DealLawyers.com Blog

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 Vice Chancellor Will found that these projections were both “outdated and unreliable” and that it was inappropriate for the Court to order the defendants to disgorge profits that never materialized.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