I. Introduction
Transactions that involve special purpose acquisition companies (SPACs) have risen at a meteoric rate in recent months, from $3 billion in 2020 to $166 billion in the first three months of 2021 alone.[1] With sponsors ranging from venture capital moguls like Chamath Palihapitiya to NBA legends like Shaquille O’Neal, all signs indicate that SPAC investment will continue to rise.
Despite their increasing popularity, SPAC investments have generated extensive criticism. New York Times columnist Andrew Ross Sorkin, co-creator of the television show Billions, has spoken out about what he perceives as starkly misaligned incentives between SPAC sponsors and SPAC investors.[2] In February of this year, the Harvard Business Review prognosticated that the “SPAC Bubble is About to Burst.”[3] And in the clearest expression of an oncoming deluge of governmental enforcement actions, the SEC’s acting director for the Division of Corporate Finance wrote an extensive public statement concerning the liability risks for SPACs and their sponsors under securities laws.[4]
Given the fervent pitch of public investment on the one hand, and the rising tide of criticism and regulatory saber-rattling on the other, an increase in SPAC-related litigation appears imminent. Indeed, Stanford University’s Securities Class Action Clearinghouse reports that from January 30, 2019 to April 2, 2021, 22 class actions involving SPACs have been filed in federal court. (This is in addition to state court cases such as Kwame Amo v. MultiPlan Corp., which was filed in Delaware Chancery Court on March 29, 2021).
This article examines, at a high level, some legal issues that could arise should the wave of SPAC litigation come to pass. It also provides sponsors—including private equity firms and investment banks—with a general outline of steps that may mitigate legal exposure.
II. Overview: The SPAC Process
In its infancy, a SPAC is a merely a shell corporation and conducts no operations; its purpose is to generate investment. The SPAC lifecycle starts with an IPO. The funds generated through the offering are placed in an interest-bearing trust account and used to fund the SPAC’s acquisition of a private company—the so-called de-SPAC transaction.[5] This transaction usually must occur no later than two years after completion of the IPO. If, however, a suitable target is not identified, then the corpus of the trust account must be returned to the SPAC’s investors along with any accrued interest.
III. Legal Issues Facing SPACs
Probable legal claims will likely fall into two categories: i) claims based on alleged misrepresentations associated with the IPO process, and ii) claims based on the fiduciary duties owed to investors by SPAC officers, directors, and even sponsors.
1. Misrepresentation and Fraud Issues.
Restrictions on False and Misleading Statements. As publicly traded entities, SPACs are subject to federal securities laws, most notably The Securities Exchange Act of 1934. The 1934 act provides a host of restrictions on what are and are not appropriate statements from an effective securities registration statement.[6]
These provisions come into play in connection with projections on the performance of the company after completion of the de-SPAC transaction as well as with valuations of the post-de-SPACed company.[7]
The Applicability, or Lack Thereof, of the PSLRA Safe Harbor. An oft-cited feature of SPACs, as opposed to traditional IPOs, is their ability to use the Private Securities Litigation Reform Act’s (PSLRA) Safe Harbor provision.[8] The safe harbor protects forward-looking statements that are i) identified as such and ii) accompanied by cautionary language stating that a company’s actual performance could vary from what is predicated in a disclosure from liability in private litigation.[9]
The PSLRA’s Safe Harbor is one of the recent and more contentious issues that will certainly be litigated. On the one hand, sponsors gravitate towards SPACs because, as Chamath Paliphapitiya explains: “In a traditional IPO you can’t show a [financial] forecast and you can’t talk about the future of how you want to do things, you’re just not allowed … Because the SPAC is a merger of companies, you’re all of a sudden allowed to talk about the future … when you do that, you have a better chance of being more fully valued.”[10]
The prospect of “being more fully valued” appeals to the core of a SPAC’s purpose—generating capital for an eventual acquisition. Conversely, however, the SEC’s recent guidance articulates a radically diametric view: “It is not clear that claims about the application of securities law liability provisions to de-SPACs provide targets or anyone else with a reason to prefer SPACs over traditional IPOs. Any simple claim about reduced liability exposure for SPAC participants is overstated at best, and potentially seriously misleading at worst. Indeed, in some ways, liability risks for those involved are higher, not lower, than in conventional IPOs …”[11]
Specifically regarding the PSLRA’s Safe Harbor, the SEC went further to note that the protection applies only in private litigation and not in an agency enforcement action.[12] Moreover, even if the Safe Harbor was applicable, a SPAC in possession of “multiple sets of projections that are based on reasonable assumptions, reflecting different scenarios of how the company’s future may unfold” would be on shaky ground vis-à-vis the Safe Harbor if it “only disclosed favorable projections and omitted disclosure of equally reliable but unfavorable projections.”[13] Finally, the SEC noted the exclusion of “blank check companies” from the Safe Harbor’s protections.[14]
Practical Guidance. The easiest and most effective way for sponsors to reduce litigation risk in connection with federal securities issues is to continue with best practices in conducting diligence, performing valuations, and making disclosures about the de-SPAC transaction. Cautionary language regarding the nature of forward-looking projections, as well as warnings about an investor’s ability to rely on such projections, should always be included in a SPAC’s disclosures. Simply put: If sponsors wish to avoid legal liability, they should steer clear of the brazen approach suggested in Paliphapitiya’s quote.
2. Fiduciary Duty Issues.
Fiduciary Duty Claims. A number of potential self-dealing issues—which engender claims for breach of fiduciary duty—may arise once a de-SPAC transaction has been consummated. Such self-dealing can occur in a number of ways:
- The sponsor may install their choice of directors and officers to the SPAC’s board, creating a conflict between the SPAC’s best interest (e.g. not going through with a de-SPAC transaction that involves an underperforming or unprofitable target) and the sponsor’s best interest (e.g. completing the de-SPAC transaction and obtaining its founder’s “promote”—typically 20 percent of the outstanding shares of the SPAC). Notably, these are the facts of a class action filed in Delaware Chancery Court on March 25, 2021.[15]
- A similar issue as the above could arise if the sponsor promises incentive awards or bonuses to the SPAC’s directors and officers contingent upon closing the de-SPAC transaction.
- The sponsor may, if the IPO fails to generate enough interest, be forced to inject or loan additional funds into the SPAC. In such a scenario, the terms of the capital infusion could be viewed as a self-dealing transaction with the sponsor standing on both sides of the loan.
Fraud/Fraudulent Inducement Claims. Potential issues may arise if, for example, a SPAC sponsor downgrades or reduces their level of involvement after publicly seeking investment. These issues would tend to affect prominent, celebrity promoters of SPACs such as Shaquille O’Neal or Alex Rodriguez. Chamath Paliphapitiya and the SPAC intended to bring Virgin Galactic public to illustrate this hypothetical situation. As The New York Times noted, in 2019 “Mr. Paliphapitiya sold the deal to public investors—many of whom were mesmerized by his words and the future of space travel—in part by investing $100 million of his own money into the business.”[16] Yet just this past month, Paliphapitiya exited his personal position without warning investors.[17] Should the de-SPACed entity fail financially, it is not hard to envision a flurry of suits alleging state law based claims of fraud and fraud in the inducement based on Paliphapitiya’s words and the sudden exit of his personal position in the SPAC.
Practical Guidance. With respect to the fraud issues raised above, there are several possibilities for reducing litigation risk. One, suggested by Lynn Turner, the former chief accountant for the SEC, would be to disallow SPAC sponsors from selling their shares for the full duration of the financial projections that were used to obtain public investment in the first place.[18] Another, suggested by Paliphapitiya, would be to require the plan sponsor to invest a minimal threshold, e.g. 10 percent, of the overall planned transaction amount.[19] According to Paliphapitiya, the “more they invest, the more they would need to scrutinize the projections … this has always been the only meaningful way to align sponsors, management, and investors.”
With respect to the fiduciary duty issues raised above, many of the problems regarding a de-SPACed company’s board or director’s duties of loyalty can be addressed through independent committees who can advise the board in a watchdog capacity. Because such committees would be comprised of independent directors, their blessing of a de-SPAC transaction could take the bite out of a plaintiff’s fiduciary duty claims.
IV. Conclusion
The overwhelming amount of money invested in SPACs over the past 15 months, along with the enormous scrutiny such transactions now face, suggest that SPAC-related litigation will shortly be on the rise. Plan sponsors need to begin apprising themselves of the potential issues that can arise in litigation and do everything in their power to address them before appearing in a courtroom. While much more can and will be written on the subject, the foregoing is intended to provide a glimpse of what is likely to come.
[1] https://markets.businessinsider.com/news/stocks/spac-investing-strategies-risks-expert-advice-commentary-analysis-2021-3-1030229612.
[2] https://www.nytimes.com/2021/02/10/business/dealbook/spac-wall-street-deals.html.
[3] https://hbr.org/2021/02/the-spac-bubble-is-about-to-burst.
[4] https://www.sec.gov/news/public-statement/spacs-ipos-liability-risk-under-securities-laws.
[6] See, e.g., 17 CFR § 240.14a-9. Rule 14a-9 contains one of the most popular bases for plaintiffs’ allegations in a securities fraud case: No solicitation subject to this regulation shall be made by means of any proxy statement, form of proxy, notice of meeting or other communication, written or oral, containing any statement which, at the time and in the light of the circumstances under which it is made, is false or misleading with respect to any material fact, or which omits to state any material fact necessary in order to make the statements therein not false or misleading or necessary to correct any statement in any earlier communication with respect to the solicitation of a proxy for the same meeting or subject matter which has become false or misleading.
[7] https://www.sec.gov/news/public-statement/spacs-ipos-liability-risk-under-securities-laws.
[8] Id.
[9] 15 U.S. C § 78u–5(c)(1).
[10] https://www.bloombergquint.com/gadfly/why-chamath-palihapitiya-loves-spacs-so-much.
[11] https://www.sec.gov/news/public-statement/spacs-ipos-liability-risk-under-securities-laws.
[12] Id.
[13] Id.
[14] See, 15 U.S. C § 78u–5(b)(1)(B). Analysis of whether the commission’s assertion is beyond the scope of this short article.
[15] Kwame Amo v. MultiPlan Corp., et al., C.A. No.2021-0258 (Del. Ch. Court 2021) (available at https://www.dandodiary.com/wp-content/uploads/sites/893/2021/03/Multiplan-delaware-complaint.pdf.)
[16] https://www.nytimes.com/2021/03/31/business/dealbook/spac-sponsors.html.
[17] Id.
[18] For more discussion of this alternative, see https://www.nytimes.com/2021/03/31/business/dealbook/spac-sponsors.html.
[19] Id.
