Over the past several months, the Securities and Exchange Commission (SEC) has increasingly focused on special purpose acquisition companies (SPACs), issuing a series of investor alerts, disclosure guidance, and public statements alerting the public and market participants to potential issues in SPAC transactions. The SEC’s Enforcement Division also has weighed in, launching several SPAC-related investigations.
The SEC’s attention to SPACs is not surprising given the explosion in SPAC initial public offerings (IPOs) in 2020 and the first quarter of 2021. In 2020, there were 248 SPAC IPOs, which raised a total of $83.4 billion. In just the first three months of 2021, there were over 300 SPAC IPOs, which raised nearly $100 billion. To put these numbers in perspective, there were just 59 SPAC IPOs in 2019, with $13.6 billion raised.
The SEC’s recent actions demonstrate that the agency is ramping up regulatory scrutiny of SPAC transactions. Those involved in SPACs should pay close attention to the areas of concern identified by the SEC.
A SPAC is a blank check company with no operations, formed by a management team, or sponsor, which receives securities at formation commonly known as “founder shares.” The SPAC shortly thereafter undergoes an IPO to raise additional capital, with the intention of later acquiring or combining with an operating company that will then be listed on an exchange in the US. In the IPO, the SPAC issues securities, often units consisting of a share of common stock and a fraction of a warrant, which are listed on an exchange and publicly traded. In addition, the sponsor purchases additional securities, known as the “risk capital,” with an amount of cash sufficient to cover the offering expenses and working capital of the SPAC, which is typically an amount equal to 3-4 percent of the IPO proceeds. The SPAC then deposits an amount equal to the IPO proceeds into a trust account from which the holders of the shares of common stock sold to the public in the IPO (but not the founder shares) can redeem their shares in certain circumstances.
The SPAC has a specified period (generally 18-24 months) to identify a target company and complete a business combination. If a combination occurs (called a de-SPAC transaction), the combined company is a publicly traded company and carries on the target operating company’s business.
The circumstances in which the SPAC’s public stockholders are entitled redeem their shares and receive their pro rata share of the aggregate amount then on deposit in the trust account are: (a) if the SPAC does not complete a business combination within the specified period of time; (b) if the SPAC seeks permission for a longer period of time to complete a business combination or otherwise proposes to make certain types of amendments to its charter; and most importantly and somewhat surprisingly, (c) if the SPAC completes a business combination (ie, even if a SPAC is successful, the public stockholders can take their money back, and they can do so even if they vote for the business combination).
Thus, public stockholders in the SPAC have the right to redeem their shares and receive a pro rata share of the funds held in trust or remain a stockholder in the combined company. If a business combination does not occur, the sponsor loses its risk capital, as that money has been spent by the SPAC as offering expenses and working capital and the founder shares are not allowed to participate in the redemption from the trust account.
The SEC begins to weigh in: December 2020-March 2021 investor alerts and disclosure guidance
At the end of a record year for SPACs in 2020, the SEC began to act. The agency first issued an Investor Bulletin related to SPACs on December 10, 2020 (December Bulletin). The December Bulletin provided investors with a basic overview of SPACs and how a de-SPAC transaction works.
Importantly, however, the December Bulletin previewed certain themes to which the SEC would return in later statements and that appear to be driving some of the SEC’s concerns regarding SPACs. These themes included:
- Whether the terms of the SPAC investment are adequately disclosed, including equity interests held by the sponsor, the business background of the sponsors and SPAC management team, how SPAC IPO proceeds will be invested, and the terms of any warrants offered in the transaction
- Whether there are more SPACs than there are attractive merger targets in light of the rapid growth of SPAC IPOs
- Potential conflicts of interest between the sponsors and public stockholders.
Less than two weeks later, the SEC’s Division of Corporation Finance reiterated some of those themes in Special Purpose Acquisition Companies, CF Disclosure Guidance, Topic No. 11 (December Disclosure Guidance). The December Disclosure Guidance highlighted key disclosure concerns for both the IPO and the de-SPAC transaction. Regarding the SPAC IPO, the Division highlighted the need for disclosure of:
- Conflicts of interest, including (i) conflicts relating to other business activities of the sponsors, directors and officers of the SPAC, (ii) conflicts related to the pursuit of a target in which the sponsors, directors or officers have an interest, (iii) the process by which the SPAC will address potential conflicts of interest, and (iv) conflicts arising from the securities ownership and compensation arrangements of sponsors, directors and officers
- Business combination decisions, including (i) the financial incentives of SPAC sponsors, directors, and officers to complete a business transaction, (ii) the impact on the sponsors, directors, and officers of failing to close a transaction and how that might result in a divergence of interest from that of public stockholders, (iii) sponsor, director, and officer control over the decision to pursue a combination and whether it includes the ability to amend provisions in the SPAC’s governing provisions without stockholder consent or the ability to extend the time to complete a transaction, and (iv) the prior experience of the sponsors, directors, officers and their affiliates
- Financing, including (i) the terms of PIPE (private investment in public equity) and other financing arrangements used to raise additional capital, and (ii) how those arrangements might impact stockholder interests
- Underwriter compensation arrangements.
Regarding de-SPAC transactions, the Division highlighted the need for disclosure of:
- Additional financing, including (i) its impact on public stockholders; (ii) the terms of any additional securities issued in the financing and how they compare to the price and terms of the securities sold in the IPO, and (iii) sponsor, director, officer, or affiliate participation in the additional financing
- Newly issued convertible securities including (i) their terms and (ii) their impact on the beneficial ownership of the combined company
- The process for evaluating and deciding to propose the transaction, including (i) what factors the board considered and how it evaluated the interests of sponsors, directors, officers, and affiliates, (ii) a description of and consideration of conflicts of interest, and (iii) how sponsors, directors, officers or affiliates will benefit from the transaction and how much of the combined company they will own
- Underwriter compensation and services, including (i) fees contingent upon completion of the transaction, (ii) a description of additional services and fees, and (iii) underwriter conflicts of interest.
As SPAC transactions continued to explode in 2021, the SEC issued an investor alert in March focused on SPAC promotion efforts, Celebrity Involvement with SPACs (March Investor Alert). The March Investor Alert cautioned investors against making investment decisions solely on the basis of endorsements. This concern is not new. The SEC issued a similar alert related to Initial Coin Offerings (ICOs) in November 2017. But, in this Investor Alert, the SEC again emphasized that, “sponsors may have conflicts of interest so their economic interests in the SPAC may differ from shareholders.” (Emphasis in original.)
The SEC focuses on target company readiness: March 31, 2021 staff statements
On March 31, 2021, the SEC issued two statements expressing concern that, given the accelerated timeline on which private operating companies can become public through de-SPAC transactions, those companies may not have engaged in the advanced planning and investment in resources necessary to meet their obligations as a public company. The Division of Corporation Finance’s Staff Statement on Select Issues Pertaining to Special Purpose Acquisition Companies served as a reminder that, although the target company does not go through the traditional IPO process, it nonetheless must be prepared to meet the “books and records” and “internal controls” provisions of the Securities Exchange Act of 1934 (Exchange Act), the minimum listing standards of the national securities exchanges, and the qualitative standards regarding corporate governance at the time of the de-SPAC transaction. The Division observed that “[t]here is a risk that a private operating company that has not prepared for an initial public offering and is quickly acquired by a SPAC may not have these elements in place.”
The statement by Acting Chief Accountant Paul Munter, Financial Reporting and Auditing Considerations of Companies Merging with SPACs, similarly emphasized the need for target companies to have the plans, people, processes, and technology in place to meet their financial reporting, internal controls, and other public company obligations post-merger. Munter cautioned companies, their auditors, audit committee members, and other stakeholders to give “careful consideration of whether the target company has a clear, comprehensive plan to be prepared to be a public company.”
The SEC issues new warnings: April 2021 statements on forward looking statements and accounting for warrants
The SEC’s actions and statements between December 2020 and the end of March 2021 showed that the SEC was paying close attention to SPACs but addressed issues that could be anticipated. It is not unusual for the SEC to caution the public regarding potential risks related to newly popular investments. And the SEC has long focused on conflicts of interest, disclosure issues, internal controls, and issues surrounding public company readiness.
Statements issued on April 8 by John Coates, Acting Director of the Division of Corporate Finance and April 12, 2021, by Coates and Paul Munter, raised new issues, however.
Forward looking statements. Coates’s April 8 statement, SPACs, IPOs and Liability Risk under the Securities Laws, challenged views held by some practitioners and commentators that an advantage of a de-SPAC transaction over traditional IPOs “is lesser securities law liability exposure for targets and the public company itself.” In Coates’s view, the liability risks for those involved in de-SPAC transactions may be higher than in conventional IPOs, “due in particular to the potential conflicts of interest in the SPAC structure.” In addition to potential liability under the securities laws for material misstatements and omissions, de-SPAC transactions also may give rise to liability under state law, which may impose more stringent requirements in conflict of interest settings.
Coates also addressed liability considerations regarding projections and other valuation materials often included in SEC filings made in connection with de-SPAC transactions but not commonly found in conventional IPO prospectuses. Coates first reminded practitioners of the limits of the PSLRA safe harbor for forward looking statements, including:
- The PSLRA does not apply in enforcement actions by the SEC.
- The safe harbor does not protect against false or misleading statements made with actual knowledge that the statement was false or misleading. According to Coates, “A company in possession of multiple sets of projections that are based on reasonable assumptions, reflecting different scenarios of how the company’s future may unfold, would be on shaky ground if it only disclosed favorable projections and omitted disclosure of equally reliable but unfavorable projections …” (emphasis added).
- Statements about current valuation or operations may fall outside of the safe harbor, even if they are derived from or linked to forward-looking projections or statements.
- The safe harbor is not available unless forward-looking statements are accompanied by “meaningful cautionary statements.”
Second, and more significantly, Coates cautioned practitioners and market participants about assuming the safe harbor applies to forward-looking statements made in the context of de-SPAC transactions. The PSLRA safe harbor contains an exclusion for statements made in connection with an “initial public offering.” According to Coates, many market participants believe that de-SPAC transactions are not “initial public offerings,” and therefore do not fall within the exclusion. Coates noted that the term “initial public offering” is not defined in the statute and stated that he is “unaware of any relevant case law on the application of the ‘IPO’ exclusion.” Coates observed, however, that the “legislative history includes statements that the safe harbor was meant for ‘seasoned issuers’ with an ‘established track-record.’”
Coates went on to discuss the “economic substance” of a de-SPAC transaction. Although a de-SPAC transaction is not an IPO by the SPAC, Coates pointed out that it is “commonly understood” that the de-SPAC transaction is the transaction by which the target company itself “goes public”—that is, engages in its initial public offering. Moreover, in many cases, the de-SPAC transaction is “the first time that public investors see the business and financial information about a company.” Coates, expressing his personal policy views and without pointing to any case law, then opined:
If these facts about economic and information substance drive our understanding of what an ‘IPO’ is, they point toward a conclusion that the PSLRA safe harbor should not be available for any unknown private company introducing itself to the public markets. Such a conclusion should hold regardless of what structure or method is used to do so. The reason is simple: the public knows nothing about this private company. Appropriate liability should attach to whatever claims it is making, or others are making on its behalf.
Coates suggested, again without any reference to case law, that “any alleged liability difference between SPACs and conventional IPOs” is “uncertain at best.”
Coates’s concerns regarding the information asymmetries between private companies and investors in connection with de-SPAC transactions may be driven in part by investigations and enforcement actions in which questions were raised regarding the target company’s operations and prospects very shortly after the company went public. For example, in June 2019, the SEC brought an enforcement action against Ability, Inc., its Chief Executive Officer, and its Chief Technology Officer, alleging that the defendants painted a “rosy but false picture of Ability’s existing business and projected future revenues” in order to convince SPAC shareholders to vote in favor of the proposed merger. Similarly, in September 2020, the SEC brought an enforcement action against Akazoo SA alleging that it made a number of false statements to investors regarding its finances, operations, and subscriber base in connection with its SPAC merger.
Press reports indicate that the SEC’s Division of Enforcement has contacted various investment banks seeking voluntary information related to SPAC transactions on topics such as deal fees, volume, compliance, reporting and internal controls. And the SEC’s Division of Enforcement is currently investigating at least three other companies that recently went public through de-SPAC transactions. Each of these investigations was commenced shortly after the de-SPAC transaction closed and each appears to have been prompted by short seller reports asserting that the company made false and misleading statements leading up to its SPAC merger.
Accounting for warrants. The April 12 statement, Staff Statement on Accounting and Reporting Considerations for Warrants Issued by Special Purpose Acquisition Companies, concerned accounting and reporting for warrants issued by SPACs. According to Coates and Munter, there are “certain features of warrants issued in SPAC transactions [that] may be common across many entities” and that may require the warrants to be classified as a liability under Generally Accepted Accounting Principles (GAAP), rather than as equity.
The statement discussed two fact patterns involving warrants issued by a SPAC that were recently evaluated by the SEC Office of the Chief Accountant (OCA). According to the Staff Statement, the first fact pattern purportedly involved warrants that provided for potential changes to the settlement amounts depending on characteristics of the holder of the warrant. The second fact pattern purportedly involved warrants with a tender offer provision that provided that all warrant holders would receive cash in the event of a successful cash tender offer while only certain common stockholders might be entitled to receive cash. In both scenarios, OCA concluded that the warrants at issue should be classified as a liability measured at fair value with changes in fair value each period reported in earnings.
In discussing these scenarios, Coates cautioned that accounting for warrants “requires careful consideration of the specific facts and circumstances for each entity and each contract,” suggesting there may be other fact patterns that would require warrants to be classified as liabilities rather than equity under GAAP. Coates also advised SPACs and their independent auditors to evaluate whether restatements of previously issued financial statements may be necessary to correct material errors after consideration of his April 12 statement.
- SPAC sponsors, management, underwriters and accountants should pay careful attention to the sufficiency of disclosures surrounding conflicts of interest, the terms of a proposed de-SPAC transaction, and the process that led to the recommendation of that specific transaction and the financial incentives related to the de-SPAC transaction.
- The SEC is likely to closely scrutinize statements regarding target company operations and projections in connection with de-SPAC transactions – and compare pre-transaction statements to post-transaction performance.
- SPAC sponsors and targets should exercise caution when including projections, forecasts and future plans in their filings. These disclosures should have a reasonable basis that is capable of documentation. SPAC sponsors and targets should work closely with counsel to ensure that any forward-looking statements are defensible and accompanied by adequate risk disclosures. Private plaintiffs may begin to challenge whether forward-looking statements made in connection with de-SPAC transactions can fall within the PSLRA safe harbor.
- SPAC sponsors, directors and officers should work with a target company to help it become public-ready with appropriate internal controls and governance structures.
- Warrants offered or to be offered in connection with any SPAC or de-SPAC transaction should be evaluated carefully under GAAP to determine the appropriate classification and whether any financial statement restatement is necessary.
We anticipate that the SEC’s focus on SPACs will continue unabated. The agency’s rapidly growing body of investor alerts, guidance, and public statements suggests that the SEC views SPACs and de-SPAC transactions as posing risks to retail investors and that it has concerns about whether market participants are sufficiently addressing those risks. SPAC sponsors, management, underwriters and accountants should review the SEC’s statements and guidance carefully and work with counsel to understand their implications. These pronouncements offer a road map to the agency’s areas of concern and potential enforcement risks.
If you have any questions, please contact one of the authors or your DLA Piper relationship partner.