On April 20, 2015, the Delaware Court of Chancery issued a decision awarding $171 million in damages to the common unitholders of a limited partnership against its general partner in connection with a “dropdown” transaction. The decision is the latest in a series of decisions by the Chancery Court concerning the conduct of directors and advisers in conflict of interest and/or sale of the company transactions. See also In re Rural/Metro Corp. S’holders Litig., No. 6350-VCL (Del. Ch. Oct. 10, 2014); Chen v. Howard-Anderson, No. 5878-VCL (Del Ch. April 8, 2014); In re Orchard Enter., Inc. S’holder Litig., No. 7840-VCL (Del. Ch. Feb. 28, 2014). The decision yet again highlights areas that should be of concern to boards and their advisers in such transactions.
El Paso Pipeline concerns a series of related-party transactions known as dropdowns, in which a controlled entity purchases assets from its parent. In the energy industry, companies often “drop” terminal, storage and pipeline assets into a controlled limited partnership in order to obtain tax advantaged, low cost capital via the cash paid by the controlled entity for the asset. The El Paso Corporation (“EPC”), a natural gas and energy provider that has since been acquired by Kinder Morgan, controlled El Paso Pipeline Partners, L.P. (“El Paso Partners”) through the ownership of its sole general partner (the “General Partner”). In March 2010, EPC executed the first of the challenged dropdowns, selling a 51% stake in one of its subsidiaries (“Elba”), a natural gas terminal and pipeline owner, to El Paso Partners for approximately $963 million in cash (the “Spring Dropdown”). Then, in November 2010, EPC sold El Paso Partners the remaining 49% interest, plus a 15% interest in another EPC subsidiary (“Southern”) for $1.412 billion (the “Fall Dropdown”).
Both of these transactions were evaluated and approved by a committee of three directors of the General Partner’s board (the “Committee”). The Committee was advised on both occasions by outside counsel and a financial adviser, Tudor, Pickering, Holt & Co. (“Tudor”).
In late 2011, plaintiff-unitholders in El Paso Partners sued the General Partner, challenging both the Spring and Fall Dropdowns and alleging that, in approving the transactions, the General Partner breached a provision of the limited partnership agreement (the “Agreement”) requiring that the Committee members “subjectively believe” that the dropdowns were in the “best interests” of El Paso Partners. The Court granted defendants summary judgment as to the Spring Dropdown, but permitted the case to proceed as to the Fall Dropdown. After a bench trial, Vice Chancellor Laster found that the Committee members had not formed a subjective belief that the Fall Dropdown was in the best interests of El Paso Partners. The Court held that the Committee members “viewed [El Paso Partners] as a controlled company that existed to benefit [EPC]” and, consequently, failed to “vigorously” vet the deal or negotiate with EPC to obtain the best possible price. The Court also concluded that Tudor manipulated its financial analysis in order to make the transactions appear more favorable to El Paso Partners then in fact they were. The Court found that the General Partner breached the Agreement and awarded plaintiff-unitholders $171 million in damages.
Takeaways and Analyses
- The Court found that the Committee members “subordinated their independently held views to [EPC’s] wishes.” In September, for instance, one member of the Committee emailed another that it was “really not in the best interests of [El Paso Partners] to have too much of its interests tied up” in Elba. The other Committee member replied, “it is as though you are reading my mind.” These and similar comments “evidenced the Committee members’ actual belief that it was not in the best interests of [El Paso Partners] to buy more of Elba in 2010.” But, only two months later, those Committee members supported doing just that, approving El Paso Partners’ acquisition of the remaining 49% of Elba. Based on this about-face, the Court concluded that the Committee had simply “caved in to” EPC’s wishes. Additionally, during negotiations with EPC regarding the Fall Dropdown, the Committee members abandoned the price ranges that they had said in emails they believed were fair in favor of a higher range that obviously benefitted EPC. Again, the Court attributed this decision to the Committee members’ “wanting to please [EPC] management” and “rationaliz[ing] away [their] objections . . . to satisfy [EPC’s] desires.”
An abrupt change of heart—whether by a member of a deal committee or a financial adviser—will invite sharp judicial scrutiny. Here, evidence showed that the Committee members had formed views on the fall transaction—and communicated those views to each other contemporaneous with their consideration of the transaction—but flip-flopped after speaking with and under pressure from EPC. Additionally, the Court found the Committee members’ contemporaneous emails (which revealed a reluctance to acquire more of Elba) more persuasive than what it characterized as their different, “litigation-driven” testimony at trial. Although it should go without saying, counsel needs to carefully consider its litigation strategy and trial presentation in light of the powerful effect of contemporaneous writings and communications.
- The Court found that, in negotiating the Fall Dropdown, “the Committee members consciously disregarded the learning they supposedly gained from the Spring Dropdown.” After the Spring Dropdown was consummated, the market responded negatively—common units of El Paso Partners traded down 3.6% on the news. In response to the market reaction, one of the members of the Committee wrote to his colleagues that “next time we will have to negotiate harder.” However, the Court found that the Committee did not attempt to “negotiate harder” in connection with the Fall Dropdown. While the Committee asked for and received a 3% ($48 million) reduction in the asking price, overall it did not make “the types of arguments that one would expect a motivated bargainer to make.” For example, the Committee did not advocate for a lower price in the fall based on the fact that El Paso Partners was acquiring a minority stake. Additionally, the Committee did not cite the “deterioration in the [liquefied natural gas] market” since the spring as a basis to reduce the price. And, when the deal closed, El Paso Partners ended up paying $31 million more for the 49% stake than the parties had previously agreed upon, thereby negating most of the 3% price reduction (an outcome attributable to the Committee’s failure to analyze and negotiate separate prices for the two assets at issue in the Fall Dropdown).
This aspect of the decision recalls the saying “Fool me once, shame on you. Fool me twice, shame on me.” The Committee realized that it had agreed to an unfavorable deal in connection with the Spring Dropdown. However, the Committee did not take that lesson to heart and alter its bargaining strategy to avoid the same mistakes in connection with the Fall Dropdown. When negotiating a transaction, a committee and its advisers need to negotiate forcefully on behalf of the entity they represent and take into account developments following prior comparable deals.
- The Court observed that while the Committee members were outside directors who met the NYSE’s audit committee independence standards, two had significant ties to EPC. Each had been a high ranking executive at EPC or an affiliate and still had a significant portion of his net worth tied up in the company. These relationships called the Committee’s independence into question. The Court also recognized that Tudor, the financial adviser, was retained “as a matter of course” for each of the dropdowns involving El Paso Partners, had engaged in “back-channel” discussions with EPC concerning these transactions—thereby circumventing the Committee—and structured its fee so it was contingent on a dropdown being consummated.
This decision underscores the importance a court will attribute to the existence of a truly independent deal committee. Although this case was examined under a contractual standard (as opposed to the standards typically applied in public company deals such as the business judgment rule or entire fairness), the Court was clearly bothered by the Committee’s connections to the parent company. Directors should take care to ensure that deal committee members do not have material ties to the controlling or counter party and are afforded and exercise sufficient discretion to negotiate forcefully on behalf of the entity they represent.
- The Court found that the Committee had failed to inform itself about relevant, potentially comparable transactions in assessing whether El Paso Partners was paying a fair price in the Fall Dropdown. In February 2010, EPC was offered the opportunity to purchase a 30% interest in a Mississippi natural gas terminal at a price that implied a multiple of 9.1x 2010 EBITDA (which was significantly lower than the multiple proposed by EPC in connection with the Fall Dropdown). EPC declined to purchase the 30% interest and the CEO characterized the opportunity as “not a pretty picture.” Then, shortly after the Spring Dropdown had been consummated, another energy company had sold a 30% interest in an arguably comparable liquefied natural gas entity for $104 million. The Committee, however, seemingly did nothing to inform itself about why EPC had passed on the opportunity to purchase an interest in a natural gas asset or the details of the $104 million transaction.
One way to determine whether the Fall Dropdown was in the best interests of the partnership was to analyze similar deals. The fact that the Committee and its advisers knew about but failed to investigate transactions that might be comparable was significant to the Court. In discussing this issue, it stated that the Committee members “consciously disregarded” their own views and available information. Directors and advisers need to unearth and understand relevant information, and certainly not turn a blind eye to comparable transactions.
- The Court also found that the Committee members were focused on the wrong metric: “[r]ather than concluding that the Fall Dropdown was in the best interests of [El Paso Partners], the Committee members determined that [the transaction] was accretive.” In this context, an “accretive” transaction is one that increases earnings per share. At trial, one of the Committee members explained that “our job was to look out for the best interests of the unaffiliated unitholders” and the paramount consideration was to “increas[e] cash distributions to the unitholders.” The Court disagreed, finding that “[a]n accretion analysis says nothing about whether the buyer is paying a fair price” because “anyone can make a deal look accretive just by playing with the consideration used.” In becoming “myopically” fixated on short-term accretion to the unitholders and ignoring the deal’s long-term potential to add value, the Committee “failed to carry out their known contractual obligation to determine whether the Fall Dropdown was in the best interests of [El Paso Partners].”
In evaluating a potential transaction, the Committee was charged with determining whether the deal is in the “best interests” of the organization. To Vice Chancellor Laster, however, “best interests” did not mean “short term profits” for a business that was continuing as a going concern. Rather, the Committee should have assessed whether the transaction added long term value. Here, the Committee did not identify any economic benefit to the limited partnership other than an increase in short-term cash flows.
- In very strong terms, the Court took issue with the role played by the General Partner’s financial adviser, finding that “Tudor’s work product further undermined any possible confidence in the Committee.” In addition to engaging in suspicious “back-channel” communications with EPC (an entity it did not represent), the Court found that Tudor did not fairly evaluate the Fall Dropdown and instead “manipulated its presentations [to the Committee] in unprincipled ways to justify the deal.” Among other criticisms, the Court found:
- Tudor did not use “appropriate numbers for its [discounted cash flow] analysis”: When it valued the 49% Elba interest, Tudor used El Paso Partner’s cost of capital rather than the cost of capital for the entity it was acquiring. The Court found that there was no basis for doing so because the “the measure of risk inherent in the cash flows” should be derived from the asset being purchased, not the acquirer. And by using the cost of capital for El Paso Partners, a domestic pipeline business, Tudor did not capture the risks associated with an “import terminal.”
- Tudor manipulated the discount rate: In performing its analysis of previous dropdowns, Tudor’s report included a discount rate range between 8% and 14.5%. While Tudor claimed to have used the same inputs for the Fall Dropdown, Tudor “cut off the upper bound at 12% . . . [and] could not provide any explanation for this [change].”
- Tudor manipulated the precedent transaction analysis: In the report prepared for the Spring Dropdown, Tudor had divided its precedent transactions in separate minority-acquisition and majority-acquisition groups (depending on whether El Paso Partners purchased a majority or minority stake in the EPC subsidiary being sold). For the Fall Dropdown, where El Paso Partners purchased a minority 49% interest, “Tudor lumped all of the precedents together without calling the change to the Committee’s attention and explaining it.”
Ultimately, the Court found that Tudor had simply “crafted a visually pleasing presentation designed to make the dropdown of the moment look as attractive as possible.” In other words, “Tudor’s real client was the deal, and the firm did what it could to justify the Fall Dropdown, get to closing, and collect its contingent fee.”
The Court described the “real work of an adviser to a committee” as “helping . . . develop alternatives, identify arguments, and negotiate with the controller.” Obviously, the Court concluded that Tudor did not do that here. As in Rural/Metro and Chen, the Chancery Court will view with great skepticism any effort to rig a financial analysis to fit a preordained conclusion. A court’s assessment of a committee’s evaluation of a transaction will be adversely impacted, perhaps fatally, when there is evidence of this type of manipulation by a financial adviser that goes unquestioned by a committee.