The U.S. Court of Appeals for the Ninth Circuit ruled last week that the securities-law requirement to plead a “strong inference” of scienter does not apply to claims under § 14(e) of the Securities Exchange Act even where the challenged statement is a statement of opinion. The decision in Grier v. Finjan Holdings, Inc. (In re Finjan Holdings, Inc. Securities Litigation) (9th Cir. Jan. 20, 2023) held that, because § 14(e) claims – which arise in connection with tender offers – can be based on mere negligence instead of knowing or reckless misconduct, a plaintiff needs to plead only a “reasonable inference,” rather than a “strong inference,” of an opinion’s subjective falsity.
Last week, the Fifth Circuit reversed a decision from the United States District Court for the Northern District of Texas that had dismissed a class action against Six Flags Entertainment Corporation. The complaint in Oklahoma Firefighters Pension and Retirement System v. Six Flags Entertainment Corp., et al., alleged Six Flags and its former CEO and CFO violated federal securities laws in connection with statements regarding the construction of new theme parks in China. In overturning the lower court’s decision, the Fifth Circuit provided important guidance regarding the weight of confidential witness allegations in securities class actions, as well as evaluating legal doctrines on forward-looking statements, puffery, and scienter.
On January 1, 2021, Congress enacted the Corporate Transparency Act as part of the Anti-Money Laundering Act of 2020 to “better enable critical national security, intelligence, and law enforcement efforts to counter money laundering, the financing of terrorism, and other illicit activity.” FinCEN issued the final rule on Beneficial Ownership Information Reporting Requirements on September 29, 2022 requiring a range of entities, primarily smaller, otherwise unregulated companies, to file a report with FinCEN identifying the entities’ beneficial owners—the persons who ultimately own or control the company—and provide similar identifying information about the persons who formed the entity. On December 16, 2022, FinCEN proposed the Beneficial Ownership Information Access and Safeguards, and Use of FinCEN Identifiers for Entities rule laying out the protocols for access to the beneficial ownership database by authorized recipients, while still maintaining the highest levels of data protection and oversight.
In the first insider trading case involving cryptocurrencies, a crypto trader was convicted of insider trading in federal district court and recently sentenced to 10 months in prison.
The defendant, Nikhil Wahi, pleaded guilty in the U.S. District Court for the Southern District of New York to illegally trading on information tipped by his brother, a former Coinbase product manager. According to his plea, Wahi used that information to trade on 40 different kinds of crypto assets were scheduled to be listed on the Coinbase platform between April 2021 and July 2022, when he was arrested. Prosecutors alleged that Wahi used those tips to sell crypto assets for a profit. Under the terms of the plea agreement, Wahi agreed to serve ten months in prison. Wahi’s brother, Ishan Wahi, has pleaded not guilty and is due to appear in court in March.
The Delaware Court of Chancery yesterday denied a motion to dismiss a class action alleging that the directors and sponsor of a special-purpose acquisition company (a “SPAC”) breached their fiduciary duties by disloyally depriving the SPAC’s public stockholders of information material to their decision whether to redeem their stock before the SPAC merged with a private company in a “de-SPAC” transaction. The decision in Delman v. GigAcquisitions3, LLC (Del. Ch. Jan. 4, 2023), adds to the growing body of cases analyzing potential conflicts in SPAC transactions and applying the rigorous “entire fairness” standard of review.
The Delman ruling also is notable for its substantial reliance on allegations from an academic article discussing the high costs embedded in the SPAC structure. One of the authors of that article appeared for the plaintiff in Delman.
The SPAC at issue was a typically structured SPAC. It was formed and managed by a sponsor, and it then offered shares to the public through an IPO. The corporate charter required the SPAC to complete a de-SPAC transaction with a not-yet-identified private company within 18 months or to liquidate if a merger could not be completed within that time. Upon liquidation, a trust holding the IPO proceeds plus accrued interest would be distributed to the SPAC’s public stockholders, but the founder shares – approximately 20% of the SPAC’s post-IPO equity – would become worthless.
The SPAC entered into a merger agreement with a target company within the required period. The SPAC’s proxy statement invited stockholders to vote on the merger and informed public stockholders of their right to redeem their stock (for the original purchase price of $10 per share plus accrued interest) if they did not want to become stockholders in the post-merger entity. The proxy statement contained projections prepared by the target’s management forecasting explosive growth over the next five years. It also disclosed potential conflicts of interest between the SPAC’s sponsor and Board, on the one hand, and its public stockholders, on the other, including that the sponsor, officers, and directors would lose their entire investment in the SPAC if the merger were not consummated by the applicable deadline.
The stockholders approved the merger, but the post-merger company’s performance suffered, and its stock price fell dramatically. A stockholder who had purchased the SPAC’s stock before the merger then filed a putative class action asserting direct claims for breach of fiduciary duty against the SPAC’s Board, sponsor, and controlling stockholder, and a claim for unjust enrichment against the sponsor and the directors. The court denied the defendants’ motion to dismiss, holding that “it is reasonably conceivable” that the defendants breached their fiduciary duties by depriving the public stockholders of material information they needed to decide whether to redeem their SPAC shares before the merger.
Chancery Court’s Decision
The court began by rejecting two threshold arguments that the defendants had raised: (i) the asserted claims were derivative, rather than direct, and (ii) the claims were impermissible “holder” claims.
- The claims for breach of fiduciary duty were direct, not derivative, because the allegedly disloyal conduct had deprived the SPAC’s public stockholders of information they needed to decide whether to exercise their own redemption right. That right is personal to the public stockholders, and an injury could not be redressed through a recovery flowing to the SPAC. Similarly, the unjust-enrichment claim was based on the sponsor’s and the Board’s enrichment because of the supposed informational imbalance. That alleged harm also was separate from any potential injury to the SPAC itself.
- The claims were not “holder” claims because they did not allege that the public stockholders had been wrongfully induced to hold their stock instead of selling it. Rather, the claims were predicated on the stockholders’ having been asked to make a decision: whether to redeem their stock before the de-SPAC merger occurred. A stockholder “who opted not to redeem chose to invest her portion of the trust in the post-merger entity. This affirmative choice is one that each SPAC public stockholder must make. There is no continuation of the status quo,” as there is with a “holder” claim.
The court then turned to the claims for breach of fiduciary duty and the allegation that the defendants had disloyally hindered the public stockholders from being able to exercise their redemption right effectively. The court viewed the redemption right as “the primary means protecting stockholders from a forced investment in a transaction they believe is ill-conceived.” A SPAC’s fiduciaries thus “must ensure that right is effective, including by disclosing fully and fairly all material information that is reasonably available about the merger and target to inform the redemption decision.”
As in most cases involving alleged breaches of fiduciary duty, a threshold and potentially outcome-determinative decision concerns the standard of review that the court should apply: the relatively deferential business-judgment rule or the more rigorous “entire fairness” standard, which requires the defendants to demonstrate that the challenged act or transaction was entirely fair to the corporation and its stockholders in terms of both price and process. The court here applied the entire-fairness standard because of “inherent conflicts between the SPAC’s fiduciaries and public stockholders in the context of a value-decreasing transaction.” The court held that the plaintiff had plausibly pled facts showing that the de-SPAC merger was a “conflicted controller transaction” and that a majority of the SPAC’s Board was not disinterested or independent.
- The de-SPAC merger plausibly was a conflicted transaction in that “the defendants were incentivized to undertake a value-decreasing transaction because it led to colossal returns on the Sponsor’s investment, without regard to whether public stockholders were better served by liquidation.” If the merger (or some other merger) did not take place within the required 18-month period, the sponsor and other defendants who had invested in the SPAC would lose their investment, but the public stockholders would get back their money plus interest. Thus, for the sponsor, a flawed deal allegedly was better than no deal at all, while the opposite was true for the public stockholders. The defendants therefore allegedly had an incentive to provide inadequate or overly optimistic disclosures about the merger to discourage redemptions (which would deplete funds available for the merger) and ensure the transaction’s consummation.
- The non-sponsor members of the SPAC’s Board were not independent and disinterested because they had numerous overlapping business ties to the conflicted sponsor, which clearly was interested, and one of those other Board members was also the wife of the sponsor’s controlling shareholder.
Under the entire-fairness standard, the court held that the plaintiff had pled viable claims for relief. The “public stockholders knew that if they redeemed, they were promised $10 per share plus interest,” but they were given “incomplete information about what they would receive if they instead opted to invest” in the post-merger entity. The allegedly inadequate information concerned both what the SPAC itself would invest in the target and what the SPAC would receive from the merger.
- The proxy statement said that the merger consideration to be paid to the target’s stockholders consisted solely of SPAC stock valued at $10 per share. Thus, non-redeeming SPAC stockholders who exchanged their SPAC stock worth $10 per share could expect to receive equivalent value in return. However, the plaintiff alleged that the actual amount of net cash per share that the SPAC would invest in the target was only about $5.25. The proxy statement thus allegedly “misstated and obfuscated the net cash – and thus the value – underlying [the SPAC’s] shares.” The alleged disparity between the SPAC’s purported contribution of $10 per share and its actual contribution of $5.25 arose from the supposedly hidden costs involved in SPAC transactions and the understated number of pre-merger shares involved. The economic analysis came from an article called “A Sober Look at SPACs,” by Michael Klausner, Michael Ohlrogge, & Emily Ruan, published last year in the Yale Journal on Regulation.
- As for what the SPAC and its stockholders would receive from the merger: the proxy statement projected dramatic growth over the next five years, including annual revenue growth of more than 22,100% and an increase in annual gross profits from zero to more than $500 million. But those “lofty projections” – which have not materialized to date – “were not counterbalanced by impartial information.” The SPAC’s stockholders thus “were kept in the dark about what they could realistically expect from the combined company.” The court held that the plaintiff had plausibly alleged that the defendants “knew (and should have disclosed) or should have known (but failed to investigate)” that the target’s projections would be difficult to achieve. And without an accurate portrayal of the target’s financial health, “the public stockholders could not fairly decide whether it was preferable to redeem for $10 plus interest or to invest in a risky venture.”
The court therefore could not conclude at the pleading stage that the transaction was the product of fair dealing. The court also ruled that unfair price could be inferred from the allegation that the public stockholders were left with target shares worth far less than the redemption price of $10 per share.
The Delman ruling does not break new ground in light of other recent Delaware decisions on SPAC transactions, potential conflicts of interest in the SPAC structure, and the importance of adequate disclosures to protect public stockholders’ redemption right. But the decision highlights issues concerning the economics and expenses underlying the SPAC structure, a topic explored in great depth in the Yale Journal on Regulation article, one of whose authors (Professor Michael Klausner, of Stanford Law School) appeared for the plaintiff in this case. That article concluded that the “costs embedded in the SPAC structure are subtle, opaque, higher than has been previously recognized, and higher than the cost of an IPO.” The Delaware court made clear that, at the pleading stage, it was not assessing the accuracy of the plaintiff’s allegations based on the Yale Journal article and was not endorsing any specific formula or method for calculating the net cash per share that the SPAC had contributed to the merger. But the article attracted attention when it was published in 2022, and, in light of the Delman decision, it is likely to be cited in other SPAC-related litigation.
The decision also raises another interesting issue concerning the choices facing public stockholders of SPACs when they receive a proxy statement inviting them to vote on a de-SPAC merger and informing them of their redemption right. The court observed that, in the SPAC context, public stockholders’ voting interests are “decoupled from their economic interests” because the stockholders can choose to redeem their shares and still vote in favor of the merger. In fact, they arguably have some incentive to vote in favor even if they want to redeem: they generally received warrants as well as shares in the SPAC’s IPO, and those warrants would be worth something if the merger occurs, but nothing if it does not. Public stockholders thus have no reason to vote against a bad deal. As the court noted, however, a merger vote “could have greater importance if stockholders’ voting and economic interests had been ‘recoupled’ by requiring redeeming stockholders to vote against the deal.” The court cited another article from the Yale Journal on Regulation arguing that “recoupling the vote with the redemption right can help ensure that good [de-SPAC] deals go forward – and bad deals don’t.” Whether this idea will gain any traction remains to be seen.
On December 14, 2022, the SEC adopted amendments to Rule 10b5-1 under the Securities Exchange Act of 1934 and added related new disclosure requirements. Rule 10b5-1 provides an affirmative defense to insider trading liability for individuals and companies in circumstances where, subject to certain conditions, the trade was pursuant to a written plan adopted when the trader was not aware of material nonpublic information. As anticipated, the SEC has tightened up the availability of this defense by codifying many existing “voluntary” practices, imposing new procedural requirements, and requiring new disclosure obligations by issuers and Section 16 filers. The SEC will likely follow this rulemaking process with enforcement action.
The Second Circuit held yesterday that a government agency’s nonpublic, pre-decisional regulatory information does not constitute “property” for purposes of the federal insider-trading and wire-fraud statutes. The decision in United States v. Blaszczak (2d Cir. Dec. 27, 2022) (“Blaszczak II”) effectively vacated convictions under those statutes for defendants who had traded on nonpublic, market-moving information that had been obtained from a government agency.