Why Alternative Entities May Not Protect Investors
Authored by Edward M. McNally
Originally published in the Delaware Business Court Insider on October 19, 2011
In recent years, limited liability companies and limited partnerships have become the preferred form of entity for new businesses. In Delaware, for example, there are now more LLCs and LLPs formed each year than Delaware corporations. There are various reasons for this development, particularly the flexibility of management these alternative entities permit.
That is all fine when the entity has a single owner or a close-knit group of owners. But the story is very different when there are outside equity investors involved. Then the lack of a uniform governance structure in these alternative entities may cause problems. It is apparently for just that reason that few alternative entities have been used as a vehicle to issue publicly traded securities, such as limited partnerships or membership interests. Instead, entities formed as LLCs or LLPs frequently convert to the corporate form just before they go public.
The Delaware Court of Chancery's Sept. 30 decision in Brinckerhoff v. Enbridge Energy Co. illustrates the uncertainty involved in an alternative entity investment. Somewhat simplified, the facts of Brinckerhoff are typical of the governance structure of a Delaware limited partnership. Enbridge Energy Partners L.P. (the LLP) is controlled by its general partner, a corporation (the GP) that in turn is controlled by the people who set up the LLP (the controllers). The LLP had a potentially lucrative business opportunity, but in 2008 temporarily lacked access to enough capital to take that opportunity. The controllers then decided to fund the new business on terms favorable to themselves and possibly better than the LLP might have obtained later after the credit meltdown in 2008. When the controllers had the LLP make the investment with the controllers' new capital but on those favorable terms, Peter Brinckerhoff sued on behalf of the other limited partners claiming the LLP was shortchanged in the deal. He lost.
Here is why. The LLP agreement had a provision that permitted self-dealing by the controllers as long as the terms of the transaction "are no less favorable to [the LLP] than those generally being provided to or available from unrelated third parties." Was that test met? The agreement further provided that critical question was to be answered by the GP, notwithstanding its controllers were the parties to the transaction under review. The only constraint on the GP's judgment was that it be taken in "good faith." Further, the LLP agreement said that the GP would be deemed to act in good faith if it followed the advice of an investment banker. The GP received advice from an investment banker that the deal terms "were representative of an arm's length transaction." The court held that insulated the deal from Brinckerhoff's complaints.
Brinckerhoff primarily attacked the approval of the transaction on the basis that the banker's opinion was inconsistent with its own published criteria and that the negotiation of the transaction failed to follow any of the procedures that a controller of a Delaware corporation would be required to use in a similar self-dealing transaction. Those procedures might include use of a truly independent negotiating committee to act for the minority investors, a favorable vote by a majority of the public equity holders or a market check. But as the court pointed out, Delaware law on these alternative entities does not require any of those safeguards be used.
Instead, Delaware's alternative entity law allows the entity's operating agreement to permit almost any form of governance, waiver of fiduciary duties and the setting of loose standards to approve self-dealing transactions by management. All the agreement cannot do is abolish the "covenant of good faith and fair dealing." Considering that the Brinckerhoff case may permit an operating agreement to define what constitutes "good faith and fair dealing," there is little restraint on what an alternative entity agreement may contain to let management do whatever it wants. In effect, if carried to its logical extreme, an operating agreement could say its managers must operate in "good faith" and then say "good faith" means whatever the managers decide is fair. No Delaware court has gone that far. I predict no Delaware court will go that far. Yet how far is too far remains to be seen. Indeed, the Brinckerhoff decision cited to other factors to support its conclusion. At this point, all that seems safe to conclude is that an outsider's blessing of a transaction may satisfy the "good faith" test if the operating agreement says so.
Of course, no one is forced to invest in one of these LLCs or LLPs. The investor chooses to accept the terms of the operating agreement to reap the potential returns the entity might generate. Delaware law holds those investors to their bargain. That is how it should be. After all, any other result would have the courts make the parties' contract for them. That is a task no court is equipped or wants to undertake.
But the question still remains - should these alternative entities adopt operating agreements that virtually free management from duties to the investors? Economic theory says that the investors will be paid higher returns for agreeing to take the governance risks involved in such an investment. In reality, it seems doubtful that those risks can ever be adequately anticipated, however. Moreover, corporate entities with much more standardized governance norms with greater investor protection have long flourished and raised capital. The corporate governance form benefits from its predictability and presumably raised capital effectively without the added risk of unpredictable governance provisions. Thus, the theoretical justification for letting alternative entities be governed loosely may not be valid.
Finally, these attempts to add exculpatory provisions to operating agreements are themselves often risky to controllers. Years ago, we had a case where a master limited partnership's 60-page operating agreement attempted in great detail to spell out how to handle conflict of interest transactions involving its general partner. After consulting a national legal expert on limited partnerships, the general partner bought limited partnership interests following what it thought was the correct process. It was promptly sued, lost and paid millions of dollars in damages. The court held it followed the wrong process, and in doing so had breached its duty to the partnership. Complexity has its own risks.
Perhaps then in these complicated alternative entities it is both those who invest and those who manage that have cause for concern over governance issues.