The importance of cyber governance has been elevated over the past two years due to:
Increased sophistication of cyber attacks resulting in significant business interruption losses and theft of confidential and proprietary data.
Information security governance standards and best practices that require specific actions of directors and senior management.
Increased legal and regulatory requirements mandating governance directors and officers take certain steps in overseeing information security.
Cyber-event driven litigation and a series of recent holdings in Delaware case law that collectively work to narrow, under certain circumstances, the deference given to boards, particularly with respect to meeting their duty of loyalty and good faith oversight.
General counsels and outside firms can play a significant role in helping directors and officers meet their fiduciary duty and avoid derivative shareholder suits by confirming a cyber governance framework is created that identifies key cyber risks, ensures appropriate data about these risks is reported to the board, and establishes a board process to review this information and monitor the risks.
Changes in the Cyber Threat Environment
The bad guys are still winning, and the pandemic gave them a boost. The cyber threat environment today is dramatically different than three years ago. There are four primary reasons:
Cybercriminals openly released a treasure trove of cyber offensive tools developed by the U.S. intelligence community
Nation state-sponsored cyber attacks and attacks using sophisticated malware have increased dramatically
Internet of Things (IoT) devices and Artificial Intelligence are being exploited by attackers
Cybersecurity programs have not matured to keep pace with the threat environment.
In 2016-17, a hacking group called the “Shadow Brokers” made five releases of NSA-developed cyber weapons that were capable of infecting millions of computers around the world. Between March-September 2017, Wikileaks made 23 releases of information and code on CIA-developed cyber tools used to hack smart phones, computers, and smart televisions. Combined, these releases of the U.S. Government’s cyber assets provided countries, cybercriminals, and terrorists around the globe with some of the most sophisticated offensive cyber weapons.
Many of the tools leveraged vulnerabilities in software that the U.S. intelligence community had discovered, but had not informed the software providers about. Thus, patches had not been developed, and all of the users of these systems were vulnerable. Any unpatched systems today remain vulnerable to these “clickless attacks” that do not require tricking someone to click on an attachment or link; the malware can enter a system by exploiting an unpatched software vulnerability.
Then came the pandemic. The cybercriminals realized that computer rooms were unmanned, cybersecurity personnel were not able to monitor the system as effectively, patches were not being applied as consistently, and people were working from devices that did not have an up-to-date operating system or current antivirus software. They also preyed on people’s desire for information on the coronavirus, the need to buy face masks and personal supplies, and the desperate need felt by so many for financial assistance.
Just a couple of months into the pandemic, the FBI’s Internet Crime Complaint Center reported a 300% increase in cybercrime complaints. Cybersecurity Ventures recently predicted the global cost of cybercrime will hit $6 trillion in 2021. The privacy/security company Blackfog reported that ransomware attacks were highest in the U.S. and U.K. Experts predicted that a company will be hit with ransomware every 11 seconds and the cost of these attacks will be $20 billion by the end of 2021.
Now, consider there are more than 20 billion IoT devices connected to the Internet, and many of them utilize artificial intelligence technologies. Most of these devices were not built with security in mind, and thus the data they collect and transmit are a rich target. Deloitte noted in a recent report that securing IoT systems is complicated by (1) the sheer amount of data being generated and collected, (2) the fact that much of the data is accessed or held by third parties, and (3) decentralized approaches to risk management. Cyber governance requires an enterprise approach.
Recent Holdings in Delaware Case Law & Increased Derivative Suits
The 1996 Delaware Caremark Derivative Litigation case set forth important case law regarding a board’s duty to ensure that it has adequate information flows to enable it to meet its fiduciary duty of loyalty and good faith oversight. Caremark involved a shareholder derivative action that alleged the board breached its fiduciary duty when it failed to detect and stop employee violations of state and federal laws applicable to health care providers, which resulted in the company paying $250 million in fines and payments to injured parties. The court noted that directors’ fiduciary duty includes a duty to act in good faith to ensure that an adequate corporate information and reporting system is established and monitored, and the failure to do so may cause a director to be liable for losses caused by compliance violations.
Caremark claims have been considered to be one of the most difficult cases to win, in that the plaintiff essentially had to prove that the directors acted in bad faith because they completely failed to implement an information and reporting system and failed to monitor it. In 2019 and 2020, Delaware courts issued four opinions that collectively work to narrow, under certain circumstances, the deference given to boards, particularly with respect to their oversight of compliance risks.
One of the cases, Clovis Oncology, noted that, “Delaware courts are more inclined to find Caremark oversight liability at the board level when the company operates in the midst of obligations imposed upon it by positive law yet fails to implement compliance systems, or fails to monitor existing compliance systems, such that a violation of law, and resulting liability, occurs.” The cases indicate that regulated industries and companies with a high level of compliance requirements should ensure that they have implemented board-level oversight systems, with appropriate information flows and reporting, to enable the board to monitor compliance and key risks and respond in a timely manner.
Information Security Governance Standards and Legal Requirements
The International Organization for Standardization (ISO) and International Electrotechnical Commission (IEC) standard, ISO/IEC 27001, is the “gold standard” for information security globally and is followed by most multinational corporations. The ISO/IEC issued the only global standard on governance of information security, ISO/IEC 27014, in 2013 and updated it at the end of 2020. Best practices on governance of cybersecurity also have been developed by the National Institute of Standards and Technology (NIST) and the Federal Financial Institution Examination Council (FFIEC) and other private sector organizations.
The New York Department of Financial Services (NYDFS) enacted Regulation 500, which became effective March 1, 2017, and requires financial institutions to establish a complete cybersecurity program, including policies and procedures, training, risk assessments, vulnerability scans and penetration testing, access controls, and encryption of non-public information. The board chair or an officer must submit a signed statement annually to NYDFS certifying that the organization is in compliance with the requirements of the rule. The National Association of Insurance Commissioners’ (NAIC) Data Security Model Law has similar governance requirements and has been adopted in eleven states. On a federal level, the Health Insurance Portability and Accountability Act (HIPAA) and the Federal Information Security Management Act (FISMA) also contain governance requirements.
Cyber governance standards may be deemed to have established a known duty to act, and laws require compliance. Today, D&Os that do not have a defined process for managing and overseeing cyber risks gamble being found liable for failure to act reasonably and in good faith to ensure their organization complies with legal or regulatory requirements and best practices regarding privacy and cybersecurity.
Management of Cyber Incidents
The management of a major cyber incident is more difficult – and risky – if the organization does not have well-developed and tested incident response plan (IRP) and business continuity/disaster recovery (BC/DR) plan. D&Os need to ensure their organization’s IRP is aligned with best practices and standards and they can restore data if it becomes corrupted, erased, or encrypted.
The board and senior management should ensure that digital asset inventories are developed in accordance with best practices, including assignment of owners, data classification, and application risk categorization. The IRP must be able to guide the organization through any form of attack. It should include an Incident Response Management Policy that has been approved by the board and defines roles and responsibilities during an incident, escalation of incidents, and steps to mitigate losses. Rosters of internal and external personnel that may be needed during a response are an essential component of an effective IRP.
Boards and senior management have an important role to play in managing a serious attack. They should take part in tabletop exercises to ensure the IRP is aligned with operations, roles and responsibilities are appropriate, and the plan can effectively guide the organization through various types of incidents.
Depending upon the severity of the incident, the board may wish to retain a trusted advisor to help it analyze the various data flows from an incident and review response options. All remediation efforts should be documented and presented to insurance carriers in an attempt to minimize insurance rate increases after the attack.
Conclusion
All of this means that the cybercriminals are winning and plaintiffs may be too if boards fail to ensure a cyber governance framework is established that identifies key cyber risks, ensures appropriate data flows on these risks, and establishes a board process to review this information and monitor cyber risks and compliance requirements. Such a failure may be viewed as a breach of the D&O duty of loyalty and a failure to act in good faith.
Boards and executives need to begin the hard work of governing cyber risks by following best practices and standards, allocating appropriate resources to cybersecurity, and developing risk transfer strategies. A Ponemon/AttackIQ report released in September 2019 indicated that “only 28% percent of respondents say their board and CEO determines and/or approves the acceptable level of cyber risk for the organization.” If companies focus on only one area of their cybersecurity programs this year, let it be cyber governance.
Through the first half of 2021, special purpose acquisition companies (SPACs) raised approximately $113 billion across 366 initial public offerings (IPOs).[1] That level far exceeded the previous records, which were set in 2020 ($83.4 billion raised in 248 IPOs) and 2019 ($13.6 billion in 59 IPOs).[2] Given their unique structure and rapid growth, it is not surprising that SPACs have attracted growing regulatory attention and are increasingly the subject of litigation and enforcement actions.
This article explores the role of due diligence in mitigating litigation and enforcement action risks associated with both the SPAC IPO and subsequent business combination (de-SPAC). Because SPACs involve a number of complexities and novel attributes, this article is sequentially structured with each section building on the foundational information conveyed in the sections that precede it. First, we explain SPACs and how they work, highlighting some of the structural features that have garnered the most controversy. We then summarize the relevant regulatory regime within which SPAC litigation typically arises and explain the role of due diligence (including explicit and implicit due diligence defenses) within that regime. Building on these foundational elements, we then examine recent regulatory developments and survey a sample of informative pending SPAC lawsuits. Finally, we offer insights regarding how many of the risks associated with SPACs may be mitigated through effective due diligence and related disclosure practices.
I. THE SPAC PROCESS
A. Overview
SPAC is an acronym for special purpose acquisition company. Initially, a SPAC is a shell company with no operations or assets. It is formed to raise capital through an underwritten initial public offering (IPO), the proceeds of which are intended to be used within a defined period of time to identify and acquire an existing operating company through a de-SPAC transaction.[3] Thus, at inception, a SPAC has only the cash proceeds derived from the IPO and investments associated with those cash proceeds.
SPACs are sponsored by entities (sponsors) that typically have expertise and experience in a given industry. While the sponsors may intend to acquire an operating company in a particular sector,[4] they typically have not identified a specific target at the time of the IPO. As a result, the offering documents contain more limited disclosures than are commonly associated with a traditional IPO. Given the relative simplicity of the process, including the limited disclosures and lower upfront costs, merging into a SPAC through a de-SPAC transaction has become a popular vehicle for achieving public company status.
Over its life cycle, a typical SPAC engages in a number of due diligence and related disclosure processes. These processes involve potential litigation risks for participants, including the sponsor, directors, and officers. In addition, the SPAC IPO involves risks for the underwriter(s), and the de-SPAC transaction involves risks for the advisory firm (which is sometimes affiliated with the original underwriter[5]).
B. SPAC IPO
Like a traditional IPO, a SPAC IPO involves the filing of a Form S-1 registration statement and prospectus with the Securities and Exchange Commission (SEC or Commission). However, given the absence of operations and assets, SPAC IPOs have a number of attributes that distinguish them from traditional IPOs.
For example, whereas a traditional IPO involves the issuance of shares of common stock, a SPAC IPO involves the issuance of a bundled unit of securities (a SPAC unit) consisting of one share of common stock and one warrant typically priced at $10 per unit. The warrant entitles the holder to purchase an additional share (or fraction thereof) of common stock from the company, typically at a price of $11.50 per whole share (i.e., higher than the initial SPAC unit offer price).[6] After the IPO, the SPAC unit initially trades on an exchange as a single combined security. Thereafter, the common stock and warrants may trade separately under independent trading symbols.[7]
In a traditional IPO, underwriters typically receive an underwriting discount at closing (a discount of the purchase price paid by the underwriters for the shares) approximating 5%–7% of the gross IPO proceeds.[8] In contrast, the typical discount at closing in a SPAC IPO is in the range of 2%, with an additional amount (often in the range of 3%–5%) deposited into the trust account and payable only upon consummation of the de-SPAC transaction.[9] Therefore, if the SPAC is unable to complete a subsequent de-SPAC business combination within the specified time period, the deferred portion of the underwriter’s compensation is never paid.
Sponsors of a SPAC also implicitly receive compensation. In exchange for a nominal initial investment and the work they will perform in identifying a potential business combination, sponsors typically receive fully diluted post-IPO shares in the range of 20%–25% (sponsor shares).[10] Sponsors also often make additional cash investments through the purchase of warrants. The proceeds of the latter are intended to cover the SPAC’s out-of-pocket IPO and initial operating costs.[11] Sponsor shares and warrants only have potential value if a business combination is consummated; they do not represent an interest in the trust funds and have no value if the trust dissolves.[12]
As explained later in this article, recent SPAC litigation has alleged that sponsors, directors, officers, and underwriters have an economic interest that favors consummation of a de-SPAC business combination whether or not it is in the best interests of the shareholders.[13]
C. De-SPAC
At closing, the net proceeds of the SPAC IPO are placed in trust. The trust invests those funds in U.S. treasury securities pending a subsequent business combination (typically a merger) between the SPAC and a target company. This transaction is commonly referred to as a “de-SPAC” or an “initial business combination.”[14] A de-SPAC transaction involves the merger of a private operating company (target) and a publicly traded SPAC (or a subsidiary of the SPAC). In the merger, target shareholders receive consideration consisting of either shares of the SPAC, cash, or a combination of both. If the merger consideration involves the issuance of shares of common stock, the SPAC must file a registration statement on Form S-4 with the SEC to register those shares. The S-4 is subject to review and comment by the SEC, and the SEC may request modified or additional disclosures.
The de-SPAC merger involves a number of activities and associated litigation risks. These include the solicitation of shareholder consent, the preparation and dissemination of an Information Statement, the registration and issuance of SPAC securities constituting part of the merger consideration, and the private offering and issuance of securities immediately prior to the merger to provide additional required capital.[15]
Upon consummation of the de-SPAC transaction, the target becomes a public company whose shareholders typically include non-redeeming SPAC IPO investors (i.e., those who did not exercise the redemption right discussed below), SPAC sponsors, and any entities that acquired shares as part of a pre-merger financing round (also discussed below). If the merger consideration includes shares of the SPAC, the shareholder base also includes former target company shareholders.
A SPAC must consummate a de-SPAC transaction within a disclosed time period, typically 24 months after the IPO (although some SPACs have elected shorter periods).[16] If it does not do so, then the funds held in trust (including interest earned on those funds) must be returned to the shareholders entitled to receive them.[17]
If the SPAC identifies a suitable business combination opportunity within the permitted window, SPAC shareholders will have the opportunity to redeem their shares (and receive their pro rata amount of the funds held in the trust account) and, in most cases, vote on the initial business combination transaction.[18] If a shareholder elects to exercise this redemption right, it no longer is a shareholder but retains the warrants (if the warrants were not sold) that were part of the bundled SPAC unit acquired in the IPO.[19] If the de-SPAC merger involves shareholder approval, the SPAC must file a proxy statement[20] pursuant to Section 14 of the Securities Exchange Act of 1934 (Exchange Act).[21] Where public shareholder approval is not required (for example, where the sponsors hold enough votes to approve the transaction independently), the SPAC will provide shareholders with an Information Statement on Schedule 14C. If the merger consideration includes SPAC shares, the Form S-4 and proxy are typically combined in a joint registration/proxy statement.
Depending upon the number of redeeming shareholders and the amount of cash required to satisfy the redemptions, a SPAC may require additional capital at the time of the de-SPAC transaction to fund the redemption obligations, finance operations, and meet the liquidity needs of the combined entity. This additional funding has typically been raised through a private placement of SPAC securities structured as a private investment in public equity (PIPE) transaction.[22] Thus, the sources of cash to fund a de-SPAC merger typically involve the initial capital raised in the IPO (net of redemptions), sponsor-purchased shares, and proceeds of the PIPE transaction.
While the PIPE offering is a private placement and therefore not subject to Section 11 of the Securities Act of 1933 (Securities Act),[23] claims for intentional misconduct or negligent misrepresentation may be based on the anti-fraud provisions of the Exchange Act,[24] common law, or state securities laws.[25]
Finally, within four business days after consummation of the initial business combination, the company must file with the SEC a Form 8-K (sometimes referred to as a “Super 8-K”) containing information substantially equivalent to that required in a traditional registration statement and similar to the information contained in the Form S-4.
II. DUE DILIGENCE: FUNDAMENTAL CONCEPTS
Given the number of disclosure events associated with a typical SPAC life cycle, it is not surprising that due diligence is often a central theme in SPAC litigation and enforcement actions. Our survey of pending cases shows that plaintiffs often allege due diligence failures that either led to material misstatements or omissions in the at-issue disclosure documents or that were elemental components of a breach of a defendant’s fiduciary duties (typically, the duty of care). Therefore, before addressing how effective due diligence and related disclosure practices can mitigate these risks, it is important to understand the concept of due diligence.
A. Due Diligence
The term “due diligence” is not defined in statutes or regulations. Instead, it is a term of art that is part of the regulatory, judicial, scholarly, and practical lexicon. In its simplest formulation, due diligence is the investigation conducted by and/or the reliance placed on others in a business transaction. At a more granular level, it is the process and practice of using reasonable efforts, appropriate in the context, to investigate (or reasonably rely on others regarding) the material aspects of a proposed transaction so that a reasonable person (such as a potential investor in a securities offering) can make an informed decision.
While due diligence is an affirmative obligation of underwriters,[26] all parties to a securities offering or other business transaction, including those involving SPACs, have an interest in conducting reasonable due diligence because, among other things, it:
Enhances investment and other business decisions
Minimizes the risk of post-closing disputes and litigation
Supports the material accuracy and completeness of disclosures in securities offering documents
Protects reputations and business franchises
Facilitates compliance with applicable laws and regulations, and
Establishes a basis for one or more affirmative due diligence defenses.
B. Reasonableness
The standard by which due diligence is measured is “reasonableness,” not “perfection.”[27] In the context of a lawsuit, reasonableness is a legal conclusion made by a court or trier of fact,[28] though the term also has a common understanding in the industry that mirrors the legislative, regulatory, and judicial understandings.[29] Under both, reasonableness is based on what a prudent person in a similar context would have done in the management of their own property.[30] Reasonableness is measured by a negligence standard[31] involving the use of “ordinary care.”[32]
Reasonableness is assessed in “a specific factual context.”[33] The Due Diligence Task Force of the American Bar Association (ABA) expressed this concept as follows: “as a standard of conduct, ‘reasonableness’ is meaningless except in a specific factual context.”[34] Similarly, the National Association of Securities Dealers (NASD), the predecessor of the Financial Industry Regulatory Authority (FINRA), the self-regulatory organization for broker-dealers (including those acting as underwriters), has stated that the “type of due diligence investigation that is appropriate will vary….”[35] And the formal report of the SEC’s Advisory Committee on Corporate Disclosure[36] stressed that “the important point is that each subject person should evaluate the surrounding facts, including the extent of his prior relationship with the registrant, and utilize techniques of investigation appropriate to the circumstances of the offering….”[37]
As explained below, SPAC sponsors, officers, directors, underwriters, and financial advisors, among others, conduct due diligence at both the SPAC IPO and de-SPAC stages. This due diligence involves, for example, assessing the material accuracy and completeness of disclosures in public and private placement offering documents and the operational, financial, and other attributes of target companies. Given some of the novel attributes of SPACs, the scope and character of due diligence can differ from that associated with more traditional securities offerings and business combination transactions.
For example, traditional IPO offering documents contain a range of disclosures such as historical information about the issuer, its business, operations, management, and past financial performance. Because a SPAC is a shell company, these are not relevant (or even possible) disclosures in SPAC IPO offering documents.[38] As a result, FINRA has stated that the unique nature of SPACs leads to relatively less due diligence and disclosure at the SPAC IPO stage compared to a traditional IPO.[39]
Nonetheless, for the reasons explained above, sponsors, directors, officers, and underwriters conduct due diligence into the material accuracy and completeness of SPAC IPO disclosures.[40] However, given the narrower scope and more limited character of SPAC IPO disclosures, the risk of material misstatements or omissions in SPAC IPO offering documents clearly is more limited than in a traditional IPO (and correspondingly the prophylactic effects of due diligence, while still present, are less pronounced).
Moreover, investor redemption rights (whereby investors redeem their shares at a slight premium to their original IPO purchase price) substantially reduces the likelihood of a SPAC IPO investor incurring a loss (damages) on the investment. Indeed, based on our research, to date there have been no suits brought forth under Section 11 of the Securities Act related to SPAC IPOs, and, absent regulatory changes, it seems unlikely that SPAC IPO offering document disclosures will be a primary focus in future litigation and enforcement actions. At the de-SPAC stage, however, the topics addressed in disclosure documents expand significantly and litigation exposure is correspondingly increased.
Thus, both SPAC IPOs and de-SPAC transactions involve due diligence, and that due diligence, as explained below, can mitigate risk in litigation and enforcement actions.
III. DUE DILIGENCE IN THE SPAC LIFE CYCLE: REGULATORY REGIME AND DEFENSES
Based on our survey of recent cases, SPAC litigation often involves allegations of material misstatements and omissions in disclosure documents and unreasonable due diligence into those disclosures. These allegations have arisen in the context of claims asserted under the Securities Act, the Exchange Act, state securities laws, and various fiduciary duty laws. This section offers a brief overview of these laws and explains their relevance in the context of SPAC litigation.
A. Securities Act and Exchange Act
The Securities Act imposes civil liability for material misstatements and omissions in registered securities offering documents including those related to the SPAC IPO and the de-SPAC transaction.[41] In addition, the anti-fraud provisions of the Exchange Act prohibit fraudulent conduct in connection with securities transactions (both public offerings and private placements) and establish disclosure standards that are particularly relevant at the de-SPAC stage. While the two Acts employ different standards for determining liability (the Exchange Act, for example, requiring proof of scienter), taken together they are the bedrock of the regulatory regime governing modern securities issuances and trading in the United States.
Parties to SPAC transactions, including issuers, sponsors, directors, officers, underwriters, and advisory firms (such as an advisory firm in a de-SPAC transaction), are potential defendants under both Acts. However, a number of these potential defendants[42] can avoid liability by proving that they acted reasonably in conducting due diligence. For example, the Securities Act contains three affirmative “due diligence” defenses that are available to enumerated defendants including directors and underwriters. The first two are set forth in Section 11—reasonable investigation[43] and reasonable reliance.[44] The third—reasonable care—is set forth in Section 12(a)(2).[45] Each requires a “reasonableness” determination by the court.[46]
Parties to SPAC transactions also have potential fraud-based liability under the Exchange Act, including Section 10(b) and Rule 10b-5.[47] Unlike the Securities Act, the Exchange Act contains no express due diligence defenses. However, a number of courts have held that establishing a reasonable due diligence defense under the Securities Act negates the existence of scienter (a mandatory element of an Exchange Act fraud-based claim).[48]
As is clear from the formulation of each of the three express Securities Act due diligence defenses, and the implicit due diligence defense that arises from judicial interpretations of the implications of reasonable due diligence for the Exchange Act’s scienter requirement, reasonableness of due diligence is often a central issue in litigation arising under both Acts.
As explained earlier, each transaction is unique, and what is reasonable due diligence in one context may or may not be reasonable in another. Therefore, there is no one-size-fits-all checklist of mandatory or appropriate due diligence processes or practices to be followed in every context.
However, over the course of more than 60 years, a number of authoritative and informative sources have offered constructive guidance regarding what may constitute reasonable investigation and reliance (the two primary components of due diligence) in various contexts. These include the SEC;[49] special committees and task forces, such as the SEC Advisory Committee on Broker-Dealer Compliance,[50] the SEC Advisory Committee on Corporate Disclosure,[51] and the ABA Due Diligence Task Force;[52] self-regulatory organizations such as FINRA and its predecessor the NASD;[53] and judicial rulings.[54] While the pronouncements regarding reasonableness are not extensive in number and some are of early vintage, they involve a variety of transactional, situational, positional, and temporal contexts, and explore the issue of reasonableness in due diligence from a diverse range of perspectives. Taken together, they provide essential insight into reasonableness in securities offering due diligence, including for SPACs.
B. State “Blue Sky” Laws
In addition to the federal laws and regulations summarized above, each state has its own securities laws and regulations governing the offer and sale of securities within the state’s boundaries or to citizens of the state. These are commonly referred to as “Blue Sky” laws.[55] While such laws tend to mirror many core concepts of the federal regulatory regime, they can differ in some important ways. For example, Blue Sky laws typically require registration (or in the case of private placements, exemptions from registration) for securities offerings and establish a legislatively empowered state body (often a “state securities commission”) to regulate securities issuances and to deal with other matters such as the registration of broker-dealers and investment advisors. They may also contain different due diligence defenses and may potentially offer a wider range of protections than are available under federal law.[56]
C. Fiduciary Duty Laws
Finally, in addition to bringing claims under federal and/or state securities laws, shareholders may sue for breaches of fiduciary duties.[57] The majority of such SPAC-related lawsuits we have identified to date allege breaches of fiduciary duties by directors and/or officers regarding a de-SPAC business combination. However, some also include claims against the SPAC, the target company (and its board or officers), and/or others for allegedly aiding and abetting fiduciary duty breaches by the SPAC board.
A fiduciary is defined as “someone who is required to act for the benefit of another person on all matters within the scope of their relationship.”[58] Directors and officers[59] have a fiduciary relationship with the company and its shareholders. Directors are responsible for oversight and compliance.[60] Officers, as delegates of the board, are responsible for day-to-day operations. Both directors and officers must act in the best interest of the corporation when exercising their responsibilities[61] and must exercise reasonable care and diligence in performing their functions. Their conduct in these regards is assessed with reference to the conduct of a similarly situated prudent person.[62]
Director and officer fiduciary duties are addressed in, among others, state corporation laws (and such suits often are brought in state court). While fiduciary duty laws vary somewhat from state to state, most are based on the ABA’s Model Business Corporation Act (MBCA). The MBCA identifies two primary fiduciary duties of directors—the duty of care (sometimes called the “duty of care and diligence,” which incorporates a duty of good faith) and the duty of loyalty:
(a) Each member of the board of directors, when discharging the duties of a director, shall act:
(i) in good faith, and
(ii) in a manner the director reasonably believes to be in the best interests of the corporation.
(b) The members of the board of directors or a board committee, when becoming informed in connection with their decision-making function or devoting attention to their oversight function, shall discharge their duties with the care that a person in a like position would reasonably believe appropriate under similar circumstances.[63]
The duty of care requires that directors make informed decisions based on a reasonable process, including a reasonable due diligence process. The duty of loyalty requires directors to place the interests of the corporation above their personal interests and those of their affiliates.
If these duties are deemed to have been satisfied, the defendant’s conduct typically is measured according to the “business judgment rule,” which provides that the court will defer to the defendant’s judgment provided the decision was made in good faith and the defendant reasonably believed that he or she was acting in the best interests of the company.[64] Conducting reasonable due diligence is one of the ways defendants seek to establish that the duty of care was met.
When a defendant invokes the business judgment rule and the court finds that the presumption applies, then the burden of proof is on the plaintiff to prove that the business judgment rule does not apply. Plaintiffs typically endeavor to do so on the basis of bad faith, conflicts of interest, or gross negligence, including in connection with the defendant’s due diligence. If the court concludes that the plaintiff has met this burden of proof, then the court will judge the matter according to the “entire fairness standard” pursuant to which the defendant must prove that the process was fair and the decisions were informed.[65]
As explained below, our review of recent and pending SPAC litigation involving fiduciary duty breach allegations reveals a focus on allegations that the defendants conducted inadequate due diligence into the proposed target company merger, failed to conduct proper due diligence into statements made (or omitted) in de-SPAC stage disclosure documents, and/or had undisclosed or inherent conflicts of interest.
While the pending litigation is still at an early stage, given the potential for conflicts of interest inherent in SPAC business combinations, recent SEC and staff pronouncements, the large number of SPAC s formed to date, and the more than 400 de-SPAC transactions yet to be completed,[66] we anticipate an increase in fiduciary duty breach allegations. As explained above, that litigation is likely to present questions about the application of state-law rules, and in particular the application of the “business judgment rule” and the “entire fairness” standard with a focus on the defendant’s due diligence.
IV. RECENT SEC COMMENTARY, GUIDANCE, AND PRONOUNCEMENTS
A. Overview
In recent months, the SEC has issued guidance regarding SPAC due diligence and related disclosure and accounting practices. In addition, SEC staff members, including Chairman Gary Gensler and Acting Director of the SEC’s Division of Corporation Finance John Coates, have addressed SPACs in personal commentary.
For example, on April 8, 2021, Acting Director Coates issued a public statement (which was not officially endorsed by the SEC) confirming the Commission’s increased interest in and focus on SPACs and the disclosures made at both the IPO and de-SPAC stages (Coates Commentary). Among other things, Acting Director Coates stated: “The staff at the Securities and Exchange Commission are continuing to look carefully at filings and disclosures by SPACs and their private targets. As customary, and in keeping with the Division of Corporation Finance’s ordinary practices, staff are reviewing these filings, seeking clearer disclosure, and providing guidance to registrants and the public. They will continue to be vigilant about SPAC and private target disclosure so that the public can make informed investment and voting decisions about these transactions.”[67]
Subsequently, on May 26, 2021, Chairman Gensler summarized his concerns regarding SPACs as follows:
First and foremost, are SPAC investors being appropriately protected? Are retail investors getting the appropriate and accurate information they need at each stage—the first blank-check IPO stage and the second target IPO stage? Second, how do SPACs fit in to our mission to maintain fair, orderly, and efficient markets? It could be the case that SPACs are less efficient than traditional IPOs. One recent study shows that SPAC sponsors generate significant dilution and costs. SPAC sponsors generally receive 20 percent of shares as a “promote.” The first-stage investors can redeem when they find the target, leaving the non-redeeming and later investors to bear the brunt of that dilution. In addition, financial advisors are paid fees for the first-stage blank-check IPO, for the PIPEs, and for the merger with the target. Further, it’s often the case that the investors in these PIPEs are buying at a discount to a post-target IPO price. It may be that the retail public is bearing much of these costs. I’ve asked staff to consider what recommendations they would make to the Commission for possible rules or guidance in this area. Our Corporation Finance, Examinations, and Enforcement Division staffs will also be closely looking at each stage to ensure that investors are being protected. Each new issuer that enters the public markets presents a potential risk for fraud or other violations.[68]
According to a March 25, 2021 Reuters article, the SEC’s enforcement division recently sent voluntary cooperation letters of inquiry to at least four major investment banks seeking information about their fees, volumes, compliance, reporting, internal controls, and other matters associated with their involvement in SPAC IPOs and subsequent de-SPAC transactions.[69] The Commission’s decision to contact the investment banks reflects the fact that the original underwriter or an affiliate entity may “provide additional services such as identifying potential targets, providing financial advisory services, acting as a placement agent in a private offering or underwriting or arranging debt financing….”[70] Consistent with this, a July 13, 2021 article stated that the SEC was focused on better understanding potential conflicts when a bank is serving as both the underwriter and a financial advisor in the de-SPAC transaction.[71]
On June 11, 2021, the Commission announced a target date of April 2022 for proposed amendments to rules governing SPACs.[72] While it did not specify the precise nature of the forthcoming amendments, our analysis of the SEC’s recent guidance and commentary suggests that the amendments are likely to focus on several areas. The first is disclosures, especially those related to sponsor compensation and potential conflicts of interest that may incentivize SPAC participants to consummate a de-SPAC transaction not deemed to be in the best interests of SPAC shareholders. The second is due diligence processes and practices related to assessing the appropriateness of the potential de-SPAC target company and the statements made in the contemporaneous disclosure documents. Third is accounting treatment and related practices.
B. SPAC Due Diligence and Disclosure: IPO Stage
Despite the existence of a shareholder redemption right and the corresponding difficulty of proving damages, the SEC has shown an interest in heightened disclosure at the SPAC IPO stage, especially with respect to the relationship between the SPAC and its sponsor(s) and underwriters. For example, in a September 2020 interview, then-SEC Chairman Jay Clayton stated: “One of the areas in the SPAC space I’m particularly focused on, and my colleagues are particularly focused on, is the incentives and compensation to the SPAC sponsors… What are their incentives?”[73] Also, on December 22, 2020, the SEC issued CF Disclosure Guidance: Topic No. 11[74] (CF Disclosure Guidance) encouraging SPACs to include certain disclosures in the IPO offering documents regarding, among others:
The sponsors’, directors’, and officers’ potential conflicts of interest;
Whether and how sponsors, directors, and officers may be compensated for services to the SPAC, including whether any payments will be contingent on the completion of a business combination transaction and the amount of any such contingent payments;
The financial incentives of SPAC sponsors, directors, and officers to complete a business combination transaction, including how they differ from the interests of the public shareholders, and information about the losses the sponsors, directors and officers could incur if the SPAC does not complete a business combination transaction;
Whether the underwriter of the IPO may provide additional services such as identifying potential targets, providing financial advisory services, acting as a placement agent in a private offering or underwriting, or arranging debt financing, and what fees the SPAC may pay for such services;
Whether payment for any such additional services will be conditioned on the completion of a business combination transaction; and
Any conflict of interest the underwriter may have in providing such services if IPO underwriting compensation is to be deferred until the completion of a business combination transaction.[75]
C. SPAC Due Diligence and Disclosure: De-SPAC Stage
The Commission also has made recent statements regarding the de-SPAC business combination, and in particular the due diligence conducted in connection therewith.
For example, in an October 29, 2020 comment letter associated with Legacy’s de-SPAC merger with Onyx Enterprises Int’l Corp, the SEC specifically inquired about and sought revisions to the disclosure documents to include additional disclosures pertaining to the due diligence that was conducted as part of the de-SPAC merger, including, among others:
Comment 1: “Please tell us how you arrived at the Business Combination Consideration amount. Please include sufficient details and assumptions that went into determining the Business Combination Consideration, including any relevant industry and business stage information as well as any financial projections you may have relied upon. Revise to disclose the Aggregate Purchase Price, as of a current date, in order to give context to how this amount will be determined.”
Comment 3: “Please revise your disclosure to include the details surrounding your search [for possible target businesses], the basis on which you evaluated each potential target business, including why certain of the other potential target businesses were not pursued and what parties or advisors were involved in the process.”
Comment 4: “We note that the terms of the Business Combination were the result of ‘extensive arms’ length negotiations.’ Please revise your disclosure in this section to include a description of the negotiations relating to material terms of the transaction.”
Comment 6: “Please provide a summary of the financial, business, and legal due diligence questions that arose during your diligence meetings.”
Comment 9: “To the extent applicable, please include how valuations, comparable companies, and advisors played a role in approving and signing the Business Combination Agreement.”
Comment 11: “Explain how you determined the transaction to be fair to shareholders when it does not appear that the Board took into account the consideration to be received in exchange for Legacy shares.”[76]
In addition, the SEC’s CF Disclosure Guidance[77] also addressed de-SPAC stage disclosure. This component of the guidance was directed particularly to “SPAC sponsors, directors and officers” and to “the underwriter of the SPAC’s IPO [that] may have provided services in addition to those associated with the underwriting of the IPO….” [78] According to this guidance, de-SPAC-related disclosure documents should contain, among other things:
Detailed information about how the SPAC and its sponsors, directors, officers, and advisors evaluated and decided to propose the identified transaction, including why the target company was selected as opposed to alternative candidates and who initiated contact, including what material factors the board of directors considered in its determination to approve the transaction;
A clear description of any conflicts of interest of the sponsors, directors, and officers in presenting this opportunity to the SPAC, how the SPAC addressed these conflicts of interest, and how the board of directors evaluated the interests of sponsors, directors, and officers;
Detailed information regarding how the sponsors, directors, and officers will benefit from the transaction, including by quantifying any material payments they will receive as compensation, the return they will receive on their initial investment, and any continuing relationship they will have with the combined company;
Information on fees that the underwriter of the IPO will receive upon completion of the business combination transaction, including the amount of fees that is contingent upon completion of a business combination transaction; and
Information on services the underwriter provided, the cost of those services, and how the underwriter and/or its affiliates were compensated for those services, including disclosure of whether those services were conditioned on the completion of the business combination transaction and whether the underwriter may have a conflict of interest, given any deferred IPO underwriting compensation.[79]
Similarly, the Coates Commentary also addressed de-SPAC stage due diligence and related disclosure practices. Among other things, it queried whether “current liability provisions give those involved—such as sponsors, private investors, and target managers—sufficient incentives to do appropriate due diligence on the target and its disclosures to public investors.”[80] In addition, it challenged the notion that the Private Securities Litigation Reform Act (PSLRA) safe harbor for forward-looking statements (such as those related to projections and other valuation metrics)[81] applied to de-SPAC disclosures.[82] It further noted that, even assuming the PSLRA safe harbor provision applied to de-SPAC transactions, the safe harbor only applies to private litigation, and not to SEC enforcement actions.[83]
The Coates Commentary also expressed the view that the de-SPAC transaction is akin to a traditional IPO in that “it is the first time that public investors see the business and financial information about a company.”[84] It further indicated that the SEC could use rulemaking or guidance to explain its views regarding how, or if at all, the PSLRA safe harbor should apply to de-SPACs, and cautioned that any claim about reduced liability exposure for SPAC participants relative to a traditional IPO is “overstated at best, and potentially seriously misleading at worst.”[85]
Finally, Acting Director Coates questioned whether the SEC should reconsider the concept of an “underwriter” in de-SPAC transactions, and whether additional guidance is needed about how projections and related valuations are presented and used in de-SPAC transactions.[86] He concluded by stating that “we should focus the full panoply of federal securities law protections” on de-SPAC transactions, adding that “[i]f we do not treat the de-SPAC transaction as the ‘real IPO,’ our attention may be focused on the wrong place, and potentially problematic forward-looking information may be disseminated without appropriate safeguard.”[87]
D. Accounting and Reporting Considerations
In addition to commentary regarding due diligence and related disclosure practices, the SEC also has issued guidance related to SPAC accounting practices.[88] For example, on April 12, 2021, Acting Director Coates and Acting Chief Accountant Paul Munter issued a statement discussing “the potential accounting implications of certain terms that may be common in warrants included in SPAC transactions.”[89] The statement expressed the authors’ views that certain contractual provisions that are common in warrants issued in connection with a SPAC transaction (such as provisions related to settlement amounts and tender offers) should be analyzed to determine if the warrants should be accounted for as liabilities rather than equity, and if so, whether the impact of the change in accounting treatment is material, requiring a restatement of previously issued financial statements.[90] Warrants issued in connection with SPAC transactions have historically been classified as equity;[91] classifying warrants as liabilities would require a measurement of fair value, with changes in fair value reported in earnings for each period.[92]
Commentators have noted that the change in accounting treatment, if it were to become law, would require SPACs to perform quarterly valuations of warrants as debt (versus a one-time equity valuation), a process that would potentially make SPACs less attractive to targets and other investors.[93] In certain cases, the change in accounting treatment could also lead to restatement of prior financial statements.[94]
E. Summary
SPACs are an increasing area of focus for the SEC and its senior staff. Primary areas of interest include due diligence and disclosure practices involving potential conflicts of interest, investment banking involvement (including compensation) in the various phases of the SPAC process, and, at the de-SPAC stage, inadequate due diligence of the target catalyzed by potential conflicts of interest related to economic incentives to the sponsors and other parties.
This increased level of scrutiny and attention is not remarkable given the dramatic and rapid increase in SPAC activity (as noted above, through the first half of 2021, SPACs raised approximately $113 billion across 366 IPOs[95]). While recent developments suggest that this increased regulatory focus may be contributing to a decline in SPAC IPO activity (approximately 300 SPAC IPOs occurred during the first quarter of 2021 versus approximately 60 during the second quarter of 2021[96]), as of July 2021, more than 400 SPACs were seeking acquisition targets.[97]
Given the SEC’s recent guidance and commentary regarding SPACs, as well as the statements of senior SEC staff, we anticipate more developments, including in response to the new regulations that the SEC has stated are forthcoming. In the meantime, the pronouncements and statements made to date are clear indications of the Commission’s primary areas of concern, and they offer constructive insight regarding how effective due diligence can minimize risk to SPAC participants.
V. RECENT LITIGATION DEVELOPMENTS
A. Overview
According to the Stanford Law School Securities Class Action Clearinghouse, shareholders filed 30 federal class action lawsuits involving SPACs between January 2019 and July 2021, more than half of which were filed in 2021.[98] In addition, between October 2020 and April 2021, more than 60 shareholder lawsuits involving SPACs were filed in state courts (including in New York[99] and Delaware[100]). In many respects, the allegations made in these cases mirror the areas of concern addressed in the regulatory developments and commentary discussed above. These include allegedly inadequate due diligence and disclosures regarding sponsor compensation and potential conflicts of interest, and the extent and character of due diligence and disclosure related to the de-SPAC business combination. Following is a brief survey of some of these cases.
B. Securities Law Claims
On July 13, 2021, the SEC announced charges against SPAC Stable Road Acquisition Company (Stable Road), its sponsor, and its CEO, as well as against Momentus Inc. (Momentus)—the SPAC’s proposed merger target, an early-stage space transportation company—and Momentus’s founder and former CEO Mikhail Kokorich for misleading claims regarding Momentus’s technology and national security risks purportedly associated with Kokorich.[101] According to the SEC’s press release, it has filed a complaint against Kokorich in the U.S. District Court for the District of Columbia (all other parties have agreed to a settlement that includes total penalties of more than $8 million, certain investor protection undertakings, and, if the merger currently scheduled for August 2021 is approved, forfeiture by the SPAC sponsor of founder’s shares it stands to receive).[102]
The SEC claims include that:
Kokorich and Momentus repeatedly told investors that Momentus had “successfully tested” its propulsion technology in space whereas, according to the SEC, the company’s only in-space test “had failed to achieve its primary mission objectives or demonstrate the technology’s commercial viability.”
Momentus and Kokorich misrepresented the extent to which national security concerns associated with Kokorich “undermined Momentus’s ability to secure required governmental licenses essential to its operations.”
Stable Road repeated Momentus’s misleading statements in public filings related to the proposed merger and failed to satisfy its due diligence obligations to investors. According to the SEC, despite Stable Road’s claim that it conducted extensive due diligence of Momentus, it never received sufficient documents to assess the national security risks posed by Kokorich or reviewed the results of Momentus’s in-space test. Specifically, with respect to due diligence, Chairman Gensler stated:
This case illustrates risks inherent to SPAC transactions, as those who stand to earn significant profits from a SPAC merger may conduct inadequate due diligence and mislead investors. Stable Road, a SPAC, and its merger target, Momentus, both misled the investing public. The fact that Momentus lied to Stable Road does not absolve Stable Road of its failure to undertake adequate due diligence to protect shareholders. Today’s actions will prevent the wrongdoers from benefitting at the expense of investors and help to better align the incentives of parties to a SPAC transaction with those of investors relying on truthful information to make investment decisions.[103]
As a result of the alleged inadequate due diligence, Stable Road’s registration statements and proxy solicitations were inaccurate.[104]
According to the SEC, the SEC’s complaint against Kokorich includes factual allegations that are consistent with these claims.[105] Following the SEC’s announcement of these charges and partial settlement, a federal class action lawsuit was filed on July 15, 2021 by investors of Stable Road containing similar allegations.[106]
In re Akazoo S.A. Securities Litigation includes several consolidated federal and state securities class actions regarding Akazoo S.A., a global music streaming platform that was formed through a 2019 merger of Modern Media Acquisition Corp. (MMAC), a SPAC, and Akazoo Limited. Plaintiffs allege violations of Sections 10(b) and 14(a) of the Exchange Act, as well as Section 11 of the Securities Act (regarding statements made in the Form S-4 filed in connection with the de-SPAC merger). These alleged violations arise from purportedly false and misleading statements regarding the target company, including:
the number and growth of registered users and subscribers;
the company’s revenue and profit;
the size of the company and its services;
the areas in which the company operated; and
its relationships with mobile operators in various markets.
Sections 10b and 14(a) defendants include Akazoo, officers and directors of MMAC, and Akazoo Limited. Section 11 defendants include the same parties as well as Akazoo Limited’s independent auditor.[107] On April 23, 2021, the parties reached a $35 million partial settlement.[108] In addition, the SEC filed an enforcement action against Akazoo on September 30, 2020 seeking permanent injunction against Akazoo and disgorgement of allegedly ill-gotten gains,[109] which resulted in an agreed order of judgment on April 2, 2021 that permanently enjoins and restrains Akazoo under Section 17(a) of the Securities Act, and Sections 10(b), 13(a), 13(b)(2)(A), and 13(b)(2)(B) of the Exchange Act.[110]
Pitman et al. v. Immunovant, Inc. et al, filed in the Eastern District of New York on February 19, 2021, involves the pharmaceuticals industry de-SPAC business combination of SPAC Health Sciences Acquisition Corp. (HSAC) and Immunovant Sciences, Ltd. (Immunovant). Plaintiffs allege violations of Section 10(b) and Rule 10b-5 of the Exchange Act resulting from allegedly inadequate pre-merger due diligence that plaintiffs assert would have revealed safety and efficacy problems with the target company’s clinical trials of a monoclonal antibody drug (the application was withdrawn after consummation of the business combination). Among other things, plaintiffs allege that:
HSAC performed inadequate due diligence into Immunovant prior to the merger;
defendants ignored or failed to disclose safety issues associated with Immunovant’s monoclonal antibody drug; and
the at-issue drug was less safe than the company had led investors to believe, which foreseeably diminished the drug’s prospects for regulatory approval, commercial viability, and profitability.[111]
Borteanu et al. v. Nikola Corporation et al. is a class action filed in the District of Arizona on September 15, 2020. Plaintiffs allege violations of Section 10(b) and Rule 10b-5 of the Exchange Act in connection with the de-SPAC acquisition of Nikola Corporation in June 2020 by VectoIQ Acquisition Corp. Among other things, the complaint asserts that the SPAC failed to “engage in proper due diligence,” which plaintiffs allege would have revealed misrepresentations by the target regarding its technology and business model. More specifically, the complaint alleges that:
VectoIQ did not engage in proper due diligence regarding its merger with Nikola;
Nikola overstated its in-house design, manufacturing, and testing capabilities; and
Nikola overstated its ability to lower the cost of hydrogen fuel and the work experience and background of key Nikola employees.[112]
Welch et al. v. Meaux et al., filed in the Western District of Louisiana on September 26, 2019 (amended October 16, 2020), involves a de-SPAC combination between SPAC Landcadia Holdings and Waitr, an online food ordering and delivery service. Plaintiffs allege violations of Section 10(b), Rule 10b-5, and Section 14(a) of the Exchange Act. The complaint alleges material misstatements in the de-SPAC Information Statement and other documents regarding:
the market opportunity for Waitr’s services;
Waitr’s business model and growth strategy; and
Waitr’s accounting practices and internal controls.
Section 14(a) defendants include Waitr, its directors and officers, and the investment bank involved in the de-SPAC transaction. Section 10(b) and Rule 10b-5 defendants include Waitr and its directors and officers; the complaint alleges, among other things, material misstatements after completion of the de-SPAC transaction in a scheme to artificially inflate and maintain the price of Waitr following the de-SPAC combination.[113]
C. Fiduciary Duty Claims
Delman v. Croskey is a shareholder derivative action filed in the Delaware Court of Chancery on May 24, 2021, arising from the combination of SPAC Live Oak Acquisition Corp. and Danimer Scientific (Danimer), which produces bioplastic replacements for traditional petrochemical-based plastics such as water bottles, food containers, and drinking straws. The plaintiff, a shareholder of Danimer, claims that Danimer’s board members breached their fiduciary duties by:
disseminating misleading statements about the biodegradability and future prospects of Danimer’s Nodax product in order to keep Danimer’s stock price above $18, the threshold at which Danimer’s board members and affiliated entities would be entitled to exercise stock warrants to buy shares at a discount;
misrepresenting the company’s capacity to manufacture Nodax products at a scale sufficient to meet revenue estimates; and
failing to maintain adequate internal controls in the company’s hiring practices.[114]
In Amo v. Multiplan Corp., filed in the Delaware Court of Chancery on March 25, 2021, a shareholder of Multiplan asserts breach of fiduciary duty claims under Delaware state law in connection with the merger of SPAC Churchill Capital Corp III and Multiplan, a provider of data analytics and technology management solutions to the U.S. healthcare industry. The complaint alleges that the sponsor of the SPAC and its board members breached their fiduciary duties by prioritizing their personal and financial interests in going forward with the de-SPAC merger to the detriment of shareholders. Specifically, the complaint alleges that the sponsor of the SPAC and its board members had conflicts of interest stemming from:
the need to complete a deal within the SPAC’s two-year expiry period to preclude the value of the “sponsor” or “founder” shares, which had been granted to both the sponsor and the outside directors, becoming worthless;
the board members’ alleged personal and financial ties to the sponsor; and
the SPAC’s retention of an entity affiliated with the sponsor to serve as its financial advisor, rather than an independent third party.
The complaint also asserts that the defendants breached their fiduciary duties because the disclosures surrounding the merger were allegedly false and misleading in that they highlighted the “extensive due diligence” performed and projected Multiplan’s financial success, while failing to disclose that one of Multiplan’s main customers, UnitedHealth Group Inc., was in the process of “abandoning MultiPlan in favor of its own competing data analytics platform.”[115] Notably, the Amo v. Multiplan Corp. complaint asserts that the defendants’ conduct should be judged under the “entire fairness standard” rather than the “business judgment rule,” which as discussed above is a level of heightened scrutiny that, if applicable, would require the defendants to demonstrate that the transaction was both procedurally and substantively fair.
VI. CONCLUSIONS AND INSIGHTS
Reasonable due diligence, both with respect to disclosures and target companies, can mitigate many of the litigation and regulatory enforcement action risks described in this article. Accordingly, we conclude with a few general recommendations. In considering these recommendations, it is important to understand that there is no one-size-fits-all approach to SPAC IPO, de-SPAC, or any other kind of due diligence. Each transaction is contextually unique; therefore, our recommendations should be considered a point of departure to be supplemented and tailored to the context as appropriate.
A. Monitor the Evolving Risk Landscape
The SPAC landscape is rapidly evolving, regulatory interest is mounting, and lawsuits alleging SPAC-related misconduct are proliferating. Accordingly, SPAC participants should monitor and consider developments, especially as they relate to sponsor compensation, potential conflicts of interest, and the extent and character of due diligence and disclosure related to the de-SPAC business combination. We anticipate more regulatory guidance and rulemaking (indeed, the SEC has announced as much), as well as new and novel allegations in litigation. Both should be monitored closely, and due diligence and disclosure practices adjusted in light of them.
B. Be Mindful of Fiduciary Duties and “Gatekeeping” Roles
Directors, officers, underwriters, and others involved in securities offerings sometimes are referred to as “gatekeepers.” Gatekeepers are persons or entities who have “the background and knowledge to conduct a sufficient investigation to protect the investor.”[116] In general terms, gatekeepers are deemed to “bear a duty to investors to monitor the quality of … disclosures.”[117] Or stated differently, they “are ‘reputational intermediaries’ in the securities markets.”[118] We anticipate future authoritative and informative guidance regarding the relevance and significance of the gatekeeper role in SPAC transactions. Until then, directors, investment banks, and other potential gatekeepers should be conscious of the commentary to date regarding gatekeeping and fiduciary roles, and should act accordingly.
C. Establish a Diligence Process and Conduct Guidance-Based Due Diligence
Authoritative and informative guidance over many decades makes clear that process matters in securities offering and business combination due diligence. Therefore, prior to a SPAC IPO and subsequent de-SPAC business combination, sponsors, boards, underwriters, advisors, and others should establish a due diligence process tailored to the context and consistent with historical guidance regarding what the SEC, courts, and other sources have considered reasonable. In tailoring that process, attention may be given to a range of factors, including, for example, staffing and leadership, scope and character of investigation and reliance, third-party support (such as legal opinions, negative assurance letters, and fairness opinions), and due diligence documentation.
As explained in this article, SPAC litigation and regulatory enforcement actions often involve allegations of inadequate due diligence and disclosures regarding sponsor compensation, potential conflicts of interest, the extent and character of due diligence and disclosure related to the de-SPAC business combination, and other matters. Thus, due diligence and related disclosures should be a focus at each stage of the SPAC process. Disclosure due diligence is guided by more than six decades of authoritative and informative publications and pronouncements, including from the SEC[119] and its Advisory Committee on Corporate Disclosure,[120] FINRA,[121] the ABA Task Force on Due Diligence Defenses,[122] SIFMA,[123] and an abundance of practitioner and scholarly literature.[124] While not a guarantee against litigation, following this guidance in conducting due diligence is likely to result in better due diligence and investment decisions and a corresponding level of mitigation of litigation exposure.
In summary, SPACs involve a range of legal risks, such as potential violations of the Securities Act, the Exchange Act, and state laws, including those addressing fiduciary duties. Many of these risks can be mitigated with securities offering and business combination due diligence that is consistent with longstanding, well-established authoritative and informative guidance.
[2] “SPAC Hot Streak Put on Ice by Regulatory Warnings,” The Wall Street Journal, April 16, 2021; https://spacinsider.com/stats/. Recent and ongoing developments regarding SPAC accounting treatment and other matters may slow the proliferation of SPACs in the future, but the trend to date has been one of strong and expanding growth.
[8]See generally, William K. Sjostrom, Jr., The Untold Story of Underwriter Compensation Regulation, 44 UC Davis L. Rev. 625 (Dec. 2010) at https://ssrn.com/abstract=1582498.
[18] In some cases, the sponsor and its affiliates may hold enough votes to approve the transaction. In that case, the SPAC does not solicit the approval of public shareholders, but rather provides shareholders with an Information Statement. In either case, typical disclosures include a description of the proposed merger, governance mechanisms, and extensive information about the target company including historical financial statements, management’s discussion and analysis (MD&A), and pro forma financial statements.
[20] Sometimes, though it is less common, a SPAC will opt to conduct a tender offer (giving the SPAC’s shareholders the option of tendering their shares), in lieu of seeking shareholder approval. “A New SPAC Structure May Lead to Renewed Interest in SPAC Offerings,” Bloomberg Law Reports, 2011.
[22] PIPEs are a type of secondary offering in which a publicly traded issuer sells equity at a discounted rate relative to the market price to an accredited investor. The PIPE funding ensures that the SPAC has sufficient capital commitments prior to entering into the definitive de-SPAC business combination agreement. These funds typically ensure that the SPAC has sufficient funds to consummate the de-SPAC transaction by, among other things, replenishing capital expended to redeeming shareholders (see, e.g., https://corpgov.law.harvard.edu/2018/07/06/special-purpose-acquisition-companies-an-introduction/#8b).
[24] 15 U.S.C. § 78j. While the anti-fraud provisions of the Exchange Act do not expressly provide for a private right of action (as does Section 11, for example), for many decades federal courts have recognized an implied right. See, e.g., Kardon v. National Gypsum Co., 69 F. Supp. 512, 514 (E.D. Pa. 1946). Moreover, the U.S. Supreme Court has confirmed the right. See Herman & MacLean v. Huddleston, 459 U.S. 375, 378 (1983).
[26] Although the SEC has observed that “there is no express provision in the [Securities] Act requiring an underwriter to conduct a due diligence investigation….” (“New High Risk Ventures,” Securities Act Release No. 33-5275, 1972 WL 125474 at *4 (July 27, 1972)), it has repeatedly expressed the view that underwriters have a non-statutory affirmative obligation to conduct reasonable due diligence (beyond having an affirmative defense). For example, as early as 1953, the SEC held that an underwriter “owe[s] a duty to the investing public to exercise a degree of care reasonable under the circumstances of the offering to assure the substantial accuracy of representations made in the prospectus….” (In re Charles E. Bailey & Co., 35 S.E.C. 33, 41, [1952–1956 Transfer Binder] Fed. Sec. L. Rep. [CCH] 76,218 (Mar. 25, 1953)). And, in a 1963 administrative proceeding, the SEC found a registration statement false and misleading and criticized the underwriter for failing to perform a reasonable investigation. In re Richmond, 41 S.E.C. 398, (1961–1964 Transfer Binder) Fed. Sec. L. Rep. (CCH) 76,904 (Feb. 27, 1963) at *7 (an underwriter: “[b]y associating himself with a proposed offering … impliedly represents that he has made such an investigation in accordance with professional standards. Investors properly rely on this added protection which has a direct bearing on their appraisal of the reliability of the representations in the prospectus. The underwriter who does not make a reasonable investigation is derelict in his responsibilities to deal fairly with the investing public.”). In another proceeding, the SEC emphasized the responsibilities of underwriters and selling agents. In re Hamilton Grant & Co., Securities Act Release No. 6724, 38 S.E.C. Docket 1030, 1987 WL 755965 (July 7, 1987) at *5. FINRA and its predecessor the NASD have expressed similar views regarding an underwriter’s affirmative duty to conduct reasonable due diligence despite the absence of an express statutory mandate.
[27]In re Int’l Rectifier Corp. Sec. Litig., No. CV91-3357-RMT (BQRX), 1997 WL 529600 (C.D. Cal. 1997) at *11.
[28] “Circumstances Affecting the Determination of What Constitutes Reasonable Investigation and Reasonable Grounds for Belief Under Section 11 of the Securities Act,” Securities Act Release No. 33-6335, 1981 WL 31062 (Aug. 6, 1981) (“SEC Release 33-6335”) at *13–14. See also, In re WorldCom Sec. Litig., 346 F. Supp. 2d 628, 670 (S.D.N.Y. 2004) (“the SEC cautioned that ‘only a court can make the determination of whether a defendant’s conduct was reasonable under all the circumstances of a particular offering’.”).
[29]See, e.g., National Association of Securities Dealers, “Special Report Due Diligence Seminars” (July 1981) (“NASD Special Report”) at 5; NASD Notice to Members 73-17, Proposed New Article III, Section 35 of the Rules of Fair Practice Concerning Underwriter Inquiry Standards Respecting Distributions of Issues of Securities to the Public, National Association of Securities Dealers, March 14, 1973 (“NASD Notice 73-17”); FINRA Regulatory Notice: Obligation of Broker-Dealers to Conduct Reasonable Investigations in Regulation D Offerings, Notice 10-22 (Apr. 2010) (“FINRA Notice 10-22).
[30] 15 U.S.C. § 77k (Section 11(c) of the Securities Act). While this definition is contained in the Securities Act and applies to public offerings of securities, the concept has been universally embraced as the appropriate standard of transactional due diligence in any context. The standard for reasonableness in due diligence is commonly described as one of negligence. See, e.g., Ernst & Ernst v. Hochfelder, 425 U.S. 185, 208 (1976) (“the standard for determining ‘reasonableness’ in a ‘reasonable investigation’ and ‘reasonable ground for belief’ in the two affirmative [due diligence] defenses is a negligence standard, i.e., ‘that required of a prudent man in the management of his own property.’”).
[31]See, e.g., Joseph K. Leahy, The Irrepressible Myths of BarChris, 37 Del. J. Corp. L. 411, 455 (2012) (“The ‘prudent person’ standard, located in Section 11(c), was originally borrowed from the law of trusts. It is the standard to which a trustee is held [but that] standard…has evolved in ways that are not relevant to due diligence….”). See also, House Committee on Interstate and Foreign Commerce, “Report of the Advisory Committee on Corporate Disclosure to the Securities and Exchange Commission,” November 3, 1977 (SEC Advisory Committee Report), at 669 (“Negligence is the standard of liability….”).
[32]See, e.g., Joseph K. Leahy, The Irrepressible Myths of BarChris, 37 Del. J. Corp. L. 456 (2012) (“[the standard requires] ‘the exercise of reasonable care, skill, and caution.’ [citing Restatement Third of Trusts]. To this extent, the prudent [man] standard is simply a negligence standard-the duty to exercise ordinary care.”). See also, Memorandum of Law of Amicus Curiae the Securities Industry and Financial Markets Association in Opposition to Lead Plaintiffs’ Motion for Partial Summary Judgment,” In re Refco Inc. Securities Litigation, No. 05 Civ. 8626 (GEL) (S.D.N.Y May 6, 2009) at 14, available at https://www.sifma.org/wp-content/uploads/2017/05/refco-inc-securities-litigation.pdf (“Discussing the 1934 revision of the definition of reasonable inquiry, Professor Folk observed that the common law is ‘indispensable’ in interpreting a ‘prudent man’ standard, as it ‘resembles one of the classic common law tests of a director’s duty of care’ which requires ‘the same degree of care which a business man of ordinary prudence generally exercises in the management of his own affairs.’ [citing Folk, 55 Va. L. Rev. at 42-43]”.); Robert J. Haft, Arthur F. Haft, and Michelle Haft Hudson, Due Diligence—Periodic Reports and Securities Offerings, § 7:3, (West, 2015-2016 Ed.) (“Due diligence may be construed as a standard that depends to some extent on what constitutes commonly accepted corporate or commercial practice. If it can be established that the steps taken meet the standard of the trade as it presently exists, a court should not, in applying the Section 11(c) standard, hold one liable for not being duly diligent….”).
[33] Committee on Federal Regulation of Securities, “Report of Task Force on Sellers’ Due Diligence and Similar Defenses Under the Federal Securities Laws,” The Business Lawyer, Vol. 48, May 1993, 1185 (ABA Due Diligence Task Force Report) at 1232.
[35] National Association of Securities Dealers Notice to Members: 03-71, Non-Conventional Investments: NASD Reminds Members of Obligations When Selling Non-Conventional Investments (Nov. 2003), http://www.complinet.com/file_store/pdf/rulebooks/nasd_0371.pdf (NASD Release 03-71).
[38]https://www.finra.org/rules-guidance/notices/08-54. If a SPAC had identified potential acquisition targets prior the IPO, it would need to disclose information including the target’s financials in its registration statement which would lead to additional required due diligence. Also, as discussed more fully later in this article, some commentators and participants in SPACs have asserted that financial projections made in connection with a de-SPAC transaction fall within Private Securities Litigation Reform Act’s (PSLRA) safe harbor for forward-looking statements. Commentary from the SEC suggests that the Commission may disagree.
[39]https://www.finra.org/investors/insights/spacs (“One key difference between a traditional IPO and SPAC IPO process is that the SPAC IPO is much faster. From the decision to proceed with a SPAC IPO, the entire IPO process can be completed in as little as eight weeks and without much of the financial reporting, due diligence and disclosure involved in a traditional IPO. However, the later SPAC step of merging with the target company involves many (but not all) of the same requirements that would apply to an IPO of the target business, including audited financial statements and other disclosure items. In other words, the SPAC process back-loads the documentation requirements to the latter stages of the process, sometimes referred to as ‘De-SPACing.’”)
[40] For example, John Coates, the Acting Director of the SEC’s Division of Corporation Finance, stated on April 8, 2021: “To be clear, in the initial offering by a SPAC, when the shell company is first raising funds to finance all (or more commonly a portion) of its hoped-for acquisition of the yet-to-be-named target, disclosures clearly have a role to play under the federal securities laws. Investors need to know about sponsors and their financial arrangements, the procedural protections of the SPAC structure, and what kinds of returns the SPAC is likely to generate for investors absent a de-SPAC transaction or for those who choose to exit before the de-SPAC is completed. But it also is clear that investors at the time of the initial SPAC filing cannot understand all aspects of the long-term value proposition of the offering, precisely because a SPAC does not have operations or a business plan beyond a search for a target.” (https://www.sec.gov/news/public-statement/spacs-ipos-liability-risk-under-securities-laws)
[41] Section 11 of the Securities Act provides a cause of action for material misstatements or omissions in offering documents. Section 12 of the Securities Act prohibits the selling of securities through distribution of a prospectus or oral communication that omits or falsifies material facts (15 U.S.C. § 77k(a), § 77e, § 77I(a)(2)).
[42] An issuer does not have a due diligence defense under Section 11 of the Securities Act. The situation under Section 12(a)(2) is more nuanced, but the result appears to be effectively the same. See SEC Advisory Committee Report at 451 (“The company [issuer] itself has no defenses under the 1933 Act.”); Jack C. Auspitz and Susan E. Quinn, Litigator’s View of Due Diligence, Conducting Due Diligence 2003 (2003) at 146 (citing Robert Alan Spanner, A Litigation Perspective on Prospectus Preparation Process for an IPO, 116 Sec. Reg. L.J. 115, 127 (1988)) (“There is no statutory due diligence defense for issuers under Section 11 or Section 12(a)(2). Issuers are held to the highest standards of liability, because for them ‘omniscience is virtually presumed and omnicompetence is required.’”). See also Herman & MacLean v. Huddleston, 459 U.S. 375, 382 (1983) (“[l]iability against the issuer of a security is virtually absolute, even for innocent misstatements.”).
[46] SEC Release No. 33-6335 at *13 (“The Commission also believes that only a court can make the determination of whether a defendant’s conduct was reasonable under all the circumstances of a particular offering.”).
[48]In re Int’l Rectifier, No. CV91-3357-RMT (BQRX), 1997 WL 529600 at *12 (“by virtue of the extensive due diligence they conducted, they cannot be said to have acted “recklessly…the Underwriters’ establishment of a due diligence defense under Sections 11 and 12(2) of the 1933 Act negates the existence of scienter under Section 10(b) of the 1934 Act.”). See also,In re Software Toolworks Sec. Litig., 789 F. Supp. 1489 (N.D. Cal. 1992), aff’d in part and rev’d in part, 38 F.3d 1078 (9th Cir. 1994), opinion amended and sup’d, 50 F.3d 615, 626 (9th Cir. 1994) (“[b]ecause we conclude that the Underwriters acted with due diligence in investigating Toolworks’ Nintendo business and OEM revenues, we also hold that the Underwriters did not act with scienter regarding those claims.”).
[49]See e.g., 17 C.F.R. § 230.176 (2008) (Rule 176); The Regulation of Securities Offerings, Sec. Act. Release No. 33-7606A, 63 Fed. Reg. 67,174, 67,231 (Dec. 4, 1998) (proposing unadopted changes to Rule 176 that would have added six due diligence practices to be considered by a court when assessing the reasonableness of due diligence for certain offerings) [hereinafter Aircraft Carrier Release].
[50]See Report of the Broker-Dealer Model Compliance Program Advisory Committee to the Securities and Exchange Commission (Nov. 13, 1974).
[53]See, e.g., NASD Notice 73-17 and NASD Notice 75-33. Under the Securities Act, the SEC has authority to regulate broker-dealers, and Section 15(a) of the Exchange Act requires all broker-dealers who are engaged in interstate commerce involving securities transactions to register with the Commission. See 15 U.S.C. § 78o(b)(8). This regulatory oversight function is largely accomplished through FINRA. As the primary self-regulatory organization for broker-dealers in the United States, FINRA oversees the conduct of thousands of brokerage firms, including licensed investment banks and broker-dealers, all of which are legally required to be members of FINRA. FINRA was created in 2007 through the merger of the NASD’s and the New York Stock Exchange’s member regulation arms. https://www.finra.org/media-center/news-releases/2007/nasd-and-nyse-member-regulation-combine-form-financial-industry.
[54]See, e.g., Weinberger v. Jackson, 1990 WL 260676 at *2 (N.D. Cal. Oct. 12, 1990); Endo v. Albertine, 863 F. Supp. 708, 727-33 (N.D. Ill. 1994)
[55] The term is of unclear origin, but appears to derive from an early Supreme Court ruling in which Justice Joseph McKenna noted: “[t]he name that is given to the [state securities] law indicates the evil at which it is aimed, that is, to use the language of a cited case, ‘speculative schemes which have no more basis than so many feet of ‘blue sky.’” Hall v. Geiger-Jones Co., 242 U.S. 539 (1917).
[58] Black’s Law Dictionary, Ed. Bryan A. Garner (10th ed., Thomson Reuters, 2014) at 1257.
[59]See, e.g., Gantler v. Stephens, 965 A.2d 695, 709 (Del. 2009) (“…fiduciary duties of officers are the same as those of directors.”); Hampshire Grp., Ltd. v. Kuttner, 2010 WL 2739995, at *11 (Del. Ch. July 12, 2010) (“… duties of corporate officers are similar to those of corporate directors. Generally, like directors, [they are] expected to pursue the best interests of the company in good faith (i.e., to fulfill their duty of loyalty) and to use the amount of care that a reasonably prudent person would use in similar circumstances (i.e., to fulfill their duty of care).”).
[60]See generally National Association of Corporate Directors Center for Board Leadership, Report of the NACD Blue Ribbon Commission on Director Professionalism (National Association of Corporate Directors 2011).
[64]See, e.g., Aronson v. Lewis, 473 A.2d 805, 812 (1984); Kaplan v. Centex Corp., Del. Ch., 284 A.2d 119, 124 (1971); Robinson v. Pittsburgh Oil Refinery Corp., Del. Ch., 14 Del. Ch. 193, 126 A. 46, 49 (1926).
[65]See, e.g., Stephen B. Brauerman, Delaware Insider: When Business Judgment Isn’t Enough: The Impact of the Standard of Review on Deal Litigation, Business Law Today (2014).
[81] The safe harbor referred to bars private actions based on material misstatements or omissions regarding statements containing certain kinds of financial projections and future economic performance or describing targeted objectives or future plans. 15 U.S. Code § 78u–5 – Application of safe harbor for forward-looking statements.
[86] “[F]orward-looking information can of course be valuable. Modern finance and valuation techniques focus on risk and expected future cash flows. Investors and owners commonly view forward-looking information as decision-useful and relevant. That is true for companies being acquired, as well as for companies going public. But forward-looking information can also be untested, speculative, misleading or even fraudulent, as reflected in the limitations on the PSLRA’s liability protections, even when the safe harbor applies. Reflected in the PSLRA’s clear exclusion of ‘initial public offerings’ from its safe harbor is a sensible difference in how liability rules created by Congress differentiate between offering contexts. Private companies that combine with SPACs to enter the public markets have no more of a track record of publicly-disclosed historical information than private companies that are going through a conventional IPO. If there are risks to the use of cost-effective, complete, and reliable forward-looking information in any setting, those risks should be carefully evaluated in light of the goals of the federal securities laws. At the same time, the risk of misuse of such information should also be carefully evaluated in light of the economic realities of the capital formation process.” Id.
[100]See, e.g., Laidlaw v. Acamar Partners Acquisition Corp., filed on January 7, 2021; Pels v. Fintech Acquisition Corp. IV, filed on March 2, 2021; Amo v. Multiplan Corp., filed on March 25, 2021; and Delman v. Croskrey et al., filed on May 25, 2021.
[114] Delman v. Croskrey et al., Case No. 2021-0451-, May 24, 2021. On June 24, 2021, Delman v. Croskrey was stayed pending the resolution of motions to dismiss filed in several concurrent federal securities class actions filed in the Eastern District of New York and Middle District of Georgia involving similar alleged misstatements and claims brought forth under the Exchange Act (Rosencrants v. Danimer Scientific, Inc., Case No. 1:21-cv-02708-MKB-RLM (E.D.N.Y.) and Skistimis v. Danimer Scientific, Inc., Case No. 1:21-cv-02824-MKB-RLM (E.D.N.Y.); Caballero v. Danimer Scientific, Inc., et al., Case No. 1:21-cv-00095-LAG (M.D. Ga.) and Wilkins v. Danimer Scientific, Inc., Case No. 21-cv-00096-LAG (M.D. Ga.)).
[116] Arthur B. Laby, Differentiating Gatekeepers, 1 Brook. J. Corp. Fin. & Com. L. 119, 132 (2006).
[117] Peter Oh, Gatekeeping, 29 J. Corp. L. 735, 741 (Summer 2004).
[118] Reinier H. Kraakman, Gatekeepers: The Anatomy of a Third-Party Enforcement Strategy, 2 J.L. Econ. & Org. 53, 61 (note 20). As applied to underwriters, the term refers to the fact that underwriters perform due diligence on behalf of investors given that investors typically do not have the opportunity to conduct some kinds of due diligence activities independently.
[119]See, e.g., 17 C.F.R. § 230.176; see also, Securities Act Release No. 7606A at *92-99.
[120]See SEC Advisory Committee Report. While the Committee rejected the notion of rigid definitions and checklists, it did conclude that it would be advisable for the SEC to adopt a rule setting out several non-exclusive, contextually oriented factors courts might consider in assessing the issue of reasonableness as it relates to the due diligence defenses. Rule 176 was part of the response to this recommendation.
[121] FINRA (and its predecessor the NASD) have consistently stated that there is no one-size-fits-all approach to due diligence, and that what is appropriate can only be determined considering the context presented.
[122]See generally ABA Due Diligence Task Force Report at 1232-33; 1204 (quoting a November 6, 1981 letter from the Securities Industry Association Corporate Finance and Federal Regulation Committees to the SEC Committee: “We believe that what constitutes a reasonable investigation depends on all the surrounding circumstances, including, but not limited to, those described in proposed Rule 176. We believe these include the quality of the issuer (its size, the type and stability of business or businesses in which it is engaged, whether it is regulated, its financial condition, its earnings history and its prospects); the type of the security (including the terms of the security, the size of the issue and, if debt, its maturity and credit rating, if any); the quality of its management, auditors and outside counsel, if any, involved; the time available for an investigation and the degree of cooperation extended by management…”); 1232 (“As a standard of conduct, ‘reasonableness’ is meaningless except in a specific factual context.”).
[123] SIFMA Refco Brief (“Like any flexible standard of prudent conduct, the Section 11 due diligence defense has no content in the abstract. It only has meaning in a specific factual context, i.e., the conduct of underwriters of a particular registered public offering of securities. Congress did not enact a detailed code of specific obligations for underwriters, as it did with the extensive disclosure requirements imposed on issuers by a web of SEC rules and forms. Instead, it commanded judges and juries to determine what was ‘reasonable’ or ‘prudent,’ using those commonly-accepted common law terms as their only guide.”)
[124]See, e.g., Due Diligence in Business Transactions; Due Diligence: Investigation, Reliance & Verification; Robert J. Haft, Arthur F. Haft, and Michelle Haft Hudson, Due Diligence—Periodic Reports and Securities Offerings, § 7:3, (West, 2015-2016 Ed.
Supply chain management as a center of excellence within corporations emerged as a professional vocation in the 1980s. This need arose as the dual concepts of outsourcing and globalization gained prominence. During this time, specialization in supply chain disciplines emerged to meet the needs of businesses seeking to expand their operations into these emerging global markets. As this expertise developed, the power of the global market was unleashed and resulted in a decreased cost of production driven by higher efficiency, specialization, and having manufacturing facilities migrated to low-cost labor regions. As a result, the cost of goods decreased, access to goods and services increased, and profit margins rose over the following decades.
While profitability increased, so did supply chain complexity. No longer were traditional supply chains limited to local or regional hubs to find expertise in manufacturing and services. Modern supply chains now stretch across the globe. The diverse physical locations of parts and assembly services required to produce goods often mean that the components required to produce finished products will have come from multiple continents and traversed the globe several times before a product is completed. These global supply chains have established critical shipping lanes, ports, a need for logistics expertise, and service providers who specialized in moving products and materials across and through multiple jurisdictions. Shipping, air freight, rail, and truck transportation have also boomed, as goods traveled longer distances, requiring many modes of transportation to arrive at the customer’s desired location.
Another central motivation for outsourcing and globalization has been an increase in the cost of production resulting from increases in wages and regulatory controls in developed economies. While the cost of compliance has been studied and cost-conscious decisions were readily made, other considerations were rarely assessed. For example, consideration was rarely given to the reason the developed economy put the regulations in place by either the organization seeking to shift operations or the new country that was to become the new hub for manufacturing. As a result, not only were the manufacturing operations and associated jobs outsourced but also were the underlying pollution, safety/labor concerns, and product hazards.
This reality created a conundrum and generated the need for a new regulatory regime that was reoriented around the complexity of modern supply chains and the associated harms in the new production ecosystem. Regulations rarely occur in real time but will always follow innovation by business. Once the business processes have been established, industry standards will align around best practices and seek to deter undesirable and unethical actions. In time, this pattern and/or the resulting cases that highlight the consequences of failing to abide by industry norms will lead to defined laws. The laws, in turn, will establish rules that businesses and their suppliers are expected to abide by.
This pattern of regulatory evolution was coined the “race to the top,” meaning that once a best practice or undesirable activity was identified and regulated, others would all adapt to incorporate the new best practice. Historically, this trend has also led to traditional environmental and commerce regulation focused on the manufacturing process or point source regulations on facilities. Unfortunately, these existing point source laws were found to be insufficient by many major economies, as cases and problems began to emerge around supply chain actors or the finished products entering into a country. To close this gap, regulators began to establish a new series of laws that regulated the sale of products into the country that was receiving the goods.
To overcome issues of jurisdiction, regulations were oriented around the import of physical products and goods. Therefore, the jurisdictional hook became a call for transparency regarding what was in a product, what party/parties produced the product, and how the product was produced before it was imported into the country. These new regulations can be categorized into three groups:
Product Compliance: Regulations that mandate compliance with material restrictions in products, safety standards, and conformance with norms within the region. Failure to meet these product regulations results in a loss of the ability to sell into a market.
Vendor Management: Regulations that increase the cost of goods by requiring certain classifications and/or costs through the imposition of tariffs, fees, or sanctions. Failure to consider these vendor regulations results in an increased cost of goods and/or a loss of margin.
Corporate Social Responsibility (CSR): Regulations that mandate transparency disclosures if a business sells into a given market. Failure to perform adequate due diligence or to disclose the use of inhumane practices, engage in unethical practices, or environmental degradation during production can commonly result in fines, a loss of customer goodwill, and a net decrease of future sales opportunities.
In totality, these regulations have created market forces and legal obligations that frequently demand rapid changes and coordinated efforts from suppliers, contract manufacturers, distributors, logistics providers, customers, and solution providers. As a result, a growing need has emerged to have internal and external expertise dedicated to the supply chain compliance function within most businesses. These supply chain compliance professionals have emerged over the last decade as a critical component of managing the emerging risks associated with outsourcing and/or globalization strategy. To mitigate risk, companies have attempted to extend and shift the burden of compliance onto the supply chain and the importer of finished goods through warranties, contracts, and/or certifications of compliance. To accomplish this burden shifting, complex databases that can track, evaluate, and disclose due diligence records must be maintained and accessible by key personnel. These databases establish chains of custody and support the identification of where supply chain breakdowns are occurring through systematic record keeping.
A curious tidbit lurks in section 1505 of Chapter 15 of the Bankruptcy Code. Most practitioners know that Chapter 15 applies to the recognition in the United States of a foreign insolvency proceeding. Section 1505 permits a U.S. bankruptcy court to authorize a domestic “trustee” to act in any foreign country on behalf of an estate created under section 541 of the Bankruptcy Code. Among the various parties specially defined as a “trustee” for this unique purpose is a debtor under Chapter 9 of the Bankruptcy Code – a municipality! Why might a municipality need to interact with the foreign representative of a foreign bankruptcy? How might a foreign jurisdiction react to the appearance of a U.S. municipality in its local affairs? And, because there is no estate created in a municipal Chapter 9 case, exactly what authority might a municipality be able to muster? Not unexpectedly, the answers to these questions are rather elusive.
Chapter 15 was enacted in 2005 and is the vehicle under which the foreign representative of a foreign insolvency proceeding enlists the aid of a U.S. bankruptcy court in order to protect and administer the property of a foreign debtor. Chapter 15 presumes the existence of a foreign debtor – i.e., an entity organized abroad. Chapter 15 is intended to be flexibly interpreted to achieve cooperation among domestic and foreign insolvency participants.
Chapter 15 applies in three principal settings: (1) where parties to a foreign proceeding seek assistance in the United States, (2) where parties to a domestic bankruptcy case seek assistance in a foreign country, and (3) where a foreign proceeding and a domestic case for the same debtor are pending concurrently. 11 U.S.C. § 1501(b) (unless otherwise noted, all section references are to the Bankruptcy Code, i.e., Title 11 of the U.S. Code). A case under Chapter 15 is known as an ancillary case (as compared to a plenary case under Chapters 7 or 11 of the Bankruptcy Code), and is commenced by filing a petition with the Bankruptcy Court for “recognition” of the foreign proceeding.
Where can a Chapter 15 ancillary case be commenced? An ancillary case may be commenced in any district: (a) where the foreign debtor has a principal place of business or assets in the United States or, if none, (b) where an action against the debtor is pending in a federal or state court or, if none, (c) where consistent with the interests of justice and the convenience of the parties. 28 U.S.C. § 1410.
Who may be a debtor under Chapter 15? Almost any foreign entity may be a debtor under Chapter 15, except mainly banks with U.S. branches, stockbrokers, or individuals with debts below the Chapter 13 thresholds. A foreign insurance company, although ineligible to be a debtor under other chapters of the Bankruptcy Code, is explicitly eligible for recognition under Chapter 15.
However, there is some ambiguity in the use of the term “debtor” under Chapter 15. “Debtor” is defined in Bankruptcy Code section 101(13) as a person concerning which a case under this title has been commenced. The Bankruptcy Code (i.e., Title 11), embraces cases under Chapters 7 (liquidation), 9 (municipalities), 11 (reorganizations, railroads and small businesses), 12 (family farmers), 13 (individuals with regular income) and 15 (cross-border). Section 109(a) provides that “only” a person that has a domicile, place of business, or property in the U.S. may be a debtor under Title 11 (again, under any of its various chapters, including Chapter 15). But Chapter 15 has a separate definition of a debtor applicable solely to Chapter 15: “an entity that is the subject of a foreign proceeding.” Thus, although not free from doubt, Chapter 15 only permits the commencement of an ancillary case if the debtor is both the subject of a foreign proceeding and has a domicile, place of business, or property in the U.S. See In re Barnet, 737 F.3d 238 (2nd Cir. 2013).
All of Chapter 15 is qualified by a public-policy escape hatch – the Bankruptcy Court may refuse “to take an action governed” by Chapter 15 if it “would be manifestly contrary to the public policy of the United States.” 11 U.S.C. § 1506. The cases that have considered this public policy override have concluded that it is a narrow exception intended to be applied only in exceptional circumstances concerning matters of “fundamental importance” (e.g., constitutional guarantees). E.g.,In re PT Bakrie Telecom Tbk, 601 B.R. 707, 724 (Bankr. S.D.N.Y. 2019) (key consideration is whether the procedures used in the foreign proceeding meet “our fundamental standards of fairness”); Jaffé v. Samsung Electronics Co., Ltd., 737 F.3d 14 (4th Cir. 2013).
The process to launch a Chapter 15 case is relatively straightforward. A foreign representative may commence an ancillary case by filing a petition for recognition. 11 U.S.C. §§ 1504, 1509, 1515. Section 1509 – which is the source of a foreign representative’s direct access to the Bankruptcy Court – applies whether or not another case for the debtor is pending under any other provision of the Bankruptcy Code. 11 U.S.C. § 103(l)(2). Once filed, Chapter 15 contemplates an expedited process to either grant or deny recognition of the foreign proceeding.
A foreign proceeding might be a main proceeding (i.e., located in a country where the debtor has the center of its main interests, or “COMI”), or a nonmain proceeding (i.e., located in a country where the debtor has an “establishment,” that is, “any place of operations where the debtor carries out a nontransitory economic activity”). 11 U.S.C. § 1502(2). Chapter 15 does not define the COMI, although it is presumed to be the debtor’s registered office under section 1516(c). The COMI determination is often a matter of some dispute, particularly in light of the differing rights that flow from recognition of a main instead of a nonmain foreign proceeding.
The entry of a recognition order by the Bankruptcy Court under section 1517 is the predicate for triggering the various rights and remedies available to a foreign representative under Chapter 15. Chapter 15 entrusts the Bankruptcy Court as the “gatekeeper” for a foreign representative’s access to the Bankruptcy Court and other domestic courts. Indeed, if the Bankruptcy Court denies recognition (either because it refuses to act on the petition if contrary to the public policy of the U.S. or because the petition is otherwise flawed because it does not comply with the requirements of § 1517), the Bankruptcy Court may enter any order necessary to prevent the foreign representative from obtaining comity or cooperation from courts in the United States. 11 U.S.C. § 1509(d). On the other hand, if recognition is granted, the foreign representative will have the capacity to sue and be sued in any court in the U.S.
Once a foreign main proceeding has been recognized, certain provisions of the Bankruptcy Code (such as the automatic stay and the restrictions on the use or sale of property under § 363) will, pursuant to section 1520, automatically apply to the foreign debtor and its tangible property located “within the territorial jurisdiction” of the United States. Chapter 15’s “territorial jurisdiction” provision is intended to replicate the scope of an “estate” otherwise created under the Bankruptcy Code, which concept does not apply to an ancillary case.
This provision will also reach any intangible property of a foreign debtor that is “deemed under applicable nonbankruptcy law to be located” within that territory. 11 U.S.C. § 1502(8). For example, under the UCC, patents, trademarks, copyrights, and software are each generally considered a “general intangible” to which a security interest may attach and be perfected (although in some cases not merely by filing a financing statement). The deemed location where that security interest is enforceable would establish territorial jurisdiction.
In addition to the relief that is automatically granted upon recognition of a foreign proceeding, Chapter 15 identifies further categories of discretionary relief that the Bankruptcy Court may grant to the foreign representative at various stages of the recognition process. These categories are: “provisional relief,” “appropriate relief,” and “additional assistance.”
First, once a petition is filed, and an ancillary case commenced, the Bankruptcy Court can order “provisional relief” if urgently needed pending a decision on recognition (such as staying execution against the debtor’s assets). 11 U.S.C. § 1519. This provisional relief expires upon entry of the recognition order unless expressly extended in the order.
Second, if recognition is granted, the foreign representative can also request “appropriate relief” from the Bankruptcy Court under section 1521 (such as the selected application of other provisions of the Bankruptcy Code) to bolster the automatic relief granted under section 1520. It is not uncommon for a recognition order to be festooned with further “appropriate relief,” particularly because section 1521(a)(7) permits the court to also grant any “additional relief” that may be available to a trustee.
Notably, however, the Bankruptcy Court may not extend the reach of sections 547, 548 and 550 (avoidance and recovery of preferential and fraudulent transfers) to the ancillary case. Accordingly, a foreign representative does not have authority in an ancillary case to commence garden-variety avoidance actions, and must instead commence a plenary case in order to invoke those rights. On the other hand, turnover proceedings under sections 542 and 543 are not excluded from the “additional relief” that may allowed in an ancillary case under section 1521.
Any appropriate relief that is granted under section 1521 may also be modified or terminated upon request of the foreign representative or an entity affected by such relief. 11 U.S.C. § 1522(c). In other words, if a recognition order initially makes a provision of the Bankruptcy Code applicable to the ancillary case (such as § 365, regarding the treatment of executory contracts), either the foreign representative or another affected party may later seek to modify that relief.
Third, after recognition, a foreign representative can also (i) ask for “additional assistance” under the Bankruptcy Code or any other laws of the U.S. pursuant to section 1507, and (ii) commence a plenary domestic bankruptcy case pursuant to section 1511. See 11 U.S.C. §§ 1511, 1520(c) and 1528. The commencement of a plenary case under Chapter 11 or 7 would entitle the foreign representative to further remedies not otherwise available in an ancillary case, but would also require the invocation of certain coordination and cooperation provisions under section 1529.
Why might a foreign representative whose foreign proceeding has just been recognized (thus invoking the stay of acts against the foreign debtor and any of its assets in the U.S.) also commence a domestic Chapter 11 case? One reason is to obtain the benefit of avoidance powers that are otherwise unavailable in an ancillary case (compare § 1523(a) and § 1521(a)(7)). Another reason is to invoke the expanded reach of an “estate” created under section 541 (which applies to all property of the debtor “wherever located”). This expanded reach, however, is limited only to the extent that such other, non-U.S. assets are also beyond the “jurisdiction and control” of the foreign proceeding. Even if a plenary case is commenced, section 305 empowers the Bankruptcy Court to dismiss or suspend proceedings in that case if the purposes of Chapter 15 would be best served by such dismissal or suspension.
This brings us back to section 1505. Section 1505 permits a Bankruptcy Court to authorize any “trustee” to act in a foreign country on behalf of an estate. It is seemingly misplaced in Chapter 15 because it has no specific tether to either the existence of a foreign proceeding or the commencement of an ancillary case. Rather, it is intended to facilitate the ability of a representative in an existing domestic case to act abroad in an officially enrobed manner. Thus, section 1505 applies whether or not a Chapter 15 case is pending and perhaps more properly belongs in Chapter 1 of the Bankruptcy Code (which contains general provisions applicable to all chapters). Indeed, section 103(l), which provides that Chapter 15 applies only to an ancillary case under such chapter, has an exception for section 1505 that makes it applicable in all cases under the Bankruptcy Code (e.g., a liquidation under Chapter 7, a reorganization under Chapter 11, or the adjustment of municipal debts under Chapter 9, among others).
Section 1505 is derived from Article 5 of the UNCITRAL model law on cross-border insolvency (which was the platform for Chapter 15 of the Bankruptcy Code, enacted as part of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005). UNCITRAL is the United Nations Commission on International Trade Law. The model law was enacted by the general assembly of the U.N. in 1997. See G.A. Res. 52/158, UNCITRAL Model Law on Cross-Border Insolvency with Guide to Enactment (Jan. 30, 1998). Its main purpose was to serve as a recommended textual platform for countries to legislate a framework to handle instances of cross-border insolvency.
The model law was accompanied by a detailed guide explaining the intent behind each provision. The remarks accompanying Article 5 (the basis for § 1505) suggest that its purpose is to “equip administrators or other authorities appointed in insolvency proceedings in the enacting State to act abroad as foreign representatives of those proceedings. The lack of such authorization in some States has proved to be an obstacle to effective international cooperation in cross-border cases.”
The domestic legislative history to section 1505 is also illuminating. Section 1505 varies from the model law because, according to that history, it requires a trustee to “obtain court approval before acting abroad.” The model law, by contrast, automatically permitted an administrator to act abroad. This change was made to “ensure that the court has knowledge and control of possibly expensive activities, but it will also have the collateral benefit of providing further assurances to foreign courts that the United States debtor or representative is under judicial authority and supervision.” In fact, the legislative history suggests that “first-day orders in reorganization cases should include authorization to act” under section 1505. See H.R. Rep. No. 31, at 108-09, 109th Cong., 1st Sess. (2005).
Notwithstanding the requirement for court approval, section 1505 is permissive, not mandatory. Very often, trustees or other representatives in domestic bankruptcy cases are able to act abroad, quite capably, without the court’s seal of approval under section 1505. Section 1505, thus, is perhaps best employed when a foreign entity either disputes a trustee’s mandate or requires further corroboration of a trustee’s credentials. Conversely, in fact, there is no requirement that a foreign representative of a foreign proceeding actually commence a Chapter 15 case as a condition to exercising control over U.S. property owned by the foreign debtor. Neither federal nor state law requires a foreign representative to obtain a prior order from a court in the United States before disposing of property located in the United States. In re Iida, 377 B.R. 243 (B.A.P. 9th Cir. 2007). Likewise, section 1509(f) does not affect any right that a foreign representative may have to sue in a U.S. court to collect a claim that is property of the debtor, whether or not an ancillary case has been commenced or recognized.
Another domestic adaptation in section 1505 is to specifically identify the various parties qualified to act abroad. Section 1505 empowers any trustee, as defined in section 1502(6), or “another entity (including an examiner)” to act abroad. A trustee can be any trustee appointed under the Bankruptcy Code, a debtor in possession, or a municipal debtor in a Chapter 9 case. The express inclusion of a municipality was needed because Chapter 9 does not permit the appointment of a trustee to exercise municipal affairs. Rather, for purposes of Chapter 9, whenever a provision of the Bankruptcy Code that otherwise applies to a trustee is invoked in Chapter 9, it is deemed to refer to the municipal debtor itself. (There is an odd quirk in Chapter 9, however, that permits the court to appoint a trustee to pursue avoidance actions that the municipality refuses to pursue; this type of trustee, if appointed, would likely fit within the catchall bucket of trustees that may be empowered under § 1505.)
According to the legislative history, section 1505 “also contemplates the designation of an examiner or other natural person to act for the estate in one or more foreign countries where appropriate. One instance might be a case in which the designated person had a special expertise relevant to that assignment. Another might be where the foreign court would be more comfortable with a designated person than with an entity like a debtor in possession. Either are to be recognized under the Model Law.” This flexibility – to appoint a particular, named individual – would certainly be worthwhile to overcome the resistance that foreign entities might have to distinctive U.S. concepts such as the debtor in possession.
As noted, section 1505 applies whether or not a foreign proceeding involving a foreign debtor is pending abroad. It also applies whether or not the foreign country where the trustee appears has enacted its own matching legislation based on the UNCITRAL model law. Hence, a trustee in a domestic case can be authorized to take steps in any foreign country to advance the administration of a domestic estate. This might entail the sale of property located abroad but titled in a domestic debtor. Or, regulatory approval to domesticate cash or other assets maintained in a foreign financial institution. Or perhaps obtaining testimony or other evidence that might aid the prosecution of an adversary proceeding in the domestic case. If, however, a foreign proceeding is in fact pending abroad, section 1505 works in tandem with sections 1526 and 1527 of Chapter 15 to provide that the trustee, if authorized by the Bankruptcy Court and subject to its supervision, may “communicate directly with a foreign court or a foreign representative.”
It will, at this point, come as no surprise that there is no such creature as a cross-border municipal bankruptcy case. Yet, just like any other trustee of a domestic bankruptcy case, a municipality may need to act in a foreign country to facilitate a consensual adjustment of its debts, perhaps because municipal bonds may be registered for the benefit of foreign owners. Another plausible scenario where foreign cooperation might be needed is in the case of municipal special revenue bonds based on cross-border projects or systems (such as flood control or irrigation districts). It is, of course, quite natural that municipalities, like private debtors, will increasingly enjoy the advantages of foreign investment and trade.
Section 1505 marshals a potentially unlimited toolbox to maximize the value of a domestic estate. Whether and how the need to act abroad might arise, practitioners in any case under the Bankruptcy Code should keep in mind this overlooked statutory nugget. Although buried within Chapter 15, any debtor in any case under the Bankruptcy Code has the power to seek the court’s imprimatur to act abroad. Indeed, the court can tailor the relief to appoint any person with “special expertise” relevant to the task – even, potentially, an elected official of a municipality. There appear to be no limits to the ingenuity of a court, debtors and creditors to dispatch a bankruptcy envoy to roam abroad.
What a stressful, scary, “who knows what is the right thing to do” time to be considering a return to the office. They say COVID-19 is abating. They say the Delta variant is more dangerous. They say you are to return to the office in September. They say you could consider a hybrid work arrangement.
If you were anxious in 2020, you are probably terrified in 2021. Today, the health-inducing anxieties continue as work options become real. If you were hired or hope to be hired during this pandemic-influenced time period, your decisions today could influence your career for decades to come. This is especially true if your firm goes hybrid and you decide to work remotely some or all of the time.
Let’s look at some of the issues you could face and some actions you may want to consider.
Flexibility Is a Requirement
The details of back to work decisions are especially important for the “Born Digital” generations, Millennials [ages 25 to 40] and Gen Z [ages 9-24]. According to a report from Citrix Systems, 90 percent of them do not want to return to full-time, in-office work. The 90 percent break down into
three categories:
51% want to work from home all or most of the time,
21% would like to split their time evenly between home and office, and
18% want to split their time with more time in the office.[1]
The survey found a sizable disconnect between what leaders thought these workers want and what they said they want. For example, among the Born Digital respondents, 87 percent “are focused primarily on career stability, security and a healthy work-life balance. … Nearly 60 percent of business leaders thought that younger workers want to spend ‘most or all’ of their time at an office.”[2]
Leaders have to make decisions with far-flung consequences in an ever-evolving situation that seems to have no end. “The decisions business leaders make in the coming months to enable flexible work will impact everything from culture and innovation to how organizations attract and retain top talent.”[3] Nowhere are decisions more important than in regard to Born Digital workers.
Advantages of Working in the Office
Microsoft 365 CVP Jared Spataro sees in-office encounters as an important way for leaders to connect with employees to assess their frame of mind. “Those impromptu encounters at the office help keep leaders honest. With remote work, there are fewer chances to ask employees, ‘Hey, how are you?’ and then pick up on important cues as they respond.”[4]
The Citrix survey found that most young workers want engagement with colleagues and bosses. Many of them have been very lonely during lockdown. According to Donna Kimmel, Citrix executive VP, while younger workers want the flexibility of a hybrid schedule, they also “understand the need for in-person interaction, and companies need to provide opportunities for employees to come together both physically in offices and virtually from home to keep them connected, engaged and prepared for the future of work.”[5]
Disadvantages of Working from Home
“Being the lone remote member of a mostly in-office team isn’t just a recipe for FOMO─that is, fear of missing out. It can also be an obstacle to your productivity and professional advancement, not to mention the pleasure you get from work.”[6]
In-office colleagues have the chance to rub shoulders with their boss, hit the proverbial water cooler for time with friendly colleagues, and make themselves visible, effective members of the team. “When they work apart, younger employees lose chances to network, develop mentors and gain valuable experience by watching colleagues close-up, veteran managers say.”[7]
How “Born Digital” Generation Lawyers Can Level the Playing Field
Begin by reviewing your goals for the next few years. Then make a list of people you need to get to know and create a plan to incorporate coffee-chats, breakfast meetings, shared beers and lunch with someone three-four days a week.
If you like your firm but not your practice area, identify people you want to get to know in other practice areas as a way of learning more about what they do.
If you like your current work, list colleagues in your age cohort and older whom you want to get to know better, as well as your boss and other partners you would like to work with.
Look to become friends with your “class” of new lawyers as well as others in your age cohort. As you move through your career these people will be not only your friends, but also key referral and knowledge resources.
Prioritize time with your mentor because they can help you understand the culture of the firm and your practice area. Explain your career ideas to them and ask them to point out approved behaviors and routes to personal success.
If your firm has not set up rules designed to make meetings inclusive for those joining remotely, research the options and then make suggestions. In the meantime, try to find a “meeting buddy,” someone who will cue you in to in-person meeting currents you might miss, and make sure you are included in the conversation.
“It is especially important to connect with colleagues you may not know well, or have lost touch with during the pandemic. Reach out on social media, in addition to setting up a rotation of one-on-one sessions to ask questions about what is going on at the office or to offer your concrete assistance on projects.”[8]
Encourage your colleagues to use a mixture of online chat options and in-person meetings. On the days you do go into the office make a point of exchanging greetings with as many people as possible. Leave time in your schedule for in-person informal, ad hoc or planned, get-togethers. Think ahead about topics you want to discuss, issues you want to know more about, training you need. By planning these conversation points ahead of time, you will be more likely to find opportunities to insert them into conversations, and express your pre-planned points more coherently.
Conclusions
Millennials and Gen Zers are the workforce of the future. As such you have leverage in creating a new way of thinking about work. Use it to help traditional work-only firms begin to include flexibility and work-life balance issues into their culture. For yourself, create a one-on-one visibility program to make sure your physical absence doesn’t preclude an effective team presence.
[1] Rachel Tillman, “How do Gen Z, Millennials feel about returning to full-time work?” https://spectrumlocal.com/nys/centrail-ny/news/2021/06/16/ millennial-gen-z-work-force-pandemic-office–
[2] Jonathan Greig, “90% of millennials and Gen-Z do not want to return to full-time office work post-pandemic,” May 25, 2021, https://www.zdnet.com/article/90-of-millennials-and-Gen-Z-do-not-want-to-return-to-full-time-office-work-post-pandemic-report/
[3] Microsoft 2021 Work Trend Index: Annual Report, p. 4.
On July 7, 2021, Erin Gilmer, a lawyer and disability rights activist, died of suicide at age 38. Her work centered on the view of health as a human right. Erin fought tirelessly for patient-centered care and for a health care system that was more responsive and compassionate to the needs of patients.
Gilmer’s advocacy was based on her firsthand experience as a patient. She had an array of complicated health conditions, including rheumatoid arthritis, diabetes, borderline personality disorder, and occipital neuralgia. She shared her own experiences to illustrate the barriers, difficulties, and degradations she found to be inherent in the modern medical system, from the 15-minute doctor visits to the trauma of the health care experience, and to being dismissed as being “difficult” when she tried to advocate for herself.
Gilmer encouraged people to advocate for themselves, writing a free guide entitled What You Should Know as an Advocate. She included the voices of over 100 advocates from every walk of life to share what they wish they knew going into advocacy and what advice they’d give to other advocates. The guide focused on what it really means to be an advocate, in particular “the challenges you’ll face, the ups and downs you’ll experience, the realities of the commitment involved, the people skills that will impact your work, and the toll it can take.”
Erin demonstrated the realities involved in being an advocate, how hard it is and the amount of perseverance it takes. She shared her health struggles and the pain she felt worsening daily, calling on those in the medical profession to acknowledge patients’ lived experiences, truly listen to them, believe that they are suffering, try to find a reason for their suffering, allow patients to become colleagues in their care and share in decision-making, find humility, and extend compassion. Erin let us see into the reality of her struggles. In the end, she didn’t feel heard, believed, or cared for by the medical profession and decided she could not keep living in so much pain. The hope is that we can carry on her fight.
The ABA Young Leaders in Securitization and Structured Finance is a growing subcommittee of the Business Law Section (BLS) Committee for Securitization and Structured Finance. The committee and the Young Leaders are at the forefront of discussing and tackling new issues in the growing field of structured finance. Among the many topics discussed are cutting edge vehicles that manages leverage and risk, issues with warehousing and collateralized loan obligations and the effects of the latest Supreme Court decisions, such as, Collins v. Yellen, and their implications for the mortgage market. The Young Leaders take an active role in these discussions. Most recently, the Young Leaders hosted a practical workshop on the payment waterfall.
The workshop, hosted by the Young Leaders and joined by the panelists Alfredo Moreira, a Director at BofA Securities, Inc., and Nikolas Ortega, an associate at Cadwalader, Wickersham & Taft LLP, was a practical introduction taking attendees through how the priority of payments is crafted from term sheet to final document. The workshop was a great success and useful not only for associates and newcomers into the securitization sector,but served as an important refresher for more seasoned market participants in the intricacies of structured financial products.
The BLS Committee for Securitization and Structured Finance, and the Young Leaders subcommittee are both planning to hold additional events furthering interest and development in the securitization sector The Young Leaders also hope to continue to host events for young lawyers who are in the sector or are interested in it.
A decade ago, almost no one even had heard the word “cryptocurrency,” and gambling was a subject reserved to those who visited Las Vegas, Atlantic City, offshore poker websites, and, as ever, the movies. In 2021, both are mainstream and—increasingly—converging.
Supported by blockchain digital infrastructure, cryptocurrencies purport to offer the possibility of commercial and wealth-management activities outside the purview of publicly regulated markets and state treasuries and central banks. While employing currency-related terminology like “coins” and “tokens,” the adaptability and seemingly unconstrained purposes of cryptocurrencies present fundamental questions about their nature. Existent only in digital form and not created by any government mint, are they nevertheless akin to conventional currencies? Often volatile in value and not issued by a particular corporate entity, are they nevertheless akin to securities?
Of course, traditional currencies also bear features of both media of exchange and securities, and the facts that government actors neither create nor fully understand something do not necessarily prevent them from trying to regulate it. Indeed, to varying degrees, this is the circumstance of many business-lawyer clients, who are responsible for the generation of their business outputs and, vis-à-vis public regulators, tend to be the real experts in their respective fields. When it comes to cryptocurrencies, however, that degree of variance can be so extreme, and their relatively recent emergence and growing popularity coupled with a core identity that is openly hostile to state oversight, has thus far made it difficult for governments to develop workable regulatory models.
That regulatory uncertainty appears to have done little to slow the use of cryptocurrencies, which is not expressly outlawed. Cryptocurrency ownership requires a blockchain wallet, and available statistics show that the number of unique blockchain wallets has been growing at high rates in recent years. Anecdotal indicators, such as financial news sources like CNBC regularly displaying the live value of Bitcoin, perhaps the most popular cryptocurrency, alongside major stock exchange indices, also are consistent with the increasingly mainstream status of cryptocurrencies. Even government actors in countries like El Salvador and states such as Wyoming have expressed approval of the legal use of cryptocurrencies.
Meanwhile, gambling has pressed its way into the mainstream milieu in recent years as well, largely kickstarted by the Supreme Court’s decision in Murphy v. NCAA (No. 16-476, 584 U.S.___ (2018)) that the federal statutory prohibition on state-run sports wagering (the Professional and Amateur Sports Protection Act (“PASPA”)) was unconstitutional. Since then, about a dozen states, including New Jersey, Tennessee, Pennsylvania, and Michigan, have authorized sports and other gambling activities, with similar initiatives churning through many other state legislatures. Driven, to varying extents, by public interest, prior experience with online daily fantasy sports (“DFS”) and other games, and COVID-19-induced stay-at-home requirements, these state gambling authorizations and bills increasingly allow for mobile gaming applications that require little or no player interaction with brick-and-mortar casinos.
The Murphy decision was not quite the broad-scale legalization measure that some in the general public thought it to be, but there is little doubt that it signaled a call to entrepreneurs large and small to begin exploring in earnest the development of gambling and gambling-adjacent products. Some of these products, naturally, came in the form of sports books at land-based casinos that had not previously hosted them.
Far more of these new products, though, were mobile apps. Past experience with online poker, DFS, conventional fantasy sports, and internet casino (“iCasino”) games showed that an audience for mobile gaming exists, and it certainly seems easier to build a smartphone app than a brick-and-mortar casino. Incorporation of cryptocurrency compatibility and blockchain infrastructure made both practical and cultural sense: why not use the latest technology and do so in a way that might appeal to player preferences toward confidentiality in a so-called vice activity? Open, distributed, and decentralized technologies also lend themselves to the creation of different types of gaming experiences, such as peer-to-peer structures that, at least on their face, appear to bypass or invert the traditional concept of “the house.”
While the Supreme Court, in Murphy, ended a nationwide prohibition, the practical consequence was not nationwide, uniform legalization. As referenced above, the way forward was and remains a patchwork quilt of unique state-by-state authorizations that, for developers, represent another layer (or many other layers, depending on the scope of operation) of regulatory obstacles to navigate. Including cryptocurrency components might make engagement easier or more enticing for players, but it adds yet another regulatory web to an already highly regulated industry.
Gambling and currency are not remotely new to the human experience. Today, though, technology is permitting them to interact in new ways that pose new and exciting questions. Business lawyers navigating these overlapping regulatory environments also must think beyond basic licensing and compliance matters and consider significant security and privacy responsibilities.
Some of the most valuable assets for any company are its employees, key service providers, and advisors. This is particularly true for startups and emerging companies. A talented and dedicated team is essential to a company’s growth and scaling its operations. Yet, it can be hard to find and retain qualified employees, advisors and consultants. Established companies can typically offer more competitive salaries, generous benefit plans, perks and the promise of stability. In an integrated global economy where there is a worldwide competition for top talent, the reality is that startups and emerging companies need to be innovative, not just in their technology and services, but also in how they attract and retain talent.
One way startups and emerging companies can attract talent and incentivize employees, advisors and consultants (“Service Providers”) is by offering equity in the company. This is typically in the form of issuing shares or granting options to purchase shares in the future. By granting Service Providers equity in the business, organizations can ensure that the interests of these key stakeholders align with those of the company. This article will explore how startups and emerging companies can effectively use options to attract talent and scale.
What are Options?
An option grants the Service Provider the right to purchase shares at a predetermined price in the future. The assumption is that the company’s value will increase over time and that the Service Provider will be able to purchase shares at a significant discount at the time of exercise, or cash-out on a liquidity event such as the sale of the company. For a high-growth company, this offers Service Providers significant upside. Notably, as options are only a contractual right to purchase shares in the future, an optionee is not the same as a shareholder. Optionees do not have the rights or privileges of shareholders, such as the right to vote or receive dividends – until the optionee exercises the right to purchase shares.
Vested options are exercisable at the discretion of the Service Provider. Thus there is little downside to the optionee as the optionee may choose when or if it will exercise the options. Options also result in more favorable tax treatment for Service Providers when compared to issuing shares directly. This is because the Service Provider will generally only realize a taxable benefit in the year the options are exercised (assuming that the Service Provider is not paying fair market value for the shares). This ability to defer taxes may not apply in certain circumstances, such as where the entity issuing options is a non-Canadian controlled private corporation with consolidated group revenue of more than $500 million. The tax treatment of options is beyond the scope of this article and should be discussed with a tax advisor who has experience with options.
Stock Option Plan
Before issuing options, startups and emerging companies will generally put a Stock Option Plan (“SOP”) in place. SOPs are not required, but are recommended as they outline the rights and restrictions related to any issuance of options. A SOP is a policy document that outlines the terms and conditions of how a company will issue and manage the options it has granted. A SOP also outlines the rights and obligations of the optionee. It specifies what will happen to the options on the occurrence of a specific event, such as the sale of the company or the termination of the employment or engagement of a Service Provider. Typically, each optionee will enter into an option agreement with the company that will specify key terms associated with their options, such as the number of shares being awarded to the Service Provider, the exercise price the Service Provider will eventually pay for vested options and the vesting schedule.
Startups and emerging companies typically grant options to Service Providers based on a predetermined vesting schedule. This means that the options will not vest, and the Service Provider will conversely not have the right to exercise its options, until a predetermined event or events have occurred. This vesting schedule can be tied to years of service or the successful accomplishment of a milestone, such as securing a key client. If the vesting schedule is tied to years of service, a portion of the options may vest on each anniversary of the Service Provider’s start date. This will assist in incentivizing the Service Provider to remain with the company.
When devising a SOP, many factors need to be considered for the plan to be effective. Some key considerations are outlined below.
Considerations
1. Optionee Selection
Careful consideration should be given when choosing which Service Providers should be granted options. For example, long-term key employees in management roles who can directly impact the growth and performance of the business are usually preferred over roles subject to high turnover.
2. Selecting the Option Pool
A SOP will specify the total number of shares and class of shares that may be allocated pursuant to the SOP. The size of the option pool is typically a percentage of the company’s cap table and is negotiated by the key shareholders of the company, including the founders, key investors or other significant shareholders. The bigger the pool, the more the dilution in ownership can occur for each shareholder. The company must balance the risk of dilution with the need to ensure that the option pool is large enough to attract key talent. Though option pools typically range between 5%-20% of the company’s cap table, stakeholders should determine the appropriate size based on the unique factors the organization faces. The size of the option pool will typically be “topped up” on future equity financing rounds.
3. Strike Price
The strike price (or exercise price) is the predetermined price that the optionee must pay for the shares underlying the options. The strike price is usually set at fair market value at the time of the option grant unless there is a desire to reward past service by allowing the strike price to be set at less than the current value. Early-stage companies may set the strike price at a nominal amount to reflect the fact that the company’s valuation is typically low.
4. Vesting Period
The vesting period is the length of time that an optionee must wait to be able to exercise their options. Typically, options are not immediately available to be sold, exercised or transferred. The vesting period should be carefully considered because it could seem unattainable if the period is too long. However, if it’s too short, the optionee may exercise their options and then leave the organization, defeating the intended retention goal. It is common for startups and emerging companies to set a four-year vesting period for their Service Providers with 25% of the options vesting after the first year with the balance vesting monthly, quarterly or annually in equal installments over the following three years. Companies looking to reward past work of current employees may consider having a portion of the options vest immediately.
5. Termination of the Service Provider
The SOP will stipulate when the options will expire. This option expiry date is when the Service Provider will no longer be able to exercise their options. There are certain instances under which the option expiry date will be brought forward, for example, if a Service Provider is no longer engaged by the company. What will happen on termination is usually dependent on the reasons surrounding the termination of the relationship. What is typical is that if the Service Provider’s relationship with the company is terminated for any reason other than cause, the Service Provider will have a limited period following termination to exercise their vested options (e.g., 30 days following termination). If a Service Provider is terminated for cause, then the Service Provider’s right to exercise any vested options usually terminates immediately. In either scenario, the Service Provider’s unvested options are typically canceled. Startups and emerging companies should also consider including the option to repurchase any shares held by the Service Provider following termination. There are numerous reasons for doing so, including the desire to limit the company’s ownership for those who have received “sweat equity” to only those actively involved in the business.
6. Triggering Events
The SOP should also address what will happen if certain defined triggering events are to occur. This could include the termination of the employment or engagement of the Service Provider, the sale or restructuring of the startup or emerging business or a going public transaction. In the context of a sale of the company, organizations may want to consider if all or a portion of the unvested options will automatically vest. In addition, the company should ensure that it can force the exercise and sale of any vested options at the time of the sale of the company as a potential purchaser may be unwilling to acquire the business if it cannot acquire all of the shares of the company. If the exercise of the options takes place concurrently with the sale of the company, the options could be subject to a cashless exercise that would allow the optionee to exercise its options without having to pay cash to cover the exercise price. This is achieved by decreasing the number of shares the optionee will receive by an amount equal to the exercise price that the optionee would have been required to pay for exercising its options.
Conclusion
Options offer startups and emerging companies a method to attract and retain one of their most critical assets. Although there is significant upside in using options, companies should carefully consider how they structure options and SOPs to ensure they limit their exposure to risk, the ambiguity of terms and avoid unintended consequences in terms of the alignment of the company and the optionee.
The Supreme Court of Pennsylvania recently affirmed a Superior Court order in Pittsburg Logistics Systems, Inc. v. Beemac Trucking, LLC et al., No. 31 WAP 2019, finding a no-hire provision between competing, sophisticated businesses to be void as a matter of public policy and enforceable.[1] While the Supreme Court reviewed out-of-state and federal case law discussed by the parties on the enforceability of no-poach provisions and noted the federal government’s recent efforts to curb no-poach use, it focused its analysis and ruling on the balancing test set forth in the Restatement (Second) of Contracts. Under that test, the court reasoned that while there was a legitimate interest for the no-hire provision in the first instance, the restraint was both overly broad and harmful to the public on balance in this case. Therefore, although the outcome represents a victory for Beemac after a long road of litigation, the impact of this decision on future no-poach/no-hire cases remains unclear.
Background
The case concerned a preliminary injunction to enforce a no-hire provision that Pittsburgh Logistic Company (“PLS”) sought to impose against certain shipping companies, Beemac Trucking LLC and Beemac Logistics LLC (“Beemac,” collectively). Through the no-hire provision, Beemac agreed that during the one-year contract and for a period of two years following the contract’s termination, it would not “directly or indirectly hire, solicit for employment, induce or attempt to induce any employees of PLS or any of its Affiliates to leave their employment with PLS or any Affiliate for any reason.” But while the contract was in force, Beemac hired four former PLS employees, causing PLS to seek a preliminary injunction. The trial court denied the preliminary injunction request because it found the no-hire provision was void as a matter of public policy and therefore, PLS could not meet its burden to show a likelihood of success on the merits. An en banc panel of the Superior Court was convened after one of its panels affirmed the trial court decision. In exercising a highly deferential standard of review as to the grant or denial of preliminary injunctions, the court affirmed that the no-hire provision was an unenforceable restraint on trade, finding that it violated public policy because it allowed PLS to restrain employees without providing the employees with consideration. In reaching its decision, the Superior Court noted there was no Pennsylvania law on point, and therefore it relied entirely on out-of-state or federal decisions.
The Supreme Court allowed PLS’s appeal to consider whether “contractual no-hire provisions which are part of a services contract between sophisticated business entities [are] enforceable” under Pennsylvania law.
Supreme Court Opinion
The Supreme Court acknowledged that “Pennsylvania common law has treated restrictive covenants as restraints of trade that are void as against public policy unless they are ancillary to an otherwise valid contract.” If the restraint is ancillary, the court employs a balancing test to determine if the provision is reasonable, using the Restatement (Second) of Contracts test for evaluating the reasonableness of the provision. Specifically, the Restatement balancing test reads:
A promise to refrain from competition that imposes a restraint that is ancillary to an otherwise valid transaction or relationship is unreasonably in restraint of trade if
the restraint is greater than is needed to protect the promisee’s legitimate interest, or
the promisee’s need is outweighed by the hardship to the promisor and the likely injury to the public.
—Restatement (Second) of Contracts § 188(1)
Applying the Restatement test, the court found that the no-hire provision was an unreasonable restraint on trade because two commercial businesses used the provision to limit competition in the labor market “ancillary to the principal purposes of the shipping contract between PLS and Beemac.” The court recognized PLS’ legitimate interest in preventing its business partner from poaching its employees. However, the no-hire provision was “greater than needed to protect PLS’s interest and create[d] a probability of harm to the public.” The provision was overbroad because it precluded Beemac from hiring, soliciting, or inducing PLS employees for the one-year term of the contract plus an additional two years regardless of whether the PLS employee had worked with Beemac during the contract. Under the Restatement, the Court’s overbroad finding should have been enough to void the provision.
Nevertheless, the court went on to find that the no-hire provision created a likelihood of harm to the public in both specific and general ways. First, the provision specifically “impair[ed] the employment opportunities and job mobility of PLS employees” not party to the contract without their knowledge or consent. Under the facts of the case, this represented “real” rather than “hypothetical” harm because PLS sought the preliminary injunction to prevent Beemac from employing former PLS employees who had already taken a position with Beemac. Second, the court found that the provision generally undermined free competition in the labor market, creating a likelihood of harm to the general public. The court’s analysis did not explicitly weigh Beemac’s hardship and the public harm against PLS’ legitimate need except in a conclusory fashion in a statement at the end of the opinion.
Takeaways
The opinion is notable because it represents the first Pennsylvania state case to weigh in on the enforceability of a no-hire provision between two commercial businesses. The true import of the decision, however, will come only with time. One could argue, based on this decision, that any ancillary no-hire provision that impairs employment opportunity and mobility is unenforceable under Pennsylvania law. At the same time, the analysis used by the Pennsylvania Supreme Court indicates that every restraint on trade is subject to the balancing test under the Restatement and therefore, the outcome is based on the facts of each case. One wonders if the legal outcome would have been different had the no-hire provision been effective only for the life of the service contract and only applied to PLS employees who worked directly with Beemac.
The precedential value of the court’s analysis regarding harm to the public is also questionable. While the court found harm to the public in the record, it weighed that harm against PLS’ legitimate interest — an express requirement under the Restatement — only in a conclusory manner. This is significant because any no-hire or no-poach provision can be said to harm employee mobility in some regard. That is the purpose of the provision. On the other hand, one could argue that the court’s public harm analysis is merely dicta because the court had already determined that the restraint was overly broad. Put another way, once the court found the provision as overbroad, it did not need to also find that it harmed the public to be unenforceable. In the end, the court’s analysis here (while short) could have a significant impact on how employers in the state of Pennsylvania use no-hire provisions in their commercial contracts.
About the authors: Troutman Pepper Business Litigation Practice Group litigators A. Christopher Young, Jan P. Levine, Robyn R. English-Mezzino and Christopher J. Moran help clients analyze and solve their most emergent and complex problems through negotiation, arbitration, and litigation.
[1] See previous Troutman Pepper article on the Superior Court’s decision and its potential ramifications here.
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