A principal difference between alternative entities and corporations under Delaware law is the ability in the former to modify or eliminate fiduciary duties. A Delaware court is required by statute to give effect to the principle of freedom of contract in interpreting limited liability company or master limited partnership agreements. When properly drafted, agreements modifying or eliminating fiduciary duties in alternative entities have real-world consequences particularly in conflict-of-interest transactions. A transaction with a controlling party that may not pass muster when challenged by equity holders in the corporate setting may be dismissed at the pleading stage when investors attacking the transaction must overcome the contractual standards in an alternative entity agreement. The recent case of In re Kinder Morgan Corporate Reorganization Litigation, Cons. C. A. No. 10093-VCL (August 20, 2015), illustrates this principle and reaffirms that Delaware courts will enforce alternative entity agreements as written.
Background to the Transaction
The Kinder Morgan transaction involved a corporate reorganization whereby the ultimate parent of a publicly-traded master limited partnership would survive as the sole publicly traded entity. To accomplish the transaction, the partnership would merge with a wholly owned subsidiary of its general partner and the entity to which the general partner had delegated authority to manage the partnership would merge into a different wholly owned subsidiary of the general partner. As permitted by the partnership's governing agreement, the general partner sought special approval of the transaction by a committee of the board of directors of the general partner composed of three individuals who were neither officers nor employees of the general partner or its affiliates. The partnership committee was not empowered to review or explore transactions involving third parties; its review and special approval was limited to the proposed merger with the ultimate parent or alternatives that involved the parent. The same three individuals who served on the partnership committee also served on a committee to review and if appropriate approve the delegate merger.
Plaintiffs Allege Committee Members Acted in Bad Faith
In alleging bad faith, the partnership unitholder plaintiffs asserted the partnership committee yielded to the wishes of the parent in not disagreeing that the stockholders in the delegate merger would receive the same consideration as the partnership's unitholders even though the shares of the GP delegate traded at a discount to those of the partnership and the consideration to be received by the GP delegate stockholders would be tax-free. Net of taxes, the plaintiffs complained that holders of common units lost in the aggregate 4 percent of the value of their units in the partnership merger while the GP delegate stockholders realized a 21 percent gain in the delegate merger. Other evidence of lax negotiations was the failure to insist on a majority-of-the-minority vote to approve the partnership transaction. At the same time, the plaintiffs also alleged the partnership faced serious financial challenges, that it had to engage in a merger or other strategic transaction and that the partnership merger resolved those concerns.
Failure to Allege Noncompliance With Partnership Agreement
Relying on the Delaware Supreme Court's decision in Norton v. K-Sea Transportation Partners L.P., 67 A. 3d 354, 360 (Del. 2013), which interpreted identical language to the pertinent provisions of the LP agreement, the court held the plaintiffs failed to state a claim. The LP agreement eliminated fiduciary duties and instead required that the general partner "believe that its action is in the best interest of, or not inconsistent with, the best interests of the partnership." For a conflict-of-interest transaction, approval by a special committee consistent with the LP agreement "shall be conclusively deemed fair and reasonable to the partnership." Under Norton, the committee "must believe (i) subjectively that the action taken was on terms 'fair and reasonable' to the partnership and (ii) both subjectively and reasonably that the action taken was 'in the best interests of, or not inconsistent with, the best interests of the partnership.'" The LP agreement also provided that in making that determination, the committee was not required to determine whether the merger consideration was fair to the limited partners.
Under the applicable contractual standard, the court dismissed the plaintiffs' complaint, holding the plaintiffs failed to identify a violation of the contractual requirements for special approval. The court did so while also finding that the allegations of "a pattern of concessions, a blind eye towards contradictory market evidence, the transfer of significant value in the form of tax benefits from the limited partners to the controller, and substantial opposition from disinterested unitholders" would have sufficed to support a pleading-stage inference of a lack of good faith had fiduciary duty standards applied. However, the court held that "the members of the committee did not have to believe that the [partnership] merger was in the best interests of the limited partners. They rather had to believe in good faith that the [partnership] merger was in the best interests of the partnership. The complaint's allegations do not provide a basis to question the committee's decision from the standpoint of the partnership. ... The inference that the complaint's allegations actually support is that the committee acted reasonably and in the best interests of the partnership by agreeing to the [partnership] merger and solving the partnership's cost-of-capital conundrum."
A complaint that may pass muster attacking a corporate transaction that favors a controller at the expense and to the detriment of minority stockholders will fail in the alternative entity context if the operative partnership or LLC agreement eliminates fiduciary duties and the controllers comply with the standards of the parties' contract. The Kinder Morgan case reaffirms that Delaware courts give maximum effect to principles of freedom of contract as the Delaware General Assembly requires in the alternative entity statutes. Unless a plaintiff can allege noncompliance with a partnership or LLC agreement, a transaction that may reflect a breach of fiduciary duty is not subject to challenge if the applicable agreement eliminates those duties.