The court denied the defendants’ motion to dismiss, finding a conflicted transaction triggering the entire fairness standard of review. The conflict was rooted in the asymmetry of incentives between the SPAC Sponsor and the Sponsor-affiliated Board and the public stockholders during the pre-merger redemption process. In this context, the Court found that the plaintiffs adequately alleged that the defendants breached their fiduciary duties of loyalty, disclosure, and candor by failing to disclose – allegedly to prioritize their own personal and financial interests – material information necessary for the public stockholders to make an informed choice on redeeming their stock.
Background
A SPAC is a publicly traded company that is created for one purpose: to raise capital through an initial public offering and then merge with a private company and take it public. Unlike most companies that go public, a SPAC has no operations of its own. SPACs are often created and controlled by an individual or management group known as the SPAC “sponsor.”
The SPAC in this case, Churchill Capital Corp. III (Churchill), was formed as a Delaware corporation in October 2019. Churchill’s $1.1 billion initial public offering closed in February 2020. Churchill’s Sponsor was compensated in the form of “founder” shares. The founder shares constituted 20 percent of the SPAC’s equity and were purchased for a nominal price ($25,000 for the entire 20 percent of the equity). The Sponsor was also compensated in the form of an option to purchase warrants in the SPAC, and Churchill made a private placement of 23 million warrants to the Sponsor at $1 each.
The Sponsor was led by defendant Michael Klein, who hand-picked the directors of the SPAC. The directors, in turn, were given valuable economic interests in the Sponsor. In contrast, the initial public stockholders purchased IPO units at $10 per unit, each of which consisted of one common share plus a fractional warrant. The proceeds of the IPO were placed into a trust account.
Once a potential merger was disclosed, but before the stockholder vote, the public stockholders would choose between (i) cashing out and receiving their $10 per unit back from the trust account plus interest, or (ii) investing in the post-combination entity. The public stockholders could choose to redeem their shares regardless of whether they voted for or against the merger. They would also retain their warrants at no cost. If the business combination occurred within a two-year completion window, the founder shares would convert into common stock upon closing. On the other hand, if the SPAC failed to close a transaction within that time, the SPAC would liquidate. The consequence of liquidation would be that the founder shares and the Sponsor’s warrants would be rendered worthless, but the public stockholders would receive a refund of their full investment plus interest.
Churchill’s Sponsor team selected MultiPlan, Inc., “a healthcare industry-focused data analytics and cost management solutions provider,” as their acquisition target. On September 18, 2020, Churchill issued its definitive proxy statement, containing information about the deal and soliciting stockholder votes. In response, the vast majority of the stockholders voted to approve the merger, and fewer than 10 percent of the public stockholders chose to cash out. The merger closed in October 2020, and the non-redeeming public stockholders became common stockholders in the new entity. The founder shares were likewise converted into common stock in the new entity.
After closing, the NewCo stock declined in value to “several dollars below” the $10 plus interest that the public stockholders would have received if they had chosen to cash out. However, the value of the post-closing shares in NewCo was pure upside to the Sponsor, whose original shares were purchased for a nominal price.
The plaintiffs alleged that Churchill’s Sponsor team withheld material information on the deal, hence depriving the public stockholders of their right to make an informed choice on whether to cash out before the merger. Specifically, the plaintiffs alleged that the Sponsor team withheld information indicating that MultiPlan’s largest customer, on which MultiPlan was dependent, was building a competing in-house platform and planned “to move all of its key accounts from MultiPlan to [the in-house platform] by the end of 2022.” The proxy was not accompanied by an independent valuation or fairness opinion. The plaintiffs pled four counts: three counts styled as direct claims for breach of fiduciary duty, and an aiding and abetting claim against an affiliate of Klein that served as financial advisor on the merger.
The defendants moved to dismiss on grounds pursuant to Chancery Rule 23.1 for failure to plead demand futility and Chancery Rule 12(b)(6) for failure to state a claim. The defendants principally argued that the fiduciary duty claims, while styled as direct claims, were actually primarily derivative in nature (an overpayment claim or a waste claim) and that the business judgment rule should apply.
Analysis
As a threshold matter, the Court found that the claims were direct in nature. The Court explained that “this is not a typical overpayment or dilution case.” Instead, “[t]he Complaint centers around the allegation that the Board impaired the public stockholders’ informed exercise of their redemption right,” which was a right that was personal to the public stockholders and not shared with Churchill. The Court recognized an analogy between the redemption right and the stockholders’ right to vote but observed that “given the mechanics of a SPAC, the [redemption right] arguably takes on greater importance.” The Court concluded that to cast the claim as an overpayment claim would be incorrect. The plaintiffs were dissatisfied not with the merger terms but with the loss of the opportunity to make an informed choice on pre-merger redemption.
The Court also rejected the defendants’ argument that the redemption right is contractual and hence fiduciary duty claims arising out of the same facts should be dismissed as superfluous. While it was uncontested that Churchill’s certificate of incorporation provides for the redemption right, the plaintiffs alleged not that they did not have the chance to redeem, but that they were prevented from making an informed choice on redemption due to defendants’ breaches of the duty to disclose.
The Court further rejected the defendants’ argument that even if the claims are direct and not barred as contractual claims, they should be dismissed as “holder claims” (a cause of action brought by a person wrongfully induced to hold stock rather than selling it) for which class action treatment is inappropriate under established Delaware law. The Court found that the plaintiffs’ claims were not “passive” holder claims. Instead, the plaintiffs were called upon to make “an active and affirmative” investment decision “to divest or invest in the post-merger entity.”
Turning to the allegations of breach of fiduciary duty, the Court found “two independent – and individually sufficient – reasons for why entire fairness applies.” First, the Court found that the merger, including the redemption process, was a conflicted controller transaction. Second, a majority of the Board was conflicted because the directors were self-interested or lacked independence from Klein.
The defendants argued that Klein was not conflicted because he received no unique benefit “because he did not receive any greater or different consideration than other Churchill stockholders in the merger.” But the Court found a unique benefit to Klein in connection with the misalignment of interests during the pre-merger redemption process. Both the Sponsor’s founder shares and warrants would have been worthless if Churchill did not complete a deal. And, given the nominal consideration the Sponsor paid for its shares, almost any deal – even a value-decreasing deal – would present a windfall to the Sponsor and to Klein. The Court rejected the defendants’ arguments that they should not be held liable because the structure of the SPAC, and the asymmetries in incentives, were both typical to SPACs and disclosed in the prospectus. The Court explained that the issue was not that the public stockholders were in the dark about incentives but rather that the defendants allegedly withheld material information pertinent to the redemption choice.
The Court concluded that the complaint “contains well-pleaded allegations that false and misleading disclosures impaired Class A stockholders’ exercise of their option to redeem,” noting that “[i]f public stockholders, in possession of all material information about the target, had chosen to invest rather than redeem, one can imagine a different outcome.” The Court hence denied the motion to dismiss, except with respect to the claims against one of the individual defendants who served as Churchill’s CFO.
Client Alert 2022-029
