In this en banc decision, the Delaware Supreme Court held that where the contractual standard of conduct contained in a limited partnership agreement requires a belief that a decision or other action by the managers is in the best interests of the partnership to establish good faith, the actor’s subjective belief is examined. The Court held that such a standard, while precluding a Delaware court from applying an objective, reasonable person standard, still permits the court to examine objective factors to inform its analysis, and may be challenged with allegations of subjective bad faith or that, as a result of a conscious disregard, no subjective belief was formed.
This appeal arose from the Court of Chancery’s dismissal of a class action complaint challenging the merger of a limited partnership, Encore Energy Partners LP (“Encore”), with its general partner’s controller, Vanguard Natural Resources, LLC (“Vanguard”). Vanguard acquired Encore’s general partner (“Encore GP”) and 46% of Encore’s common units from a third party in late 2010. On March 24, 2011, when Encore’s unit price closed near a two-week low relative to Vanguard’s unit price, Vanguard made its initial merger proposal, which proposed to convert each Encore common unit into 0.72 Vanguard common units (reflecting a 0.2% premium to Encore’s preannouncement closing price). Vanguard also announced it would not consider selling Encore or Encore GP to a third party and that it would not condition the merger on a vote by the majority of Encore’s unaffiliated unitholders. Encore GP delegated authority to a conflicts committee (the “Conflicts Committee”) to evaluate and negotiate the proposed merger because a majority of the Encore GP’s board members were employees of Vanguard and Vanguard owned Encore GP and 46% of Encore’s common units. The Conflicts Committee responded to Vanguard’s offer by proposing a 1:0.75 exchange ratio, but because Vanguard’s units had experienced a company-specific price drop between Vanguard’s offer and the Conflicts Committee’s response, the counteroffer represented a 9.1% discount to Vanguard’s opening offer. Vanguard ultimately agreed to the counteroffer. The Conflicts Committee’s financial advisor rendered a fairness opinion stating that the merger’s terms were financially fair. The valuation metrics, however, indicated that the Conflicts Committee’s counteroffer fell below the midpoint on the average valuation range reflected in the fairness opinion. The Conflicts Committee unanimously approved the merger and recommended it to the Encore board, which in turn approved the merger and submitted it to Encore’s unitholders. A majority of Encore’s unitholders (which including Vanguard as a 46% unitholder) approved the merger. Plaintiff filed suit challenging the transaction, and defendants (Vanguard, Encore GP, and the Encore GP’s board) sought dismissal of the complaint, which the Court of Chancery granted.
On appeal, the Delaware Supreme Court first reviewed the contractual standards that applied to defendants’ alleged conduct. The Court determined that Encore’s limited partnership agreement (the “LPA”) created a contractual duty replacing common law fiduciary duties, and that the contractual duty required any determination made or action taken by Encore GP to be done in good faith, including consenting to any merger of Encore with another entity. The LPA defined “good faith” as a “belie[f] that the determination or other action is in the best interests of [Encore].” The LPA also included a process by which the Conflicts Committee acting in good faith could provide Special Approval to a transaction, which would deem a transaction approved and Encore GP and its affiliates not in breach of their duties under the LPA or of any other duty they might owe. The Court held that only subjective good faith was required because the LPA did not specifically require a “reasonable belief.” Accordingly, under the LPA, an act is deemed in good faith if the actor subjectively believes that it is in the bests interests of Encore.
Notwithstanding its interpretation of the contractual standard of conduct, the Delaware Supreme Court rejected the trial court’s holding that a plaintiff must plead subjective bad faith in order to plead a breach of a subjective good faith standard. Although the Court held that pleading subjective bad faith is one way to plead a breach of the subjective good faith standard, the Court explained that a plaintiff may also plead that defendants intentionally failed to act in the fact of a known duty—i.e., that defendants consciously disregarded their contractual duty to form a subjective belief. The Court acknowledged, however, that it would take an extraordinary set of facts to plead a breach of the subjective good faith standard under a conscious disregard theory.
The Court also rejected the Court of Chancery’s conclusion that the objective reasonableness of the Conflicts Committee’s determination was not relevant to the LPA’s subjective standard. The Court held that pleaded facts indicating that a transaction’s terms fell below an objective standard of reasonableness are logically relevant to analyzing whether a defendant satisfied an objective standard. The Court explained that some actions could objectively be so egregiously unreasonable that they are essentially inexplicable on any ground other than subjective bad faith. In addition, in less egregious transactions, the Court explained that it may be reasonable to infer subjective bad faith when a plaintiff alleges objective facts indicating that a transaction was not in the best interests of the partnership and that the directors knew of those facts. Accordingly, the Court held that objective factors may inform a court’s analysis of a defendant’s subjective belief to the extent they bear on the defendant’s credibility when asserting that belief. The Court, however, cautioned against using an objective, “reasonable person” standard under the circumstances, noting that the ultimate inquiry must focus on the subjective belief of the specific directors accused of wrongful conduct and must measure the directors’ approval of a transaction against their knowledge of the facts and circumstances surrounding the transaction.
The Court held that the complaint failed to allege facts sufficient to reasonably infer subjective bad faith. In particular, the Court explained that, without more, showing that the Conflicts Committee negotiated poorly does not permit a reasonable inference that they subjectively believed they were acting against Encore’s best interests. The Court also explained that the Conflicts Committee’s decision to approve a transaction below the median of the valuation ranges was not so far beyond the bounds of reasonable judgment to infer subjective bad faith and did not support a reasonable inference that the Conflicts Committee did not subjectively believe that the merger was in Encore’s best interests. The Court similarly posited that allegations that the merger closed at a discount to the original offer and led to initially lower distributions to unitholders does not allow the Court to infer subjective bad faith, because poor transaction planning does not translate to subjective bad faith and those allegations alone do not justify a reasonable inference that the Conflicts Committee did not subjectively believe the merger provided a better long-term opportunity for Encore unitholders than remaining independent. The Court emphasized that plaintiff entered into an LPA that created a duty of subjective good faith; therefore, plaintiff had no contractual basis to argue that the LPA required the Conflicts Committee to bargain to plaintiff’s satisfaction or achieve a better result.
Moreover, the Court held that the complaint failed to allege any facts from which it could reasonably be inferred that the Conflicts Committee members consciously disregarded their contractual duties. The Court explained that in order to adequately plead this theory, the complaint must allege facts that the Conflicts Committee members consciously disregarded their duty to form a subjective belief that the merger was in Encore’s best interests. The Court noted that the Conflicts Committee members’ conduct is relevant only to the extent it shows the members failed to form such a subjective belief. The Court concluded that allegations that the Conflicts Committee should have started with a higher counteroffer, should have negotiated more forcefully, and should thereby have achieved a better result do not support a reasonable inference that the Conflicts Committee consciously disregarded its duty to form a subjective belief that the transaction was in Encore’s best interests. For the foregoing reasons, the Delaware Supreme Court affirmed the trial court’s dismissal of plaintiff’s complaint.
The full opinion is available here.