Chancery’s Second Decision on SPAC Fiduciary Duties Reaffirms Entire Fairness Review But Still Leaves Open Whether It Would Apply If Disclosure Was Adequate—Delman

In Delman v. GigAcquisitions3 (Jan. 4, 2023), the shareholder-plaintiff claimed that the sponsor of a SPAC, the sponsor’s controller, and the SPAC’s directors undertook a value-decreasing de-SPAC transaction that benefitted them to the detriment of the public stockholders for whom, the plaintiff argued, liquidation of the SPAC would have been preferable. The Delaware Court of Chancery, applying longstanding Delaware fiduciary principles, and reaching the same result as in last year’s MultiPlan decision, held at the pleading stage that, based on conflicts of interest inherent in the typical SPAC structure, the most onerous standard of judicial review—entire fairness—applies to the court’s evaluation of fiduciary claims in connection with a de-SPAC transaction. In addition, the court held (as in MultiPlan) that it was reasonably conceivable (the standard of proof at the pleading stage) that the de-SPAC at issue was not entirely fair.

Importantly, as the court found in both Delman and MultiPlan that the disclosure to stockholders may have been materially inadequate (such that the stockholders’ redemption right was impaired), it remains an open question whether entire fairness would apply to a de-SPAC challenge in a case in which the court found that the disclosure was adequate.

Key Points

• The court, at every turn, concluded that the SPAC structure involves inherent conflicts, mandating entire fairness review. As it did in MultiPlan, the court pointed to typical features of SPACs—including the sponsor’s compensation structure, the directors’ ties to the sponsor, and the “decoupling” of the public stockholders’ voting and economic interests—and concluded that the sponsor, its controller, and the directors were “incentivized to undertake a value-decreasing transaction” that benefitted them, to the detriment of the public stockholders. The court viewed the sponsor as a “conflicted controller” who stood to receive a “unique benefit” in the de-SPAC merger given that the sponsor would receive an “enormous return” on its founder shares even in a de-SPAC that was value-decreasing for the public stockholders. Further, if a de-SPAC was not completed and the SPAC was liquidated, the sponsor’s founder shares would be worthless but the public stockholders would receive back their investment plus interest.
• Notably, the court stated that, even if the disclosure had been adequate, the stockholder approval would not have led to business judgment review under Corwin. The court found it reasonably conceivable that, although the disclosure about conflicts was robust, the disclosure was otherwise materially inadequate. But even when the disclosure is adequate, the court stated, the stockholder vote on a de-SPAC is “meaningless” for Corwin purposes, as, based on the SPAC structure, the public stockholder’s economic and voting interests are “decoupled”—as they can vote for the merger but still redeem their shares, and they are incentivized to vote even for a “bad deal” to preserve any value in the warrants they hold.
• However, importantly, the court expressly declined to address whether entire fairness would apply in a case in which the disclosure was adequate such that the public stockholders’ redemption right was not impaired. Practitioners have long viewed the right to redeem shares after a proposed de-SPAC transaction is announced as a distinguishing feature of SPACs that would significantly mitigate fiduciary duty risk for SPAC sponsors and directors in connection with de-SPACs (as compared to controllers and directors in the non-SPAC context). As the court, in both MultiPlan and Delman, found that the disclosure to public stockholders was materially inadequate and that the redemption right therefore was impaired, it remains an open question whether entire fairness would apply in a case in which there was adequate disclosure. Of note, the court’s discussion in both cases stressed the primacy of the redemption right as a protection for a SPAC’s public stockholders.
• The court held that it was reasonably conceivable that the de-SPAC was not entirely fair—as unfair price could be inferred from its being significantly “value-decreasing” and unfair dealing could be inferred from the disclosure being materially inadequate.
• The court found the disclosure materially inadequate based on a failure to disclose (i) the actual (rather than the nominal) value of the SPAC shares and (ii) information that may have suggested that the target’s projections that were disclosed were not realistic. The court stated that the “net cash per share” value of the SPAC shares just prior to the de-SPAC (i.e., the value taking into account costs and dilution) was material, particularly if (as would often be the case) it was a “sizeable difference” between that value and the nominal value. The court also stated that the board should have disclosed “impartial information” (such as likely difficulties in scaling the business) that would have “counterbalanced” the target’s “lofty” projections.
• Thus, heightened judicial scrutiny is yet another headwind facing SPACs. Since the 2020-2021 SPAC boom, new SPACs have essentially ground to a halt as regulatory obstacles have increased, PIPE financing has become less available, stockholder redemption rates have soared, a record number of SPACs have liquidated after being unable to complete a de-SPAC transaction within the required time period, and de-SPACed companies have had generally disappointing stock price performance. Additional headwinds against SPACs include the current negative macroeconomic conditions and the current slowdown in M&A activity more broadly. MultiPlan and Delman indicate that SPACs also will face strong judicial skepticism and scrutiny.

Background. In February 2020, GigAcquisitions3, LLC (the “Sponsor”) formed GigCapital3, Inc. (“Gig3”), a Delaware SPAC. Gig3 had a typical SPAC structure. For the nominal sum of $25,000, Gig3 issued to the Sponsor, as a promote, “Founder Shares” (representing 20% of Gig3’s equity after its initial public offering (“IPO”)). In May 2020, Gig3 completed its IPO, in which units consisting of Gig3 shares and warrants were issued to the public. After Gig3 identified and announced a proposed de-SPAC transaction, the public shares could be redeemed for their nominal value of $10 per share, plus interest (and redeeming stockholders could retain their warrants). If a de-SPAC was not completed within 18 months of the IPO, the SPAC would have to liquidate. In a liquidation, the public stockholders would receive back their investment plus interest. Gig3 also conducted a private placement (the “Private Placement”) in which units consisting of shares and warrants (“Private Placement Units”) were purchased by the Sponsor, the IPO underwriters, the financial advisors (two of whom were also underwriters in the IPO and deferred their underwriting fees to the closing of a de-SPAC), and PIPE investors. The Founder Shares and the Private Placement shares lacked redemption and liquidation rights and were subject to lock-ups (thus they would become worthless if a de-SPAC was not completed before the deadline for liquidation).

In December 2020, Gig3’s board (the “Board”) approved a de-SPAC merger with Lightning eMotors Inc., an electric vehicle manufacturer (referred to, post-merger, as “New Lightning”). Gig3’s stockholders overwhelmingly approved the de-SPAC, with 98% of the votes cast being in favor. 29% of the public stockholders elected to exercise their right to redeem their Gig3 shares (for their nominal value of $10 per share, plus interest). The merger closed on May 6, 2021. The plaintiff brought suit in August 2021, claiming breach of fiduciary duties and unjust enrichment. After briefing and oral argument, Vice Chancellor Lori Will rejected the defendants’ motions to dismiss the plaintiff’s claims.

Of note, Gig3 had planned to raise $100 million to $150 million in PIPE financing for the de-SPAC, based on a valuation of Lightning at $899 million. Ultimately, it had to lower its valuation of Lightning to $539 million to obtain $75 million in PIPE financing (from a single investor, who was Lightning’s largest stockholder). Due to the low amount of PIPE financing, it also had to issue dilutive convertible notes (the “Notes”) to support the merger. Before the stockholder vote on the de-SPAC merger, Gig3’s stock had traded around the redemption price (i.e., about $10 per share). By the closing date of the de-SPAC about a month later, the stock price had fallen to $7.82 per share—although the Founder Shares were then worth more than $39 million. Ten days after the de-SPAC closed, New Lightning issued its first quarter results and reduced its 2021 guidance by about 13% from the projections that were disclosed in the proxy statement for the de-SPAC merger (the “Proxy”). Two months after the closing, the stock price had fallen to $6.57 per share; and the day before the court’s opinion was issued, the price was $0.41 per share.

Discussion

The court held, at the pleading stage, that the entire fairness standard of review applied due to conflicts of interest inherent in the SPAC structure. Although the Sponsor owned less than a quarter of Gig3’s voting power at the time of the de-SPAC, the court found it reasonably conceivable that it was a controller as a sponsor has “unrivaled authority” over a SPAC’s business affairs, “control[ing] all aspects of the entity from its creation until the de-SPAC transaction.” The court viewed the Sponsor as conflicted because, based on “the economic structure of the SPAC,” its “interests diverged from public stockholders “in the choice between a bad deal and a liquidation.” The court noted that, in this case, despite the post-merger “plunge” in New Lightning’s stock price, the Founder Shares were worth nearly $32.7 million when this litigation was filed, but would have been worthless if the SPAC had liquidated. By contrast, for the public stockholders, “no deal was preferable to a deal worth less than the liquidation price.” The court also noted that, once a merger agreement is signed, a sponsor is incentivized to minimize redemptions (so that there is sufficient cash for the merger and because, if the merger closes, the value of the sponsor’s interest increases with fewer redemptions). The court expressly rejected (as it had in MultiPlan as well) the contention that the fact that there was a period of time left (in this case, eleven months) until the deadline for completion of a de-SPAC “changed the potential for misaligned incentives.”

The court rejected the argument that, under Corwin, entire fairness should not have applied because the public stockholders approved the de-SPAC merger. The court stated that, even if the disclosure had been adequate, Corwin business judgment review would not apply. “[T]he structure of [a SPAC’s] stockholder vote is inconsistent with the principles animating Corwin,” the court wrote, because SPAC stockholders have no reason to vote against a bad deal given that they can redeem their shares whether they vote for or against the merger, and stockholders who redeem their shares remain incentivized to vote in favor of a deal, even a bad deal, to preserve the value of the warrants they received in the SPAC’s IPO.

The court rejected the argument that entire fairness should not apply because the conflicts of interest were fully disclosed. The court stated that an investor does not “waive[] loyalty claims by tacitly consenting to a conflicted arrangement when investing,” and the court is not “barred from applying entire fairness if the conflicts triggering that standard of review were disclosed.” Such an approach would be “inconsistent” with Delaware corporate law, which “does not allow for a waiver of the directors’ duty of loyalty.”

Importantly, it remains an open question whether entire fairness would apply in a case in which the disclosure was adequate such that the stockholders’ redemption right was not impaired. As it had in MultiPlan, the court expressly declined to address whether with adequate disclosure entire fairness might not apply on the basis that the stockholders’ real protection—their right to elect to redeem their SPAC shares prior to a de-SPAC—would be unimpaired (because they could decide, on a fully informed basis, whether to redeem or invest). Thus, it remains uncertain whether, in a case with adequate disclosure, entire fairness still would apply. In both Delman and MultiPlan, the court emphasized the primacy of the redemption right as a public stockholder protection—in Delman, calling it “a bespoke check on [a] sponsor’s self-interest” and “the primary means protecting stockholders from a forced investment in a transaction they believe is ill-conceived,” and, in MultiPlan, stating that the “core, direct harm” was the impairment of the stockholders’ redemption right.

The court held that the de-SPAC may not have been “entirely fair.” First, the court stated, “unfair price” could be inferred simply from the allegation that the de-SPAC was significantly value-decreasing (i.e., that the public stockholders were “left with shares worth far less than the $10 per share redemption price”). Second, “unfair dealing” could be inferred from the plaintiff’s sufficient pleadings that the disclosure was materially inadequate such that the public stockholders’ redemption right was impaired. The court cited as additional factors suggesting unfair dealing that the two “most highly conflicted” directors (“AK” and his spouse) led the de-SPAC negotiations; and that the Board did not obtain a fairness opinion. The court acknowledged that “Delaware courts have stated that there is no duty to obtain a fairness opinion”; however, in those cases, unlike this one, “the disinterestedness and independence of the directors were not in dispute,” “the boards undertook some effort to assess the fairness of a transaction,” and the boards relied on “independent advisors” in making their assessment. The combination of these factors might not ultimately support a finding of unfairness, the court noted, but at the pleading stage they “provide[d] some evidence that the Board failed to live up to the standard of conduct demanded of it.”

The court held that, although the directors were compensated in cash rather than SPAC shares, none of them may have been independent. The court wrote: “Despite appearing to compensate the Board members in a way that could reduce conflicts, the Sponsor appointed directors with close ties to [AK].” AK, who (with his spouse) allegedly had “dominated” the de-SPAC process and negotiations, had a controlling interest in the Sponsor and was its managing member. He was “a serial founder of SPACs” affiliated with GigCapital Global, of which he was a founding managing partner and the CEO and Chairman. He was also Gig3’s Chairman, CEO, President and Secretary. Through his control of the Sponsor, he had selected the other five members of the Board—namely, his spouse and four individuals who had ties to him and had held various positions “within [AK’s] GigCapital Global enterprise of entities.” The court found it reasonably inferable that: (i) AK had a “material conflict” given his ownership and control of the Sponsor, which in turn owned the Founder Shares (the implied market value of which, at the time of the merger, the court noted, “represent[ed] a 155,900% return on the Sponsor’s initial $25,000 investment”—and “[i]rrespective of [AK]’s personal wealth, a windfall of that magnitude [could not] easily be dismissed as inconsequential”); (ii) AK’s spouse shared AK’s interest in the merger and therefore was conflicted; and (iii) the other four directors were conflicted as they may have felt beholden to AK and under his influence. The court stated that it was fair to infer that the four directors “would expect to be considered for directorships in companies—such as other SPACs—that [AK] launches in the future”; and that it was “rational to presume that [they] received compensation for [their various GigCapital Global-related roles], which would be accretive to their compensation in connection with Gig3.” The “[t]he totality of these relationships provides ample reason to doubt at the pleading stage that any of the Board members qualify as independent of [AK],” the court stated.

The court held that the financial advisors may not have been disinterested. The court viewed the financial advisors as potentially conflicted based on their “large stakes” in shares issued to them in the Private Placement that would be “worthless,” as well as their $8 million in deferred compensation that they would not receive, if a de-SPAC was not completed.

The court held that the Proxy should have disclosed the SPAC shares’ “net cash value.” The Proxy disclosed that the merger consideration consisted of Gig3 shares, valued at $10 per share (their nominal value). The plaintiff argued that the net cash value per share (which takes into account costs and dilution) should have been disclosed. The plaintiff calculated Gig3’s total cash (i.e., cash in the treasury, minus transaction costs and fees incurred, the market value of warrants issued, and the value of the Notes’ conversion feature), and divided that result by the number of pre-merger shares (i.e., public shares issued in the IPO, Founder Shares, shares issued in the Private Placement, and shares to be issued to PIPE investors). The court stated that it was not endorsing any particular methodology for determining value, but that “the sizeable difference between the $10 of value per share Gig3 stockholders expected and Gig3’s net cash per share [which the plaintiff calculated as $5.25]…[was] information that a reasonable shareholder would consider important in deciding whether to redeem or invest in New Lightning.” In a footnote, the court cited to academic studies (that it also cited in last year’s P3 Health decision) that concluded that the actual value of SPAC shares prior to a de-SPAC often is far less than the nominal value.

The court held that the Proxy should have disclosed information that may have suggested that the target-prepared projections were unrealistic. The plaintiff alleged that the Board should have known that the business model of which the target based its projections that were disclosed in the Proxy would be difficult to achieve. “The nature of Lightning’s business model was ‘knowable’ through the sort of diligence and analysis expected of the board of a Delaware corporation undertaking a major transaction,” the court wrote. The court inferred that the Board, for example, “knew (and should have disclosed) or should have known (but failed to investigate) that Lightning’s production would be difficult to scale in the manner predicted” in the projections. While disclosure of the projections in itself was not problematic, the court stated, the Board should have disclosed “impartial information” that would have “counterbalanced” the target’s “lofty” projections (such as that the assumed scaling of the business would be difficult given that Lightning built “highly customized vehicles in small batches”). The court wrote: “Stockholders were kept in the dark as to what they could realistically expect from the combined company…. The Complaint alleges that the Board had good reason to question Lightning’s future capabilities. Yet the Proxy was silent.”

The court rejected several other theories the defendants advanced for dismissal of the claims. (i) The court rejected that the claims were derivative. “[T]his case…[is not] an ‘overpayment action’ challenging a ‘bad deal’…[through which] stockholders are harmed only derivatively so far as their stock loses value…[; rather, in the SPAC context,] [i]f a stockholder’s redemption right had not been manipulated and she chose to redeem her shares, she would receive her pro rata portion of the trust…,” the court wrote. (ii) The court rejected that the claims were impermissible “holder” claims. “[T]hat the default action was to invest…does not mean that a stockholder was ‘holding’…[; rather, the] affirmative choice [to redeem or invest] is one that each SPAC public stockholder must make.” (iii) The court rejected that, because the redemption right was in the SPAC’s charter, the claims were contractual only and solely implicated the SPAC. “The plaintiff is not asserting that Gig3 breached its obligation to provide him with a redemption right[;] [r]ather, he is claiming that the defendants disloyally hindered his ability to exercise it.”

Practice Points

• SPAC sponsors may wish to consider modifications to the typical structure that would reduce the risk of liability. For example, to reduce conflicts that support application of heightened judicial scrutiny, a SPAC sponsor may wish to appoint one or more clearly independent directors to the SPAC’s board, who could lead the de-SPAC process and approve the de-SPAC transaction. (Such directors should be compensated in cash rather than with insider shares.) To support the independence of financial advisors, the sponsor could pay them in cash (not SPAC shares) and not defer their compensation to the closing of a de-SPAC transaction. To permit the stockholder approval of the de-SPAC to function as a protection for public stockholders, the redemption right could be made inapplicable to stockholders who vote in favor of the merger. We note also that many SPACs are now incorporated in the Cayman Islands or British Virgin Islands—usually based on tax considerations, but these jurisdictions potentially may be generally more sponsor-friendly.
• Generally, SPAC directors should consider whether a proposed de-SPAC is fair to the public stockholders. Proposed rules the SEC issued last year relating to SPACs, if adopted, will require that a SPAC disclose whether it reasonably believes that a proposed de-SPAC is fair to the public stockholders, as well as the basis for the belief and whether the SPAC or its sponsor received a fairness opinion. SPACs do not generally obtain fairness opinions in connection with de-SPAC transactions; and there is not (and even under the proposed rules would not be) a duty to obtain a fairness opinion. However, based on Delman, generally, a SPAC’s board may wish to consider obtaining an opinion of outside advisors addressing valuation or fairness issues; and, in any event, generally should consider whether a proposed de-SPAC, in the board’s view, is fair to the public stockholders (including taking into consideration the effect of the sponsor’s promote). The board should be guided in this process by its independent legal and other advisors, and should maintain a record (for example, in board minutes) of its considerations and conclusion.
• SPAC boards should conduct reasonable due diligence on a de-SPAC target and disclose to the public stockholders their material conclusions. Based on Delman, a SPAC’s board generally should consider disclosing (i) the pre-de-SPAC “net cash value” of SPAC shares—at least when, as may often be the case, there is a significant difference between it and the nominal value; and (ii) “impartial information” the board may (or should) have that may undermine projections disclosed in the proxy—such as likely difficulty with achieving an assumed dramatic scaling of the business.