Fiduciary Duty Claims in the Context of SPACs: A “Quintessential Delaware Concern”

Posted on Nov 28, 2022

Manola Aillaud

I. Introduction

A special purpose acquisition company (“SPAC”) is a newly formed corporation by a prominent and qualified sponsor and management team for the purpose of raising capital in an initial public offering in anticipation of identifying and consummating a business combination and transforming a private company into a publicly-traded company within a certain time frame (usually twenty-four months). The business combination involving a SPAC and a target company which can take the form of a merger, consolidation, acquisition of assets or similar transaction is called “de-SPAC transaction.” Private operating companies have increasingly turned to de-SPAC transactions as a mean of accessing public securities markets and becoming public reporting companies. In the past two years, the U.S. securities markets have experienced an unprecedented surge in the number of initial public offerings (“IPO”) by SPACs[1], as those vehicles were viewed by some as an easier way to raise IPO money.[2] SPACs raised more than $83 billion in such offerings in 2020 and more than $160 billion in such offerings in 2021.[3]

A SPAC is organized and managed by its sponsor, which is usually compensated an amount equal to a percentage of the SPAC’s IPO proceeds (in the form of discounted shares and warrants) to be received upon the completion of a de-SPAC transaction. This sponsor compensation is often referred to as the sponsor’s “promote” or “founder shares,” which usually amounts to around 20% of the total shares of a SPAC after its IPO.[4] During the initial IPO, the public shareholders purchase “units” issued by the SPAC that represent one common share, and a warrant that represents a fraction of a common share with the hope that upon completion of a business combination, they make a lucrative investment.

If a SPAC does not complete a de-SPAC transaction within the time frame specified in its governing instruments[5], the SPAC may seek an extension of the time frame from its shareholders or may dissolve and liquidate, with the sponsor not earning the “promote” and the assets held in the trust account returned to its shareholders. If, on the other hand, a SPAC identifies a candidate for a business combination transaction, the shareholders of the SPAC have the opportunity to either (1) redeem their shares prior to the business combination and receive a pro rata amount of the IPO proceeds held in the trust account, or (2) remain a shareholder of the company after the business combination.[6]

The sponsor team that creates the SPAC, and from which the board is composed, will have to cohabitate with the public shareholders. As in every corporation, fiduciary duties are at the core of the corporation, and when breached, a suit will ensue. “Established doctrines of fiduciary duty law are, of course, far from novel.”[7] Because of the sui generis aspect of a SPAC’s structure, there are a number of potential conflicts of interest between the sponsor and public investors that could influence the actions of the SPAC. A notable example is the potential conflict of interest stemming from the contingent nature of the sponsor’s compensation, whereby the sponsor has significant financial incentives to pursue a business combination transaction even though the transaction could result in lower returns for public shareholders than liquidation of the SPAC or an alternative transaction.[8] This is especially true when the sponsor may be under pressure to find a target near the end of the period. Other potential conflicts of interest may arise when the sponsor has financial interest in the target companies, when a SPAC enters into a business combination with a company in which the sponsor is affiliated, or when the officers and directors are working for different companies and might not allocate their full working time to the SPAC, which is often the case in practice where a director or officer is a member of several companies.[9] These potential conflicts of interest can be relevant for investors to the extent that they arise when a SPAC and its sponsor are evaluating and deciding whether to recommend a business transaction to shareholders.

Delaware, where most U.S. SPACs are incorporated, has recently seen a significant number of SPAC transaction challenges. The challenges tend to focus on structural features of SPACs and alleged disclosure deficiencies which impair the shareholders’ redemption right, in particular (1) the role that the sponsor plays in SPAC governance, (2) alleged conflicts of interest between the SPAC board and management and its public shareholders, and (3) the role played by the public shareholders’ redemption right.[10]

In recent cases, the Delaware Court of Chancery has affirmed its position to enlighten the judicial scene on the novel issues raised by SPAC transactions in the context of the fiduciary duties owed to the company, and more decisions on the matter are yet to come.  

II. The entire fairness standard is the appropriate standard of review for breach of fiduciary duty claims related to SPAC transactions

Recently, the Delaware Court of Chancery considered—for the first time in the context of a SPAC—the application of Delaware’s fiduciary-duty doctrines and the appropriate standard of judicial review.[11]

In the Multiplan litigation, the court held that:

  1. the SPAC sponsor had a special benefit not shared with the public shareholders arising from the value of his stock and warrants if no business combination resulted, therefore the de-SPAC transaction was a conflicted controller transaction;[12]
  2. a majority of the SPAC’s board was conflicted because they were self-interested and not independent from the sponsor given the scope of their economic personal and employment relationship with the sponsor;[13]
  3. and even though the structure of the SPAC and the sponsor’s incentives were disclosed in the offering materials for the SPAC’s IPO, certain information of the de-SPAC transaction were not disclosed either in the offering or proxy and it is reasonably conceivable that the public stockholder would have been substantially likely to find this information important when deciding whether to redeem their shares.[14]

Using the entire fairness standard of review instead of the business judgment rule, the court held plaintiffs had adequately alleged that the SPAC sponsor, as controlling stockholder, the SPAC’s directors, and the CEO violated their fiduciary duty of loyalty to the SPAC’s stockholders by failing to disclose certain material information regarding the SPAC’s intended target. Therefore, the court denied the motion to dismiss and held that the de-SPAC transaction was a conflicted controller transaction breaching the duty of loyalty as a result of both the allegedly misleading proxy statement and because of the conflicts involved in the transaction structure, and hence entire fairness was the appropriate standard of review.[15]

The use of entire fairness[16] requires that defendants demonstrate that the transaction was entirely fair, which places the defendant in a much more difficult situation. Indeed, half of the test is about process, and the defendant will often fail to demonstrate that the process was entirely fair in the SPAC context.

III. SPAC litigation in the future will be closely monitored by the Delaware Chancery Court

In another recent case, the Court of Chancery reaffirmed its desire to tackle emerging issues of Delaware law, denying a motion to stay by holding that “the Court of Chancery ‘has long been chary’ about deferring to a first-filed action pending elsewhere when a case involves important questions of our law in an emerging area.”[17] In doing so, the Delaware Chancery Court highlights the court’s interest in SPAC issues relating to fiduciary duty claims deemed “quintessential Delaware concerns.”[18]

Specifically, in In re Lordstown Motors Corp. Stockholders Litigation, the Court declined to grant the defendants a motion to stay, reasoning that application of Delaware fiduciary duty law to SPACs “raises emerging issues” and that the Court’s “essential role in providing guidance in developing areas of our law would be impaired if the court were to denude its jurisdiction because a federal securities action resting on similar facts was filed first.”[19]

Vice Chancellor Will of the Court of Chancery held that there is a limited overlap in terms of the parties, issues, and potential remedies sought between the plaintiff’s action and the securities action. The action concerned allegations that the defendants breached their fiduciary duties of loyalty and impaired the exercise of stockholders’ redemption rights in the context of a de-SPAC transaction.[20] The core of the securities actions rested on whether Lordstown’s stock price was artificially inflated by false and misleading disclosures, when in contrast, the plaintiff’s complaint alleged that the defendants harmed the putative class members by impairing the informed exercise of their redemption rights to the defendants’ benefit.[21] Vice Chancellor Will reaffirmed also that the gap between the claims asserted by the putative class action and those in the securities action widens when the potential remedies are considered. The securities action seeks to recover damages for losses allegedly caused by the decline in Lordstown’s stock price, when in contrast, the plaintiff’s attempt recovery in the action turns on the $10 redemption right plus interest relative to the value the class received in the de-SPAC transaction.

More issues will likely come up too as underlined in In re Multiplan, where the court held that the conclusion “does not address the validity of a hypothetical claim where the disclosure is adequate and the allegations rest solely on the premise that fiduciaries were necessarily interested given the SPAC’s structure. The core, direct harm presented in this case concerns the impairment of stockholder redemption rights. If public stockholders, in possession of all material information about the target, had chosen to invest rather than redeem, one can imagine a different outcome.”[22]

Other complaints have been filed in the Delaware tackling the structure’s issues of the board. For instance, in a class action against Gigacquisitions3, the plaintiffs allege that the CEO “packed the board with loyalists and ensured that their financial interests were aligned with his.” Plaintiffs allege that rather than establishing a governance structure that addressed the conflicting interests of the public stockholders, the sponsor and the CEO, the later built a board with loyalty to himself and hence to the sponsor. Additionally, the plaintiffs allege that that “all four purportedly independent directors had direct, but largely undisclosed, financial interests aligned with the financial interests of the CEO and the sponsor.”[23]

IV. Conclusion

As Vice Chancellor Will mentioned, a “[p]laintiff’s Delaware law fiduciary duty claims are quintessential Delaware concerns.”[24] Delaware has a substantial interest in addressing the novel issues of Delaware law. We should look forward to seeing more decision from the Delaware Court of Chancery applying the entire fairness standard of review and give the take on emerging fiduciary-duty related issues in the upcoming months.  

[1] Special Purpose Acquisition Companies, Shell Companies, and Projections, 87 Fed. Reg. 29458 (proposed May 13, 2022) https://www.federalregister.gov/documents/2022/05/13/2022-07189/special-purpose-acquisition-companies-shell-companies-and-projections.

[2] SPAC IPO Transactions: Summary by Year and SPAC Status by Year of IPO, SPACInsider, https://spacinsider.com/stats/.

[3] By comparison, SPACs raised a total of $13.6 billion in initial public offerings in 2019 and a total of $10.8 billion in initial public offerings in 2018. Proceeds of SPAC IPOs in the United States from 2003 to October 2022 (illustration), in Statista Research Department, Size of SPAC IPOs in the U.S. 2003-2022,  Statista (Oct. 6, 2022, https://www.statista.com/statistics/1178273/size-spac-ipo-usa/.

[4] Special Purpose Acquisition Companies, Shell Companies, and Projections, 87 Fed. Reg. 29458 (proposed May 13, 2022) https://www.federalregister.gov/documents/2022/05/13/2022-07189/special-purpose-acquisition-companies-shell-companies-and-projections.

[5] Exchange rules require a listed SPAC to complete a de-SPAC transaction within a specified timeframe not to exceed 36 months after its initial public offering. See, e.g., NYSE Listed Company Manual Section 102.06 and Nasdaq Listing Rule IM-5101-2.

[6] According to a study of SPAC initial public offerings between 2010 and 2018, an average of 54.4% and a median of 57.1% of shares issued in an initial public offering by a SPAC during this period were redeemed prior to the completion of a de-SPAC transaction. Usha R. Rodrigues et al., Redeeming SPACs  (Research Paper Series, Working Paper No. 2021-09, 2021). Another analysis found that, between July 1, 2021 and Dec. 1, 2021, mean and median SPAC redemption rates were 55% and 66%, respectively. Michael Klausner et al., A Sober Look at SPACs, 39 Yale J. On Regul. 228 (2022).

[7] In re Lordstown Motors Corp. Stockholders Litigation, CA. No. 2021-1066-LWW (Del. Ch. March 10, 2022).

[8] Special Purpose Acquisition Companies, Shell Companies, and Projections, 87 Fed. Reg. 29458 (proposed May 13, 2022) https://www.federalregister.gov/documents/2022/05/13/2022-07189/special-purpose-acquisition-companies-shell-companies-and-projections.

[9] On the other hand, this is also what attracts the public shareholders in the first instance, that is, to invest side by side with mature and experience business person in the targeted field.

[10] Jenny Hochenberg & Justin Clarke, SPAC litigation: Current State and Beyond, in THE REVIEW OF SECURITIES COMMODITIES REGULATION (Vol. 22, 2022).

[11] In re MultiPlan Corp. Stockholders Litigation, 268 A.3d 784 (Del.Ch., 2022).

[12] As Vice Chancellor Will pointed out, “in brief, the merger had a value – sufficient to eschew redemption – to common stockholders if shares of the post-merger entity were worth $10.04. For Klein [the sponsor], given the (non)value of his stock and warrants if no business combination resulted, the merger was valuable well below $10.04. This is a special benefit to Klein”. This special benefit relies entirely on the misalignment of interests during the prior step in a de-SPAC transaction process.

[13] The court recalls the Trados case, that is, if a majority of the board approving a transaction lacks independence and is not disinterested, entire fairness is the applicable standard of review.

[14]  The proxy did not disclose that Multiplan’s largest customer was UHC and that UHC was developing an in-house alternative to Multiplan that would both eliminate its need for Multiplan’ services and compete with Multiplan. The Court rests her analysis of the materiality of the information in Morrison v. Berry, 191 A.3d 268, 282 (Del. 2018) which held that information is material “if there is a substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote” - or in this instance, in deciding whether to redeem – such that it would be viewed as “significant alter[ing] the ‘total mix’ of information made available.”

[15] In re MultiPlan Corp. Stockholders Litigation, 268 A.3d 784 (Del.Ch., 2022).

[16] Cinerama, Inc. v. Technicolor, Inc., 663 A.2d 1156 (Del.,1995).

[17] In re Lordstown Motors Corp. S’holders Litig., CA. No. 2021-1066-LWW (Del. Ch., 2022).

[18] Id.

[19] Id.

[20] Specifically, the action was brought on behalf of a putative class of former DiamondPeak stockholders who continuously held Lordstown common stock between the record date of September 21, 2020 and the closing of the de-SPAC acquisition on October 23, 2020.

[21] The claim advanced invoked both the duty of loyalty and disclosure duties implicating director loyalty.

[22] In re MultiPlan Corp. Stockholders Litigation, 268 A.3d 784 (Del.Ch., 2022).

[23] Delman v. Gigacquisitions3, Complaint.

[24] In re Lordstown Motors Corp. S’holders Litig., CA. No. 2021-1066-LWW (Del. Ch., 2022).