Earlier this week, the Chancery Court issued its decision in Enhabit, Inc. v. Nautic Partners IX, L.P. (Del. Ch.; 12/24), a case involving breach of fiduciary duty and aiding and abetting claims arising out of a former executive of Encompass Health’s usurpation of corporate acquisition opportunities. While Vice Chancellor Will found the defendants engaged in misconduct, the lack of profitability of their business venture made determining damages more challenging and led to the Vice Chancellor’s decision to impose a constructive trust entitling the executive’s former employer to a portion of the profits ultimately realized by that business.
The plaintiffs attempted to persuade the Vice Chancellor to award them rescissory damages or disgorgement in the amount of $462 million. That amount was determined using an expected gains methodology that calculated the present value of the business’s expected profits based on sets of projections prepared at the time the entities in question were acquired. Vice Chancellor Will found that these projections were both “outdated and unreliable” and that it was inappropriate for the Court to order the defendants to disgorge profits that never materialized. She also rejected the plaintiff’s alternative theory that they were entitled to $157 million in compensatory damages based on the profits it would have realized had it acquired the businesses in question for similar reasons.
That left the Vice Chancellor with a problem – traditional measures of damages were inappropriate given the lack of profitability of the defendants’ businesses, but the defendants remained bullish on their prospects, and if she couldn’t fashion a remedy, the defendants would essentially off the hook for conduct that she characterized as “nothing short of egregious.” In order to avoid that unacceptable outcome, she came up with an unconventional, albeit not unprecedented, solution:
A constructive trust is warranted here. Encompass has been wronged by its former fiduciaries and the third parties who aided them. This court must endeavor to “extinguish[] all possibility of profit [and equity] flowing from [the fiduciary’s] breach.” The trust would furnish Encompass with the “identifiable proceeds of [this] specific property”: VitalCaring’s future profits. If VitalCaring realizes gains, Encompass will be entitled to a portion of them.
The mechanics of the constructive trust and the methodology for determining the appropriate amount of the payment streams that Encompass would receive from the VitalCaring business was a fairly complicated process, and the Vice Chancellor devoted most of the last 20 pages of her opinion to it. Ultimately, she determined that appropriate solution was to permit the PE funds to recover their capital contributions while Encompass received a fixed portion of the payment stream of the profits realized by that business and the proceeds received in any exit transaction.
An Axios Pro Rata article on the decision notes that the result of this novel approach to damages will be to “take a big bite” out of the PE funds’ returns. It also suggests that the decision may provide a blueprint for other courts. If that’s the case, then this is a decision that the private equity industry needs to take to heart.
– John Jenkins
Earlier this year, I blogged about the NFL’s decision to open its franchises up to investment by a select group of private equity funds. According to this Institutional Investor article, those funds are chomping at the bit to get a piece of the NFL’s action, and it says that they like the NFL for the same reason that Willie Sutton liked to rob banks – “because that’s where the money is.” Here’s an excerpt:
Even strict limits, such as a 10 percent investment cap, haven’t sapped investors’ enthusiasm. Private equity firms also are abiding by the NFL’s requirement that they remain passive, without board representation — at least for now. NFL franchise valuations have surged a cumulative 610 percent from 2004 through 2022, according to data provider Yield Street. That compares to a 317 percent increase for the S&P 500.
Football has turned into the country’s top sport. “It’s now the most popular entertainment in the U.S.,” says Paul Hardart, a professor of entertainment and media at NYU’s Stern School of Business. “And it’s expanding to young women with the romance between Travis Kelce [of the Kansas City Chiefs] and Taylor Swift.”
Football also dominates TV, with NFL games representing 93 of the 100 top-rated broadcasts in 2023. “The demand for the NFL is insatiable among the media, driving up media rights fees,” Hardart says. In 2021, the NFL signed an 11-year, $111 billion media rights deal.
The article quotes GAMCO’s Michael Galatioto as saying that he wouldn’t be surprised to see 10 to 20 deals involving the sale of minority stakes in NFL franchises in the next two years or so. I know this is only somewhat relevant to most folks M&A practice, but it’s still kind of interesting and it also gives me an excuse to let you know that I knocked off my little brother the CEO’s team last weekend and now reside in first place heading into the final week of the fantasy football regular season.
– John Jenkins
According to a recent PitchBook article, mega PE funds have outstripped their middle market peers when it comes to returns for three quarters in a row. That’s a reversal of five quarters of underperformance following the pandemic, and this excerpt provides some insight as to what’s driving the improved performance by big players:
Greater access to cheaper debt financing and the public market rally have fueled an accelerated recovery in the higher end of the PE market,leading to a streak of superior performance for larger funds, according to Tim Clarke, lead PE analyst at PitchBook. Large PE funds, heavily weighted in large-cap companies, are more sensitive to the macro environment and tend to perform better during market upturns, he said.
The mark-to-market value of their portfolios is more susceptible to public market swings than that of mid-market funds, meaning their returns are higher when public markets thrive and decline more sharply during corrections. Additionally, recent improvements in credit conditions have particularly benefited large deals—PE funds are now more willing to pursue big-ticket buyouts or pay for higher valuations.
Speaking of big-ticket deals, PitchBook says that the total value of $1 billion-plus buyouts grew to $268 billion through November 25, 2024, compared to approximately $200 billion recorded over the same period last year.
– John Jenkins
Yesterday, the Delaware Supreme Court issued its opinion in In re Mindbody, Inc., Stockholder Litigation, (Del.; 12/24), in which it overruled the Chancery Court’s decision holding a buyer liable for aiding and abetting target fiduciaries’ breach of fiduciary duty based upon its role in reviewing the target company’s merger proxy materials.
In order to assert an aiding and abetting claim, the plaintiffs must allege that the buyer knowingly participated in a breach of fiduciary duty. The plaintiffs in this case alleged that the board and CEO breached their fiduciary duties of disclosure because target’s proxy statement failed to disclose, among other things, details about early interactions between the buyer and the target’s CEO. With respect to that aspect of the claim, Chancellor McCormick pointed to language contained Section 6.3(b) of the merger agreement, which gave the buyer the right to review the proxy statement prior to its filing.
That language, or something similar to it, has likely been included in just about every public company merger agreement ever filed. But it took on perhaps unexpected significance in the evaluation of the plaintiffs’ aiding and abetting claim against the buyer. That’s because Chancellor McCormick pointed to it as supporting the knowing conduct on the part of the buyer necessary to establish such a claim:
“[T]he merger agreement contractually entitles Vista to review the proxy and requires Vista to inform Mindbody of any deficiencies with the proxy. Vista knew that the proxy did not disclose information about Vista’s own dealings with Stollmeyer, dealings which I previously found support the plaintiffs’ claim for breach of the duty of disclosure. The plaintiffs thus adequately alleged that Vista knowingly participated in the disclosure violation related to Stollmeyer’s early interactions with Vista.”
The Delaware Supreme Court disagreed. In an opinion authored by Justice Valihura, the Court unanimously held that a buyer’s knowledge that a target fiduciary has breached its fiduciary duty is not sufficient to establish knowing participating in the breach. Instead, the plaintiff must show that the aider and abettor had actual knowledge that its own conduct was legally improper. The Court concluded that this was not established in the present case.
The Court then went on to note that in the context of an arms’- length bargaining process between a buyer and a seller, “participation” in the breach should be “most difficult” to prove. It reviewed Delaware case law establishing that in order to be regarded as participating in a breach, the defendant must provide “substantial assistance” to the primary violator. Although the Court acknowledged that some courts have held that a failure to act is sufficient to establish substantial assistance, it said that isn’t the path that Delaware has taken:
Rather, our case law in the corporate governance context has found liability only where there has been overt participation such as active “attempts to create or exploit conflicts of interest in the board” or an overt conspiracy or agreement between the buyer and the board as described above.
This substantial assistance requirement can also be understood as requiring active participation rather than “passive awareness.” As the Court of Chancery explained in Buttonwood, “passive awareness on the part of [the defendant] does not constitute ‘substantial assistance’ to any breach resulting from [the primary violator’s] failure to disclose the facts.”
In RBC, we affirmed aiding and abetting liability for a financial advisor who “purposely misled the [seller’s] Board so as to proximately cause the Board to breach its duty of care.” In Buttonwood, however, the Court of Chancery held that a financial advisor was not liable for “passive awareness . . . of the omission of material facts in disclosures to the stockholders, made by fiduciaries who themselves were aware of the information.
Applying this case law and the factors identified in the Restatement (Second) of Torts as being necessary to establish knowing participation, the Court concluded that the buyer’s passive awareness of a fiduciary’s breach of disclosure duties that would come from simply reviewing draft proxy materials was insufficient to impose aiding and abetting liability.
While the Court let the buyer off the hook, the target’s CEO didn’t fare as well. The Supreme Court upheld the Chancery Court’s ruling that he breached his fiduciary duties as well as its decision to award the plaintiff $44 million in damages for those breaches.
– John Jenkins
I know everyone is licking their wounds over the recent changes to the HSR form, so please don’t shoot the messenger on this one! Anyway, a recent paper by business school profs at Stanford & Chicago claims that GAAP is allowing buyers to avoid HSR scrutiny on a large number of potentially anticompetitive deals. Here’s an excerpt from this CFODive.com article on the paper:
Federal antitrust enforcers have stepped up their deal scrutiny in recent years, particularly in the technology and healthcare industries, and yet they’re letting hundreds of mergers a year pass without review because of the way asset values are measured, Stanford and University of Chicago researchers say.
The threshold criteria the agencies use for determining deals that get reviewed are based on valuations measured by generally accepted accounting principles, but the lion’s share of companies’ value today, especially in the most dynamic parts of the economy, are the intangible assets that GAAP mostly misses, say the researchers in a paper called Competition Enforcement and Accounting for Intangible Capital.
The paper’s authors determined the value of the intangible assets in a particular transaction by looking at the purchase price allocations in buyer’s post-closing financial statements. They contend that if the value of those intangibles had been taken into account for purposes of determining whether an HSR filing should have been made, the number of deals subject to antitrust scrutiny would’ve increased by more than 250 per year, and the number of Second Requests would increase by approximately 10% per year.
In support of their argument that the exclusion of intangibles from the size of the transaction analysis provides anticompetitive benefits, the authors note that unreported deals have premiums approximately 12% higher than reported ones, and are associated with 5.6% higher equity values for acquirers around the announcement date.
– John Jenkins