SPAC Redemption Rights—Panacea or Achilles Heel? Delaware Court Denies Defendants’ Motion to Dismiss in MultiPlan Litigation
On January 3, 2022, the Delaware Chancery Court declined to dismiss breach of fiduciary duty claims in In re MultiPlan Stockholders Litigation against a SPAC sponsor and its board of directors in connection with a de-SPAC transaction. The claims were brought by stockholders of the SPAC in a putative class action that centered on the alleged impairment of their redemption rights due to misstatements and omissions in the proxy statement for the de-SPAC transaction. In its ruling, the court drew two important conclusions:
- The court rejected the defendants’ arguments that the claims were essentially derivative in nature. This was important both in this case, because plaintiffs failed to plead demand futility, which is a basis for dismissal of derivative claims, and as precedent for future de-SPAC transactions, because it set a lower bar for copy-cat litigation.
- The court held that the transaction was subject to the entire fairness standard of review, due to conflicts of the SPAC sponsor and the SPAC board, rather than the more lenient business judgment standard. This was important because all SPACs have conflicts similar to those at issue in MultiPlan, and these conflicts are typically fully disclosed before the SPAC goes public. The court rejected the argument that it would be inequitable to allow stockholders to challenge conflicts of which they were fully aware before they bought their shares. But the court was careful to limit its holding to the situation at hand where there was also an allegation of inadequate disclosure.
MultiPlan is the first significant decision to deal directly with fiduciary duties of sponsors, directors and officers in the SPAC context. In part because it involved a ruling on a motion to dismiss, it left a great many issues unresolved. However, unless limited by subsequent judicial guidance, it appears to have provided plaintiffs’ firms with a roadmap on how to bring claims against SPACs, invoking the plaintiff-favorable entire fairness standard of review.
Churchill Capital Corp. III (Churchill, or the SPAC) completed its IPO in February 2020, using essentially a standard SPAC structure, including providing redemption rights to stockholders in connection with a de-SPAC transaction. The SPAC entered into a merger agreement to acquire MultiPlan in July 2020. The transaction was structured as a merger and related steps in which MultiPlan became a wholly owned subsidiary of the SPAC, and MultiPlan’s stockholders received mixed cash and stock consideration having an aggregate value of $5.678 billion. The SPAC’s board retained an affiliate of the SPAC sponsor as its financial advisor for the transaction, and paid it a $30.5 million fee. The SPAC delivered a proxy statement to its stockholders providing information about the transaction and soliciting stockholder approval. The proxy statement disclosed that more than a third of MultiPlan’s revenue came from a single customer, but did not disclose that this customer was likely to cease purchasing from MultiPlan because it intended to develop inhouse a competing product. The merger closed in October 2020, and fewer than 10% of Churchill’s stockholders redeemed their shares. A month later, a short seller published a report discussing the customer’s development of the competing product. MultiPlan’s shares dropped significantly.
Stockholders filed putative class action suits in Delaware Chancery Court, which were consolidated in April 2021, alleging, in essence, that the defendants failed to disclose material information regarding MultiPlan for self-interested reasons and, as result, the stockholders’ ability to make an informed decision regarding whether to exercise their redemption rights was impaired. For more background about the initial lawsuit, see our previous Advisory. Defendants moved to dismiss the complaint on several grounds.
The court first considered some critical threshold issues, and then turned to the fiduciary duty claims. It is important to remember that the court did not make conclusions on the merits of the underlying claims of the plaintiffs—meaning that the court did not find that the defendants, in fact, breached their fiduciary duties. Rather, in ruling on a motion to dismiss, the court accepted as true the factual allegations of the plaintiffs and determined that, as a matter of law, the claims could stand.
Defendants’ Arguments That Plaintiffs Improperly Brought the Suit As a Direct Action, and Other Threshold Issues
Generally stated, the defendants viewed the de-SPAC transaction as a buy-side transaction, in which any harm flowed directly to the company, and only indirectly to the stockholders, and thus claims were the quintessential derivative claims and not direct (class action) claims. According to the defendants, the plaintiffs’ claims essentially alleged that MultiPlan was worth less than the SPAC paid for it, which was an “overpayment” claim, and that it wasted assets hiring a financial adviser affiliated with the SPAC sponsor, which was a “waste” claim. Both types of claims are derivative in nature, and should be dismissed because plaintiffs had failed to plead demand futility. Plaintiffs’ claims relating to misstatements and omissions in the proxy statement should also be dismissed because the resulting damages, which flowed from the alleged overpayment, belonged to the company and only indirectly to the stockholders. The defendants also viewed the redemption rights claims as disguised “holder claims,” where stockholders allege they were wrongfully induced to hold stock instead of selling it, which claims cannot be brought as a class action and, moreover, are not clearly recognized under Delaware law.
The court rejected these arguments. Instead, the court focused on the redemption right and analogized it to a decision by the stockholders as to whether or not to tender their shares for the redemption price. Accordingly, the court viewed the SPAC stockholders as having to make an investment decision, giving rise to a direct claim and not a derivative one. The court noted that impairment of the voting right was less significant, because stockholders could have their shares redeemed regardless of which way they voted on the merger, and because they would keep their warrants even if their shares were redeemed, and thus had a built-in incentive to approve the merger.
The court also rejected an argument by the defendants that the redemption rights were contractual in nature, which would have mandated dismissal because Delaware law does not permit plaintiffs to bring fiduciary duty claims arising from the same facts as contract claims. The court noted that what was at issue was not whether the SPAC was honoring its contractual redemption obligations, but whether the directors breached their “fiduciary duty to disclose material information when seeking stockholder action” relating to stockholders’ redemption decision.
Defendants’ Arguments for the Business Judgement Rule Rather than the Entire Fairness Standard
The court considered two potential bases for application of the entire fairness standard of review: whether the transaction involved a conflicted controller, and whether the board consisted of a majority of directors who were not disinterested and independent. Regarding the first basis, the parties agreed that the SPAC sponsor controlled the SPAC. The issue therefore turned on whether the SPAC sponsor had a disabling conflict through either standing on both sides of the transaction (which all parties agreed was not the case) or because the sponsor competed with the common stockholders for consideration. The court noted that the sponsor could be deemed to compete with common stockholders if it (1) “receives greater consideration for its shares”, (2) “takes a different form of consideration” or (3) receives a “unique benefit.. The defendants argued that the SPAC sponsor was aligned with the common stockholders because the Class B shares held by the sponsor converted in the merger into the same Class A shares held by the public stockholders. Rejecting this argument, the court held that it missed the point because the SPAC sponsor had a “unique benefit” in connection with the merger. The court reasoned that the sponsor had a big structural incentive to do a deal because if the deal went ahead, its shares would be worth approximately $305 million, representing a 1,219,900% return on its $25,000 investment, but if the SPAC did not do a deal within approximately two years of its IPO, the SPAC would have to be liquidated and the sponsor’s shares would be worth zero. This reasoning is important because, as the court acknowledged, this type of “unique benefit” is present in every de-SPAC transaction.
The defendants argued that plaintiffs should be estopped from challenging the SPAC structure in this way because the structure was fully disclosed to them before they purchased shares of the SPAC. The court disagreed with this characterization, holding instead that by investing in the SPAC the public stockholders “agreed to give the Sponsor an opportunity to look for a target company with the understanding that they retained an option to make a redemption decision. They did not, however, agree that they did not require all material information when the time came to make that choice.” The court noted that its analysis might have been different were it not for the inadequate proxy disclosure. The court held that the $30.5 million financial advisory fee paid to the affiliate of the SPAC sponsor bolstered its conclusion.
The court made light work of finding that the plaintiffs had sufficiently alleged that a majority of the board members were not disinterested and independent. The court held that the plaintiffs had sufficiently pled that the directors were interested because they held founders’ shares, and thus had a similar conflict to the SPAC sponsor, described above. The court held that the plaintiffs also sufficiently alleged a majority of the board was not independent of the SPAC sponsor because all of the directors were appointed, and could be removed, by the SPAC sponsor, five of them had been appointed by the sponsor to sit on other SPACs formed by the sponsor where they stood to make millions of dollars in compensation, and two had family or employment ties to the sponsor.
Applying the entire fairness rule to the stockholders’ allegations, the court found it easy to determine that the stockholders’ claims included sufficient allegations to withstand a motion to dismiss. The court noted that it is rare to dismiss claims decided under this more stringent standard because determining whether a transaction was entirely fair to stockholders is a necessarily fact-intensive exercise. Noting that the “fair dealing” aspect of the entire fairness standard implicates the duty of disclosure, the court held that the stockholders had plausibly alleged that the directors “failed, disloyally, to disclose information necessary for the plaintiffs to knowledgably exercise their redemption right.” The court again noted, in dicta, that it was not addressing the validity of claims against the directors based solely on conflicts, where the disclosure was adequate. According to the court, “[t]he core, direct harm presented in this case concerns the impairment of stockholder redemption rights. If public stockholders, in possession of all material information about the target, had chosen to invest rather than redeem, one can imagine a different outcome.”
The court’s decision raises a series of important considerations from the perspective of litigation and also some lessons for SPACs from a transaction perspective.
While much remains to be seen as this litigation progresses, there are numerous takeaways from a litigation perspective:
1. The Litigation Door is Opened. Although the court did not rule on the merits of plaintiffs’ claims, the decision should be viewed as opening the door to future plaintiffs’ s on other de-SPAC transactions. The key elements of the litigation were the combination of the SPAC sponsor incentives, the stockholder redemption right, the disclosure claim, and the drop in market price of the stock below the redemption price. The sponsor incentives and stockholder redemption right are basic structural components of SPAC transactions, and likely to be present in any deal. Therefore, the case can be seen as an incentive for plaintiffs’ firms to gin up disclosure claims and bring them as class action lawsuits under an entire fairness standard of review, whenever there is a significant drop in a SPAC’s trading price in the aftermath of its de-SPAC transaction.
2. Redemption Rights. It is ironic that the redemption right, which is a structuring tool that is intended to mitigate the effects of conflicts, was central to plaintiffs’ claims. Despite the MultiPlan decision, redemption rights nonetheless serve an important purpose in attracting SPAC investors and mitigating conflicts, and are unlikely to disappear following this decision.
3. Class Actions v. Derivative Suits. The ability to bring these claims as class actions instead of derivative actions lowers the bar meaningfully for plaintiffs’ attorneys. Derivative actions are typically harder to bring because of the demand refusal/futility requirement. In a typical SPAC deal, independent and disinterested board members join the board upon closing of the de-SPAC transaction. The existence of independent/disinterested board members will make demand futility much harder to establish, as those board members have no demonstrable incentive to ignore a plaintiff’s demand. Moreover, even when they are brought derivative actions are usually analyzed under the far more forgiving business judgment standard. Perhaps most significantly, plaintiffs attorneys have a much greater incentive to bring class actions because class actions typically result in much higher attorneys fees than derivative actions.
4. Entire Fairness. Two procedural devices that can be used to avoid the burden of proving entire fairness are approval by a special committee consisting of independent and disinterested directors, and uncoerced majority-of-the-minority stockholder approval.1 In the de-SPAC transaction context, majority-of-the-minority stockholder approval does not seem workable. It would not provide any protection where the approval is based on material misstatements and omissions in the proxy statement, which, based on MultiPlan, is the reason for having entire fairness apply in the first place. Another problem, as noted by the MultiPlan court, is that the stockholder vote in de-SPAC transactions is not completely free from coercion because SPAC stockholders have an economic incentive to approve a de-SPAC transaction even if they exercise their redemption rights. Accordingly, it is questionable whether a court would find majority-of-the-minority approval achieves the necessary sanitizing effect to rescue the SPAC sponsor from having to prove entire fairness. What may be possible, however, is for SPACs to have the de-SPAC transaction approved by a special committee of disinterested and independent directors. While this would result in some loss of control by the SPAC sponsor and potential loss of their ability to impart their expertise (the SPAC’s ability to leverage the expertise of the SPAC sponsor is used to justify the large sponsor promote), there may be a way of structuring the SPAC sponsor’s role so as to make it practicable.
5. Damages. It is unclear what the damage remedy would be if the plaintiffs prevail at trial. In the complaint, in addition to a generic award of “damages in an amount which may be proven at trial”, the plaintiffs seek an equitable “re-opening [of] the redemption window” to permit stockholders who do not exercise their redemption rights to do so or, in the alternative, rescission of the merger and a return of capital to the SPAC stockholders, plus other rescissory damages. It is very difficult to image a court ordering rescission of the merger, given that “the metaphorical merger eggs have been scrambled”.2 As noted by defendants’ counsel in their opening brief in support of their motion to dismiss, opening the redemption window would be seeking a remedy against the SPAC, which was not a named defendant. It would also negatively impact other innocent stockholders, given the ensuing loss in value to their shares. Given the procedural stage of the decision, the court did not address the damages issues.
6. Precedential Impact. MultiPlan provides useful, and for SPAC sponsors troublesome, guidance on how Delaware courts will evaluate the implications of SPAC sponsor promotes in de-SPAC transactions. However, the decision left open a lot of questions, including what the implications are when there is no alleged disclosure violation. It is also a decision on a motion to dismiss, and could be decided very differently in a post-trial ruling, whether by the Chancery Court or the Delaware Supreme Court. There are a number of aspects of the decision that could be challenged in a subsequent proceeding, including the “threshold” issues described above. Alternatively, MultiPlan could become a beachhead from which the entire fairness standard of review is extended into situations that are not centered on proxy statement disclosure violations.
Sponsors and their directors and officers should recognize that the MultiPlan decision will likely invite more litigation attention on SPACs, and that is in the context of already substantial regulatory focus on SPACs, about which we have we written in prior client alerts. See, e.g., our April 2021 Advisory. As a result, here are some things to consider for SPACs, their sponsors and current and future directors and officers to mitigate the risk of future litigation and regulatory scrutiny:
1. Director Independence. Having a sufficient number of independent and disinterested directors can help to mitigate the negative effect of SPAC sponsor conflicts. Such directors should be individuals who do not have familial or business ties to the SPAC sponsor, and could be paid directors’ fees in cash, so as to avoid the founders’ shares issue present in MultiPlan. In many SPAC transactions, there is a tacit assumption that director independence and disinterestedness does not matter until the de-SPAC transaction occurs because the SPAC is a funding vehicle that is controlled by the SPAC sponsor, and conflicts can be adequately addressed through full disclosure. MultiPlan makes clear the risks of such an approach.
2. Special Committee. Forming a special committee of independent and disinterested directors would help to mitigate SPAC sponsor conflicts, including through avoiding the burden of proof under an entire fairness standard of review. The challenge will be whether the special committee can be given a sufficiently robust mandate to be perceived as effective under Delaware law, without completely jettisoning the expertise and effectiveness of the SPAC sponsor.
3. Independent Financial Advisor and Fairness Opinion. Depending on the circumstances, the Board of the SPAC might consider retaining an independent financial advisor and also getting a buy-side fairness opinion regarding the proposed de-SPAC transaction. To date, this has not been the common practice with SPACs.
4. Avoid Unnecessary Conflicts. The MultiPlan court noted that receipt by an affiliate of the SPAC sponsor of a $30.5 million advisory fee bolstered its conclusion that entire fairness was the applicable standard of review. While perhaps not outcome determinative, having an independent financial advisor would have at least helped the optics and mitigated, instead of exacerbated, the conflicts.
5. Should SPACs Avoid Delaware? It is an open question whether the courts and laws of other jurisdictions, such as the Cayman Islands, may provide a safer place to form new SPACs, compared to Delaware after the MultiPlan decision. That kind of question involves the weighing of several factors. Nevertheless, it is a genuine question that should be considered.
6. Diligence & Disclosure. The MultiPlan decision turned on the inadequacy of the disclosure in the SPAC’s proxy statement. More generally, Plaintiffs’ counsel took the position that if the SPAC officers and directors knew of MultiPlan’s business risks, they should have adequately disclosed them, and if they did not know of the risks, they failed to adequately diligence MultiPlan and thus their statements in the proxy statement about having engaged in extensive diligence were materially inadequate. The takeaway is that SPAC officers and directors should ensure that there is a thorough diligence process in connection with de-SPAC targets, and that all material risks are fully disclosed.
© Arnold & Porter Kaye Scholer LLP 2022 All Rights Reserved. This Advisory is intended to be a general summary of the law and does not constitute legal advice. You should consult with counsel to determine applicable legal requirements in a specific fact situation.
In controlling stockholder “freezeout” transactions, use of both protections can result in reducing the standard of review to business judgment (see Kahn v. M&F Worldwide Corporation, 88 A.3d 635 (Del. 2014)) and use of either protection can result in flipping the burden of proof to the plaintiff (see Kahn v. Lynch, 638 A.2d 1110 (Del. 1994)). In some other contexts, either protection can be used to reduce the standard of review to business judgment.