How can the general partner of a master limited partnership get hit with the nine-digit liability over an asset sale to the MLP when everyone expects such deals to favor the corporate sponsor based on long-standing industry practice?

How can it be successfully sued when the nominally (but not really) independent directors who approved the deal are legally entitled to use flawed logic and math to arrive at an unreasonable conclusion, so long as they cannot be proven to have acted against their own subjective judgement?

Thanks to the hapless directors of El Paso Pipeline Partners, the unscrupulous bankers who advised them and a Delaware judge who’d seen enough of their farce, we now have answers to these burning questions.

Here’s how to get hit with a verdict for $171 million, plus interest and costs, over a “dropdown” transaction very much like the scores of others concluded every year between MLPs and their sponsors:

• Have the MLP directors tasked with negotiating the deal express serious reservations about its advisability, privately but in writing, just months before signing off on it;

• Have them agree in internal deliberations to demand a hefty discount to the sponsor’s asking price, accept a token discount at the first hint of the sponsor’s impatience soon after and then lose track of the numbers to in fact pay a premium instead of any discount at all by the time the deal is finalized;

• Make sure they’re unable to recall in subsequent testimony how they reached the conclusions they did beyond relying on the fact that the dropdown would increase the MLP’s distribution in the short run, emphatically and embarrassingly unaware that such increases are in no way a measure of value;

• Expose the fact that they treated a biased advisory opinion based on blatantly manipulated numbers as gospel, while ignoring known business and credit risks attached to the purchased business.

 The case arose from two separate 2010 transactions in which El Paso Pipeline Partners — subsequently merged into Kinder Morgan (NYSE: KMI) — acquired from its El Paso corporate parent a liquefied natural gas import terminal shortly before the shale drilling boom made LNG imports uneconomical. Despite the private misgivings of the board members tasked with making sure the deals were fair, the MLP ended up paying through the nose just as its sponsor wanted.

Which would have been fine with the Delaware courts except for the inconvenient paper trail suggesting that the MLP directors ignored public information, their own privately stated doubts and lessons they should have learned from the first part of a two-stage dropdown in striking a deal favorable to the general partner.

Sold to you: the Elba LNG terminal

The trial judge’s explanation as to how he came to side with plaintiffs in a case legally stacked against them is particularly damning:

“For me, the number of problems reached a tipping point. The composite picture that emerged was one in which the [MLP’s Conflicts] Committee members went through the motions,” wrote the judge, Vice Chancellor J. Travis Laster.

 “…Standing alone, any single error or group of errors can be excused or explained. But at some point, the story is no longer credible. …Despite their trial testimony, the Committee members did not conclude that the Fall Dropdown was in the best interests of the Partnership. They viewed El Paso MLP as a controlled company that existed to benefit Parent by providing a tax-advantaged source of inexpensive capital. They knew that the Fall Dropdown was something Parent wanted, and they deemed it sufficient that the transaction was accretive for the holders of common units. …Everyone understood the routine and expected the transaction to go through with a tweak to the asking price. No one thought the Committee might bargain vigorously or actually say no.”

Laster’s entire ruling is well worth every MLP investor’s time for the light it sheds on industry practices, and in particular the dropdowns that drive so much of the growth in partnership distributions.

It shows that it’s perfectly legal for the MLP yes-men to:

• Hire an investment banking advisor that only collects a fee only if it calls the negotiated deal fair and that depends heavily on repeat business from executives who work first and foremost for the seller;

• Do exactly as the sponsor asks without delving too deeply into relevant facts, so long as there is no preponderance of evidence that they did not, in fact, subjectively believe the deal was not in the MLP’s best interest;

• Be much more heavily invested in the sponsor’s equity than the MLP’s and to have come by their board seats after a career spent working for the sponsor or the businesses it bought, all without disqualifying themselves from service on the board’s conflicts committee;

• So long as the partnership agreement is appropriately vague, consider the interests of limited partners as no more important than those of employees, suppliers or other stakeholders.

 This is great news for all the law firms that have already distilled Laster’s ruling into a virtual road map for clients who’d like to exploit affiliated MLPs for all they’re worth without the nuisance of paying legal damages.

 The lack of any real MLP investor protections in the partnership’s founding document (and, for the most part, in Delaware law) could also prove handy for Kinder Morgan if it chooses to appeal the damages award, as it has said it may. The company insists the Elba LNG dropdown was properly negotiated.

The real check on sponsored dropdowns, and the reason we continue to recommend some partnerships involved in such related-party dealings, is that an MLP repeatedly forced into value-destroying deals will eventually struggle to grow under the burdens of excessive debt and dilutive equity offerings, depriving the sponsor of the goose that lays the golden eggs.

And in fact, not long after El Paso was bought out by Kinder Morgan, its affiliated MLP found itself unable to continue increasing distributions. At which point Kinder bought out the partnership for a modest premium, getting the tax benefits that would otherwise have gone to its limited partners. The MLP’s board approved the deal based in part on a fairness opinion from the same investment bank that helped it pay $171 million too much for an LNG import terminal in 2010.