SPAC Governance: In Need of Judicial Review

SPACs have gotten their share of critical attention over the past year, including by us here and here. But there has been little attention paid to the weak corporate governance of many SPACs, and less attention paid to judicial review of alleged breaches of fiduciary duties. We have recently posted a paper on those topics here. In this post, we summarize that analysis.

The Delaware Chancery Court has recently gotten its first look at SPAC governance in the In Re Multiplan Stockholders Litigation case, which is currently pending. The defendants in the case have essentially argued that the conduct of sponsors and boards should be immune to judicial review when they enter into a merger (or “deSPAC”). That would be an unfortunate result for SPAC shareholders, and in our view the wrong answer under Delaware law.

The Central Conflict in a SPAC

In our earlier article and blog post, we explained how the economic structure of a SPAC creates an inherent conflict between a SPAC’s sponsor and its public shareholders. That conflict centers on the only decision a SPAC’s management must make—to merge or to liquidate.

Although the sponsor would like its SPAC to enter into a merger that is value-increasing for all shareholders, if it can find one, the sponsor will nonetheless make millions of dollars even in a merger that is a losing proposition for the SPAC’s public shareholders. On the other hand, in a liquidation, the sponsor loses its initial investment and gains nothing, while the public shareholders receive their pro rata share of the SPAC’s IPO proceeds—$10 per share—plus interest.

When a SPAC proposes a merger, each public shareholder has the right to redeem its shares—for $10 per share plus interest. Those who view the merger as yielding less will presumably redeem. If the volume of redemptions is high, there is a danger that a merger will not close. And even if the merger closes, more redemptions will reduce the value of the sponsor’s shares in the post-merger. A sponsor, therefore, has an interest in keeping redemptions low.

SPAC Governance

The governance challenge for a SPAC is to protect its public shareholders from the conflicting interests of the sponsor in choosing to merge. There are two mutually reinforcing responses to this challenge. The first is the shareholders’ redemption right. The second is for the sponsor to put independent directors in control of the SPAC’s merger decision. The redemption right is required under stock exchange rules, but an independent board will be put in place only if the sponsor so chooses.

The redemption right is central to the protection of a SPAC’s public shareholders. It is supported by a trust that holds the proceeds of a SPAC’s IPO. Under the terms of the trust, shareholders that redeem their shares have first claim to that cash. The cash in the trust is not distributed to the SPAC until each public shareholder decides whether to retrieve its cash by exercising its redemption right. Once shareholders have made that decision, the trust pays out the remaining cash to the SPAC. The redemption right will not serve its function unless shareholders receive all material information related to the value of their shares in a proposed merger.

The role of independent directors in a SPAC is essentially the same as in any controlled corporation. The only difference is that the board of a SPAC has only one decision to make: whether to approve a merger. Putting approval of a merger in the hands of truly independent directors can protect public shareholders from the sponsor’s incentive to accept a value-decreasing merger rather than a liquidation. Assuming the directors are loyal and exercise due care, they will approve a merger only if they conclude that it will deliver greater value to public shareholders than liquidation Furthermore, having independent directors oversee the production of information provided to public shareholders in connection with a proposed merger enhances the likelihood that the shareholders’ redemptions decisions will be fully informed. Those that disagree with the independent directors’ judgment can retrieve their cash rather than invest in the merger.

Unfortunately, sponsors often fill their boards with individuals with whom they have strong financial or personal ties, and they compensate them in ways that align the directors’ financial interests with the sponsor’s interest—not the public shareholders’ interest. One common arrangement is to give directors “founder shares,” the class of shares the sponsor holds. Those shares do not participate in a liquidation, so the directors share the sponsor’s interest in accepting a value-decreasing merger rather than liquidating. A SPAC governed by directors who have ties with a sponsor and who are compensated in this way is equivalent to a SPAC governed by a sponsor—a duty of loyalty breach waiting to happen.

Implications for Judicial Review

If a SPAC enters into a value-decreasing merger about which the public shareholders have been poorly informed, the public shareholders have two intertwined claims against the SPAC’s sponsor and board: one for a breach of the duty of loyalty and one for a breach of the duty of candor. The case will be a class action on behalf of public shareholders that did not redeem their shares. The shareholders’ argument will be that they were not sufficiently informed of material facts relevant to the proposed merger, and as a result they could not exercise their redemption rights effectively to avoid investing in the bad deal. For purposes of the analysis below, we will assume that the board of the SPAC has interests aligned with the sponsor, as we describe above. The Multiplan case provides a roadmap for how defendants will try to avoid judicial review.

Derivative or Direct Suit?

The SPAC’s sponsor and board will argue that the shareholders’ suit is derivative rather than direct, and that the shareholders must therefore make a demand on the post-merger company’s board to bring the suit. If the court agrees, the suit will be dead. After a SPAC merges, the majority of the post-merger company’s board is typically composed of individuals affiliated with the target company. So, demand will not be excused. And if demand were made, there is no reason to expect that the post-merger board would sue the SPAC sponsor and former board members.

The SPAC shareholders’ suit, however, is properly characterized as a direct suit. Under Tooley v. Donaldson Lufkin & Jenrette, a shareholder suit is direct if (a) the shareholders suffered the alleged harm and (b) the recovery would flow directly to the shareholders and not the corporation. Both prongs of the Tooley test favor the SPAC shareholders’ suit being deemed direct, and not derivative. First, the public shareholders’ core allegation is that the board’s breach of its duty of candor harmed them by impairing their ability to exercise their redemption right. The redemption right is a right that a SPAC’s charter grants to each public shareholder, individually, and is supported by the shareholders’ right to the cash held for their benefit in the SPAC’s trust.

The second Tooley prong also weighs in favor of the suit being direct rather than derivative. The remedy the public shareholders will seek is damages payable to them directly for the impairment of their redemption right. A recovery paid to the corporation would fail to remedy the harm to the public shareholders. Not all shareholders had a redemption right when the SPAC merged. Only shares issued in a SPAC’s IPO carry that right, and hence only holders of public shares can redeem. Founder shares (which are often held by parties other than the sponsor) do not have a redemption right, nor do shares issued to PIPE investors concurrently with a merger. If damages were paid to the post-merger corporation rather than the non-redeeming public shareholders, the non-redeeming public shareholders would receive only a fraction of what they lost (indirectly though their ownership of shares).

Consequently, the shareholders’ suit is properly characterized as direct, not derivative.

Business Judgment Rule or Entire Fairness Review?

A second way in which SPAC sponsors and board members will try to avoid judicial review is by arguing that they did not have interests that conflicted with those of public shareholders, and that the business judgment rule therefore applies. This argument is implausible for the reasons we have described above.

The conflict between a SPAC’s sponsor and board, on the one hand, and SPAC shareholders on the other is not the classic conflict one sees in ordinary mergers. The sponsor and directors do not stand on both sides of a SPAC merger, nor do they receive special benefits from the post-merger company. The conflict, as explained above, is in the structure of the SPAC itself. The sponsor and the board can make a lot of money by proposing a merger that is a losing proposition for public shareholders. If the SPAC does not merge, the sponsor and board will get nothing, and the sponsor will lose its initial investment. Furthermore, the lower redemptions are, the more value the sponsor and board will reap in a merger.

One could characterize this conflict in terms the Delaware Supreme Court has explicitly recognized: A SPAC’s sponsor and board “compete” with the public shareholders not for merger consideration, but for a share of the trust. In a merger, the sponsor and board get a large share of the trust by virtue of their shareholdings; in a liquidation they get none of it. In addition, the sponsor and board, in effect, compete with respect to redemptions. If there are few, the shareholders will invest more cash from the trust to the merger, and the sponsor and board will benefit from that investment. Conversely, if there are more redemptions, the public shareholders will get their cash back, and the interests of the sponsor and board in the post-merger company will be reduced. Regardless of the characterization, however, the inherent conflict of interest requires entire fairness review.

A Fiduciary Breach or Contract Breach?

Yet another way for a SPAC’s sponsor and board to avoid judicial review is to argue that because the redemption right is provided for in the SPAC’s charter, it is a matter of contract with the SPAC itself, and no fiduciary duty is involved. Hence, the public shareholders have no claim against the sponsor or the directors. This argument amounts to a claim that shareholders must fend for themselves when presented with a merger proposal.

There is no basis in the SPAC charter or the overall structure of a SPAC for inferring such a lack of shareholder protection. To the contrary, for the SPAC structure to make any sense, the duty of candor must apply to the redemption right. In Malone v. Brincat, the Delaware Supreme Court stated that a board owes shareholders a duty of disclosure in connection with “shareholder action.” A shareholder’s decision whether to invest in a proposed merger or to reclaim its cash from the trust is a shareholder action—indeed, it is the only action a SPAC shareholder takes. Furthermore, in Loudon v. Archer-Daniels-Midland, the Court held that damages are an appropriate remedy “where disclosure violations are concomitant with deprivation to stockholders’ economic interests.” By preventing SPAC shareholders from exercising their redemption rights with full information, the breach of the duty of candor is concomitant with the loss of an economic interest.

The fact that the redemption right is provided for in a SPAC’s charter has no bearing on whether the duty of candor applies to the exercise of the right. The cases in which the courts have held contract rights not to be subject to fiduciary duties are cases in which there was an alleged breach of explicit rights of a preferred shareholder provided for in a charter, or where there has been a breach of a separate contract with a party that is a shareholder. In those cases, the shareholders have tried to expand their contract rights by arguing that those same rights are subject to a fiduciary duty gloss. In Nemec v. Shrader, the Delaware Supreme Court responded to such an effort, stating that it would not “rewrite the contract,” and holding that “where a dispute arises from obligations that are expressly addressed by contract, that dispute will be treated as a breach of contract claim,” not a breach of fiduciary duty.

The redemption right is entirely different from the contract rights involved in Nemec v. Shrader and similar case. The SPAC charter does not “expressly address[]” what information shareholders shall receive in connection with the exercise of their redemption right. Thus, requiring a board to abide by its duty of candor would not “rewrite the contract” or “undermine the primacy of contract law.” It would instead allow the redemption right to serve the role it is intended to serve.

Are Nonredeeming Shareholders “Holders”?

A final way in which a SPAC sponsor and board may seek to avoid judicial review is to argue that a suit by non-redeeming SPAC shareholders is a “holder” case—a case in which a shareholder held its shares, rather than selling them, in reliance on a company’s misstatement or omission. Holder claims are based on common law fraud or negligent misrepresentation, which require proof of a plaintiff’s reliance. Hence, individual questions of fact predominate over common questions, and the case cannot be litigated as a class action.

A class action brought by SPAC shareholders’ is not a holder claim. It is a claim related to shareholder action—each shareholder’s decision whether to invest its cash held in trust in a merger, or to reclaim that cash. The fact that the default action is to invest—that no box on a form needs to be checked—does not turn the shareholder’s decision not to redeem into a decision to “hold.” To the contrary, a decision not to redeem is a decision by an investor to invest its portion of the trust in a merger.

Furthermore, in contrast to a holder claim, there is no impediment to litigating the SPAC shareholders’ claim as a class action. In Malone v Brincat, the Delaware Supreme Court held that when a breach of the duty of candor relates to shareholder action, shareholders need not prove reliance or causation. Consequently, there are no individual questions of law or fact that predominate over common questions, and therefore no impediment to as a class action.

Conclusion

The economic structure of a SPAC creates a conflict between its sponsor and its public shareholders over the decision to merge and over the public shareholders’ decisions to redeem their shares. Ideally, a sponsor will organize the governance of a SPAC in a way that addresses these conflicts, by appointing truly independent directors to the SPAC board and compensating them in a way that aligns their interests with those of public shareholders. Instead, many sponsors select board members and compensate them in a way that aligns their interests with the sponsor’s interests, not the public shareholders’ interests.

If the SPAC enters into a value-decreasing merger and fails to disclose material information to public shareholders, the public shareholder may well file a lawsuit for breach of fiduciary duty. The SPAC’s sponsor and board members will mount several arguments to try to ward off judicial review, none of which is valid. A suit by SPAC shareholders is a direct suit for breach of the sponsor’s and board’s intertwined duties of loyalty and candor, compensable by damages that put the shareholders in the position of having exercised their redemptions rights.

The complete paper is available for download here.