Chancery Court applies onerous full fairness standard in first SPAC decision | Coie Perkins
In one of the first decisions to analyze fiduciary duty claims in the context of a Special Purpose Acquisition Company (SPAC) merger, the Delaware Chancery Court recently upheld the legal viability of a putative shareholder class action brought against the directors, officers, majority shareholder of a SPAC, and financial advisor based on an allegedly false and misleading proxy statement. The court found that the plaintiffs had successfully pleaded “reasonably conceivable interference with the redemption rights of public shareholders – in the form of materially misleading disclosures.” The decision – which marks the first time the Chancery Court has applied Delaware law in the context of SPAC – is significant for several reasons that we highlight below and may provide a roadmap for plaintiffs’ attorneys in the developing SPAC-related lawsuits that are sure to be filed in the months and years to come. In particular, the decision suggests that the existence of SPAC’s public shareholders’ buy-out right prior to a SPAC takedown transaction – often seen as a key mitigating factor against conflicts of interest – will not protect the company’s trustees. SPAC from any liability when they failed to disclose to public shareholders information material to their decision to redeem their SPAC shares or convert them into shares of the combined public company. As we discussed in a pre-publicationFull and accurate disclosure is one of the keys to avoiding liability in U.S. Securities and Exchange Commission (SEC) investigations and shareholder lawsuits focused on SPAC’s transactions.
With the explosion of SPACs and related de-SPAC transactions over the past two years, there has been a corresponding increase in SPAC-related litigation, with over 80 lawsuits filed since June 2021. This increase in litigation is almost certain to continue through 2022 in light of the marked increase in SPAC activity in 2021, which saw over 600 SPAC initial public offerings (IPOs), totaling over $600 billion in proceeds, and over 260 de-SPAC transactions. Although dozens of lawsuits have been filed, many are still in their early stages and few decisions have been issued. The recent Delaware Chancery Court decision is notable as one of the first substantive decisions in this area and as a likely pattern for future claims by SPAC shareholders.
The case relates to the October 2020 merger between a private health data analytics company (the Company) and Churchill Capital Corp. III (Churchill), a former bank executive-sponsored SPAC that raised $1.1 billion in an IPO in February 2020. Plaintiffs allege that Churchill’s directors, officers and controlling shareholder – motivated by financial inducements not shared with public shareholders – breached their fiduciary duties by withholding material information from the proxy statement regarding the company and the proposed transaction of-SPAC. Plaintiffs allege fiduciary defendants failed to disclose that the company’s largest client – which accounted for 35% of its revenue – was building an internal platform that would compete with the company and force it to drive its key accounts away from the company. Shortly after the merger closed, an equity research firm released a report on the company that discussed, among other things, the client’s creation of a competing platform and allegedly causing the stock price to plummet. share of the company by more than 40%. Plaintiffs also allege that SPAC’s financial advisor – a wholly-owned subsidiary of SPAC’s sponsor – aided and abetted the fiduciary defendants’ breaches.
In seeking to dismiss the claim, the defendants primarily argued that (1) the plaintiffs alleged derivative (not direct) claims but did not plead futility of the claim and (2) the claims were barred by rule of Delaware Business Appreciation.
With respect to the first issue, the defendants argued that the plaintiffs alleged a duty of loyalty arising from the defendants’ alleged overpayment for the business which should be considered “solely derivative” under Tooley v Donaldson, Lufkin & Jenrette, Inc., 845 A.2d 1031 (Del. 2004). The court rejected this argument, finding that the allegations did not constitute a “typical case of overpayment or dilution”. Rather, the complaint relates to the infringement of the informed exercise by public shareholders of their right of redemption, a right exclusive to public shareholders. The harm suffered by the shareholders as a result of the defendants’ “intentionally and materially misleading disclosures” was therefore “independent and not shared with Churchill”. In addition, the court found that the public shareholders, rather than the company, would receive the benefit of the requested clawback, which is based on the shareholders’ forfeited redemption right of a guaranteed amount of $10 per share.
With respect to the second question, the court concluded that the business judgment rule should not apply. Instead, he concluded that “total fairness,” which is Delaware’s “most onerous standard of review,” applies. Since the entire fairness standard requires thorough factual inquiries into both the economics of the transaction (the fair price test) and the process leading to the transaction (the fair use test ), motions to dismiss fiduciary duty claims where the standard applies are rarely granted.
In support of its application of the entire fairness doctrine, the court first ruled that the plaintiffs adequately alleged a “conflicting controller” transaction based on the “unique benefit” that the sponsor PSPC would receive from the completion of the transaction with the firm. Specifically, the shares and warrants held by the sponsor would be worthless if Churchill did not strike a deal. As of the closing date, the Sponsor’s warrants were worth approximately $51 million and its Founder Shares were worth approximately $305 million, representing a huge gain on the Sponsor’s mere $25,000 investment. SPAC’s public shareholders, on the other hand, would have received $10 per share – which was the price of the IPO – if they had chosen to buy out or if Churchill had failed to consummate a merger and therefore liquidated. ; instead, those who did not redeem received shares of the combined public company, the value of which fell significantly as a result of the transaction. As with the promoter, the defendant directors would benefit equally from virtually any merger that “converts their otherwise worthless interests in Class B shares into [public] shares.” Second, the court found that the plaintiffs had correctly alleged that a majority of the board lacked independence given that all of the directors had been appointed by the majority shareholder to the Churchill board, as well as to the advice from other SPACs sponsored by the same person.
Finding that the full standard of fairness applied, the court dismissed the motion to dismiss the claims against the fiduciary defendants.
In addition, the court also upheld the claim for aid and abetment against SPAC’s financial adviser, who, according to the plaintiffs, “knew that [the valuation analyses] were materially misleading. Critical to the court’s analysis.
Take away food
- Full and accurate disclosure of all material facts is essential to mitigating liability. In upholding the plaintiffs’ fiduciary duty claims, the court made it clear that its decision that the plaintiffs’ claims are viable was “not simply because of the nature of the transaction or the resulting conflicts” – which are inherent in most de-SPAC transactions – but “Because the Complaint alleges that the Defendant Directors unfairly failed to disclose information necessary for the Complainants to knowingly exercise their redemption rights.” Thus, the court’s finding “does not address the validity of a hypothetical claim where disclosure is adequate and the allegations rest solely on the premise that the trustees were necessarily self-interested given the structure of the SPAC.” Indeed, “one can imagine a different result” if the public shareholders of SPAC received “all the important information on the target, [and] chose to invest rather than buy back.
- The application of “full equity” in other cases is unclear. Given the factual nature of the tribunal’s decision, which is based almost entirely on PSPC’s alleged flawed and misleading disclosures, it is too early to say whether the onerous standard of fairness applied by the tribunal will apply to other challenges to the fiduciary duty of -PSPC Operations. What is clear from the notice, however, is that those involved in a PSPC removal transaction are well advised to ensure strong and accurate disclosures. Plaintiffs’ attorneys will likely use the decision as a roadmap for crafting complaints in the future, including highlighting “material” disclosure violations and the various conflicts inherent in a de-SPAC transaction.
- Maximize director independence. To reduce the likelihood that the full fairness standard of review will apply and to increase the chances of a successful motion to dismiss, the majority of the SPAC Board of Directors should be independent of the sponsor or majority shareholder. In addition, the economic interests of the Independent Board Members in the outcome of the SPAC Deletion Transaction should be aligned as closely as possible with the interests of SPAC’s public shareholders.
- Use independent advisors whenever possible. The court’s decision to uphold the aid and abetment claim against SPAC’s financial advisor was clearly motivated by the fact that the financial advisor was owned and controlled by SPAC’s majority shareholder. In light of this alleged conflict, the court found that it was “reasonably conceivable” that the financial advisor “participated” in the board’s decision or “otherwise caused the board to make the decision” to “approve the merger while concealing important information from shareholders. .” To avoid such conflicting claims, SPACs should consider engaging third-party advisors independent of the sponsor to provide valuation reports regarding the target company. In addition to engaging an independent financial advisor, SPACs should consider adopting other procedural safeguards typically used in a traditional merger context to help mitigate risk, such as the use of a independent third-party advisor to perform due diligence, obtaining a fairness opinion as to the value of the target company, and possibly establishing an independent special committee to review the proposed transaction.
 A copy of the Chancery Court decision is available here.