Two Delaware Decisions Bring Practice Points For MLP Planners
Two recent decisions by the Delaware courts underscore the importance for a sponsor of a master limited partnership (“MLP”) to avail itself fully of the latitude provided by the Delaware Revised Uniform Limited Partnership Act to privately order the affairs of the MLP by, among other things, including conflict resolution safe-harbor provisions in the partnership agreement that, if employed, will immunize a conflict-of-interest transaction from judicial review, save for the possible limited application in rare cases of the implied covenant of good faith and fair dealing (which cannot be eliminated). In Brinckerhoff v. Enbridge Energy Co., which involved a partnership agreement that lacked a special approval mechanism for conflict transactions, the Supreme Court applied the contractual equivalent of entire fairness review, found that the unitholder-plaintiff had pled sufficient facts suggesting that the challenged dropdown transaction was not “fair and reasonable” to the partnership because it allegedly repurchased assets from the parent of its general partner for $200 million more than it sold the same assets a few years earlier, and reversed the Court of Chancery’s dismissal of the complaint. In Morris v. Spectra Energy Partners (DE) GP, LP, which involved a partnership agreement that contained a special approval mechanism that provided a rebuttable presumption of good faith, the Court of Chancery denied defense motions to dismiss in part, finding that the unitholder-plaintiff had alleged sufficient facts to rebut the presumption of good faith at the pleading stage because, in the reverse dropdown at issue, the parent of the partnership’s general partner purportedly paid the partnership $500 million less for pipeline assets than the $1.5 billion value ascribed to those assets by the parent in contemporaneous public announcements.
Below, we discuss these decisions and provide practice points for MLP planners.
In Enbridge, a common unitholder of Enbridge Energy Partners, L.P. (“EEP”) challenged a dropdown transaction whereby Enbridge, Inc. (“Enbridge”), sponsor of EEP and the ultimate parent of EEP’s general partner (“EEP GP”), sold to EEP its interest in the Alberta Clipper project, a joint venture involving a pipeline used to transport petroleum from Alberta, Canada to the United States, in consideration for, inter alia, newly issued EEP units and repayment of debt valued together at approximately $1 billion. In 2009, EEP sold to Enbridge the same Alberta Clipper pipeline interest, including expansion rights with respect to the project, at a value of approximately $800 million. In earlier litigation brought by the same plaintiff challenging the 2009 transaction, the Court of Chancery dismissed the complaint (later affirmed by the Supreme Court on appeal) for failure to allege bad faith under EEP’s limited partnership agreement (the “LPA”), notwithstanding other provisions of the LPA, including Section 6.6(e) requiring that conflict transactions with affiliates be “fair and reasonable” to EEP. In his complaint challenging the later transaction, the plaintiff claimed that the dropdown was not “fair and reasonable” to EEP as required by Section 6.6(e), alleging that EEP “agreed to pay $200 million more to Enbridge to repurchase the same asset it [previously] sold,” despite declining earnings and oil prices, as well as the absence of expansion rights transferred in the prior transaction.
The defendants moved to dismiss the complaint, arguing that the plaintiff failed to adequately allege bad faith in accordance with the Delaware courts’ prior interpretation of the LPA in the litigation challenging the 2009 transaction. The Court of Chancery agreed and dismissed the complaint. On appeal, the Supreme Court reversed, electing to “change course” from the pleading standard established in its opinion regarding the 2009 transaction.
The Supreme Court first ruled that the general good faith standard contained in the LPA did not displace the affirmative obligation in Section 6.6(e) that conflict transactions be “fair and reasonable” to EEP. The Court confirmed its earlier view that Section 6.10(d) of the LPA eliminated traditional fiduciary duties and substituted a contractual good-faith standard (i.e., a duty to act in a manner “reasonably believed by [EEP GP] to be in the best interests of [EEP]”), but explained that Section 6.10(d) “is a general standard of care that operates in the spaces of the LPA without express standards.” According to the Court, to interpret the LPA otherwise would effectively eliminate those specific obligations, and it cited the familiar contract interpretation principles that specific provisions trump general ones and that individual provisions should not be interpreted to nullify others. Thus, the “fair and reasonable” requirement in Section 6.6(e) was such an express standard that applied in place of the good faith standard. For similar reasons, the Court found that Sections 6.8(a) (good faith exculpates indemnitees from money damages), 6.9(a) (conflict resolution provision for transactions not specifically addressed elsewhere in the LPA), and 6.10(b) (conclusive presumption of good faith when relying on professional advisors) did not modify the specific obligation set forth in Section 6.6(e). Applying Section 6.6(e)’s “fair and reasonable” standard, which it described as akin to entire fairness review in the corporate context, the Court held that the complaint adequately pled a breach because EEP allegedly “paid $200 million more to repurchase the same assets it sold in 2009” notwithstanding, among other things, “declining EBITDA, slumping oil prices, and the absence of the expansion rights sold in 2009.”
The Court then turned to the effect of the LPA’s exculpatory provision at Section 6.8(a), which shields EEP GP and its affiliates from liability for monetary damages arising from actions taken in good faith (without expressly defining good faith). In its earlier opinion regarding the challenge to the 2009 Alberta Clipper transaction, the Supreme Court determined that Section 6.8(a) required a plaintiff to plead “bad faith” in accordance with notions of corporate waste, meaning that the challenged action must be “so far beyond the bounds of reasonable judgement that it seems essentially inexplicable on any ground other than bad faith.” Here, the Supreme Court departed from that earlier ruling and instead adopted the approach it took in Norton v. K-Sea Transportation Partners, L.P., finding that the contractual standard of care (essentially the same as Section 6.10(d) in EEP’s LPA) “also supplied the definition of good faith for the stand-alone good faith requirement in the exculpatory provision.” Accordingly, the Court held that to plead EEP GP did not act in good faith, plaintiff “must plead facts supporting an inference that EEP GP did not reasonably believe that the Alberta Clipper transaction was in the best interest of the Partnership.” The Court then ruled that the complaint supported an inference that EEP GP did not act in good faith because it, through the director defendants, did not reasonably believe that the dropdown was fair and reasonable to EEP, noting the plaintiff’s allegations that, among other things, the defendants purportedly knew of but improperly disregarded the prior Alberta Clipper transaction as well as the project’s declining earnings, the negative oil pricing environment, and the lack of expansion rights sold in 2009. The Court also held that Section 6.8(a) would not preclude equitable, as opposed to monetary, remedies, and accordingly reversed dismissal of plaintiff’s claims for reformation and rescission.
The Court also rejected the defendants’ reliance on Section 6.10(b), which supplied a conclusive presumption of good faith when EEP GP acts “in reliance upon the opinion [of an advisor] as to matters . . . reasonably believe[d] to be within such [advisor’s] professional or expert competence,” reasoning that a determination whether EEP GP “reasonably believed” that the financial advisor was competent depended on the factual record developed through discovery, and accepting plaintiff’s allegation that EEP GP could not have reasonably relied on a financial advisor that did not consider the arguably most relevant comparable transaction (i.e., the prior Alberta Clipper transaction). The Court also indicated, in light of the pleadings, that EEP GP’s reliance on a fairness opinion on a “fully baked” deal may not be the manner of reliance contemplated by Section 6.10(b), stating that if the financial advisor “had been charged in the first instance to value the Alberta Clipper Interest, and the Special Committee had reasonably relied on [the advisor’s] valuation to set the sale price, [the advisor’s] role and the Special Committee’s reliance on its valuation might be a more comfortable fit with the reliance language of Section 6.10(b).”
In Spectra, a common unitholder of Spectra Energy Partners, LP (“SEP”) challenged a “reverse dropdown” wherein SEP, allegedly in exchange for less than $1 billion of consideration, sold pipeline assets to Spectra Energy Corp. (“SE Corp”), the ultimate parent of SEP’s general partner, which earlier had pledged to contribute those assets to a joint venture with a third party and publicly described them as worth $1.5 billion. SEP received as consideration partnership units owned by SE Corp (the “Redemption”) and a reduction of incentive distribution rights (“IDR”) payable to SE Corp (the “IDR Reduction”). In addition, the transfer of the assets from SEP to SE Corp had the effect of reducing the distributions owed by SEP to its general partner (the “Reduced GP Distributions”). The transaction received “Special Approval” from a conflicts committee of the general partner’s board, after the committee received a fairness opinion from its financial advisor. The financial advisor valued the consideration (not including the Reduced GP Distributions) at $946 million and opined that the consideration was accretive to SEP because the consideration exceeded the value to SEP of the pipeline assets, which it valued at $700 to $875 million. The financial advisor did not include the Reduced GP Distributions in its valuation of the consideration paid by SE Corp to SEP, but separately valued the Reduced GP Distributions at approximately $500 million.
The plaintiff filed suit in the Court of Chancery challenging the transaction and asserting that the defendants breached Section 7.9(b) of SEP’s limited partnership agreement (the “LPA”), which, combined with Section 7.9(e)’s displacement of common law fiduciary duties, prescribed a general duty to act in subjective good faith—defined in the LPA as a belief “that the determination or other action is in the best interests of [SEP].” In response, the defendants argued that the transaction was immunized from judicial review by operation of receipt of special approval of the conflicts committee, and that the committee’s reliance on its financial advisor’s fairness opinion provided, pursuant to Section 7.10(b), a conclusive presumption of good faith.
On defense motions to dismiss, the Court of Chancery found that the plaintiff had adequately pled a breach of the contractual duty of good faith contained in the LPA. The Court found inapplicable Section 7.10(b)’s conclusive presumption of good faith, explaining that Section 7.10, entitled “Other Matters Concerning the General Partner,” was a general provision that did not apply in the context of conflict transactions explicitly governed by the more specific Section 7.9, entitled “Resolution of Conflicts of Interest; Standards of Conduct and Modification of Duties.” In so ruling, the Court distinguished the instant LPA from agreements in other cases wherein a conclusive presumption was contained within the conflict resolution safe harbor section. Accordingly, even though the general partner, through its conflicts committee, relied on a fairness opinion in approving the transaction, the conclusive presumption afforded in Section 7.10(b) did not apply and only the rebuttable presumption afforded in Section 7.9(a) by virtue of the conflicts committee’s special approval applied.
The Court then found that the complaint adequately rebutted Section 7.9(a)’s presumption of good faith. Viewing the allegations in the light most favorable to the plaintiff, the Court held that the defendants’ purported knowledge (and public announcement) of the $1.5 billion market value of the assets sold to SE Corp for less than $1 billion supported a pleading-stage inference of subjective bad faith. While the defendants argued that the value of the Reduced GP Distributions should be added to the financial advisor’s $946 million valuation of the Redemption and IDR Reduction (which would bridge the valuation gap), the Court found that the complaint contained sufficient factual allegations to support an inference that the Reduced GP Distributions were not thought by the parties to be an aspect of the consideration. The Court observed that SE Corp’s initial proposal purportedly did not reference the Reduced GP Distributions (suggesting they were not viewed as an element of the consideration) and that the financial advisor “allegedly flip-flopped” regarding whether to include the Reduced GP Distributions as an element of consideration and ultimately did not include them in calculating the value of the consideration paid by SE Corp to SEP. These allegations, the Court found, adequately rebutted the presumption of subjective good faith at the pleading stage.
Subtle distinctions result in substantive differences.
For the most part, MLP partnership agreements are similarly structured and use common terminology. But differences matter, and the Enbridge and Spectra cases again demonstrate that the Delaware courts will scrutinize the precise language of the limited partnership agreement at issue and will give effect to the “significant nuanced substantive differences” between such agreements. Several of the rulings in Enbridge will have limited applicability to most modern MLPs. Most importantly, the Enbridge LPA did not contain a conflict resolution safe-harbor or special approval mechanism that would cause a conflict transaction to be deemed fair and reasonable to the MLP. Most, if not all, modern MLPs have safe harbor procedures that, if followed, immunize conflict transactions from judicial challenge or otherwise “deem” a deal to be fair and reasonable. Accordingly, the Enbridge rulings on the fair and reasonable standard will have limited precedential value to other MLPs. Similarly, unlike the agreement in Spectra that provided only a rebuttable presumption of good faith when special approval by a conflicts committee is obtained, several modern MLP agreements provide for conclusive presumptions that immunize the approval from judicial inquiry into good faith. As such, the Court’s ruling in Spectra will not be universally applicable.
Undefined good faith no longer judged by corporate waste standard.
As noted above, in its opinion relating to the 2009 Alberta Clipper transaction (referred to as “Brinckerhoff III”), the Supreme Court interpreted “good faith”—which was not defined in EEP’s LPA—for purposes of the exculpatory provision at Section 6.8(a) by relying on “corporate notions of waste,” and held that, for a plaintiff to adequately plead non-exculpated bad faith, EEP GP’s conduct “must be ‘so far beyond the bounds of reasonable judgment that it seems essentially inexplicable on any ground other than bad faith.’” In Enbridge, the Court, relying on Norton, “depart[ed] from [its] earlier decision in Brinckerhoff III, and h[e]ld that to plead a claim that EEP GP did not act in good faith, [the plaintiff] must plead facts supporting an inference that EEP GP did not reasonably believe that the Alberta Clipper transaction was in the best interests of [EEP].” Accordingly, MLP agreements that (like the EEP LPA) fail to define good faith will likely be interpreted in a similar manner. However, most modern MLP agreements contain an express definition of good faith like the one in Spectra, so the Supreme Court’s Enbridge ruling on this point should have limited application.
Subjective vs. objective (reasonable) good faith.
Most MLP agreements that define good faith do not adopt a reasonableness or objective standard, so that good faith is based on the subjective belief of the decision-maker. The subjective standard should make pleading (and proving) a breach of the contractual duty of good faith difficult. However, as indicated in Spectra and other cases such as In re El Paso Pipeline Partners, L.P. Derivative Litigation, the right mix of objective facts can be used to call into question the actual belief of the directors.
Significant “value gap” alone may rebut directors’ subjective beliefs.
Once the Court in Enbridge determined that the dropdown was subject to entire fairness-like review by operation of the “fair and reasonable” standard, it was not surprising that specific factual allegations of a significant value gap (essentially allegations of an unfair price) withstood a motion to dismiss. Spectra, on the other hand, indicates that a large enough value gap may be sufficient grounds for the Court to second-guess a conflicts committee’s actual belief regarding a transaction. Deal planners should be aware of this risk and create a record that accounts for indications of value that vary from the agreed deal price and that adequately explains the rationale for the disparity.
Fairness opinions and the conclusive presumption of good faith.
Perhaps the most conspicuous aspect of both Enbridge and Spectra is the cabining of the contractual conclusive presumption of good faith when relying on the opinion of an advisor, which is found in essentially all MLP partnership agreements. Enbridge limits the conclusive presumption in two ways: first, by suggesting that the required “reasonable belief” in the advisor’s competence can easily morph into a requirement that reliance on the opinion itself be reasonable (in other words, perceived flaws in the advisor’s analysis may be used as a means to challenge the reasonableness of the determination that the advisor is competent, which is usually made by the general partner’s board or conflicts committee at the time of engagement); and, second, by suggesting that advice resulting from “opinion-only” engagements of financial advisors will not qualify for the conclusive presumption. Spectra appears to further cut back on the availability of the conclusive presumption by holding it plays no role when conflict resolution safe-harbor procedures are employed, such as special approval by a conflicts committee. In light of these rulings, deal planners would be wise not to rely exclusively on a fairness opinion to provide a conclusive presumption of good faith in connection with a dropdown or other conflict transaction. Nonetheless, fairness opinions will remain valuable in conflict transactions. For transactions under modern MLP agreements that contain a special approval safe harbor and subjective good-faith standard of conduct, boards and conflicts committees can rely on fairness opinions to support their subjective belief that a transaction is in, or is not opposed to, the best interests of the partnership. Deal planners should also consider whether, in light of these cases, conflicts committees should be specifically empowered to negotiate the financial terms of a proposal (rather than just having “thumbs up or down” authority), and whether financial advisors engaged by the conflicts committee should serve a more comprehensive structuring role and assist in negotiations, rather than just be brought in to provide a fairness opinion on a final proposal. Finally, for new MLPs coming to market, partnership agreement drafters may want to consider revising the conclusive presumption provision by changing reasonable belief of competence to subjective belief, and to expressly provide that the conclusive presumption will apply to conflict transactions that are also subject to a rebuttable presumption of good faith by virtue of special approval or other safe harbor.
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These are but some of the issues MLP sponsors and their counsel may evaluate following the Enbridge and Spectra decisions. As noted, when forming a new MLP or considering amendments to an existing partnership agreement, full advantage should be taken of the flexibility afforded by Delaware law to adopt contractual safe-harbor provisions and other favorable terms found in modern MLP agreements to accommodate conflict transactions. To be sure, whatever the terms of an MLP agreement, when structuring and executing a conflict transaction, it is important to follow its provisions closely and to utilize contractual safe harbors if available in order to best position the transaction to withstand (or be immune from) judicial scrutiny.
This article was originally published in the August 29, 2017 issue of Law360.