On January 3, 2022, the Delaware Court of Chancery denied a motion to dismiss a shareholder lawsuit against a SPAC’s sponsor, its directors, and financial advisor claiming among items, breach of fiduciary duty. The facts supporting the claim mirror common factual scenarios in SPAC and de-SPAC (acquisition transaction) transactions where the post SPAC public company has a decline in stock value. As such, the case is being closely watched by SPAC sponsors and boards of directors.
Background on SPACs
A special purpose acquisition company (SPAC) is a blank check company formed for the purpose of effecting a merger, share exchange, asset acquisition, or other business combination transaction with an unidentified target. Generally, SPACs are formed by sponsors who believe that their experience and reputation will facilitate a successful business combination and public company. SPACs are often sponsored by investment banks together with a leader in a particular industry (manufacturing, healthcare, consumer goods, etc.) with the specific intended purpose of effecting a transaction in that particular industry.
SPACs follow substantially the same structure. A sponsor receives founder shares for a fixed price of $25,000, which founder shares will typically represent 20% of the total issued and outstanding capital stock immediately following the closing of the SPAC IPO. The sponsor must also invest enough capital to cover the IPO costs, ongoing SPAC upkeep legal and accounting fees, and costs associated with the de-SPAC transaction (locating and conducting due diligence on a target and transaction costs associated with the merger), which is generally approximately 5% of the total IPO amount. This amount is referred to as the sponsor PIPE, and the terms of the sponsor PIPE is more favorable than the IPO terms. The sponsor PIPE may involve a different class of stock, warrants or a combination of both. Sponsor capital is at risk – sponsors do not make money unless a successful business combination is completed.
The common stock and warrant received by a sponsor are generally the same as those sold in the IPO with a few key differences. The sponsor common stock is not redeemable in a business combination transaction (i.e., it stays at risk) and agrees to vote in favor of any business combination approved by the board of directors. The sponsor common stock converts into regular common stock on a one-for-one basis upon completion of the business combination but is subject to a 12-month lock-up period thereafter (though the lock-up may be released upon achieving certain trading price milestones). Sponsor warrants usually are not callable and contain cashless exercise provisions.
A SPAC IPO is usually structured as one share of common stock and either a whole, half or quarter warrant for a unit price of $10.00. The unit may sometimes also contain an additional “right” (similar to a warrant). Whereas a warrant has an exercise price, a right is usually just exchanged for a new security. For example, a SPAC unit may include a right to receive 1/10th of a share of common stock upon completion of a business combination, and so holders of 10 rights could exchange those rights for a share of common stock. The exercise price for a warrant is almost always $11.50 with a call option by the company if the stock trades at $18.00 or higher for 20 out of 30 trading days. Warrants sometimes have a downward adjustment on exercise price for if the SPAC trades below $9.20.
A SPAC generally has 24 months to complete a business combination; however, it can get up to one extra year with shareholder approval. If a business combination is not completed within the set period of time, all money held in escrow goes back to the shareholders and the sponsors will lose their investment.
The value of the acquisition target is negotiated by the sponsor, the target and any investors that are putting in new money at the closing (the closing PIPE) and as a result, the valuation of a target entity may be higher in a SPAC transaction than an IPO. In a traditional IPO, neither the underwriter nor the IPO company relies on future growth projections and same are almost never included in a registration statement or as part of a road show. The reason is that the Securities Act imposes the stricter Section 11 liability standard on a company and its underwriters in an IPO process. Although a new Securities Act registration statement may be filed as part of the de-SPAC process, it is not a necessary component.
The Churchill SPAC
Churchill Capital Corp III (“Churchill”) was sponsored by dealmaker and former Citi executive Michael Klein. Churchill was the third in what is now seven SPACs sponsored by Klein, including one that brought Lucid Motors, Inc. public in February 2021. The Churchill SPAC was structured the same as most SPACs – units consisting of one share of Class A common stock and ¼ redeemable warrant sold for $10.00 per unit. The Klein led sponsor purchased approximately 23 million shares of Class B common stock for the nominal price of $25,000 and invested $23 million in a PIPE transaction purchasing warrants at $1.00 per warrant, upon the closing of the IPO. The IPO closed in February 2020 and raised $1.1 billion.
In July 2020 Churchill entered into a merger agreement with MultiPlan which valued MultiPlan at approximately $11 billion. Churchill hired the Klein Group, LLC, an entity controlled by Michael Klein as its financial advisor. The SPAC did not obtain an independent third-party valuation of MultiPlan or a fairness opinion. Following a special meeting of stockholders in which the deal was approved by a vast majority, the merger closed in October 2020. Less than 10% of the owners of redeemable Class A shares exercised their redemption rights.
Following the closing of the merger, a research report was issued reporting that MultiPlan’s largest customer was forming a competitor entity and as a result, MultiPlan’s stock dropped significantly. The proxy materials relating to the MultiPlan merger did not disclose this competitive issue or the potential loss of the company’s largest customer.
A shareholder class action followed, alleging among other items, that the SPAC structure itself created a conflict of interest between Class A and Class B shares and that the sponsors prioritized its interests over those of the stockholders (breach of fiduciary duty). The complaint also included a fraud allegation for failing to disclose pertinent facts in the proxy materials. The SEC has been ringing the bell with concerns of SPAC conflicts of interest and inadequate disclosures for a while now (see, for example, the SEC statements in March 2021 – HERE) and has included increased SPAC regulations on its two most recent regulatory agendas.
In denying the motion to dismiss, the Delaware Chancery Court found that the entire fairness standard of review is applicable. See below for a discussion on the standards of review, including the entire fairness standard. The Court found that Klein through the sponsor entity had a conflict of interest in that he would realize a unique gain on his investment (his initial $25,000 investment for Class B shares was worth $356 million on the closing date of the merger) which gain would be completely obviated if a deal had not closed in the time required. In contrast, Class A stockholders would have received $10.04 per share if the SPAC failed to consummate a transaction and liquidated, or if they had redeemed their shares. Thus, the court concluded that there was a “potential conflict between Klein [and the Sponsor] and public [Class A] stockholders resulting from their different incentives in a bad deal versus no deal at all.”
That is, the Class B stockholders were incentivized to support any deal, rather than no deal at all, even if the value post-merger turned out to be less valuable to the Class A stockholders than a liquidation. I note that this particular set of facts exists in every SPAC transaction.
Likewise, the court found that the individual board members were conflicted as they each owned Class B (Sponsor) equity. Moreover, the court found an additional conflict as each board member was handpicked by Klein and had served on other SPAC boards with Klein as the sponsor and had an anticipation of serving on future boards with Klein. Therefore, the board members were not independent of Klein. This particular set of facts may exist in many other SPACs but is not universal across the board.
In addition to the individual breach of fiduciary claims, the court also found that the plaintiff’s adequately pleaded that the proxy disclosures were false and misleading.
Board of Directors and Key Officers’ Fiduciary Duties in the Merger Process
State corporate law generally provides that the business and affairs of a corporation shall be managed under the direction of its board of directors. Members of the board of directors have a fiduciary relationship to the corporation, which requires that they act in the best interest of the corporation, as opposed to their own. Key executive officers have a similar duty. Generally, a court will not second-guess directors’ decisions as long as the executives have conducted an appropriate process in reaching its decisions. This is referred to as the “business judgment rule.” The business judgment rule creates a rebuttable presumption that “in making a business decision the directors of a corporation acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the company” (as quoted in multiple Delaware cases including Smith vs. Van Gorkom, 488 A.2d 858 (Del. 1985)).
However, in certain instances, such as in a merger and acquisition transaction, where a board or top executives may have a conflict of interest (i.e., get the most money for the corporation and its shareholders vs. getting the most for themselves via either cash, job security or as in Churchill a large up-side to the transaction closing), the board of directors’ and executives actions face a higher level of scrutiny. This is referred to as the “enhanced scrutiny business judgment rule” and stems from the Unocal and Revlon cases discussed below, both of which involved hostile takeovers.
A third standard, referred to as the “entire fairness standard,” is only triggered where there is a conflict of interest involving officers, directors and/or shareholders such as where directors are on both sides of the transaction or as in this case, where they will benefit from the transaction and lose economics without the transaction. Under the entire fairness standard, the executives must establish that the entire transaction is fair to the shareholders, including both the process and dealings and price and terms. The entire fairness standard is a difficult bar to reach and generally results in a finding in favor of complaining shareholders.
In all matters, directors’ and executive officers’ fiduciary duties to a corporation include honesty and good faith as well as the duty of care, duty of loyalty and a duty of disclosure. In short, the duty of care requires the director/officer to perform their duty with the same care a reasonable person would use, to further the best interest of the corporation and to exercise good faith, under the facts and circumstances. The duty of loyalty requires that there be no conflict between duty and self-interest. The duty of disclosure requires the director/officer to provide complete and materially accurate information to a corporation. Where a director’s duty is to the shareholders, an executive officer can have duties to both the board of directors and the shareholders.
As with many aspects of securities law, and the law in general, a director’s or officer’s responsibilities and obligations in the face of a merger or acquisition transaction depend on the facts and circumstances. From a high level, if a transaction is not material or only marginally material to the company, the level of involvement and scrutiny facing the board of directors or key executives is reduced and only the basic business judgment rule will apply. For instance, where a company’s growth strategy is acquisition-based, the board of directors may set out the strategy and parameters for potential target acquisitions but leave the completion of the acquisitions largely with the C-suite executives and officers who, in turn, will be able to exercise their business judgment in implementing the transactions.
Moreover, the director’s responsibilities must take into account whether they are on the buy or sell side of a transaction. When on the buy side, the considerations include getting the best price deal for the company and integration of products, services, staff, and processes. On the other hand, when on the sell side, the primary objective is maximizing the return to shareholders, though social interests and considerations (such as the loss of jobs) may also be considered in the process.
The law focuses on the process, steps and considerations made by the board of directors and executive officers, as opposed to the actual final decision. The greater the diligence and effort put into the process, the better, both for the company and its shareholders, and the protection of the directors and officers in the face of scrutiny. Courts will consider facts such as attendance at meetings; the number and frequency of meetings; knowledge of the subject matter; time spent deliberating; advice and counsel sought by third-party experts; third party valuation and fairness opinions, requests for information from management; and requests for and review of documents and contracts.
In the performance of their obligations and fiduciary responsibilities, a board of directors and executive officers may, and should, seek the advice and counsel of third parties, such as attorneys, investment bankers, and valuation experts. Moreover, it is generally good practice to obtain a third-party fairness opinion on a transaction. Most investment banking houses that do M&A work also provide fairness opinions on transactions. Furthermore, most firms will prepare a fairness opinion even if they are not otherwise engaged or involved in the transaction. In addition to adding a layer of protection to the board of directors and executives, the fairness opinion is utilized by the accountant and auditor in determining or supporting valuations in a transaction, especially where a related party is involved.
Delaware Case Law – Revlon Duties
As with all standards of corporate law, practitioners and state courts look to both Delaware statutes and court rulings to lead the way.
Stemming from Revlon, Inc. vs. MacAndrews & Forbes Holdings, Inc., 506 A.2d 173 (Del. 1986), once a board of directors has made the decision to sell or merge the company, it triggers additional duties and responsibilities, commonly referred to as the “Revlon Duties.” The Revlon Duties provide that once a board has made a decision to sell, it must consider all available alternatives and focus on obtaining the highest value and return for the shareholders. The Revlon case focuses on duties in a sale or breakup of a company rather than a forward growth acquisition. A board of directors in a Revlon situation is, in essence, acting as an auctioneer seeking the best return. However, although the premise of Revlon remains, later decisions take into account the reality that the highest return for shareholders is not strictly limited to dollars received.
Although most of the cases are sell side, the principles of director duties remain the same. In the case of Smith vs. Van Gorkom, 488 A.2d 858 (Del. 1985), the Court found that the board was grossly negligent where it approved the sale of the company after only a few hours of deliberation, failed to inform itself of the chairman’s role and benefits in the sale, and did not seek the advice of outside counsel. Similarly in Cede & Co. vs. Technicolor, Inc., 634 A.2d 345 (Del. 1993), the court found that the board was negligent in approving the sale of a company where it did not search for real alternatives, did not attempt to find a better offer, and had insufficient knowledge of the terms of the proposed merger agreement.
On the other hand, the court in In re CompuCom Sys., Inc. Shareholders Litigation, 2005 Del. Ch. LEXIS 145 (Del. Ch. Sept. 29, 2005), upheld the board of directors’ business judgment even though the transaction price per share was less than market value, as the board showed it was adequately informed, acted rationally and sought better deals.
In Family Dollar Stores, Inc. Stockholder Litigation, C.A. No. 9985-CB (Del. Ch. Dec. 19, 2014), the court continued to apply the Revlon Duties but supported Family Dollar Stores’ decision to reject Dollar General Corp.’s higher dollar offer in favor of seeking a shareholder vote on Dollar Tree, Inc.’s offer. The court found that the board properly considered all factors, including an evaluation of the relative antitrust risks of selling to either suitor. The court upheld the board’s process in determining maximum value for shareholders, and that such determination is not solely based on a price per share value.
Cleansing Through Shareholder Approval
In 2015 the Delaware Supreme Court case of Corwin v. KKR Financing Holdings held that a transaction that would be subject to enhanced scrutiny under Revlon would instead be reviewed under the deferential business judgment rule after it was approved by a majority of disinterested, fully informed and uncoerced stockholders. In addition to federal securities law requirements imposed on public companies, Delaware law requires disclosure of all material facts when stockholders are requested to vote on a merger. Corwin provides a strong incentive for companies to ensure full disclosure and as discussed below, based on the new case of In re Xura, Inc. Stockholder Litigation the failure to provide such disclosure may nullify the otherwise strong Corwin defense.
In the current Churchill SPAC case, the court found that the proxy disclosures were not adequate and as such, any Corwin defense was lost.
Following the Corwin decision, several Delaware courts enhanced the ruling, finding that the business judgment rule becomes irrebuttable if invoked as a result of a stockholder vote; Corwin is not limited to one-step mergers and thus also applies where a majority of shares tender into a two-step transaction; the ability of plaintiffs to pursue a “waste” claim is exceedingly difficult; even interested officers and directors can rely on the business judgment rule following Corwin doctrine stockholder approval; and if directors are protected under Corwin, aiding and abetting claims against their advisors will also be dismissed. In Churchill, the aiding and abetting claim against Klein’s advisory firm was held up.
Once the business judgment rule is invoked, a shareholder generally only has a claim for waste, which is a difficult claim to prove. Corwin makes it difficult for plaintiffs to pursue post-closing claims (including those that would have nuisance value) because defendants will frequently be able to dismiss the complaint at the pleading stage based on the stockholder vote. It is thought that Corwin will help reduce M&A-based litigation which has become increasingly abusive over the years and imposes costs on companies, its stockholders and the marketplace.
Although following Corwin a string of cases strengthened and expanded its doctrine, the recent (December 2018) case of In re Xura, Inc. Stockholder Litigation reminded the marketplace that in order for Corwin to provide its protections, the stockholder approval must be fully informed. In Xura the court found that the disclosures made by the CEO to the board of directors and shareholders and that ultimately were included in the company’s proxy statement were so deficient as to preclude a fully informed, uncoerced decision.
Conflicts of Interest – the Entire Fairness Standard
The duty of loyalty requires that there be no conflict between duty and self-interest. Basically, an officer or director may not act for a personal or non-corporate purpose, including to preserve the value of an investment. Where a transaction is not cleansed using the Corwin doctrine, where an officer or director is interested in a transaction, the entire fairness standard of review will apply. It is very difficult for an officer or director to defeat a claim where a transaction is being reviewed under the entire fairness standard.
Some states, including Delaware, statutorily codify the duty of loyalty, or at least the impact on certain transactions. Delaware’s General Corporations Law Section 144 provides that a contract or transaction in which a director has interest is not void or voidable if: (i) a director discloses any personal interest in a timely matter; (ii) a majority of the shareholders approve the transaction after being aware of the director’s involvement and all pertinent facts; or (iii) the transaction is entirely fair to the corporation and was approved by the disinterested board members.
The third element listed by the Delaware statute has become the crux of review by courts. That is, where an executive is interested, the transaction must be entirely fair to the corporation (not just the part dealing with the director). In determining whether a transaction is fair, courts consider both the process (i.e., fair dealing) and the price of the transaction. Moreover, courts look at all aspects of the transaction and the transaction as a whole in determining fairness, not just the portion or portions of the transaction involving a conflict with the executive. The entire fairness standard can be a difficult hurdle and is often used by minority shareholders to challenge a transaction where there is a potential breach of loyalty and where such minority shareholders do not think the transaction is fair to them or where controlling shareholders have received a premium.
To protect a transaction involving an interested executive, it is vital that all officers and directors take a very active role in the merger or acquisition transaction; that the interested executive inform both the directors or other directors, and ultimately the shareholders, of the conflict; that the transaction resemble an arm’s-length transaction; that it be entirely fair; and that negotiations be diligent and active and that the advice and counsel of independent third parties, including attorneys and accountants, be actively sought. In Churchill the court seems to believe that there are no disinterested directors and that all directors breached their duty of loyalty.
Delaware courts have emphasized that involvement by disinterested, independent directors increases the probability that a board’s decisions will receive the benefits of the business judgment rule and helps a board justify its action under the more stringent standards of review such as the entire fairness standard. Independence is determined by all the facts and circumstances; however, a director is definitely not independent where they have a personal financial interest in the decision or if they have domination or motive other than the merits of the transaction. The greater the degree of independence, the greater the protection. As mentioned, many companies obtain third-party fairness opinions as to the transaction