If you are interested in learning more about SPACs, I invite you to attend The SPAC Conference 2021 with me on June 23 to June 24 in Rye, New York. The SPAC Conference is the largest forum for networking and learning about SPACs. On June 23, my colleagues Emily Maier and Yelena Dunaevsky will be presenting a fascinating case study on Immunovant’s litigation, reps and warranties insurance, and D&O insurance. On June 24, I will be speaking on the SPAC Public Company Readiness Playbook panel. Hope to see you at this in-person event. Please come up and say hi. You can also attend on-line.
Last May, I speculated that the SPAC craze could lead to more litigation. Then in October, I wrote about how the Securities and Exchange Commission was sharpening its focus on SPACs. SPAC deals remain alive and well, to be sure, and the future of SPAC-related D&O litigation is coming into focus.
As predicted, private litigation in SPAC world is on the rise. The lawsuits that SPACs face today include a variety of allegations, ranging from accounting issues and conflicts of interest to management issues, product issues, M&A, and more.
According to Woodruff Sawyer’s proprietary D&O litigation database, the D&O Databox, 12% of the 276 SPACs with announced and/or closed deals through the first quarter of 2021 have been hit with M&A-related litigation.
For reasons that will be discussed below, this is probably the least consequential category of litigation in most cases. More important are the other two categories of interest, both of which impact deals that have already closed: Derivative suit actions and securities class action lawsuits.
SPACs with Shareholder Actions through 1Q2021
|Type of Action||% Sued||Number of Companies|
|M&A Actions (including demand letters)||12%||33 of 276 announced and completed mergers|
|Derivative Actions*||4%||7 of 157 completed mergers**|
|Securities Class Actions*||10%||15 of 157 completed mergers***|
* Filed after the close of the de-SPAC merger.
** 5 of 7 derivative actions involved parallel securities class actions.
*** Includes GTT Communications – a de-SPAC that occurred in 2006.
Sources: SPACInsider and Woodruff Sawyer Databox
The plaintiffs’ bar is bringing to the de-SPAC party its well-developed playbook from public-public M&A suits. The typical pattern is for plaintiffs to sue the directors and officers of a target company, claiming breaches of fiduciary duty (selling the company for too little) and material omissions in the proxy statement sent to shareholders to vote on the deal.
In most cases, the plaintiffs agreed to settle for a large plaintiff attorney fee when the defendants agreed to make what were usually pretty trivial changes to their disclosures. This type of litigation became so common and was regarded as so frivolous that eventually, the Delaware Court of Chancery stopped routinely allowing these types of settlements.
The court’s view of these cases diminished their profitability for plaintiff attorneys, if not their enthusiasm for bringing these cases. Rather than attempt to garner a large settlement, the plaintiff attorneys now often look to settle cases by agreeing to additional disclosures in proxy statements in exchange for a more modest mootness fee.
In the de-SPAC context, the companies that SPACs are targeting for investment are private companies, not public companies. As a result, the litigation opportunity for the plaintiffs’ bar is more muted.
Instead, the plaintiffs’ bar is pivoting to sue (or, in some cases, just threatening to sue) the SPAC and the SPAC directors and officers. The allegations are the same: Claims of breaching fiduciary duties (this time for paying too much) and material omissions in the proxy statement being sent to shareholders.
I fully expect that plaintiffs will continue to file these types of largely frivolous suits related to de-SPAC transactions so long as they find this activity to be lucrative. Over time, the courts will likely become frustrated and stop being open to letting plaintiffs extract value from companies in frivolous M&A suits related to de-SPAC transactions.
Indeed, some have suggested that the reason so many of these suits are being brought in New York is precisely to avoid Delaware court precedent. For this reason, Delaware-incorporated SPACs may want to consider adopting state choice of forum provisions in favor of Delaware courts.
Securities Class Actions
Securities class actions are the most concerning type of litigation that SPACs are facing right now for a couple reasons. The volume of this type of litigation is growing … although it is too soon to tell if this is merely a function of deal volume or something else.
From 2019 through 2020, there were seven securities class action cases against companies that had completed de-SPAC transactions. Two occurred in 2019 and then the plaintiff’s bar picked up the pace in 2020 and filed five cases.
|2019 and 2020 Activity|
7 cases (2 cases in 2019 and 5 cases in 2020)
|Note: Akazoo also settled a SPAC/PIPE lawsuit for $30.1M for a total settlement of $35M ($9M funded by insurance).|
In the first quarter of 2021, however, there were 11 cases.
January thru April – 11 cases
|*Excluding merger suits brought in connection with the De-SPAC|
This litigation trend is not wholly unexpected. As I have discussed before, new public companies are more likely to be sued than mature public companies (a big reason why new public companies pay so much more for D&O insurance compared to mature public companies).
Classic securities class action lawsuits involve plaintiffs bringing claims when public companies disclose information that then leads to a precipitous stock drop. These lawsuits allege that the company had made material misstatements or omissions in their earlier public statements, including their SEC filings.
Many of these will be brought as what is known as 10(b) suits. While they are serious and take time and money to defend, these cases are often won by defendants on a motion to dismiss—meaning no settlement will be paid to plaintiffs.
Newly public companies that went public via a de-SPAC transaction are not just vulnerable because, like all new public companies, their management may be less practiced at the rigors of public company life, including forecasting. They are also vulnerable because most will have filed an S-1 registration statement shortly after completing the de-SPAC transaction to register the shares of the SPAC sponsors and the PIPE shares.
Registration statements have a three-year statute of limitations. So, for example, a company can be sued for misstatements or omissions in the S-1 up to three years after going public if the stock price falls below the registration statement price.
Registration statement-related suits are commonly referred to as Section 11 lawsuits, and they have been on the rise. This type of suit is particularly difficult for defendants to win a motion to dismiss because the company has strict liability for the disclosures in its registration statements.
The good news is that federal forum provisions have proven to be a promising way to curtail frivolous Section 11 suits by forcing them out of state courts and back into federal courts where plaintiffs have to meet a higher pleading standard.
To date, we are seeing the plaintiffs mostly file 10(b) suits against companies that recently went public through a de-SPAC transaction, which is good news since these are the somewhat easier cases for defendants to win without paying a settlement.
That is not to say that this litigation is not serious. Consider the April 2021 settlement by Akazoo, a case with extremely troubling allegations of fraud and even an SEC enforcement action. The various private plaintiff lawsuits named the SPAC, Akazoo, and the directors and officers of both corporate entities.
The parties agreed to mediate all the cases and reached a partial settlement (excluding the terminated CEO and the auditor) for $4.9 million. A much larger settlement, approximately $30 million, was paid to the PIPE investors.
For more details about these types of suits, my colleague Yelena Dunaevsky published an excellent article, here.
A Chilling Securities Class Action Side Note
A discussion of securities class action lawsuits would not be complete without mentioning the extraordinary securities class action suit brought by shareholders of Churchill Capital Acquisition Corporation IV against Churchill IV, its CEO, and CFO. Also named in the suit are Lucid Corporation and its CEO.
What makes this case particularly interesting is that the securities class action lawsuit was filed before the deal closed. The context includes the fact that the CEO of Lucid was making public statements concerning Lucid’s ability to deliver 6,000 vehicles in 2021; at that time there was a rumor that Churchill IV was in talks to merge with Lucid. On February 18, 2021, the shares of Churchill IV reached a high of $58, a considerable increase from its $10/unit initial IPO price.
Churchill IV first announced its deal with Lucid on February 22, 2021. Later that day the Lucid CEO publicly cut his production estimates by 90%. Needless to say, the price of Churchill IV fell precipitously on this news.
Plaintiffs brought a 10(b) suit, alleging material misstatements and omissions. While this is an easier suit for defendants to win on a motion to dismiss compared to a Section 11 suit, it is still serious—and likely costly—litigation.
What makes this suit extraordinary is the effort by plaintiffs to hold Churchill IV responsible for stock movement taking place on rumors of a deal, which is to say at a time when Churchill IV would not have had control of statements being made by the CEO of its potential merger partner.
Having said that, announcing the deal before Lucid’s CEO issued his corrective disclosure looks very much like an “own goal” situation. It is certainly the sort of corrective disclosure that I am sure the directors of Churchill IV wish had been made prior to the deal being announced.
Post-Closing Derivative Suits
If a company stumbles shortly after its de-SPAC transaction closes, another suit that might hit is a breach of fiduciary duty suit brought derivatively. This, again, is not very different from what we see against mature public companies when they stumble: About two-thirds of securities class action suits are accompanied by derivative suits, although they can be brought on a standalone basis as well.
Derivative suits are always a concern for directors and officers because, for Delaware corporations and many others, the company cannot indemnify derivative suit settlements. This means that if there is not enough D&O insurance (the “Side A” portion of D&O insurance, to be specific), then individual directors and officers would have to pay for the settlement personally.
Many of the securities class action suits filed in 2021 have been accompanied by derivative suits that allege serious breaches of fiduciary duties.
The theory that the plaintiffs’ bar is promoting is that the structure of SPACs themselves creates financial incentives that cause SPAC directors and officers to purposefully neglect their fiduciary duties. As a result, they either conduct poor diligence or obfuscate company problems that their diligence uncovers in order to persuade their shareholders to vote for the deal.
These are serious allegations. Without appropriate corporate governance protocols in place (more on this, below), some of these cases will prove costly to defend.
This litigation trend against SPACs is confirming insurance carriers’ initial forecasts that companies that go public through a de-SPAC transaction would attract a flurry of securities class actions, just as their traditional IPO counterparts have.
Carriers are also concerned that lower-quality companies will choose to go public through a de-SPAC transaction because these companies cannot handle the rigors of the traditional IPO process. It is too soon to tell if this concern will be borne out by the data. However, it seems likely that, as for most categories of transactions, some will be high-quality transactions, and others will not.
The result? D&O insurance for SPAC IPOs continues to be priced at elevated rates. The same is true for D&O insurance for companies going public through a de-SPAC transaction. Indeed, we are seeing pricing and self-insured retentions (similar to deductibles) for de-SPAC transactions trending higher than for companies going public through a traditional IPO process.
What Steps Can Directors and Officers Take to Protect Themselves?
I often observe that the bad risk is the one you do not see coming. The good news is that the SPAC litigation landscape is fairly well illuminated at this point, which brings clarity to what directors and officers should do to protect themselves and the companies they serve. These steps fall into two categories: corporate governance and risk transfer.
On the corporate governance side, consider these suggestions as a starting point:
- Observe corporate formalities like board meetings and the distribution of board materials. Outside counsel should be engaged to provide good advice concerning things such as projections and valuation reports.
- Create board minutes that reflect the board’s diligence when it comes to the board’s review of alternative transactions, the board’s understanding of its own fiduciary duties, and the board’s efforts when it comes to its own diligence.
- Operate with a heightened sensitivity to potential conflicts of interest, including the perception of conflicts that may be created due to social relationships or corporate incentive structures.
- Where there may be affiliated people or entities on both sides of a transaction, consider if your deal would benefit from using a special committee and obtaining a fair opinion from an unconflicted financial advisor.
- Ensure that your disclosures are robust and, where appropriate, ask an M&A litigator to review them before filing your S-4 registration statement and other documents with the SEC.
The law firm Goodwin Procter has written an excellent piece outlining similar and other smart corporate governance steps boards can take to mitigate the risk of D&O litigation.
On the risk transfer side of things, here are some steps to take:
- Take the time to thoroughly understand your risks so that you are better able to spot them when you are entering particular danger zones.
- Ensure that the indemnification agreements of all directors and officers (on the SPAC side and the de-SPAC side) are state-of-the-art.
- Purchase D&O insurance from a broker who is an expert when it comes to SPAC IPOs and de-SPAC transactions.
The D&O insurance part of the equation is particularly challenging given how high the cost of D&O insurance is for SPACs and target companies looking to go public via a de-SPAC transaction.
In addition, on the SPAC side of the equation, there is an often-repeated myth that SPACs have very little exposure until they announce their proposed de-SPAC transaction. The statement is used to justify either underinsuring or purchasing an insurance product with an (arguably dubious) accordion feature that balloons the limit after a deal has closed.
It is true that SPACs have less exposure closer to the IPO compared to when a deal is announced. However, it is important to remember that litigation filed when you announce your deal will fall under the limit placed at the time of the SPAC IPO. It is also the SPAC’s IPO-related D&O insurance that will respond if the SPAC and its directors and officers are sued after the deal has closed.
Also, keep in mind that class actions before the deal closes that name the SPAC as a defendant are now not unheard of after the Churchill IV/Lucid Motors suit described above. In addition, recall that SEC regulates all publicly traded companies, including SPACs. They can begin an investigation any time. It is the D&O insurance arranged at the time of the SPAC IPO that will respond for individuals.
Bottom line: As with anything else in commerce, nothing is free. If an insurance carrier is charging a lower price in an efficient market, it is because the carrier is offering lesser coverage. This might be the business choice you make. If you are making this choice, you want to do so only after understanding the tradeoffs.
Asking the right questions goes a long way to ensuring you are protected. For more about D&O insurance for SPAC IPOs, including how to save money, see Woodruff Sawyer’s Guide to D&O Insurance for SPAC IPOs.
The target side of the equation has a similar set of dynamics when it comes to D&O insurance: The landscape is exceedingly complex, so it is best to work with a broker who has a lot of experience working with new public companies. For example, an experienced broker will help more mature target companies differentiate themselves by emphasizing good internal controls and serious corporate governance.
In all cases, the risk of litigation remains serious. For that reason, directors and officers will want to start the D&O insurance process early. For more, see Woodruff Sawyer’s Guide to D&O Insurance for De-SPAC Transactions.
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As some recent lawsuit dismissals have demonstrated, state choice of forum provisions have helped companies control what was otherwise the problem of duplicative, multi-jurisdictional breach of fiduciary duty suit litigation.