In the following guest post, Sarah Abrams, Head of Claims Baleen Specialty, a division of Bowhead Specialty, takes a look at the recent dismissal of a securities class action lawsuit arising out of a failed merger, and considers the implications for the dismissal, particularly with respect to securities suits involving SPAC transactions. I would like to thank Sarah for allowing me to publish her article on this site. I welcome guest post submissions from responsible authors on topics of interest to this site’s readers. Please contact me directly if you would like to submit a guest post. Here is Sarah’s article.
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Does a recent dismissal of proposed securities class action, Water Island Event-Driven Fund v. MaxLinear, et. al, (Water Island case), provide insight into future case outcomes involving failed merger opportunities, including those involving SPACs? It may. The procedural and substantive hurdles identified in the Water Island case decision may exist for shareholder plaintiffs bringing securities fraud claims tied to failed or troubled SPAC mergers. These hurdles may be significant in limiting exposure for D&O insurers if identified early.
The following summarizes the Water Island case and the Southern District of California’s decision, highlighting its findings that the plaintiffs lacked standing, did not make material misrepresentations, and that the Core Operations Theory did not apply. The analysis then draws comparisons to dismissal decisions in two SPAC-related securities class actions, offering prospective takeaways for D&O underwriters.
First, a brief background of the Water Island case. The plaintiffs were investors who purchased American Depositary Shares (ADS) in Taiwanese chipmaker Silicon Motion (SIMO). In May 2022, American telecommunications company MaxLiner announced that it would acquire SIMO for $3.8 billion, which resulted in an $8 billion valuation of the future combined company (the Merger). In June 2023, MaxLinear’s CEO stated during a business conference panel that, even with both company revenues down, “the basic rationale [for the Merger] has not changed at all.” MaxLinear filed a Form 425 SEC disclosure statement regarding his comments the next day. On July 26, 2023, a day after Chinese regulators approved the Merger, MaxLinear issued a press release stating that it was unilaterally terminating the Merger.
According to the Water Island case plaintiffs, MaxLinear’s announcement that it was pulling out of the Merger deal caused “the immediate collapse of the price of [SIMO ADS].” Specifically, the plaintiffs alleged that MaxLinear had already determined that the Merger would be terminated if Chinese regulators approved the transaction, despite overt signals that MaxLinear was fully committed to the deal. And yet, both SIMO and MaxLinear purportedly signaled to the SIMO ADS investors that the merger was on track to close. In addition, the plaintiffs alleged that SIMO omitted that there may be a condition to prevent the deal closing (specifically, merger approval by Chinese regulatory authorities), failed to properly follow merger investigation procedures, and failed to review MaxLinear’s statements or its update prior statements regarding the Merger breach. As a result, plaintiffs alleged that MaxLinear, SIMO, and company executives made materially false and misleading statements in violation of Sections 10(b) and 20(a) of the Securities Act Exchange Act.
For D&O underwriters, the Water Island case fact pattern and subsequent securities complaint may feel like a familiar one; particularly the resulting scrutiny from shareholders when a merger deal is called off. However, the Water Island Court’s decision is interesting in that it may inform prospective exposure from a SPAC-related securities case. As an initial matter, the decision and bases for dismissal are considered.
The Water Island Court’s ruling to dismiss the securities class action was based on its determination that (1) SIMO did not make false statements or omit material information and thus did not commit securities fraud, and that (2) SIMO ADS shareholders did not have standing to bring 10(b) Claims against MaxLinear. The following discusses the court’s findings and rationale, beginning with the issue of shareholder standing.
Following the bright-line (Birnbaum Rule) rule that limits standing to bring such a securities class action claim to “purchasers or sellers of the stock in question,” the Water Island Court dismissed the SIMO ADS plaintiffs’ 10(b) claims against MaxLinear. The SIMO ADS plaintiffs did not own shares in MaxLinear or a combined company because the deal did not close. It is noteworthy that the Water Island Court cited Churchill Capital IV. v. Lucid Motors (Lucid Motors case) to support its decision. The Lucid Motors case highlights that SPAC shareholders bringing a securities class action may face a fate similar to that of the SIMO ADS shareholders: dismissal for lack of standing.
As D&O Diary readers may recall, the Lucid Motors case involved the SPAC deal where Churchill Capital Acquisition Corporation IV (Churchill IV) merged with Lucid. Before the merger was announced, Lucid’s CEO made declarations about production and prospective revenue during appearances on various media outlets. The evening the merger was announced, Lucid’s CEO went on another media program to announce a delay in vehicle production. After the merger closed, the company announced further reductions in production and a revised production timetable. Pre-merger purchasers of the SPAC stock filed their securities class action against Lucid and its CEO. The case against Lucid and its CEO was dismissed because the plaintiff SPAC stock purchasers lacked standing.
The second of the two bases on which the Water Island Court granted dismissal was its finding that SIMO did not commit securities fraud because, in part, the Court found SIMO’s public statements to be factually accurate. The Court reasoned that SIMO referencing one closing condition did not require disclosing all risks, such as an alleged breach, and thus, there was no omission of a material fact. The Court further found that there were no specific allegations or documents showing actual knowledge of the Merger breach by SIMO executives.
In addition, the Court’s basis for dismissing the 10(b) claims against SIMO included finding that SIMO ADS shareholders failed to prove scienter under the Core Operations Theory. Specifically, the Core Operations Theory (or “core operations inference”) is a judicial doctrine used primarily in securities fraud litigation under Section 10(b) and Rule 10b-5. It allows a court to infer scienter (i.e., fraudulent intent or severe recklessness) when a plaintiff alleges that a misstatement or omission concerns a matter so significant and central to the company’s operations that senior executives must have known it was false or misleading.
In the Water Island case, the SIMO ADS plaintiffs alleged that SIMO executives knew of MaxLinear’s lack of merger integration activity and lack of intent to close the deal should China regulators approve the transaction, because the SIMO executives were in some ways involved in merger-related activities. The court disagreed, finding that there was not “a single particularized fact about any information” the executives knew or should have known during merger preparation.
The Water Island Court noted that “It is ‘unusual’ and ‘exceedingly rare’ to find the core operations inference—without any detailed allegations of actual knowledge—sufficient to clear a 12(b)(6) motion under the PSLRA….This case is especially rare in that Plaintiffs seek to establish a strong inference not of a company’s management’s knowledge of internal activity at their own company, but at another company.” For D&O underwriters considering whether Core Operations Theory allegations in a SPAC securities class action may face a similar fate, the answer is perhaps.
The Southern District of New York took a similar view in the In Re Lottery.com, Inc. Securities Case, which involved a SPAC of Lottery.com. Once the transaction had closed, it was subsequently uncovered that internal controls, cash balances, and revenue had been overstated, leading to executive departures and a stock drop. The Lottery.com Court rejected the security class action plaintiffs’ argument that the Core Operations Theory should apply to find that executives acted with scienter. Specifically, the Lottery.com Court found that it is not enough for plaintiffs to argue that defendants must have known that their statements were false or misleading just because of the magnitude of the restatement of revenue.
Conclusion
The dismissal of the Water Island case and its parallels to SPAC-related litigation, like Lucid Motors and Lottery.com, may provide important legal and strategic lessons for prospective plaintiffs and D&O underwriters evaluating securities claims in failed SPAC merger contexts. Specifically, who has standing to bring the securities case? In both the Water Island and Lucid cases, the plaintiffs were investors in a target or SPAC entity, not in the company alleged to have made the misstatements. SPAC or target company investors generally cannot bring Section 10(b) claims against the other party to a failed deal.
Also, which scienter allegations will survive a motion to dismiss a SPAC securities case? Courts, such as those deciding the Water Island and Lottery.com cases, may require particularized facts demonstrating actual knowledge or recklessness; speculative arguments that executives “must have known” due to the deal’s size or importance will not be sufficient. For D&O insurers, early identification of these two failure points, lack of standing and weak scienter allegations, may help mitigate exposure when a SPAC securities claim is made.
The views expressed on this article are exclusively those of the author, and all of the content in this article has been created solely in the author’s individual capacity. This article is not affiliated with her company, colleagues, or clients. The information contained in this site article is provided for informational purposes only, and should not be construed as legal advice on any subject matter.