Chancery Court Holds That a Limited Partner’s Claims are Dual-Natured and Can Be Pursued After a Related-Party Merger; $171 Million Award to Be Recovered Pro Rata By Unaffiliated Limited Partners

By Scott Waxman and Joshua Haft

The Chancery Court held that a plaintiff’s claim that a general partner was liable for breach of a limited partnership agreement, for which the general partner was previously found liable by the Chancery Court, was best viewed as a dual-natured claim.  Dual-natured claims should be viewed as derivative for purposes of Chancery Court Rule 23.1 and the demand doctrine, but should be viewed as direct for purposes of claim termination after a merger that extinguished a limited partnership.  Thus, the Chancery Court granted pro-rata recovery of a liability award for breach of a limited partnership agreement to limited partners who were not affiliated with the general partner at the time of the related-party merger that resulted in termination of the limited partnership.

In In re: El Paso Pipeline Partners, L.P. Derivative Litigation, the General Partner moved to dismiss litigation in which plaintiff challenged transactions in which El Paso Corporation (“El Paso Parent”) sold to El Paso Pipeline Partners, L.P., an NYSE-traded master limited partnership (“El Paso MLP”) membership interests in three limited liability companies.  El Paso Parent was the parent company of El Paso MLP’s general partner, El Paso Pipeline GP Company, L.L.C. (the “General Partner”); and thus, El Paso Parent exercised control of El Paso MLP through the General Partner.  The Chancery Court issued a post-trial opinion on April 20, 2015 (the “Post-Trial Opinion”) which held that the General Partner breached El Paso MLP’s limited partnership agreement (the “LP Agreement”) with respect to a November 2010 transaction in which El Paso Parent dropped-down to El Paso MLP a 49% interest in two El Paso Parent subsidiaries for at least $931 million and 15% of another El Paso Parent subsidiary, for total consideration of $1.412 billion (the “Fall Dropdown”).  Plaintiff’s claims were based on the theory that El Paso MLP was injured by El Paso MLP paying too much money to El Paso Parent for the Fall Dropdown.  The Chancery Court calculated the damages from the Fall Dropdown to be $171 million, plus pre- and post-judgment interest from the date of the transaction (the “Liability Award”).

Kinder Morgan, Inc. (“Kinder Morgan”) acquired 100% of the equity of El Paso Parent through a 2012 merger while this litigation was pending.  Although Kinder Morgan indirectly controlled the General Partner after its acquisition of El Paso Parent, El Paso MLP’s common units remained separately publicly traded.  After the trial, on December 31, 2014, Kinder Morgan, El Paso Parent, El Paso MLP, and the General Partner consummated a merger pursuant to which, among other things, the General Partner was merged into Kinder Morgan Energy Partners, L.P. (“KM Partners”), El Paso MLP was merged into KM Partners, and El Paso MLP thus no longer existed as a separate publicly-traded entity (the “Merger”).  After the Merger, KM Partners became the successor to El Paso MLP’s right to recover against the General Partner under the Post-Trial Opinion and the General Partner’s liability for the Liability Award.  The General Partner then moved to dismiss this litigation due to the Merger on the ground that plaintiff’s claims were exclusively derivative and plaintiff lost standing to pursue his claims because of the Merger.

Under Delaware law, an action belonging to a corporation is a corporate asset that passes to the surviving entity in a merger.  If a stockholder derivative claim belonging to the corporation exists at the time of a merger, the merger extinguishes the plaintiff’s standing to sue, but if a stockholder direct claim exists at the time of the merger, the plaintiff does not lose standing to sue.  Direct claims can be asserted by a plaintiff in its own name and include causes of action to enforce rights of limited partners under a partnership agreement.  Derivative claims, on the other hand, may be brought by a limited partner on behalf of a limited partnership.  By analogy to the limited partnership context, the Chancery Court explained that the Delaware Supreme Court, in Tooley v. Donaldson, Lufkin, & Jenrette, Inc., acknowledged the direct nature of a stockholder’s cause of action for injury to its contractual rights as a stockholder, even when a plaintiff asserted the same contractual right in a representative posture on behalf of all stockholders.

The outcome determinative question under this framework was whether the plaintiff’s claim was individual or derivative.  According to the Chancery Court, if Delaware law required the court to classify plaintiff’s claims as either exclusively derivative or exclusively direct, then the claim for breach of the LP Agreement, which was the basis for the Liability Award, was classified by the Chancery Court as a direct claim, the Merger did not result in plaintiff losing standing to sue, and the limited partners who were unaffiliated with the General Partner at the time of the Merger should be entitled to receive their proportionate share of the Liability Award.  The court explained that a limited partnership has contractual freedom, as articulated by the content of the limited partnership agreement, and thus, “[o]ne consequence of a contractual entity is that the resulting rights are contractual.  Consequently, parties to the contract can enforce them directly.”

However, despite this analysis, the Chancery Court explained that Delaware law does not require this “bipolar” choice because the Delaware Supreme Court has recognized another category of claims that have features of both derivative and direct claims: dual-natured claims.  The Chancery Court explained that dual-natured claims “exist because some injuries affect both the corporation and the stockholder and can be remedied either at the corporate or stockholder level.”  The Delaware courts have used the two part Tooley test to determine whether a claim has dual characteristics.  The test is as follows: (1) who suffered the alleged injury, the partnership or the limited partners individually; and (2) who would receive the benefit of recovery, the partnership or the limited partners individually.  In the Chancery Court’s view, the Fall Dropdown affected both El Paso MLP and the non-participating limited partners, so the answer to both prongs of the Tooley test is that both parties suffered injuries and would receive the benefit of a remedy.

Thus, the Chancery Court concluded that the better view is that plaintiff’s cause of action that resulted in the Liability Award was a dual-natured claim with aspects that were both derivative and direct; and thus, plaintiff could continue to litigate his claim after the Merger.  The Chancery Court explained that, although there is some controversy with respect to the Delaware Supreme Court’s cases that recognized dual-natured claims, Delaware should treat dual-natured claims as derivative for purposes of Rule 23.1 and demand doctrine, but as direct for purposes of claim termination when plaintiff should be able to continue to litigate a dual-natured claim as a direct claim after a merger or the entity has otherwise terminated.

The Chancery Court further explained that prioritizing derivative aspects of a claim for purposes of Rule 23.1 and other doctrines regarding the board’s role in overseeing the corporation serves the policy goal of screening for meritless claims.  However, after a merger, there is no need to screen again for meritless claims and accountability should be a public policy consideration.  The Chancery Court noted that granting this motion to dismiss would be a windfall for the General Partner at the expense of unaffiliated limited partners who would benefit from the lawsuit.  The proxy statement filed in connection with the Merger did not attribute any consideration value to the Liability Award, so under the General Partner’s theory, the limited partners would not receive any benefit from the Liability Award and the General Partner would evade accountability.  In this case, plaintiff’s claim is best viewed as dual-natured so that plaintiff can continue to pursue the claim and the limited partners who were not affiliated with the General Partner at the time of the Merger can obtain pro rata recovery of the Liability Award.

In addition, the Chancery Court explained that plaintiff is not estopped from enforcing the Liability Award through a pro rata recovery because there was no reliance on plaintiff’s characterization of the claim as derivative nor was there prejudice to the General Partner.  Although plaintiff described the claims as derivative, this characterization was not binding on the court and, thus, the General Partner did not have a reliance interest in the derivative characterization.  The General Partner was not prejudiced by pro rata recovery of the Liability Award because, although it is an exception rather than the rule, ample authority supports the Chancery Court’s ability to grant pro rata recovery to investors on a derivative claim and because the General Partner triggered the need to recast the claim as dual-natured through the related-party Merger.

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