In re Energy Transfer Equity, L.P. Unitholder Litig., C.A. No. 12197-VCG (Del. Ch. May 17, 2018) (Glasscock, V.C.)
In this Memorandum opinion, the Delaware Court of Chancery declined to cancel securities issued in connection with a limited partnership’s private offering or issue a permanent injunction preventing the conversion or transfer of such securities. Even though the Court found that the private offering was a conflicted transaction that was not objectively fair and reasonable to the partnership, in violation of the limited partnership agreement (“LPA”), the Court concluded that the equitable relief sought by the plaintiffs was not warranted.
Soon after Energy Transfer Equity, L.P. (“ETE”), a Delaware master limited partnership, entered into an agreement to merge with The Williams Companies, Inc. (“Williams Co.”), the energy sector entered a precipitous decline. Facing the prospect of a credit rating downgrade, ETE explored various deleveraging options. In February 2016, the board of directors of ETE (the “Board”) approved a public offering of convertible preferred units. Pursuant to the offering, subscribing unitholders were to receive one security for each common unit such unitholder elected to participate. In return, the participating unitholder would forego quarterly distributions payable on participating common units above $0.11 per unit for eight quarters. After the plan period, each security would convert into a fraction of a common unit based on a stated formula.
Pursuant to the terms of the merger agreement, Williams Co.’s consent was necessary to consummate the public offering. When Williams Co. declined to consent, the Board changed course and, instead, pursued a private placement, which did not require Williams Co.’s consent. The terms of the private offering were largely the same as those of the public offering, with one key difference—the private offering set the accrual on the securities as the difference between the $0.11 the subscriber received and the then-current distribution rate of $0.285, regardless of whether any distribution to common unitholders was actually made. This change, the Court noted, eliminated downside risk—if distributions were eliminated, subscribers would receive a quarterly accrual of $0.285. The private offering was approved and consummated. Importantly, at least 70% of the individuals invited to participate were either affiliated with ETE or related to affiliated individuals. Out of ETE’s over 400 institutional investors, only three were invited to participate. Following the private placement, the ETE-Williams Co. merger agreement was terminated and the issued securities were scheduled to convert into common units in May 2018.
Unitholders brought suit advancing two primary theories of liability. First, the plaintiffs argued that the securities issuance was a non-pro-rata distribution of partnership securities in violation of the LPA. Second, the plaintiffs argued that the securities issuance violated the LPA’s provisions governing conflicted transactions. Plaintiffs sought cancellation of the securities issued pursuant to the private offering and a permanent injunction to prevent the conversion or transfer of the issued securities.
The Court first analyzed whether the private offering constituted a non-pro-rata distribution in violation of the LPA. The term “distribution” was not defined in the LPA. Although the parties agreed that “distribution” in the context of the LPA was unambiguous, they disagreed as to its meaning. The Court agreed that the term “distribution” was unambiguous and, applying principles of contract interpretation, held that the private offering did not constitute a distribution; instead, the private offering was an issuance of securities in exchange for value.
The Court next turned to whether the private offering was “fair and reasonable” to ETE, as was required for conflicted transactions under the LPA. Quoting Brinckerhoff v. Enbridge Energy Co., Inc., 159 A.3d 242, 256–57 (Del. 2017), the Court observed that “[t]he fair and reasonable standard is something similar, if not equivalent to, entire fairness review.” Despite the elimination of default fiduciary duties in favor of contractual obligations, the Court found that the defendants had the burden of showing that the issuance was fair and reasonable to ETE.
Consistent with the terms of the LPA, defendants could have conclusively demonstrated that the issuance was fair and reasonable through one of four possible safe harbors. Here, defendants relied primarily on the use of a Conflicts Committee to approve the transaction. The Court concluded, however, that the Conflicts Committee was subject to certain fatal flaws. In particular, the Court noted that two of the three committee members appointed by the Board were directors or employees of ETE’s general partner; accordingly, pursuant to the terms of the LPA, those individuals were ineligible to serve on the Conflicts Committee. Despite belated attempts by ETE to reconstitute the Conflicts Committee, the Court found that the Board failed to properly do so. After finding that the safe harbor of reliance on a Conflicts Committee was not available to the defendants, the Court also considered defendants assertion that the contractual standards for a conflicted transaction were satisfied because the terms of the issuance were “no less favorable to [ETE] than those generally being provided to … unrelated third parties.” The Court rejected this theory, noting that due to the unique and complex nature of the security, there were no “generally” similar transactions to which to compare it.
Having found that defendants had not reached safe harbor, the Court turned to the factual question of whether defendants met the burden of demonstrating that the issuance was objectively fair and reasonable to ETE, taking into account both fair process and fair price. Based on the evidence, the Court found that the defendants failed to make such showing. Critically, the Court observed that inclusion of terms eliminating downside risk by ensuring a minimum quarterly accrual represented a substantial transfer of wealth to subscribers and there was nothing in the record indicating that the directors found the new accrual term to be fair and reasonable or that the board had even considered the consequence of such term. In light of the foregoing, the Court could not find that the private placement was fair and reasonable to ETE and the transfer of the subject securities to the ETE general partner or its affiliates constituted a breach of the LPA.
As a remedy for breach of the LPA, the plaintiffs—having represented to the Court that damages were unavailable—sought equitable relief. The Court held, however, that cancellation of the securities and their accrued credits was an inappropriate remedy because it would be unfair to the unaffiliated subscribers that took the gamble on the offer. Rescission, the Court held, “would deny [subscribers to the private offering] the benefit of their bargain.”
Critical to the Court’s analysis was the fact that the Court determined, and the plaintiffs did not demonstrably contest, that the initial terms of the public offering were fair and reasonable to ETE. The private offering, on the other hand, included the $0.285 accrual term, which served as a downside hedge for subscribers without an apparent benefit to ETE, except in the unlikely event that distributions went up during the plan period. As it turned out, the energy market boomed, the Williams Co. merger failed, ETE’s unit price more than doubled, and the unlikely event came to pass—the distribution rate on common units was at or above $0.285 each quarter following the issuance of securities under the private offering. Because of these factors, subscribers to the private offering actually fared worse than they would have under the unlimited accrual of the initial terms of the public offering. The added accrual term of the private offering, therefore, caused ETE no damages and, in fact, slightly reduced the cost of the offering to ETE. The Court, therefore, denied the plaintiffs’ request for rescission and permanent injunctive relief.