Congress now seems to be all over this SPAC phenomenon. Last week a subcommittee of the House Financial Services Committee held a hearing on “Going Public: SPACs, Direct Listings, Public Offerings, and the Need for Investor Protections.” What is the headline from the hearing? All the witnesses agreed that, to prevent regulatory arbitrage, all IPO vehicles, whether traditional IPOs or SPACs, should operate on a level playing field and be subject to the same type of regulation of disclosure and liability. Many House members also took the opportunity to promote their own proposed or pending legislation about the capital markets, and several House members offered their recommendations for a happy marriage. At a separate hearing, SEC Chair Gary Gensler gave testimony before a different subcommittee, which in part addressed SPACs. Is some kind of Congressional action in the offing?
House Subcommittee Hearing
[Based on my notes, so standard caveats apply.]
Participating as witnesses in the hearing were representatives of the CFA Institute and a policy analyst for a financial non-profit, as well as a law professor and a venture capitalist. Several key themes emerged: the problems associated with traditional IPOs that have given rise to SPACs and direct listings, the problems associated with SPACs, the two-tier capital markets as a driver of wealth inequality, and the decline in public companies and how to address that issue.
Traditional IPOs. According to some of the witnesses on the panel, although the traditional IPO process has worked fairly effectively in terms of investor protection, such as through Section 11 liability and the unavailability for IPOs of the PSLRA safe harbor for forward-looking statements, the emergence of alternative IPO pathways, such as SPACs and direct listings, indicates that there may be some flaws that these alternatives are intended to address. Nevertheless, the competition created by the availability of multiple alternatives has led to some improvements. For example, the IPO process was described as a slow and highly regulated process, subject to significant pricing uncertainty. According to the venture capitalist on the panel, IPO pricing mechanisms have improved as a result of the competition of multiple pathways to IPO, and the traditional lock-up structure has been revisited. Some witnesses raised concerns regarding the rigid IPO commission structure of 7% paid to underwriters and the system of lock-ups, as well as the issue of mispricing the deal. Some of the alternative processes that have developed address some of these issues, even if they each also have their own flaws.
Direct listings. Direct listings involve a registered sale directly into the public market with no intermediary underwriter, no underwriting commissions (just advisory fees) and no roadshow or similar expenses. The initial pricing is set during the opening auction, not by agreement among the company and underwriters, as in a traditional IPO, thereby offering improved price discovery and lower likelihood of mispricing. Insiders are often especially pleased with direct listings because, unlike with underwritten IPOs, there is typically no “lockup period,” and shareholders are free to sell their shares right away. To be sure, with direct listings, companies conduct less direct marketing, otherwise typically done through the roadshow meetings with the assistance of bankers, which means, the venture capitalist on the panel asserted, that candidates for direct listings often need to have a sufficiently prominent brand ID. In addition, as the venture capitalist observed, to date, all of these transactions have been only secondary, so they have not been useful for companies that need to raise capital. (However, the SEC has approved the applications of both the NYSE (see this PubCo post) and Nasdaq to allow primary direct listings, so they may become more common over time.)
SPACs. Not surprisingly, most of the hearing was focused on SPACs, and they came in for quite a bit of criticism. SPACs offer the advantage of speed and more certainty as to initial pricing, according to some of the witnesses. A Representative also suggested that, because of the availability of the safe harbor, they can provide investors with projections, not available in IPOs. The representative of the CFA Institute indicated that there were two starkly different stories associated with SPACs: on the one hand, there are the sophisticated SPAC sponsors and hedge funds and other institutions that invest at the IPO stage, but then largely exit when the de-SPAC merger is announced. Then there are individual retail investors who buy their shares, post-announcement, in the public markets. He claimed these groups face starkly different results: lucrative profits for the sponsors and hedge funds that exit, and poor returns for the retail investors. He pointed to three design features that contribute to these results. First, there is dilution that results from the sale of SPAC units that include redeemable shares and detachable warrants; when these hedge funds and other IPO investors redeem their shares for money back plus interest, they keep the warrants. Second, he argued, is the problem of misaligned incentives; that is, the sponsor has a strong incentive to complete a merger, regardless of the quality of the transaction. Third, as opposed to IPOs, SPACs have available the safe harbor protection in the PSLRA for forward-looking statements, such as projections, a safe harbor not available in an IPO. He suggested that Congress look at these areas going forward.
Congress has apparently already begun. A discussion draft of a bill to amend the Securities Act and the Exchange Act would specifically exclude SPACs from the safe harbor for forward-looking statements. In effect, the bill would substitute for “blank check” company the new phrase ‘‘a development stage company that has no specific business plan or purpose or has indicated that its business plan is to acquire or merge with an unidentified company, entity, or person.’’
The representative of the non-profit reported that over $100 billion has already been issued in SPACs this year, over ten times the amount in 2018. That growth was especially concerning, he said, because SPACs tend to perform poorly for retail investors. He noted that SPACs are not a new concept, but rather date back to the 1980s. After some of those early SPACs were later accused of being vehicles for fraud, Congress adopted legislation regarding penny stocks, and the SEC adopted rules about blank-check companies. Current SPACs, he said, are structured to avoid these rules. The structure of SPAC transactions also means that forward-looking statements made in connection with the de-SPAC merger (the transaction in which a private operating company undertakes a business combination with a SPAC, ultimately becoming a public operating company) have generally been considered to be protected under the safe harbor for forward-looking statements in the PSLRA, allowing SPAC sponsors and other SPAC participants to disclose projections—often “rosy” projections he suggested—and other valuation material that would normally not be disclosed in conventional IPO prospectuses. He urged Congress to address these issues, including aligning the PSLRA protections to be consistent with IPOs.
But is there really lower risk of liability in a SPAC? Corp Fin Acting Director John Coates isn’t so sure. In this statement, he discusses liability risks potentially arising out of SPAC and de-SPAC transactions. The essence of his message is: why should a SPAC be treated differently from a traditional IPO? According to Coates, the claim among some practitioners and commentators “about reduced liability exposure for SPAC participants is overstated at best, and potentially seriously misleading at worst. Indeed, in some ways, liability risks for those involved are higher, not lower, than in conventional IPOs, due in particular to the potential conflicts of interest in the SPAC structure.” There is no “free pass” for material misstatements or omissions in de-SPAC transactions. Material misstatements in or omissions from the de-SPAC registration statement are still subject to liability under Section 11 and the related proxy statement is subject to liability under Section 14(a) and Rule 14a-9, which has typically been assessed under a “negligence” standard. In addition, tender offers are subject to liability under Section 14(e).
And about that thorny question of PSLRA protection? Don’t be so sure, Coates contends. First, he argues, the PSLRA does not provide any protection against SEC enforcement, nor does it “protect against false or misleading statements made with actual knowledge that the statement was false or misleading.” But just putting all that aside, is it even true that the PSLRA safe harbor provides protection for SPACs? That, Coates argues, “is uncertain at best.” Specifically excluded from the safe harbor are statements made in connection with an offering of securities by a blank check company, those made by a penny stock issuer and those made in connection with an initial public offering. But there is no definition provided for “initial public offering” and, in Coates’s view, “that phrase may include de-SPAC transactions.” Isn’t it really a question of economic substance over form? (See this PubCo post.)
The professor introduced the metaphor of a wedding, comparing the traditional wedding to the traditional IPO, with all the prep and long-term planning that goes into both: with an IPO, the company starts out many months ahead in selecting bankers who vet the company, preparation of a prospectus, working through the SEC comment process and going on a roadshow. A SPAC, however, was more like a Las Vegas wedding—a quick wedding that ends up in marriage, to be sure, just like the SPAC process ends up in a publicly traded company, but without the same level of preparation and vetting. As a result, she supported extending potential Section 11 liability and eliminating the safe harbor for forward-looking statements for SPACs.
She also observed that SPACs used to allow a vote on the de-SPAC merger in which, if 20% elected to redeem, the deal wouldn’t close. Now there is just a majority vote, but the vote is “meaningless,” she said, because investors can vote in favor of the merger but still redeem—essentially a decoupling of the vote and the economic interest. She suggested that this issue be addressed by requiring that if 50% of the SPAC investors want to redeem, the acquisition should not go forward.
Of course, no one could pass up the wedding metaphor. One of Representatives commented that it doesn’t matter whether it’s a traditional wedding or a Las Vegas wedding, the marriage works only if you love your spouse and don’t cheat. Of course, I waited to hear where he was going with this metaphor, but it turns out he wasn’t taking it anywhere; instead, he had de-metaphored the concept and was simply offering his own marriage advice. Subcommittee Chair Brad Sherman then reattached the metaphor—sort of—with recommendation not to “undervalue” your spouse.
The venture capitalist on the panel focused primarily on ways to enhance capital formation and access to investment opportunities for all Americans. He first observed that the raw number of IPOs has declined from an average of 300 per year in the period 1980 to 2000 to 108 per year in the period from 2001-2016. Companies also tend to stay private twice as long, resulting in more mature companies with higher valuations at IPO. Why should we care, he asked? First, the number of public companies has declined by about 50%. Later, he observed that it’s no fun to be a small cap, low float public company that’s not well followed by analysts, perhaps accounting for some of the decline. Second, public companies drive employment growth and are key to expanding geographic access to economic opportunity. Third, under the current market structure, the vast majority of share appreciation accrues to early private investors, largely institutions and wealthy individuals who can invest in the private markets, while retail investors are relegated to the public markets. This two-tiered market structure, he said, contributes to income and wealth inequality. Recently, there has been some good news in the growth in the number of IPOs, attributable in part to the JOBS Act and to the fact that there is now a choice in the approaches to going public. That choice drives competition, reduces expenses and allows more companies to seek capital.
How can the Congress make it easier to go public at an earlier stage, he asked? One way, he suggests, would be to ease the regulatory burden by expanding the JOBS Act to extend from five years to ten years the benefits of status as emerging growth companies and to provide a one-year transition from EGC status for filers that trigger large-accelerated filer status for the first time. He later remarked that one-size-fits-all regulation can be problematic. He also noted that small cap companies that trade at very low volumes are especially vulnerable to shorting, and so Congress should consider requiring short position disclosure. He also recommended that EGCs be enabled to opt out of unlisted trading privileges and to select trading venues to consolidate trading volume. He also recommended that we ensure the continuation of choices for going public: they engender fair competition, enhanced price discovery and improved retail participation. With regard to direct secondary listings, he noted that there is some uncertainty in connection with the tracing rules and potential liability that Congress might clarify. He later also suggested looking at the impediments to providing research for smaller companies, such as whether the Global Research Analyst Settlement has had any lingering adverse effect. While he did not comment on SPACs, he did agree that there should be a level playing field and that the regulatory regime applicable to traditional IPOs should also apply to SPACs. He also suggested that the Congress look at ways to enhance access to the private markets for non-institutional investors, with appropriate standards and oversight, such as by expanding the accredited investor definition or making it easier for retail investors to participate in private fund investments. He also commented on blockchain and crypto, which he thought needed clearer regulatory guidance. He later recommended that, prior to adopting legislation or regulation, the fundamental question should be whether it helps or hinders access to capital and helps or hinders retail access to these market opportunities.
How much of a deterrence from going public is regulatory burden? At a meeting of the SEC’s Investor Advisory Committee in 2017, a panelist reported that, when a number of CFOs were asked why they would decide not to go public, at the top of the list was the need to maintain decision-making control. In the private market, another panelist suggested, companies and investors have a kind of unspoken “pact” about long-term strategy. But, said one panelist, the rise of hedge-fund activism in tech and other product-cycle-driven public companies has fueled concerns among founders and other management that they will be hampered in pursuing long-term strategic goals by activists with short-term perspectives. These companies fear that activity that may have significant long-term payout, but a near-term adverse price impact (e.g., M&A activity, change in product strategy, substantial investment in R&D), will draw scrutiny and intervention from hedge-fund opportunists. Hence, the recent prevalence of dual-class capital structures, which one panelist characterized as merging some private company benefits into a public company structure. Perhaps dual-class structures are a blunt instrument, the panelist indicated, but it’s one tool that is available. (See this PubCo post and this PubCo post.) At the bottom of the CFO list of reasons not to go public was the burden of regulatory compliance. As one academic on the panel explained, while regulatory cost has been the dominant narrative, that narrative ignores the impact of deregulation of private-capital raising—it’s now much easier not only to raise private capital (e.g., changes to Reg D) but also to stay private (e.g., changes to the Exchange Act registration threshold). With low interest rates, debt has also been an attractive option for funding in lieu of an IPO. In addition, markets have provided more opportunities for liquidity through secondary trading of privately held shares. The panelist also argued that private companies enjoy the benefit of information asymmetry relative to public companies, which are subject to much more significant disclosure requirements. (See this PubCo post.)
In contrast to some of the concerns raised in the House subcommittee hearing discussed above, in his testimony before the Subcommittee on Financial Services and General Government of the House Appropriations Committee, SEC Chair Gary Gensler seemed to characterize the IPO market as pretty healthy. He observed that there has been a substantial
“acceleration of new public company listings. We are in the midst of a once-in-a-generation wave of traditional initial public offerings—companies that are seeking to go public via the stock market. From January 1 to May 19 of this year, nearly 400 companies filed traditional IPO S-1 forms. That is rapidly approaching the number of companies that filed for public offerings in all of 2016. Since the beginning of 2021, 118 traditional IPOs have been completed. In all of 2016, there were 138 traditional IPOs. At the current rate, I expect there will be more traditional IPOs than there were during the dot-com peak of 2000.”
He also remarked that we are “witnessing an unprecedented surge” in SPACs: so far in 2021, the SEC has received 700 S-1 SPAC filings, and 300 of these “blank-check IPOs” have been completed so far this year, compared to just 13 in all of 2016. (Tellingly, he also refers to de-SPACs transactions as “target IPOs,” because “they enable target companies to access public markets for the first time.”) To Gensler, the SPAC surge raises several policy questions, including whether investors are being appropriately protected and receiving “the appropriate and accurate information they need at each stage—the first blank-check IPO stage and the second target IPO stage.”
SPACs, he observed, may actually be less efficient than traditional IPOs. Consistent with some of the testimony from the witnesses in the hearing discussed above, Gensler cited a recent study showing that
“SPAC sponsors generate significant dilution and costs. SPAC sponsors generally receive 20 percent of shares as a ‘promote.’ The first-stage investors can redeem when they find the target, leaving the non-redeeming and later investors to bear the brunt of that dilution. In addition, financial advisors are paid fees for the first-stage blank-check IPO, for the PIPEs, and for the merger with the target. Further, it’s often the case that the investors in these PIPEs are buying at a discount to a post-target IPO price. It may be that the retail public is bearing much of these costs.”
He said that he has “asked staff to consider what recommendations they would make to the Commission for possible rules or guidance in this area. Our Corporation Finance, Examinations, and Enforcement Division staffs will also be closely looking at each stage to ensure that investors are being protected. Each new issuer that enters the public markets presents a potential risk for fraud or other violations.