For private operating companies, merging with a Special Purpose Acquisition Company (SPAC) has become an increasingly common way of “going public.”
So far, the current SPAC phenomenon has not resulted in significant amounts of litigation. That may well change. Sheer probabilities, and history, suggest that, as more SPACs attempt to acquire target companies, some of the transactions will not work out, and litigation will result. Potential SPAC targets, SPAC sponsors, and SPACs themselves should be aware of these litigation risks and potential nuances in the SPAC context.
As set forth in more detail in a previous Baker Botts client alert, a SPAC, also known as a blank-check company, is formed to raise a “blind pool” of capital through an initial public offering (IPO) for the purpose of taking an existing (but yet to be identified) private company public via an acquisition.
Following its IPO, a SPAC has fixed time period (Liquidation Window), usually 18-24 months but sometimes subject to extension, to combine with a target through reverse merger, commonly called a “de-SPAC” transaction or an “initial business combination.” If an acquisition does not take place during that time, the SPAC liquidates and returns its funds, which to that point had been held in trust, to investors.
If the SPAC does identify a target, the SPAC’s investors must approve the acquisition and can request redemption of their shares if they don’t like the proposed deal. Getting shareholder approval for the de-SPAC typically involves the filing and furnishing of proxy statements.
In addition, once the de-SPAC is approved, SEC rules require the new company to file a detailed Form 8-K, colloquially called a “Super 8-K.” The content of the Super 8-K is similar to the information the company would include in a Form 10 or Form S-1 registration statement if the issuer were conducting a traditional IPO.
Where May Litigation Arise?
Pre-Business Combination. While some “broken deal” litigation may arise between SPACs and potential targets, such litigation is likely to be highly fact-specific and dependent on the terms and conditions of the agreement(s) between the parties.1 In addition, SPACs are, by their nature, publicly traded companies, albeit ones with limited operations before the de-SPAC. They must comply with all SEC filing requirements, and the SPAC’s directors are subject to the same duties of loyalty and care as the directors of any other public company would be.
Post-Business Combination. We believe most significant SPAC-related litigation will likely arise after the de-SPAC transaction. Particularly if the combined company fails to meet projections, we expect to see the plaintiffs’ bar scour any proxy solicitation, Super 8-K, or other public statements around the time of the de-SPAC to attempt to find allegedly false or misleading statements. Unlike in a traditional IPO, financial projections may be used in the proxy statement filed in connection with a de-SPAC transaction, which could potentially increase the likelihood of litigation if the projections were not reasonable. In addition, disgruntled shareholders may seek to bring state-law breach of duty claims against the SPAC’s directors.
What are the Most Likely Claims and Theories?
Shareholder plaintiffs, and potentially the SEC, will rely on a number of different statutes to bring SPAC-related claims.
Section 10b of the Exchange Act and Rule 10b-5. Section 10b and Rule 10b-5 broadly prohibit false or misleading statements or fraudulent schemes “in connection with the purchase or sale of a security.” These are, by far, the securities fraud provisions most frequently used by both private plaintiffs and the government. In the SPAC context, they will present a number of issues, including:
- Scienter. Section 10b/Rule 10b-5 claims require that the defendant acted with scienter, meaning deceptive intent or at least recklessness. Indeed, private plaintiffs must plead a “strong inference” of scienter to survive a motion to dismiss.2 Scienter is generally pled, and proved, through circumstantial evidence. In the SPAC context, at least one court found it probative, but not dispositive, of scienter where a SPAC identified and closed a deal with a target in the final two months before it the Liquidation Window closed, reasoning the SPAC’s desire to avoid liquidation gave a motive to disseminate misleading statements seeking investor approval of the deal.3 While other factors also militated towards scienter in that case, we expect to see more cases where plaintiffs cite the fact that a business combination came together near the end of the Liquidation Window as indicative of scienter.
- Target Company Officer/Director Liability. Under Section 10b/Rule 10b-5, as well as the other securities fraud theories discussed herein, a target company’s directors and officers may face liability for statements in the SPAC’s proxy statement or Super 8-K, particularly where those filings contain business or sales data regarding the target. For example, a court in the Southern District of New York recently declined to dismiss the SEC’s suit against a former director of a SPAC target for false statements in the proxy materials, citing the director’s alleged decision-making authority regarding the information about the target that would be provided in those materials.4
- Not limited to SEC filings. Section 10b/Rule 10b-5 are not limited to statements in securities filings. For example, in a recent high-profile case, the SEC brought Section 10b/Rule 10b-5 claims against a CEO for statements he made on Twitter.5 Thus, in making statements on social media or in other less formal fora about the de-SPAC process or about the combined company’s prospects of success, target companies and SPACs should be aware that the plaintiffs’ bar and regulators may be sifting through those materials, just as much as SEC filings, for alleged false and misleading statements.
Section 14(a) of the 1934 Exchange Act and Rule 14a-9. Section 14(a) and Rule 14a-9 prohibit false and misleading statements in connection with proxy solicitations. Given the use of proxy solicitations in the de-SPAC transaction, several issues are worth noting regarding potential 14a/14a-9 claims:
- No scienter requirement. Although applicable only to proxy solicitations, Section 14(a)/Rule 14a-9 claims generally do not require plaintiffs to plead or prove scienter; instead, the plaintiff must show the defendant knew or should have known the proxy materials contained false statements.6
- Standing. Generally, only shareholders who were entitled to vote on the proxy solicitation have standing to bring claims under Section 14(a)/Rule 14a-9.7
- “Foreign Private Issuers” Exempt. Section 14(a) does not apply to foreign private issuers, and a court in the Southern District of New York dismissed Section 14(a)/Rule 14a-9 claims against a foreign private issuer SPAC on that basis.8 However, many SPACs will be unlikely to meet the regulatory definition of foreign private issuer, which, among other things, requires that more than 50% of the outstanding voting securities are held by non-U.S. residents.
Other Federal Securities Claims and Issues. In some cases, a SPAC may also need to file a registration statement in connection with the de-SPAC transaction. This could occur, for example, where the SPAC needs to raise additional capital to close the business combination. False statements in a registration statement could expose the SPAC, its directors, and others who certified the registration statement to claims under Section 11 of the Securities Act by purchasers of securities issued in any such offering. While a detailed discussion of Section 11 claims is beyond the scope of this article, it bears noting that Section 11 contains no scienter or causation requirement.
In addition, in televised remarks last month, SEC Chairman Jay Clayton stated that the SEC is “particularly focused on . . . the incentives and compensation to the SPAC sponsors,” including “How much of the equity do they have now? How much of the equity do they have at the time of the IPO-like transaction? What are their incentives?”9 In light of the Chairman’s comments, SPACs would be well advised to ensure that the proxy materials and other SEC filings adequately disclose any such incentives and compensation.
Similarly, potential SPAC sponsors who are also affiliated with a private equity or venture capital fund should carefully review their fund documents to ensure a SPAC transaction would not cause a conflict of interest in violation of the fund’s requirements.
State Law Claims Against Directors. Plaintiffs may also claim that the SPAC’s directors breached their duties of care and loyalty to the shareholders in failing to adequately diligence a potential target. Notably, courts have held that a failure to conduct diligence claim in this context is not protected by the business judgment rule.10 We also expect to see claims that directors breached their duty of loyalty to the SPAC, because the SPAC’s compensation structures incentivized them to close a deal with a target, rather than looking out for the best interests of a SPAC’s shareholders.11
As the results of more SPAC business combinations play out, we are likely to see post-hoc challenges to the disclosures filed in connection with those transactions. Both the SPAC and the target company must take steps to ensure the accuracy of materials or information disclosed in the Super 8-K, the proxy statement, and any other statements made in connection with the de-SPAC transaction. For the target company, this means being honest and accurate in providing diligence materials to the SPAC before the deal is consummated. For the SPAC, it may mean including appropriate sourcing language or caveats and potentially conducting independent diligence, where appropriate. Further, SPACs should ensure that any compensation and incentives to SPAC directors and sponsors are appropriately disclosed to investors.
1 See, e.g., Morgan Joseph Triartisan LLC v. BHN LLC, No. 651969/2014, 2017 WL 3951623 (N.Y. Sup. Ct. Aug. 21, 2017) (granting in part and denying part motion for summary judgment arising out of failed SPAC transaction).
2 See, e.g., Tellabs Inc. v. Makor Issues & Right Ltd., 551 U.S. 308, 322 (2007).
3 In re Stillwater Capital Partners Inc Litig., 858 F. Supp. 2d 277, 288 (S.D.N.Y. 2012)
4 SEC v. Hurgin, No. 19 Civ. 5705 (MKV), 2020 WL 5350536, at *8 (S.D.N.Y. Sept. 4, 2020) (citing Janus Cap. Grp. v. First Derivative Traders, 564 U.S. 135, 142 (2011)).
5 See, e.g., Complaint, Securities & Exchange Comm. v. Musk, No. 18 Civ. 8865 (S.D.N.Y.. Sept. 27, 2018), ECF No.1.
6 SEC v. Hurgin, 2020 WL 5350536, at *11.
7 See, e.g., DCML LLC v. Danka Bus. Sys. PLC, No. 08 Civ. 5829 (SAS), 2008 WL 5065928, at *2 (S.D.N.Y. Nov. 26, 2008)
8 In re Stillwater Capital Ptrs. Litig., 853 F. Supp. 2d 441, 457 (S.D.N.Y 2012).
9 Dave Michaels and Alexander Osipovich, Blank-Check Firms Offering IPO Alternative Are Under Regulatory Scrutiny, The Wall St. Journal, Sept. 24, 2020.
10 Parsifal Partners B_ LP v. Zugel, 651174/17, 2018 N.Y. Misc. LEXIS 2748, at *23 (N.Y. Sup. Ct. July 2, 2018) (applying Delaware law and asserting that “[b]ecause the plaintiff is not challenging a ‘business decision,’ the court agrees with plaintiff that the business judgment rule is not applicable here.’”); see also See, e.g., AP Servs., LLP v. Lobell, 651613/12, 2015 N.Y. Misc. LEXIS 2314 at *24-33 (N.Y. Sup. Ct. June 19, 2015).
11 See, e.g., AP Servs., LLP v. Lobell, 651613/12, 2015 N.Y. Misc. LEXIS 2314 *17-24 (N.Y. Sup. Ct. June 19, 2015).
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