In this lengthy memorandum opinion, the Court of Chancery dismissed claims relating to a series of complex transactions in which a hedge fund, previously organized as a private limited partnership, was converted by its controller into a publicly traded limited partnership to satisfy liquidity concerns during the height of the financial crisis. Plaintiff, a minority stockholder in a publicly traded portfolio company that was 85% owned by the controller and merged with the hedge fund to create the new entity, filed a complaint asserting direct and derivative claims against a number of individuals and entities involved in the transaction. The Court dismissed the derivative claims for failure to make demand and dismissed the direct claims, brought against members of the portfolio company’s special committee who evaluated the transaction, for failure to state a claim. Defendants did not move to dismiss one remaining count of the complaint, which the Court did not address in its opinion.
In 2008, defendant hedge fund Steel Partners II, LP faced a liquidity crisis when many investors sought to exit their investments in the fund. Rather than liquidate the fund, the hedge fund’s controller, defendant Warren Lichtenstein, developed a plan to convert Steel Partners II into a publicly traded limited partnership so that investors could redeem their investments by selling their interests on an exchange rather than withdrawing cash from the fund. Under the plan, Lichtenstein would merge Steel Partners II with his majority-owned portfolio company, WebFinancial Corporation, and then convert WebFinancial from a publicly traded corporation to a publicly traded limited partnership, Steel Partner Holdings LP (“SPH”). Investors in WebFinancial, including plaintiff, would have their stock exchanged for SPH partnership units.
Lichtenstein brought his proposal to the WebFinancial board of directors, who appointed individual defendants Schwarz and Mullen to a special committee to consider the transaction. The special committee retained legal counsel and Houlihan Lokey as financial advisor to aid it in its review and negotiation of a proposed Limited Partnership Agreement (the “LPA”) and Exchange Agreement prepared by Steel Partners II. During the course of that review, the special committee learned of a Deferred Fee Liability owed by an affiliate of Steel Partners II to an investment management services company majority-owned by Lichtenstein, WGL Capital Corp. (“WGL”). Because the Exchange Agreement called for this Deferred Fee Liability to be transferred to the newly-created SPH, the special committee requested more information about the debt owed, including its size, but did not receive any, and Houlihan subsequently issued a fairness opinion that did not account for the Deferred Fee Liability. Pursuant to the special committee’s mandate, the fairness opinion also only considered the proposed merger from the financial point of view of SPH, as successor to WebFinancial, rather than the minority stockholders of WebFinancial. The special committee recommended approval of the merger, the WebFinancial board approved the Merger Agreement, and WebFinancial stockholders (including the 85% interest held by Steel Partners II) voted in favor of the transaction. The 15% interest in WebFinancial held by the minority stockholders was exchanged for a 0.5% interest in SPH. The transaction closed on January 1, 2009, and Steel Partners II GP, LLC, which had been the general partner of Steel Partners II, became general partner of SPH (the “General Partner”), with Lichtenstein serving as managing member.
When investors in Steel Partners II voiced discontent with the merger, Lichtenstein proposed two options that would allow investors to either (1) receive units in SPH and continue their investment, or (2) terminate their investment and receive distributions of Steel Partners II portfolio securities and cash. Lichtenstein subsequently modified the proposal, granting those who chose to exit their investment (the “Option B Investors”) SPH common units in addition to cash and distributions in kind of Steel Partners II portfolio securities. As managing member of the General Partner, Lichtenstein also executed a written consent authorizing the amendment of the merger documents to allow for a partial unwind of the Exchange transaction (the “Partial Unwind”) that would provide compensation to the Option B Investors, who ultimately accounted for 56% of the Steel Partners II investors. Lichtenstein executed the Partial Unwind in July 2009, transferring a total of $750 million in cash and assets out of SPH to the Option B Investors, and leaving the partnership with a net asset value of approximately $450 million.
In effecting the Partial Unwind, and on various other occasions throughout 2009, Lichtenstein sought the approval of Mullen and Schwarz before taking action. The General Partner did not have a board of directors following the merger on January 1, 2009, and Lichtenstein informed Mullen and Schwarz at that time that they would serve as directors of the General Partner, and that the General Partner would not take any action requiring board approval under the LPA without their prior written consent. Although Mullen and Schwarz never took any official action as directors of the General Partner, on at least four occasions where Lichtenstein requested their approval, most notably in connection with the Partial Unwind, counsel for Mullen and Schwarz responded by email stating, “Schwarz and Mullen have not refused to grant their consent to any action that we are aware is proposed to be taken.” A new slate of directors was informally announced by the General Partner in July on the date of the Partial Unwind, although the board was not officially formed until October 2009. The new General Partner board approved a series of agreements throughout late 2009 and 2010 that had the effect of increasing SPH’s obligation under the Deferred Fee Liability. It also authorized a Lichtenstein affiliate to pursue any corporate opportunity to acquire SPH common units.
Plaintiff’s complaint alleged direct claims against the special committee members, Mullen and Schwarz, for breach of fiduciary duty relating to their actions taken both before and after the merger. The complaint also alleged derivative claims on behalf of SPH that Steel Partners II, Lichtenstein, the WebFinancial directors, the General Partner directors, WGL, and other entities, breached their fiduciary and contractual duties, and/or aided and abetted breaches of those duties, throughout the entire conversion process.
Regarding the direct claims against the special committee, the Court found that, because the WebFinancial charter contained a 102(b)(7) provision and plaintiff had failed to establish director interest or a lack of independence, plaintiff was required to demonstrate that the special committee acted in bad faith leading up to the merger. Plaintiff claimed that the special committee failed to protect WebFinancial’s minority stockholders in the merger, by, for example, accepting Steel Partners II’s valuation terms for the merger, failing to disclose certain information to the WebFinancial’s minority stockholders, relying on a flawed fairness opinion that did not adequately consider the Deferred Fee Liability, and failing to obtain a majority-of-the-minority voting requirement. The Court held that these alleged deficiencies implicated only the special committee’s duty of care, as plaintiff failed to allege that the directors knowingly failed to undertake their responsibilities. The Court also dismissed plaintiff’s claims regarding actions taken after the merger, particularly the Partial Unwind. The complaint made clear that the General Partner operated without a board until October 2009, and the correspondence from the special committee members stating they were not withholding their consent was insufficient to constitute directorial power.
Before turning to an analysis of each derivative claim, the Court preliminarily rejected plaintiff’s argument that the demand futility analysis in the limited partnership context considers the potential liability of the general partner itself, and not the general partner’s board. While there is support for that view where limited partners have no say in how a general partner is governed or operated, the Court noted that the present facts lead to a different conclusion. Here, the LPA required the election of the General Partner board by the limited partners, and the members of the General Partner board explicitly owed fiduciary duties to the limited partners. Thus, demand must be directed at the General Partner’s board. The Court also rejected plaintiff’s argument that the LPA’s exculpatory provisions were ambiguous or otherwise did not apply to the challenged transactions. Not only was the LPA unambiguous, but the Court concluded that it contractually eliminated the General Partner’s liability to the greatest extent allowed by law with respect to its performance of any agreement contemplated under the LPA.
Having laid out the demand futility analysis, the Court then addressed each of plaintiff’s derivative claims. Count IV of the complaint challenged SPH’s assumption of the Deferred Fee Liability, an amendment to the assumption agreement that increased the size of the obligation, and the decision to authorize a Lichtenstein affiliate to purchase corporate opportunity units. Plaintiff contended that these claims were both direct and derivative, and therefore demand was not required, at least with regard to the direct claims. Plaintiff attempted to rely on Delaware Supreme Court precedent holding that a transaction in which a controlling stockholder (1) causes a corporation to issue excessive shares of its stock to the controlling stockholder in exchange for lesser-valued assets, and (2) transfers through the exchange an increased percentage of the outstanding shares from the minority to the controller, a plaintiff can then assert claims that are both direct and derivative because such action constitutes an expropriation of economic value and voting power from the minority to the controller. In such a case, the direct claim is against the controlling stockholder only. Here, the Court found that each claim in Count IV failed to satisfy this test and was therefore derivative in nature. The assumption of the Deferred Fee Liability did not result in the issuance of SPH common units or the dilution of any minority unitholder. Although the subsequent payment to Lichtenstein’s company, WGL, under the Deferred Fee Liability diluted the minority interest, that decision was authorized by the independent General Partner board and was not a claim against the controlling stockholder. Finally, the claim regarding Lichtenstein’s authorization to purchase corporate opportunity units was derivative, as Lichtenstein’s purchase of units may have diminished the minority’s voting power but did not affect the economic value of the units.
Next, in considering whether demand was excused for the claims in Count IV, the Court determined that the Rales analysis applied to the assumption of the Deferred Fee Liability, as that decision was enacted by Lichtenstein before there was a General Partner board, and that Aronson applied to the amendment and overpayment of the Deferred Fee Liability, and the corporate opportunity authorization. The Court held that the General Partner board members did not face a substantial likelihood of liability regarding the assumption as the action was permitted under the LPA and therefore within the bounds of the LPA’s exculpatory provisions. As to the other claims, both the amendment to the assumption agreement and the corporate opportunity authorization provided certain benefits to SPH and were thus a valid exercise of the board’s business judgment.
Count V of the complaint alleged that the issuance of SPH common units to Option B investors unfairly diluted the non-Option B investors and affected their economic rights following the Partial Unwind. The Court again applied Rales, since the issuance was not a board decision, and held that plaintiff failed to show a substantial likelihood of liability for the General Partner board. The exchange and Partial Unwind were key components of the transaction, and the LPA clearly exculpated the board for certain contemplated actions effectuating the transaction.
Counts VI and VII of the complaint included claims regarding the same conduct in Count V, but were based in contract law and the implied covenant of good faith and fair dealing, and the Court dismissed them under the same analysis. Two additional claims by Plaintiff met a similar fate. Counts VI and VII also alleged that the General Partner committed breach by acting without board oversight from January 1, 2009 to October 2009, and by distributing “all or substantially all” of SPH’s assets to the Option B investors in the Partial Unwind without limited partner consent, in violation of a provision of the LPA. Once again, the Court held that demand was not excused on the General Partner’s board. First, the board did not face liability for ratifying the General Partner’s actions in October 2009, as the LPA did not require board approval for any of the actions taken, and the actions were nevertheless exculpated under the LPA as key components of the transaction. Second, while the LPA limited the transfer of partnership assets without limited partner consent, this restriction was further qualified by other sections of the LPA allowing the General Partner to take actions without consent that were designed to effectuate the merger.
Finally, having dismissed the underlying breach of fiduciary duty claims, the Court dismissed Count VIII of the complaint, which alleged that Lichtenstein, the General Partner Board, and others aided and abetted the General Partner’s breach of common law and contractual fiduciary duties.
The full opinion is available here.