One of the reasons for Delaware’s popularity as the venue of choice for the formation of limited liability companies, limited partnerships and other alternative entities is its willingness to enforce contracts as written. Delaware’s respect for the freedom of contract is reflected yet again in a recent decision by Vice Chancellor Donald F. Parsons Jr., In re Encore Energy Partners Unitholder Litigation, C.A. No. 6347-VCP (Del. Ch. Aug. 31, 2012), dismissing a unitholder derivative suit challenging a self-interested merger approved by the general partner of a master limited partnership.
Prior to the merger challenged in the lawsuit, Encore Energy Partners GP (Encore GP) was a wholly owned, indirect subsidiary of Vanguard Natural Resources and served as the general partner of Encore Energy Partners LP (Encore). Encore is a publicly traded, master limited partnership involved in the acquisition, exploration and development of oil and natural gas reserves from onshore fields in the United States managed by Encore GP. A seven-member board of directors managed Encore GP, four of whom Vanguard appointed and three of whom were independent directors who comprised Encore GP’s conflicts committee.
Vanguard acquired approximately 45.5 percent of Encore’s outstanding common units and 100 percent of Encore GP on December 31, 2010. The complaint alleged that after this acquisition, Vanguard began a campaign to artificially deflate Encore’s unit price in order to reduce the cost of later acquiring the balance of Encore’s public equity. The plaintiffs also alleged that Vanguard caused Encore to provide forecasts that were substantially below analysts’ expectations to further depress the Encore unit price. Contemplating a merger since its initial acquisition of Encore units, Vanguard was alleged to have monitored the spread between its trading price and Encore’s, so it could announce the merger when the implied exchange ratio of Vanguard to Encore units was most favorable.
The exchange ratio troughed on March 24, 2011, and Vanguard publicly proposed a merger of Encore into a Vanguard subsidiary. Under the proposal, each Encore unit would convert into .72 Vanguard units. The Vanguard offer represented a premium of only $.05 more than Encore’s trading price on the date of merger. In the merger offer, Vanguard stated it would not entertain any proposal to sell its own interests in Encore, nor would it agree to condition the merger on the approval of a majority of Encore’s unaffiliated unitholders.
Vanguard’s unwillingness to exclude its 45.5 percent interest from the merger vote was motivated primarily by the conflict of interest provision contained in Encore’s limited partnership agreement. Specifically, the limited partnership agreement provided a “special approval” mechanism whereby Encore GP could approve a self-interested transaction on behalf of Encore upon the approval of a majority of the members of the conflicts committee. The conflicts committee consisted of three directors, none of whom had any affiliation with Vanguard. The committee provided “the sole process protection for [Encore’s] public investors with respect to the merger” because the Encore limited partnership agreement jettisoned traditional fiduciary duties.
To evaluate the proposed merger, the conflicts committee retained two independent law firms and an independent financial adviser. The committee had broad authority to “study, review, evaluate and negotiate” the terms of the proposed merger or any alternative and to determine whether the merger or any alternative was in the best interests of Encore and its unaffiliated unitholders. After obtaining indemnification agreements from Encore GP and negotiating standstill and confidentiality agreements between Encore and Vanguard, the conflicts committee conducted a six-week due diligence process. The court noted that the complaint did not contain any allegation that the conflicts committee failed to properly inform itself concerning the transaction, nor was it interested in the proposed merger.
Although the conflicts committee determined the .72 exchange ratio inadequate, it concluded that Vanguard was unlikely to agree to an exchange ratio that diluted its own interest in Encore. The conflicts committee countered Vanguard’s March 24, 2011, offer with an exchange ratio of .75, the ratio at which the committee believed Vanguard’s shares would start to get diluted. Vanguard countered with an exchange ratio of .74, but the conflicts committee insisted on .75. Vanguard subsequently acceded to the conflicts committee’s demand. After negotiating a merger agreement and receiving a fairness opinion from its financial adviser, the committee unanimously resolved that the merger was fair and reasonable and in the best interest of Encore and its public unitholders and recommended that Encore GP approve the merger. A majority of Encore’s unitholders, including all of Vanguard’s 45.5 percent, approved the merger on November 30, 2011, and the merger closed on December 1, 2011.
Although the conflicts committee succeeded in obtaining a 4.17 percent increase in the merger consideration, the complaint nonetheless challenged the committee’s decision because the increased exchange ratio was paltry and changes to the implied value per Encore unit (based on Vanguard’s trading price) resulted in less consideration to the common public unitholders notwithstanding the greater exchange ratio. In other words, according to the plaintiffs, the conflicts committee took three months to reduce the merger consideration by 9.1 percent. The complaint also challenged the methodologies employed by the committee’s financial adviser, which they claimed should have required an exchange ratio closer to 1.0.
The complaint sought damages based on the defendants’ breach of their contractual duties by proposing, approving and consummating the merger, which the plaintiffs claimed was unfair, unreasonable and undertaken in bad faith. The defendants moved to dismiss the action because the limited partnership agreement waived traditional fiduciary duties and immunized self-interested transactions (like the merger) through use of the “special approval” process, so long as the conflicts committee acted in good faith (i.e., had a subjective belief that the disputed determination was in Encore’s best interests). Notably, the limited partnership agreement afforded the conflicts committee a conclusive presumption of good faith when it relied upon the advice of a legal or financial adviser within such person’s professional or expert competence.
The court identified two contractual duties Encore GP and its conflicts committee owed the common stockholders: a duty of subjective good faith in reviewing and approving the transaction and an implied covenant of good faith and fair dealing. While the court noted that the complaint alleged that the conflicts committee ran a “shoddy negotiation process” that might not satisfy a traditional fiduciary analysis, it did not allege facts from which the court could conclude that the committee members subjectively believed they were acting contrary to Encore’s best interests by giving special approval to the merger. The court explained that the objective reasonableness of the approval was irrelevant under the limited partnership agreement. The court also noted the conflicts committee’s reasonable reliance on credible experts gave its special approval a conclusive presumption of good faith that the complaint did not endeavor to rebut.
Dispensing with the direct contractual claim, the court turned to the implied covenant of good faith and fair dealing. The court explained that to state a claim under the implied covenant, the complaint must allege “how the conflicts committee’s allegedly feckless negotiations ‘frustrated the fruits of the bargain that the parties reasonably expected.'” The court noted that the limited partnership agreement judged the conflicts committee on a deferential, subjective good-faith standard; presumed that the conflicts committee acted in good faith – conclusively when relying on experts as it did here; exculpated the defendants from all monetary liability unless they acted in bad faith; and eliminated common law fiduciary duties. Thus, the court concluded that the contractual framework was “inimical to requiring that a transaction receiving special approval be objectively fair and reasonable.” Given this flexible and deferential contractual framework, the court determined that the actions of the conflicts committee, however ineffectual, could not have frustrated the plaintiffs’ contractual expectations.
In dismissing the complaint, the court noted that the “near absence … 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” Encore GP. Having taken that leap of faith, in search of the large returns a master limited partnership investment might yield, the court would not permit the unitholder plaintiffs to reintroduce a fiduciary review they waived in the limited partnership agreement “‘through the backdoor of the implied covenant.'”
In dismissing, at the pleading stage, a complaint challenging the approval of a transaction that might have received a very different reception if judged under traditional fiduciary duty standards, the Court of Chancery’s decision in Encore confirmed once again the deferential approach Delaware courts will give to the provisions of complex agreements entered into by sophisticated investors. The certainty that comes with enforcing contracts as written continues to cement Delaware’s supremacy in the alternative entity business.
Reprinted with permission from the October 18, 2012 issue of Delaware Business Court Insider. (c) 2012 ALM Media Properties, LLC. Further duplication without permission is prohibited.