November 8, 2010
In a recent opinion, the Delaware Court of Chancery further clarified the role of the implied covenant of good faith and fair dealing in interpreting a limited partnership agreement. This issue is critically important in the area of alternative entities, where partnerships, limited liability companies and statutory trusts are all governed by contracts and these contracts, regardless of fiduciary duty waivers, are all subject to the implied covenant.
The plaintiff in this case (the “Plaintiff” or “Lonergan”) held limited partner units in defendant Enterprise GP Holdings, L.P. (“Holdings”), a publicly traded Delaware master limited partnership. Lonergan brought this action on behalf of himself and a putative class of holders of Holdings limited partner units, challenging a proposed merger (the “Merger”) between Holdings and Enterprise Products Partners L.P. (“Partnership”), an affiliated Delaware limited partnership, which was also publicly traded.
The relevant entities were organized in a two-tier MLP structure, with Holdings, through its 100 percent ownership of Partnership’s general partner, controlling Partnership. The Merger was intended to simplify the overall capital structure of the organization, and the agreement contemplated that Holdings would merge with a subsidiary of Partnership and that Holdings’ priority economic interest in Partnership would be cancelled. The Holdings unitholders would then receive Partnership units. EPE Holdings, LLC (“Holdings GP”), Holdings’ general partner, would have its interest in Holdings converted into a general partner interest in Partnership. Holdings GP’s general partner interest in Holdings would be converted to a general partner interest in Partnership. After the Merger, Holdings GP would be the direct general partner of Partnership.
Because of the potential conflicts of interest involved in the transaction, the board of directors delegated its authority to negotiate, and ultimately approve or disapprove, the proposed transaction to its audit committee (the “Audit Committee”), which consisted of three independent directors. The terms of the Merger were negotiated over the course of several weeks, and the Audit Committee received a fairness opinion from its financial advisor, Morgan Stanley, confirming that the transaction was fair from a financial point of view to the Holdings unitholders. Ultimately, the Audit Committee approved the Merger; this approval, argued the defendants, constituted “Special Approval” of the transaction as defined by the Holdings’ partnership agreement (the “Holdings LP Agreement”).
The Plaintiff challenged the Merger, claiming that Holdings GP and its board of directors breached the implied covenant of good faith and fair dealing and moved for expedited proceedings. The defendants opposed the motion for expedited proceedings. The Court of Chancery found that the Plaintiff had failed to state a colorable claim and therefore denied the motion.
The Holdings LP Agreement contained a fiduciary duty waiver—eliminating the general partner’s default fiduciary duties under Delaware law. Recognizing this contractual limitation, the Plaintiff brought three claims, each framed as a breach of the implied covenant but making allegations that were reminiscent of more traditional breach of fiduciary duty claims. The first claim, similar to a Revlon claim, alleged that there had not been a fair and adequate sale process. The second claim, similar to a claim under Kahn v. Lynch, alleged that the Merger should be conditioned on a majority of the minority approving the transaction. Finally, in his third claim, the Plaintiff alleged a failure to disclose all material information regarding the Merger. In its opinion, the Court concluded that each of the Plaintiff’s claims were noncolorable attempts to transform fiduciary duty claims into implied covenant claims.
At the outset, the Court reiterated that the implied covenant was not a substitute for a court’s traditional fiduciary duty analysis. Noting that the implied covenant is always applied cautiously by Delaware courts, the Court emphasized that “[w]hen a [limited partnership agreement] eliminates fiduciary duties as part of a detailed contractual governance scheme, Delaware courts should be all the more hesitant to resort to the implied covenant.” Ultimately, according to the Vice Chancellor, the parties had made a bargained-for decision to remove the Court’s fiduciary duty review power. The Court found that “when parties exercise the authority provided under the [Limited Partnership Act] to eliminate fiduciary duties, they take away the most powerful of a court’s remedial and gap-filling powers. As a result, the parties must draft [a limited partnership agreement] as completely as possible, and they bear the risk of incompleteness.” Where “parties fail to address a future state of the world—and they necessarily will because contracting is costly and human knowledge imperfect—then the elimination of fiduciary duties implies an agreement that losses should remain where they fall.” As the Court explained, “[i]f the parties wanted courts to be in the business of shifting losses after the fact, then they would not have eliminated the most powerful tool for doing so.”
Thus, the Court held that the Holdings LP Agreement, which contained provisions eliminating traditional fiduciary duties, “establishe[d] a contractual standard of review that supplants” the Court’s analysis under Revlon and Kahn. The Court therefore analyzed the Plaintiff’s claims under the terms of Section 7.9 of the Holdings LP Agreement, which expressly governed conflict of interest transactions. This allowed the Court to quickly dispense with the Plaintiff’s claim that the implied covenant required that the transaction be approved by a majority of the minority unitholders, holding that since Section 7.9 of the Holdings LP Agreement provided for four alternatives for approving a conflicted transaction, “the implied covenant cannot be invoked to override express provisions of a contract.”
Addressing the Plaintiff’s claim regarding the “Special Approval” process, the Court recognized that the implied covenant could operate to constrain the special approval process set forth in a partnership agreement. That is, “special approval” is not absolute. To set forth a colorable claim, however, the Plaintiff must plead “particularized facts from which [the] Court could infer that the members of the Audit Committee acted arbitrarily or in bad faith” in granting “special approval.” The Court concluded that the allegations of the complaint failed to suggest such arbitrary or bad faith conduct, given a record of active negotiation by the Audit Committee and the Morgan Stanley fairness opinion.
Finally, in rejecting the Plaintiff’s disclosure-based claims, the Court concluded that, where fiduciary duties have been contractually eliminated, the implied covenant does not “support a generalized duty to disclose all material information reasonably available.” The bargained-for fiduciary duty waiver, the Court found, “reflects a conscious decision to eliminate all fiduciary duties, including the duty of disclosure.” Of course, the Court noted, “the absence of a Delaware disclosure duty does not mean that the holders of [limited partner] units will lack for information. Publicly traded MLP’s remain subject to the federal securities laws.”
The Lonergan opinion reaffirms Delaware’s strong public policy in favor of freedom of contract and suggests that Delaware’s Court of Chancery will continue to resist efforts to use the implied covenant of good faith and fair dealing to replace fiduciary principles where fiduciary duties have been eliminated by contract.
Richards, Layton & Finger was involved in Lonergan, but the views expressed herein are those of the writers and not necessarily those of Richards Layton or its clients.