On April 20, 2015, the Delaware Court of Chancery issued a post-trial opinion in the case In Re: El Paso Pipeline Partners L.P. (C.A. No. 7141-VCL), finding El Paso Pipeline GP Company LLC, the general partner (GP) of El Paso Pipeline Partners L.P. (MLP), liable for the MLP’s overpayment of $171 million for certain assets purchased from its parent, El Paso Corporation (EP). The damages are significant, but the court’s opinion is noteworthy for the lessons it offers with respect to the review and approval process for a transaction with a conflict of interest between a sponsor and a master limited partnership.

The case arose from two transactions completed between EP and the MLP in the spring and fall of 2010. In March 2010, EP sold 51 percent of its combined equity interests in Southern LNG Company L.L.C. (Southern I) and Elba Express L.L.C. (Elba) to the MLP for $963 million. Following that transaction, the MLP’s units lost 3.6 percent of their value. In November 2010, EP sold the remaining 49 percent of Southern I and Elba along with 15 percent of Southern Natural Gas L.L.C. (Southern II) to the MLP for $1.4 billion. The MLP’s units lost approximately 8 percent of their value after the second transaction.

The MLP’s unitholders challenged both transactions, based on the failure to obtain approval in accordance with the MLP’s limited partnership agreement leading to an overpayment by the MLP for the assets. The MLP’s limited partnership agreement allowed the MLP to engage in conflict transactions with EP in certain circumstances, one of which was if the transaction received “special approval” from a conflicts committee comprised of independent members of the GP’s board of directors (Committee). To grant special approval, the Committee’s members had to believe in good faith that the transaction was in the best interests of the MLP.

The plaintiffs challenged the price paid for Southern I and Elba, but not the price paid for Southern II. In an earlier opinion released on June 2014, the court found no issue with the March 2010 transaction, but ordered a trial with respect to the November 2010 sale. After trial, the court held that the Committee could not have concluded in good faith that the November 2010 transaction was in the best interests of the MLP.

Turning to the issue of damages, based on evidence entered at trial related to multiples and discount rates similar to the March 2010 sale, the court concluded the MLP paid “at least” $931 million for the 49 percent of Southern I and Elba in the November 2010 sale. The court then considered expert testimony from both sides as to the total enterprise value of Southern I and Elba at the time of the fall transaction, and found plaintiffs’ expert more convincing. Multiplying that expert’s enterprise value of Southern I and Elba by 49 percent, and subtracting the result from the assumed $931 paid by the MLP, the court found that the MLP overpaid for the November 2010 assets by $171 million (an approximate 19 percent overpayment) and held the GP liable for that amount. No personal liability was imposed on the Committee’s members or other members of the GP’s board.

The court based its decision on four main factors:

• The Committee’s beliefs − Emails evidenced that the Committee expressed initial concerns that the November 2010 transaction did not make strategic sense for the MLP. However, the court found the Committee either ignored or rationalized away these concerns to appease EP.
• Focus on accretion − The Committee granted special approval based largely on the belief that the November 2010 transaction would be accretive to distributions from the MLP, and not whether the purchase price represented overall value to the MLP.
• Failure to improve negotiations − After the MLP’s unit price fell following the March 2010 transaction, the Committee recognized that the MLP may have overpaid for the initial assets. However, rather than negotiating a better purchase price in the November 2010 sale, the Committee accepted the same high EBITDA (earnings before interest, taxes, depreciation and amortization) multiple used in the March 2010 transaction. Furthermore, the Committee acquiesced to the application of that same multiple to all three of Southern I, Elba and Southern II, despite the fact that Southern II held an entirely different set of assets than did Southern I and Elba.
• Failures of the financial advisor − The Committee’s financial advisor did not value the November 2010 transaction independently from the March 2010 deal, but instead treated the November 2010 sale as a continuation of the first transaction. The court further found that the advisor was not consistent in its valuations of the assets. Finally, the court believed that the advisor manipulated its analysis to posture the November 2010 transaction in a more favorable light to increase the likelihood of closing.

In addition to these specific factors cited by the court, several additional considerations emerged from the court’s opinion.

• Independence of the Committee – The members of the Conflicts Committee met stock exchange independence standards, but two out of the three members of the Committee had meaningful individual ownership in EP and prior relationships to EP. This caused the court to remark that the “composition of the GP’s Board reflected [EP’s] control” of the MLP.
• Retention of financial advisors – The court noted that the Committee interviewed several legal and financial advisors before its first drop down in 2008, but thereafter hired the same advisors “as a matter of course.” In addition, the financial advisor’s engagement letter provided that the advisor’s fee would be contingent upon the issuance of a fairness opinion, which the court viewed as influencing the advisor’s actions to achieve the result necessary to be paid.
• Sponsor influence – Trial evidence showed that EP management had several conversations with the Committee’s financial advisor that resulted in the advisor supporting EP management’s proposals to the Committee. These conversations were never communicated to the Committee and influenced the way financial information was presented to the Committee. The court also noted that the transaction unfolded “almost exactly” on the schedule initially proposed by EP.
• Records – During depositions, the Committee could not point to analysis of the transaction, but rather spoke in generalities. The Committee was unable to indicate that it had followed, or had recollection of, a specific process.

The court noted that mere bad business decisions would not have led to this result. However, the weight of the totality of the circumstances described above caused the court to react harshly.

Cumulatively, these factors provide useful insight into how other master limited partnerships can use the result from this case to improve upon their process to consider and approve drop-down transactions. These improvements include the following:

• Transparency − A conflicts committee must be made aware of the material commercial terms of a transaction in detail. If a commercial term is used to support valuation, the committee must be able to understand how and why it is being used and its effect on the transaction. The financial advisor’s work will be imputed to the committee, so both the advisor and the committee must seek out, understand and communicate details behind the various valuation methodologies. The sponsor should answer all questions from the committee and its advisors and timely provide all relevant information.
• Records − Maintain detailed records of internal and external committee discussions. Not only may these records be useful for contemporaneous use, but they also could be admitted into evidence at trial to show due consideration of the issues by the committee. Eliminate or minimize private conversations between the sponsor and the committee’s financial advisor. The committee should be reminded not to send emails to management on any topic during the review process. Although common sense, the committee should be reminded that typing an email is akin to plastering it on a billboard or posting it on a public blog. A better tactic is to ensure that all conversations, emails and information between the sponsor and the Committee or its advisors go through legal counsel who can keep a record of the exchanges and ensure the information is disseminated to the committee.
• Valuation − Accretion should be just one factor, rather than the main focus, in determining overall valuation of the assets to be sold or contributed to the master limited partnership. All valuation methodologies must be explained to the committee’s satisfaction. Disparate or unrelated assets that are included in the same transaction should be valued independently and subject to a separate fairness opinion, or at least a separate fairness statement in the same opinion, from the financial advisor.
• Independence − If possible, provide separate internal and external negotiating teams for the sponsor and the master limited partnership on business, legal and financial issues. Consider whether members of the conflicts committee are truly independent from the sponsor. Although stock exchange rules on independence generally should be followed by a court, the more closely the committee members are tied to the sponsor, the more that factor can be perceived poorly in light of other missteps.
• Financial Advisor − The financial advisor’s fee should not be contingent on delivery of its fairness opinion and the same financial advisor should not be routinely hired for each deal. Engagements should be put out for bid to determine the best advisor for each transaction. Each advisor’s independence should be reviewed for each deal and a statement of that independence should be included in the engagement letter.
• Separation − The sponsor should not control or dictate the deal. The committee must have the time and resources to make informed decisions and both sponsor and master limited partnership should work to build a culture and process through which the committee is encouraged to assert itself when appropriate.

Most of the factors that influenced the court’s decision in the El Paso case related to the failure of the Committee’s process. It is important for a sponsor to understand that, although it controls its master limited partnership through a general partner, the sponsor still needs to ensure that the master limited partnership has the ability to make the right decision for itself and its unitholders. In light of a sponsor’s control and the fact that usually all of the employees working on a deal (even if taking the side of the master limited partnership) are employees of the general partner, a sponsor’s view of “fairness” to the master limited partnership should consider the degree by which the presumption for “fairness” should tilt toward the master limited partnership. By creating a fulsome process to allow a conflicts committee and its advisors to explore and understand the ramifications of a transaction, all parties will benefit from a better deal. Employing these lessons learned and process improvements certainly will not deter unitholder suits entirely, but a good process will provide a master limited partnership and its sponsor a better opportunity to minimize their risks in the event of a trial. At the end of the day, it’s all about the process.