The SPAC Explosion: Beware the Litigation and Enforcement Risk

Special Purpose Acquisition Companies (SPACs) have exploded in popularity. These so-called “blank check” companies are used as vehicles to take companies public without going through a traditional IPO process. In the life cycle of a SPAC, a management team forms a new public company (the SPAC) for the express purpose of identifying and acquiring an existing (but unspecified) private operating company and the SPAC sells shares of stock in the SPAC to the public (the SPAC IPO). Later, the SPAC’s management team identifies a private operating company for acquisition and then merges the target and the SPAC to create a continuing public entity that is the successor to the target’s business (the de-SPAC transaction). The year 2019 saw a record $13.6 billion raised across 59 SPAC IPOs. In 2020 through December 14, the value of SPAC investments has more than quintupled with $77.5 billion raised across 230 IPOs.

Although SPAC-related litigation has been relatively infrequent to date, that is likely to change given 2020’s explosion in SPAC IPOs. Tellingly, the price of D&O insurance for SPACs has reportedly nearly doubled in recent months, with insurers reducing their maximum exposure limits from $10 million to $5 million but continuing to charge similar premiums. In this climate, SPAC sponsors, investors and targets should be mindful of litigation risks presented by the SPAC process. In particular, any litigation filed after the de-SPAC transaction is complete will almost inevitably embroil all three of these constituencies and could prove a significant distraction to the continuing public entity that is the successor to the target’s business. Risks include litigation based on: (1) SPAC IPO registration statements; (2) de-SPAC proxy statements; (3) potential de-SPAC registration statements; (4) financial projections—which significantly distinguish SPAC disclosures from those made in traditional IPOS; (5) redemption of SPAC shares; (6) de-SPAC deadlines; and (7) post-SPAC public status.

SPAC IPO Registration Statement

Because a SPAC is a new company formed for the express purpose of acquiring a company not yet identified, the SPAC IPO process is quicker and requires fewer disclosures than the traditional IPO process for an existing company. Nevertheless, like any IPO, a SPAC requires the filing of a registration statement with the SEC and exposes SPAC management to the risk of strict liability under Section 11 and other provisions of the Securities Act of 1933 (’33 Act) for misstatements and omissions in that document. If ’33 Act litigation is commenced or still pending after the de-SPAC transaction, the surviving entity could end up with liability, either directly or because it has obligations to indemnify and defend the SPAC’s directors, officers and underwriters.

While SPAC growth has been fueled in part by the participation of high-quality sponsors—as well as blue-chip investors and bulge bracket underwriters—some SPACs are being launched by unconventional management teams, including SPACs helmed by former House Speaker Paul Ryan, Oakland Athletics executive Billy Beane, and Shaquille O’Neal. Given that SPAC IPO investors are essentially betting on a management team, any overstatement of that team’s credentials or track record in the SPAC offering documents could be a basis for disappointed investors that purchased in the offering to bring ’33 Act litigation.

De-SPAC Proxy Statement

A de-SPAC transaction typically requires approval of a majority of SPAC shareholders in accordance with SEC proxy rules—i.e., disclosure of the transaction in a proxy statement filed with the SEC, review and comment by the Commission, distribution of the statement to SPAC shareholders, and a shareholder vote on the transaction. Recently, the Director of the SEC’s Division of Corporation Finance indicated that such proxy statements are subject to comparable review as registration statements for traditional IPOs. If shareholders believe a proxy statement lacks adequate disclosures for them to make an informed decision, they can challenge the statement under Section 14(a) of the Securities Exchange Act of 1934 (’34 Act), which governs the solicitation of proxies, as well as Sections 10(b) and 20(a) of that statute. Such challenges have been based on the alleged inadequacy of disclosures regarding issues like financial projections and risks of the target company, SPAC negotiations with other potential targets, conflicts of interest of the deal’s financial advisers, and employment opportunities for SPAC management at the post-transaction entity. Outside the SPAC context, such lawsuits target almost every merger of any size, and there is little reason to think the same may not prove true of de-SPAC transactions. While most are nuisance suits and readily resolved for less than the potential cost of litigating them, occasionally some become more serious.

If a potential deficiency is raised before the de-SPAC transaction is completed (as is typically the case for mergers outside the de-SPAC context), it can often be addressed through a relatively painless amendment to the proxy statement and the payment of a “mootness” fee to the plaintiffs’ lawyers. In Wheby v. Greenland Acquisition Corporation, for instance, a SPAC investor sued for violation of the ’34 Act based on the proxy statement’s alleged failure to make a litany of disclosures, including line items and reconciliations underlying financial statements, financial projections, terms of non-disclosure agreements and letters of intent with potential acquisition targets, compensation and affiliations of consultants, the basis for not hiring a financial adviser, financial analyses relied on in recommending the de-SPAC transaction, the nature of pre-existing relationships between SPAC sponsors and PIPE investors also involved in the de-SPAC transaction, and communications regarding future employment of the SPAC sponsors. See Complaint, Wheby v. Greenland Acquisition Corp., No. 1:19-cv-01758-MN, 30-41 (D. Del. Sept. 19, 2019), ECF No. 1. One week after the complaint was filed, the SPAC revised the proxy statement to include additional information mooting the investor’s claims and then negotiated a mootness fee with the investor. See Stipulation and Order of Dismissal, Wheby v. Greenland Acquisition Corp., No. 1:19-cv-01758-MN (D. Del. Oct. 14, 2019), ECF No. 4.

When challenges to the proxy statement are made or continue post-transaction, however, most likely because the share price of the continuing public entity proves a disappointment to SPAC investors, there is a far greater likelihood for protracted litigation. Such litigation is likely to prove time-consuming and expensive for both the SPAC sponsors and the surviving public entity (although insurance coverage may help mitigate the costs). For example, In re Heckmann Corporation Securities Litigation involved class action litigation against both a SPAC and the post-merger public company it created, alleging that the class had been denied an informed vote on the merger due to misleading statements about the target’s past financial results, future growth prospects, and valuation; the qualifications of the target’s management; and the level of diligence performed by the SPAC. 869 F. Supp. 2d 519, 532 (D. Del. 2012) (denying motion to dismiss). As discussed further below, financial projections distinguish de-SPAC transactions from traditional IPOs and are a frequent subject of proxy statement litigation despite certain safe harbor protections. Ultimately, “after 3 ½ years of hard-fought and contentious litigation,” the class achieved a $27 million settlement agreement to be paid half in cash and half in stock. Motion for Final Approval, In re Heckmann Corp. Sec. Litig., No. 1:10-cv-00378-LPS-MPT, at 1 (D. Del May 22, 2014), ECF No. 298.

In some cases, target leadership may even be directly liable for the alleged shortcomings of a proxy statement. For example, in a recent SEC matter, the Commission alleged, inter alia, that the financial projections for the target disclosed to SPAC shareholders were based on misleading pipeline and backlog information. Sec. & Exch. Comm’n v. Hurgin, No. 19-cv-5705-MKV, 2020 WL 5350536, at *8 (S.D.N.Y. Sept. 4, 2020). The court found that the SEC had “adequately allege[d] that [the CTO of the target and ongoing company] put his reputation in issue in the proxy materials such that he owed a duty to the [SPAC] shareholders.” Id. at *12.

Thus, it is in the interest of both the SPAC and the target to ensure complete and careful drafting of proxy statements seeking approval of the de-SPAC transaction. Thorough proxy statements will also help ensure the protections of the business judgment rule—and thereby mitigate the risk of state law breach of fiduciary duty claims—given the cleansing impact of approval by a majority of fully informed disinterested stockholders. This is particularly important in the SPAC context, where courts have found inherent conflicts for SPAC directors. See AP Services, LLP v. Lobell, No. 651613/12, 2015 WL 3858818, at *6 (N.Y. Sup. Ct. June 19, 2015) (allegations regarding SPAC structure—in which a majority of SPAC directors held stock and warrants that would be rendered worthless absent a de-SPAC transaction—sufficient at the pleading stage to rebut presumption of business judgment). Similarly, the Chair of the SEC recently indicated that the Commission is “particularly focused” on the “incentives and compensation to the SPAC sponsors.”

De-SPAC Registration Statement

In addition to a proxy statement, some de-SPAC transactions will also require a registration statement. For example, using a so-called “double dummy” structure, a new holding company may acquire both the SPAC and the target company in exchange for holding company shares, file a registration statement on Form S-4 or F-4, and become the continuing public entity. Although such registration statements generally include comparable content to proxy statements, they can expose the continuing public entity to strict liability under the ’33 Act. Specifically, where the de-SPAC transaction requires issuance of shares in a new public company, purchasers of shares that are traceable to the de-SPAC registration statement can bring Section 11 and 15 claims against the new company and those officers and directors responsible for the registration statement’s contents and dissemination.

A complaint was recently filed in In re Akazoo S.A. Securities Litigation, alleging gross overstatements in the users, subscribers, revenues and profits of a SPAC-acquired music streaming platform. See Amended Complaint, In re Akazoo S.A. Sec. Litig., No. 1:20-cv-01900-BMC, 9, 19 (E.D.N.Y. Sept. 8, 2020), ECF No. 15. Because the de-SPAC transaction had involved the filing of a registration statement on form F-4, class plaintiffs brought ’33 Act claims on behalf of those who “purchased or otherwise acquired Akazoo common stock pursuant or traceable to the Company’s registration statement and prospectus issued in connection with the September 2019 Merger.” Id. 1, 118 (also pursuing claims under the ’34 Act based on the proxy statement).

Financial Projections

Financial projections in a proxy statement or registration statement filed with the SEC in connection with a de-SPAC transaction significantly distinguish SPACs, and their attendant litigation risks, from traditional IPOs. This is because such projections are generally protected by the safe harbor for forward-looking statements afforded by the Private Securities Litigation Reform Act (PSLRA), whereas projections made in connection with traditional IPOs are outside the PSLRA’s safe harbor. Thus, compared to a traditional IPO, a SPAC acquisition presents the opportunity for an operating company to speak more directly to the market about its financial prospects. Even with such safe harbor protection, however, financial projections made in connection with a de-SPAC transaction can, and likely will, still be challenged by shareholders if they are not properly identified as forward-looking, not accompanied by meaningful cautionary language, or knowingly false when made. Thus, it is advisable to conduct a well-documented critical review of such projections to ensure that they are expressly forward-looking, provide cautionary language disclosing known risks, and are fundamentally reasonable (for example, do not overstate the likelihood of achieving any predicted results or the quality of the assumptions and data on which the projections are based).

An October 16, 2020, class action complaint involving food delivery app Waitr, which went public via a 2018 SPAC merger, highlights this risk. Amended Complaint, Welch v. Meaux, No. 2:19-cv-01260-TAD-KK, 15-19 (W.D. La. Oct. 16, 2020), ECF No. 37 (“Welch Compl.”). Specifically, plaintiffs allege that there was no basis to believe that Waitr could achieve the 2019 and 2020 revenue guidance provided in the SPAC’s proxy statement because it was already clear at the time of the merger that Waitr’s business model was unsustainable. Id. 35-36. If these allegations prove to be true, and the projections were knowingly false when made, then the projections would not be entitled to safe harbor under the PSLRA. Similarly, in Hurgin, financial projections were based largely upon an oral agreement between the target and the management of its largest customer, but failed to disclose that the employees who orally agreed to order the target’s products had been terminated. 2020 WL 5350536, at *7. As the court explained, even if the target’s CEO “sincerely believed the supposed three-year deal would go forward, the Commission has adequately alleged that [he] omitted information whose omission would make his statement about the deal misleading to a reasonable investor.” Id.

Redemption Right

The de-SPAC approval process also typically requires a pre-transaction offer to all SPAC shareholders—regardless of whether they voted to approve the transaction—to redeem their SPAC shares. These shareholders will receive a pro-rata portion of the SPAC’s investment fund rather than shares of the post-acquisition company, thereby reducing the funds available for investment in the target company and the number of shareholders in both the SPAC and the continuing public entity. A significant reduction in shareholders could lead to involuntary delisting under exchange rules—which generally require minimum shareholder numbers—and resulting shareholder suits alleging breaches of fiduciary duties. The reduction in funds may also lead the SPAC to attempt to renegotiate its deal with the target company and to litigation between the SPAC and target on that basis. See, e.g., Manichaean Capital, LLC v. SourceHOV Holdings, Inc., No. CV 2017-0673-JRS, 2020 WL 496606, at *4 (Del. Ch. Jan. 30, 2020) (recognizing in SPAC-related appraisal litigation brought by target company shareholders that redemption rights “can result in last-minute re-negotiations of SPAC deals when there are more redemptions than anticipated”), reconsideration denied, No. CV 2017-0673-JRS, 2020 WL 1166067 (Del. Ch. Mar. 11, 2020).

Accordingly, it behooves both parties to a de-SPAC transaction to ensure that the terms of their agreement anticipate and account for such contingencies as best as possible, such as through minimum cash provisions and/or an accompanying capital-raising transaction such as a PIPE or private placement. To the extent such a capital-raising transaction requires offering new shares in the continuing public company pursuant to a registration statement, however, the company may face suits for strict liability under Section 11 and other provisions of the ’33 Act from those purchasing in the offering. Ancillary transactions aimed at ensuring there is enough capital to close can also lead to traditional deal litigation.

For example, in January 2020, the SPAC Far Point Acquisition Corporation entered into an agreement to acquire international travel company Global Blue Group AG, funded in part by institutional PIPE investors, including seven hedge funds and a private Swiss bank that collectively agreed to purchase $110 million of stock from the new Global Blue public entity. See Letter Opposing Stay of Disclosure, SL Globetrotter, L.P. v. Suvretta Capital Management, LLC, No. 652769/2020, at 1 (N.Y. Sup. Ct. Oct. 22, 2020). As reported in the media, however, Global Blue’s business began to suffer due to the COVID-19 pandemic and Far Point recommended in May that its shareholders vote against the $2.6 billion deal. Following concessions from Global Blue’s private equity owners, the deal was ultimately approved, but investors holding approximately $487 million in Far Point opted for redemption rather than shares in the new Global Blue entity. [1] Further, when the de-SPAC transaction eventually closed on August 28, the PIPE investors did not meet their funding obligation, allegedly based on pretextual arguments that closing conditions had not been satisfied, causing Global Blue to file a series of breach of contract lawsuits. Id. at 1-2.

De-SPAC Deadline

Under its incorporating documents, a SPAC typically has 24 months from the date of its IPO to either find a suitable target company or liquidate and return funds to investors. Where a de-SPAC transaction is entered into near that liquidation deadline, and the share price suffers post-transaction, shareholders may allege that SPAC management rushed into an unfavorable transaction to avoid liquidation. See, e.g., Welch Compl. 89 (alleging SPAC sponsors “raced to enter a merger agreement with Waitr” to avoid being “forced to return $250 million” and “to protect their reputations as high-power deal-makers”); In re Stillwater Capital Partners Inc. Litig., 858 F. Supp. 2d 277, 288 (S.D.N.Y. 2012) (“desire to avoid impending liquidation was also a motivating factor for the [SPAC] officers”). Moreover, as discussed above, because SPAC sponsors generally stand to lose their “founder’s shares” if the SPAC is liquidated, their interests may not be sufficiently aligned with stockholders to warrant the business judgment presumption.

While limited in practice thus far, SPAC management can mitigate such risk by seeking an extension of the liquidation deadline from SPAC shareholders before executing a de-SPAC transaction agreement. Target companies can also include a provision in such agreements requiring the SPAC to seek a shareholder extension prior to the closing of the transaction. Where SPAC stockholders have been asked to vote on such an extension, however, they have typically been given the same opportunity to redeem their shares that accompanies the vote on the de-SPAC transaction. Thus, while mitigating deadline risk, extensions can increase the redemption risk discussed above.

Post-SPAC Public Status

The SEC requires a SPAC to file a so-called “Super 8-K” within four business days of completion of the de-SPAC transaction. This filing must contain all of the information that would be required in a non-IPO Form 10 registration statement, but this document does not create any strict liability under the ’33 Act. Nonetheless, starting with the Super 8-K, the new public company will face the same risks as any public company, including shareholder suits alleging false and misleading statements under the ’34 Act and the short-seller attacks that can presage such litigation. [2]

Conclusion

As the hundreds of SPACs created over the past years pursue and consummate de-SPAC transactions, we expect a significant number of such transactions to become the target of civil litigation and/or SEC enforcement activity. To avoid such scrutiny, or at least mitigate its potential impact, SPAC participants should keep in mind that the SPAC process—like traditional M&A and IPO activity—requires responsible diligence, disclosures and forecasting.

In particular, participants should be wary of the following issues in SPAC matters:

• Incentive of SPAC sponsors to consummate even a questionable de-SPAC transaction rather than refund investors;
• Transparency of de-SPAC negotiations with and diligence regarding ultimate target and other potential targets; and
• Undisclosed relationships involving SPAC sponsors, target management, consultants, financial advisers and participating PIPE investors—including anticipated employment with the continuing public entity.

Endnotes

1See, e.g., Joshua Franklin, “Third Point-backed Far Point green lights $2.6 billion Global Blue deal,” Reuters, Aug. 24, 2020, available at https://www.reuters.com/article/us-far-point-m-a-global-blue-vote-idUSKBN25K2AS.(go back)

2See, e.g., Ortenca Aliaj, “‘The great 2020 money grab’: Muddy Waters unloads on Spacs,” Financial Times, Nov. 11, 2020, available at https://www.ft.com/content/fc744cca-8109-4b4b-8b91-f592b8736be8.(go back)