As SPAC Deal Flow Increases, Expect Litigation to Follow Suit

With the recent rise in popularity of special purpose acquisition companies (“SPACs”), expect an uptick in SPAC related litigation to follow. SPAC’s are referred to as “blank check” companies because they are shell companies formed by a sponsor group to raise funds in an initial public offering (“IPO”) for the purpose of acquiring a yet-to-be-identified privately held target company. After the IPO, the SPAC has a specified period of time – often two years – to identify and combine with a private company through a reverse merger (a “de-SPAC-ing” transaction), the result of which is that the formerly private company gets the SPAC’s place in the public stock market. After the “de-SPAC-ing” transaction, the SPAC’s investors may become shareholders of the newly combined company or redeem their common stock portion of the investment. If no “de-SPAC-ing” transaction occurs within the set timeframe, the public investors’ money must be returned.

An uptick in SPACs, An uptick in Litigation

In 2020, SPACs were quite popular, raising a record-setting $83.4 billion even though M&A transactions slowed considerably as a result of the uncertainty surrounding the COVID-19 pandemic. So far, 2021 has far outpaced 2020. In fact, it took the SPAC market only three months to exceed the record-setting 2020 capital raise. In light of the deal volume over the last few years, the SEC has signaled a renewed interest in SPACs, particularly due to instances of sharp post-acquisition share price declines. Specifically, the SEC has signaled that it will be scrutinizing SPAC deal fees, incentives for SPAC sponsors, and SPAC filings and disclosures, among other things.

Civil litigation relating to SPACs is also heating up. So far, most claims arise after the “de-SPAC-ing” transaction and are based on securities violations. For example, a recent class action suit in the Eastern District of New York alleges that the SPAC and its managers issued proxy statements containing materially false and misleading statements because they ignored or failed to disclose that the SPAC’s target, a pharmaceutical company, had discovered safety issues during its clinical trials of one of its products.[1] Similarly, another class action case brought in the Central District of California alleges that the SPAC and its managers failed to disclose that the SPAC’s target, an electric vehicle manufacturer, changed its business model and that a key partnership with an established car manufacturer fell through after having been highlighted in the registration statement.[2]

Securities law violations, however, are not the only basis for civil suits. Like directors of any other corporation, SPAC directors owe fiduciary duties to SPAC shareholders. In a recent lawsuit brought in Delaware, a shareholder sued directors for allegedly breaching their fiduciary duties by acquiring a target company through a “deeply flawed and unfair process, including several disclosure defects, [which] led to a grossly mispriced transaction.” Often the same set of facts may give rise to both claims of securities law violations and state law breach of fiduciary duty claims.

What you can do

Sponsors, directors, and officers should be sensitive to the potential conflicts of interest inherent in SPAC deals. The financial incentives for a sponsor to complete a transaction may tempt the sponsor to overlook red flags or apply a relaxed standard of diligence in the name of getting the deal done, resulting in a combination that is not in the best interests of shareholders. That risk is compounded by the relatively short time frame a SPAC sponsor is afforded to identify a target and complete a transaction. Close to the deadline deals will likely face enhanced scrutiny from unhappy shareholders. Given the flow of money pouring into SPACs, the lucrative deal structure for sponsors, and the time pressures of getting a deal done, it would not be surprising to see a significant wave of claims relating to conflicts of interest and other breaches of fiduciary duties.

Minimizing risk

To minimize the risk of litigation, conduct a broad search for targets and document the process thoroughly. Likewise, document the breadth of the negotiations with targets and the due diligence prior to closing, which both should be consistent with a traditional M&A deal. Where there are affiliated parties on both sides of a transaction, the sponsor should obtain a fairness opinion from an independent third-party or form a special committee comprised of individuals without a direct or indirect financial interest. Above all, ensure that disclosures are comprehensive and thorough, including the scope of any potential conflicts of interest.

Please feel free to contact Eric S. Rein and Matthew R Barrett with questions.

[1] See, Pitman v. Immunovant, Inc., 2021 WL 668546 (E.D.N.Y. Feb. 19, 2021)

[2] See, Kojak v. Canoo, Inc., et al., 2:21-cv-02879 (C.D. Cal. 2021).