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ESG Capital Partners II, LP v. Passport Special Opportunities Master Fund, LP: Delaware Court of Chancery Permits Investors to Pursue Claims that Preferential Transfer of Partnership's Facebook Shares Breached Partnership Agreement

January 28, 2016

In a recent opinion, the Delaware Court of Chancery considered, among other things, the impact of an integration clause contained in a subscription agreement for interests in a Delaware limited partnership on a side letter between the limited partnership and an investor, as well as the authority of a general partner to cause the limited partnership to enter into such a side letter. On the facts of this case, the Court found that the subscription agreement's integration clause rendered the side letter a nullity and that the general partner did not have the authority to grant certain rights purported to be provided in the side letter.

In ESG Capital Partners II, LP v. Passport Special Opportunities Master Fund, LP, C.A. No. 11053-VCL (Del. Ch. Dec. 16, 2015), Timothy Burns formed ESG Capital Partners II, LP, a Delaware limited partnership (the "Partnership"), for the limited purpose of raising money from investors to purchase shares of Facebook stock before its anticipated IPO. Following the IPO, it was anticipated that the Partnership would then distribute to its investors the Facebook shares or their equivalent cash value, as stipulated in the Partnership's partnership agreement. The partnership agreement gave each of the investors an equity stake in the Partnership and provided that any distribution was to be made to all of the investors in proportion to their respective percentage interests in the Partnership. Following Facebook's IPO, Mr. Burns wrongfully diverted cash, shares and other Partnership property and, before his wrongdoing was discovered, made preferential transfers of Facebook stock to certain limited partners of the Partnership (the "Favored LPs") instead of complying with the distribution provisions set out in the partnership agreement. The Favored LPs received one Facebook share for each of their Partnership units without regard to their actual percentage interests in the Partnership. As a result of Mr. Burns' wrongful actions, the other limited partners of the Partnership (the "Disfavored LPs") either did not receive any Facebook shares or received less than one Facebook share for each of their Partnership units. Mr. Burns was subsequently indicted criminally and convicted for his misconduct. The Disfavored LPs sued the Favored LPs, asserting that the Favored LPs had breached the partnership agreement by receiving the excess Facebook shares, had wrongfully converted property, and were unjustly enriched.

In connection with a motion to dismiss, the Court denied the Favored LPs' primary defense that they held an ownership interest in the Partnership's Facebook shares and, therefore, did not breach the distribution provisions of the partnership agreement because they were entitled to receive a number of Facebook shares equal to the number of units they held in the Partnership. The Court struck down this argument, finding that it was contrary to (i) the Delaware Revised Uniform Limited Partnership Act (the "LP Act"), which provides that a partnership is a separate legal entity and the individual partners of a partnership do not have any rights in specific partnership property but instead have an interest in the profits and losses of the partnership; and (ii) the plain language of the partnership agreement, which contemplated distributions being made to all of the partners as a class in accordance with their respective percentage interests in the Partnership and not as one-off preferential transfers to certain limited partners.

The Court further disagreed with the Favored LP's proposition that the sole means for challenging any Partnership distribution was through Section 17-607(b) of the LP Act, and because the Disfavored LPs did not use this means, their claim should be dismissed. The Court held that what occurred was not a distribution, but was in fact a preferential transfer to the Favored LPs. Additionally, the Court held that Section 17-607(b) of the LP Act is not the exclusive means of challenging a distribution, as such provision does not contain any text implying exclusivity. The Court concluded that while Section 17-607 of the LP Act does impose a limitation on distributions, it is not the exclusive limitation, and here it was not an applicable limitation with respect to the preferential transfer made to the Favored LPs.

Of particular interest to practitioners and investors who deal with side letters is the Court's examination and analysis of a side letter (the "Side Letter") that was entered into between the Partnership and one of the Favored LPs. The Side Letter purported to provide a Favored LP with certain preferential rights not provided to other limited partners, including a provision that such Favored LP "held" a specific number of Facebook shares. The Court rejected the argument that the preferential transfer of Facebook shares to the Favored LP was protected because of the specific rights provided under the Side Letter. The Court held that the Side Letter was rendered a nullity because of the integration clause in the Favored LP's subscription agreement that was entered into after the Favored LP entered into the Side Letter. The Court further concluded that even if the Side Letter remained in effect notwithstanding the integration clause contained in the subscription agreement, the Side Letter rights at issue were not valid because (i) the general partner of the Partnership lacked the authority to grant such rights, and the Favored LP knew about such limitation on the general partner's authority; and (ii) the Side Letter could not be used as a means to amend the partnership agreement without complying with the partnership agreement's amendment provisions.

Side letter agreements are regularly used as a means of interpreting, establishing rights under, altering or supplementing the terms contained in partnership agreements and subscription agreements. Practitioners and investors who deal with side letters should give careful consideration to the Court's side letter analysis and whether side letters being entered into in particular transactions are permitted to grant the applicable rights under applicable governing documents and are consistent with relevant integration clauses.