Special purpose acquisition companies (“SPACs”) have been in the litigation spotlight recently. As SPAC disputes play out in courts nationwide, one especially interesting field of play is in the Delaware Chancery courts where SPAC shareholders are pursuing breach of fiduciary duty cases against SPAC sponsors, officers, and directors. How did this litigation develop, and where does it stand now?

The SPAC Framework

The basic framework of a SPAC transaction is that the SPAC, a blank check company with no commercial operations, goes public through an initial public offering (“IPO”) to raise money to acquire a target company, which it must typically identify within 18-24 months post-IPO (the “completion window”). The SPAC then holds the investors’ funds in “trust” while it seeks an investment target. Once the SPAC identifies the privately-held target, they combine in a reverse merger or “de-SPAC” transaction, resulting in an operating company with publicly traded shares. Shareholders have two options in connection with a proposed merger: (1) they can redeem their shares, or (2) they can invest their shares in the newly merged company.

Alternatively, if the SPAC fails to identify a target company within the completion window, it must return the funds held in trust to its shareholders and dissolve.

SPAC Use Surges in the Last Decade

The fundamental SPAC investment structure was developed in the 1990s[1] in response to SEC Rule 419, which was meant to stop the fraudulent “pump and dump” schemes used by “blank check” companies in the 1980s.[2] But it wasn’t until recently that SPACs began to account for a meaningful portion of all IPOs.[3] In fact, because only the SPAC—a shell company with no operations—and not the target must comply with the initial SEC registration process, SPAC use grew immensely in the past decade.

At their peak, SPACs became the go-to method of going public, accounting for most United States IPOs in 2021.[4] They were cheaper, faster, and said to offer less securities law liability because the target company’s private shareholders, whose interests would become public through the reverse merger, would be unlikely to have been deceived by SPAC disclosures, which dealt mostly with the target company’s own projections.[5]

SPACs have also been popularized by celebrity endorsements or backing and have been seen as an opportunity for retail investors to get in on the next big tech start-up that they could not have invested in through at traditional IPO. This SPAC hype has led to large losses for unscrupulous retail investors.

SPACs Face Recent Scrutiny

For years, SPACs were touted as an attractive alternative method for taking companies public. More recently, however, they have come under fire not only for securities law violations but also in actions by SPAC shareholders who have made direct claims against SPAC sponsors, officers, and directors, alleging an impairment of their redemption rights in connection with the disclosures regarding the merger. The core of their claims hinge on the inherently conflicted nature of the SPACs, as described by the Delaware Chancery court when it first confronted these claims in In re MultiPlan Corp. Shareholders Litigation (“MultiPlan”).[6]

In addition to the basic SPAC structure described above, a SPAC sponsor—a separate entity that typically controls the SPAC’s formation and handpicks the SPAC’s officers and directors—is compensated for its efforts in identifying a suitable merger candidate with “founder shares” at a nominal price. In Multiplan, the founder shares, which represented 20% of the outstanding stock of a $1.1 billion IPO, were purchased by the sponsor for $25,000—less than even a penny per share.[7] The sponsor also is generally compensated through private placement warrants, which it can purchase at another nominal price—in MultiPlan just $1.00, whereas the exercise price was $11.50, the same as the warrants associated with the IPO.[8]

The sponsor then typically passes on some amount of founder shares (for the same nominal price) to the individuals serving on the SPAC board of directors—often individuals who are in other ways associated with those who control the sponsor. In MultiPlan, the directors included the sponsor’s control person, his brother, and individuals who had served on boards of his related companies.[9]

The SPAC board—consisting of individuals handpicked by the sponsor who have been given thousands of founder shares for pennies or less on the dollar—is tasked with identifying the SPAC’s target and recommending the merger. But if no business combination is completed within the completion window, the founder shares and private placement warrants become worthless, and the funds held in trust must be returned to investors.

“Inherently Conflicted”

Thus, the characteristic structure of the SPAC—indeed what the MultiPlan judge in another case referred to as the “typical SPAC playbook”[10]—is rife with conflicts. The sponsor and the SPAC board, not only through the influence and control of the sponsor but also due to the founder shares awarded to the directors themselves, would benefit immensely from a merger, even in a value-decreasing deal. Notwithstanding this conflict, “[t]he Sponsor, through its control of the Board, exercise[s] power over the most crucial decision facing the Company: merge or liquidate.”[11]

A sponsor and the board, then, might very well recommend a deal that was bad for public stockholders but would nonetheless represent a huge windfall to themselves. For example, in a recent complaint brought by shareholders in the SPAC acquiring Latch, Inc., stock dropped to less than a dollar (from a price of over $11 at merger close), but still represented a nearly 26,000% return on investment for the founders’ shares.[12] Latch’s stock was later delisted from Nasdaq for failure to file financial statements.

The Standard of Entire Fairness

Given the inherent conflicts in the SPAC process, the Delaware Chancery courts have applied the standard of entire fairness, rather than the business judgment rule, to their review of the SPAC transactions.[13] As the “most onerous standard of review,” entire fairness is the standard most favorable to plaintiffs.[14] So far, each of these direct breach of fiduciary duty cases brought in Delaware Chancery court have survived motions to dismiss.[15] But none of the cases have gone to trial; In re MultiPlan, for example, settled for over $30 million dollars approximately 10 months after the motion to dismiss was denied.[16]

In order to satisfy entire fairness, the transaction must have resulted from fair dealing and resulted in a fair price. Thus, while the SPAC structure’s inherent conflicts may invoke the standard, there must be evidence that the merger process was flawed, or the price was unfair. This requires that beyond the conflicted nature of the transaction, the disclosures made during the merger were materially inadequate. So far, these claims have not been tested at trial, and it will be interesting to see how they play out once they are.

Kaja Elmer is special counsel in Fishman Haygood’s Litigation section and works on a wide range of commercial matters in state and federal court. She recently brought a class action complaint on behalf of Phanindra Kilari and other stockholders of TS Innovation Acquisitions, Inc. (TSIA), a SPAC that merged with Latch, Inc., in the Delaware Court of Chancery.

[1] Daniel S. Riemer, Special Purpose Acquisition Companies: Spac and Span, or Blank Check Redux?, 85 Wash. U.L. Rev. 931, 945 (2007).

[2] Usha Rodrigues, Mike Stegemoller, Exit, Voice, and Reputation: The Evolution of Spacs, 37 Del. J. Corp. L. 849, L.876 (2013).

[3] Usha Rodrigues, Mike Stegemoller, Exit, Voice, and Reputation: The Evolution of Spacs, 37 Del. J. Corp. L. 849, L.878–79 (2013).

[4] https://www.spacanalytics.com/

[5] Daniel J. Morrissey, Special Purpose Acquisition Companies: Wall Street’s Latest Shell Game, 75 Ark. L. Rev. 465, 483 (2022).

[6] In re MultiPlan Corp. S’holders Litig., 268 A.3d 784, 809 (Del. Ch. 2022).

[7] Id. at 794.

[8] Id.

[9] Id. at 794-95.

[10] Laidlaw v. GigAcquisitions2, LLC, No. 2021-0821-LWW, 2023 WL 2292488, at *1 (Del. Ch. Mar. 1, 2023).

[11] Delman v. GigAcquisitions3, LLC, 288 A.3d 692, 717 (Del. Ch. 2023).

[12] See In re TSIA Acquisitions Sponsor, L.L.C. Stockholder Litigation, C.A. No. 2023-0509-LWW (Del. Ch. Consolidated Complaint filed August 8, 2023).

[13] See, e.g., Delman v. GigAcquisitions3, LLC, 288 A.3d 692, 718 (Del. Ch. 2023).

[14] In re MultiPlan Corp. S’holders Litig., 268 A.3d 784, 809 (Del. Ch. 2022).

[15] See, e.g., In re MultiPlan Corp. S’holders Litig., 268 A.3d 784 (Del. Ch. 2022); Delman v. GigAcquisitions3, LLC, 288 A.3d 692 (Del. Ch. 2023); Laidlaw v. GigAcquisitions2, LLC, No. 2021-0821-LWW, 2023 WL 2292488 (Del. Ch. Mar. 1, 2023).

[16] See https://investors.multiplan.us/latest-news/news-details/2022/MultiPlan-Corporation-Announces-Settlement-of-Delaware-Litigation/default.aspx.