On April 12, 2021, the U.S. Securities and Exchange Commission (SEC) published a joint statement by John Coates, Acting Director of the Division of Corporation Finance, and Paul Munter, Acting Chief Accountant, which provides their view on the accounting treatment of warrants issued by special purpose acquisition companies (SPACs). This statement, titled Staff Statement on Accounting and Reporting Considerations for Warrants Issued by Special Purpose Acquisition Companies (SPACs),1 suggests that the SEC staff has concerns that the warrants issued by many SPACs should be properly accounted for under the liability method on the balance sheet. As such, the staff advises that companies with these outstanding warrants (whether SPACs or the combined company following a de-SPAC transaction) consider the need to amend previously-filed audited and unaudited financial statements.
Warrants are common features in SPAC transactions, with SPACs typically selling warrants to their sponsors to help fund their initial costs, and also selling units comprised of shares and warrants at the IPO. These latter warrants are presented as an added benefit for the initial SPAC investors, who may be required to wait as many as 18 to 24 months for the SPAC to enter into a business combination with an operating company. Historically, many SPACs, with the support of several accounting firms, have classified the warrants as part of equity of the entity. However, citing U.S. Generally Accepted Accounting Principles (GAAP), Acting Director Coates and Acting Chief Accountant Munter indicate that warrants with certain features that are common in SPACs should probably more rightly be classified as a liability. Classifying these warrants as liabilities may have a broader impact on the financial statements than the balance sheet, including non-cash impacts to the statement of operations on a period to period basis that may result from a change in warrant classification.
Relevant Factors Leading to Liability Treatment
The two fact patterns included in the statement, which resulted in the staff of the Office of the Chief Accountant (OCA) concluding that the warrants in question should be classified as liabilities were the following:
- Indexation and variability of settlement provisions based on holder of warrant. In the first fact pattern, the terms of the warrants provided that the warrant settlement amount could vary depending "upon the characteristics of the holder of the warrant." While noting that there are certain variables that would not preclude classification of warrants as equity, the statement observed that, based on GAAP, "the holder of the instrument is not an input into the pricing of a fixed-for-fixed option on equity shares," and thus, the warrants in this fact pattern could not be indexed to the entity's stock. Consequently, the staff concluded that "the warrants should be classified as a liability measured at fair value, with changes in fair value each period reported in earnings."
- Tender offer provisions. In the second fact pattern, the terms of the warrants provided that "in the event of a tender or exchange offer made to and accepted by holders of more than 50% of the outstanding shares of a single class of common stock, all holders of the warrants would be entitled to receive cash for their warrants." According to the statement, GAAP generally provides "that if an event that is not within the entity's control could require net cash settlement, then the contract should be classified as an asset or a liability rather than as equity." There is an exception to this general rule whereby GAAP might allow classification of the warrants as equity in circumstances where there is a fundamental change of ownership of the entity "if net cash settlement can only be triggered in circumstances in which the holders of the shares underlying the contract also would receive cash." However, the staff concluded, in this fact pattern, that 1) the tender offer is an event not within the entity's control and 2) only warrant holders would be entitled to cash, and not necessarily holders of the underlying shares, and thus these warrants should "be classified as a liability measured at fair value, with changes in fair value reported each period in earnings."
How to Address Prior Errors
If there were errors in the classification of warrants in previously-filed financial statements, the staff urges the registrant to assess the materiality of such errors on its financial statements in order to determine whether it should restate previously-filed financial statements. If material, the staff also reminds issuers to consider the need to file a Form 8-K filing under Item 4.02, Non-Reliance on Previously Issued Financial Statements or a Related Audit Report or Completed Interim Review. The statement reminds registrants that these accounting errors "may affect several fiscal quarters and years of a registrant's previously-filed reports[,]" and advises that the registrant can correct these accounting errors by amending their annual report on Form 10-K and any subsequently filed quarterly reports on Form 10-Q, and including in such filings: 1) restated financial statements and footnote disclosures; 2) restated quarterly financial information under Item 302 of Regulation S-K; and 3) revisions to information provided in Management's Discussion and Analysis of Financial Condition and Results of Operations under Item 303 of Regulation S-K.
In addition to any restatement that may be required, the statement also advises registrants to assess prior disclosures relating to internal control over financial reporting (ICFR) and disclosure controls and procedures (DCP), and whether prior disclosures relating to ICFR and DCP need to be modified in the amended filings. Of note, the statement says that "[t]he evaluation of the severity of any control deficiency should not be limited to the actual misstatement that occurred or whether that misstatement was material, but instead should consider the magnitude of the potential misstatement resulting from the deficiency or deficiencies, amongst other considerations."
For those registrants that determine that there were accounting errors in the classification of previously issued warrants, but conclude that these accounting errors were not material, the statement advises that in order to facilitate the Division of Corporation Finance's processing of pending filings, the registrant may provide the SEC staff with a written representation to that effect in correspondence on EDGAR. In addition, the statement provides a reminder about the obligations of Regulation FD not to selectively disclose material nonpublic information.
What to Do Now?
SPACs, targets in pending de-SPAC transactions, or the combined companies following de-SPAC transactions, should review carefully the terms of any outstanding warrants, including those issued in connection with the formation of the SPAC and at the initial public offering of the SPAC. Management, in consultation with counsel and the independent auditors, should review the warrant agreements in their entirety in order to determine whether the warrants trigger liability accounting. This review and determination should be documented, as the company's independent auditors may well require supporting documentation for any determination of the classification of such warrants.
If the warrants were previously classified as equity but should have been accounted for as debt, then companies should work in close coordination with counsel and their independent auditors in order to determine what periods may require fair value determinations, and whether those determinations will need to be performed by valuation specialists. In addition, companies should also undertake a SAB 99 materiality analysis to determine whether the accounting errors were material and, if so, whether a restatement of previously-filed financial statements will be necessary, which would require a Form 8-K filing under Item 4.02 as well as amendments to previously-filed Form 10-K and Form 10-Q filings, or whether only a revision will be necessary, which would require error corrections to be included in the next filed Form 10-K or Form 10-Q.
Regardless of whether a restatement is required, companies should also re-evaluate their obligation to maintain ICFR and DCP, as well as whether there were any deficiencies in their existing controls procedures and processes that may need to be disclosed and whether and to what extent improvements to ICFR and DCP should be implemented.
The potential for restatements is likely to impact the SPAC market in a number of ways.
First, for pending deals, the staff has indicated that they will not allow registration statements to go effective if the accounting is not considered correct and, if a restatement is needed, until the restatement is complete. As such, this may necessarily cause delays in completion of pending de-SPAC transactions. While the restatement may be fairly easily accounted for once the proper accounting treatment is determined, the process of review by the SPAC's accounting firm along with its risk management review of a restatement and any necessary interaction with the SEC staff will likely mean these restatements could take weeks to complete, particularly when many are in the process at the same time.
Second, for completed deals, the combined company may need to delay periodic filings while it evaluates these issues and completes a restatement, if required. Any delay in such filings or suspension of existing registration statements could affect the liquidity of securities held by PIPE investors, employees, and others.
Third, the near-term risk of delays in execution of de-SPAC transactions or suspension of resale registration statements as a result of a restatement may impact the appetite of investors in the PIPE market or spur them to seek contractual remedies. Despite the fact that the impact of any change is non-cash as an accounting matter, SPACs and their targets should consider whether to proactively disclose potential warrant liability accounting at the PIPE marketing stage to attempt to address investor concerns early.
Fourth, SPAC targets should consider the risk of delay and assuming potential combined liability risk for prior statements in a SPAC IPO related to warrant accounting. While the non-cash nature of impact of the warrant accounting ought not be meaningful to investors, the prospect of restated financials could prove to be an appealing target for class-action claims. Target companies should consider the risk of combining their balance sheet with a SPAC that may be at greater risk with respect to any such claim.
 The Acting Director’s and Acting Chief Accountant’s statement can be found here: https://www.sec.gov/news/public-statement/accounting-reporting-warrants-issued-spacs (last accessed on April 13, 2021).