Without a doubt, the trendiest transactions on Wall Street during 2020 and the first half of 2021 were the formation of special purpose acquisition corporations (SPACs) and the follow-on mergers (known as “de-SPAC” transactions) that enable private companies to achieve public company status without the rigors, risks and expenses associated with traditional IPOs.
Standard & Poor’s Capital IQ database reports that 294 SPACs formed in 2020, up from 51 in the prior year, and more than double the number of SPACs formed in the prior three years. Equally impressive is the long list of prominent individuals associated with SPACs. Their credentials (or at least notoriety) conferred an aura of respectability upon this asset class which it had not previously enjoyed.
The sheer volume of recent SPAC transactions, coupled with the impressive pedigrees of some SPAC sponsors, suggest that they have made real progress toward overcoming the taint associated with their ancestors. The much-maligned reverse shell mergers of the early 2000s and discredited “blank check” public companies of the 1980s have moved more into the mainstream of the U.S. capital markets.
Yet, a recently filed Delaware class action complaint contends that the typical SPAC governance structure is so “conflict-laden” that it “practically invites fiduciary misconduct.”
Filed in April 2021, Franchi v. Multiplan Corp., et al. challenges the way most SPAC boards are structured and compensated, as well as the less than rigorous manner in which some de-SPAC transactions have been executed.
Do SPAC directors have a structural conflict?
As the Franchi complaint portrays it, the heart of the problem is that most SPAC directors are compensated with heaping portions of founders’ shares received either as an outright grant, or purchased for a nominal amount, sometimes as low as $25,000. These founders’ shares are potentially worth of millions of dollars to individual directors if a de-SPAC transaction is completed and the market assigns even a lackluster valuation to the post-merger public company.
On the other hand, under SEC rules and market practice, if no suitable merger candidate is found within two years, the SPAC’s initial public investors receive their money back with interest, the SPAC folds, and the directors’ shares become essentially worthless. Given this financial version of “Sophie’s choice,” Franchi sees SPAC directors as hopelessly conflicted when deciding whether to support a de-SPAC transaction.
It is, of course, quite common for public company directors to hold shares when acting on a business combination involving their company. However, in virtually no other public company merger setting (other than pending insolvency) is a director faced with a binary result in which their vote can render their shares potentially valuable or condemn them to be worthless.
This, says the Franchi complaint, is the rub. Although it does not use the term, the complaint essentially views the founders’ shares as little more than a contingent fee that can only be realized by the directors if they act to complete a de-SPAC transaction before the two-year deadline. While not highlighted in the Franchi complaint, presumably this structural conflict only becomes worse as the clock ticks down on that two-year period and the directors essentially face a “last call” before the party abruptly ends.
Franchi asserts a variety of other problems with the de-SPAC transaction it attacks. Michael Klein, the sponsor of the SPAC in question (known as Churchill Sponsor III), had sponsored six other SPACs. Most of the directors of Churchill III had served on many of these six other SPAC boards, where they received similar grants of founders’ shares. Another of Churchill III’s directors was Klein’s brother. The complaint cites these financial and familial relationships as an indication that Churchill III’s directors were not truly independent and that they were instead financially-beholden to Klein.
Indeed, following Churchill III’s de-SPAC merger with its chosen merger partner — Multiplan Corp. — its directors (other than Klein) held, on average, founders’ shares valued at over $3 million. Franchi urges the court to see this level of compensation, along with the directors’ desire for continuing involvement in Klein’s other SPACs, as a powerful economic incentive for them to support the Multiplan merger even in the face of factors that should have caused them to turn away from that deal. These included the fact that Multiplan was facing the sure and imminent loss of its largest customer and that its private equity owners had been “shopping” Multiplan for a prolonged period of time with no takers.
Importantly, the Franchi complaint alleges that Multiplan’s financial woes were not properly disclosed to the Churchill III investors in the proxy statement published in connection with the merger, thus depriving them of the information they deserved to know when voting on the de-SPAC transaction and exercising the redemption right granted to a SPAC investor who disfavors the merger advanced by the SPACs board of directors.
The Franchi complaint also alleges that Churchill III’s directors did not secure the fairness opinion that would routinely be obtained in most public company mergers, and that they did not employ an independent financial advisor. Instead, the SPAC was advised by an investment bank controlled by Klein, which received a fee of over $30 million for its advice on the deal, characterized in Franchi as a “skim.”
The allegations in the Franchi complaint have yet to be tested in the crucible of litigation and it remains to be seen how the case will progress. It is important to note, however, that although Franchi’s allegations are presented in the novel context of a de-SPAC transaction, they are not markedly different in kind or character than the attacks commonly leveled against public company directors approving any merger. The claims might even be seen as “garden variety,” but for the SPAC context and what might fairly be characterized as more than trivial deviations from typical public company merger practices.
However, in Franchi these familiar allegations are coupled with the binary financial result looming over SPAC directors facing the personal financial consequences of failing to complete a de-SPAC transaction. Indeed, it is reasonable to predict that the directors’ multimillion-dollar financial interest in the completion of the Multiplan transaction will be prominently featured in Franchi’s effort to establish that the Churchill III directors breached not only their duty of care, but also their duty of loyalty.
What’s a well-advised SPAC board to do?
Just as the claims against the Churchill III directors come from a well-known plaintiff’s playbook, it is also true that there is a time-tested set of tools for mitigating a board’s exposure to these kinds of claims. Any director considering a SPAC board seat or currently sitting on a SPAC board awaiting a de-SPAC transaction would be well advised to consult legal counsel about implementing the following measures:
Assure proper board composition. The SPAC board should have a majority of directors who are, and who will be seen to be, independent of the sponsor and capable and willing to exercise independent judgment. If the board has already been formed without this, consider augmenting it.
Consider using a special committee of independent directors. If it is important or necessary for several of the SPAC’s directors to have ties to the sponsor’s organization, consider using a special committee of independent directors with no ties or allegiances to the sponsor a broad mandate to manage, review, negotiate and make a recommendation regarding the de-SPAC transaction as well as alternatives. The resulting approach will not be unlike the “conflicts committees” used in many master limited partnerships (MLPs) to consider and act upon proposed transactions between the MLP and its sponsor.
Consider having the special committee receive only (or primarily) cash compensation. Experienced legal counsel have long advised public company board members to avoid any type of contingent compensation for service in connection with a merger transaction. Until like Franchi resolve the founders’ shares issue in a manner favorable to their continued use, the better part of valor may be to staff SPAC boards and special committees with directors receiving mostly reasonable cash compensation.
Use an independent financial advisor with no ties to the sponsor. If a special committee is in place, that committee should have the power to select, retain, direct and fire the advisor.
Secure an appropriate fairness opinion. Not all fairness opinions are created equal. Inquire about whether the procedures used in rendering the opinion, in particular the valuation methodologies, will withstand challenge. Assure that the advisor rendering the opinion is free of conflicts presented if the advisor is also securing financing for the transaction and earning a large fee for doing so.
Build a strong record of board diligence and care. The Franchi complaint stridently criticizes the lack of due diligence done by the Churchill III board concerning its chosen merger partner. Board members should work with counsel and their financial advisors to assure that there is a robust record of the committee’s activities and a clear statement of the rationale for its decision.
The record should reflect not only that the directors affirmatively determined that the de-SPAC merger was not just an acceptable transaction, but that it was superior to available alternatives — including other mergers or returning funds to the SPAC investors.
Read the disclosure. Merger proxy statements are not known to be pithy and compelling reading. Still, directors need to review the disclosure provided to shareholders and make sure that it adequately portrays the prospects of the combined company following the merger. The merger target should be fairly and accurately described — warts and all — as should the board’s rationale for the transaction.
One of the attributes of a SPAC merger, unlike an IPO, is that SEC regulations permit forward-looking projections to be delivered to shareholders voting on the merger. The directors should satisfy themselves that these projections are reasonable and defensible, that they do not materially vary from internal projections, and that they are consistent with both the projections relied upon by the board’s financial advisor in rendering its fairness opinion and with any projections given to third parties providing debt financing in connection with the merger. Nothing will give greater aid and comfort to a plaintiff seeking to attack the integrity of the board than a situation in which multiple sets of projections are being used to tell different stories to different audiences.
Experienced boards and their advisors take great care when handling a public company merger, realizing that their conduct is likely to draw considerable scrutiny. While de-SPAC mergers are relatively new on the scene and have some unique attributes, they must be thoughtfully managed in much the same manner as any other public company merger transaction. While the Franchi case is in its early days, waiting to see if the claims it asserts will succeed would be ill-advised.
Frank M. Placenti is a senior partner of Squire Patton Boggs (US) LLP, where he leads the U.S. corporate governance practice. He was the founding president of the American College of Governance Counsel and serves as the chair of the corporate governance committee of the American Bar Association. He conceived and edited The Directors Handbook: A Field Guide to 101 Situations Commonly Found in the Boardroom and is an adjunct professor of corporate governance in the Distinguished Practitioners in Residence Program of the Moritz College of Law at The Ohio State University.