The surge in SPAC litigation shows no signs of stopping. Fenwick’s SPAC litigation resource guide provides a snapshot of notable developments in this space, and our Securities Litigation team is here to help.
The past two years have seen the meteoric rise of the use of the special purpose acquisition company (SPAC) as an alternative vehicle to traditional initial public offerings. In 2021 alone, nearly 500 companies were taken public through business combinations with SPACs, up from more than 200 in 2020, and less than 60 in 2019. While this slowed in the second half of 2021—and many believe that 2022 will see a significant decline in the use of SPACs as a means for going public—SPAC-related litigation is likely to increase as disputes arise from less-than-ideal circumstances.
The unique nature of SPACs and the parties involved in these transactions have permitted plaintiffs and their attorneys to pursue more creative lawsuits that are not easily dismissed. While many SPAC actions are still in their infancy, the recent influx of litigation has crystalized the potential risks that accompany SPAC transactions. With this insight into the framing of SPAC-related lawsuits, those considering a business combination with a SPAC can better understand the types of lawsuits and claims that might be asserted against them.
Although SPAC activity may diminish in 2022, litigation related to SPACs is not going away anytime soon, especially as key decisions are rendered in these cases. The Securities Litigation team at Fenwick will continue to update this guide with significant developments, can provide guidance at all stages of the SPAC process, and litigate matters as necessary.
A SPAC is a shell company with no commercial operations that is formed to raise capital in an IPO solely in anticipation of identifying and acquiring an existing private company within a set period of time, commonly 24 months. The business combination between the private company and the SPAC (often referred to as the de-SPAC transaction) typically results in the private company being acquired by the SPAC and thereby becoming a public reporting company with publicly traded shares. If the SPAC does not find a target to acquire within the allotted time period, the SPAC must liquidate.
SPACs are often formed and controlled by an individual, management group or financial institution, in each case referred to as a SPAC sponsor. Sponsors receive founder shares in return for a small capital contribution and their investment of time and expertise, which are typically structured to represent 20% of the SPAC’s outstanding shares following the IPO. After formation, the SPAC raises capital through its IPO from public investors and deposits the IPO proceeds in a trust account. The public investors typically receive both shares and warrants to purchase shares in the future. In addition, in connection with the IPO closing, the sponsor purchases warrants to fund the SPAC’s start-up costs, IPO underwriter commissions and working capital.
Following the IPO, the SPAC searches for a company to acquire and, once it identifies and enters into a business combination agreement with a target, the SPAC publicly announces a de-SPAC transaction. The SPAC will then typically hold a special stockholder meeting to approve the de-SPAC transaction and, in connection with that meeting, file a proxy statement and related registration statement on Form S-4 that describes the terms of the transaction and provides detailed information regarding the target company.
In addition, public investors have the right to redeem their shares at the closing of the de-SPAC transaction or can decide to keep their investment in the post-business combination company. Redemptions are funded with the cash in the trust account, and any remaining proceeds are distributed to the post-business combination company.
Many have observed that this structure creates an inherent conflict between SPAC sponsors and public investors. Sponsors only realize financial benefit if the SPAC completes a de-SPAC transaction and will typically receive nothing if the SPAC is liquidated. Thus, some argue that sponsors are potentially incentivized to complete a transaction within the allotted time period, even if that acquisition does not ultimately create value for a SPAC’s public investors.
Securities Class Actions
The vast majority of SPAC-related cases are securities class actions. Plaintiff shareholders often bring familiar claims under Sections 10(b), 14(a) and 20(a) of the Securities Exchange Act of 1934 alleging false and misleading statements in the SPAC proxy statement/prospectus, offering documents or other public statements. Claims under Sections 11 and 12 of the Securities Act of 1933 have been less common.
The structure and nature of SPACs make them particularly good targets for securities class actions. SPACs are often the chosen vehicle to take less mature companies public and often involve companies focusing on new technologies in unproven markets. These companies must frequently use projections to market their transactions.
Those facts—coupled with the limited period for SPACs to find a target, the inclusion of the target company’s projections in the SPAC’s public SEC filings and the fact that the SPAC process generally involves less diligence than a traditional IPO—can lead to situations ripe for securities class actions.
Some common themes in allegations relate to the viability of technology, market readiness and underperformance related to sales projections or production timelines. For example:
- In Welch v. Meaux, plaintiffs brought securities fraud claims against Waitr, a food delivery startup taken public through a de-SPAC transaction, certain directors and officers of Waitr and the SPAC, and the financial adviser for the de-SPAC transaction, alleging false and misleading statements regarding Waitr’s ability to maintain its low-cost restaurant fees and technological advantage over competitors in new markets, among other things. Plaintiffs alleged that Waitr was identified as a target close to the SPAC deadline and was rushed to market through a de-SPAC transaction before it was IPO-ready.
- In In re Lordstown Motors Corp. Sec. Litig., plaintiffs brought claims against electric truck manufacturer Lordstown, the SPAC and certain of those entities’ directors and officers. Plaintiffs alleged false and misleading statements by the defendants about Lordstown’s ability to commence production of its flagship vehicle on time, the amount of and legitimacy of pre-orders touted by the company and demand for the vehicle.
- In Lavin v. Virgin Galactic, plaintiffs brought securities fraud claims against space travel company Virgin Galactic, its controlling shareholder and certain of its directors and officers (including the chairman of its board who was previously the chairman of the SPAC’s board), alleging false and misleading statements regarding the viability and safety of Virgin Galactic’s space flight technology. In particular, the action focused on the interests held by the SPAC’s chairman in consummating the deal with Virgin Galactic as the deadline to acquire a target loomed. The SPAC chairman had laid the groundwork for multiple other SPACs. Plaintiffs alleged that a failure to complete this deal with Virgin Galactic and the subsequent reputational hit caused by that failure would have had far-reaching consequences on his other SPACs.
- In Cieko v. PureCycle Technologies, plaintiffs brought securities fraud claims against recycling technology company PureCycle Technologies, certain of its directors and officers and the chairman and CEO of the SPAC, alleging false and misleading statements regarding the viability of the technology underlying PureCycle’s process for restoring waste polypropylene into virgin resin, the availability of raw materials necessary for this process, and its financial projections.
Plaintiffs also exploit other issues unique to SPACs when bringing securities class actions, including:
Lack of clarity around the applicability of the PSLRA safe harbor for forward-looking statements. As a part of the de-SPAC process, SPACs often include financial projections for the post de-SPAC entity in the proxy statement and S-4 registration statement filed with the SEC in connection with the de-SPAC transaction. Because projections provide investors visibility into the target’s future financial growth, they may be especially attractive to companies that will not be profitable for a few years. Although the Private Securities Litigation Reform Act (the PSLRA) safe harbor protection for forward-looking statements technically applies to forward-looking statements made in de-SPAC transactions, recent commentary from the SEC calls that protection into question:
“If we do not treat the de-SPAC transaction as the ‘real IPO,’ our attention may be focused on the wrong place, and potentially problematic forward-looking information may be disseminated without appropriate safeguards.”
Plaintiffs have seized on the SEC’s commentary in a number of cases (including the cases involving Waitr and Lordstown discussed earlier in the guide) to suggest that the safe harbor should not apply to forward-looking statements made in the context of de-SPAC transactions. Courts have not yet weighed in on this issue; although, decisions are pending.
Legislators have also taken action to amend the PLSRA. In November 2021, H.R.5910 was introduced in the U.S. House of Representatives. If passed, the bill would exclude SPACs from the PSLRA safe harbor.
Failure to conduct adequate due diligence. Due to the incentive to complete a de-SPAC transaction within a set time period, SPACs have often conducted significantly less due diligence on the target company as compared to due diligence conducted in traditional public offerings or business combination transactions. This leaves SPAC sponsors, officers, directors and advisers open to claims that they failed to perform appropriate due diligence on the target company.
In Jedrzejczyk v. Skillz, plaintiffs alleged, among other claims, that certain financial advisers in the de-SPAC transaction relating to gaming company Skillz were partly liable for the SPAC’s misrepresentations regarding user base and expansion plans into India due to their failure to conduct adequate due diligence. Despite their access to confidential corporate information, the financial adviser defendants had allegedly failed to discover or disclose the ongoing issues with Skillz.
Similar failures in due diligence were alleged in In re Stable Road Acquisition Corp. Sec. Litig. against the SPAC that merged with Momentus, a commercial space flight company. Specifically, plaintiffs alleged that the SPAC and certain of its officers and directors failed to appropriately investigate national security concerns associated with the company’s then-CEO and issues with the company’s technology.
More categories of defendants to sue. Another unique feature of the SPAC—and one that makes it particularly appealing to plaintiffs—is the wide range of potential defendants involved in the de-SPAC transaction: the SPAC, SPAC sponsors, SPAC management and directors, the financial advisers and the target company and its officers and directors. Importantly for plaintiffs, this cast of characters means multiple sources for damages. On a related note, it is often the case that both the SPAC and target company have purchased directors’ and officers’ liability insurance to cover litigation risks. This makes SPAC-related lawsuits more attractive for plaintiffs’ lawyers.
Many of the same plaintiffs’ firms that routinely file actions to enjoin M&A litigation in the non-SPAC context have filed similar suits to enjoin de-SPAC transactions. These cases allege that proxies are materially misleading or contain material omissions. Much like non-SPAC M&A litigation, these suits are usually resolved through the filing of supplemental disclosures and payment of a mootness fee to plaintiffs in connection with a voluntary dismissal of the action.
For example, in Wheby v. Greenland Acquisition Corporation, plaintiffs brought an action seeking to enjoin the de-SPAC transaction between the SPAC, Greenland Acquisition Corp., and its target, Zongchai Holding, alleging that the proxy statement seeking stockholder approval for the de-SPAC transaction omitted material information such as line items used to calculate EBIT and EBITDA, a reconciliation of all non-GAAP to GAAP metrics of the target, certain financial projections and details relating to other potential acquisition targets, consultants and financial advisers to the transaction. Shortly after the SPAC’s filing of supplemental disclosures to remedy certain of these alleged deficiencies, the case was voluntarily dismissed.
Fiduciary Duty Claims
Plaintiffs have also brought claims for breach of fiduciary duty against SPAC sponsors, directors and other SPAC-related parties in state court. The Delaware Court of Chancery’s long-awaited decision in In re Multiplan Corp. Stockholders Litig. rendered in January 2022—applying the onerous entire fairness standard to such claims—will likely further embolden plaintiffs to bring such claims.
There, the SPAC at issue—Churchill Capital Corp. III—took Multiplan, a healthcare data analytics and cost management solutions provider, public via a de-SPAC transaction. Following the de-SPAC transaction, Multiplan’s stock price plummeted when it came to light that its largest customer was building an in-house system to replace Multiplan, a fact not revealed in the de-SPAC proxy statement. Plaintiffs alleged that defendants (certain of the SPAC directors, officers, and sponsor) had breached their fiduciary duty by omitting this material information from the proxy statement thereby impairing plaintiffs’ rights to redeem their stock at the time of the de-SPAC transaction, and that the financial adviser to the transaction aided and abetted in such breach.
On motion to dismiss, defendants argued that the less stringent business judgment rule should apply to plaintiffs’ claims. The court disagreed and held that the entire fairness standard applied, finding “inherent conflicts between the SPAC’s fiduciaries and public stockholders in the context of a value-decreasing transaction.”
First, the court found that it was reasonably conceivable that the de-SPAC transaction was a conflicted controller transaction because Michael Klein—who controlled the SPAC through the sponsor entity—would receive a windfall on his investment if the de-SPAC transaction closed, but nothing if the SPAC failed to acquire a target thereby incentivizing him to close a bad deal versus no deal. Second, the court found that because the SPAC directors approving the de-SPAC transaction had economic interests in the sponsor, they too were conflicted. Moreover, the board lacked independence from Klein given that many of them sat on boards of other SPACs Klein controlled. Accordingly, the court found that the entire fairness standard should apply to its review of the de-SPAC transaction.
It is nearly impossible for a complaint to be dismissed at the pleading stage on a motion to dismiss where the entire fairness test applies. Practically speaking, this means that such cases will proceed to a decision on the merits regarding factual questions of substantive and procedural fairness, which can be protracted, expensive and provide significant leverage to plaintiffs in settlement discussions.
Given the Delaware Court of Chancery’s application of the plaintiff-friendly entire fairness standard in the Multiplan action, similar fiduciary duty cases (as well as precursor Section 220 cases) will likely follow in the decision’s wake. For example, a recent Section 220 action brought against View refers to the Multiplan decision in seeking inspection of books and records to investigate whether allegedly conflicted SPAC sponsors and directors breached their fiduciary duties in negotiating, endorsing and proposing the de-SPAC transaction with View, including whether they conducted a reasonable investigation of View’s financial and operational prospects and whether they disclosed all material information to the SPAC’s public stockholders in connection with their decision as to whether to exercise their redemption rights.
Cases Alleging Applicability of the Investment Company Act and Investment Advisers Act to SPACs and Their Sponsors
A unique breed of cases for SPACs is the ongoing attempt to classify SPACs as investment companies and certain individuals as investment advisers, and thus subject to regulation under the Investment Company Act of 1940 (the ICA) and Investment Advisers Act of 1940 (the IAA).
The first SPAC targeted under this theory was Pershing Square Tontine Holdings, which planned to take Universal Media Group public, a deal that ultimately fell through. In addition to the original case (Assad v. Pershing Square Tontine Holdings), two other cases were also filed by the same plaintiffs: Assad v. E.merge and Assad v. Go Acquisition. In summary, the three cases assert that: (1) SPACs are unregistered investment companies; (2) thus, per the ICA, they may not issue shares of common stock for less than their net asset value; and (3) accordingly, the contracts which compensate a SPAC’s sponsors and directors are illegal. Relatedly, managing individual members of a sponsor, or the SPAC itself, are investment advisers per the IAA, voiding other agreements as well.
In response to these actions, more than 60 law firms (including Fenwick) issued a statement in opposition to this theory, citing the plain text of the statutes and the fact that, to date, more than 1,000 SPACs have proceeded without any application of these laws. Plaintiff’s position is not without its support, however. John Coates, current Harvard Law School professor and former acting director for the Division of Corporate Finance at the SEC, recently opined that SPACs may plausibly be categorized as investment companies because nothing in the ICA nor relevant SEC rules exempts SPACs, which in their first phase function like mutual funds. Motions to dismiss remain pending in all three of these cases, however, and it is far from certain where courts will land on this issue.