Article 227.1 of the LSC in its new wording requires directors to perform their duties “acting in good faith and in the best interests of the company”. Some may think that, with this change with respect to the more parsimonious previous wording, we have not gained anything. Legislative morality. Others, perhaps with more reason, consider it valuable for the legislator to specify, in moral language, how those who manage – partially – other people’s assets should act. The courts of Delaware (which is not a tax haven), have used such a reference in the bylaws of a Limited Partnership (LP) to condemn the general partner – in English, “general partner” (GP) – who is the sole manager, similar to our limited partnership by shares or limited partnership, without more, when there is only one general partner and a set of limited partners who merely contribute funds that are managed by the general partner, to compensate with 171 million dollars to the limited partners. The Harvard blog summarizes the ruling.
What the partnership agreement said was that these transactions were to be approved by a three-member committee of the GP’s board of directors – look at the slightest precautions to avoid the potential conflict of interest! and that, in making their decisions, the members of this committee were to “subjectively believe” (subjectively believe) that the transactions were made “in the best interests” of the limited partnership (in the “best interests”).
The transaction in which the GP was in conflict of interest with its limited partners in the limited partnership involved the sale of assets (with a combined value of over $2 billion) by a partnership – seller – controlled by the GP to the limited partnership – purchaser – of which GP was the general partner (to see a chart of how these investments are organized, click here). In other words, the GP – a private equity fund – was on both sides of the transaction. It controlled the parent and it controlled the subsidiary and induced the subsidiary to buy over $1 billion worth of assets from the parent.
These types of transactions are normal within groups controlled by private equity fund managers and are, in fact, the way in which the fund manager invests the funds provided by the investors participating in the private equity fund, which takes the legal form of a limited partnership (see here and here). The logic of these transactions is as follows: the company managing the funds (the GP) looks for assets that are profitable or whose profitability can be improved by introducing changes in the management or financing of the companies holding those assets. The GP then transfers them to the limited partnership when these assets produce a regular source of dividends.
The courts dismissed the limited partners’ claim with respect to the first of the two phases into which the transaction was divided (at first, the acquisition of 51% of the assets was approved and at a second stage, the acquisition of the remaining 49% was approved). But, in relation to the second phase, the Delaware Chancery found that the GP – its directors – had breached their duty of loyalty and had not acted, in approving the transaction on the terms that were approved, in the best interests of the company they were entrusted to manage.
These transactions are called, in the jargon, “dropdown” which, graphically, indicates that it is the parent company that sells assets to a subsidiary. In this way, the parent company obtains liquidity, can realize the capital gains from previous investments and distribute the proceeds to its shareholders, and provides assets to the limited partnerships formed with private investors, allowing the latter to participate in the subsequent increase in value or returns on such assets. As can be imagined, the risk of the parent charging an excessive price for the assets to the subsidiary is enormous. GPs, however, protect themselves against any claims by the limited partners by denying them any participation in investment or divestment decisions – which corresponds to the type of limited partnership in which the limited partner has no participation in the management and an apparently limited right of information – and even trying, as far as possible, to deprive the limited partners of any right to claim for breaches of their duties as manager by the general partner – of the GP -. It is not surprising that the LSC has expressly declared the mandatory nature of the duty of loyalty but, in the USA, this right has also been considered available in the sense that the investors – the limited partners – waive the right to sue the general partner (and here). In the case, the articles of association expressly allowed the GP to enter into transactions with the limited partnership, even in conflict of interest.
Why does the Court conclude that the limited partnership managers had not acted in the best interests of the company?
The Judge says that, at trial, a “state of mind” of the directors should have been proven or argued because the issue was whether they sincerely believed that the transaction was in the best interest of the company.
The evidence at trial has convinced me that, when the directors approved the autumn intragroup sale, the directors on the committee did not act with independent judgment in the best interests of the company and did what the parent company wanted them to do, assisted by a financial advisor who presented each of the two sales in the most favorable light possible regardless of whether these descriptions were contradictory to the advisor’s previous work on earlier transactions or were consistent with the rules on asset valuations.
In other words, the directors of the subsidiary did what was in the best interest of the parent and did so on the advice of a consultant who also advised what was in the best interest of the parent and not the subsidiary and who said the opposite of what he had said in his advice in similar and prior transactions.
As the limited partner’s advisors were the general partner’s advisors, the judge sentenced the general partner to indemnify the limited partners (not the limited partnership but, directly, the limited partners), which makes sense in contractual partnerships, although the formally correct thing to do would be to indemnify the limited partnership.
The Court begins by examining whether the three general partner directors who formed the committee that had to decide whether the transaction was “in the best interests” of the limited partnership were independent. Which it denies. All three had more or less close ties to the general partner and parent company (Kinder Morgan). And then he examines the ways provided for in the limited partnership’s bylaws to approve the transactions (the dropdowns). In the bylaws, in addition to approval by that special committee formed by three GP directors, there was the possibility that the transactions could be approved by the assembly of the limited partners or that the transaction could be made on terms identical to those offered by third parties unrelated to the GP or the limited partners. The GP chose, in all cases, the route of approval by the special committee (which is indicative of the degree of loyalty with which the GP acted).
The special committee hired lawyers and a financial advisor (Akin and Tudor respectively) as advisors to the limited partnership. Tudor charged $500,000 per dropdown.
The plaintiffs attacked the fall transaction – the second dropdown – on the basis that the price was not justified – was unduly high – compared to the price paid in the first transaction. The judge reviews the process through which the terms of the second transaction were determined and noted that one of the GP’s directors who was not a member of the committee that had to approve it and who was, simultaneously, a director of the parent company, contacted the subsidiary’s advisors to – allegedly – “soften them up” and influence the valuation they would provide to the subsidiary. It was also found that the income that would be earned by the assets that were transferred to the subsidiary was not guaranteed, i.e., that it was not certain that the assets would produce the income that had been used to calculate their value (in the form of discounted cash flows). However, Tudor told the subsidiary that these revenues were accompanied by “substantial guarantees” (even though these guarantees only covered 20% of the revenues).
The judge also reproached Tudor for playing with the “control premium” over the assets. The two transactions involved shares in a company. The subsidiary first bought 51% and then the remaining 49%. Then the operation was varied and the subsidiary bought, in the first dropdown, 49 % and then, in the second one, the rest. Tudor played with the control premium, at first, but then considered it irrelevant. In such a transaction, there is no control premium because the company whose shares were being sold was a mere holder of assets – a gas pipeline – which generated revenues – the tolls paid by gas companies to transport gas through that pipeline – which were recurrent and fixed by very long-term contracts, so that the majority shareholder could not obtain any particular advantage by virtue of being a majority shareholder. So it made no sense for the 51% price to be proportionally higher than the 49% price.
The market responded to the first dropdown negatively. That is, the shares of the subsidiary dropped in price when the first transaction became known, an unequivocal sign that the market considered the price paid by the subsidiary to be too high.
Between the first and the second transaction there was another transaction that was not challenged but which the plaintiffs used as a term of comparison to challenge the second transaction.
The second transaction consisted of the sale to the subsidiary of the remaining shares of the company whose 51% had been sold in the first transaction together with a minority interest in another company not connected to the first transaction. In the meantime, the market for liquefied natural gas had worsened and so had the profitability of the pipelines. Tudor presented the parent’s offer to the subsidiary in a manner unduly favorable to the interests of the parent because it induced the subsidiary to pay a higher price:
Tudor presented bars from its different discounted cash flow analyses and did not show those for the previous transaction or for comparable business operations. What explains Tudor’s behavior is that it made the changes that made the parent’s offer appear on more favorable terms. Tudor did not explain to the committee that it had made these changes and the committee did not become aware of them until after the lawsuit was filed.
Ultimately, the committee approved a joint price for the remaining 49% and a stake in another company.
How and why did the judge come to the conviction that the members of the special committee of the subsidiary’s board of directors had not acted with independent judgment in the best interests of the company when they approved the transaction?
There are two key aspects. The first is that
“in fact, the committee members never knew exactly what price they were paying for 49% of the shares”.
That is, by presenting the transaction as the combined acquisition of that 49% and a minority stake in another company and asking them to approve a joint price for both, the directors of the subsidiary could not – because they did not know – have formed an opinion as to whether the price they were paying for the remaining shares of that company they acquired was a “fair” price in terms of the returns to be expected from that company (“In fact, the Committee members never learned enough about the price to make that determination”).
Second and more importantly, regardless of whether the price paid by the subsidiary for the remaining share capital of the company they were acquiring was “fair”, it was not in the subsidiary’s interest to acquire the entire share capital of that company because, in doing so, the subsidiary was over-concentrating its investments in the gas sector, i.e., the second transaction involved a concentration of risk incompatible with the profitability of the investments. They already had enough invested in the sector for it to be sensible to invest more. Especially when they were talking about hundreds of millions of dollars. And the judge imputes to the directors the subjective conviction that this transaction could not be considered in the best interest of the subsidiary.
But the judge’s conviction is affirmed when he compares the directors’ behavior in the first transaction and in the second:
“In the second transaction, the committee did more than negotiate poorly with the parent. After they had the evidence that the price paid in the first transaction was excessive, and after they were aware that they had to do better in the second transaction because it involved the shares of the same company, the committee forgot the lessons they should have learned. They simply let the criteria that were used to determine the price of the first transaction also apply to the second transaction. They did not separately value the two assets they were acquiring in the second transaction, they accepted a joint price for both assets and waived the minimum price reduction they had obtained.”
And they accepted a price that was 26% higher than the price that, internally, the committee members considered reasonable. People can be wrong,” says the judge, “and the committee members were wrong in the first transaction. But being wrong twice, and both times to the benefit of the parent company with which the directors, who were supposed to defend the interests of the subsidiary, had links, cannot excuse the behavior of these directors. Errare humanum est, perseverare, diabolicum seems to say the judge. The administrators knew that they had not sufficiently defended the interests of the subsidiary in the first transaction and that they had to do better the next time. And they didn’t.
Then he goes after Tudor, after criticizing the data used by the consultant, the consistency of his valuations in the first and second transaction and even the use of the discounted cash flow system, he concludes that he did everything possible to favor the parent company instead of working in the interest of the subsidiary which was the one paying him. Since he was only paid if the transaction took place, he did everything he could to ensure that the subsidiary approved the transaction and that it was executed.