Not according to 49 major law firms! Earlier this month, a shareholder of Pershing Square Tontine Holdings, Ltd., filed derivative litigation against the company’s board, its sponsor and other related companies, contending that the company, a SPAC organized by a billionaire hedge-fund investor, is really an investment company that should be registered under the Investment Company Act of 1940 and that its sponsor is really an investment adviser that should be registered under the Investment Advisers Act of 1940. Had they registered, so the argument goes, they would have been subject to substantial regulation regarding the rights of the SPAC’s shareholders and the form and amount of the SPAC managers’ compensation. According to the complaint, under the ICA, “an Investment Company is an entity whose primary business is investing in securities. And investing in securities is basically the only thing that PSTH has ever done.” The complaint sought “a declaratory judgment, damages, and rescission of contracts whose formation and performance violate” the ICA and IAA. What’s especially notable about the litigation—aside from its novel premise—is that the plaintiff’s lawyers include Yale law professor John Morley and Robert Jackson, an NYU law professor and former SEC Commissioner. Now, a group of 49 major law firms—including Cooley—have issued a joint statement pushing back on the plaintiff’s claims, asserting that there is no legal or factual basis for the allegation that SPACs are investment companies.
More specifically, the complaint charged that “PSTH is an investment company under the ICA because its primary business is to invest in securities. Since the Company’s initial public offering more than a year ago, investing in securities is all the Company has ever done. From the moment of its IPO, PSTH has invested all of its assets in securities of the United States government and shares of money market mutual funds. PSTH and its advisers have spent most of their time working for PSTH negotiating a purchase of still more securities in a recently-abandoned agreement.” Because the Company and its sponsor did not register, the plaintiff argues, the defendants were able “to use their positions of control to extract compensation from PSTH in forms and amounts that violate federal law. Rather than pay reasonable fees and structure them in the standardized and transparent ways required by the ICA and IAA, the Company has paid its investment advisers indirectly, in the form of complex securities of the Company that were never offered for purchase by the Company’s public investors. The Defendants’ actions pose the precise danger the ICA and IAA sought to address.” In addition, the complaint alleged that “less than twelve months after the Company allowed the Sponsor and Director Defendants to purchase identical warrants on PSTH shares, the Company agreed to repurchase some of those warrants at a valuation that implied the warrants were worth, in the aggregate, more than $880 million—thirteen times what the Sponsor and Director Defendants originally paid for them. This staggering compensation was promised at a time when the returns to the Company’s public investors have starkly underperformed the rest of the stock market. That is hardly the arms’-length bargain the ICA and IAA demand.”
Although the hedge fund investor objected that the claims in the complaint were without merit, it has been reported that he still elected to make significant changes to the SPAC to avoid the time-sink that litigation could entail—not to mention the monkey wrench that litigation could throw into the search for a de-SPAC merger partner. In the meantime, it’s also been reported that the plaintiff has filed similar complaints against three other SPACs. Citing two unnamed sources, CNBC is reporting that the plaintiff’s lawyers “may file as many as 50 lawsuits against SPACs in the coming months,” raising the specter of series of SPAC challenges that might derail the SPAC trend.
Section 3(b)(1) of the ICA provides that a company is not an investment company within the meaning of the ICA if it is “primarily engaged, directly or through a wholly-owned subsidiary or subsidiaries, in a business or businesses other than that of investing, reinvesting, owning, holding, or trading in securities…” In In re Tonopah Mining Co., the SEC applied a five-factor test to determine whether a company was primarily engaged in a non-investment business for purposes of Section 3(b)(1): historical development; public representations of policy; activities of officers and directors; nature of assets and sources of income. There are also a number of exceptions to the registration requirements under the ICA on which companies (or companies that intend to become operating companies), frequently rely to avoid mischaracterization as investment companies. For example, Rule 3a-8, which provides an exception to the definition of “investment company” for certain research and development companies, was designed to avoid inadvertently capturing young biotechs that were certainly operating companies but had not yet begun to report significant income; because these companies raised substantial funds in public offerings and invested them in securities until these funds could be deployed for research and clinical trials, they sometimes took on the appearance of investment companies, requiring them to unduly restrict the nature of their investments. Rule 3a-1 is another exception on which companies frequently rely, applying an assets-and-income test (excluding Government securities and cash items). Rule 3a-2 provides a temporary exception for a company that “has a bona fide intent to be engaged primarily, as soon as is reasonably possible” in a non-investment business, as evidenced by the company’s business activities and board resolutions.
To counter this legal challenge, 49 law firms signed a statement asserting that conventional SPACs are not investment companies within the meaning of the ICA. According to the statement, SPACs’ investment of their IPO proceeds in short-term treasuries and qualifying money market funds does not make them investment companies under the ICA as professed in the litigation. Rather, the statement observes, “[u]nder the provision of the 1940 Act relied upon in the lawsuits, an investment company is a company that is or holds itself out as being engaged primarily, or proposes to engage primarily, in the business of investing, reinvesting or trading in securities. SPACs, however, are engaged primarily in identifying and consummating a business combination with one or more operating companies within a specified period of time.” Pending either a de-SPAC merger or the failure to complete a de-SPAC merger within a specified timeframe, “almost all of a SPAC’s assets are held in a trust account and limited to short-term treasuries and qualifying money market funds.”
The statement continues: “Consistent with longstanding interpretations of the 1940 Act, and its plain statutory text, any company that temporarily holds short-term treasuries and qualifying money market funds while engaging in its primary business of seeking a business combination with one or more operating companies is not an investment company under the 1940 Act. As a result, more than 1,000 SPAC IPOs have been reviewed by the staff of the SEC over two decades and have not been deemed to be subject to the 1940 Act.”
In conclusion, the signatories to the statement “view the assertion that SPACs are investment companies as without factual or legal basis and believe that a SPAC is not an investment company under the 1940 Act if it (i) follows its stated business plan of seeking to identify and engage in a business combination with one or more operating companies within a specified period of time and (ii) holds short-term treasuries and qualifying money market funds in its trust account pending completion of its initial business combination.”