Top 10 Practice Tips: Master Limited Partnerships

Posted on 12-19-2017

By: Joshua Davidson, Baker Botts LLP

If you are internal counsel to a publicly traded corporation that has decided to form a master limited partnership (MLP) and would like to become better educated about MLPs before starting the IPO process, below are 10 practice tips for you.

1. Obtain a basic understanding of the tax qualifying income rules.

MLPs have a special tax status. Unlike corporations, they are not taxed at the entity level and unitholders are taxed on their allocated share of income, not on their distributions. This is only the case, however, if the MLP satisfies certain complex qualifying income rules. Ninety percent of the MLP’s income must be from certain activities related to natural resources or other qualifying sources. If the MLP fails that test in any one year, it will become taxable as a corporation. Although specialist tax counsel handles the qualifying income analysis, you should be aware of the following:

  • Equity investors care very much about the qualifying status of MPLs and so outside counsel will be required to give what is known as a will opinion on qualifying income for each equity raise.
  • In order to give this opinion, outside counsel will perform detailed diligence on the sources of income and require certifications from management.
  • When the company makes an acquisition, it will need to carefully investigate the qualifying nature of the acquired company’s income.
  • How customer contracts are structured (e.g., lease vs. services agreement) or whether the MLP’s customer is an end user of the product can affect whether the revenue from that contract is qualifying.

2. Read an MLP partnership agreement

Unlike a corporation, a Delaware limited partnership is a creation of contract and a court will look to the words of the partnership agreement to determine the rights of the parties. MLP agreements generally contain very similar provisions. The key provisions deal with:

  • The replacement of default fiduciary duties with contractual duties
  • Methods of resolving conflicts of interest
  • Cash distribution policy
  • Governance
  • Indemnification
  • Unitholder voting rights
  • Tax allocations
  • Dissolution

The agreement runs close to 100 pages, which demonstrates how many aspects of the MLP are governed by contract.

3. Understand the fiduciary duty provisions of the partnership agreement.

When the general partner or its officers and directors are acting on behalf of the partnership, they must act in good faith, meaning that they must subjectively believe that their decision is in, or not opposed to, the best interest of the MLP (or in some cases, simply not adverse to the MLP). In any case, the actor is presumed to have acted with the requisite standard and a plaintiff will have the difficult burden of showing otherwise. When the general partner or the parent acts in its own capacity, it owes no fiduciary duty to the MLP.

4. Appreciate how MLP boards operate differently from corporate boards.

An MLP is governed by its general partner, which will be a subsidiary of the parent corporation. The board sits at the general partner level and therefore its directors (who manage the MLP) are appointed by the parent corporation (as the sole shareholder of the general partner) and are not elected by the public unitholders of the MLP. An MLP board is not required to have a majority of independent directors, and typically a majority of directors are officers of the parent. MLPs are also not required to have a governance or compensation committee but are required to have a standard audit committee of three independent directors

5. Figure out the relationship between officers of the parent and the general partner.

The general partner will have officers, who are frequently also officers of the parent corporation. Key issues to consider are:

  • Whether any officers of the general partner should not be officers or employees of the parent
  • How to allocate a shared officer’s or employee’s time between the MLP and the parent
  • How much authority to delegate to officers
  • Whether to compensate the officers of the general partner with restricted or phantom units under the MLP’s long-term incentive plan

6. Learn the dropdown process.

The MLP’s principal source of acquisitions is likely to be the parent corporation. When an MLP buys assets from its parent in exchange for cash or units, it is called a dropdown. Because the parent controls the MLP and therefore sits on both sides of the transaction, a conflicts committee of at least two independent directors is usually empowered to evaluate and negotiate the dropdown with the parent. Approval by an appropriately constituted conflicts committee doing its job properly will cleanse any conflict of interest and place a high bar for a plaintiff seeking to challenge the dropdown. Key points to keep in mind:

  • In addition to meeting Securities and Exchange Commission (SEC) or exchange independence requirements, conflicts committee members may not own an interest or may own only a minimal interest in the general partner or the parent.
  • The committee will retain its own financial and legal advisors, who must be independent of the parent and the MLP, and will obtain a fairness opinion from its financial advisor.
  • It is important that you not dictate advisors for the committee, though you can recommend lawyers and bankers experienced in the field and advise whether any are conflicted.
  • The committee and its advisors will conduct a thorough examination of the acquired assets and should not be pressured to complete this work in a short time frame.
  • The committee will operate autonomously without your participation once it has been charged.
  • You should advise your management that the committee must retain the power to say no to the transaction and will likely try to negotiate a better deal for the MLP.

7. Understand the cash distribution policy.

One of the key selling points in the marketing of MLPs is that they generally distribute all of their available cash except for reserves necessary in the business. Acquisitions and capital projects are very often funded with external capital. The typical MLP has three types of limited partner interests at IPO, each with its own cash distribution priorities: common units, subordinated units, and incentive distribution rights. You should become familiar with concepts such as subordination period, high splits, distribution coverage ratio, operating surplus, and adjusted operating surplus.

8. Appreciate different treatment under federal securities laws.

MLPs are subject to all federal securities laws, except that there are no annual proxy statements for the election of directors since the directors are appointed by the owner of the general partner. Proxy statements are required to the same extent as corporations for actions requiring unitholder votes, such as the approval of new stock incentive plans or material corporate transactions. Furthermore, limited partnerships are ineligible issuers for anything other than firm commitment underwritings, which means that an MLP that is a well-known seasoned issuer (WKSI) cannot use a WKSI shelf registration statement for at-the-market programs or resale shelves that contemplate a plan of distribution other than a firm commitment underwriting.

9. Be aware that other regulatory authorities treat MLPs differently.

Three principal differences to be aware of are:

  • There are significant restrictions on the ability of limited partnerships to sell securities into European countries and Canada, which (along with adverse tax considerations) make marketing into those countries unusual.
  • The Financial Industry Regulatory Authority (FINRA), which regulates the compensation of underwriters in securities offerings, regulates MLPs differently than it does corporations. FINRA considers MLPs to be direct participation programs. This is mostly of concern to underwriters’ counsel, but your securities counsel should be aware of this different regulatory scheme as well.
  • MLPs are not subject to New York Stock Exchange and NASDAQ Stock Market rules limiting the ability of a listed company to issue more than 20% of its outstanding publicly traded equity in a transaction not involving a public offering. This is of significant benefit to MLPs, which often do large private investments in public equity offerings.

10. Understand the ways in which MLP financial information can be presented differently.

MLPs follow generally accepted accounting principles (GAAP) and Regulation S-X (17 C.F.R. § 210.1-01 - § 210.12-29), but there are a few noteworthy differences. First of all, because dropdowns are transactions between entities under common control, MLPs will often be required to recast their quarterly and annual historical financial results to reflect the acquisition as if made at the beginning of the period. Secondly, MLPs very often use a non-GAAP measure called cash available for distribution. As MLPs are cash distribution vehicles, a great deal of attention is paid to this metric by investors. Getting the SEC comfortable with your non-GAAP presentations can require some work. Third, because MLPs are so acquisitive, and because they often acquire partial interests in entities, you will be required to become familiar with the nuances of acquisition and joint venture accounting (Regulations S-X 3-05 (17 C.F.R. § 210.3-05) and 3-09 (17 C.F.R. § 210.3-09)).

Joshua Davidson is a partner in Baker Botts’ Houston office and handles a wide range of corporate and securities work. He is nationally recognized for his experience in transactions involving MLPs, YieldCos, and royalty trusts. Mr. Davidson is head of the firm’s Capital Markets and MLP/YieldCo Practice and has concentrated on MLPs for almost 25 years. He has participated in hundreds of equity and debt public offerings and private placements of MLPs and other alternative entities, including more than 60 initial public offerings. Mr. Davidson works with companies in the pipeline, midstream, oil and gas, renewable energy, shipping, refining, coal, propane, and heating oil industries.

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