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Enemy of the SPAC: Law Professor Takes Deal Sponsors to Court

Sept. 22, 2022, 9:00 AM

Stanford Law Professor Michael Klausner toiled in academic obscurity for decades until 2020, when he wrote a paper slamming special purpose acquisition companies as a rip-off of everyday investors.

Now he’s taking his newfound cache to Delaware Chancery Court. He’ll argue in a Friday hearing that blank-check company GigCapital3 Inc. did what SPACs across the industry do—hide from investors how much money they give to insiders through the promise of nearly free shares.

“Somebody’s got to say, I’m paying $10 to invest $5 or $6,” Klausner said in an interview. “If that’s fully disclosed, which I think it should be and will be, there might be” fewer SPACs. “It will be scaled back a lot.”

Klausner’s lawsuits targeting GigCapital3 and two other SPACs highlight potential legal risks for investors, known as sponsors, who launched blank-check vehicles during their recent boom years. He seeks to claw back for ordinary investors the millions of dollars sponsors made in closing deals.

His research has been influential as the US Securities and Exchange Commission and members of Congress take a skeptical view of the vehicles, scrutiny that has contributed to the SPAC craze’s flame-out. There have been 76 SPAC initial public offerings this year, down from 613 in 2021 and 248 in 2020, according to SPAC Research.

GigCapital3 in May 2021 closed its merger with Lightning eMotors, a company that electrifies commerical vehicle fleets. The sponsor made about $39 million on the deal, Klausner’s lawsuit alleges, and the SPAC’s shares fell from $10 to $7.82 the day the merger was completed. This week shares traded for less than $2.

A lawyer for GigAcquisitions3, the sponsor of the GigCapital3 SPAC, did not respond to a request for comment.

The company’s lawyers, from global firm DLA Piper, argue that the lawsuit doesn’t allege a single material misstatement or omission to investors. They say the information that Klausner uses to back the suit comes from the SPAC’s own public disclosures—meaning investors had access to it.

Klausner is also targeting GigCapital2 Inc. and Pivotal Investment Corporation II in separate lawsuits.

‘Sober Look’

Klausner, 67, has called himself an “obscure academic.”

“Most of what I’ve written has been academic debates where my primary audience was other academics,” he said.

In 2018, he began researching SPACs. It wasn’t long before people began noticing.

He co-authored a 76-page paper, “A Sober Look at SPACs,” in November 2020 that has been downloaded nearly 40,000 times. His most popular paper before that, 19 years earlier, garnered about 3,000 downloads. None of his previous research has contributed to policy debates.

The upshot of his research, co-authored by New York University assistant professor Michael Ohlrogge, is that for every $10 an investor gives to a SPAC, only about half goes toward actually buying a company.

The rest is diverted to insiders and service providers like law firms and investment banks. The amount of shares given to insiders “dilutes” the value of shares held by public investors, Klausner argues, and that dilution is not easily discerned by everyday investors.

The US Securities and Exchange Commission cited the paper 19 times when proposing new rules for the vehicles in March. Sen. Elizabeth Warren (D-Mass.) relied on the analysis for her scathing 26-page report on the industry in May.

Still, Klausner has his critics.

SPAC lawyer Douglas Ellenoff, who has been working on blank-check deals since long before the recent surge, said it’s overblown to credit Klausner’s research as crucial to the SEC’s proposals. The commission’s plan didn’t address Klausner’s concerns, said Ellenoff, who called the dilution argument “silly” and obvious.

‘You’ve Gotta be Kidding’

Klausner clerked for US Supreme Court Justice William Brennan early in his career and worked at Gibson Dunn & Crutcher before joining Stanford in 1997. He said he became interested in SPACs about four years ago. He had invited a lawyer to talk with his students, marking the first time he heard the transactions explained.

He learned about deal sponsors, who put up the initial chunk of money that a SPAC eventually uses to purchase a private company. Sponsors typically receive 20% of the newly public company’s shares as a reward for crafting the deal and putting their capital on the line.

Klausner was skeptical. “These people take 20% off the top?” he recalls asking the lawyer in his classroom. “You’ve gotta be kidding.”

Klausner and Ohlrogge decided to study the financial performance of SPACs that went public in 2015 and completed mergers by 2018. “We found they did disastrously poorly for their investors,” he said.

Their paper was set to publish in early 2020. But the authors decided to refocus their efforts after industry participants told them the quality of SPAC sponsors had changed significantly in the interim.

Klausner and Ohlrogge then studied the 47 SPACs that merged between January 2019 and June 2020. Their views on the deals didn’t change.

Sponsors Targeted

SPAC sponsors reap a windfall in shares when a deal is consummated, which makes them likely to push through bad deals against the best interest of long-term shareholders, Klausner and Ohlrogge argued in their research. If no deal is made, sponsors don’t get the payout.

They also argued that SPACs are a far costlier way to invest in newly public companies. That’s largely because of the sponsor’s shares in the new company and similar grants to other early investors through warrants.

The share grants dilute the value of public investors’ holdings, Klausner and Ohlrogge said. On average, 31% of the initial SPAC investment was spent compensating sponsors after a merger. Warrants ate up another 14% on average, they argued.

Another 14% was spent on average paying underwriters and lawyers, Klausner and Ohlrogge wrote. That meant the average SPAC in the study only had 41% of its initial fundraising used to purchase a company. The median SPAC did somewhat better at 57%, they found.

An updated version of Klausner’s paper argued that investors who held onto SPAC shares through completed mergers in 2019 and 2020 suffered an average share price decline of 64% through October 2021.

Klausner concluded that this dilution wasn’t properly disclosed to investors. He enlisted the law firm Grant & Eisenhofer, which has one of the largest practices in the Delaware Chancery Court.

SPAC Lawsuits Rising

There has been a wave of SPAC-related lawsuits in Delaware.

A first-of-its-kind ruling in January sided with investors who argued a blank check merger with MultiPlan Corp. robbed them of information to make an educated decision about whether to cash out their shares—an argument Klausner makes in his cases.

The Delaware Chancery Court, in a ruling which cited Klausner’s paper, said the SPAC sponsors in that deal earned $305 million worth of shares for their $25,000 investment, a more than 1.2 million percent return.

Klausner’s research has had an effect on the SPAC debate, Anna Pinedo, co-leader of Mayer Brown’s global capital markets practice, acknowledged. But some findings—like that SPAC trading performance has been far worse than similarly sized traditional IPOs—is off, she added.

“I don’t necessarily agree with everything he writes,” Pinedo said of Klausner. “But certainly everything he produces is clearly quite well-researched.”

It “stands to reason” that SPAC litigation would increase after the boom in activity last year, Pinedo said.

GigCapital3 Suit

Klausner’s suit against GigAcquisitions3 alleges that at the time of the merger, the SPAC had less than 60% of the money it raised to spend on buying the company.

Lightning eMotors, an electric vehicle manufacturer, inflated its valuation to make up the gap in the SPAC’s pot of cash that would be taken out by sponsors and warrants, the suit claims.

The company’s lawyers counter that the SPAC was focused on providing accurate projections of Lightning’s business and even disclosed a downward revision before the merger.

The chancery court hearing Friday will precede a judge’s decision to toss the case or allow it to proceed. Klausner has appeared in the Delaware courtroom as an expert witness, but this week will mark his first appearance behind the counsel’s table.

“This is not my day job, but it came out of my day job, which is doing research and writing,” Klausner said of his lawsuits. “I felt so strongly about the fact that SPACs are abusive that I just took it on myself to get involved.”

To contact the reporter on this story: Roy Strom in Chicago at rstrom@bloomberglaw.com

To contact the editors responsible for this story: Chris Opfer at copfer@bloomberglaw.com; John Hughes at jhughes@bloombergindustry.com