01/26/2022 | News release | Distributed by Public on 01/26/2022 17:12
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 sustained the legal viability of a putative shareholder class action brought against a SPAC's directors, officers, controlling shareholder, and financial advisor based on an allegedly false and misleading proxy statement.[1] The court concluded that the plaintiffs had successfully pleaded "a reasonably conceivable impairment of public stockholders' redemption rights-in the form of materially misleading disclosures." The decision-which marks the first time that the Chancery Court has applied Delaware law in the SPAC context-is important for several reasons we highlight below and may provide a roadmap for plaintiffs' attorneys in crafting SPAC-related lawsuits that are sure to be filed in the coming months and years. Most notably, the decision suggests that the existence of the SPAC public shareholders' right of redemption prior to a de-SPAC transaction-often thought of as a key mitigating factor against conflict of interest claims-will not shield SPAC fiduciaries from liability where they have failed to disclose information to the public shareholders that is material to their decision of whether to redeem their SPAC shares or convert them to shares in the combined public company. As we discussed in a prior publication, complete and accurate disclosure is one of the keys to avoiding liability in connection with both U.S. Securities and Exchange Commission (SEC) investigations and shareholder lawsuits focusing on de-SPAC transactions.
Background
With the explosion of SPACs and related de-SPAC transactions over the past two years, there has been a corresponding surge in SPAC-related litigation, with over 80 lawsuits filed since June 2021. This litigation surge is almost certain to continue throughout 2022 in light of the marked increase in SPAC activity in 2021, which saw over 600 SPAC Initial Public Offerings (IPO), totaling over $600 billion in proceeds, and over 260 de-SPAC transactions. Although scores of lawsuits have been filed, many remain in the early stages and few decisions have been issued. The recent decision by the Delaware Chancery Court is notable as one of the first substantive decisions in this area and as a likely template for future claims by SPAC shareholders.
The Lawsuit
The case centers on the October 2020 merger between a private healthcare data analytics firm (the Firm) and Churchill Capital Corp. III (Churchill), a SPAC sponsored by a former bank executive that had raised $1.1 billion in a February 2020 IPO. Plaintiffs allege that Churchill's directors, officers, and controlling stockholder-motivated by financial incentives not shared with public stockholders-breached their fiduciary duties by withholding material information in the proxy statement concerning the Firm and the proposed de-SPAC transaction. Plaintiffs allege that the fiduciary defendants failed to disclose that the Firm's largest customer-which accounted for 35% of its revenues-was building an in-house platform that would compete with the Firm and cause it to move its key accounts away from the Firm. Shortly after the merger closed, an equity research firm issued a report about the Firm that discussed, among other things, the customer's creation of a competing platform and allegedly caused the Firm's stock price to drop by over 40%. Plaintiffs also allege that the SPAC's financial advisor-a wholly owned subsidiary of the SPAC sponsor-aided and abetted the fiduciary defendants' breaches.
The Decision
In moving to dismiss the complaint, the defendants argued principally that (1) the plaintiffs alleged derivative (not direct) claims but failed to plead demand futility and (2) the claims are barred by Delaware's business judgment rule.
With respect to the first issue, the defendants argued that the plaintiffs alleged a duty of loyalty claim arising from defendants' alleged overpayment for the Firm that should be viewed as "exclusively derivative" under Tooley v. Donaldson, Lufkin & Jenrette, Inc., 845 A.2d 1031 (Del. 2004). The court rejected this argument, holding that the allegations do not amount to a "typical overpayment or dilution case." Rather, the complaint centers on the impairment to the public stockholders' informed exercise of their redemption right-a right exclusive to the public stockholders. The harm suffered by the stockholders as a result of the defendants' "purposefully and materially misleading disclosures" was thus "independent of and not shared with Churchill." Moreover, the court found that the public shareholders, rather than the company, would receive the benefit of the recovery sought, which is based on the stockholders' lost redemption right of a guaranteed $10 per share.
With respect to the second issue, the court concluded that the business judgment rule should not apply. Instead, it found that "entire fairness," which is Delaware's "most onerous standard of review," applies. As the entire fairness standard requires intensive factual inquiries into both the economics of the transaction (the fair price test) and the process leading to the transaction (the fair dealing test), motions to dismiss fiduciary duty claims where the standard is found to apply are rarely granted.
In support of its application of the entire fairness doctrine, the court first ruled that plaintiffs adequately alleged a "conflicted controller" transaction based on the "unique benefit" that the SPAC sponsor would receive from consummation of the transaction with the Firm. Specifically, the shares and warrants held by the sponsor would be worthless if Churchill did not complete a deal. As of the closing date, the sponsor's warrants were worth roughly $51 million and its founder shares were worth approximately $305 million, representing an immense gain on the sponsor's mere $25,000 investment. The SPAC's public stockholders, on the other hand, would have received $10 per share-which was the price of the IPO-if they had chosen to redeem or if Churchill had failed to consummate a merger and therefore liquidated; instead, those that did not redeem received shares in the combined public company, which dropped significantly in value following the transaction. As with the sponsor, the director defendants would similarly benefit from virtually any merger that would "convert their otherwise valueless interests in Class B shares into [public] shares." Second, the court found that plaintiffs adequately alleged that a majority of the board lacked independence given that all of the directors were appointed by the controlling stockholder to the Churchill board, as well as to the board of other SPACs sponsored by the same individual.
Finding that the entire fairness standard applied, the court denied the motion to dismiss the claims against the fiduciary defendants.
In addition, the court also upheld the aiding and abetting claim against the SPAC's financial advisor, which, according to plaintiffs, "knew that [the valuation analyses] were materially misleading." Critical to the court's analysis was the fact that the financial advisor was not an independent third party, but rather an entity controlled by Churchill's controlling stockholder that plaintiffs allege was engaged simply to provide a "patina of financial analysis."
Takeaways
Endnotes
[1] A copy of the Chancery Court's decision can be found here.
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