SPACs are often called “blank check companies” because the SPAC itself has no corporate purpose other than to acquire or merge with a private company.
Special purpose acquisition companies, or SPACs, have quickly become a part of the Wall Street vernacular, but until recently, they were rare. In fact, the New York Stock Exchange went 10 years without listing a SPAC until 2017. The last year, however, saw a dramatic rise in their use, both in number and in profile. In 2020 alone, 248 public offerings occurred by way of a SPAC, representing 77 percent of all initial public offerings (IPOs) during that year. They raised more than $82 billion in capital in 2020—more than the last 10 years combined—and were responsible for taking many high-profile companies public.
Although the market seems to have embraced SPACs, regulatory authorities, including the U.S. Securities and Exchange Commission (SEC), have expressed concern that these investment vehicles may present certain risks for investors. In fact, the SEC has taken note of this market sensation and has issued several public statements about SPACs and the potential violations of securities laws that may occur during the life of a SPAC. Even before his confirmation, SEC Chair Gary Gensler stated his desire for heightened scrutiny of SPAC activity. Thus, we expect regulators to intensify their scrutiny and bring enforcement actions on this front. In this Alert, we discuss what those enforcement risks may be and what we can expect from regulators in the coming months.
The ABCs of SPACs: What They Are and How They Work
SPACs are often called “blank check companies” because the SPAC itself has no corporate purpose other than to acquire or merge with a private company. In the last few years, they have become the preferred alternative to traditional IPOs. Put simply, SPACs are easier, faster and more cost-effective. While traditional IPOs offer greater market exposure, access to capital and prestige, they are costly and very time consuming. There are significantly more regulatory hurdles involved with an IPO and it can take up to three years for a deal to close. SPACs, on the other hand, are generally required to enter into a transaction within 24 months, and more importantly, there are fewer regulatory obstacles.
Conceptually—and in practice—SPACs offer a more streamlined path for private companies to access the public markets. Rather than invest in a private company through a traditional IPO, investors essentially pool their money in a shell corporation that is already listed on an exchange with registered and redeemable securities called “units.” The entity or management team that forms the SPAC and is responsible for finding a target company is called the “sponsor.” The units sold are made up of one share of common stock and a fraction of a “warrant” to purchase a share of common stock in the future. Finally, in what is called the “de-SPAC transaction,” investors are presented with a redemption offer and can either sell their units on the secondary market or have their shares redeemed before or shortly after the transaction. The advantage of this approach is that the target company is listed on an exchange and receives an immediate influx of capital in record time without all the paperwork involved in a standard IPO.
So What’s the Catch? Enforcement Risks and Pitfalls
Superficially, the SPAC model looks like the penny stock market, in that they both have been characterized as “blank check companies.” Penny stocks, of course, fell out of favor as early as the 1980s due to their association with “pump and dump” market manipulation schemes. But the securities laws and listing requirements applicable to SPACs have changed considerably since then. Among other things, SPACs are typically required to place cash raised through an initial offering in a trust, which is unavailable to the SPAC’s management until the day an acquisition is made. Until that time, the cash is placed in low-risk government securities or money market funds that invest only in government securities. Plus, a SPAC is on a short clock—they are generally required to make an acquisition within 24 months. Notwithstanding these reforms, SPACs are still vulnerable to a variety of risks. In its April 8, 2021, statement, the acting director of the SEC’s Division of Corporation Finance identified these concerns to be risks associated with fees, conflicts, sponsor compensation, celebrity sponsorship and the potential for retail participation drawn by baseless hype. Each of these risks, described further below, is present to some degree in the two stages of the SPAC model: the initial offering stage and the de-SPAC stage.
Enforcement Risks at the Offering Stage
One of the first targets for SEC scrutiny will be whether a SPAC has adequate disclosures at the fundraising and initial offering stage. On the one hand, when it comes to disclosures, the SEC has emphasized that investors need to know about the sponsors and their financial arrangements, the downside protections in the SPAC structure and what kinds of returns the SPAC is likely to generate for investors in the event the SPAC fails to secure a target company or for those who choose to exit before the de-SPAC is completed. On the other hand, the SEC recognizes that it can be difficult in the initial SPAC filing to define the long-term value proposition of the offering, precisely because, at its inception, a SPAC does not have operations or a business plan beyond searching for a target.
Mindful of this balancing act, the SEC in its December 2020 guidance laid out in great detail what sponsors ought to consider in their initial disclosures. This guidance is a useful indicator of the SEC’s enforcement priorities going forward, and we can expect the SEC to evaluate the sufficiency of disclosures at the offering stage for the following:
- The facts and circumstances informing the decision to pursue the target company;
- The extent of any conflicts of interest of the sponsors, directors, officers and their affiliates in presenting the target company to the SPAC and how the SPAC addressed these conflicts of interest;
- The sponsor compensation scheme and whether enough information has been provided as to how the sponsors, directors, officers or their affiliates will benefit from the transaction, including the return on their initial investment and any continuing relationship they will have with the combined company;
- The differences between the public shares and the sponsor shares, the material terms for conversion of sponsor shares and the potential dilutive impact on public shares; and
- The expectation, if any, of seeking additional funding and how the terms of units issued or to be issued in private offerings compare to the terms of units offered in the IPO.
The initial offering stage also invites heightened scrutiny for insider trading. Sponsors are uniquely susceptible because there is a risk of trading in the SPAC’s securities after the target company is confirmed, but before it is announced or the de-SPAC transaction is affected. The risk is particularly acute because, unlike a traditional IPO, the sponsors have a hand in determining the value of the target company and what the SPAC will pay. We can expect the SEC to scrutinize SPAC offering documents for adequate disclosures, but they will also be closely examining the trading activity during this initial offering stage. We can also expect that the SEC will coordinate its investigations of trading activity with the Department of Justice and the FBI. Sponsors should consider adopting compliance policies that address trading by insiders and the confidentiality of nonpublic information.
Enforcement Risks at the De-SPAC Stage
Once a target company has been identified and the SPAC approaches the transaction stage, there are a number of other risks for SEC enforcement. One of those risks concerns the sponsor’s projections and forward-looking statements. The SEC has explained that 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. For that reason, the SEC has asserted that any claim about reduced liability exposure for SPAC participants under the safe harbor provisions of the Private Securities Litigation Reform Act is overstated at best and potentially seriously misleading at worst.
The SEC—through its Division of Corporation Finance and Office of the Chief Accountant—has warned that where these projections and forward-looking statements miss the mark, liability can attach. Further, the SEC has stressed that the newly combined public company is under a duty to ensure accurate financial reporting and maintain proper internal controls. Thus, we can expect the SEC to focus its enforcement actions on de-SPAC companies that fail to satisfy filing and disclosure requirements and deadlines or that fail to comply with the accounting standards expected of a publicly traded company. Indeed, we are already starting to see the chilling effect of the SEC’s scrutiny on this front. In March 2021, there were a record 109 new SPAC deals. But since the issuance of the SEC’s statement about the accounting treatment of SPAC warrants, SPAC activity has come to an abrupt halt with only 10 new deals since the beginning of April.
The volume of public statements and guidance from the SEC on this topic suggests that SPACs are high on the enforcement priority list. There are a number of potential enforcement pitfalls involved with the SPAC method of taking a company public, and we expect the SEC will bring enforcement actions against entities that run afoul of the securities laws either at the offering stage or in the de-SPAC stage. One of the casualties of increased regulatory attention may be that this avenue for capital formation is not fully utilized. We think that this would be unfortunate because SPACs provide advantages both for companies seeking access to public markets and for investors. But, as with any market trend that has invited the attention of regulators, participants in the SPAC space should continue to exercise care and due diligence in satisfying the expectations and following the guidance the SEC has released.
For More Information
If you have any questions about this Alert, please contact Mary P. Hansen, Michael J. Rinaldi, Jovy Dedaj, any of the attorneys in our Trial Practice Group, any of the attorneys in our White-Collar Criminal Defense, Corporate Investigations and Regulatory Compliance Group or the attorney in the firm with whom you are regularly in contact.
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