The “economic structure” of SPACs creates an ‘inherent conflict” between the SPAC sponsor and the SPAC’s public shareholders, according to a new paper from two leading law professors. The conflict arises from the SPAC sponsor’s financial interest in completing a merger even if the merger is not value-creating, which may conflict with the shareholders’ interest in redeeming their shares if they believe that the proposed merger is disadvantageous. Because of the potential conflict, it is critical that the SPAC’s board independently reviews the proposed merger and inform shareholders about the merger with appropriate candor. However, if the board members’ compensation aligns their interests with those of the sponsor, the sponsor’s conflict could extend to the directors themselves – a circumstance the paper’s authors call the “epitome of bad governance.”
The solution, the authors suggest, is for the SPAC to structure the board members’ compensation in a way that aligns the directors’ financial interests with those of the shareholders. Moreover, the authors contend, courts reviewing shareholders’ allegations that a SPAC’s board members breached their fiduciary duties should consider the potential for conflict inherent in the SPAC’s structure and accordingly review the underlying circumstances using the “entire fairness” standard. These considerations are relevant to cases now pending in the Delaware courts, which have the potential to be “groundbreaking.” Stanford Law Professor Michael Klausner and NYU Law Professor Michael Ohlrogge’s November 19, 2021 paper entitled “SPAC Governance: In Need of Judicial Review” can be found here.
The Conflict Between the Sponsor and the Public Shareholders: As the paper discusses, if a SPAC does not find a merger target during the search period, the SPAC must liquidate. However, the SPAC sponsor gets nothing for its “founder’s shares” in a liquidation. The SPAC sponsor only realizes a financial benefit if the SPAC completes a merger. Thus, the sponsor has an incentive to complete a merger even if the transaction is not otherwise value creating. Public shareholders have the option to redeem their shares at the time of the merger rather than keeping their investment in the go-forward company. From the SPAC sponsor’s perspective, the more cash that remains in the merged company, the more likely it will succeed. Thus the sponsor not only has an incentive to merge when doing so is not in the shareholders’ interest, but it also “has an incentive to dissuade the public shareholders from redeeming their shares.”
Managing the Conflicts of Interest: These aspects of SPACs’ structure present a “central governance challenge” for SPACs, which is to “manage the conflict between the sponsor and the public shareholders.” The shareholders can be protected if the merger decision is in the hands of independent directors. However, some sponsors design their SPAC’s governance in a way that undermines the directors’ independence. In some instances, the directors have strong financial ties with the sponsor. In other instances, the sponsor grants them “founder shares” or ownership interests in the sponsor entity. This type of compensation aligns the directors’ financial interests with those of the sponsor. A SPAC governed by directors who have ties to the sponsor or who are compensated in this way is “the epitome of bad governance.”
These governance shortcomings can be averted if the directors are compensated in cash or with the same class of shares as the SPAC issues to public shareholders. Either of these approaches would “align the interest of the board with the interests of shareholders.”
Shareholder Claims Concerning Redemptions Rights: The primary reason to try to align the directors’ interests with those of the shareholders is that if the interests are misaligned, there is the concern that the sponsor and the board “will fail to inform shareholders sufficiently to allow them to protect themselves through the exercise of their redemption rights.” If the merger turns out badly, a fiduciary duty suit may follow. The likely claimants are the shareholders who did not redeem their shares. They will allege that they were not sufficiently informed of material information related to the proposed merger and as a result could not exercise their redemption rights effectively.
Reasons that Objections to Judicial Review Fail: The defendants in a lawsuit of this type will likely raise four arguments in order to try to avoid judicial review, each of which the authors address in order to show that “each of these arguments fails.”
First, the defendants will argue that a suit of this type is derivative rather than direct, and therefore subject to the pre-suit demand requirement (a requirement that, because of the high standard for establishing demand futility would mean that “the merger will be insulated from judicial review”). The authors argue that because the lawsuit seeks damages for harm suffered by the shareholders for economic damage that the shareholders’ themselves suffered (rather than for harm suffered by the corporation), the shareholders’ action would be direct, not derivative.
Second, the defendants will argue that their interests did not conflict with those of the shareholders and therefore that the business judgment rule applies. The authors suggest that this argument is implausible with respect to the sponsor, and if the board members are compensated in a way that aligns their financial interests with those of the sponsor, it is “equally implausible with respect to the SPAC board.” The inherent conflict of interest in these circumstances “requires entire fairness review.” Without “meaningful court review” of SPAC mergers, shareholders “will predictably suffer.”
Third, in order to try to avoid judicial review, the defendants will argue that a SPAC board does not owe the shareholders a fiduciary duty in connection with their exercise of their redemption rights. The defendants will argue that the redemption rights are a contract right and that the source of the redemption rights is the SPAC’s charter, and that the contracting party is the SPAC itself, not the sponsor or the board. The authors contend the fact that the redemption right is addressed in the charter has no bearing on whether the sponsor and the directors owe the shareholders a duty of candor; the charter says nothing about what information the sponsor and the directors must provide the shareholders. Requiring the board to abide by its duty of candor will therefore not rewrite the contract or undermine the primacy of contract law.
Fourth, the defendants will argue that the shareholders’ claims are so-called “holder claims” – that is, a claim in which the plaintiff alleges that they relied on a misrepresentation in choosing not to sell their shares. Delaware’s courts have not settled whether holder claims are cognizable, but they have held that they cannot proceed as class actions because of the individual reliance issues involved. The authors argue that the decision whether or not to redeem is a decision whether or not to convert cash held in trust into an investment in the combined company. Choosing to invest in the proposed merger is not the same as a decision to “hold.” Moreover, there is no impediment to the shareholders’ claims proceeding as a class action.
The authors note at the outset of their paper that, up until this point, despite the extensive amount of financial activity involving SPACs in recent months, there has been “relatively little light shed on how poorly SPACs are structured from a corporate governance standpoint.” However, because of cases pending in the Delaware Chancery Court, these issues may now be addressed. In their paper, the authors specifically refer to the Multiplan case now pending in the Delaware Chancery Court (which I discussed here, at the time the case was filed). The Multiplan case is only one of the “breach of fiduciary duty/entire fairness” cases currently pending in the Delaware Chancery Court (refer here for another example).
The parties presented oral arguments on the motion to dismiss in the Multiplan case in October. The court has not yet ruled. According to the paper’s authors, the Multiplan case “has the potential to be groundbreaking” both with respect to “how closely the court will review allegations that a SPAC sponsor and board breached their fiduciary duties of loyalty and candor in connection with a merger” and “in setting the rules for how SPACs will be governed going forward.” The defendants in the case, raising the kinds of arguments that the authors addressed in their paper, have “essentially argued that courts should play no role in enforcing fiduciary duties owed by SPAC sponsors and boards to public shareholders.” This outcome, the authors suggest, “would be an unfortunate result for SPAC public shareholders and a regrettable development in Delaware law.”
The need to avoid this “unfortunate result,” the authors contend, requires “a novel application of Delaware precedent” in order to “preserve Delaware fiduciary principles in the SPAC context.”
Accordingly, the outcome of the pending dismissal motion in the Multiplan case has important implications, at least with respect to SPACs organized under the laws of Delaware. Clearly the outcome of the pending motion will be important to watch.
The authors’ analysis of SPAC governance issues also has important implications for anyone considering the litigation risks relating to SPACs. Clearly, the nature of the directors’ compensation has a direct bearing on whether or not shareholders or others will be able to try to argue that the directors’ interests were aligned with those of the sponsor and therefore conflicted with those of the SPAC’s shareholders. The likelihood that claimants or others will be able to try to make these arguments will be increased to the extent that the directors are compensated with founder’s shares; are compensated with an ownership interest in the sponsor entity; or otherwise have strong financial ties with the sponsor. The ability to make these arguments will be diminished to the extent the directors are compensated in cash or with the same class of shares as the public shareholders.
One final note. The authors discussion about legal issues relating to SPACs and the potential for conflicts of interest is all geared toward SPACs organized under the laws of Delaware. However, many SPACs, particularly those organized by sponsors based outside the U.S., are organized under the laws of the Cayman Islands (or of other jurisdictions). It is not clear how the analysis would work under the Cayman law or the laws of other jurisdictions; the authors do not address these issues. However, one thing that is clear is that the possibility for conflicts of interest arising from the misalignment of the directors’ financial interests with those of the sponsor exists regardless of the jurisdiction in which the SPAC is organized.