On Feb. 29, Chancellor Leo Strine of the Delaware Court of Chancery issued a landmark ruling that promises to change the way Wall Street handles conflicts of interest.
For lawyers and most other professionals, there is a clear obligation to recuse yourself from an engagement if your financial interests are adverse to the interests of a client. Mr. Strine's opinion in the case — In re El Paso Corp. Shareholder Litigation — highlights the disturbing fact that, even following the recent financial crisis and a consistent stream of stunning revelations and corporate scandals, some Wall Street firms and corporate executives still think these basic ethical and professional rules do not apply to them.
In 2006, Goldman Sachs and others acquired pipeline operator Kinder Morgan in one of history's largest private equity buyouts. To this day, Goldman owns a $4 billion equity stake in Kinder Morgan and two Goldman managing directors serve on Kinder Morgan's board of directors.
In spring 2011, Goldman was advising the El Paso Corp. board regarding a spinoff of the company's exploration and production business. After the spinoff was announced, Kinder Morgan privately approached El Paso CEO Douglas Foshee about buying the entire company. Despite Goldman's massive equity stake in Kinder Morgan, Goldman sought and obtained a key role advising El Paso on the sale. In the end, Goldman secured a $20 million advisory role, staffing the engagement with a banker who personally owned more than $300,000 in Kinder Morgan stock.
Rather than remove Goldman from the transaction altogether, El Paso retained Morgan Stanley as a second financial adviser. The retention of Morgan Stanley did nothing to cleanse Goldman's conflict. Morgan Stanley's entire $38 million fee was contingent on a sale to Kinder Morgan. While Morgan Stanley asked the El Paso board to establish a fee structure that would pay Morgan Stanley in the event El Paso pursued the spinoff instead of the sale to Kinder Morgan, Goldman vociferously objected to any such fee arrangement. In other words, Morgan Stanley, which was supposed to be providing the board with unbiased advice, was given a powerful incentive to justify a sale to Kinder Morgan regardless of whether this was the best alternative for El Paso's shareholders.
Corporate insiders also had misaligned personal incentives. Mr. Foshee and other members of El Paso's senior management had ambitions of purchasing the company's exploration and production business from Kinder Morgan, but neglected to inform the board of this debilitating conflict. The desire to purchase the E&P business provided Mr. Foshee with a strong incentive to avoid squeezing every last nickel out of Kinder Morgan in the sale of El Paso. Put simply, while a management buyout of a public company would draw heavy investor scrutiny and challenges, as long as management ensured a sale to Kinder Morgan, they could then present a buyout proposal of a privately owned business unburdened by the limits of fiduciary obligations to public shareholders.
Each of these conflicts came to the forefront when Kinder Morgan, after initially agreeing to pay $27.55 per share of El Paso stock, informed El Paso's board that there was a “bust” in Kinder Morgan's valuation model and the deal had to be renegotiated. Instead of calling out Kinder Morgan's gamesmanship, Mr. Foshee and his financial advisers readily agreed to renegotiate the deal at a lower price and to accept stock warrants of speculative value.
A group of public pension fund shareholders filed a class action alleging, among other things, that the El Paso board breached its fiduciary duties in connection with the sale to Kinder Morgan and that Goldman Sachs aided and abetted the board's breaches. Based on the powerful evidence uncovered during the discovery process, Mr. Strine found that “Foshee's velvet glove negotiating strategy — which involved proffering counteroffers at levels below the level he was authorized by the board to advance — can now be viewed as having been influenced by an improper motive.” Similarly, Mr. Strine held that he could not “readily accept the notion that Goldman would not seek to maximize the value of its multibillion investment in Kinder Morgan at the expense of El Paso ...” As a result of Goldman and Mr. Foshee's misconduct, the chancellor concluded “plaintiffs have a probability of showing that more faithful, unconflicted parties could have secured a better price from Kinder Morgan.”
Mr. Strine's opinion is a strong wake-up call to corporate fiduciaries and gatekeepers who are entrusted with investors' money, as well as a significant statement by one of the nation's most important judges.
Without the efforts of the public pension fund investor plaintiffs in this instance, these facts would not have come to light. It is essential that institutional investors continue to play a significant role in ensuring that Wall Street firms and corporate titans play by the rules.
Mark Lebovitch is a partner and Jeremy Friedman is an associate at the New York office of Bernstein Litowitz Berger & Grossmann LLP.