did not protect the directors are not found in more recent LPAs, which have adopted a somewhat different structure for resolving conflicts of interest. For instance, modern agreements provide a general duty on directors to act in good faith, which is generally defined to mean that the director subjectively believed that the action or decision was in, or not opposed to, the best interests of the partnership (or sometimes merely not adverse to the partnership). The EEP LPA, by contrast, imposed no such subjective good faith standard. Instead, it included provisions requiring that related-party transactions (specifically including a sale of assets by the GP or its affiliates to the partnership) be fair and reasonable to the partnership, thereby introducing an objective standard into the analysis. Given this specific provision, it is not surprising that the Supreme Court held that a requirement to plead bad faith should not bar a claim based on breach of the specific provision. Furthermore, the EEP LPA lacks a cornerstone of modern LPAs, namely a provision that a conflict of interest approved by a special or conflicts committee of independent directors acting in good faith constitutes the deemed approval by all partners of any such conflict of interest, and thus forecloses a claim for breach of the LPA. (EEP used a special committee as a best practice for handling the conflict of interest, but its approval did not in and of itself have any special operative effect under the LPA.)
The more troubling aspect of the Supreme Court’s decision is its failure to give effect to a provision granting directors a conclusive presumption of good faith for decisions taken upon reliance on an opinion of a financial advisor whom the directors reasonably believe has the competence to render the opinion -- a provision that is largely unchanged in modern MLP LPAs. The Court allowed plaintiff to argue that the directors could not reasonably have believed the financial advisor was competent given that it did not compare the transaction to the 2009 transaction in which the MLP and Enbridge formed the joint venture. The Court further seemed to reason that the conclusive good faith presumption that arises from reliance on a financial advisor can only be triggered if the financial advisor served a structuring role in the transaction (i.e., wasn’t retained simply to react to a proposal that was already on the table). The Court observed, “Financial advisors will often advise the board on valuation issues. In those situations, the advice established the appropriate methods and terms on which the general partner then acts to consummate a transaction. If [advisor] had been charged in the first instance to value the [conveyed] Interest, and the Special Committee had reasonably relied on [the] valuation to set the sale price, [the advisor’s] role and the Special Committee’s reliance on its valuation might be a more comfortable fit” with the contractual good faith presumption. Instead, the Court emphasized that “according to the complaint’s allegations, the financial terms were fully baked by the time [the advisor] appeared on the scene to render a fairness opinion.” Thus, the Court concluded, the defendants did not rely on the financial advisor in the manner contemplated by the good faith presumption provision.
This portion of the Supreme Court’s decision is of importance to conflicts committees of independent directors, who rely heavily on fairness opinions from their financial advisors. There are several potential ways to mitigate this concern, however. First, under modern LPAs, the transaction and directors individually are protected as long as the directors subjectively believed that the transaction was in, or not opposed to, the best interests of the partnership; they can hold this belief upon reliance, in part, on a fairness opinion, even if the conclusive presumption language is not available. Second, there was no negotiation of the price in the challenged EEP transaction. It is unclear whether the Court would have applied the good faith presumption if there had been a price negotiation such that the financial terms were therefore not “fully baked.” Whether or not to attempt to negotiate the financial terms of a transaction is generally within the powers of a conflicts committee. Finally, practitioners will consider whether to amend this section of the LPA to permit reliance on financial advisors whom the directors subjectively believe (as opposed to “reasonably believe”) to be competent in rendering fairness opinions.
1As the Supreme Court noted, this was not the first time plaintiff had sued over its EEP investment, nor the first time Delaware’s highest court was called upon to consider the parties’ rights under the LPA. Plaintiff brought the first case in 2009, challenging the sale to the GP affiliate of the very position that EEP subsequently repurchased, i.e., the basis for the pending case. That the same parties have been spending the better part of a decade commuting between the Delaware Chancery and Supreme Courts is a stark reminder of precisely how litigious MLP transactions have become -- and why exceptional care in drafting these deals is critical.