Despite the challenges posed by COVID-19, 2020 saw an eruption of IPOs by special purpose acquisition companies (SPACs), used to raise nearly $79 billion from investors. The Wall Street Journal reports that the trend is continuing in 2021, already averaging five new SPACs each business day. A surge in related litigation has already begun, and it can be expected to grow and become a feature of SPAC deals throughout 2021.
SPACs are publicly traded companies created as vehicles to take promising private companies public. A SPAC offers securities for cash, and places the offering proceeds into a trust or escrow account to be used to acquire one or more operating companies. After the IPO, the SPAC generally has a limited amount of time to identify acquisition targets. SPACs sometimes are called “blank check companies” because their investors give management discretion to identify and acquire private companies after the IPO. Investors in SPACs may redeem their shares for the purchase price once the target company is identified. Without such an election, the investors become owners of the newly merged company. Typically, the management team puts up 20 percent of the equity at the outset, and the remaining 80 percent is sold to the public via the IPO. They may have other financial incentives that differ from those for public shareholders, such as compensation arrangements or relationships with affiliated entities.
On Dec. 22, 2020, the U.S. Securities and Exchange Commission (SEC) Division of Corporation Finance (Corp Fin) issued guidance highlighting the potential for conflicts of interest between a SPAC’s management team, directors and officers on the one hand, and the public shareholders on the other. Corp Fin warned SPACs to consider carefully their disclosure obligations in this regard. The guidance also emphasized the importance of fulsome disclosures about the business combination between the SPACs and their target companies. Just two weeks before that, the SEC’s Office of Investor Education and Advocacy issued an investor alert about SPACs.
Right now, there is a growing trend of SPAC shareholder lawsuits filed soon after announcements of mergers between SPACs and their target companies. Those business combinations are often called “de-SPAC transactions.” The lawsuits typically seek both money damages and injunctive relief to prevent the culmination of the transaction. In addition to individual shareholder suits, class actions are being filed.
The allegations generally center around the same issues identified in Corp Fin’s guidance. Plaintiffs usually allege a failure to adequately disclose to shareholders the potential conflicts of interest between management and public shareholders, as well as a failure to adequately disclose material information about the de-SPAC transaction — thus depriving public shareholders of the opportunity make an informed decision about whether to redeem their shares. After the merger is consummated, plaintiffs may amend their complaints to allege that they would have redeemed their shares for the purchase price if they had known the allegedly withheld information.
Some suits also allege violations of the Securities and Exchange Act of 1934. Such allegations claim the SPAC or its officers made false or misleading statements in the prospectus the SPAC must file with the SEC prior to the de-SPAC transaction. One of the beneficial features of using a SPAC to acquire and take a private company public is that the SPAC can take advantage of the “safe harbor” provisions of the Private Securities Litigation Reform Act for forward-looking statements. See 15 U.S.C. § 78u-5. The safe harbor excludes IPOs, but a prospectus issued in connection with a de-SPAC transaction is covered if the statements are identified as forward-looking and if suitable, “meaningful cautionary statements” accompany the information.
Plaintiffs can and do still allege, however, that a prospectus lacked the disclaimers and “meaningful cautionary statements” required to fall within the safe harbor provision or that the allegedly false statements involved then-existing facts, thus removing them from the safe harbor. Plaintiffs also allege a moral hazard of the typical SPAC arrangement: The management team has a limited time from the IPO to complete the business combination, or the SPAC terminates. The management group stands to make a substantial profit if a deal is completed but will lose out if the SPAC terminates without a merger. This can be said to create an incentive to just get some deal done — irrespective of whether it is good for the shareholders.
While it may be an uphill battle to persuade a court to enter a temporary or preliminary injunction to stop a de-SPAC transaction, the mere threat of it can add uncertainty and affect the market price of the SPAC’s publicly traded shares. If the court denies injunctive relief and the deal closes, the new business combination will incur the costs and distraction of defending such lawsuits.
As a matter of defense strategy, parties to a SPAC transaction should always point out the obvious: If a shareholder does not like the proposed de-SPAC transaction, there is an immediate and obvious remedy — simply redeem the shares and walk away. This makes any claim for damages difficult, and the avenues available to the shareholder are limited to asking for either (1) the lost opportunity to earn growth on the value of the shares in some other investment during the period the SPAC shares were owned, or (2) the lost value the shareholder would have realized had the de-SPAC transaction been handled differently. The former is of limited value in most cases, and the latter is rather speculative.
As SPAC IPOs and the ensuing de-SPAC transactions increase in frequency, expect a corresponding increase in related securities litigation. Parties are advised to retain litigation counsel experienced in defending against shareholder suits and class actions.