Shareholders of cannabis co in Jay-Z empire can sue over de-SPAC deal - Delaware court

Jay-Z inside the stadium before the Super Bowl, Maimi Feb. 2, 2020 . REUTERS/Mike Blake

(Reuters) - For the second time in recent months, Delaware’s Chancery Court has ruled that shareholders can sue board members for breaching their duties in a so-called de-SPAC deal.

On Monday, Vice Chancellor Morgan Zurn refused to dismiss a lawsuit by shareholders of Left Coast Ventures Inc, a privately-held cannabis company that was acquired in 2021 by the special purpose acquisition company Subversive Capital Acquisition Corp. Subversive subsequently partnered with entrepreneur Shawn Carter, better known as Jay-Z, to form The Parent Co, which bills itself as California’s leading cannabis business.

Zurn ruled that Left Coast shareholders could pursue direct claims against the private equity fund Fireman Capital Partners LLC and three Left Coast board members affiliated with the fund, including principal Dan Fireman. Fireman Capital provided a crucial loan to Left Coast as the company was negotiating its complex de-SPAC deal with Subversive.

The plaintiffs allege that board members with ties to Fireman allowed the fund to capitalize on the leverage it obtained as a Left Coast creditor – including majority control of the board and a proxy for more than 80% of the company’s voting rights – and to ram through last-minute amendments to Left Coast’s debt instruments.

Those amendments, according to plaintiffs lawyers from Prickett, Jones & Elliott, effectively allowed Fireman to divert $40 million from the Subversive takeover away from Left Coast shareholders and options holders. (The complaint doesn’t detail the terms of the de-SPAC merger, but, according to a defense filing, Subversive agreed to pay about $142 million for Left Coast, although Left Coast simultaneously agreed to pay about $76 million for the acquisition of another cannabis company.)

Defense lawyers from Paul, Weiss, Rifkind, Wharton & Garrison moved to dismiss the lawsuit last July, arguing primarily that shareholders were asserting derivative claims that belonged to the company, not direct claims on their own behalf. That’s a key distinction in cases alleging breaches of duty in M&A transactions because shareholders from target companies do not have standing to assert post-merger derivative claims.

Paul Weiss argued that the plaintiffs – Left Coast founders who “benefited happily and quietly from the merger” – were, in fact, alleging that the last-minute amendments to the company’s debt instruments diluted the shareholders’ stake. “But any purported dilution,” Paul Weiss said, “would be a purely derivative injury suffered by Left Coast, and not by any stockholder.”

The dismissal motion pointed to Delaware Supreme Court precedent from 1999’s Parnes v. Bally Entertainment Corp, which held that shareholders must allege a merger was unfair in order to assert a direct claim arising from it. The Left Coast shareholders, Paul Weiss argued, did not claim the merger itself was unfair, instead touting the de-SPAC deal as a synergistic opportunity to create long-term value.

In Monday’s ruling, Zurn undertook a lengthy analysis of the Parnes ruling and subsequent Chancery Court interpretations of it in the context of mergers that included side payments to certain shareholders. The Vice Chancellor discerned a three-part test for when allegations of a side deal give rise to a direct claim. “The side transaction must divert merger consideration from stockholders, rather than from the acquirer; the diversion must be ‘improper,’ that is, the product of misconduct by the defendants; and the diversion must materially affect the merger's process or price, calling the merger's fairness or validity into question,” she wrote.

Left Coast shareholders’ allegations, Zurn said, satisfied all of the prongs of the test. Shareholders, she said, claimed that Fireman improperly “hijacked merger negotiations” and threatened to derail the SPAC’s acquisition of the company unless the board approved debt instrument amendments that benefited the fund. The $40 million allegedly diverted to Fireman was material, Zurn said, in a deal valued at $120 to $130 million. And the timing of the amendments indicated that the money would otherwise have gone to Left Coast shareholders, the judge said.

“Plaintiffs have successfully alleged [that] an improper side transaction intertwined with the merger rendered the merger itself unfair,” Zurn wrote. “Because that claim calls the merger's fairness into question, it is direct.”

Defense lawyers Audra Soloway and Jaren Janghorbani of Paul Weiss didn’t respond to an email query. Plaintiffs lawyers Marcus Montejo and John Day of Prickett Jones also didn’t get back to me.

As I mentioned, Zurn is the second Delaware Chancery judge to allow shareholders to go after directors over claims arising from a de-SPAC deal. In a ruling in January in a closely watched shareholder suit against the Churchill Capital Corp III SPAC, Vice Chancellor Lori Will held that Churchill investors could pursue direct claims that SPAC insiders failed to provide them with critical information about the SPAC’s target, healthcare cost management company MultiPlan Corp. (I told you last week that Churchill contends investors were actually tricked by the short seller Muddy Waters, which, according to Churchill, published a misleading report about MultiPlan’s biggest client.)

Obviously, the MultiPlan and Left Coast cases are quite different. Left Coast shareholders are not claiming that SPAC insiders at Subversive did anything wrong. And Subversive’s shareholders aren’t suing anyone. In that regard, it doesn’t even matter that Left Coast’s acquirer was a SPAC.

But with renewed momentum for SPACs in 2022, this week’s ruling is a reminder that even innovative SPAC deals in cutting-edge industries are subject to the same old Delaware law.

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Alison Frankel has covered high-stakes commercial litigation as a columnist for Reuters since 2011. A Dartmouth college graduate, she has worked as a journalist in New York covering the legal industry and the law for more than three decades. Before joining Reuters, she was a writer and editor at The American Lawyer. Frankel is the author of Double Eagle: The Epic Story of the World’s Most Valuable Coin.