Delman v. GigAquisitions3, LLC et al.: The Inherent Conflicts of de-SPAC Mergers

In 2021 and continuing into 2022, the magnitude of SPAC deals was historic. While the number of announced SPAC deals slipped in 2022 (by as much as half) and the number of withdrawn SPACs increased, the initial wave of “busted SPACs” has started, and many are approaching deadlines to consummate business mergers or consider liquidation and restructuring alternatives.

At the same time, post-merger transactions are finding their way to the Delaware Court of Chancery. In Delman v. GigAcquisitions3, LLC, et al., [1] the Chancery Court identified what it viewed as an inherent conflict as between SPAC shareholders and sponsors in connection with the decision to vote for a de-SPAC merger and, as such, provides guidance for go-forward SPAC structures and shareholder solicitations. Due to the magnitude of SPAC deals in the past three years, this article suggests best practices for mitigating liability for post-merger claims.

SPAC Structure

The de-SPAC merger transaction follows the following deal structure:

• A shell company raises cash in an initial public offering (IPO), pursuant to which the shareholders receive shares and fractional warrants to purchase additional shares;
• The proceeds from the IPO are put into trust for the benefit of the shareholders;
• The SPAC sponsor administers the SPAC (having selected the board), receives a percentage of the SPAC equity (founder shares), and invests in the SPAC to cover underwriting, legal, and other fees and costs;
• The organizational documents provide a fixed period within which a de-SPAC transaction — a reverse merger with a private company — must be completed or the SPAC will liquidate and the trust proceeds will be distributed to the public SPAC shareholders with interest; and
• In the event of a liquidation of the SPAC, the Founder Shares become worthless and the founder is not reimbursed for the fees and costs that it advanced.

This SPAC structure seems like a “win-win.” Shareholders invest in the SPAC and preserve the right to invest in the post-merger de-SPAC entity. The invested funds are held in trust for the shareholders. If a merger partner is identified, the shareholders then have the opportunity to choose between investment in the de-SPAC or redemption of their investment. However, as the Chancery Court determined in Delman, the risk for shareholders may, in certain circumstances, be more material than contemplated.

The Potential Inherent Conflict

The court began its analysis by noting the importance of a shareholder’s right to redeem, noting that

[t]he right to redeem is the primary means protecting stockholders from a forced investment in a transaction that they believe is ill-conceived. It is a bespoke check on the sponsor’s self-interest, which is intrinsic to the governance structure of a SPAC. [2]

Having identified the importance of shareholders’ right of redemption, the court detailed the inherent potential conflict in de-SPAC mergers as between the interests of the sponsor and shareholders:

• In a de-SPAC merger, the founder typically receives founder shares and warrants in the post-merger entity as consideration for its obligations and responsibilities. At that time, the SPAC will have incurred substantial underwriting, legal and other fees and costs, from which the shareholder trust-funds are shielded and for which the sponsor bears responsibility;
• There are (at least) three reasons that the sponsor would overwhelmingly favor a merger as opposed to shareholder redemptions:
  • First, the costs of the transaction will be satisfied through a merger, saving the founder from bearing the substantial costs (millions) if the SPAC were liquidated;
  • Second, the sponsor receives its sponsor shares, which, even if the value is materially diluted, can nevertheless be valuable as compared to the founder’s de minimis investment;
  • Third, if cash funding is necessary to satisfy the SPAC’s merger with the target, then substantial redemptions by SPAC shareholders could leave the SPAC without sufficient capital to close the de-SPAC transaction; and
  • As a result, the sponsor is “incentivized to undertake a value-decreasing transaction because it [will lead] to colossal returns on the [sponsor investment] …”; [3]
• Conversely, a redemption provides the shareholders with the option to receive the value of their investment, with interest, from the trust. Without full disclosure regarding a de-SPAC merger transaction, a decision by shareholders to invest in the post-merger de-SPAC entity can pose considerable uncertainty and risk of loss; and
• Importantly, as in Delman, shareholders’ “voting interests [are] decoupled from their economic interests” since they could “simultaneously divest themselves of an interest in [the SPAC] by redeeming and [still] vote in favor of the deal.” [4] Since even redeeming shareholders retained their warrants in the post-merger business, they had no incentive to vote against even a bad deal.

Since the sponsor stands to materially benefit from consummating the de-SPAC merger, and since shareholders may be materially impaired by the merger if not adequately informed about the decision to redeem or invest, it is critical that all aspects of the proposed merger are disclosed to shareholders to enable them to be fully informed when deciding what to do with their investment.

Delman

Since the contextual considerations and concerns of the Chancery Court arose in connection with the claims and allegations in Delman, it is not surprising that the facts mirror and support the court’s conclusions. The court found and ruled as follows:

• In spite of the fact that the controller owned less than 50% of the pre-merger SPAC shares, it nonetheless “controlled” the SPAC since the controller created the pre-merger entity, selected the board, controlled the board (with whom there were close ties and influence), and controlled the most important decision of the SPAC: to merge or liquidate;
• The members of the SPAC board were all affiliated with the sponsor and closely aligned with the sponsor;
• The “unique” value for the sponsor in the merger was evidenced by its “enormous return” on account of a $25,000 investment: post-merger sponsor shares valued at more than $39 million at closing [5] (and $32 million when the litigation was filed) and payment of transaction costs;
• The merger agreement required that the SPAC contribute $150 million at closing, $50 million of which was to come from the shareholder trust account, which could be insufficient should there be a high number of redemptions;
• The projections from the target company included in the proxy provided hockey-stick increases over a five-year period in profits ($0 to $500 million) and revenue ($9 million to $2 billion), without an impartial/independent financial analysis;
• While the proxy assessed a post-merger value of $10/share, such value failed to account for substantial dilution resulting from significant transaction costs, the market value of outstanding warrants, and the amount of certain public equity (or PIPE) subscription agreements and notes, all of which cut the value/share in half;
• The voting and economic interests of the shareholders were de-coupled, since the shareholders were able to redeem but nonetheless vote in favor of the transaction (which preserved value for their warrants). It is not surprising that 98% of shareholders voted in favor of the transaction even though 29% of shareholders elected to redeem; and
• The defendants argued that the presumption of entire fairness due to the purported conflicts as rebutted, and the business judgment standard of review applied, since under Corwin v. KKR Financial Holding, LLC, [6] the vote was cleansed through a vote of a “fully informed, uncoerced majority.” However, the court summarily rejected the argument since it found that the proxy was “materially false and misleading….” [7]

As a result of the court’s findings regarding conflict and the insufficiency of proxy disclosures, the defendants’ motion to dismiss was denied, as it was “reasonably conceivable that the defendants breached [their] duties of loyalty depriving public stockholders of information material to the redemption decision.” [8]

What to Do?

When considering go-forward best practices regarding the structure and utilization of SPACs and de-SPAC mergers, Delman provides some go-forward guidance: (1) establish independence at the board to preserve review under the business-judgment rule; and (2) be clear to disclose in detail in the merger proxy (a) the specific nature and extent of any board conflict(s); (b) the financial benefits to the sponsor; (c) deductions to value (costs, PIPE interest and notes); (d) the actual post-merger stock value (after accounting for costs and dilution); and (e) an impartial assessment of the post-merger projections and enterprise value.

However, since the rapid ascension of SPAC deals has been meet with an equally swift decline, the “practical remedy” available to potential director, officer and sponsor defendants is primarily defensive, as de-SPAC mergers are finding their way to Chancery Court. The establishment of a special committee of the board to review and render judgment regarding potential claims may assist the court’s assessment of the merits of shareholder claims against a purportedly conflicted board.

When establishing a special committee, there are three critical components: (1) the committee member(s) must be independent; (2) the special committee must have exclusive authority to investigate the subject claims and provide a recommendation regarding pursuit of such claims; and (3) the special committee must have independent counsel to assist and advise regarding the subject investigation. While the empowerment of a special committee might not be dispositive regarding the litigation outcome, the judgment of a special committee that is disinterested and independent and that has acted in good faith will receive substantial deference from a Delaware court.

In the event that the post-merger entity finds itself insolvent, in the zone of insolvency, or in a liquidity crisis that necessitates the need to commence a chapter 11 proceeding, the utilization of an independent special committee or independent director to conduct a review of such claims will enable a company to mitigate the cost and uncertainty of derivative claims in three ways. First, the judgment of an independent fiduciary who has conducted a review of potential claims will provide support for debtor releases under a chapter 11 plan. Second, in the event that derivative claims are acquired by a buyer in a sale pursuant to §  363 of the Bankruptcy Code, the judgment of such an independent fiduciary will be important in assessing the value ascribed to such claims (if any) to be sold to the buyer. Finally, in the event that any viable claims of value are identified by the independent fiduciary in the course of its good-faith investigation, such claims can be settled in the chapter 11 case pursuant to Bankruptcy Rule 9019.