Despite the frothy market for special purpose acquisition companies (SPACs) in 2021, companies considering such a transaction have been met recently with significant market headwinds, a short supply of suitable targets, the onset of a highly anticipated SEC rule and, in recent weeks, new SEC enforcement actions targeting alleged investment adviser disclosure failures involving alleged conflicts of interest. When considering these cases along with a recent Wall Street Journal article highlighting the billions of dollars that SPAC founders and insiders reaped from de-SPAC transactions before share prices of the new public companies collapsed, rough waters may still lie ahead for SPAC participants.
In this post, we provide an overview of one of the SEC's enforcement actions and additional color on the magnitude of SPAC founder share trading, while offering some key takeaways.
SPAC Basics
Although the four-letter acronym for "special-purpose acquisition company" has become a common reference in recent years, a baseline refresher is in order. A SPAC is an investment vehicle used to bring a private company public in a different manner than the traditional initial public offering (IPO). A SPAC begins as a blank-check company listed on a national securities exchange with limited operations. That entity raises money from investors through a traditional IPO. The proceeds from the IPO are to be used for a specific aim, namely acquiring a private company – generally, one that conforms with the SPAC's previously identified selection criteria – in what is commonly referred to as a "business combination." Until the business combination, a SPAC is supposed to keep IPO proceeds in an interest-bearing trust account.
A SPAC typically has 18 to 24 months to achieve a business combination or it will be dissolved and its funding is returned to investors. If a SPAC successfully identifies an acquisition target, the SPAC shareholders have the right to either approve the transaction or redeem their shares in the blank-check company "sponsor" and have their initial investment returned. Although not a requirement, the SPAC will typically raise additional funds through private investments in public equity, or "PIPEs," to ensure sufficient capital to complete the business combination. Finally, the SPAC merges with the private target entity through the "de-SPAC," after which the target is the sole remaining operating entity – and a publicly listed and traded company.
SPAC Founders and Insiders Gaining Billions
SPAC sponsors – usually experienced executives and industry leaders – often manage the SPAC from the IPO through the de-SPAC transaction. Typically, they pay a nominal amount during the IPO in exchange for 20 percent to 25 percent of the shares (and associated warrants) that will be sold to the public after the SPAC's business combination. Due to the small amount needed to obtain them – generally at a significant discount from the $10/share price paid by other investors – these "founder shares" or "promote" offer massive financial upsides for SPAC sponsors if a business combination can be achieved.
On the other side of the SPAC transaction, executives from private companies targeted by (or themselves courting partnership with) SPACs have often extracted significant financial packages from SPAC transactions. Target company executives are frequently compensated in some form of lump sum payouts, stock options, time-vested restricted stock units and/or performance-vested restricted stock units in the de-SPAC entity. Such equity payouts tend to come with lockup provisions restricting executive trading in the shares for a certain period. Subject to other restrictions under the federal securities laws, once the lockup expires, the former private company executives are generally free to trade the shares of their now-public company.
Founder shares and executive compensation payouts have garnered significant attention because, in many instances, insiders have won big despite post-combination share prices plummeting after the de-SPAC. The Wall Street Journal recently concluded that, based on insider stock sale reporting, 232 of the 460 de-SPAC entities it analyzed had company insiders who engaged in significant stock sales of their de-SPAC entities. On average, these insiders sold approximately $22 million worth of stock to the broader market during a time period when SPACs collectively lost more than $100 billion of market value.1 For example, in what the article described as an "extreme case," Trevor Milton, founder and former CEO of electric truck maker Nikola Motors, sold the shares he received in connection with the transaction for a total of $374 million following Nikola's SPAC-fueled business combination in 2021. Nikola stock is currently trading under a dollar a share after a high near $100 during the summer of 2020.
Nikola not only presents a cautionary tale for significant insider transactions, but also the heavy cost associated with failures to comply with federal securities laws. For its part, Nikola since agreed to pay the SEC a $125 million penalty to settle allegations that it defrauded investors in myriad ways. Milton, who was also sued by the SEC, now faces significant prison time after being convicted of securities and wire fraud in a parallel criminal case. Milton has appealed the conviction. The SEC's civil action against Nikola and Milton is similar to other cases (here and here) in which the Division of Enforcement targeted SPAC sponsors and de-SPAC companies and executives.
As illustrated by a recent enforcement action, the SEC continues to focus on SPACs, using its enforcement reach to charge investment advisers who participated in such transactions.
Investment Advisers Facing SEC Enforcement Wrath
Since 2022, the SEC has filed multiple enforcement actions against investment advisers in connection with alleged failures to disclose conflicts of interest regarding advisory personnel's ownership of SPAC sponsors. The SEC's recently settled order against Corvex Management LP (Corvex), an SEC-registered investment adviser, highlights the potential pitfalls for advisers.
As described in the SEC's order, Corvex served as an adviser to several pooled investment vehicles, including those that invested in SPACs. In addition to providing investment advice, the company functioned as a sponsor for three SPACs. As a result, Corvex personnel were entitled to receive a portion of the SPAC sponsor compensation.
In addition to serving as a sponsor of the SPAC, Corvex advised some of its funds to invest more than $100 million in PIPE transactions associated with the SPACs where it served as a sponsor. According to the order, "Corvex personnel had material conflicts of interest that could affect the advisory relationship between Corvex and its advisory clients, and could cause Corvex to render advice that was not disinterested." The order found that Corvex did not timely disclose these alleged conflicts of interest to the boards of the private funds it advised and did not include fulsome disclosures in its Form ADV Part 2A brochure.2 Additionally, the SEC found that Corvex did not exercise its contractual ability to create an advisory committee to opine on the transactions and did not otherwise seek consent from the independent representatives of the funds to enter into the PIPE transactions. Finally, the order found that Corvex failed to comply with Advisers Act Rule 206(4)-7, known commonly as the "compliance rule," as it did not adopt and implement policies and procedures reasonably designed to prevent disclosure violations associated with conflicts of interest.
As a result, without admitting or denying the findings in the order, Corvex agreed to settle to allegations that it willfully violated Section 206(2) of the Advisers Act for its disclosure deficiencies and Section 206(4) of the Advisers Act and Rule 206(4)-7 thereunder, for its failure to adopt and implement policies and procedures designed to prevent violations of the Adviser Act and its rules. Without admitting or denying the allegations, Corvex agreed to cease and desist from committing or causing future violations of the Advisers Act and its rules, to be censured and to pay a $1 million civil penalty.
Takeaways
SPACs remain a viable and legitimate means of taking a private company public. Nevertheless, SPAC participants are still in the crosshairs of the SEC and derivative plaintiffs alike, and the list of actors subject to suit and enforcement actions continues to grow. While SPAC sponsors typically garner the most headlines – especially given the lucrative positions insiders can hold – the SEC is not shying away from scrutinizing those more removed from a SPAC's operations.
It is paramount that investment advisers, as well as sponsors, target companies and other gatekeepers, understand potential pitfalls and take steps to make certain that they are operating transparently and in compliance with securities laws. Specifically, investment advisers should ensure: 1) investors are fully apprised of the function of the promote and the potential incentives for insiders, including the advisers themselves; 2) they adopt, implement and follow clear and concise policies and procedures on disclosing conflicts of interest and other relevant topics (compliance audits probably wouldn't hurt in this regard, either); 3) Form ADV Part 2A brochures are up to date and disclose all material conflicts of interest accurately; and 4) independent committees are at least considered and, where appropriate, established and consulted prior to recommending investment in or otherwise engaging in a SPAC transaction – especially when an adviser has multiple roles in a business combination.
The Holland & Knight SECond Opinions Blog will continue to monitor SPAC developments and provide updates.
Notes
1 Additionally, as reported in the Wall Street Journal, of the companies that went public through a de-SPAC, 12 have filed for bankruptcy and more than 100 others are in financial peril due to high interest rates and rising costs.
2 Under SEC rules, registered investment advisers are required to provide certain full and truthful disclosures to current and prospective clients in their firm brochure as part of Form ADV Part 2A, including any material conflicts of interest between the adviser and its clients that could affect the advisory relationship.
