Tomorrow, in addition to Rule 10b5-1 plan recommendations (see this PubCo post), the SEC’s Investor Advisory Committee is slated to take up draft subcommittee recommendations regarding SPACs. The new SPAC recommendations address SPAC regulatory and investor protection issues that have been under scrutiny as a result of the proliferation of SPACs in 2020 and 2021. The IAC subcommittee observes that the SEC and its staff have addressed many issues related to SPACs in staff guidance, and the topic’s appearance on the SEC’s most recent agenda signals that it may be headed for further regulatory action. With that in mind, the recommendations are focused “œon the practical challenges SPAC investors face in fully assessing the risks and opportunities associated with these investment vehicles. ” In light of the dynamic nature of the SPAC market in recent months, however, the subcommittee frames its recommendations as “œpreliminary, ” and indicates an intent “œto revisit the issue of SPAC governance ” in the future as more data becomes available. [Update: this recommendation was approved by the Committee for submission to the SEC.]
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The recommendation observes that the SEC staff have already issued significant guidance and bulletins on SPAC regulatory and investor protection issues. Among the items cited are CF Disclosure Guidance Topic No. 11 (see this PubCo post), Financial Reporting and Auditing Considerations of Companies Merging with SPACs issued by the Office of the Chief Accountant in March, and a Corp Fin Staff Statement on Select Issues Pertaining to Special Purpose Acquisition Companies (see this PubCo post). In April 2021, SEC staff issued SPACs, IPOs and Liability Risk under the Securities Laws (see this PubCo post) and Staff Statement on Accounting and Reporting Considerations for Warrants Issued by SPACs. For a discussion of this statement, in which the staff issued warnings about SPAC warrants, catalyzing hundreds of restatements, see this PubCo post). In addition, the SEC’s reg flex agenda identifies SPAC regulation on the short-term list. In testimony before a House subcommittee, SEC Chair Gary Gensler raised several policy questions, including whether investors are being adequately protected and receiving “œthe appropriate and accurate information they need at each stage “”the first blank-check IPO stage and the second target IPO stage. ” (See this PubCo post.) Gensler testified that he had “œasked staff to consider what recommendations they would make to the Commission for possible rules or guidance in this area. ” The agenda identifies April 2022 as the target date for issuance of a proposal. (See this PubCo post.)
The recommendations identify some of the underlying concerns that the subcommittee sought to address:
- “œEffectiveness of disclosure about the risks, economics and mechanics of SPACs as a result of the complexity of these transactions and the staggered nature of the disclosure process. “
- “œInherent conflicts of interest between the sponsors/insiders of SPACs and retail investors. “
- “œConcerns that the sponsors and targets of SPACs may effectively be conducting regulatory arbitrage by seeking a deal structure with a staggered disclosure approach which amounts to [a] less-restrictive path to the public markets. “
- “œPotential lack of sufficient SPAC targets, which may incentivize sponsors to take substandard targets to market that are generally unprepared to satisfy legal, regulatory, and overall market expectations. “
- “œQuestions about whether the targets are of sufficient size for the economics of the sponsor to be reasonable. “
- “œThe number of investors who vote in favor of a de-SPAC transaction while redeeming their shares, which implies that the investors do not actually have faith in the prospects of the merged entity but vote to approve the merger anyway. “
The subcommittee offers two broad recommendations, the first regarding “œdisclosure ” and the second regarding “œanalysis, ” as well as some additional recommendations regarding protections and liability.
Disclosure. The first recommendation is that the SEC intensify its regulation of SPACs through “œenhanced focus and stricter enforcement of existing disclosure rules, ” including increased disclosure in the SPAC registration statement, with particular focus on the following:
1. Enhanced disclosure regarding the SPAC sponsor (and/or insiders or affiliates such as celebrity sponsors/advisors), including “œthe sponsor’s appropriateness, expertise, and capital contributions. ” The disclosure should also address any potential conflicts of interest, including the potential divergence of the sponsor’s financial interest from the interests of the retail investors in the SPAC. Why is this disclosure so critical? The subcommittee contends that “œSPACs by their very nature are rife with conflicts of interest which must be disclosed to potential investors. Even where those conflicts are disclosed, their import may not be clear to an unsophisticated investor. Because the purpose of the SPAC is to invest in a yet-to-be-determined company, the investors must place a great deal of trust in the SPAC sponsor to find the best candidate for merger. Even then, there may be financial arrangements that constitute conflicts of interest that are not fully disclosed or understood by investors. Further, the investors may not understand (or have the means to determine) whether the risks of keeping their shares in the merger may outweigh the benefits. ” The subcommittee suggests that the SEC consider requiring “œa standardized disclosure of the sponsor’s total investment in the transaction; the value of the sponsor’s interest if the proposed merger closes including all management and promoter fees; and the break-even post-merger price for the sponsor. It should be clear to investors that the sponsor has an interest in completing a transaction even if this might not benefit the remaining investors after the de-SPAC. “
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In CF Disclosure Guidance: Topic No. 11, the staff’s fundamental message was to be on the alert for potential conflicts of interest “”particularly the potentially competing or different economic interests (including compensation) of the SPAC sponsors, directors, officers and affiliates on the one hand and the public shareholders on the other “”and to be sure to provide clear disclosure about those potential conflicts. For example, conflicts may arise as sponsors, directors, officers and affiliates evaluate and decide whether to recommend a de-SPAC transaction to shareholders and as they negotiate the acquisition. In contrast to a traditional IPO, where the securities offered are valued through market-based price discovery, in a de-SPAC transaction, “œthese individuals are solely responsible for deciding how to value the private operating company and how much the SPAC will pay for it. ” The guidance identifies a number of other potential conflicts that could arise and need to be examined. For example, SPAC sponsors, directors and officers may not work exclusively on behalf of the SPAC to identify acquisition targets for the de-SPAC transaction and may have fiduciary or contractual obligations to other entities, even entities that compete with the SPAC for business combination opportunities. Similarly, the SPAC’s sponsors, directors, officers and their affiliates have investments in the SPAC and, as a result of securities ownership, compensation arrangements or relationships with affiliated entities, may have financial incentives that differ from those of the public shareholders, which could result in conflicts when evaluating potential opportunities for de-SPAC transactions. In addition, in selecting the target (among alternatives) for the de-SPAC, the SPAC sponsors, directors, officers and affiliates may have interests and incentives that conflict with those of the public shareholders. (See this PubCo post.)
2. Plain English disclosure in the SPAC registration statement about the deal economics, including the “œpromote ” paid to the “œfounders, ” and their dilutive effect. The disclosure should be presented in “œplain English ” to allow “œa retail investor to make a meaningful comparison of the upside potential and downside risks of a SPAC transaction compared to other SPACs as well as other types of investment opportunities. ” To the extent that precise terms are not yet available, the SEC should encourage disclosure of ranges of acceptable terms. In this context, the subcommittee cited research findings that “œSPACs are likely to be a much better investment vehicle for the issuer and perhaps the target company than for the individual retail investor who buys shares in the IPO and holds those shares through the de-SPAC process. ” Among the factors identified as contributing to this result were “œthe sponsor’s 20% “˜promote’ fee; warrants and rights given to investors who liquidated their shares during the de- SPAC; the underwriting fee paid for all IPO shares, including those redeemed in the de-SPAC; and the redemption of a significant number of shares in the de-SPAC by more institutional and PIPE investors. ” One possibility suggested in the discussion was to require “œa table of the cash per share contingent on specified levels of redemption, paralleling the cash net of fees required on the cover of an IPO prospectus, so [potential investors] understand the impact of de-SPAC dilution. “
3. A clear description (along with any useful graphics) in the SPAC registration statement of the SPAC process, including mechanics and timeline, the “œprecise nature of the instrument being purchased, the events required in the next two years for value appreciation of that instrument, ” and the de-SPAC merger shareholder approval process, including whether shareholders are permitted to vote for the merger while simultaneously redeeming their shares.
4. A clear discussion in the SPAC registration statement of “œthe opportunity set and target company areas of focus, “ including “œthe boundaries of the search area and attributes of acceptable and unacceptable companies and the ground rules for any changes to the search area. ” The discussion in the recommendation observes that recent research on SPACs suggests “œthat the greatest risk of SPACs to investors may remain ahead with the merger being a point of significant inflection for investors “”and their related risk and returns. ” In addition, “œthe separation in time between the IPO disclosure and the company specific disclosure means that investors do not learn what they are investing in until after the fact and therefore, their invested funds are tied up for a period of time while the investors rely on the sponsors to find an appropriate target. ” The discussion acknowledged that SPAC registration statements “œtend to be minimal given that there is no operating company to discuss, but additional disclosure about the structure and plans of the SPAC for its de-SPAC transaction could be included. “
5. Disclosure regarding the competition for merger targets (which has recently intensified) and related risks of identifying appropriate targets and negotiating acceptable prices. The subcommittee suggests that disclosure only in the risk factors section of the SPAC registration statement may be inadequate for this purpose. The disclosure should also make clear that the sponsor may be required to absorb expenses in the event there is no de-SPAC transaction.
6. Disclosure of the “œacceptable range of terms ” of potential additional funding, such as a PIPE transaction, at the time of the de-SPAC merger. The subcommittee suggests that the SEC “œconsider requiring disclosure of the identity and relationship of PIPE investors, and whether any side payments are to be made to certain shareholders as an inducement not to redeem their shares. ” The discussion in the recommendation observes that, at “œthe time of the merger, often over two thirds of the SPAC’s shares are tendered for redemption and the sponsor or third parties purchase shares in a private investment in public equity ( “œPIPE “) transaction to replenish cash the SPAC paid to redeem its shares, diluting the original investors’ slice of the new company’s equity. “
7. Disclosure of how the sponsor will assess potential targets’ governance and control environments, and whether the sponsor plans any steps to ensure the target’s adequacy for operation as a public company.
8. Disclosure about the due diligence that the sponsor will conduct prior to the de-SPAC merger regarding the target’s accounting practices, including “œaudit history, use of GAAP and non-GAAP pro forma numbers, and audit committee (composition; communication between committee, auditor, and management). “
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According to Reuters, analysts think the SEC has been “œworried about how much due diligence is performed by SPACs before acquiring assets, and about disclosures to investors. ” In July, the SEC took enforcement action in connection with a de-SPAC merger, alleging misleading claims and inadequate due diligence. SEC Chair Gary Gensler weighed in “”a rare comment on a litigation settlement, perhaps signaling the significance of the case: “œThis case illustrates risks inherent to SPAC transactions, as those who stand to earn significant profits from a SPAC merger may conduct inadequate due diligence and mislead investors “¦.Stable Road, a SPAC, and its merger target, Momentus, both misled the investing public. The fact that Momentus lied to Stable Road does not absolve Stable Road of its failure to undertake adequate due diligence to protect shareholders. Today’s actions will prevent the wrongdoers from benefitting at the expense of investors and help to better align the incentives of parties to a SPAC transaction with those of investors relying on truthful information to make investment decisions. ” (See this PubCo post.)
Analysis. The analysis that the subcommittee is recommending here is not from the SPAC or its sponsor, but rather from the SEC. The recommendation suggests that the SEC “œprepare and publish an analysis of the players in the various SPAC stages, their compensation, and their incentives. ” The subcommittee believes that the analysis would be in the public interest and promote investor protection. The recommendation indicates that, based on the analysis, the subcommittee may follow-up with additional actions and recommendations.
Protections and Liability. The subcommittee suggests that the playing field for SPACs and conventional IPOs may need to be levelled. In particular, the subcommittee recommends that the safe harbor for projections be eliminated for SPAC transactions: “œThe public communications of SPAC promoters should be treated in the same way as public communications for an IPO, particularly for the de-SPAC transaction. It very likely may be appropriate for underwriter liability to be extended on the same basis for SPACs as for IPOs under sections 11 and 14. ” Due diligence appears to be a key concern. The discussion observes that there is “œno underwriter in the merger process and no Section 11 liability. There is also no comfort letter and the sponsor may or may not have involvement in the target post-merger. ” Due diligence that may be conducted by PIPE investors, the subcommittee contends, “œis not necessarily done with the interests of retail investors in mind. ” The subcommittee suggests that the SEC examine the data to determine whether the absence of these standard IPO protections “œputs retail investors at a disadvantage and whether the SEC should make any recommendations to Congress regarding necessary statutory changes. Further, when the SEC reviews the S-4, F-4 of DEF 14A in connection with a de-SPAC transaction we recommend that they make inquiries regarding the due diligence completed by all parties to the transaction. “
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In SPACs, IPOs and Liability Risk under the Securities Laws, then-Acting Corp Fin Director John Coates (current SEC General Counsel) questioned the common assertion that SPACs involve lower securities law liability risk. He observed that some practitioners and commentators have made this argument because, in contrast to traditional IPOs, SPACs are entitled to rely on the safe harbor for forward-looking statements in the PSLRA, allowing SPAC sponsors, targets, and others involved in the SPAC to disclose projections and other valuation material that would normally not be disclosed in conventional IPO prospectuses. In that case, he queried, are protections for investors voting on or buying shares in the de-SPAC transaction adequate? Do the current protections fail to adequately incentivize SPAC participants and private investors to perform appropriate due diligence on the target and its disclosures to public investors, especially given that the de-SPAC transaction may not involve a traditional underwriter? Importantly, should the level of liability be determined by the form of the IPO pathway, rather than the substance of the entire transaction? Further, is it even true that the PSLRA safe harbor provides protection for SPACs? That, Coates argues, “œis 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 “œinitial public offering ” and, in Coates’s view, “œthat phrase may include de-SPAC transactions. ” That raises questions of economic substance over form. According to Coates, the
“œeconomic essence of an initial public offering is the introduction of a new company to the public. It is the first time that public investors see the business and financial information about a company. As a result, Congress, markets, analysts, and the SEC staff typically treat these introductions differently from other kinds of capital raising transactions “¦.An IPO is where the protections of the federal securities laws are typically most needed to overcome the information asymmetries between a new investment opportunity and investors in the newly public company. To be sure, some elements of the SEC’s regulatory regime reflect a recognition that small or new public companies may not be as able to shoulder the costs of all disclosure requirements as older, larger companies. But it remains true that IPOs are understood as a distinct and challenging moment for disclosure. If these facts about economic and information substance drive our understanding of what an “˜IPO’ is, they point toward a conclusion that the PSLRA safe harbor should not be available for any unknown private company introducing itself to the public markets. Such a conclusion should hold regardless of what structure or method it used to do so. The reason is simple: the public knows nothing about this private company. Appropriate liability should attach to whatever claims it is making, or others are making on its behalf. “
(See this PubCo post.)
