Delaware Supreme Court Reverses El-Paso MLP Judgement On Standing Grounds

Michael Holmes and Craig Zieminski are partners at Vinson & Elkins LLP. This post is based on a Vinson & Elkins publication by Mr. Holmes, Mr. Zieminski, and Megan Coker, and is part of the Delaware law series; links to other posts in the series are available here.

The Delaware Supreme Court recently reversed a $171 million damages award in El Paso Pipeline GP Co., L.L.C. v. Brinckerhoff, ___ A.3d ___, 2016 WL 7380418 (Del. Dec. 20, 2016) (en banc), concluding that an MLP unitholder plaintiff lacked standing to pursue a derivative claim that an MLP overpaid for assets it acquired from its parent in a dropdown transaction.

The Court reasoned as follows:

  • The lawsuit presented a classic “overpayment” or “dilution” claim, which generally may be pursued only derivatively on behalf of the MLP (as opposed to a claim brought directly by the unitholder).
  • To sue derivatively, a plaintiff must hold equity in the MLP throughout the litigation.
  • The plaintiff lost his ownership interest in the MLP when the MLP was acquired in a merger prior to the resolution of the lawsuit.
  • Therefore, the plaintiff lacked standing to sue derivatively, and the lawsuit could not be maintained as a direct action, invalidating the otherwise “well-reasoned” $171 million judgment.

Key takeaways from the court’s decision include: (1) the general derivative standing rules apply equally to partnerships as to other entities; and (2) the cases in which equity holders may sue directly for breaches of the MLP contractual “good faith” standard are limited. The court emphasized that equity holders with overpayment claims have an adequate remedy even if a subsequent merger eliminates their derivative standing because they can challenge the merger itself through direct claims asserting unfair dealing or an unfair price. The court also declined to extend in the partnership context the so-called Gentile exception, which allows for “dual” direct and derivative claims where there is an improper transfer of both economic value and voting power to a controlling shareholder. See Gentile v. Rossette, 906 A.2d 91, 100 (Del. 2006). Indeed, a concurrence by Chief Justice Strine may indicate a retreat from the Gentile exception altogether if the court agrees with him in a future case presenting the issue.

Background

The dropdown transaction in this case was one of a series of transactions in which El Paso Corp. (“El Paso”) sold LNG terminal/pipeline subsidiaries to El Paso Pipeline Partners, L.P. (“El Paso MLP”). El Paso MLP was managed and controlled by the board of directors of its general partner, El Paso Pipeline GP Company, L.L.C. (or “El Paso GP”). A derivative challenge to one of the transactions went to trial, where the Chancery Court found that the committee members who approved the relevant transaction did not do so in good faith because they did not truly believe the transaction was in El Paso MLP’s best interests. [1]

A potential standing issue arose when Kinder Morgan, Inc. acquired El Paso MLP in a merger before the Chancery Court ruled on the plaintiff’s overpayment claim. Under Delaware law, an equity-holding plaintiff is required to maintain continuous ownership during the life of a derivative lawsuit. See Lewis v. Anderson, 477 A.2d 1040, 1049-50 (Del. 1984). A merger extinguishes a plaintiff’s standing to pursue a derivative suit because the derivative claim is transferred from the target company to the acquiring company after the merger. Nevertheless, the Chancery Court held that the plaintiff had direct standing to pursue the overpayment claim for two reasons.

  • First, the court concluded that the test for direct versus derivative claims, articulated in Tooley v. Donaldson, Lufkin & Jenrette, Inc., 845 A.2d 1031, 1039 (Del. 2004), did not apply because the plaintiff, as a party to the partnership, could state a direct claim for a breach of the partnership agreement.
  • Second, the court alternatively applied the Tooley test, which determines whether a claim is direct or derivative by asking who (1) suffered the alleged harm and (2) would receive the benefit of a recovery. See id. The Chancery Court held that the plaintiff stated a “dual” direct and derivative claim because both the limited partners and El Paso MLP suffered harm and would benefit from any recovery.

The Delaware Supreme Court’s Analysis

The Delaware Supreme Court disagreed with both of the Chancery Court’s conclusions. First, plaintiff could not avoid the Tooley analysis by stating a claim for breach of the partnership agreement. Although limited partners are parties to an MLP’s partnership agreement, the allegedly breached provision of the partnership agreement required El Paso GP (or those acting on its behalf, such as a conflicts committee) to act “in good faith,” defined as a belief they were acting “in the best interests of the Partnership.” El Paso, 2016 WL 7380418, at *7 (emphasis added). As the court explained, because this “contractual duty of good faith was owed to the Partnership, not the individual limited partners,” an MLP unitholder’s breach of contract claims might be “derivative, direct, or both.” Id. at *8.

Dispelling any confusion related to the unique nature of contract-based entities, the court next held that “[t]he Tooley direct/derivative test is ‘substantially the same’ for claims involving limited partnerships.” Id. at *9. Moreover, the court made clear that “whether a claim is solely derivative” or dual-natured must turn solely on who suffered the alleged harm, who would receive the benefit of any remedy, and proof that the equity holder “can prevail without showing an injury to the [entity].” Id. at *10. This case fit the mold of traditionally derivative claims under Tooley because it alleged that El Paso MLP had paid too much to acquire assets. The plaintiff only alleged and presented evidence of how the partnership was harmed, and the pro rata recovery for the limited partners (in proportion to their ownership interests) confirmed the derivative nature of the remedy.

The Supreme Court also rejected the notion that the plaintiff had asserted a “dual” direct/derivative claim under the Gentile exception. See 906 A.2d at 100. The dropdown transaction did not involve any change to the partners’ voting rights or El Paso GP’s control of El Paso MLP; thus, the Gentile exception could not apply. The court “decline[d] to extend Gentile further” in this case because without requiring a loss of voting power, the Gentile exception “would swallow the general rule that equity dilution claims are derivative.” El Paso, 2016 WL 7380418, at *12. Finding no dilution of voting power, the court reversed the Chancery Court’s decision and held that the plaintiff lacked direct standing to challenge the transaction.

Chief Justice Strine penned a concurrence that may signal the court’s willingness to back away from the Gentile doctrine altogether in an appropriate case. He reasoned that Gentile has “muddie[d] the clarity” of Delaware law concerning direct/derivative claims without providing additional protection for shareholders. Id. at *14 (Strine, C.J., concurring). The kind of voting-power dilution targeted by Gentile is only problematic for an entity with “a diversified group of public equity holders” that have lost voting power, he reasoned, and Revlon [2] already provides a direct claim to such equity holders. Id. at *14.

Conclusions and Key Takeaways

  1. Tooley’s standard applies to contract rights and contractual entities. The Delaware Supreme Court’s decision shows that overpayment claims involving limited partnerships or other “creatures of contract” generally do not differ from those involving non-contractual entities. While the court reasoned from interpretation of the specific partnership agreement in this case, that agreement was not atypical. It limited the duties of the controlling general partner and the conflicts committee to acting in “good faith”—in the “best interests of the Partnership.”
  2. MLP plaintiffs may have limited opportunities to file direct claims. Nearly all MLP unitholder lawsuits are premised on alleged breaches of the contractual “good faith” duty. Such lawsuits are derivative-only absent a showing of individual harm to limited partners that is distinct from the harm inflicted on the partnership. Derivative lawsuits have additional procedural hurdles, such as requiring the plaintiff to either make a pre-suit demand (requesting that the board of directors address the alleged wrongdoing) or establish that such a demand would have been futile.
  3. The “safe harbor” provisions in MLP partnership agreements remain optional. Most MLP partnership agreements have a general “good faith” standard (described above) and a number of “safe harbor” provisions that allow the general partner to shield itself from liability when resolving a conflict of interest (e.g., via approval by a conflicts committee or the vote of a majority of the unaffiliated unitholders). The Chancery Court held that El Paso GP was required to fulfill one of the safe harbor provisions, in contrast to prior Delaware Supreme Court authority interpreting analogous provisions as optional. The Supreme Court held that it was unnecessary to reach this issue but suggested that its earlier authority remained valid.

Endnotes

1This conclusion rested on a number of underlying factual findings that are not relevant to the Delaware Supreme Court’s opinion. The Chancery Court’s decision has been reversed, but the Supreme Court labeled this a “troubling case” and called the decision “well-reasoned.” Thus, lessons from the Chancery Court’s merits analysis remain helpful to businesses and practitioners. See Michael Holmes & Craig Zieminski, Lessons from Delaware Court of Chancery’s Recent El Paso Decision (May 6, 2015), available at http://www.velaw.com/Insights/Lessons-from-Delaware-Court-of-Chancery-s-Recent-El-Paso-Decision/.
(go back)

2Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc., 506 A.2d 173 (Del. 1986).(go back)

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