The Delaware Court of Chancery yesterday denied a motion to dismiss a class action alleging that the directors and sponsor of a special-purpose acquisition company (a “SPAC”) breached their fiduciary duties by disloyally depriving the SPAC’s public stockholders of information material to their decision whether to redeem their stock before the SPAC merged with a private company in a “de-SPAC” transaction.  The decision in Delman v. GigAcquisitions3, LLC (Del. Ch. Jan. 4, 2023), adds to the growing body of cases analyzing potential conflicts in SPAC transactions and applying the rigorous “entire fairness” standard of review.

The Delman ruling also is notable for its substantial reliance on allegations from an academic article discussing the high costs embedded in the SPAC structure.  One of the authors of that article appeared for the plaintiff in Delman.

Background

The SPAC at issue was a typically structured SPAC.  It was formed and managed by a sponsor, and it then offered shares to the public through an IPO.  The corporate charter required the SPAC to complete a de-SPAC transaction with a not-yet-identified private company within 18 months or to liquidate if a merger could not be completed within that time.  Upon liquidation, a trust holding the IPO proceeds plus accrued interest would be distributed to the SPAC’s public stockholders, but the founder shares – approximately 20% of the SPAC’s post-IPO equity – would become worthless.

The SPAC entered into a merger agreement with a target company within the required period.  The SPAC’s proxy statement invited stockholders to vote on the merger and informed public stockholders of their right to redeem their stock (for the original purchase price of $10 per share plus accrued interest) if they did not want to become stockholders in the post-merger entity.  The proxy statement contained projections prepared by the target’s management forecasting explosive growth over the next five years.  It also disclosed potential conflicts of interest between the SPAC’s sponsor and Board, on the one hand, and its public stockholders, on the other, including that the sponsor, officers, and directors would lose their entire investment in the SPAC if the merger were not consummated by the applicable deadline.

The stockholders approved the merger, but the post-merger company’s performance suffered, and its stock price fell dramatically.  A stockholder who had purchased the SPAC’s stock before the merger then filed a putative class action asserting direct claims for breach of fiduciary duty against the SPAC’s Board, sponsor, and controlling stockholder, and a claim for unjust enrichment against the sponsor and the directors.  The court denied the defendants’ motion to dismiss, holding that “it is reasonably conceivable” that the defendants breached their fiduciary duties by depriving the public stockholders of material information they needed to decide whether to redeem their SPAC shares before the merger.

Chancery Court’s Decision

The court began by rejecting two threshold arguments that the defendants had raised:  (i) the asserted claims were derivative, rather than direct, and (ii) the claims were impermissible “holder” claims.

• The claims for breach of fiduciary duty were direct, not derivative, because the allegedly disloyal conduct had deprived the SPAC’s public stockholders of information they needed to decide whether to exercise their own redemption right.  That right is personal to the public stockholders, and an injury could not be redressed through a recovery flowing to the SPAC.  Similarly, the unjust-enrichment claim was based on the sponsor’s and the Board’s enrichment because of the supposed informational imbalance.  That alleged harm also was separate from any potential injury to the SPAC itself.

• The claims were not “holder” claims because they did not allege that the public stockholders had been wrongfully induced to hold their stock instead of selling it.  Rather, the claims were predicated on the stockholders’ having been asked to make a decision:  whether to redeem their stock before the de-SPAC merger occurred.  A stockholder “who opted not to redeem chose to invest her portion of the trust in the post-merger entity.  This affirmative choice is one that each SPAC public stockholder must make.  There is no continuation of the status quo,” as there is with a “holder” claim.

The court then turned to the claims for breach of fiduciary duty and the allegation that the defendants had disloyally hindered the public stockholders from being able to exercise their redemption right effectively.  The court viewed the redemption right as “the primary means protecting stockholders from a forced investment in a transaction they believe is ill-conceived.”  A SPAC’s fiduciaries thus “must ensure that right is effective, including by disclosing fully and fairly all material information that is reasonably available about the merger and target to inform the redemption decision.”

As in most cases involving alleged breaches of fiduciary duty, a threshold and potentially outcome-determinative decision concerns the standard of review that the court should apply:  the relatively deferential business-judgment rule or the more rigorous “entire fairness” standard, which requires the defendants to demonstrate that the challenged act or transaction was entirely fair to the corporation and its stockholders in terms of both price and process.  The court here applied the entire-fairness standard because of “inherent conflicts between the SPAC’s fiduciaries and public stockholders in the context of a value-decreasing transaction.”  The court held that the plaintiff had plausibly pled facts showing that the de-SPAC merger was a “conflicted controller transaction” and that a majority of the SPAC’s Board was not disinterested or independent.

• The de-SPAC merger plausibly was a conflicted transaction in that “the defendants were incentivized to undertake a value-decreasing transaction because it led to colossal returns on the Sponsor’s investment, without regard to whether public stockholders were better served by liquidation.”  If the merger (or some other merger) did not take place within the required 18-month period, the sponsor and other defendants who had invested in the SPAC would lose their investment, but the public stockholders would get back their money plus interest.  Thus, for the sponsor, a flawed deal allegedly was better than no deal at all, while the opposite was true for the public stockholders.  The defendants therefore allegedly had an incentive to provide inadequate or overly optimistic disclosures about the merger to discourage redemptions (which would deplete funds available for the merger) and ensure the transaction’s consummation.

• The non-sponsor members of the SPAC’s Board were not independent and disinterested because they had numerous overlapping business ties to the conflicted sponsor, which clearly was interested, and one of those other Board members was also the wife of the sponsor’s controlling shareholder.

Under the entire-fairness standard, the court held that the plaintiff had pled viable claims for relief.  The “public stockholders knew that if they redeemed, they were promised $10 per share plus interest,” but they were given “incomplete information about what they would receive if they instead opted to invest” in the post-merger entity.  The allegedly inadequate information concerned both what the SPAC itself would invest in the target and what the SPAC would receive from the merger.

• The proxy statement said that the merger consideration to be paid to the target’s stockholders consisted solely of SPAC stock valued at $10 per share.  Thus, non-redeeming SPAC stockholders who exchanged their SPAC stock worth $10 per share could expect to receive equivalent value in return.  However, the plaintiff alleged that the actual amount of net cash per share that the SPAC would invest in the target was only about $5.25.  The proxy statement thus allegedly “misstated and obfuscated the net cash – and thus the value – underlying [the SPAC’s] shares.”  The alleged disparity between the SPAC’s purported contribution of $10 per share and its actual contribution of $5.25 arose from the supposedly hidden costs involved in SPAC transactions and the understated number of pre-merger shares involved.  The economic analysis came from an article called “A Sober Look at SPACs,” by Michael Klausner, Michael Ohlrogge, & Emily Ruan, published last year in the Yale Journal on Regulation.

• As for what the SPAC and its stockholders would receive from the merger:  the proxy statement projected dramatic growth over the next five years, including annual revenue growth of more than 22,100% and an increase in annual gross profits from zero to more than $500 million.  But those “lofty projections” – which have not materialized to date – “were not counterbalanced by impartial information.”  The SPAC’s stockholders thus “were kept in the dark about what they could realistically expect from the combined company.”  The court held that the plaintiff had plausibly alleged that the defendants “knew (and should have disclosed) or should have known (but failed to investigate)” that the target’s projections would be difficult to achieve.  And without an accurate portrayal of the target’s financial health, “the public stockholders could not fairly decide whether it was preferable to redeem for $10 plus interest or to invest in a risky venture.”

The court therefore could not conclude at the pleading stage that the transaction was the product of fair dealing.  The court also ruled that unfair price could be inferred from the allegation that the public stockholders were left with target shares worth far less than the redemption price of $10 per share.

Implications

The Delman ruling does not break new ground in light of other recent Delaware decisions on SPAC transactions, potential conflicts of interest in the SPAC structure, and the importance of adequate disclosures to protect public stockholders’ redemption right.  But the decision highlights issues concerning the economics and expenses underlying the SPAC structure, a topic explored in great depth in the Yale Journal on Regulation article, one of whose authors (Professor Michael Klausner, of Stanford Law School) appeared for the plaintiff in this case.  That article concluded that the “costs embedded in the SPAC structure are subtle, opaque, higher than has been previously recognized, and higher than the cost of an IPO.”  The Delaware court made clear that, at the pleading stage, it was not assessing the accuracy of the plaintiff’s allegations based on the Yale Journal article and was not endorsing any specific formula or method for calculating the net cash per share that the SPAC had contributed to the merger.  But the article attracted attention when it was published in 2022, and, in light of the Delman decision, it is likely to be cited in other SPAC-related litigation.

The decision also raises another interesting issue concerning the choices facing public stockholders of SPACs when they receive a proxy statement inviting them to vote on a de-SPAC merger and informing them of their redemption right.  The court observed that, in the SPAC context, public stockholders’ voting interests are “decoupled from their economic interests” because the stockholders can choose to redeem their shares and still vote in favor of the merger.  In fact, they arguably have some incentive to vote in favor even if they want to redeem:  they generally received warrants as well as shares in the SPAC’s IPO, and those warrants would be worth something if the merger occurs, but nothing if it does not.  Public stockholders thus have no reason to vote against a bad deal.  As the court noted, however, a merger vote “could have greater importance if stockholders’ voting and economic interests had been ‘recoupled’ by requiring redeeming stockholders to vote against the deal.”  The court cited another article from the Yale Journal on Regulation arguing that “recoupling the vote with the redemption right can help ensure that good [de-SPAC] deals go forward – and bad deals don’t.”  Whether this idea will gain any traction remains to be seen.