How should damages be calculated when the offending party is a start-up, with little to no assets?
The Delaware Chancery Court recently faced this exact conundrum. In the memorandum opinion for Enhabit Inc. v. Nautic Partners IX, L.P., the Court held that two private equity firms (the “Private Equity Defendants”) had conspired with a pair of home healthcare executives (the “Executives”) to surreptitiously create a competitor entity (the “Competitor”).
While serving as high-ranking corporate officers of a home healthcare company (“Encompass”), the Executives secretly enlisted the services of the Private Equity Defendants to develop a new home healthcare entity—one that would directly compete with Encompass. Their deceptive antics, which involved explicit instructions to avoid creating paper trails, using spouses’ phones, and passing documents on golf courses, are just some of the noteworthy aspects of the cartoonish scheme. The Executives’ liability was a clear-cut case for the Court, as was the determination that the Private Equity Defendants had aided and abetted the Executives’ violations.
Although liability was a simple evaluation, the remedy proved to be a far trickier analysis. The Competitor was conceived during the height of the COVID-19 pandemic, but since then, the home healthcare industry at large has shrunk as society has returned to normal. At the time of this lawsuit, the Competitor had few to no assets, as it had drastically underperformed its own projections.
When it came to assessing damages, the fledgling Competitor’s shaky finances presented the Court with a “remedial quandary” (Opinion, p.82). To summarize the predicament, the Court wrote, “It would be inequitable for the Private Equity Defendants to retain the entirety of [future gains] simply because this trial occurred before they were realized” (Opinion, p.84).
In their lawsuit, Encompass asked the Court to award rescissory damages, disgorgement of profits, and compensatory damages. The Court reviewed the Private Equity Defendants’ original financial forecasts when the Competitor was launched, and found them to be outdated and unreliable, as they did not present an accurate reflection of the Competitor’s finances at the time of the lawsuit. With no proper basis to assess damages in a just and equitable way, the Court wrestled with all options at its disposal.
Determined to ensure that the “egregious breaches” (Opinion, p.82) that took place at Encompass’ expense were properly remedied, the Court ultimately decided to impose a constructive trust on the Private Equity Defendants. In justifying its decision, the Court described the constructive trust as “‘an equitable remedy of great flexibility’” (Opinion, p.84) and pointed to precedent where constructive trusts had been used as a solution when future profits are too speculative to grant a presently available award. However, the Court did note the downsides of the remedy—specifically, the ongoing monitoring required to ensure compliance, as well as a court-appointed trustee to oversee the program.
After settling on the constructive trust, the Court exhaustively deliberated on the proper way to set up the trust in the most equitable way possible. The first possible iteration would involve the Private Equity Defendants retaining 100% of every dollar of the Competitor’s profits until their initial capital contributions were recovered. Once the Private Equity Defendants had fully recovered their investments, Encompass would receive 100% of the Competitor’s profits from that point on. Applying a practical analysis, the Court decided against this model, fearing that the Private Equity Defendants would solely be incentivized to recover their investments and would have no incentive to develop the business long-term.
The Court, emphasizing its responsibility to “‘extinguish all possibility of profit [and equity] flowing from [the fiduciary’s] breach,’” (Opinion, p.86) ultimately settled on a profit-sharing arrangement. For every dollar the Competitor made, the Private Equity Defendants would retain 57% of the profits, while Encompass would receive 43% (Opinion, p.105). In deciding these specific amounts, the Court relied on the expert testimony of a financial analyst. As part of his analysis, the analyst looked at the Private Equity Defendants’ 2021 projected earnings, as well as the modified 2023 projected earnings, reflecting the Competitor’s lesser-than-anticipated financial results.
Ultimately, he divided the Private Equity Defendants’ initial capital contributions (330.1M) by the projected equity value at exit (580.9M) in order to determine how much they stood to earn in proportion to every dollar they contributed. Using this formula, the Private Equity Defendants and the Executives would be incentivized to grow the business of the Competitor while paying over damages to Encompass. Under the trust arrangement, a court-appointed trustee would monitor the Competitor’s profits and ensure that Encompass received quarterly payments, up to and including its share of the Private Equity Defendants’ exit from the Competitor.
Now, as a direct result of their bad actions, the Private Equity Defendants are locked in a marriage of inconvenience of sorts. It is unclear how long it will take the Competitor’s business to materialize profits, if at all, but this arrangement still gives the Private Equity Defendants the chance to earn their initial investments back. However, until that day, nearly half of every dollar will be deposited in Encompass’ accounts instead.
This case is an important reminder that Delaware Courts are willing to go to great lengths to uphold core principles of corporate law and enforce fiduciary obligations of corporate officers, all while establishing a powerful remedy for breaches of the obligation.
If you have any further questions regarding fiduciary loyalty and corporate compliance, please contact Charles Hughes, Thomas White, and Eric Albrecht.
Charles B. Hughes
Eric M. Albrecht
Thomas C. White