SPACs: Disclosing Before Closing

Given the sheer volume and scale of SPAC listings on the New York Stock Exchange and Nasdaq, SPACs have caught the eye of the US Securities and Exchange Commission (SEC) as well as hungry plaintiffs. Much of the focus to date, from an enforcement and litigation perspective, has been on the adequacy (or inadequacy) of disclosure associated with the business combination transactions entered into by SPACs. However, as the critique of SPACs inevitably increases, we may see disclosure based claims focusing on other areas of the SPAC life cycle.

Earlier this year, SEC Commissioner Hester Peirce said that it is important to “ensure SPACs are providing sufficient disclosures to enable informed investment decision-making at each stage [of the SPAC life cycle].”  Subsequently, Mr. John Coates, the Acting Director of the SEC’s Division of Corporate Finance, cautioned that SEC enforcement teams are “continuing to look carefully at filings and disclosures by SPACs and their targets.”  He also observed that “with the unprecedented surge has come unprecedented scrutiny”.  

Spotlight On Adequacy Of Disclosure

The disclosure burdens associated with the initial public offering (IPO) of a SPAC are, in contrast to a traditional IPO, minimal. SPACs, which are “blank-check” vehicles, have limited operations and relatively unrestricted and non-specific investment guidelines when they are created. As a result, at the time of the SPAC's IPO, disclosure is focused on: (i) the mechanics of the securities being issued by the SPAC; (ii) the expertise of the SPAC's directors and officers; and (iii) the potential conflicts between the SPAC's sponsor and the other equity holders in the SPAC that are inherent in all current SPAC structures.

SPACs are promoted by sponsors who raise capital by way of an IPO. The objective is that the sponsor group will use the capital they have raised to identify and acquire a privately held target company. Generally, the sponsor group will have expertise and connections within a particular industry or sector, creating synergies between the SPAC and the target. Whilst the nature of a SPAC IPO prevents the sponsors entering into discussions with a target before listing, an investor will often invest on the understanding that the sponsor group, through the directors and officers it places with the SPAC, will pursue opportunities within a discrete part of the market in light of the relevant group’s particular skill-set.

Currently, plaintiffs are focusing on allegations that: (a) SPACs have failed to conduct appropriate due diligence on the de-SPAC target and have subsequently failed to make adequate disclosure concerning the diligence in the shareholder proxy solicitation document (or F-4 / S-4 Registration Statement); and (b) SPACs (or the sponsors promoting the SPAC) have rushed to complete a transaction before the redemption window against the best interests of investors. But the potential exists for other types of claims and we expect that novel arguments, which may be informed by the jurisdictions in which plaintiffs are able to formulate a nexus, will be forthcoming.

These claims are not merely a transaction tax raised by plaintiff's lawyers. As the use of SPACs has become more prevalent and widely-publicised, many retail investors have started to subscribe alongside institutional investors. Law makers and financial regulators often differentiate between: (i) “mom-and-pop” or retail investors; and (ii) more sophisticated investors. Where retail investors go, regulatory concerns soon follow.

Duties Owed To Investors

Directors of SPACs owe fiduciary and non-fiduciary duties to those who have invested in the SPAC. An example of a fiduciary duty is that each director has a duty not to place himself or herself in a position where an actual or potential conflict exists between duties owed to the company (i.e., in most scenarios, the shareholders) and personal interests.

The concept of a fiduciary originates in the law of equity and is influenced by the concept that a person who has been placed in a position of trust should protect the interests of those s/he is appointed to serve (i.e., in the SPAC context, duties are owed to the public shareholders). As Millet LJ put it in one of the leading judgments from the English Court of Appeal on the definition of a fiduciary and the nature of fiduciary duties:  

“… the distinguishing obligation of a fiduciary is the obligation of loyalty. The principal is entitled to the single-minded loyalty of his fiduciary. This core liability has several facets. A fiduciary must act in good faith; he must not make a profit out of his trust; he may not act for his own benefit or the benefit of a third person without the informed consent of his principal.”

(see Bristol and West Building Society v Mothew [1996] EWCA Civ 533)

SPACs have faced harsh criticism for alleged misalignment of incentives in the SPAC structure. One of the most recent high-profile class action complaints filed in relation to MultiPlan Corp in Delaware asserts that the SPAC model itself is “conflict-laden and practically invites fiduciary misconduct” (see Amo v. MultiPlan Corp., Del. Ch., No. 2021-0258, complaint filed 25 March 2021). SPAC sponsors typically have a windfall profit if a business combination is completed - even if the resulting combined company's actual results fall far short of those pitched to investors. On the other hand, if a SPAC does not complete a business combination within a specified timeframe, SPAC sponsors stand to lose millions of dollars in capital advanced to the SPAC.

Accordingly, in order to protect investors, the SEC has released a range of guidance on SPAC investments. In particular, the SEC has focused on conflicts of interest inherent in the process and related disclosure obligations. On December 2020[i], the SEC set out lists of disclosure considerations and specific questions to be asked at both the IPO stage and business combination stage.

The economic interests of the promoters of the SPAC may not align with the economic interests of those investing in the SPAC. The SPAC sponsor group often negotiates the business combination transaction which may include preparing a valuation of the target and pitching the opportunity to SPAC equity holders for any necessary approvals. In parallel, individual members of the sponsor group are likely to take on fiduciary and tortious duties in their capacity as directors and officers of the SPAC. It is this rare combination of roles, interests and responsibilities which gives rise to unique issues for all involved and the need for careful disclosure.

Parallel Cayman Islands And US Considerations

Given the advantages the Cayman Islands can offer as an international finance centre, many SPACs (particularly those who may be considering a non-US private company target for their de-SPAC) start life in the Cayman Islands. Of the 437 SPACs listed in the United States in the first nine months of 2021, 181 were incorporated in the Cayman Islands. A number of these Cayman SPACs may ultimately complete transactions with targets organised outside the United States but listed on US exchanges and still others may be domesticated or continued on to another country (e.g., the US or Canada) as part of the business combination transaction. 

Because the SPAC life cycle is becoming increasingly multinational (e.g., IPO vs. the business combination vs. post-combination activities) the laws of different jurisdictions may apply. Consequently, it may be necessary to choose between multiple jurisdictions when deciding how to frame and where to file a complaint. And, on the other side of the equation, SPACs and their stakeholders need to consider this multijurisdictional exposure when prophylactically adopting best practices against such claims.

Taking the surge in Cayman SPACs as an example, Cayman SPACs (as well as their directors, officers and sponsors) listed in the United States will need to grapple with SEC guidance, applicable listing rules, and their directors’ duties as a matter of Cayman Islands law.

It is alleged in many recent US complaints that SPAC directors have either knowingly or recklessly breached fiduciary and/or non-fiduciary duties owed to investors, often based on a combination of inadequate disclosure and conflicts of interest. These types of actions are also framed on the basis that directors owe overarching duties of loyalty to shareholders and must act in their best interests at all times. These fiduciary duties come into particular focus during the business combination process when the board of directors of the SPAC approve the business combination with the target company and then recommend that transaction to the shareholders of the SPAC for approval.

One important practice note for Cayman SPACs is that the competency-based duty of care, skill and diligence is treated as a non-fiduciary duty in the Cayman Islands. This means that different standards may apply when bringing US actions, as opposed to Cayman Islands proceedings, against SPAC directors.

In the Cayman Islands, the applicable skill and care test is that of a reasonably diligent person having both: (i) the knowledge, skill and experience that may reasonably be expected of a person carrying out the same functions as are carried out by that director in relation to the company; and (ii) the knowledge, skill and experience that the particular director actually has. It is a mixed objective and subjective test.

In light of the highly specialised background and skill-set of many of the SPAC sponsors (whose biographies are the basis for marketing to potential investors during the IPO of the SPAC), the subjective second limb of the test could hold such directors and officers of SPAC sponsors to higher standards than many of their peers. While this legal argument has not yet been tested in this specific context as far as we are aware, this difference between US and Cayman law is a feature that practitioners should bear in mind when working on cross border SPACs.

Comment

As representatives of the SEC have emphasised, the fundamental concern is that investors must be in a position to make an informed decision based on accurate and fulsome disclosure. If conflicts of interest are not brought to the attention of investors or if the independence of SPAC directors is compromised, shareholders and regulators will have little sympathy for the sponsors when the newly-merged entity under performs.

There are, of course, best practices to adopt to guard against allegations of breach of duty and other misconduct in each relevant jurisdiction. For example, in response to recent litigation and enforcement activity, many SPACs are being advised to form special committees to ensure that they have robust governance processes in place and to assist with the valuation and due diligence exercise. In a growing number of instances, SPACs are also seeking fairness opinions to validate valuations of target companies. Due to the cross-border nature of many of these transactions, it is critically-important that all stakeholders in a SPAC transaction take advice on disclosure obligations and their rights to information based on the applicable legal regime.

 

Footnotes:

[i] See Special Purpose Acquisition Companies, Division of Corporation Finance Securities and Exchange Commission, CF Disclosure Guidance: Topic No. 11 dated 22 December 2020. https://www.sec.gov/corpfin/disclosure-special-purpose-acquisition-companies