The Delaware Court of Chancery, in In re: El Paso Pipeline Partners, L.P. Derivative Litigation , C.A. No. 7141–VCL, 2015 WL 1815846 (Del. Ch. Apr. 20, 2015), found that a master limited partnership ("MLP") overpaid its parent corporation by $171 million for certain "dropdown" assets because the Conflicts Committee of its general partner failed to form a subjective belief that the dropdown was in the best interests of the MLP.
This decision could bolster the power of activist investors and should serve as a cautionary tale for MLPs and Yieldcos alike.
The Transactions at Issue
El Paso Corp. ("Parent") formed El Paso Pipeline
Partners, L.P. ("El Paso MLP") to maximize the amount of
capital it could raise and to lower the cost of that capital by
transferring to El Paso MLP assets generating stable cash flows.
Parent controlled El Paso MLP through its ownership of El Paso
Pipeline GP Company, L.L.C. ("General Partner"), a
subsidiary of Parent that served as El Paso MLP's sole general
partner.
In March 2010, Parent dropped down to El Paso MLP a 51 percent
interest in Southern LNG Company, L.L.C. and Elba Express, L.L.C.
(together, "Elba") for $963 million (the "Spring
Dropdown"). Several months later, Parent dropped down its
remaining 49 percent interest in Elba and a 15 percent interest in
Southern Natural Gas, L.L.C. ("Southern") for $1.412
billion (the "Fall Dropdown"). An El Paso MLP limited
partner brought a derivative suit claiming that El Paso MLP had
been harmed by the overvaluation of these assets. The court granted
summary judgment to the defendants as to the Spring Dropdown.
However, it found the General Partner liable for breach of El Paso
MLP's Limited Partnership Agreement ("LP Agreement")
in the Fall Dropdown, in no small part because it determined, based
on a comparison of the terms and negotiations of the Fall Dropdown
with those of the Spring Dropdown, that the Conflicts Committee had
affirmatively ignored certain lessons learned and acknowledged in
the earlier transaction. In doing so, according to the court, the
Committee had caved in to pressure from Parent regarding the price
of the Fall Dropdown assets.
The LP Agreement permissibly waived the common law fiduciary
duties that the General Partner would have otherwise owed El Paso
MLP's limited partners under Delaware law and replaced them
with contractual standards relating to the governance of El Paso
MLP. In relevant part, the LP Agreement permitted approval of
related-party transactions such as those between Parent and El Paso
MLP, despite the inherent conflict of interest, as long as one of
several conditions was met. Among these was "Special
Approval," i.e., "approval by a majority of the members
of the Conflicts Committee [of the General Partner's board of
directors] acting in good faith." For the Conflicts Committee
to act in good faith, the LP Agreement required only that its
members subjectively "believe that the determinations or other
action is in the best interests of the Partnership."
Deficiencies of the Fall Dropdown
The court identified a variety of problems with the Conflicts
Committee's consideration of the Fall Dropdown. Ultimately, the
decision paints a picture of the Conflicts Committee as one that
simply "went through the motions" and whose judgment was
subordinated to the twin goals of increasing distributions to
common unitholders and raising inexpensive capital for its Parent.
The court noted that while it expected the Committee and its
financial advisor(the "FA") to "provide a credible
account" of how they evaluated and negotiated the Fall
Dropdown and determined that it was in the best interests of the
MLP, it instead concluded that they lacked explanation of such
details. Whether because they did not learn the relevant
information, disregarded information they did learn, or were
overruled by Parent, the court found that the Committee "did
not subjectively believe that approving the Fall Dropdown was in
the best interests of [El Paso MLP]." In reaching this
determination, the court considered the Conflicts Committee's
disregard for lessons learned in the Spring Dropdown, its
preoccupation with "accretion" over value add, and the
failing of the FA.
The Conflicts Committee's Conscious Disregard of
Lessons Learned. In both the Spring and Fall Dropdowns, El
Paso MLP acquired a share of Parent's Elba assets. During the
several months between the two transactions, the Conflicts
Committee members appear to have decided that it would not be
"in the best interests of [El Paso MLP] to have too much of
its assets tied up in the LNG trade" because of a negative
outlook and limited growth prospects for LNG generally. Moreover,
the Conflicts Committee members became convinced that El Paso MLP
had paid too much in the Spring Dropdown because the markets
reacted negatively and because an unrelated LNG facility
transaction closed at a comparatively lower valuation. For these
reasons, the Conflicts Committee resolved to negotiate harder with
Parent for the next dropdown.
Despite these intentions expressed by the Conflicts Committee in
contemporaneous email communications among its members, the court
outlined the ways in which the Conflicts Committee did not act in
accordance with its actual views and "consciously
disregarded" the lessons it learned in the Spring Dropdown. As
an initial matter, the court found that the Conflicts Committee
"accommodated" Parent by agreeing to acquire its
remaining interest in Elba. With respect to valuation for the Fall
Dropdown, the court found that the Committee "did more than
simply negotiate poorly." According to the court, they allowed
the Spring Dropdown price to anchor the Fall Dropdown negotiations,
ignored what evidence they had regarding a fair value for the Elba
assets, and did not use Parent's Spring Dropdown valuation
arguments to push back against its proposed Fall Dropdown
valuation. Although the Conflicts Committee successfully argued for
the inclusion of the Southern assets in the Fall Dropdown in
exchange for agreeing to acquire the remaining Elba assets, the
court found that they did not stand firm on their own stated
interest in separate valuations for the two. This allowed Parent to
increase the price El Paso MLP paid for the Elba assets above the
agreed-upon valuation without the Committee realizing it.
The Preoccupation with Accretion. The court also
found that rather than determining that the Fall Dropdown was in
the best interests of El Paso MLP, the Conflicts Committee appears
to have, by focusing on whether the transaction would be accretive
to the holders of El Paso common units, failed to acknowledge or
understand that "accretion" is not a part of valuation.
The court found that the Committee "fixated myopically on
accretion" despite the fact that accretion would not add
value—the fundamental feature of a sound acquisition
according to the court.
The Failings of the Financial Advisor. The
court's decision portrays the Conflicts Committee's FA as
ineffective at best, and misleading or manipulative at worst. The
court implies that the FA acted as if Parent, rather than the
Conflicts Committee, was its client, noting that each dropdown
began with a diligence session performed with Parent and that
Parent "back channeled" throughout the Fall Dropdown with
the FA. With respect to the Fall Dropdown, the court found that the
FA viewed it as an "update" on its work on the Spring
Dropdown and noted that the FA failed to perform any new analyses
notwithstanding that it was specifically requested to do so by the
Conflicts Committee. Furthermore, the court noted that the FA's
valuation methodology changed between the Spring and Fall
Dropdowns, but that the FA failed to explain these changes to the
Conflicts Committee.
In fact, the court pointed out that the FA, the Conflicts
Committee, and Parent all produced a number of inconsistent
justifications for the valuation work that was performed for the
Fall Dropdown. The court also noted specifically that the FA worked
on a contingent fee basis and would not get paid until and unless
the deal closed, concluding that the FA specialized in producing
"visually pleasing presentation[s] designed to make the
dropdown look as attractive as possible," but was not
aggressive about seeking out information that would help it produce
a fair valuation. The court concluded that to ensure that the deal
would go through, the FA was not entirely truthful with Conflicts
Committee members and manipulated its valuation analyses (e.g.,
shifting the meaning and purported value of majority and minority
stakes, carefully selecting precedent transactions to show that the
Fall Dropdown valuation had a comparably favorable EBITDA multiple,
and using misleading or erroneous inputs (cost of capital, discount
rate, terminal value) for its discounted cash flow analysis). The
court also rejected the FA's fall-back argument—that the
FA had exercised its "judgment"—on the grounds that
the FA's "judgment" routinely benefitted Parent
instead of El Paso MLP. In short, the court concluded that the FA
"failed to perform the real work of an advisor to a
committee" and "[r]ather than helping the Committee
bolster its claim to have acted in good faith, [the FA] undercut
it."
Ultimately, the court found that El Paso MLP overpaid for the Fall
Dropdown assets by $171 million and imposed damages against the
general partner in that amount. In so finding, the court emphasized
that ritualistic, nonsubstantive dropdowns to MLPs (and, by
analogy, to Yieldcos) can pose a danger if not handled carefully.
Indeed, the court's extensive opinion may provide a road map to
activists intent on derivative litigation second-guessing business
decisions and demonstrates that the elimination of board fiduciary
duties in constituent documents is not sufficient to shield against
such suits. MLPs, Yieldcos, and financial advisory firms should
take note and handle such intercompany dropdown transactions with
due care.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.