• The Role of Due Diligence in Mitigating SPAC Litigation Risks

    With shareholder litigation taking a sharp upturn regarding disclosures and conflicts of interest related to special purpose acquisition companies, or SPACs, reasonable due diligence remains as important as ever.

    Over the past several years, SPACs have become increasingly popular as alternatives to traditional IPOs for achieving public company status. For example, the aviation – and now, aerospace – entrepreneur Richard Branson partnered with a SPAC to take his space tourism company Virgin Galactic public in 2019, and most recently, in August 2021 he proposed to follow the same funding route for his satellite launch spin-off, Virgin Orbit.

    A SPAC is a “blank-check” company formed to raise capital through an underwritten IPO, the proceeds of which are intended to be used within a defined period of time (typically two years) to first identify and then acquire a private operating company. If the search is successful, the target company merges with the publicly traded SPAC through a de-SPAC transaction (sometimes called a de-SPAC combination). If the search is unsuccessful, funds must be returned to the investors.

    Compared to a traditional IPO, the SPAC IPO process is simpler, has lower upfront costs, and has limited disclosure requirements in offering documents. A traditional IPO involving a business that already has assets, employees, and (in some cases) revenues requires offering documents containing a range of disclosures, including historical information about the issuer and its business, operations, management, and past financial performance. But at its formation, a SPAC is a shell company with no operations or assets, and so the offering documents contain more limited disclosures.

    De-SPAC Transaction Litigation

    In contrast, a de-SPAC transaction involves a number of activities and associated litigation risks, including the solicitation of shareholder consent, the preparation and dissemination of an Information Statement, the registration and issuance of SPAC securities constituting part of the merger consideration, and the private offering and issuance of securities immediately prior to the merger to provide additional capital.

    De-SPAC transactions entail more rigorous securities filing requirements, such as filing proxy statements pursuant to Section 14 of the Securities Exchange Act of 1934 (Exchange Act); under certain conditions, providing shareholders with an Information Statement on Schedule 14C; and filing a Form 8-K (sometimes referred to as a “Super 8-K”) containing information substantially equivalent to that required in a traditional registration statement. To the extent that financial projections are included in proxy statements, these may expose the de-SPAC transaction to litigation risk if shareholders or investors come to believe the projections were not reasonable.

    Consequently, de-SPAC transactions afford investors or shareholders more opportunities to pursue litigation than do the initial SPAC IPOs. Potential defendants under both the Securities Act of 1933 (Securities Act) and the Exchange Act may include SPAC issuers, sponsors, directors, officers, underwriters, and advisory firms. In addition, litigation can be brought under the so-called “Blue Sky” laws of individual states – that is, the set of securities laws and regulations governing the offer and sale of securities within a state’s boundaries or to citizens of that state. Finally, shareholders may sue for breaches of fiduciary duties.

    What Claims Are Typically Made?

    All of the SPAC-related litigation we reviewed involved only de-SPAC transactions. According to the Stanford Law School Securities Class Action Clearinghouse, shareholders filed 30 federal class action lawsuits involving SPACs between January 2019 and July 2021, more than half of which were filed in 2021. In addition, between October 2020 and April 2021, more than 60 shareholder lawsuits involving SPACs were filed in state courts (including in New York and Delaware).

    Our survey of pending cases showed that, for de-SPAC transactions, plaintiffs often allege due diligence failures that either led to material misstatements or omissions in the at-issue disclosure documents or that were elemental components of a breach of a defendant’s fiduciary duties (typically, the duty of care).

    For example, In re Akazoo S.A. Securities Litigation includes several consolidated federal and state securities class actions regarding Akazoo S.A., a global music streaming platform that was formed through a 2019 merger of Modern Media Acquisition Corp. (MMAC), a SPAC, and Akazoo Limited. Plaintiffs allege the defendants made false and misleading statements regarding the target company in connection with the de-SPAC merger, including:

    • the number and growth of registered users and subscribers;
    • the company’s revenue and profit;
    • the size of the company and its services;
    • the areas in which the company operated; and
    • its relationships with mobile operators in various markets.

    On April 23, 2021, the parties reached a $35 million partial settlement. Previously, on September 30, 2020, the Securities and Exchange Commission (SEC) had also filed an enforcement action against Akazoo seeking permanent injunction against Akazoo and disgorgement of allegedly ill-gotten gains.

    Another example, Amo v. MultiPlan Corp., alleges breach of fiduciary duties under Delaware state law. A shareholder of MultiPlan filed in the Delaware Court of Chancery on March 25, 2021, in connection with the merger of SPAC Churchill Capital Corp III and MultiPlan, a provider of data analytics and technology management solutions to the US health care industry.

    The complaint alleges that the sponsor of the SPAC and its board members prioritized their personal and financial interests in going forward with the de-SPAC merger to the detriment of shareholders. Specifically, the complaint alleges that the sponsor of the SPAC and its board members had conflicts of interest stemming from:

    • the need to complete a deal within the SPAC’s two-year expiry period to preclude the value of the “sponsor” or “founder” shares, which had been granted to both the sponsor and the outside directors, becoming worthless;
    • the board members’ alleged personal and financial ties to the sponsor; and
    • the SPAC’s retention of an entity affiliated with the sponsor to serve as its financial advisor, rather than an independent third party.

    The complaint also asserts that the defendants breached their fiduciary duties because the disclosures surrounding the merger were allegedly false and misleading in that they highlighted the “extensive due diligence” performed and projected MultiPlan’s financial success, while failing to disclose that one of MultiPlan’s main customers, UnitedHealth Group Inc., was in the process of “abandoning MultiPlan in favor of its own competing data analytics platform.”

    Our paper “A Bridge Over Troubled Waters,” published in the ABA’s Business Law Today, provides several other examples from recent and ongoing litigation.

    What Can We Expect Next?

    On June 11, 2021, the SEC announced a target date of April 2022 for proposed amendments to rules governing SPACs, and on September 9, 2021, an SEC advisory committee recommended that SPACs be required to make sufficient disclosures about the role of the SPAC sponsor, the economics of the various parties involved, the types of targets that will be considered, and the minimum due diligence the sponsor will perform regarding the target’s accounting practices, among other things.

    Additionally, the SEC has gone on record (for example, in CF Disclosure Guidance: Topic No. 11, issued in December of 2020) recommending heightened disclosure at the SPAC IPO stage, especially with respect to the incentives and compensation of SPAC sponsors and underwriters. (See below, “A Due Diligence Checklist for De-SPAC Transactions.”)

     


    “First and foremost, are SPAC investors being appropriately protected? Are retail investors getting the appropriate and accurate information they need at each stage—the first blank-check IPO stage and the second target IPO stage?”

    – SEC Chairman Gary Gensler, May 26, 2021

    Adhering to Sound Due Diligence Principles

    Reasonable due diligence, with respect both to disclosures and to target companies, can mitigate many of the litigation and regulatory enforcement action risks described in this article. Of course, there is no one-size-fits-all approach appropriate for any kind of due diligence.

    At a minimum, directors, officers, underwriters, and others involved in SPAC-related securities offerings should:

    1. monitor and consider regulatory and litigation developments – especially as they relate to sponsor compensation, potential conflicts of interest, and the extent and character of due diligence and disclosure related to the de-SPAC business combination – and adjust their due diligence and disclosure practices in light of them;
    2. be mindful of fiduciary duties and “gatekeeping” roles; and
    3. establish a due diligence process that takes into account more than six decades of authoritative and informative publications and pronouncements, as well as an abundance of practitioner and scholarly literature. ■
  • A Due Diligence Checklist for De-SPAC Transactions

    According to the SEC’s CF Disclosure Guidance, de-SPAC-related disclosure documents should contain, among other things:

    • Detailed information about how the SPAC and its sponsors, directors, officers, and advisors evaluated and decided to propose the identified transaction, including why the target company was selected as opposed to alternative candidates and who initiated contact, including what material factors the board of directors considered in its determination to approve the transaction;
    • A clear description of any conflicts of interest of the sponsors, directors, and officers in presenting this opportunity to the SPAC, how the SPAC addressed these conflicts of interest, and how the board of directors evaluated the interests of sponsors, directors, and officers;
    • Detailed information regarding how the sponsors, directors, and officers will benefit from the transaction, including by quantifying any material payments they will receive as compensation, the return they will receive on their initial investment, and any continuing relationship they will have with the combined company;
    • Information on fees that the underwriter of the IPO will receive upon completion of the business combination transaction, including the amount of fees that is contingent upon completion of a business combination transaction; and
    • Information on services the underwriter provided, the cost of those services, and how the underwriter and/or its affiliates were compensated for those services, including disclosure of whether those services were conditioned on the completion of the business combination transaction and whether the underwriter may have a conflict of interest, given any deferred IPO underwriting compensation.
  • This article is condensed from “A Bridge Over Troubled Waters: The Role of Due Diligence in Mitigating SPAC Litigation Risks,” published in the ABA’s Business Law Today.



    Kevin Gold, Vice President, Analysis Group
    Ahmer Nabi, Vice President, Analysis Group
    Gary M. Lawrence, Executive Chairman and Chief Investment Officer, Pacific Financial Group; Executive Director, Center for Advanced Due Diligence Studies, Southern Methodist University; Adjunct Faculty, SMU Dedman School of Law