November 8, 2010
In another recent opinion, the Delaware Court of Chancery applied standard Delaware contract interpretation principles to interpret a limited partnership agreement of a Delaware master limited partnership (“MLP”) and permitted a strategically compelling simplification transaction to proceed. This issue is important in the area of alternative entities where partnerships, limited liability companies, and statutory trusts are all governed by contracts, which may substitute alternative standards in lieu of traditional fiduciary duties, and where the simplification of two-tier MLP structures has become a way for some MLPs to stay competitive in the marketplace.
The plaintiffs in this case (“Plaintiffs”) held common units in defendant Inergy, L.P. (“Inergy”), a publicly traded Delaware MLP. Plaintiffs brought this action on behalf of themselves and a putative class of holders of Inergy common units, challenging a proposed simplification transaction (the “Transaction”) between Inergy and Inergy Holdings, L.P. (“Holdings”), another publicly traded Delaware MLP.
In a typical MLP structure, the limited partners own common units and the general partner owns incentive distribution rights (“IDRs”). The holders of IDRs are entitled to receive an ever-increasing share of the cash distributions by the MLP as the distributions to the common units grow. Here, the relevant entities were organized in such a two-tier MLP structure, with Holdings, through its 100 percent ownership of Inergy’s managing general partner, Inergy GP, LLC (“Inergy GP”), controlling Inergy. Despite the fact that Holdings and Inergy are separate, publicly traded entities, there is only one management and one set of business operations. The Transaction was intended to simplify the overall capital structure of the organization by, among other things, exchanging the IDRs held by Holdings for Inergy common units. The agreement governing the Transaction (the “Merger Agreement”) also contemplated that Holdings would merge with a wholly owned subsidiary (“MergerCo”), Holdings would cease to survive as a publicly traded entity, and Holdings unitholders would receive Inergy common units in exchange for their Holdings common units.
Because of the potential conflicts of interest involved in such a transaction, the board of directors of Inergy GP (the “Board”) delegated its authority to review, evaluate, and, if deemed appropriate, negotiate the terms and conditions of any potential transaction to an independent special committee (the “Inergy Special Committee”). Since there was only one Board member who was independent of both Inergy and Holdings, that person was the sole member appointed to the Inergy Special Committee. Holdings also appointed a member of its board to serve on a conflicts committee (the “Holdings Conflicts Committee”) to represent the interests of Holdings and its unitholders. The Inergy Special Committee and the Holdings Conflicts Committee negotiated the terms of the Transaction over the course of several weeks. Ultimately, the Inergy Special Committee received a fairness opinion from its financial advisor, Robert W. Baird & Co. Incorporated, confirming that the Transaction was fair from a financial point of view to the Inergy common unitholders. The Board then concluded that the Transaction was fair and reasonable to, and in the best interests of, Inergy.
Plaintiffs challenged the Transaction, claiming that Inergy and its Board violated Inergy’s limited partnership agreement (the “Partnership Agreement”) by proceeding to consummate the Transaction without obtaining approval of a majority of Inergy common unitholders and by failing to treat Inergy common unitholders fairly. Plaintiffs moved for a preliminary injunction to prevent defendants from consummating the Transaction. After expedited discovery, briefing, and argument, the Court of Chancery denied Plaintiffs’ motion for a preliminary injunction, thereby allowing the Transaction to proceed.
To succeed on a motion for a preliminary injunction, Plaintiffs had to demonstrate (1) a reasonable probability of success on the merits; (2) that they will suffer irreparable injury if an injunction does not issue; and (3) that the balance of the equities favors the issuance of the injunction. Plaintiffs were unable to demonstrate any of these elements.
First, the Court noted that the default rule under Section 17-211(b) of the Delaware Revised Uniform Limited Partnership Act (“DRULPA”) provides that limited partners must approve mergers involving their limited partnerships unless the relevant partnership agreement provides otherwise. Here, the Court found that Article XIV of the Partnership Agreement was directly on point and rendered the DRULPA default rule inapplicable. Furthermore, when interpreting the language of Article XIV, the Court found that whether Inergy unitholders are entitled to vote on the Transaction turned on whether Inergy was “merging” or “consolidating” with another entity so that it was a constituent party to such merger or consolidation. Here, the constituent parties to the merger contemplated by the Merger Agreement were Holdings and MergerCo, not Inergy, so Inergy unitholders were not entitled to vote.
Second, the Court discussed Section 17-1101(d) of DRULPA, which permits a limited partnership agreement to restrict or eliminate any duties, including fiduciary duties, a partner may owe to the limited partnership or other limited partners. Here, the Court applied that statutory provision because the Partnership Agreement expressly replaced common law fiduciary duties and other standards of care with specific standards set forth in the Partnership Agreement. As for the applicable standard in the Partnership Agreement, Plaintiffs argued that the Court should apply Section 7.6(e), which provided that Inergy GP and its affiliates may not sell, transfer, or convey any property to, or purchase any property from, Inergy unless pursuant to transactions that are “fair and reasonable.” Defendants contended that even if Section 7.6(e) was applicable with respect to the Transaction, the standard set forth in Section 7.6(e) must be applied in conjunction with Section 7.10(d), which provided that “[a]ny standard of care and duty imposed by this Agreement or under the [DRULPA] or any applicable law, rule or regulation shall be modified, waived or limited to the extent permitted by law, as required to permit the General Partners to act under this Agreement . . . so long as such action is reasonably believed by the Managing General Partner to be in, or not inconsistent with, the best interests of the Partnership.” The Court agreed with defendants that even if the plaintiff-friendlier standard of Section 7.6(e) were applicable, it had to be applied in light of Section 7.10(d). The Court then found that none of Plaintiffs’ arguments demonstrated a likelihood that they would succeed in showing that Inergy GP and the Inergy Special Committee did not reasonably believe their actions in negotiating and approving the Transaction were in the best interests of Inergy.
Importantly, the Court was not overly concerned by the one-person special committee in this instance, given that the Board had a majority of outside directors but only one director was independent of Holdings. In addition, the Court found that the Inergy Special Committee understood its mandate and considered alternatives to the ultimate Transaction. Finally, although Plaintiffs argued that the Inergy Special Committee selected financial and legal advisors who were conflicted and unable to render independent advice, the Court found that it was not unreasonable for the Inergy Special Committee to retain the financial and legal firms that it did.
Plaintiffs also challenged the exchange ratio used in the Transaction of 0.77 Inergy common units for each Holdings common unit as being excessively high and reflecting a premium over current market prices. The Court found, however, that Inergy reasonably could have believed that it would benefit from the elimination of IDRs, which, like synergies in a corporate merger, can justify a premium. The Court also noted that the Inergy Special Committee successfully negotiated a meaningful decrease in the exchange ratio from 0.8 to 0.77 and that the Inergy Special Committee and Holdings Conflicts Committee engaged in “serious, arm’s-length negotiations over a number of weeks.”
Although the Court of Chancery frequently finds that being deprived of a right to vote constitutes irreparable harm, there could be no irreparable harm on that basis in this instance because the Court determined that Inergy common unitholders were not entitled to vote on this Transaction. Plaintiffs also argued that money damages would be inadequate because unscrambling the distributions after the Transaction would be a near impossible task. Nevertheless, the Court found that Plaintiffs’ claims indeed could be adequately remedied by money damages or the issuance of additional stock if Plaintiffs ultimately succeed on their claims at trial. As for the balance of the equities, the Court found them essentially in “equipose.”
The Inergy opinion reaffirms Delaware’s strong public policy in favor of freedom of contract and suggests that simplification transactions of two-tier Delaware MLPs, if done in compliance with the relevant standards in the applicable partnership agreements, are likely to withstand scrutiny.
Richards, Layton & Finger was involved in Inergy, but the views expressed herein are those of the writers and not necessarily those of Richards Layton or its clients.