• SPACs: Market Trends and Litigation Considerations

    Early in 2022, Analysis Group invited two affiliated experts, Yael Hochberg and Gary Lawrence, to join a webinar examining litigation risks related to special purpose acquisition companies, or SPACs.

    • Professor Hochberg is the Ralph S. O’Connor Professor in Entrepreneurship at the Jesse H. Jones Graduate School of Business at Rice University. She serves as the head of the Rice Entrepreneurship Initiative and of the Liu Idea Lab for Innovation and Entrepreneurship.
    • Mr. Lawrence is the executive chairman and chief investment officer for the Pacific Financial Group, and the executive director of the Center for Advanced Due Diligence Studies at Southern Methodist University. He also serves on the adjunct faculty at SMU Dedman School of Law, and is the author of Due Diligence in Business Transactions, a leading text in the field for more than 20 years.

    To share their knowledge of investment practices, due diligence standards, and securities litigation, Professor Hochberg and Mr. Lawrence spoke with Managing Principal Mark Howrey, Principal Kevin Gold, and Vice Presidents Lauren Hunt and Ahmer Nabi.

    What is a SPAC?

    Essentially, a SPAC is a “blank check” company – a shell with no operations or assets that goes public through an underwritten IPO to raise capital in order to fund the search for a non-listed private company with which to merge. Following what is called a de-SPAC transaction or acquisition, the merged company then becomes publicly listed. If an acquisition target is not agreed upon within a specified period of time (typically 18 to 24 months), the SPAC is liquidated and the IPO funds are returned to investors.

    Who are the key players?

    Key players in this process include the initial sponsors, who launch the IPO, conduct the search for the acquisition target, and negotiate terms of the merger with the target; investors, who purchase SPAC units and then vote on the proposed merger; underwriters of the IPO; shareholders of the target business; and advisors to the SPAC and the target.

    Market and Litigation Trends for SPACs

    To set the stage, Mr. Gold presented a series of charts illustrating the surge of interest in SPACs that started in mid-2020 and hit its high point in the first quarter of 2021. Mr. Gold noted that the main industries targeted by SPACs include high tech (especially software companies) and health care. He pointed out that SPACs that had completed a merger had been underperforming compared with the S&P 500 Index.

    Underperformance of SPACs has contributed to a rise in shareholder litigation brought under the US Securities and Exchange Commission’s Rule 10b-5 or Section 14 of the Securities and Exchange Act. Typical claims involve alleged misstatements or omissions, incomplete or inadequate disclosures and due diligence, conflict of interest, and breach of fiduciary duties.

    SPAC Structures and Processes in the Context of Litigation

    Dr. Hochberg emphasized that a sponsor’s return typically depends on a successful close within the 18-to-24-month timeline, which can raise the risks of pursuing unattractive mergers. Additionally, while the public shareholders in a SPAC are the ones who vote to approve or disapprove the deal proposed by the sponsor, they have the option of redeeming their SPAC shares while still retaining some upside in the form of warrants that allow them to purchase additional shares of the merged company following the de-SPAC transaction.

    Dr. Hochberg also noted that sponsors can earn positive returns even when post-merger investors may not, and if the investors buying into the de-SPAC transaction end up losing money, sponsors, underwriters, and the post-merger business itself may all find themselves in court. According to Dr. Hochberg, a startup that becomes a public company via a SPAC transaction too early in its life cycle may experience growing pains that can negatively affect the stock price. Consequently, pursuing an exit via a SPAC transaction may involve more uncertainty and higher risk for shareholders of the pre-merger target company relative to continuing to operate as a traditional startup.

    Standards of Due Diligence

    Mr. Lawrence then talked about the two main categories of SPAC due diligence: (1) acquisition due diligence into the de-SPAC targets, and (2) disclosure due diligence, both for the initial IPO and for the de-SPAC transaction. Some attributes of SPACs can lead to increased scrutiny, according to Mr. Lawrence. For example, there are potential conflicts of interest involving sponsors and underwriters, given the way incentives are structured. In addition, financial advisors to a SPAC may also have conflicts, depending on, among other things, how they are compensated.

    Mr. Lawrence explained that currently there are no due diligence standards unique to SPACs, and in SPAC litigation to date, courts have affirmed the application of the “prudent person” rule, which is commonly applied in securities cases. Mr. Lawrence noted that courts apply this benchmark in both disclosure and negotiated transaction due diligence and that a number of courts have described it as a “negligence standard.”

    Mr. Lawrence went on to explain how the actions of defendants such as directors and officers in SPAC transactions have been judged by some courts under the “entire fairness standard,” as opposed to the “business judgment rule.” Under the entire fairness standard, a defendant must affirmatively prove that the process used to make a business judgment was fair and that the decisions were informed. For this reason, noted Mr. Lawrence, due diligence processes and practices may assume even greater significance in the court’s analysis and ultimate rulings.

    Still, as Mr. Lawrence explained, each transaction involves a unique context, and courts customarily assess the due diligence conducted with reference to that context.  For that reason, according to Mr. Lawrence, in these cases “context is king.”

    Moreover, Mr. Lawrence advised SPAC participants to be mindful of the likely focus by the court on the due diligence processes followed and their relationship to investor disclosures. He closed with a recommendation that SPAC participants consider such factors early in the process and be prepared to defend the scope and character of the due diligence conducted, especially at the de-SPAC stage. ■