March 5, 2012

Plenty of Warnings As El Paso Deal Squeaks By in Delaware

Last week, Kevin Miller blogged about the hearing transcript in the In re El Paso S’holder Litig. case that wound up being decided the next day. This WSJ commentary by Ronald Barush analyzes Chancellor Strine’s opinion:

Wednesday, Chancellor Leo Strine, who heads the Delaware Court of Chancery, all but threw up on parts of the negotiation process of Kinder Morgan’s acquisition of El Paso. But in the end he decided that if shareholders, who are being told of the troubling facts, can live with it and vote for it, he can hold his nose and let the deal move forward. It doesn’t mean that down the road the defendants, if they don’t settle, won’t be looking at big damages. We will come back to that.

But you have to hand it to El Paso. It gave Chancellor Strine a lot of grist for the mill of his criticism. For example, the CEO got caught considering a management buyout of El Paso’s E&P assets (which Kinder Morgan was always planning to sell) without telling his board, the opinion says. Frankly, it is not clear that he went very far with that interest, but this is a bit like getting caught with too big a lead off of first base. He was just asking to be picked off. Any CEO should know there is going to be litigation and that conflicting interests will be searched for. And it costs nothing to move closer to base and tell your board everything.

And then there is Goldman Sachs. Goldman, one of El Paso’s financial advisers, had different issues. Goldman thought it had fully disclosed its conflict (its PE arm owns a big stake in Kinder Morgan). But in another unforced error, according the Chancellor Strine, even though an attempt was made to wall off the part of Goldman with that interest, no one bothered to tell El Paso that the Goldman lead banker on the El Paso account personally owned $340,000 of Kinder Morgan stock. And in addition, Strine characterized the efforts to address Goldman’s disclosed conflicts as “inadequate.”

But what is more significant than the salacious details–since, after all, if the shareholders vote for the deal Strine will let it close–is the unstated messages of Strine’s opinion. It is filled with implicit warnings to both investment bankers and directors.

First, this decision caps a series of recent decisions where courts have been critical of investment bankers’ conduct and conflicts. The world of investment banking is filled with conflicts. Bankers trade securities, they have proprietary interests (like Goldman’s 19.9% interest in Kinder Morgan) and they seek M&A advisory roles–all at once. There is no code of conduct for investment bankers–they can have conflicts. They should disclose them to their clients, but if clients can live with them, up until recently it would appear to be up to the board of directors’ business judgment as to what to do about them.

But Thursday’s decision, as well as other recent decisions, was highly critical of the conduct of investment banks. Under the business-judgment rule, in which courts defer to disinterested directors, one would expect these matters to be the realm of the business judgment of the directors and not subject to second guessing by a court. However, Chancellor Strine concluded that the plaintiffs have “a reasonable likelihood of success in proving that the Merger was tainted by disloyalty.”

Chancellor Strine does not say it, but the courts are coming very close to the conclusion that investment-banker conflicts are deserving of some form of enhanced scrutiny by a court to determine if a process has been “tainted” by those conflicts–even if they are fully disclosed. That is a big warning to both investment banks and directors that more vigilance is required. As a result, bankers may be forced to pass on more assignments where they have conflicts, even if their client does not object.

There is another subtle warning to directors as well. The court did not criticize the directors for not ferreting out the El Paso chief executive’s desire to buy the E&P products which, according to the Court, gave him a conflicting interest. Indeed the court said it thought it unlikely the directors (other than the CEO) would be held liable for any damages in this case.

Rather, the court was critical of the negotiating strategy of the CEO–largely with the concurrence of the board- which the court characterized as “velvet gloved.” In future cases, directors cannot count on judges being so sympathetic to sale processes that go awry if independent directors are not actively exercising real time oversight. To entrust a CEO with full authority to negotiate a sale of a company without close independent director supervision could lead to something more disastrous. And after the El Paso experience, not to question the CEO carefully about conflicts could damage how a judge looks at a board’s conduct.

This case isn’t over. The court found that the plaintiffs have a reasonable likelihood of prevailing on the merits of the case and the lawsuit has now turned into a damages action. Chancellor Strine hints that he sees exposure in the half billion dollar range (and there will be no jury and he is the judge).

It is likely that in the end Kinder Morgan will end up paying most of any damages since, once the deal is completed, Kinder Morgan will own El Paso and have indemnity obligations to pretty much all of the defendants: the directors, the CEO and Goldman. With a record like this, look for Kinder Morgan to find a way to settle the case and write some checks without the agony of a full-blown trial.