John Solak v. Mountain Crest Capital LLC, et al., C.A. No. 2023-0469-SG (Del. Ch. Oct. 18, 2024)—The Delaware Court of Chancery ruled that the direct claims of a stockholder of a special purpose acquisition company (SPAC) against the sponsor and board of directors related to alleged misstatements in a proxy statement survived the defendants’ motion to dismiss. Drawing all inferences in favor of the plaintiff’s claims at this initial stage of the proceedings, the Court found that the plaintiff pleaded a viable breach of fiduciary duty claim in which the pleadings demonstrated a conflict of interest between the defendants and the stockholders and a material omission by the defendants in the proxy statement recommending approval of the merger that could have affected the stockholders’ decision to redeem their shares.
Factual Background
Mountain Crest Acquisition Corp. II (the Company) was formed as a SPAC. Its sole purpose was to merge with another entity. Defendant Mountain Crest Capital LLC was the Company’s sponsor. Defendant Suying Liu was the Company’s chief executive officer, the chairman of its board of directors, and the managing member of the Company’s sponsor and four related entities. Liu, through the sponsor, selected the other four members of the Company’s board; these directors also served on the boards of his other companies.
The Company issued 1,437,500 founder shares. The defendants owned a portion of these founder shares. Unlike public shares, the founder shares waived the right of redemption and the right to participate in a liquidation. As a result, the founder shares were worthless unless the Company consummated a merger within a specified period of time.
In January 2021, the Company completed its initial public offering (IPO), which resulted in the sale of 5 million units at $10 per unit. Each unit equated to one share of common stock plus the right to receive one-tenth of a share of common stock upon consummation of a merger. The proceeds from the IPO were placed in trust to redeem the shares, contribute to a merger, or return the public stockholders’ investment in the event of a liquidation.
In April 2021, the Company entered into a merger agreement with Better Therapeutics, Inc. In October 2021, it mailed its proxy statement to stockholders, which recommended approval of the merger and attributed a value of $10 to each public share in the Company. However, the proxy statement failed to account for the dilutive effect of redemptions, the existence of the founder shares, and merger-related costs that would result in $7.50 net cash per public share—a 25 percent difference in share value.
The stockholders approved the merger in late October 2021. Following the merger, the value of the shares in the new company plummeted to as low as $1.28 per share. In April 2023, the plaintiff filed suit, alleging that the defendants authorized misstatements in the proxy statement related to share value that interfered with his decision to redeem his shares in the Company.
Legal Standard
A director of a Delaware corporation owes duties of care and loyalty. The duty of loyalty requires the director to act in the best interests of the corporation. A director’s obligation to communicate with stockholders implicates both the duty of care and the duty of loyalty. However, as alleged in this lawsuit, where the board of directors failed to act in good faith related to their approval of a disclosure, the violation implicates the duty of loyalty.
The Court of Chancery found that the complaint alleged facts demonstrating a conflicted transaction that rebutted the presumption of the business judgment rule in favor of the entire fairness standard. Under the more rigorous entire fairness standard, the defendants bear the burden of demonstrating that their actions were entirely fair to the corporation and its stockholders. Delaware courts have frequently applied the entire fairness standard relating to stockholders’ redemption rights in light of the inherent conflict between SPAC fiduciaries and stockholders in a value-decreasing transaction.
In Solak, the Court found that the complaint adequately established the defendants’ control over the Company. Often, the structure of a SPAC allows its sponsor to control all aspects of the entity. The Company was no different; its sponsor caused the Company to incorporate in Delaware and selected its board of directors. The plaintiff further alleged that the other four members of the Company’s board possessed certain financial incentives that caused them to be beholden to the wishes of Liu and the sponsor.
The Court also found that the complaint in Solak alleged facts demonstrating a conflicted transaction. A conflicted transaction may arise when a controller extracts value that is unique to the controller and at the expense of the stockholders. In this case, the plaintiff alleged that the nature of the defendants’ founder shares, which became worthless in the event of a liquidation, created an incentive to consummate a merger regardless of its value. This financial incentive was at odds with the stockholders’ interests, in which stockholders were bound to recover no less than their initial investment plus interest under a liquidation scenario. Accordingly, the Company’s stockholders would only benefit from a merger worth more than $10 per share.
Finally, the Court found that the complaint established a material omission in the proxy statement approved by the defendants. In this context, the plaintiff had to plead facts demonstrating that the conflicted defendants deprived the stockholders of a fair chance to exercise their redemption rights. Where the wrongful act concerned a disclosure, the defendants must have made a material misstatement or omission affecting the stockholders’ decision to redeem their shares. Statements in the proxy statement related to share value underlined the plaintiff’s claim, in which the defendants approved a proxy statement that omitted the net value of the Company’s shares under the merger. While the failure to disclose net cash per share alone does not constitute a fiduciary breach, the Court concluded that a proxy statement’s assertion of a $10 per share valuation could be found material to a stockholder’s redemption decision. At this initial stage of the proceedings, the complaint alleged sufficient facts to survive the defendants’ challenge.
Legal Takeaways
The incentive structure of a SPAC may present an inherent conflict between founders and stockholders. Founders frequently create and control the SPAC, hold founder shares and director positions, and often have a financial incentive to consummate a merger within a specified period of time. This incentive may be at odds with the interests of stockholders in maximizing value, thereby implicating the fiduciary duty of loyalty. This potential conflict is perhaps one reason why, as the Court in Solak noted, SPAC-related lawsuits persist in Delaware and often survive a pleadings stage challenge despite a slowed down market generally for SPAC transactions. It also may be why SPACs, like the one at issue in Solak, may choose not to make use of corporate mechanisms, e.g., independent directors, special committees, etc., that traditionally insulate directors from liability. For instance, in Solak, the implementation of a special committee of disinterested and independent directors may have resulted in a more complete disclosure; however, in that instance, it may be the case that stockholders would not have voted to approve the merger.