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Supreme Court Chips Away at Concept of Direct And Derivative Claims

Just in time for Christmas, on December 20, 2016, the Delaware Supreme Court issued a Christmas present – or lump of coal, depending on your view – in its opinion in El Paso Pipeline GP Company LLC v. Brinckerhoff.  In this opinion, the Supreme Court reversed the Court of Chancery’s opinion holding that claims of a limited partner challenging a drop down transaction between the general partner’s parent and the partnership as a breach of the limited partnership agreement were direct, and therefore survived the merger of the limited partnership after trial with a third party.  The Court of Chancery had awarded $171 million in damages for the breach.  The general partner had argued that the merger extinguished the limited partners’ claims.

The Supreme Court’s opinion addresses the thorny and, as described by Chief Justice Strine in his concurring opinion, confusing issue of whether to characterize a claim as derivative, direct, or both.  In El Paso, the Supreme Court held that although the claim involved breach of the limited partnership agreement, the claim was derivative under a Tooley analysis because at its heart, the plaintiff’s claim was that the partnership paid too much for the assets acquired in the drop down and the benefit of any recovery would flow solely to the partnership.   The Court distinguished this type of claim from its prior holding in Gentile v. Rosette, where the Court found that a dilutive transaction between the company and its controlling stockholder was derivative and direct, on the grounds that unlike in Gentile, the general partner did not gain additional voting power or control as a result of the transaction.  Because the Supreme Court held that the claim was derivative, it did not survive the merger.

Although the Court carefully limited its opinion to the facts before it, Chief Justice Strine’s concurring opinion indicates that at least he doubts the viability of the holding in Gentile generally.  Describing the holding in Gentile as “a confusing decision, which muddies the clarity of our law in an important context,” the Chief Justice agreed that because in this case the transaction had no effect on the limited partners’ voting rights, the Court need not consider whether to overrule or modify Gentile.  He suggested, however, that Gentile should be overruled to the extent that it allows for a direct claim in dilution cases with a controlling stockholder.  The Chief Justice also argued that even if there were no controlling stockholder, Delaware has other doctrines, such as Revlon, that permit a stockholder to assert a direct claim when a transaction shifts control of a company from a diversified investor base to a single controlling stockholder.  Although the majority opinion did not modify or overrule Gentile, the Chief Justice called it “a big step in the right direction.”