The Delaware Chancery Court’s August 2012 opinion in In re: Encore Energy Partners LP Unit Holder Litigation1 is the latest in a series of cases addressing fiduciary duties and the implied covenant of good faith and fair dealing for managers of Delaware alternative entities.2 Earlier this year, in the Auriga Capital Corp. v. Gatz Properties, LLC decision discussed in the previous edition of the GT M&A Report, the Delaware Chancery Court found that absent an effective waiver of fiduciary duties in a limited liability company agreement, default fiduciary duties apply to the managers of Delaware limited liability companies. In that case, the court concluded that the managing member of the limited liability company had breached its duties of loyalty and care in the sale of the company to the managing member’s controlling principal.
Encore, like Auriga, involved a related party transaction, but in Encore, the court found that the limited partnership agreement effectively supplanted any common law fiduciary duties that the defendants may have owed to the company’s non-affiliated unitholders. The court concluded that the defendants complied with their contractual duties and the non-waivable implied covenant of good faith and fair dealing in their application of a special approval process to approve a related party merger.
In December 2011, Encore Energy Partners LP (“Encore”), a publicly traded Delaware limited partnership, was acquired by Vanguard Natural Resources, LLC (“Vanguard”), in a unit-for-unit merger transaction. Encore’s general partner, Encore Energy Partners GP LLC (“Encore GP”), was Vanguard’s indirect, wholly owned subsidiary. Because of the related party nature of the transaction, Encore GP’s board of directors employed a “Special Approval” process established in Encore’s limited partnership agreement. Pursuant to the Special Approval process, the merger was approved by a Conflicts Committee made up of independent members of Encore GP’s board of directors. In its review of the merger proposal, the Conflicts Committee engaged independent legal counsel and an independent financial advisor.
The plaintiffs, on behalf of a class of Encore’s former unaffiliated unitholders, asserted that the Conflicts Committee’s Special Approval was defective under the terms of the company’s limited partnership agreement, that the merger reflected an unfair exchange, and that Encore GP, its board of directors and Vanguard breached their duties under the limited partnership agreement. According to the plaintiffs, in the months leading up to the merger, Vanguard intentionally drove down Encore’s trading price. In addition, the plaintiffs claimed that the Conflicts Committee conducted a perfunctory review of the merger offer and that its sole counteroffer had a corresponding value less than the exchange ratio originally proposed by Vanguard.
Chancery Court’s Analysis
Contractual Duties under the Limited Partnership Agreement
The court states in the opinion that a general partner and its affiliates “may owe fiduciary duties to a limited partnership,”3 but notes that under the Delaware Revised Uniform Limited Partnership Act, a limited partnership agreement may eliminate all duties owed to the limited partnership and the limited partners, other than the implied contractual covenant of good faith and fair dealing. Encore’s limited partnership agreement expressly stated that except as set forth in the agreement, the general partner and its affiliates had no duties or liabilities, including fiduciary duties, to the partnership or any limited partner.
Although the Encore limited partnership agreement expressly waived fiduciary duties, in a separate section, the agreement imposed an obligation on the general partner and its affiliates to act in good faith when taking any action with respect to the partnership. The agreement also provided a “Special Approval” process allowing Encore GP to delegate decisions involving potential conflicts of interest to a Conflicts Committee made up of independent directors. Under the terms of the limited partnership agreement, a transaction approved by a majority of the members of the Conflicts Committee acting in good faith, would be deemed approved by all partners and would not constitute a breach of the agreement.
The limited partnership agreement went on to define “good faith,” stating that in order for an action to be taken in “good faith” the person making such determination must believe that the action is in the best interests of the partnership. The court applied a subjective “good faith” standard to the defendants’ actions, consistent with the interpretation in a 2010 Chancery Court decision of a nearly identical contractual definition of “good faith.”4
The court looked to the disclosure in the proxy statement for the merger for evidence of the Conflicts Committee’s subject beliefs regarding the merger. Although the Conflicts Committee’s sole counter-offer represented an increase of only 4.17% above Vanguard’s original exchange ratio, and a discount to Encore’s trading price at the time, the committee stated in the proxy statement that it considered the trading price to be less important than other financial metrics. In particular, the committee believed that the market price for the partnership units already contained a premium representing the market’s expectations regarding a merger with Vanguard. The committee also stated that it believed that an acquirer was unlikely to agree to an exchange ratio that appeared to be immediately dilutive to its own distributable cash flow per unit, and that its counter-offer reflected an exchange ratio approaching the point at which the proposed merger would become dilutive to Vanguard’s distributable cash flow per unit. The proxy statement further disclosed that the committee found the merger to be in the partnership’s best interests because distributable cash flow per unit would be higher in the combined entity and the merger agreement permitted Encore to continue making quarterly distributions until the merger closed.
According to the court, it did not matter whether the Conflict Committee’s determination was objectively reasonable. “However bad the Conflicts Committee’s decision may appear from the allegations of the Complaint,” the court states, “Plaintiffs have not alleged facts from which one could infer that the Conflicts Committee made its decision in bad faith, i.e., with the subjective belief that their approval was contrary to the Partnership’s best interests.”5
Implied Covenant of Good Faith and Fair Dealing
Having found that the defendants satisfied their express obligations under the limited partnership agreement, the court turned its analysis to the default duties imposed under the non-waivable implied covenant of good faith and fair dealing. In keeping with precedent, the court described the implied covenant “as a limited gap-filling tool to infer contractual terms to which the parties would have agreed had they anticipated a situation they failed to address.”6
Plaintiff’s claimed that the Conflicts Committee’s allegedly ineffective bargaining demonstrated that the committee failed to exercise its discretion under the Special Approval process in accordance with the implied covenant of good faith. The court agreed that the discretionary use of Special Approval implicates the implied covenant of good faith, but rejected any suggestion from the plaintiffs that the covenant imposes a duty of objective fairness or effectiveness. According to the court, to state a claim under the implied covenant, the plaintiffs needed to show that the Conflicts Committee’s process frustrated their reasonable expectations.
The court noted a number of provisions of the limited partnership agreement that undermined the plaintiffs’ argument. The agreement limited the duties of the Conflicts Committee to a subjective good faith standard. The agreement neither required nor prohibited the consideration of any particular factors by the Conflicts Committee in granting Special Approval. Further, the agreement expressly presumed that, in making its decision, the Conflicts Committee acted in good faith and offered the general partner a conclusive presumption of good faith whenever it acted upon the advice of legal counsel or financial advisors. It exculpated the defendants from all monetary liability unless they acted in bad faith or engaged in fraud, willful misconduct or, in the case of a criminal matter, with knowledge that the conduct was criminal, and expressly waived common law fiduciary duties. According to the court, such a contractual framework “appears to be inimical to requiring that a transaction receiving Special Approval be objectively fair and reasonable.”7
The court goes on to give a warning to investors relying on the implied covenant to reinstate fiduciary duties that they have contractually waived. “Investors apprehensive about the risks inherent in waiving the fiduciary duties of those with whom they entrust their investments may be well advised to avoid master limited partnerships like Encore. Having decided to take a leap of faith and to reach for the kind of returns a master limited partnership investment might yield, however, plaintiffs cannot ‘re-introduce fiduciary review through the backdoor of the implied covenant’.”8
The court found that the plaintiffs failed to state a claim for breach of the implied covenant because the defendants’ actions could not have frustrated their reasonable expectations given the extremely modest protections that the plaintiffs agreed to in the limited partnership agreement. The court went on, however, to explore a second basis for its dismissal of the plaintiffs’ claim. The implied covenant only binds contracting parties, so the claim could be asserted against the general partner only, not the individual members of the Conflicts Committee or Vanguard. The limited partnership agreement provided that any action taken by the general partner upon the advice or opinion of an expert as to matters that the general partner reasonably believed to be in the expert’s competence, would be conclusively presumed to have been done in good faith. The court found that Encore GP relied on the opinion of the independent financial advisor to the Conflicts Committee and therefore was protected from a claim under the implied covenant.
Lessons from Encore and Auriga
Neither Encore or Auriga represents a dramatic departure for the Delaware Chancery Court. They are reminders, however, of the degree of care required in drafting the governing agreements for alternative entities. As Auriga demonstrated, Delaware courts will impose common law fiduciary duties on the managers of Delaware alternative entities, absent an effective waiver under the entity’s governing agreement. Encore shows, however, that the court will not step in under the guise of the implied covenant of good faith and fair dealing when the parties have effectively supplanted common law fiduciary duties with contractual duties. Investors in Delaware limited liability companies and limited partnerships, and the managers of these entities, need to carefully consider their contractual rights and duties and make sure that their operating agreement or limited partnership agreement correctly reflects their expectations.