In the latest in a series of fiduciary duty cases challenging the contractual "Special Approval" process provided in the limited partnership agreements of master limited partnerships (MLPs), the Delaware Supreme Court recently affirmed that limited partnerships may eliminate fiduciary duties in their partnership agreements, with the exception of the implied contractual covenant of good faith and fair dealing, which may not be eliminated.1 The Court’s decision supports the proposition that carefully drafted "Special Approval" provisions in limited partnership agreements may be used as a mechanism to authorize self-interested or conflicted transactions that otherwise could be deemed breaches of fiduciary duties of the MLP’s general partner and its officers or directors to the MLP or its limited partners, and may be stated as follows:
- An MLP’s partnership agreement may replace the common law fiduciary duty of good faith with a contractually adopted duty of subjective good faith.
- A Delaware court will determine whether the independent directors have breached their subjective duty of good faith by examining the precise contractual language of the agreement of limited partnership.
- In its subjective good faith determination, a court should focus on measuring the directors’ approval of the transaction against their personal knowledge of the facts and circumstances surrounding the transaction.
In Allen v. Encore Energy Partners, L.P., et. al., the Court examined whether the independent directors of Encore’s general partner breached their contractual duty to act with subjective good faith in considering an affiliate merger proposal from Encore’s indirect 46% controlling unit holder, Vanguard Natural Resources, LLC.2 Affirming the Court of Chancery’s dismissal of the complaint, the Court held that the plaintiff’s allegations did not permit a reasonable inference that the directors had breached their duties by either acting with subjective bad faith or consciously disregarding their "duty to form a subjective belief that a transaction was in Encore’s best interests."3
Because the issue turns on contractual rights, the Court examined the precise language of the limited partnership agreement. The limited partnership agreement contains the standard MLP conflict resolution provision that states:
"[. . .] whenever a potential conflict of interest exists or arises between [the general partner] or any of its [a]ffiliates, on the one hand, and the [MLP], . . . [or] any [of its unitholders], on the other, any resolution or course of action by [the general partner] or its [a]ffiliates . . . shall not constitute a breach of [the partnership agreement] [. . .] or of any duty stated or implied by law or equity, if the resolution or course of action in respect of such conflict of interest is [. . .] approved by Special Approval [. . .].4
As is customary in limited partnership agreements of MLPs, "Special Approval" is defined in the Encore limited partnership agreement as "approval by a majority of the members of the [c]onflicts [c]ommittee acting in good faith."5 The conflicts committee is composed of the general partner’s independent directors and "good faith" is defined in the Encore limited partnership agreement as a "belie[f] that the determination or other action is in the best interests of the Partnership."6 The Court notes that the drafters of Encore’s limited partnership agreement elected not to use the objective standard of "reasonable belief" but rather the subjective standard of "belief."7
The plaintiff must rebut the presumption that the independent directors acted in good faith. 8 Since the Encore limited partnership agreement replaced the common law fiduciary duties of loyalty and care with a contractual duty of good faith, "[. . .] the only duty the [independent directors] had was to form a subjective belief that the [m]erger was in Encore’s best interest."9 The Delaware Supreme Court instructs trial judges to "avoid replacing the actual directors with hypothetical real people when making the inquiry."10
In order to plead a breach of fiduciary duties, the plaintiff needed to show that the independent directors either acted with "subjective bad faith" (that is, they subjectively believed that the merger was not in Encore’s best interest) or "consciously disregarded" their contractual duty to act in good faith (that is, they actively failed to form a subjective belief that the merger was in Encore’s best interest).11 The Court flatly refused to "import standards of conduct from corporate or tort law to govern the [independent directors’] negotiation process" because of the explicit language in the limited partnership agreement.12 Therefore, the decision turned on the subjective belief of the independent directors in approving the merger transaction. The Court recognized that proving conscious disregard "would take an extraordinary set of facts."13
However, the Court reaffirmed that "objective factors may inform an analysis of a defendant’s subjective belief to the extent they bear on the defendant’s credibility when asserting that belief" 14 because directors may have known objective facts indicating that a transaction was not in the best interests of the partnership.
Analyzing the facts surrounding the merger negotiations, the Court found no conscious disregard of the independent directors’ contractual duty to act in good faith. The independent directors (a) were fully aware of Encore’s limited negotiating leverage, (b) based a counteroffer on an exchange ratio that would not dilute Vanguard’s post-merger distributable cash flow per unit (which the independent directors believed necessary for agreement on terms) and (c) believed that Encore’s unit price already reflected a premium because of the anticipated merger. 15 Although the Court noted that the independent directors "may have negotiated poorly," poor negotiation "does not permit a reasonable inference that they subjectively believed they were acting against Encore’s best interests."16
MLPs and other Delaware limited partnerships regularly take advantage of their ability to contract out of the majority of their common law fiduciary duties as permitted by the Delaware Revised Uniform Limited Partnership Act. 17 As the Encore Energy Partners decision reinforces, however, the specific provisions in the limited partnership agreement are paramount. Properly drafted limited partnership agreements minimize the exposure of general partners, directors, and committees and can create more certainty in future transactions that raise fiduciary duty issues.
Thus, if the limited partnership agreement:
- replaces common law fiduciary duties with a contractually adopted fiduciary duty of good faith;
- provides that this duty is satisfied if a committee of independent directors approves a transaction ("Special Approval"); and
- Special Approval requires that the directors act with subjective good faith,
a Delaware court will dismiss a plaintiff’s complaint as long as there is no reasonable inference that the independent directors breached their duty to act with the subjective good faith that the transaction is in the best interests of the partnership.