SPACs in the Spotlight: Skyrocketing Deal Volume Invites Regulatory Scrutiny

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Capital raising through Special-Purpose Acquisition Companies (“SPACs”) has gone through the roof in the last two years.  Last year was by far the single highest deal value for SPACs, and the first quarter of 2021 has already surpassed last year’s total deal value.[1]  Given the explosion of SPAC transactions, often backed by celebrities, it is a safe bet that the SEC will increase its scrutiny of SPACs.

In fact, on March 25, 2021, Reuters reported that the SEC has requested voluntary information from Wall Street banks on SPAC deals.[2]  Whether this inquiry broadens into a full-scale industry sweep remains to be seen, but it is clear that the hotbed of SPAC activity has captured regulatory attention.  Also notable is that the plaintiffs’ bar has been filing lots of cases arising from SPAC transactions, which can be a harbinger of SEC inquiries.  For these reasons, it is important to understand the regulatory risks of these deals.

What is a SPAC?

SPACs are also known as blank-check companies.  In a typical SPAC transaction, the SPAC raises capital in an initial public offering (“IPO”) for the purpose of later acquiring a private company.  The SPAC has two years to locate a private company to merge with and bring public.  The merger between a SPAC and a target company is referred to as a de-SPAC merger.  When a de-SPAC merger is proposed, investors in the IPO can redeem their shares, meaning that if they don’t like the merger, they can get their investment back, plus a sizable return for allowing the SPAC to hold their money for two years.  Alternatively, they can approve the de-SPAC merger and obtain equity in the combined company.

SPACs have proliferated because they can be lucrative for founders while affording the targeted private company a quicker and more streamlined process of going public than traditional IPOs.  However, there are only so many quality targets to go around, and more than 300 SPACs need to fulfill the 2-year merger requirement this year or risk being liquidated.[3]

Dilution

It is not unheard of to see dilution of shares by over 100% during the two-year period while SPACs seek a private merger partner.[4]  The founders retain shares equal to 25% of the IPO capital raise or 20% of post-IPO equity.  And SPACs give shares, warrants, and rights to parties that do not contribute cash to the eventual merger.  These free securities dilute the value of shares purchased by SPAC investors.[5]

Potential Areas of Enforcement Action and Litigation

                Disclosure of Conflicts of Interest

The SEC is sure to examine whether conflicts of interest exist among SPAC management teams that could influence their decision-making concerning acquisition targets.  In December 2020, the SEC’s Division of Corporation Finance (“Corp. Fin.”) issued guidance on sound disclosure practices.[6]  Corp. Fin. made clear that it expects disclosure of whether a SPAC’s founders owe duties or obligations to businesses other than the SPAC.[7]

The SEC will also scrutinize the valuation of acquisition targets.  A SPAC’s management – not investment bankers, as in a traditional IPO – decides how to value the acquisition target, increasing the potential for abuse.  This potential is compounded by the limited supply of quality acquisition targets mentioned above.  Thus, you can expect the SEC to scrutinize SPAC valuation practices and procedures.

Baseless Projections

SPACs enable target companies to entice investors with projections under the PSLRA safe harbor for projections in mergers.  In typical IPOs, companies tend to be reluctant to tout projections because the underwriting banks could face liability if the projections don’t pan out.  The SEC will examine the basis for overly optimistic projections in de-SPAC mergers.  If the SEC can show that the projections were not made in good faith and backed up with diligence and documentation, an enforcement action could ensue.

                Insider Trading

After a SPAC IPO, the blank-check company’s stock trades on the open market, even though it has no operations.  Abnormal or opportunistic trading patterns in the stock for these blank-check companies could suggest trading on the basis of material nonpublic information regarding, for instance, acquisition targets.  In anticipation of such risks, investment banks and other market participants would be wise to develop protocols and controls to monitor the distribution of non-public information across business units and to reasonably detect potential abuses.

Conclusion

As the SPAC craze continues, the SEC will remain focused on ensuring that SPACs disclose potential conflicts of interest. Robust disclosures that illuminate potential conflicts of interest will help with the SEC staff review and protect SPAC participants against potential securities law liability.

[1] Patturaja Murugaboopathy, Global SPAC deal volumes this year surpass total for 2020, Reuters, (Mar. 9, 2021, 9:20 a.m.), available at https://www.reuters.com/article/us-usa-markets-spac/global-spac-deal-volumes-this-year-surpass-total-for-2020-idUSKBN2B11UU

[2] Jody Godoy & Chris Prentice, U.S. Regulator Opens Inquiry Into Wall Street’s Blank Check IPO Frenzy, Reuters (Mar. 25, 2021, 9:54 PM), available at https://www.reuters.com/article/usa-sec-spacs/exclusive-u-s-regulator-opens-inquiry-into-wall-streets-blank-check-ipo-frenzy-sources-idUSL1N2LN1LA.

[3] Ivana Naumovska, The SPAC Bubble Is About to Burst, Harvard Business Review (Feb. 18, 2021), available at https://hbr.org/2021/02/the-spac-bubble-is-about-to-burst.

[4] Michael Brush, Opinion: These are the hidden dangers lurking inside SPACs that can hurt you, MarketWatch (Feb. 25, 2021 at 10:50 a.m.); available at https://www.marketwatch.com/story/these-are-the-hidden-dangers-lurking-inside-spacs-that-can-hurt-you-11614267559

[5] See generally, Michael Klausner, Michael Ohlrogge, and Emily Ruan, A Sober Look at SPACs, Harvard Law School Forum on Corporate Governance (Nov 19, 2020), available at https://corpgov.law.harvard.edu/2020/11/19/a-sober-look-at-spacs/.

[6] SEC’s Division of Corporate Finance, CF Disclosure Guidance: Topic No. 11, Special Purpose Acquisition Companies (Dec. 22, 2020), available at https://www.sec.gov/corpfin/disclosure-special-purpose-acquisition-companies.

[7] Id. at 1.  (“A SPAC preparing to conduct an IPO or present a business combination transaction to shareholders should consider carefully its disclosure obligations under the federal securities laws as they relate to conflicts of interest, potentially differing economic interests of the SPAC sponsors, directors, officers and affiliates and the interests of other shareholders and other compensation-related matters.”).

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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