Delaware Court Holds that SPAC Sponsor’s “Founder Shares” Created a Conflict of Interest with Public Stockholders
In 2021, there were 613 initial public offerings (“IPOs”) of Special Purpose Acquisition Companies (“SPACs”), after 248 SPACs went public in 2020 and 59 in 2019. Prior to 2021, there had not been more than 500 IPOs of any kind in one year in the U.S. markets since the 1990s. The SPAC explosion has led, inevitably, to litigation; often similar to the squabbles over disclosures, contracts, and failed negotiations that are standard in litigation surrounding IPOs and mergers. However, in a ruling in January, a Delaware Court of Chancery judge cast doubt on whether decisions by SPAC boards of directors to merge with private companies are entitled to the deference of the business judgment rule, which shields directors from liability for their decisions gone wrong.
As detailed below, the court in In re MultiPlan Corp. Stockholders Litig., 2022 Del. Ch. LEXIS 1 (Del. Ch. Jan. 3, 2022), held that a well-pleaded complaint alleging breach of fiduciary duty against the directors of a SPAC was entitled to the “onerous” entire fairness standard of review because of conflicts inherent in the SPAC structure. In reaching its holding, the court found that the controlling shareholder and directors were conflicted because they had interests in the “founder shares,” which are typically 20% of the SPAC’s shares given to the sponsor of the SPAC for a nominal price. The founder shares created a conflict, according to the court, because they stood to become very valuable upon any merger, even a value-decreasing merger that significantly reduced the stock price for public investors. Thus, plaintiffs’ allegations that the SPAC’s controlling stockholder and directors disloyally failed to disclose information that was material to public stockholders’ decision whether to redeem shares before the merger were sufficient to survive a motion to dismiss.
The court’s decision is significant because the standard of review applied in securities litigation often determines whether a nascent suit is dismissed or can proceed to costly and time-consuming discovery. The court made clear that its reasoning for applying the stricter standard was generally applicable to SPACs facing lawsuits that allege concrete breaches of fiduciary duty from before the SPAC merged with a private company. The increased litigation costs will not just be borne by wrongdoers but will affect the industry as a whole, as companies brought public through SPACs will face more lawsuits and higher director and officer liability insurance premiums.
The SPAC Route to Taking a Company Public
A SPAC is an investment vehicle that holds investor money but does not operate a business; it is a blank check company often created to bring a private company or companies public. SPACs are founded by “sponsors,” people or entities set up by people, hedge funds, or private equity groups that pick or serve on the SPAC’s board of directors and bring a SPAC public through an IPO to raise money. The SPAC is required to hold the money it raises from public investors in a trust account while it searches for a private company or “target company” to bring public. After the SPAC identifies and reaches agreement with a private company, the private company then becomes a public company through merging with the public SPAC, thereby gaining use of the SPAC’s capital.
In exchange for bringing the SPAC public and searching for a merger target, the sponsors typically receive the aforementioned founder shares as well as private placement warrants. Public investors in the SPAC IPO generally can purchase one share of stock and a fractional public warrant share for $10. Public investors are also afforded two rights prior to the SPAC merging with a private company: (1) to redeem their shares for $10 plus interest after the merger with the target company is announced and (2) to vote on the merger. The parties may introduce extra capital before the merger called a “Private Investment in Public Equity” or “PIPE,” sometimes to replace the capital expected to be redeemed by public investors. The merger agreements typically assign various percentages of the merged company stock to the sponsors, the private company’s shareholders, the SPAC’s public shareholders, and any PIPE investors.
The SPAC and its sponsors have a time limit in which to find and merge with a private company, commonly two years with the possibility to extend by six months if merger talks are underway. If the SPAC runs out of time without achieving a merger, it is liquidated and the public investor money is returned with interest. If a SPAC is liquidated, the founder shares and all warrants are rendered worthless.
Criticisms of the SPAC Structure
The purported advantages of SPACs over IPOs for target companies include a shorter time than an IPO from when the merger agreement is finalized to public company status, as well as the ability to take earlier stage companies public and give them access to public capital. More cynically, in an academic paper by Michael Klausner, Michael Ohlrogge, and Emily Ruan, they found that, while the costs of going public through a SPAC are higher, these costs are born by the public investors in a SPAC and not by the target companies. The authors explained that public investors purchase SPACs typically for $10 a share but the value of that share, as represented by the cash held by the SPAC per outstanding share, is diluted by the following: the provision of founder shares and warrants, the payment of costs and consulting fees, and pre-merger redemptions. The authors found that the target companies in their study negotiated merger agreements to give up the portion of the company equal to the value of the cash remaining in the SPACs after accounting for this dilution, and thus public shareholders received that diluted value, in effect paying for the costs leading to the merger.
The authors also summarized a popular critique of SPACs, that providing the sponsors with founder shares creates conflicts between the founders and public investors:
First, it provides strong incentives for sponsors to form SPACs. So long as a SPAC merges, the sponsor will do very well even if the SPAC shareholders do poorly. Second, once it has formed a SPAC, the sponsor has a strong incentive to merge, even in a deal that will be a losing proposition for shareholders. Third, when sponsors propose a merger to SPAC shareholders, they have an incentive to paint a rosy picture of the post-merger company in order to enhance the SPAC’s premerger share price and thereby minimize redemptions.
Similarly, in a May 2021 investor alert on SPACs, the SEC’s Office of Investor Education and Advocacy warned that the interests of sponsors may be misaligned with public investors as “sponsors generally purchase equity in the SPAC at more favorable terms . . . . will benefit more than investors from [a merger] and may have an incentive to complete a transaction on term that may be less favorable to [public investors].”
Delaware Court Decision
Plaintiff’s lawyers suing post-SPAC merger companies have started to leverage the above criticisms of SPACs. In January, for the first time in this new wave of SPACs, a court ruled that the conflicts inherent between SPAC fiduciaries and public investors required application of the entire fairness standard of review of the SPAC directors’ actions, rather than the more deferential application of the business judgment rule. See In re MultiPlan Corp. Stockholders Litig., 2022 Del. Ch. LEXIS 1 (Del. Ch. Jan. 3, 2022). This ruling could be a significant development for SPACs directors facing breach of fiduciary duty claims, as the business judgment rule is a deferential presumption applied by courts, respecting the good faith business judgments of disinterested and independent directors who acted on an informed basis and with the belief that the action was in the best interest of the corporation. Id. at 35-36. On the other hand, in certain situations without an ideal board, such as a majority of the board is interested or controlled, the court may review the entire fairness of the judgment, requiring defendants to demonstrate that the business decision in question had both a fair process and a fair price. Id. at 49. The court’s ruling suggests that the SPAC structure inherently creates the conflicts necessary to allow courts to second guess the judgment of the SPAC directors under the entire fairness standard.
In MultiPlan, public shareholder plaintiffs alleged that the directors and officers of a SPAC, Churchill Capital Corp. III (“Churchill”), withheld material information that the target company, MultiPlan, was at risk of losing its largest customer. Id. at 3-4. Churchill was sponsored and allegedly controlled by serial SPAC sponsor Michael Klein through a sponsor entity. Id. at 4, 6. Klein’s sponsor entity received 20% of the SPACs shares as compensation in exchange for $25,000 and it also purchased 23 million private placement warrants. Id. at 7-8. Churchill sold to public investors in its IPO 110 million shares for $10 each. Id. at 7. Each public share also came with a quarter of a warrant. Id.
Klein allegedly had exclusive power to appoint Churchill’s board of directors, appointing himself chairman of the board and also to serve as CEO. Id. at 8-9. The remaining directors were compensated with shares of the sponsor entity of which Klein was the majority shareholder, effectively giving the directors ownership over a portion of the founder shares and private placement warrants. Id. at 9. When the board approved the merger with MultiPlan, it also hired The Klein Group, owned by an entity of which Klein is managing partner, to be a financial advisor, paying it $30.5 million for its services. Id. at 12. Facilitating the merger, PIPE investors agreed to purchase $1.3 billion in equity and warrants and provide $1.3 billion in convertible debt. Id at 13.
Churchill issued a proxy statement describing the deal, the “extensive due diligence” conducted, and also disclosing that 35% of MultiPlan’s revenues came from one customer. Id. at 14 It did not disclose that this customer was creating an in-house competitor to MultiPlan’s services. Id. at 15. The proxy was not accompanied by an independent third-party valuation or fairness opinion; rather, the financial analysis was prepared by Churchill management with assistance from The Klein Group. Id.
When redemption requests and the public vote on the merger were due, Churchill’s stock had risen above $11 per share. Id. at 15-16. Fewer than 10% of public investors redeemed their shares at the set price of $10.04 per share, and the stockholders voted to approve the merger. Id. at 16. A month later, short seller Muddy Waters Research published a report about MultiPlan, including that its largest customer was developing an in-house alternative. Id. The stock of the combined public company called MultiPlan fell to $6.27 per share. Id.
Plaintiffs sued the combined company MultiPlan, as well as Churchill’s directors and officers, and the sponsor entity, alleging breach of fiduciary duty, and The Klein Group, alleging an aiding and abetting claim. Id. at 16-17. In denying a motion to dismiss, the court found that, reading the pleadings in the light most favorable to the plaintiffs, “the crux of the plaintiffs’ claims is that the defendants’ actions—principally in the form of misstatements and omissions—impaired Churchill public stockholders’ their redemption rights to the defendants’ benefit.” Id. at 21.
The court made several important rulings that could apply to SPACs at large. As a threshold matter, the defendants argued that plaintiffs’ claims, although styled as direct claims were actually derivative claims and must be dismissed for not complying with the proper procedures for bringing such claims. Id. at 22. Under Delaware’s Tooley test, to establish a direct injury, the stockholder’s claim must be independent of any injury to the corporation. Id. at 23. The court held that the alleged impairment of the stockholders’ redemption rights was independent from any injury to the corporation, as Churchill had no redemption rights or claim to the funds it held in trust until after the redemption deadline. Id. at 24.
The Tooley test also requires a recovery that flows directly to the stockholders, rather than to the corporation. Id. at 26 The court held that, unlike in an overpayment case where the corporation would seek from the directors damages to make up the difference between the value paid for an asset and its actual value, here the stockholders redemption rate was set at $10.04 and independent of any injury to the company in the inflated valuation of MultiPlan. Id. at 28-29. Thus, the court held that the redemption process common in SPACs, if impaired, could support direct claims by shareholders, and denied the motion to dismiss as to this threshold question.
On the merits, the court held that the plaintiffs are entitled to review under the less deferential entire fairness standard for two independent reasons: (1) the merger, including the opportunity to redeem, was a conflicted controller transaction, and (2) the majority of the Churchill board was conflicted. Id. at 36. As relevant, a conflicted controller transaction can trigger entire fairness review where a controlling stockholder, which the parties agreed was Klein, “competes with the common stockholders for consideration.” Id. at 37. Entire fairness review may also be appropriate where allegations establish a reasonable inference that a majority of board members are not disinterested or acting in good faith; here, plaintiffs alleged the board members were either self-interested or not independent from Klein. Id. at 43.
The court found that Klein, as controlling stockholder, received a unique benefit if shareholders did not redeem and voted for the merger: his shares and warrants would be worthless if the merger did not go through but would convert to standard shares worth hundreds of millions if it did. Id. at 38-39. Thus, Klein stood to benefit even if the merger decreased the share price well below $10.04, as long as it was materially more than zero. Id. The court held that Klein effectively competed with the public stockholders because their decision not to redeem was beneficial to him but harmful to the stockholders who were giving up $10.04 for an ultimately less valuable share of the post-merger MultiPlan. Id. at 39-40. This competition incentivized Klein to discourage redemptions if he expected the merger to decrease the value of the stock. Id. The court also found that a lock up of a portion of Klein’s shares, that the merger happened with 19 months remaining to find a target company, and that the prospectus disclosed Klein’s incentives were of no matter; the non-locked up shares were still valuable below the redemption price, the misaligned incentives were not time dependent (a bad deal to investors was a good deal to Klein at any point in time), and the prospectus did not disclose that Klein would withhold from stockholders information material to their redemption decision. Id. at 40-42.
Importantly, the court shot down the defendants’ argument that the distribution of founder shares is not unique to this transaction, but rather is common to SPAC mergers: “That this structure has been utilized by other SPACs does not cure it of conflicts. Nor does the technical legality of the [SPAC merger] mechanics.” Id. at 42-43. Thus the court made explicit that it understood its decision could be applied in similar SPAC-related litigation. The court, however, noted the importance of plaintiffs’ specific allegations that the director defendants disloyally failed to disclose information necessary to plaintiffs’ decision to exercise their redemption rights, rather than a hypothetical claim resting solely on the conflicts inherent in the SPAC structure. Id. at 50.
The court also held that the rest of the board was self-interested for the same reasons that Klein was conflicted: through their shares in the sponsor entity, they each stood to benefit from a bad deal and get nothing if there were no deal. Id. at 43-46. The court also found the rest of the board lacked independence from Klein because: he appointed and had unilateral right to remove them, several were appointed to the boards of at least five other SPACs sponsored by Klein and conceivably would be appointed to more, one was Klein’s brother, and another was his employee. Id. at 46-48.
The court noted that when entire fairness review applies, it is rare that a complaint will not survive a motion to dismiss. Id. at 49-50. The court denied the motions to dismiss as to Klein, the rest of the directors, and The Klein Group. Id. at 48-57.
Here are the key takeaways from the court’s decision in In re MultiPlan Corp. Stockholders Litig.:
- This decision lays out a roadmap for breach of fiduciary suits against SPAC directors, which, as defendants argued, relies on a structural feature common to SPACs for the conflict that triggers entire fairness review: the provision to the sponsor of founder shares at a nominal price.
- The court found that the conflict arose because the controlling stockholder, and alternatively the entire board, received founder shares that were worthless with no merger but valuable even in a value-decreasing merger. The directors also lacked independence from the controlling stockholder, as they sat on numerous boards that he controlled, worked for him, or were related to him.
- The court also found that the public stockholder ability to redeem shares, which is common to SPACs, allows for litigation over breaches of fiduciary duty from prior to the redemption decision to proceed as direct, rather than derivative, claims.
- The court stressed that the suit survived the motion to dismiss, not simply because of the inherent conflicts of a SPAC, but because the plaintiffs alleged concrete claims that the defendants disloyally failed to disclose material information before the public stockholders had to decide whether to redeem their shares.
- It is important to note that this is one court’s decision in this still developing area of law. Further this decision applies Delaware law, which will not be applicable to all SPACs, although many courts look to Delaware for guidance on topics of securities and corporate law.
- That said, this decision may encourage more SPAC litigation, especially in Delaware, and suggests that more claims may survive to discovery. The expected rise in litigation costs could impact director and officer liability premiums for all SPACs.
 “Under the business judgment rule, the judgment of a properly functioning board will not be second-guessed and absent an abuse of discretion, that judgment will be respected by the courts.” In re KKR Fin. Holdings LLC S'holder Litig., 101 A.3d 980, 989 (Del. Ch. 2014) aff’d Corwin v. KKR Fin. Holdings LLC, 125 A.3d 304, 305 (Del. 2015) (quotations and alterations adopted).
 The warrants often have a strike price of $11.50. Private placement warrants provided to the sponsor often lack restrictions of public warrants, such as forced redemption when the stock price hits $18.
 In April 2021, then-Acting Director of the SEC’s Division of Corporation Finance John Coates released a statement calling into question one supposed reason a SPAC was preferable to an IPO for earlier stage companies: that they were entitled to protection under the PSLRA safe harbor for forward-looking statements. He argued that SPAC mergers with private companies should not be treated differently than IPOs, which are not covered by the safe harbor. https://www.sec.gov/news/public-statement/spacs-ipos-liability-risk-under-securities-laws.
 Michael D. Klausner, et al., A Sober Look at SPACs, Yale Journal on Regulation, Forthcoming, at 7 (December 20, 2021), available at SSRN: https://ssrn.com/abstract=3720919https://corpgov.law.harvard.edu/2022/01/24/a-second-look-at-spacs-is-this-time-different/
 Id. at 6.
 Id. at 7.
 Id. at 8.
 “To obtain review under the entire fairness test, the stockholder plaintiff must prove that there were not enough independent and disinterested individuals among the directors making the challenged decision to comprise a board majority.” In re Trados Inc. S’holder Litig., 73 A.3d 17, 44 (Del. Ch. 2013).
 See Tooley v. Donaldson, Lufkin, & Jenrette, Inc., 845 A.2d 1031, 1033 (Del. 2004).