The SEC’s 2020 statements and guidance were relatively relaxed—the Commission focused largely on disclosure issues, including a statement from then-Chairman Jay Clayton to ensure that retail investors understand the incentives of SPAC sponsors, along with remarks by SEC officials during the 2020 SEC Speaks conference concerning risks created by potentially divergent incentives between sponsors and investors. But the SEC’s actions and rhetoric this month and last month have become more pointed, making clear that SPACs are becoming an enforcement priority. In response, new SPAC issues have slowed, and many deals remain on pause as the market digests what may be a new oversight regime. Whether the SEC’s approach cools down the SPAC market permanently remains to be seen; what is clear, however, is that SPAC participants should expect enhanced regulatory scrutiny.

The SEC’s attention follows an explosive first quarter of 2021 for SPACs. In all of 2020, itself a record year, there were 248 SPAC IPOs; by contrast, the first quarter of 2021 saw nearly 300 SPAC IPOs. While the rate of SPAC IPOs recently has declined, many expect the SPAC wave to roll on in some form. Leaving aside the new administration and new SEC personnel, including new Chairman Gary Gensler (confirmed April 14), the SEC likely also is being influenced by the rate and sheer dollar volume of SPAC transactions, which have raised concerns about disclosures, diligence, and overall risk associated with SPACs. As noted by outgoing Acting Chair Allison Herren Lee, “We have seen more and more evidence on the risk side of the equation for SPACs as we see studies showing that their performance for most investors doesn’t match the hype.”

Most practitioners agree that incoming Chairman Gary Gensler will continue the SEC’s upward trajectory of aggressively reviewing SPACs. Chairman Gensler already has indicated that the SEC’s enforcement agenda will include a focus on SPACs—thus, it is prudent to plan for an uptick in SPAC-related enforcement actions. That Chairman Gensler singled out SPACs in his initial comments about the SEC’s future enforcement agenda reveals both the political pressure on Chairman Gensler and, perhaps, his belief that there may be problems with the current iterations of SPACs.

While not statements from the new Chairman himself, two pronouncements from the SEC staff in the past 10 days show heightened concerns and perhaps a desire to dampen what in another era might have been called irrational exuberance.

Acting Director of Division of Corporation Finance Questions Safe Harbor for Forecasts

On April 8, John Coates, the Acting Director of the Division of Corporation Finance, issued a statement entitled “SPACs, IPOs, and Liability Risk under the Securities Laws.” Coates called into question whether the Private Securities Litigation Reform Act’s (PSLRA) safe harbor provision for forward-looking statements applies to de-SPAC mergers. Coates suggested that the economic substance of a de-SPAC merger, which according to Coates is more like a traditional IPO than a traditional corporate merger, points “towards a conclusion that the PSLRA should not be available for any unknown private company introducing itself to the public markets.”

In so doing, Coates cited Pillsbury’s earlier article, in which we discussed how financial projections in a SPAC-related proxy statement or registration statement distinguish SPACs, and their attendant litigation risks, from traditional IPOs. We noted that such projections are generally protected by the safe harbor for forward-looking statements afforded by the PSLRA, whereas projections made in connection with traditional IPOs are not. Thus, we concluded, when compared to a traditional IPO, a SPAC acquisition presents the opportunity for an operating company to speak more directly to the market about its financial prospects.

Coates agrees that proxy statements and registration statements issued for a de-SPAC merger almost always include projections, whereas registration statements for a traditional IPO almost never do. Coates explains—but questions—the legal justification for this difference: a de-SPAC transaction is structured as a merger and virtually all merger transactions include extensive disclosure of projections, underlying the fairness analysis that is expected by and generally mandated by state law. In contrast, the PSLRA’s safe harbor rules, dating from 1995, specifically exclude IPOs from the safe harbor, and state law does not mandate the same fairness analysis required for mergers. Hence, projections are almost never included in IPO prospectuses.

While Coates’ speech includes the usual boilerplate disclaimer that it represents only his views and not necessarily the views of the Commission itself, his remarks suggest that the SEC staff has concluded that a de-SPAC transaction might better fit within the definition of an IPO, and therefore be outside the safe harbor for projections. He says, “the PSLRA excludes from its safe harbor ‘initial public offerings,’ and that phrase may include de-SPAC transactions. That possibility further calls into question any sweeping claims about liability risk being more favorable for SPACs than for conventional IPOs.” Coates also cautions, “If we do not treat the de-SPAC transaction as the ‘real IPO,’ our attention may be focused on the wrong place, and potentially problematic forward-looking information may be disseminated without appropriate safeguards.” Coates acknowledges that the inclusion of the projections that served as the basis for a board’s approval of a transaction are generally viewed as required under Delaware law—which would create a difficult choice for boards if his interpretation of the PSLRA is correct because boards would face potential exposure in all de-SPAC transactions for either including or excluding such projections.

Coates’ statement underscores the Commission’s interest in what it might perceive as SPAC-related misconduct. It seems likely that the SEC staff will be looking for the opportunity to find a deal to target for enforcement actions if they see any potential violations. While Coates’ interpretation of the PSLRA may or may not prove to be correct, his comments highlight the distinction between the protections the safe-harbor provision may provide against private litigation as opposed to SEC enforcement actions, and his statement may tempt the shareholder plaintiffs’ bar to test whether the safe harbor applies to de-SPAC transactions. At bottom, Acting Director Coates’ comments further underscore why SPACs and their targets should ensure that their proxy statements include forecasts that are defensible and reasonably tailored. Specifically, SPACs should consider whether to disclose key assumptions underlying forecasts and any alternative forecasts that were considered (particularly if they reflect significant downside risk). Disclosures should also identify the basis for the forecast and highlight any relevant risk factors or uncertainty that might affect the validity of the forecasts being presented.

Accounting for Warrants: Equity or Liabilities?

On April 12, the Division of Corporation Finance and the Office of the Chief Accountant issued a statement regarding accounting for warrants issued by SPACs. In that statement—which almost immediately created controversy, if not consternation—Acting Director Coates and Acting Chief Accountant Paul Munter asserted that some warrants should be classified as liabilities—rather than equity or an asset—because the warrants were not indexed to the issuer’s stock. They also opined that a tender offer provision, included as a term of a warrant issued by many SPACs, required those warrants to be treated as liabilities. Although the statement was issued in the context of the staff’s review of the accounting treatment for warrants by two specific SPACs, it included a general caution that “warrants issued by a SPAC … require careful consideration of the specific facts and circumstances for each entity.” The statement also cautioned that registrants and their auditors must review any potential errors in accounting for warrants to determine whether the issuer must take any corrective measures—e.g., a restatement.

The staff’s statement surprised most observers and inevitably will cause SPACs to revisit their accounting policies and assess the adequacy of internal accounting controls regarding classification and valuation of warrants. These assessments may also lead to some SPACs filing restated or revised financial statements with the Commission. This statement also may cause a decrease (perhaps only temporary) in the volume of SPAC-related transactions as the market assesses the impact of the new guidance. In the longer term, the staff’s statement—in conjunction with other recent guidance and actions from the Commission—may suggest increasing skepticism about the SPAC market and foreshadow that SPACs will enter the Commission’s crosshairs as targets for rulemaking and for enforcement actions.

March 2021 was a Busy Month for the SEC and SPACs

The SEC had its own version of March Madness, as the Commission markedly increased its public focus on SPACs. It began with a relatively benign March 10 warning about investing with SPACs touted by celebrities and reminding investors that the interests of SPAC sponsors may differ from those of other investors. Thereafter, in late March, the Division of Enforcement reportedly sent requests to various financial institutions focused on their SPAC dealings, apparently seeking information about deal fees, deal volumes and internal controls. While these letter requests may not be formal investigative demands, they signal that formal investigations may be in the offing and, in our experience, these requests are likely to foreshadow additional SEC investigations into SPACs, their sponsors, and other SPAC market participants.

Finally, on March 31, the Division of Corporation Finance and the Office of the Chief Accountant each issued statements underscoring the need for SPACs and de-SPAC target companies to meet their accounting, financial reporting and governance obligations as public companies. We would not be surprised if these developments previewed a series of Enforcement Division inquiries concerning potential violations of securities laws. The Acting Chief Accountant’s statement emphasized the need for SPAC targets—usually private companies—to be prepared to adhere to financial reporting and other requirements prior to their SPAC merger, including but not limited to: (i) ensuring that the combined entity has adequate processes and personnel to satisfy internal controls requirements concerning financial reporting; (ii) having competent board and audit committee oversight, including independent directors; and (iii) being prepared to have audited financial statements.

Takeaways and Risk Mitigation

• Disclosures and conflicts. The SEC will continue to focus on disclosure issues and remains concerned about conflicts of interest. Likely of particular concern are whether the incentives of, and investment terms made available to, sponsors differ from those of public investors.
• Irrational enthusiasm. Given the difficulty in harmonizing a de-SPAC merger (Is it a merger? Is it an IPO?) and Director Coates’ comments, participants should place increased scrutiny on the assumptions underpinning projections that serve as the foundation for a transaction. SPACs should exercise sufficient diligence to ensure that the projections presented to their stockholders for approval account for the sponsors’ views on such projections and do not merely represent “pie-in-the-sky” aspirations.
• Scrutiny of offering documents. Offering documents likely will be scrutinized for a number of factors, including: (i) overall economic interest of sponsors, including incentives to complete an acquisition within a specific time period; (ii) relationships between the SPAC and potential target company (including between management of the respective companies), or between the SPAC and any private investors; (iii) key economic terms of the securities held by SPAC sponsors, officers, and directors, which may be different than the securities held by ordinary public shareholders; (iv) control by SPAC sponsors, directors, officers, or their affiliates over approval of a de-SPAC transaction; and (v) potential sources of dilution of shareholders’ interests in the combined company.
• De-SPACs pose additional risks for emerging companies. In addition to the SEC’s scrutiny of the strength of disclosures concerning the target company, when the target company is a less mature company lacking a robust track record, it is particularly important to devise and maintain an adequate system of internal accounting controls, along with other policies and procedures typically utilized by public companies.
• Don’t forget about insider trading risk. Amidst the attention given to recent SEC SPAC-related pronouncements, it is important not to lose sight of more traditional risks associated with SPACs, such as insider trading. SPACs, of course, are publicly traded companies, bringing with them a host of insider trading risks. For example, SPAC investors may obtain material nonpublic information (whether through its relationship with the sponsor, participation in a PIPE, association with a target company, or otherwise). We fully expect the SEC to carefully monitor trading in SPACs’ securities in the period before the announcement of the merger target. Accordingly, it is important to continue to evaluate risk mitigation strategies with respect to insider trading, including ensuring that policies and procedures are reasonably designed to prevent misuse of material nonpublic information.