Implications of Recent Court of Chancery Decisions on MLP Related Party Transactions

Introduction

In two recent decisions written by Vice Chancellor Travis Laster, the Delaware Court of Chancery provided helpful judicial guidance on the application of the covenant of good faith in the context of related party transactions involving master limited partnerships (MLPs).  In both decisions, the Court made clear that when dealing with limited partnerships, contractual terms control and that, once fiduciary duties are contractually eliminated as permitted by Delaware law, courts should not imply terms that would alter the contract or attempt to reconstruct outcomes that fiduciary duty analysis in the corporate setting would generate.

An MLP is a publicly traded limited partnership with qualifying assets that is treated as a pass-through entity for federal income tax purposes. Only enterprises that engage in certain businesses, mostly related to the use of natural resources, can qualify for such treatment. MLPs are managed by a general partner, with the officers and directors at the general partner level and with the general partner generally wholly owned by a corporate sponsor, which itself may or may not be publicly traded. Often, such sponsors will sell assets to the MLP – a transaction referred to colloquially as a “drop-down.”

Drop-down transactions are inherently conflict transactions, but are not uncommon in the life of an MLP. In light of that, sponsors contemplating the formation of an MLP will customarily build into the partnership agreement procedures and standards that contractually define one or more mechanisms to handle conflict transactions. As limited partnerships, MLPs are governed by their limited partnership agreements and, under the Delaware Limited Partnership Act (DLPA), have greater contractual freedom than corporations, which includes the ability to eliminate all common law fiduciary duties, provided that the partnership agreement may not eliminate “the implied contractual covenant of good faith and fair dealing.” It is common then for MLPs and their sponsors to avail themselves of such flexibility and to contractually eliminate all common law fiduciary duties that the general partner might otherwise owe to the MLP and its limited partners, replacing those duties with contractual commitments that apply in related party transactions between the general partner and the MLP. But even within such a construct, the partnership agreement might contractually apply an express “good faith” standard to the acts of the general partner or its board. In addition, as noted above, the parties cannot eliminate from the partnership the implied covenant of good faith and fair dealing.

The two recent decisions authored by Vice Chancellor Laster, In re El Paso Pipeline Partners, L.P. Derivative Litigation (2014 WL 2768782) and Allen v. El Paso Pipeline GP Company (2014 WL 2819005), address both the express and implied duties of good faith owed in the context of MLP conflict transactions. In both cases, the partnership agreement at issue was that of El Paso Pipeline Partners, L.P. (“El Paso MLP”). As permissible under the DLPA, the El Paso MLP partnership agreement completely eliminated the common law fiduciary duties a general partner would otherwise owe to the limited partners under Delaware law. In the place of common law fiduciary duties, the partnership agreement created a contractual structure that included processes for handling conflict transactions. Amongst the processes available for handing conflict situations, the one most often employed, and in fact employed in both of the cases in question, is the use of a special conflicts committee, comprising independent directors assigned the task of evaluating the fairness and reasonableness of the proposed conflict transaction. For such committee approval to be properly granted, the partnership agreement required that the conflict-of-interest transaction receive “approval by a majority of the members of the Conflicts Committee acting in good faith.” (emphasis added.)

Both Allen and In re El Paso featured a group of holders of limited partnership common units claiming that the directors of the general partner and the general partner itself violated their express and implied duties of good faith in engaging in conflict transactions. As a threshold issue, the Court dismissed all claims against directors, explaining that in contract only parties to the contract can breach; thus the general partner, as the only defendant party to the partnership agreement, was the only viable defendant. From there, in each case, the Court analyzed, in turn, the express and implied duties of good faith.

The Subjective Good Faith Standard

The express duty of good faith was defined in the partnership agreement as the belief that the transaction is in the best interests of the partnership. In both cases, the Court clarified that, in accordance with Delaware precedent, belief is a subjective test, such that the contractual good faith standard of the partnership agreement may only be evaluated subjectively, not objectively. Citing the Delaware Supreme Court, the Court in both cases noted that in this context “[t]rial judges should avoid replacing the actual directors with hypothetical reasonable people,” though the Court did point out that objective facts remain logically and legally relevant to the extent they permit an inference that a defendant lacked the necessary subjective belief.

In Allen, the Court further explained that the “best interests of the partnership” standard allowed the Conflicts Committee to subjectively judge the transaction from the perspectives of all partnership constituencies, whereas under normal corporate fiduciary duties the interests of the shareholders would have been of primary importance. In In re El Paso, the Court also held that subjective good faith cannot be challenged based on information that the plaintiffs admitted the members of the Conflicts Committee did not have.

Giving dispositive effect to the contractual standard in both cases, the Court emphasized the importance and primacy of contract principles when fiduciary duties have been eliminated and granted summary judgment on this claim in both cases.

The Implied Covenant of Good Faith

As to the implied duty of good faith, the Court stated that implying terms should be done carefully and sparingly under Delaware law, as supported by precedent. The Court carefully explained that implying a term must never rewrite a contract but must only fill gaps as the parties would have done had they considered the issue when drafting. For example, in Allen, the Court concluded that it would conflict fundamentally with the plain language and structure of the partnership agreement to invoke the implied covenant to require that the Conflicts Committee follow a particular course of obtaining an opinion from a financial advisor that addressed the fairness of a drop-down to the limited partners in a judicially prescribed manner, as advocated by plaintiffs. The Court went on to note that “[d]eploying the implied covenant in this fashion would rewrite Section 7.9(a) [of the partnership agreement] by changing both the nature of the Conflicts Committee’s inquiry (from best interests of the Partnership to fairness to the limited partners) and the scope of judicial review (from the subjective good faith of a majority of the committee to compliance with an obligation to obtain an opinion that analyzed fairness with a sufficient level of methodological rigor to satisfy a court after the fact).”

In In re El Paso, the Court declined to imply in the partnership agreement an affirmative obligation on the part of the general partner to disclose material information about other transactions to the Conflicts Committee.  Among other things, the Court noted the extent to which the parties to the partnership agreement had gone to expand the general partner’s freedom of action and dial back the protections that otherwise would exist if fiduciary duties applied, concluding that “[i]f the issue of voluntary disclosure had arisen at the time of contracting, then it is reasonable to assume that the drafters would have researched the fiduciary duty precedents, identified the disclosure obligation they imposed, and expressly eliminated it.”

The Court also emphasized that the concepts of good faith and fair dealing, when applied to a contract such as the partnership agreement, are not moral concepts but are instead relative to the contract; good faith meaning “faithfulness to the scope, purpose and terms of the parties’ contract,” and fair dealing referring to “a commitment to deal fairly in the sense of consistently with the terms of the parties’ agreement and its purpose.” Finding no relevant gaps in the partnership agreement, the Court dismissed, in each case, the claim that the implied covenant of good faith had been violated.

Conclusion

In applying these decisions practically, the most crucial step to remember is to eliminate at the contract formation stage, if appropriate, all common law fiduciary duties in the partnership agreement. Without doing so effectively, a partnership runs the risk of fiduciary duties still applying in certain cases, rather than being governed exclusively by contract principles. Once in the realm of contract, the major takeaway from the two recent Court decisions is that parties to a related party transaction in the MLP context should carefully and thoroughly review all applicable express contractual provisions, and be mindful that Delaware courts will defer to contractual terms and be reticent when considering implying terms. Vice Chancellor Laster’s own words sum this up most effectively:

The drafters of the LP Agreement chose a framework that maximized the General Partner’s freedom and minimized the opportunities for litigation and judicial oversight. They generally deployed the contractual freedom provided by the Delaware Limited Partnership Act to expand the General Partner’s discretion and carve back on protections that otherwise would exist under common law. Most notably, the drafters of the LP Agreement eliminated all fiduciary duties, resulting in a fully contractual relationship.

Eduardo Gallardo is a partner in the New York office of Gibson, Dunn & Crutcher LLP. Adam J. Brunk is a corporate associate in the same office.