[co-author: Whitney Shephard]
In early September, a U.S. Securities and Exchange Commission (SEC) advisory committee endorsed rule changes to increase disclosure regulations for special purpose acquisition companies (SPACs). For almost a year now, the SEC has signaled that there may be a need to beef up rules around SPAC mergers, and this recent move all but confirms its plans to do so. SEC Chairman Gary Gensler, who pushed for stricter investor protection, asked staff to “look closely at each stage of the SPAC process to ensure that all investors are being protected.” And while any action on SPAC regulation changes likely remain months away, the agency listed the matter as a “rulemaking priority.” If the previously issued guidance, public warnings from SEC officials, and a July 2021 enforcement action are any indication, the SEC will most likely look closely at stock dilution, SPAC founder incentives, conflicts, and a safe harbor for mergers allowing the use of financial projections.
SPACs, also known as “blank-check companies,” have exploded in the past year, likely driven by the unprecedented market volatility caused by the COVID-19 pandemic. In 2020, the number of proceeds raised by SPACs jumped an astonishing 462% over the previous year. SPACs are publicly traded shell companies that raise money in initial public offerings to acquire a private company and take it public. These are attractive vehicles in an uncertain market because they have a more guaranteed path to going public than a conventional IPO. However, SEC officials have warned about investor risks and cautioned against perceptions that this alternate route involves lesser liability from securities law violations than a traditional IPO.
One central area of concern for regulators is the transparency in disclosures concerning stock dilution. Gensler asked the SEC staff to take a deeper look at how these transactions impact various investors. As part of the basis for his concern, he cited an academic study conducted by Stanford Law School and New York University School of Law, which concluded that SPACs often perform poorly for the investors of the post-merger company. The SEC issued guidance last December, providing the Division of Corporate Finance’s views about certain disclosure considerations for SPACs in connection with their initial public offerings and subsequent business combination transactions. In relevant part, it advised SPAC sponsors to consider whether or not they have “clearly described the terms of the agreement and any potential dilutive impact on other shareholders” when entering into a forward purchase agreement that allows the purchaser to invest in the SPAC at the time of the merger. While the guidance did not create any new obligations for SPAC founders, it certainly provided some insight into the types of disclosure requirements the SEC may look to adopt.
Regulators also stressed the importance of clear disclosure of the incentives for original sponsors, as well as potential conflicts of interest that could influence what company the SPAC ultimately acquires. SPAC founders, who are typically experts in either private equity investments or a particular industry, are often compensated with 20% of the company’s post-IPO equity once a merger is complete. Most SPACs have a two-year deadline to find a target, and, with a considerable amount of stock on the line, there are questions over whether sponsors are legitimately pursuing acquisitions that will yield lasting value for the common investors. There has also been criticism that the major players in these types of mergers may have conflicts of interest that influence what company the SPAC ultimately acquires. Unlike the traditional IPO process, SPAC sponsors are solely responsible for deciding how to value the private operating company and how much the SPAC will pay for it. The December SEC guidance provided that the compensation and other interests that affect SPAC sponsors, directors, officers, and other affiliates should be clearly disclosed so that public investors understand their financial incentives and other potential conflicts, both at the time of the SPAC’s IPO and at the time the business combines with an operating company.
Finally, the SEC will closely examine how SPACs use financial projections when they and their targets sell themselves to investors. Unlike with traditional IPOs, the use of projections by blank-check companies is granted by a safe harbor under the Private Securities Litigation Reform Act. In a de-SPAC transaction (the name of the process that begins once the formal merger is announced), the target becomes a publicly traded company under its merger into the SPAC, and the target company can include financial projections in statements filed with the SEC. In April 2021, SEC Acting Director of the Division of Corporation Finance John Coates issued a public statement, questioning whether projections are actually covered by the safe harbor. On May 24, the U.S. House Committee on Financial Services held a hearing regarding SPACs, direct listings, public offerings, and investor protections associated with these offerings. In advance of the hearing, the committee released draft legislation, amending the Securities Act of 1933 and the Securities Exchange Act of 1934 to expressly exclude all SPACs from the safe harbor for forward-looking statements. If passed, this amendment would create increased potential liability for inaccurate information in forward-looking statements for companies looking to go public through a SPAC. SPAC investors rely heavily on the ability to freely discuss projections with potential investors, especially since many acquisition targets are young companies with minimal operating history, and such an amendment would significantly impact the draw of a SPAC over a traditional IPO.
There is still a little bit of time to deliberate over precisely what action the SEC will take — the agency’s rulemaking agenda lists April 2022 as a target for discussing changes to SPAC regulations — but all signs point to more rigorous scrutiny in this space.