The following post comes to us from Brent J. Horton, assistant professor at Fordham University Gabelli School of Business.

In my recent article, The Going-Private Freeze-Out: A Unique Danger for Investors in Delaware Non-Corporate Business Associations,[1] I examine the agreements of 86 publicly traded, non-corporate business associations (i.e., limited partnerships (“LPs”) and limited liability companies (LLCs)) for provisions that modify the fiduciary duties of management in the context of going-private freeze-outs.

One danger of investing in a public company—whether in the corporate or non-corporate context—is the going-private freeze-out.  In such a transaction, public ownership is eliminated—“cashed-out”—and the company becomes closely held.[2]

The danger is that the public owner will receive less than a fair price when they are “cashed-out”.  In the corporate context, shareholders are protected by the fiduciary standards that management (or the controlling shareholder) must meet, specifically the standard of entire fairness.  The standard of entire fairness requires fair dealing and a fair price.[3]  However, in the non-corporate context, the protections of entire fairness may not apply, because Delaware allows LPs and LLCs to draft provisions in their agreements that modify, or even eliminate, fiduciary duties.  Indeed, my empirical analysis reveals that many publicly traded LPs and LLCs do exactly that.  Here are the highlights:

• 85% of LPs and LLCs subject going-private transactions to special approval by a conflicts committee.  Special approval creates a strong presumption that management acted fairly, and can be overcome only where the members of the conflicts committee acted arbitrarily or in bad faith.

• 52% of LPs and LLCs eliminate fiduciary duties altogether.  Managers and controlling unitholders in these companies are shielded from liability in the case of a going-private freeze-out.  The only remedies for a wronged unitholder are provided in the partnership agreement, or operating agreement, if at all.

The practical result of such fiduciary waiver provisions is that unitholders often have no remedy if management decides to take the company private for an inadequate price.   This is more than a theoretical problem.  In The Going-Private Freeze-Out, I discuss several examples where provisions eliminating or modifying fiduciary duties prevented public unitholders from successfully challenging a going-private freeze-out where they claimed they received an inadequate price.[4]

Post publication of The Going-Private Freeze-Out, as if to confirm the danger, the Supreme Court of Delaware decided Allen v. Encore Energy Partners, L.P.,[5]  dismissing yet another suit challenging a going-private freeze-out.  In that case, Vanguard Natural Resources, LLC, acquired Encore’s general partner, and 46% of Encore’s common interests in late 2010.  In March 2011, Vanguard proposed a merger, whereby it would acquire the remainder of Encore’s publicly traded units.  The merger was approved by the public unitholders (including Vanguard as a 46% unitholder) and it closed on December 1, 2011.

The price paid was $20.82 per unit, and received special approval from Encore’s conflicts committee.  Allen, representing all similarly situated public unitholders, argued that the conflicts committee negotiated an inadequate price.  What made the case especially interesting was evidence that before the merger was proposed, Vanguard (allegedly) made various public statements intended to devalue Encore’s public units—and thus the amount that Vanguard would pay.  These statements included unreasonably low (and it later turned out, inaccurate) predictions of future output, which caused Encore’s common units to fall over five percent.

Unfortunately for Allen, Encore’s LP agreement eliminated common law fiduciary duties, and replaced them with a duty that the conflicts committee act in “good faith” when granting special approval.  The LP agreement further defined good faith as the subjective “belie[f] that the . . . action is in the best interests of the Partnership”[6]—not maximizing the amount paid to the unitholders.  In dismissing Allen’s cause of action, the Court of Chancery stated:

“The near absence under the [agreement] of any duties whatsoever to Encore‘s public equity holders presumably would discourage risk averse investors unwilling to take a leap of faith from investing their money in an enterprise controlled by the General Partner . . . .  [Such investors] may be well advised to avoid master limited partnerships like Encore.”[7]

In affirming the Court of Chancery decision, Chief Justice Steele echoed those remarks stating:

“If Allen seeks the protections the common law duties of loyalty and care provide, he would be well-advised to invest in a Delaware corporation. He is bound by his decision to forgo these protections.”[8]

The full paper, which was recently published in the Delaware Journal of Corporate Law, is available here.