El Paso-Kinder Morgan: A board’s worst nightmare

March 7, 2012, 6:56 PM UTC

By Eleanor Bloxham, CEO of The Value Alliance and Corporate Governance Alliance

FORTUNE — Many of us remember the campfire stories from our youth, designed to enthrall and terrify. For independent board members today, the equivalent is stories told around a conference table about CEOs they thought they knew — and later found out they could not trust.

In a court opinion, Judge Leo Strine’s description of what has happened in the El Paso-Kinder Morgan merger sounds like the kind of board horror story that elicits director fear and dread.

Merger and acquisition decisions can be tense situations for boards under any circumstance. They arouse heightened liability concerns surrounding any perceived lapses in board oversight or judgment. In the fall of 2011, according to Judge Strine’s account, the El Paso board put too much faith in El Paso CEO Doug Foshee and their investment banking advisors.

According to Judge Strine’s description of the facts, following the public announcement that El Paso would spin-off its energy exploration and production business, Kinder Morgan (KMI) made a non-public offer to buy El Paso (EP) on August 30, 2011, which the El Paso board rebuffed. When Kinder Morgan said it would publicize its intent, the El Paso board hired two advisors: Goldman Sachs (GS) (conflicted due to deep ties to Kinder Morgan through board seats and stock ownership) and Morgan Stanley (MS).

”On September 16, 2011, El Paso asked Kinder Morgan for a bid of $28 per share in cash and stock, deploying the company’s CEO, Doug Foshee, as its sole Negotiator,” and “Foshee reached an agreement in principle with Rich Kinder two days later” for $27.55, Strine wrote. On September 23, according to Judge Strine, Kinder Morgan said the amount it had promised was too high and “instead of telling Kinder where to put his drilling equipment, Foshee backed down.”

Foshee then accepted a still lower price on October 16 and, based on the advice of Morgan Stanley and Goldman Sachs, El Paso entered into a merger agreement with no-shop provisions, limiting El Paso’s future flexibility to accept higher bids.

In the negotiation process, El Paso’s board didn’t seem to have control of the CEO. According to September 30 board minutes, the board had set a floor price of $26.50, but Foshee offered Kinder Morgan $26 without authorization.

But here’s what Strine said about Foshee which, if true, would make any board member’s skin crawl: “Worst of all was that the supposedly well-motivated and expert CEO entrusted with all the key price negotiations kept from the Board his interest in pursuing a management buy-out of the Company’s [production] business.

“He kept that motive secret, negotiated the Merger, and then approached Kinder Morgan’s CEO on two occasions to try to interest him in the idea. In other words, when El Paso’s CEO was supposed to be getting the maximum price from Kinder Morgan, he actually had an interest in not doing that.”

The longevity of the relationship between El Paso’s board and its CEO only amplifies the horror these kinds of stories produce. At El Paso, five of the 11 board members have worked with the CEO for approximately nine years, and another four have worked with him for approximately six or more years. After that length of time, you expect you know the guy. A spokesperson for El Paso declined to offer comment for this story.

When the board loses trust in the CEO, it needs to take radical action. If El Paso shareholders do not approve of the sale to Kinder Morgan and this board remains, it will need to take a look in the mirror to see where it failed to spot the warning signs. It will then need to get to work to get the right people and processes in place.

At El Paso, not only did the board misjudge the CEO and engage a highly conflicted advisor (Goldman Sachs), it turns out its second advisor Morgan Stanley was conflicted as well, although the board may not have known this, according to Strine.

In fact, Judge Strine wrote that Morgan Stanley might not have been aware of its own fee arrangement (which made the bank conflicted) until October 5, 2011. But from that time forward, Morgan Stanley knew that it would be paid only if El Paso went through with the Kinder Morgan merger. Yet, “following October 5, 2011, Morgan Stanley met with the Board twice, and each time advised the Board that the final Merger consideration offered by Kinder Morgan was fair.”

The El Paso board story is not common — but not unheard of either. Many never make it to press. Boards discover their trust has been betrayed and move forward on their succession plan.

These tales gives directors the motivation to speak up when being silent might be easier and to listen to colleagues who argue for good processes and keen observation. Remembering these unfortunate stories often motivates board members to take small acts of courage, even if the natural desire to simply trust your CEO runs deep.

Eleanor Bloxham is CEO of The Value Alliance and Corporate Governance Alliance (http://thevaluealliance.com), a board advisory firm.