M&A Report – New Delaware Court of Chancery Decision Examines MLP Conflicts Committee Requirement to Act in Subjective Good Faith

April 23, 2015

On April 20, 2015, Vice Chancellor Travis Laster of the Delaware Court of Chancery issued an opinion reviewing actions taken by a committee of the general partner of a master limited partnership (an “MLP”) whose only relevant obligation was to act in subjective good faith.  In In re El Paso Pipeline Partners, L.P.,[1] the Court held that the committee failed to comply with this obligation when it approved a transaction without first determining it to be in the best interest of the MLP.  Despite testimony to the contrary, the Court found that the members of the committee “failed to form a subjective belief that the Fall Dropdown was in the best interests of El Paso MLP” in light of their failure to engage in any meaningful negotiations, disregard of their “independent and well-considered views about value,” fixation solely on accretion in valuing the transaction, failure to consider information in their possession that would affect the transaction’s price, and reliance on reports from their advisor notwithstanding obvious flaws in the advisor’s methodology.  While none of these deficiencies standing alone would have shown a lack of subjective good faith, when considered in totality they tipped the balance and led to the Court’s conclusion that the committee did not believe that the transaction was in best interest of the MLP.

Background

El Paso is the latest decision concerning a series of transactions where El Paso Pipeline Partners, L.P. (“El Paso MLP”), purchased certain assets from its controlling sponsor, El Paso Corporation (“Parent”).[2]  These transactions, often referred to as “dropdowns,” are common for sponsored MLPs because the MLP’s ability to distribute cash flows in a tax efficient manner allows the sponsor to raise capital at reduced cost through the MLP.

El Paso MLP, as is common with MLPs, was structured to facilitate such dropdowns.  Employees of Parent held four of the seven board seats at El Paso MLP’s general partner (the “General Partner”), and employees and officers of the Parent served as the employees and officers of the General Partner.  In addition, because dropdowns will typically be controlling party transactions usually subject to strict judicial review,[3] El Paso MLP’s limited partnership agreement contained provisions that eliminated “all common law duties that the General Partner and [its board] might otherwise owe to El Paso MLP and its limited partners, including fiduciary duties.”[4]  In lieu of fiduciary duties, El Paso MLP’s partnership agreement established contractual requirements applicable to various transactions. Controlling party transactions such as dropdowns were to be approved by one of four methods, including approval by the members of a “Conflicts Committee,” to be composed solely of independent members of the board, “acting in good faith.”

El Paso MLP’s partnership agreement provided that in order for a determination to be made in good faith, “the Person or Persons making such determination or taking or declining to take such other action must believe that the determinations or other action is in the best interests of [El Paso MLP].”[5]  As the Court explained, this language only required that the Conflicts Committee members “believe subjectively that [a transaction] was in the best interests of El Paso MLP.”[6]  This standard neither required a determination concerning “the best interests of the common unitholders as a class” nor contemplated that the decisions of the Conflicts Committee would be reviewed “using an objective test, such as reasonableness.”

The Court of Chancery Analysis

The plaintiff had challenged two dropdowns.  The first, in March 2010 (the “Spring Dropdown”) involved the sale of a 51% interest in certain of Parent’s subsidiaries involved in midstream liquid natural gas operations on Elba Island, Georgia (the “Elba Subsidiaries”).  The second, in November 2010 (the “Fall Dropdown”) involved the sale of the remaining 49% of the Elba Subsidiaries, as well as a 15% interest in an additional subsidiary.  The Court had previously granted summary judgment in favor of the defendant in connection with the Spring Dropdown.[7]  In the case at hand, the Court examined whether the Conflicts Committee complied with its contractual obligation to act in good faith in connection with the Fall Dropdown.

The Fall Dropdown was the fifth dropdown from Parent to El Paso MLP, all of which had followed the same pattern.  The Parent would suggest a dropdown of assets; the three independent members of the General Partner board would form an ad hoc Conflicts Committee; the Conflicts Committee would hire financial and legal advisors; one member of the Conflicts Committee would negotiate with the Parent; the negotiations would lead to a nominally better price for El Paso MLP; the Conflicts Committee would receive a fairness opinion; and the deal would be approved.  The same legal and financial advisors were hired for each dropdown.

Although the Committee followed the same process in the Spring Dropdown and the Fall Dropdown, the Court found that the Committee failed to act in subjective good faith when it approved the Fall Dropdown.  The Conflicts Committee did not incorporate lessons from the Spring Dropdown about the valuation of the Elba Subsidiaries in the Fall Dropdown.  For example, the Conflicts Committee based its valuation of the interest in the Elba Subsidiaries to be acquired in the Fall Dropdown on the price it had paid for interests in the Elba Subsidiaries in the Spring Dropdown.  However, the Court noted that the Committee was aware that the Spring Dropdown had a negative effect on the price per share of El Paso MLP.  In addition, the Conflicts Committee’s internal e-mail correspondence indicated a belief that it had overpaid in that transaction.  Further, the Conflicts Committee was aware that the liquid natural gas market had declined since the Spring Dropdown.  Nonetheless, the Court concluded that the Conflicts Committee did not use this information to try to negotiate a better price when it acquired the remaining portion of the Elba Subsidiaries in the Fall Dropdown.

Moreover, even though the Spring Dropdown involved an acquisition of 51% of the Elba Subsidiaries and was viewed as pricing in a control premium, when negotiating the Fall Dropdown the Conflicts Committee treated control as irrelevant–it continued to base its price for the remainder of the Elba Subsidiaries on the price established in the Spring Dropdown.  The Court noted that the failure of the Conflicts Committee members to use the information they had learned and their other failures to meaningfully assess the value of the assets to be acquired in the Fall Dropdown “evidenced conscious indifference to their responsibilities to El Paso MLP.”

In addition, the work of the Conflicts Committee’s financial advisor “undermined any possible confidence in the Committee.”  The Court concluded that the financial advisor made minimal effort to seek out information on comparable transactions, unquestioningly relied on information from the Parent, and failed to produce new analyses requested by the Conflicts Committee.  The Court was particularly disturbed to learn that, while the precedent transaction analysis for the Spring Dropdown was separated into a majority acquisition group and a minority acquisition group, the analysis for the Fall Dropdown “lumped all of the precedents together without calling the change to the Committee’s attention.”  Combining all the precedents, and not just those concerning the acquisition of a minority interest, allowed the financial advisor to show a higher price paid in its precedent analysis for the Fall Dropdown.  This change in methodologies, without any explanation, appeared to be an attempt to show each dropdown in the best possible light.  While the Court conceded that a “financial advisor obviously need not evaluate every transaction the same way,” it noted that “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.”[8]  In addition, the financial advisor changed the inputs it used in its valuation analysis but “could not provide any explanation” for the changes.  The Conflicts Committee was not blameless in this “malfeasance.”  It failed to “receive any explanation” or “ask any questions” about how the financial advisor constructed its key analysis.

Ultimately, the Court concluded that the “Committee members and [the financial advisor] went through the motions, but the substance was lacking.” Accordingly, by “disregard[ing] their known duty to determine that the Fall Dropdown was in the best interests of El Paso MLP, [the members of the Conflicts Committee] did not act in good faith. Consequently, the General Partner breached the [El Paso MLP’s partnership agreement] by engaging in the Fall Dropdown.”

Key Takeaways

This case provides a detailed examination of what it means to act in subjective good faith under Delaware law and provides an example of what the Court of Chancery will examine to determine whether a party has acted with subjective good faith.  While this case is most relevant in the alternate entity context where fiduciary duties may be waived, the Court identified the overlap between a contractual obligation to act in good faith and the concept of good faith that arises in the fiduciary context.[9]  More broadly, the case is a reminder of the focus the Delaware courts will put on matters of process and the work performed by financial advisors.  Some of the key takeaways of this case are:

• The most significant element distinguishing a subjective good faith standard from an objective good faith standard is actual knowledge.  The Conflicts Committee used the same process to evaluate and negotiate the Spring Dropdown that it did for the Fall Dropdown.  Despite the fact that the committee’s negotiation of the Spring Dropdown was not a violation of its duty to act it good faith, its failure to apply the lessons learned when the Conflicts Committee negotiated the Fall Dropdown caused such a failure; it was one of the most significant factors informing the Court’s determination.  Accordingly, boards[10] should make sure that they are educated on all aspects of a transaction as part of their negotiation and review, and they should carefully document this process.
• Do not underestimate the importance of building a strong contemporaneous record.  One of the recurring themes throughout the opinion is the continuous weight the Court puts on contemporaneous records, such as e-mail correspondence, over ex post facto explanations narrated during trial testimony. This decision is therefore another reminder of the importance for boards and deal makers to carefully create a contemporaneous record of deal dynamics, assumptions and changes in strategies as the deal unfolds. Written presentations delivered to the board in advance of the meeting and reasonably detailed minutes are some of the tools available to boards and their advisors to document their decision-making process.
• Board members should pay close attention to updates and other changes in the materials it reviews in connection with a deal.  One of the facts leading to the Court’s holding that the Conflicts Committee failed to act in good faith was the committee’s failure to critically review the materials that were provided by its financial advisor.  In particular, the Court noted that evaluation materials concerning the Fall Dropdown contained less information than materials concerning the Spring Dropdown.  It is not uncommon for a board to receive multiple iterations of deal materials, such as valuation analyses and due diligence reports, over the course of evaluating and negotiating a transaction.  The board should be advised of material changes to each update and seek to understand why analyses, or underlying assumptions, were modified or deleted.  While “[t]here often will be good and sufficient reasons to revise or update an analysis,” a board should request “reasoned explanations” for such changes.
• Accretion of value alone is not sufficient to find that an action is in the best interests of a company.  Importantly, a board must make sure it is trying to meet the correct standard.  The members of the Conflicts Committee believed that the Fall Dropdown would increase El Paso MLP’s cash distributions to its common unitholders and that this conclusion should end the inquiry.  The Court noted, “[a]n accretion analysis says nothing about whether a buyer is paying a fair price.”  Because, the Court stated, accretion “depends on how the acquisition is financed,” a deal could be structured to be accretive without adding value.  Rather, the opinion suggests that boards should evaluate transactions based, as the Court described it, “on their prospect for creating value, not on their immediate [earnings per share] impact.”[11]  A governing body that leaves, as in the case at hand, $171 million of value “on the table” cannot argue that it has satisfied its obligations merely because a transaction is accretive.
• Always be mindful of written communications.  Emails and other written communications may record early views of a deal.  In determining that the Conflicts Committee disregarded its own subjective views on value, the Court cited emails from committee members, drafted before there was any discussion of the Fall Dropdown, where a member speculated that it would not be in the best interests of El Paso MLP to acquire a greater interest in the Elba Subsidiaries.  This email exchange colored the Court’s view as to the committee’s beliefs about the value of the Fall Dropdown.  Transaction participants should be careful when committing preliminary impressions of a transaction to writing, and should be mindful that their content can be reviewed in isolation and with the benefit of 20/20 hindsight.

   [1]   Case No. 7141-VCL (Del. Ch. Apr. 20, 2015).  All quotations not otherwise attributed come from this case.

   [2]   For an analysis of the previous decisions arising out of these transactions, as well as a brief discussion of master limited partnerships generally, see Gallardo et al., Implications of Recent Delaware Court of Chancery Decisions on MLP Related Party Transactions, August 11, 2014, available at https://www.gibsondunn.com/implications-of-recent-delaware-court-of-chancery-decisions-on-mlp-related-party-transactions/.

   [3]   For more information about the standards of judicial review normally applicable to controlling party transactions, see Little et al., M&A Report – Determining the Likely Standard of Review Applicable to Board Decisions in Delaware M&A Transactions, November 18, 2014, available at https://www.gibsondunn.com/ma-report-determining-the-likely-standard-of-review-applicable-to-board-decisions-in-delaware-ma-transactions/.  Although the strict “entire fairness” standard of review is most often applied to transactions involving corporations, which unlike limited partnerships cannot contractually waive or modify common law fiduciary duties, the Delaware courts have also applied it to limited partnerships when a general partner is on both sides of a transaction.  See Venhill Limited Partnership v. Hillman, C.A. No. 1866-VCS, 2008 WL 2270488 (Del. Ch. Jun. 3, 2008); In re Boston Celtics Ltd. Partnership S’holders Litig., C.A. No. 16511, 1999 WL 641902 (Del Ch. Aug. 6, 1999).

   [4]   In re El Paso Pipeline Partners, L.P. Derivative Litigation, C.A. No 7141-VCL, 2014 WL 2768782 (Del. Ch. Jun. 12, 2014) (“El Paso 2014“).

   [5]   Quoting the limited partnership agreement at § 7.9(b).

   [6]   The reasoning behind this decision was explained in El Paso 2014. See Gallardo, note 1 supra.

   [7]   See El Paso 2014.

   [8]   Throughout the opinion, the Court was highly critical of the actions of the financial advisor; however, the opinion did not discuss whether the advisor might be liable under an aiding and abetting or other theory in light of the plaintiff’s waiver of such claims.

   [9]   For example, in defining good faith the Court cited to duty of loyalty cases and noted that “[t]he Delaware Supreme Court has relied on cases addressing the concepts of good faith and bad faith for purposes of the duty of loyalty when fleshing out the meaning of good faith in the limited partnership context.”

  [10]   As used in these key takeaways, the term “boards” includes committees and other governing bodies.

  [11]   Quoting Alfred Rappaport, Ten Ways to Create Shareholder Value, Harvard Business Review, Sept. 2006, at 3.

Gibson, Dunn & Crutcher’s lawyers are available to assist with any questions you may have regarding these issues.  For further information, please contact the Gibson Dunn lawyer with whom you usually work, any member of the firm’s Mergers and Acquisitions or Energy and Infrastructure practice groups, or the following authors: