On April 20, 2015, Vice Chancellor Laster of the Delaware Court of Chancery issued an opinion (In re: El Paso Pipeline Partners, L.P. Derivative Litigation, C.A. No. 7141-VCL (Del Ch. April 20, 2015)) holding the general partner of El Paso Pipeline Partners, L.P. (“El Paso MLP”) liable for $171 million in damages for not complying with the contractual standards for resolving conflicts of interest set forth in the partnership agreement of El Paso MLP when it evaluated and negotiated a proposed acquisition of assets from its parent, El Paso Corporation (“Parent”). This is a significant decision as Delaware courts have rarely, if ever, imposed liability on an MLP’s general partner in connection with a dropdown transaction that was approved by an independent conflicts committee.
The Delaware Revised Uniform Limited Partnership Act expressly permits limited partnerships to modify the default fiduciary duties that would otherwise apply, as long as the modification is written in clear and unambiguous language. MLPs utilize this statutory provision to deal with the inherent conflicts of interest that arise when their corporate or private equity sponsors seek to engage in transactions with the MLPs they control. The El Paso MLP partnership agreement provided that the duty of the general partner and its directors was to act in “good faith,” which was defined in the partnership agreement to mean that the person taking such action believed that the action was in the best interests of El Paso MLP. The El Paso MLP partnership agreement, unlike more recent agreements, did not specify that the required belief was a “subjective” one but the court interpreted it that way.
The transaction that was challenged by the plaintiffs in the case involved a dropdown acquisition of assets by El Paso MLP from Parent. It was the second of two dropdowns of interests in a liquefied natural gas terminal. El Paso MLP had purchased a majority interest in the terminal earlier in the year and was now being offered a minority interest, together with unrelated assets.
Like most MLP partnership agreements, the El Paso MLP partnership agreement provided that a conflicted transaction (such as the dropdown at issue) approved by the Conflicts Committee, acting in good faith, would be deemed approved by all partners and not a breach of the agreement. The partnership agreement also provided that the members of the Committee were presumed to have acted in good faith and placed the burden of showing the members did not act in good faith on the plaintiffs. As is customary in MLP dropdowns, El Paso MLP delegated to its Conflicts Committee the authority to evaluate and negotiate the proposed transaction on behalf of El Paso MLP. The Committee retained the independent legal and financial advisors it had used in prior dropdown transactions. The Committee negotiated some marginal improvements to the deal terms with Parent and received an opinion from its financial advisor that the transaction was fair, from a financial point of view, to the unaffiliated unitholders of El Paso MLP. Thereafter, the Committee approved the transaction and litigation ensued, with the plaintiffs claiming that the Committee did not act in good faith.
In finding that the Conflicts Committee did not subjectively believe the dropdown was in the best interests of El Paso MLP, despite the members’ testimony that they did, the Court relied heavily on various documents, including emails the members of the Committee sent one another expressing doubts about the transaction, as well as testimony from the members of the Committee and a representative of the financial advisor. Vice Chancellor Laster wrote that none of the problems he identified, or even a combination of problems, would have overcome the presumption of good faith the committee members had “as long as the Committee members reached a rational decision for comprehensible reasons.” However, “the number of problems reached a tipping point” and “the composite picture that emerged was one in which the Committee members went through the motions.”
The Court criticized the Conflicts Committee for several things, including:
- approving the acquisition when its members had significant concerns that increasing El Paso MLP’s exposure to LNG assets at the time was not in the best interests of El Paso MLP;
- not negotiating hard enough to improve the terms of the deal when its members had significant reservations about valuation, to some extent driven by their concern that the price paid for the first dropdown of the interests in the same LNG assets had been too high;
- not being better informed about certain key aspects of the assets being acquired, such as the terms of material contracts;
- focusing too much on accretion in distributable cash flow per unit at the expense of traditional valuation methodologies, such as the price paid in other dropdown transactions involving similar assets; and
- not separately valuing the LNG assets and the other unrelated assets El Paso MLP was offered by Parent.
The Court did not question the independence of the Committee members but noted that two of the three Committee members had significant past employment ties to Parent and significant ownership stakes in Parent stock.
In addition to its criticisms of the Committee, the Court criticized the rigor of the financial advisor’s valuation analysis and changes made to some of the methods and presentation of the analysis compared to the analysis done on the initial dropdown of the LNG assets.
The Court did not impose personal liability on the Committee members, saying the plaintiffs did not make any meaningful attempt to present theories of such liability, which would have involved making a showing of fraud, bad faith or willful misconduct on the part of the individual directors.
Key takeaways from the case:
- Above all else, a conflicts committee must believe that a dropdown, on the best terms that can be negotiated, is in the best interests of the MLP to undertake at the present time and under current industry and market conditions. The members of the conflicts committee must realize they have a duty to say no to a proposal if they cannot make this determination.
- A conflicts committee’s merely negotiating a deal better than the sponsor’s initial proposal will not necessarily suffice to defeat challenges to the presumption that the committee and its members acted in good faith.
- Conflicts committees should not put undue emphasis on accretion to cash flow per unit at the expense of traditional valuation methodologies. While accretion is an important factor for committees to consider when evaluating a dropdown, and one the market focuses on very intently, it is only one metric to analyze whether a transaction is in the best interests of the MLP.
- Conflicts committees that frequently evaluate dropdowns should not be lulled into complacency with the process or be too tied to a previous course of dealing.
- It is becoming increasingly common for sponsors to drop down partial interests in an asset over time. When evaluating a dropdown of additional interests in the same asset, conflicts committees and their financial advisors should take into account the methodology and conclusions reached when the assets were evaluated in the prior transactions.
- Directors should have a solid understanding of the key features of the MLP’s business and the assets subject to the proposed dropdown.
- Conflicts committees should be kept fully informed of communications between their financial advisors and management, and management should not interfere with the financial advisor’s work or materials before they are presented to the conflicts committee.
- A dropdown should not be approved simply because a conflicts committee’s financial advisor is willing to deliver a fairness opinion. Such an opinion only speaks to the fairness, from a financial point of view, of the transaction, but does not necessarily address other factors that a committee should consider in making a determination whether the transaction should be undertaken at all or is in the best interests of the MLP.
- Notwithstanding the typical MLP partnership agreement provision that an action taken by directors in reliance on an opinion of a financial advisor that the directors reasonably believed to be in the advisor’s area of competence shall conclusively be presumed to have been taken in good faith, directors should insist on adequate time to review the advisor’s materials and should make sure they have a thorough understanding of the analyses performed.
- Directors should be very careful about using email to communicate reactions and thoughts that will inevitably be interpreted without the context and subsequent consideration given to the points raised.
The Court of Chancery’s decision in El Paso should serve as a reminder to all participants in a related party transaction involving a Delaware limited partnership that the Court will carefully analyze the decision making process of a conflicts committee or its board of directors for compliance with the contractual standards for conflict resolution set forth in a partnership agreement.