Limited Partners Take a Licking in Two Delaware Supreme Court Decisions
January 02, 2017
Notwithstanding the ascendency of the limited liability company, the Delaware limited partnership continues to serve as an important, tax-advantaged vehicle for certain capital-intensive ventures — especially in the energy sector — featuring centralized management and limited liability for large numbers of passive investors.
Late last month, the Delaware Supreme Court handed down two noteworthy decisions springing from suits by limited partners challenging the fairness of conflicted transactions by general partners that were approved by conflicts committees. In one, the high court affirmed Chancery Court’s order rejecting a claim based on the implied duty of good faith and fair dealing where the transaction’s approval by the conflicts committee complied with the agreement’s safe harbor provision and thus contractually precluded judicial review. Employees Retirement System v TC Pipelines GP, Inc., No. 291, 2016 [Del. Sup. Ct. Dec. 19, 2016].
In the other, Supreme Court reversed Chancery Court’s post-trial decision holding the general partner liable in damages owed directly to limited partners for a conflicted, over-priced “dropdown” transaction by the general partner. The high court disagreed with Chancery Court’s application of the Tooley standard, instead finding that the claims were exclusively derivative and that the post-trial, pre-judgment acquisition by merger of the partnership extinguished the plaintiff limited partner’s standing to seek relief. El Paso Pipeline GP Company, LLC v Brinckerhoff, No. 103, 2016 [Del. Sup. Ct. Dec. 20, 2016].
Together, the two decisions re-affirm the primacy of contract in the realm of alternative entities including limited liability companies, limited partnerships, and master limited partnerships.
At issue in TC Pipelines was a master limited partnership’s sale of assets to the general partner’s parent company. The limited partnership agreement, which expressly contemplated conflicted asset sales between the partnership and affiliates of the general partner, included a safe harbor provision providing for review by a Conflicts Committee consisting of directors unaffiliated with the general partner.
The provision stated that a conflicted transaction “shall be conclusively deemed fair and reasonable to the Partnership” upon approval by the Conflicts Committee “as long as the material facts known to the General Partner or any of its Affiliates regarding any proposed transaction were disclosed to the Conflicts Committee at the time it gave its approval.” The agreement further immunized an approved transaction as conclusively deemed not to be a breach of the limited partnership agreement or of “any duty stated or implied by law or equity.”
The plaintiff limited partner contended, despite approval by the Conflicts Committee and absent any specific allegation of improper motive or incomplete disclosure to it of the material facts, that the transaction was economically unfair to the partnership as compared with prior, similar dropdown transactions and, therefore, the Committee must have acted in subjective bad faith in breach of the statutorily non-waivable, implied duty of good faith and fair dealing.
Chancery Court dismissed the complaint, holding that the general partner’s undisputed compliance with the safe harbor provision negated reliance on the implied duty and precluded judicial review. On appeal, Supreme Court broadly endorsed the lower court’s analysis, further commenting that:
[T]he appellant cannot escape the conclusive effect given to Conflicts Committee approval solely by attacking the fairness of the underlying transaction. If that was the case, the safe harbor would be virtually no safe harbor at all as every case would proceed to discovery so long as a plaintiff could plead facts suggesting a rational person could deem the transaction unfair. Rather, as the Court of Chancery explained, the implied covenant is narrowly applied, and if a plaintiff is to invoke it, the plaintiff must plead some specific facts suggesting that the Conflicts Committee process was tainted in some specific way by unanticipated behavior, such as the example of bribery the Vice Chancellor pointed to, or other factors bearing on whether the Conflicts Committee process fulfilled its evident contractual purpose.
Safe harbor provisions of the sort upheld in TC Pipelines are not exclusive to Delaware entities, although some would argue that their enforceability is made more certain by virtue of the freedom-of-contract and fiduciary waiver provisions in Delaware’s limited partnership and limited liability company statutes, as compared to states such as New York whose counterpart statutes lack similar provisions.
El Paso Pipeline
The El Paso Pipeline case also involved a challenged dropdown transaction by the general partner approved by a conflicts committee. Unlike in TC Pipelines, Chancery Court’s post-trial decision found that the committee and its financial advisor knew the transaction was unduly favorable to the limited partnership’s general partner to the tune of a $171 million overpayment.
But there was a twist: after the trial was completed and before any judicial ruling on the merits, the partnership was acquired by merger with a third party. The post-merger company then moved to dismiss the action, which pleaded derivative claims only, on the ground the merger extinguished the plaintiff’s derivative standing.
Chancery Court denied the dismissal motion on two independent bases, initially choosing to characterize the plaintiff’s claim as a direct one for breach of the limited partnership agreement’s conflict-of-interest provision and therefore not governed by the two-prong Tooley test for distinguishing between direct and derivative claims, that is, (1) who suffered the alleged harm and (2) who would receive the benefit of any recovery.
Alternatively, Chancery Court viewed it as a “dual-natured” claim that had inflicted distinct injuries on both the partnership and directly on the unaffiliated limited partners due to the benefits received by the general partner to the exclusion of the other investors.
In its decision reversing Chancery Court, Supreme Court opined that the limited partnership agreement’s contractual duty of good faith “was owed to the Partnership, not the individual limited partners” and necessarily implicated the Tooley analysis to determine whether the claim must be asserted derivatively or is dual in nature such that it can proceed directly.
Applying Tooley, Supreme Court held that the economic harm from the overpayment made by the limited partnership to the general partner “devolved upon [plaintiff] as an equity holder in the form of proportionally reduced value of his units — a classically derivative injury.” As the court further explained:
The alleged overpayment resulted in immediate harm to the Partnership — a reduction in the Partnership’s overall value. Here the contract right asserted was not separate and distinct from the rights of the entity. The “best interests of the Partnership” standard provided “no separation” between the Partnership’s contractual rights and any rights of the limited partners.
Supreme Court also found under the Tooley test’s second prong that “the benefit of any recovery must flow solely to the Partnership” and that the “necessity of a pro rata recovery to remedy the alleged harm indicates [plaintiff’s] claim is derivative.”
One of the more interesting passages in El Paso Pipeline is found at pages 25-29 of Supreme Court’s opinion where the court narrowly circumscribes the type of dual-natured claims for which both derivative and direct claims can be asserted, to those involving the “improper transfer of both economic value and voting power from the minority stockholders to the controlling stockholder,” adding: “We decline the invitation to further expand the universe of claims that can be asserted ‘dually’ to hold here that the extraction of solely economic value from the minority by a controlling stockholder constitutes direct injury.”
Making it even more interesting, Chief Judge Leo Strine wrote a short, concurring opinion in which he expressed strong disagreement with Delaware precedent allowing dual-natured claims even as confined by the majority opinion.
Having determined that the plaintiff’s overpayment claim is exclusively derivative under Tooley and therefore is an asset of the partnership which passed by operation of law to the acquiring company, Supreme Court declared that the merger extinguished the plaintiff’s standing to assert the claim.
Did that leave the plaintiff limited partner without a remedy? In theory, no, his recourse being, as the court wrote, “to challenge the fairness of the merger by alleging that the value of his claims was not reflected in the merger consideration.” This particular plaintiff did not elect to challenge the merger in an appraisal proceeding, hence he was left with nothing to show for his seemingly meritorious claim.
Finally, to New York practitioners handling shareholder litigation involving New York entities, I say take careful note of El Paso Pipeline‘s discussion and application of the Tooley analysis given that New York’s own jurisprudence in this area explicitly adopted the Tooley standard.
Update January 25, 2017: In contrast to the two cases discussed above, last week the Delaware Supreme Court handed a victory to a plaintiff limited partner in another case centering on the approval of a conflicted merger under the safe harbor provisions of the master limited partnership agreement, holding that the lower court erroneously dismissed the complaint which adequately pleaded a claim for breach of the implied duty of good faith and fair dealing. Read it here.
Update March 20, 2017: And yet in another case decided today, again reversing Chancery Court, the Delaware Supreme Court reinstated a limited partner’s claims arising from a conflicted transaction involving an energy MLP, holding that the LPA’s exculpation provisions did not alter the specific affirmative obligations of the LPA. Read it here.