A year following the Delaware Chancery Court’s decision in Multiplan Corp. Stockholders Litigation (f/k/a Churchill Capital Corp III), the court again issued an opinion supporting a breach of fiduciary duty cause of action against SPAC directors and sponsors and confirming that a de-SPAC transaction should be reviewed using the “entire fairness” standard. In the January 2023 case of Delman v. Gigacquisitions3, LLC, et al. the Delaware Court denied a motion to dismiss by SPAC sponsors and directors, upholding their potential liability. Interestingly, the Delman motion was in front of the same vice-chancellor as was Multiplan. My blog on the Multiplan Corp. Stockholders Litigation (f/k/a Churchill Capital Corp III) case and its ramifications can be read HERE.
In addition to confirming the inherent conflict of interest of SPAC sponsors and directors, the cases will undoubtedly cause practitioners and market participants to implement new policies and procedures related to proxy statement disclosures, diligence, board discussions, financial valuations, capital raising and de-SPAC transactions. I would suggest that these policies and procedures should track many aspects of the proposed new SPAC rules, getting ahead of both potential litigation liability and regulatory changes.
Delman v. Gigacquisitions3, LLC, et al.
GigCapital3, Inc. (the “SPAC”) with GigAcquisitions3, LLC as its sponsor (the “Sponsor”) completed its IPO in May 2020. The SPAC sold 20,000,000 units consisting of one share of Class A common stock and a ¾ redeemable warrant for $10.00 per unit for aggregate gross offering proceeds of $200,000,000. The same natural person, Avi Katz, controlled the Sponsor, was Executive Chairman, CEO, Secretary, President of the SPAC and selected the SPAC’s initial officers and directors who in turn had equity in the Sponsor as well.
As is typical in the formation of SPACs, the Sponsor held a 20 percent equity interest in the SPAC, which it obtained for a cash payment of $25,000. The Sponsor also invested $6.5 million in a PIPE simultaneously with the closing of the IPO. Also as typical, the underwriters deferred two-thirds of their underwriting compensation until a merger was accomplished. Katz is a serial sponsor completing 2 prior SPAC IPO’s and 3 subsequent.
In December 2020, the SPAC entered into a merger agreement with Lightning Systems, Inc. (Lightning) an electric vehicle manufacturer valued at approximately $899 million which valuation was lowered to $539 million pre-merger closing. Katz led the negotiations for the merger. As part of the merger, the SPAC attempted to raise between $100 and $150 million in a PIPE at the $899 million valuation but failed resulting in the lower valuation. The SPAC ultimately raised $25 million from Lightning’s largest equity holder and turned to pursuing dilutive convertible note financing to raise another $100 million.
The SPAC did not obtain a fairness opinion in connection with the transaction. The proxy statement contained forward-looking statements including projections by Lightning illustrating dramatic growth over a five-year period. The proxy also disclosed potential conflicts of interest between the Sponsor and Board on one hand and the public shareholders on the other hand.
Redemptions only totaled approximately 29% and 98% of shareholders voted in favor of the merger. Generally, in a de-SPAC transaction, redemptions are much higher as the IPO stockholders can receive their investment back (or the vast majority thereof) while keeping the warrant to ride the potential upside of the transaction.
The merger closed on May 6, 2021, and on May 17, the company reduced its 2021 revenue guidance by 12.7%. In August 2021, a lawsuit was filed against the SPAC’s directors and officers, alleging breach of fiduciary duty claims including the duty of loyalty. In particular, the plaintiff alleges that the Sponsor, individual board members and Katz undertook a value-decreasing de-SPAC merger that allegedly benefitted them to the detriment of public stockholders for whom liquidation would have been preferable. Before the closing the stock price was around the redemption value of $10.07 per share, right after closing it started to drop and by the time the court denied the motion to dismiss, the trading price was $0.41 per share.
The plaintiffs allege that the defendants breached their fiduciary duties by “prioritizing their own financial, personal, and/or reputational interests [in]approving the [m]erger, which was unfair to Gig3’s public stockholders.” Moreover, the complaint alleges that the proxy contained misrepresentations and/or omissions necessary for the stockholders to make an informed decision as to whether to redeem or to invest in post-merger company.
The defendants moved to dismiss the complaint which motion was denied. Moreover, the defendants argued that their duties of care and loyalty do not extend to redemption rights in the first place. In denying the argument, the court held that the duty was breached by interfering with the redemption right by not providing sufficient disclosures in the proxy, which is the basis of a fiduciary duty. The court continued, “[T]he right to redeem is the primary means protecting stockholders from a forced investment in a transaction they believe is ill-conceived. It is a bespoke check on the sponsor’s self-interest, which is intrinsic to the governance structure of a SPAC. If follows that a SPAC’s fiduciaries must ensure that right is effective, including by disclosing fully and fairly all material information that is reasonably available about the merger and target to inform the redemption decision.”
Consistent with the Multiplan Corp. case, the Court also found that the defendants have an inherent conflict of interest and thus the transaction is subject to the “entire fairness” standard of review. See below for a discussion of the various standards of review. The core basis for the conflict, which exists in every SPAC, is that the sponsor side (and usually board members) are incentivized to undertake a value-decreasing transaction as it could lead to huge returns on the sponsor’s investment (and avoid a complete loss of its investment), without regard to whether the public stockholders are better served by liquidation. Here the court found the board lacked independence as well. The court also found that Katz personally had fiduciary obligations as a result of his control over the company.
Board of Directors and Key Officers’ Fiduciary Duties in the Merger Process
State corporate law generally provides that the business and affairs of a corporation shall be managed under the direction of its board of directors. Members of the board of directors have a fiduciary relationship to the corporation and its stockholders, which requires that they act in the best interest of the corporation and its stockholders, as opposed to their own. Key executive officers have a similar duty. Moreover, controlling stockholders have similar duties to minority stockholders and are prohibited from exercising power to advantage themselves to the detriment of the corporation and other stockholders.
Generally, a court will not second-guess directors’ decisions as long as the executives have conducted an appropriate process in reaching its decisions. This is referred to as the “business judgment rule.” The business judgment rule creates a rebuttable presumption that “in making a business decision the directors of a corporation acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the company” (as quoted in multiple Delaware cases including Smith vs. Van Gorkom, 488 A.2d 858 (Del. 1985)).
However, in certain instances, such as in a merger and acquisition transaction, where a board or top executives may have a conflict of interest (i.e., get the most money for the corporation and its shareholders vs. getting the most for themselves via either cash, job security or as in the case here, a large upside to the transaction closing), the board of directors’ and executives actions face a higher level of scrutiny. This is referred to as the “enhanced scrutiny business judgment rule.”
A third standard, referred to as the “entire fairness standard,” is only triggered where there is a conflict of interest involving officers, directors and/or shareholders such as where directors are on both sides of the transaction or as in this case, where they will benefit from the transaction and lose economics without the transaction. Under the entire fairness standard, the executives must establish that the entire transaction is fair to the shareholders, including both the process and dealings and price and terms. The entire fairness standard is a difficult bar to reach and generally results in a finding in favor of complaining shareholders.
In all matters, directors’ and executive officers’ fiduciary duties to a corporation include honesty and good faith as well as the duty of care, duty of loyalty and a duty of disclosure. In short, the duty of care requires the director/officer to perform their duty with the same care a reasonable person would use, to further the best interest of the corporation and to exercise good faith, under the facts and circumstances. The duty of loyalty requires that there be no conflict between duty and self-interest. The duty of disclosure requires the director/officer to provide complete and materially accurate information to a corporation and its stockholders.
As with many aspects of securities law, and the law in general, a director’s or officer’s responsibilities and obligations in the face of a merger or acquisition transaction depend on the facts and circumstances. From a high level, if a transaction is not material or only marginally material to the company, the level of involvement and scrutiny facing the board of directors or key executives is reduced and only the basic business judgment rule will apply.
The law focuses on the process, steps and considerations made by the board of directors and executive officers, as opposed to the actual final decision. The greater the diligence and effort put into the process, the better, both for the company and its shareholders, and the protection of the directors and officers in the face of scrutiny. Courts will consider facts such as attendance at meetings; the number and frequency of meetings; knowledge of the subject matter; time spent deliberating; advice and counsel sought by third-party experts; third-party valuation and fairness opinions, requests for information from management; and requests for and review of documents and contracts.
In the performance of their obligations and fiduciary responsibilities, a board of directors and executive officers may, and should, seek the advice and counsel of third parties, such as attorneys, investment bankers, and valuation experts. Moreover, it is generally good practice to obtain a third-party fairness opinion on a transaction.
Conflicts of Interest – the Entire Fairness Standard
The duty of loyalty requires that there be no conflict between duty and self-interest. Basically, an officer or director may not act for a personal or non-corporate purpose, including to preserve the value of an investment. The 2015 Delaware Supreme Court case of Corwin v. KKR (and its progeny) held that a transaction that might be subject to enhanced scrutiny instead be reviewed under the deferential business judgment rule after it was approved by a majority of disinterested, fully informed and uncoerced stockholders (the “Corwin Doctrine”). Where a transaction is not cleansed by shareholder approval relying on the Corwin doctrine, and where an officer or director is interested in a transaction, the entire fairness standard of review will apply. It is very difficult for an officer or director to defeat a claim where a transaction is being reviewed under the entire fairness standard.
In Delman the court denied the argument that the transaction had been cleansed under the Corwin Doctrine. Rather, the court found that the proxy was materially false and misleading such that the stockholders were not “fully informed” or “uncoerced.”
Some states, including Delaware, statutorily codify the duty of loyalty, or at least the impact on certain transactions. Delaware’s General Corporations Law section 144 provides that a contract or transaction in which a director has interest is not void or voidable if: (i) a director discloses any personal interest in a timely matter; (ii) a majority of the shareholders approve the transaction after being aware of the director’s involvement and all pertinent facts; or (iii) the transaction is entirely fair to the corporation and was approved by the disinterested board members.
The third element listed by the Delaware statute has become the crux of review by courts. That is, where an executive is interested, the transaction must be entirely fair to the corporation (not just the part dealing with the director). In determining whether a transaction is fair, courts consider both the process (i.e., fair dealing) and the price of the transaction. Moreover, courts look at all aspects of the transaction and the transaction as a whole in determining fairness, not just the portion or portions of the transaction involving a conflict with the executive. The entire fairness standard can be a difficult hurdle and is often used by minority shareholders to challenge a transaction where there is a potential breach of loyalty and where such minority shareholders do not think the transaction is fair to them or where controlling shareholders have received a premium.
To protect a transaction involving an interested executive, it is vital that all officers and directors take a very active role in the merger or acquisition transaction; that the interested executive inform both the directors or other directors, and ultimately the shareholders, of the conflict; that the transaction resemble an arm’s-length transaction; that it be entirely fair; and that negotiations be diligent and active and that the advice and counsel of independent third parties, including attorneys and accountants, be actively sought.
Delaware courts have emphasized that involvement by disinterested, independent directors increase the probability that a board’s decisions will receive the benefits of the business judgment rule and helps a board justify its action under the more stringent standards of review such as the entire fairness standard. Independence is determined by all the facts and circumstances; however, a director is definitely not independent where they have a personal financial interest in the decision or if they have domination or motive other than the merits of the transaction. The greater the degree of independence, the greater the protection. Many companies obtain third-party fairness opinions as to the transaction.
Conclusion
In light of Multiplan Corp. Stockholders Litigation (f/k/a Churchill Capital Corp III) and Delman, and the current proposed rule changes related to SPAC’s, I would suggest that all SPAC’s proceed as if a de-SPAC transaction will be reviewed under the entire fairness standard. Moreover, I would suggest that any disclosures associated with a de-SPAC transaction include more robust information about the sponsor of the SPAC, potential conflicts of interest, and dilution (see discussion of proposed new Subpart 1600 to Regulation S-K HERE), that a SPAC always obtain a third-party fairness opinion and that the SPAC either not use financial projections or add .
For a review of my full blog series on the SPAC proposed rules, see HERE, HERE, HERE, HERE, HERE, and HERE.
The Author
Laura Anthony, Esq.
Founding Partner
Anthony L.G., PLLC
A Corporate Law Firm
Securities attorney Laura Anthony and her experienced legal team provide ongoing corporate counsel to small and mid-size private companies, OTC and exchange traded public companies as well as private companies going public on the Nasdaq, NYSE American or over-the-counter market, such as the OTCQB and OTCQX. For more than two decades Anthony L.G., PLLC has served clients providing fast, personalized, cutting-edge legal service. The firm’s reputation and relationships provide invaluable resources to clients including introductions to investment bankers, broker-dealers, institutional investors and other strategic alliances. The firm’s focus includes, but is not limited to, compliance with the Securities Act of 1933 offer sale and registration requirements, including private placement transactions under Regulation D and Regulation S and PIPE Transactions, Regulation A/A+ offerings, as well as registration statements on Forms S-1, S-3, S-8 and merger registrations on Form S-4; compliance with the Securities Exchange Act of 1934, including registration on Form 10, reporting on Forms 10-Q, 10-K and 8-K, and 14C Information and 14A Proxy Statements; all forms of going public transactions; mergers and acquisitions including both reverse mergers and forward mergers; applications to and compliance with the corporate governance requirements of securities exchanges including Nasdaq and NYSE American; general corporate; and general contract and business transactions. Ms. Anthony and her firm represent both target and acquiring companies in merger and acquisition transactions, including the preparation of transaction documents such as merger agreements, share exchange agreements, stock purchase agreements, asset purchase agreements and reorganization agreements. The ALG legal team assists Pubcos in complying with the requirements of federal and state securities laws and SROs such as FINRA for 15c2-11 applications, corporate name changes, reverse and forward splits and changes of domicile. Ms. Anthony is also the author of SecuritiesLawBlog.com, the small-cap and middle market’s top source for industry news, and the producer and host of LawCast.com, Corporate Finance in Focus. In addition to many other major metropolitan areas, the firm currently represents clients in New York, Los Angeles, Miami, Boca Raton, West Palm Beach, Atlanta, Phoenix, Scottsdale, Charlotte, Cincinnati, Cleveland, Washington, D.C., Denver, Tampa, Detroit and Dallas.
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Ms. Anthony is an honors graduate from Florida State University College of Law and has been practicing law since 1993.
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