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Delaware Supreme Court: Limited Partner’s Claim That a Transaction Violated the Partnership Agreement Was Derivative in Nature and Extinguished by a Subsequent Merger

01.18.17

(Article from Securities Law Alert, January 2017) 

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On December 20, 2016, the Delaware Supreme Court considered whether a limited partner’s claim that the partnership overpaid the general partner in an allegedly conflicted transaction, in violation of the governing limited partnership agreement, was direct or derivative in nature. El Paso Pipeline GP Co. v. Brinckerhoff, 2016 WL 7380418 (Del. 2016) (Valihura, J.). Applying the two-pronged test set forth in Tooley v. Donaldson, Lufkin & Jenrette, 845 A.2d 1031 (Del. 2004),[1] the court held the limited partner’s claim was derivative rather than direct because the harm from the alleged overpayment “solely affected the [p]artnership” and “the benefit of any recovery must flow solely to the [p]artnership.” The court further ruled that the limited partner’s claim was extinguished when the partnership was acquired in a merger.

The Delaware Supreme Court underscored that not every claim by a limited partner that implicates the terms of the limited partnership agreement is a direct claim. The court explained that the determination of whether a limited partner’s claim “is derivative or direct requires the usual examination” under Tooley “of who owns the claim.”

Background

In the case before the Delaware Supreme Court, the Chancery Court found that a limited partnership’s conflicts committee had approved a transaction that “it did not believe was in the best interests of the limited partnership” and was “unduly favorable to the limited partnership’s general partner.”

After trial but before the Chancery Court issued its ruling, the limited partnership was acquired in a merger. Defendants contended that the merger transferred the limited partner’s derivative claims to the acquiror, and extinguished the limited partner’s standing to sue. The Chancery Court found the limited partner’s claims “could also be considered direct, or, even if derivative, should survive the merger for the core policy reason that dismissal would leave the unaffiliated limited partners without recompense for the general partner’s prior unfair dealing.” Defendants appealed.

Delaware Supreme Court Holds Tooley’s Direct/Derivative Test Governs Claims Implicating the Terms of a Partnership Agreement 

On appeal, the Delaware Supreme Court acknowledged that the limited partner’s claims stemmed from the conflict-of-interest and good faith provisions of the limited partnership agreement. However, the court rejected the Chancery Court’s suggestion that Tooley’s test for determining whether a claim is direct or derivative in naturedoes not apply where the alleged harm involves contract rights.” The Delaware Supreme Court reasoned that “[s]uch a rule would essentially abrogate Tooley with respect to alternative entities merely because they are creatures of contract.”

The Delaware Supreme Court stated that a limited partnership agreement is “the constitutive contract of the [p]artnership” and not a “separate commercial contract.” While “limited partnership agreements often govern the territory that in corporate law is covered by equitable principles of fiduciary duties,” the Delaware Supreme Court stated that this “does not make all provisions of a limited partnership agreement enforceable by a direct claim.” 

Applying Tooley, Court Holds the Limited Partner’s Claims Were Derivative in Nature 

The Delaware Supreme Court then applied the Tooley test to the limited partner’s claims. Under the first prong of the Tooley analysis, the court found that the harm alleged by the limited partner “solely affected the [p]artnership.” The court explained that “claims of corporate overpayment are normally treated as causing harm solely to the corporation and, thus, are regarded as derivative.”

Pursuant to the second prong of the Tooley test, the court held that “the benefit of any recovery must flow solely to the [p]artnership.” The court observed that if the limited partner were “to recover directly for the alleged decrease in the value of the [p]artnership’s assets, the damages would be proportionate to his ownership interest.” The court found “[t]he necessity of a pro rata recovery to remedy the alleged harm indicates that [the limited partner’s] claim is derivative.”

Significantly, the Delaware Supreme Court rejected the limited partner’s effort to rely on Gentile v. Rossette, 906 A.2d 91 (Del. 2006), to argue that the claim was both derivative and direct. The court explained that Gentile involved a controlling stockholder transaction “that resulted in an improper transfer of both economic value and voting power from the minority stockholders to the controlling stockholder.” The court found that here, the limited partner’s claim did “not satisfy the unique circumstances” of the Gentile decision because there was no assertion of any “voting rights dilution.”

The Delaware Supreme Court expressly “decline[d] the invitation to further expand the universe of claims that can be asserted ‘dually’ to hold here that the extraction of solely economic value from the minority by a controlling stockholder constitutes direct injury.” The court found that “[t]o do so would deviate from the Tooley framework and largely swallow the rule that claims of corporate overpayment are derivative by permitting stockholders to maintain a suit whenever the corporation transacts with a controller on allegedly unfair terms.” 

Court Finds the Merger Extinguished the Limited Partner’s Claim 

The Delaware Supreme Court determined that the limited partner’s derivative claims “were an asset of the [p]artnership” that were “transferred to and bec[ame] an asset of the acquiring corporation as a matter of statutory law.” The court concluded the merger “therefore extinguished [the limited partner’s] standing to assert these claims.”



[1]           In Tooley, the Delaware Supreme Court held that the question of “whether a stockholder’s claim is derivative or direct . . . turn[s] solely on the following questions: (1) who suffered the alleged harm (the corporation or the suing stockholders, individually); and (2) who would receive the benefit of any recovery or other remedy (the corporation or the stockholders, individually)?” 845 A.2d 1031.