Yesterday, the SEC voted, three to one, to propose new rules and amendments regarding SPACs, shell companies, the use of projections in SEC filings and a rule addressing the status of SPACs under the Investment Company Act of 1940. The proposal arrives in the context of calls from various corners, including from SEC Chair Gary Gensler and former Acting Corp Fin Director John Coates, to treat SPACs as an alternative method of conducting an IPO under the SEC’s policy framework. (See this PubCo post, this PubCo post and this PubCo post.) And let’s not forget the extensive recommendations from the SEC’s Investor Advisory Committee addressing SPAC regulatory and investor protection issues that have been under scrutiny. (See this PubCo post.) These investor protection concerns were exacerbated as a result of the proliferation of SPACs in 2020 and 2021—raising $83 billion in 2020 and $160 billion in 2021 and, in those same two years, constituting more than half of all IPOs, according to the proposing release. (Note, however, that this volume has not been sustained this year; according to Bloomberg, only $8.9 billion has been raised in 2022, “a fraction of the 279 deals raking in $93 billion during the same period last year.”) These concerns made SPACs an alluring target for SEC rulemaking, and the SEC has approached it with another enormous effort—literally—issuing a proposal of almost 400 pages. It must be a record—a second proposal in just over a week that would add an entirely new subpart to Reg S-K!
Very loosely, SPACs are companies with no real operations formed for the purpose of raising capital in an IPO to be used to acquire an operating company. In the interim, the offering proceeds are placed into a trust or escrow account. Essentially, SPACs act as vehicles for the acquired operating companies to go public through the de-SPAC acquisition transactions.
For SEC Chair Gary Gensler, SPACs represent another opportunity to apply Aristotle’s maxim to “treat like cases alike.” (See this PubCo post.) In this case, he means that “it’s important to consider the economic drivers of SPACs. Functionally, the SPAC target IPO is being used as an alternative means to conduct an IPO.” And, accordingly, in his view, “investors deserve the protections they receive from traditional IPOs, with respect to information asymmetries, fraud, and conflicts, and when it comes to disclosure, marketing practices, gatekeepers, and issuers.” These are all policy issues, he said, that Congress addressed nearly 90 years ago, in connection with companies raising money from the public. For traditional IPOs, he said, “Congress gave the SEC certain tools, which I generally see as falling into three buckets: disclosure; standards for marketing practices; and gatekeeper and issuer obligations. Today’s proposal would help ensure that these tools are applied to SPACs.” Under the proposal, that means additional disclosure requirements regarding SPAC sponsors, conflicts of interest, dilution and financial statements, among other things; standards around marketing practices, such as the use of financial projections; and gatekeeper and issuer obligations, including expanded potential underwriter liability and potential liability by the target company and its signing persons for a de-SPAC registration statement. The proposal also includes a new safe harbor from the obligation to register under the Investment Company Act of 1940 for SPACs that meet the safe harbor’s requirements.
The concept of treating like cases alike is not new in the SPAC context. In April, then-Acting Corp Fin Director John Coates questioned the common assertion that SPACs involve lower securities law liability risk than traditional IPOs, raising the fundamental issue of whether the level of liability should be determined by the form of the IPO pathway, rather than the substance of the entire transaction. In other words, shouldn’t like activities be treated alike? (See this PubCo post.) Similarly, at a separate House hearing, 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. (See this PubCo post.) And Gensler shared his thoughts on the regulation of SPACs in 2021 in remarks before the Healthy Markets Association with the same theme drawn from antiquity. (See this PubCo post.)
Here is the press release, fact sheet and proposing release. The proposal will be open for public comment until 30 days after publication in the Federal Register or May 31 (which is 60 days after publication of the proposing release on the SEC’s website), whichever is later.
As summarized in the SEC’s fact sheet, the proposal would:
- “Enhance disclosures and provide additional investor protections in SPAC initial public offerings and in business combination transactions between SPACs and private operating companies (de-SPAC transactions);
- Address the treatment under the Securities Act of 1933 of business combination transactions involving a reporting shell company and amend the financial statement requirements applicable to transactions involving shell companies;
- Provide additional guidance on the use of projections in SEC filings to address concerns about their reliability; and
- Assist SPACs in assessing when they may be subject to regulation under the Investment Company Act of 1940.”
Enhanced disclosure and investor protections
Under the proposal, the SEC would add new Subpart 1600 of Reg S-K setting forth specialized disclosure requirements for SPAC IPOs and de-SPAC transactions. Inline XBRL would be required, of course. The enhanced disclosure provisions would require:
- Additional disclosures about the sponsor of the SPAC, potential conflicts of interest and dilution. For example, the proposal would require disclosure about the experience, material roles and responsibilities of sponsors and their affiliates and promoters, as well as any “agreement, arrangement or understanding (1) between the sponsor and the SPAC, its executive officers, directors or affiliates, in determining whether to proceed with a de-SPAC transaction and (2) regarding the redemption of outstanding securities.” The proposal would also require, among other things, disclosure of any “conflict of interest between (1) the sponsor or its affiliates or the SPAC’s officers, directors, or promoters, and (2) unaffiliated security holders,” including any conflict in determining whether to proceed with a de-SPAC transaction and any conflict arising out of the way a SPAC compensates the sponsor or the SPAC’s executive officers and directors, or the manner in which the sponsor compensates its own executive officers and directors. Narrative and tabular disclosure would also be required about potential sources of dilution in a SPAC’s structure, including dilution resulting from shareholder redemptions, sponsor compensation, warrants and PIPE financings. For example, the prospectus cover would be required to state the amount of the compensation received or to be received by the SPAC sponsor and its affiliates, and whether this compensation may result in material dilution of the purchasers’ equity interests, as well as a prescribed table showing the impact of potential redemptions. The SEC observes that dilution “may be particularly pronounced for the shareholders of a SPAC who do not redeem their shares prior to the consummation of the de-SPAC transaction and who may not realize or appreciate that these costs are disproportionately borne by the non-redeeming shareholders.”
- Additional disclosures about de-SPAC transactions, including a “reasonably detailed discussion” of both the benefits and detriments, quantified to the extent practicable, of the de-SPAC transaction and any related financing transaction to the SPAC “and its affiliates, the SPAC sponsor and its affiliates, the target company and its affiliates, and unaffiliated security holders.” The proposal would also require a statement by the SPAC as to whether it “reasonably believes that the de-SPAC transaction and any related financing transaction are fair or unfair to unaffiliated security holders of the SPAC,” and whether the SPAC or SPAC sponsor “has received any report, opinion or appraisal from an outside party relating to the consideration or the fairness of the consideration to be offered to security holders or the fairness of the de-SPAC transaction or any related financing transaction” to the SPAC.
- Certain disclosures in the prospectus summary of registration statements filed in connection with SPAC IPOs and de-SPAC transactions.
The proposal would also provide for additional procedural protections and “align the disclosures provided, as well as the legal obligations of companies, in de-SPAC transactions more closely with those in traditional initial public offerings.” More specifically, the proposal would:
- “Amend the registration statement forms and schedules filed in connection with de-SPAC transactions to require additional disclosures about the private operating company;
- Require that disclosure documents in de-SPAC transactions be disseminated to investors at least 20 calendar days in advance of a shareholder meeting or the earliest date of action by consent, or the maximum period for disseminating such disclosure documents permitted under the laws of the jurisdiction of incorporation or organization if such period is less than 20 calendar days;
- Deem a private operating company in a de-SPAC transaction to be a co-registrant of a registration statement on Form S-4 or Form F-4 when a SPAC files such a registration statement for a de-SPAC transaction, such that the private operating company and its signing persons would be subject to liability under Section 11 of the Securities Act as signatories to the registration statement;
- Amend the definition of smaller reporting company to require a re-determination of smaller reporting company status following the consummation of a de-SPAC transaction [e.g., measuring public float as of a date within four business days after the consummation of the de-SPAC transaction]; and
- Propose a definition for ‘blank check company’ that would encompass SPACs and certain other blank check companies for purposes of the Private Securities Litigation Reform Act of 1995 (PSLRA) such that the safe harbor for forward-looking statements under the PSLRA would not be available to SPACs, including with respect to projections of target companies seeking to access the public markets through a de-SPAC transaction.”
In addition, to motivate SPAC underwriters to conduct due diligence with “the care necessary to ensure the accuracy of the disclosure in these transactions,” the SEC is proposing new Securities Act Rule 140a, which “would deem anyone who has acted as an underwriter of the securities of a SPAC and takes steps to facilitate a de-SPAC transaction, or any related financing transaction or otherwise participates (directly or indirectly) in the de-SPAC transaction to be engaged in a distribution and to be an underwriter in the de-SPAC transaction” and subject to Section 11 liability for that information.
Business combinations involving shell companies
To address the concern that private companies have used public shell companies to go public in various forms of transactions, including SPACs, without conducting an IPO and without providing shell company shareholders disclosures about the private company in a registration statements, the SEC is proposing to add new Rule 145a, which would deem any business combination of a reporting shell company, involving another entity that is not a shell company (excluding business combination-related shell companies), to involve a sale of securities to the reporting shell company’s shareholders.
The SEC is also proposing to add new Article 15 of Reg S-X and related amendments to more closely align the requirements for financial statements in business combinations involving a shell company and a private operating company with those in traditional IPOs.
The proposal would also amend Item 10(b) of Reg S-K to address broader concerns regarding the use of projections generally by enhancing the reliability of projections disclosure, while proposed Item 1609 of Reg S-K would address concerns specific to de-SPAC transactions. The proposed amendments to Item 10(b)—which would apply generally and would not be limited to SPACs—would update the SEC’s view on “factors to be considered in formulating and disclosing financial projections and would specify the application of Item 10(b) to financial projections prepared by parties other than management.” Drawing on Reg G, the proposal to amend Item 10(b) is designed to “address specific concerns that some companies may present projections more prominently than actual historical results (or the fact that they have no operations at all) or use non-GAAP financial measures in the projections without a clear explanation or definition of such a measure.”
Under Item 1609, as proposed, for projections disclosed in the filing, disclosure would be required of the purpose for which the projections were prepared, and the material bases and assumptions underlying the projections and any factors that may impact the assumptions, including “a discussion of any material growth rates or discount multiples used in preparing the projections, and the reasons for selecting such growth rates or discount multiples.” If the projections relate to the performance of the SPAC, the disclosure must include whether the projections reflect the view of the SPAC’s management or board about its future performance as of the date of the filing; if the projections relate to the target company, the disclosure must state whether the target has affirmed to the SPAC that the projections reflect the view of the target’s management or board about its future performance as of the date of the filing.
Status of SPACs under the Investment Company Act of 1940
The SEC suggests that “some SPACs have sought to operate in novel ways that suggest a need for SPACs and their sponsors to increase their focus on evaluating when a SPAC could be an investment company and thus subject to the requirements under the Investment Company Act of 1940.” To help “refocus” SPACs on that issue, the SEC is proposing a new non-exclusive safe harbor from the definition of “investment company.” The conditions of the safe harbor would include, among others, that the SPAC:
- “Maintain assets comprising only cash items, government securities, and certain money market funds;
- Seek to complete a de-SPAC transaction after which the surviving entity will be primarily engaged in the business of the target company; and
- Enter into an agreement with a target company to engage in a de-SPAC transaction within 18 months after its initial public offering and complete its de-SPAC transaction within 24 months of such offering.”
You might recall some litigation in 2021, in which the plaintiff, represented by two law professors—including former SEC Commissioner Robert Jackson—contended that the company, a SPAC organized by a billionaire hedge-fund investor, was really an investment company that should have been registered under the Investment Company Act of 1940 and that its sponsor was really an investment adviser that should have been registered under the Investment Advisers Act of 1940. Had they registered, so the argument went, 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 [the SPAC] has ever done.” The complaint sought “a declaratory judgment, damages, and rescission of contracts whose formation and performance violate” the ICA and IAA. Although the hedge fund investor objected that the claims in the complaint were without merit, it was 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.
The contention that the SPAC was an Investment Company under the ’40 Act was also met with a joint statement, signed by over 55 major law firms, including Cooley, pushing back on the plaintiff’s claims and asserting that there was no legal or factual basis for the allegation that SPACs were investment companies. 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.” (See this PubCo post.)
At the open meeting
If you didn’t already guess, Commissioner Hester Peirce dissented. Her view is neatly summed up here: “The proposal—rather than simply mandating sensible disclosures around SPACs and de-SPACs, something I would have supported—seems designed to stop SPACs in their tracks.” Rather than just “mandate disclosures that would enhance investor understanding,” the proposal, in her view, “imposes a set of substantive burdens that seems designed to damn, diminish, and discourage SPACs because we do not like them.” Peirce raised objections to proposed substantive changes such as requiring the SPAC to state whether the de-SPAC transaction is fair to unaffiliated shareholders (which Peirce contended effectively mandates obtaining a third-party fairness opinion), deeming target companies to be co-registrants at the de-SPAC stage, and eliminating the PSLRA safe harbor for projections in connection with the de-SPAC transactions (which, she contended, market participants view as useful). She also took issue with the proposed provision that would deem a SPAC IPO underwriter to be an underwriter in the de-SPAC transaction if it participated (directly or indirectly) in the de-SPAC transaction; instead of encouraging due diligence by underwriters about the target, she argued, that provision would likely have the opposite effect of encouraging underwriters to do everything possible to avoid being captured by the rule. Likewise, she objected to establishing a ’40 Act safe harbor, contending that adherence to the safe harbor conditions might actually harm investors. In addition, she objected to some of the changes that go beyond SPACs to all shell companies. The SEC’s actions here go too far, she argued: “[u]nderlying this proposal may be a concern that the SPAC boom is producing public companies that are not good for investors. It is not our place to decide that SPACs are good or bad. By arming investors with enhanced disclosure, we empower them to decide whether a particular SPAC is a good investment.”
Commissioner Allison Herren Lee voted in favor of the proposal. To Lee, the “complexity and the novelty of the SPAC structure have yielded a host of questions, including whether shareholders have adequate insight into the compensation, incentives, and potential conflicts related to the SPAC sponsors, whether the absence of traditional investor protections and liability, or at least uncertainty about their application at the de-SPAC stage, leaves shareholders vulnerable, and generally whether retail shareholders may be left holding the bag on an ill-advised or underperforming business after sponsors have collected their compensation and insiders have cashed out their shares.” The proposal is designed to address these issues, she said, by imposing new disclosure requirements to enhance transparency about, among other topics, sponsor compensation, conflicts of interest and the potential for dilution of share value, and clarifying liability provisions to enhance accountability, such as by subjecting the private target private company to traditional signing liability as a co-registrant and clarifying that SPAC IPO underwriters may be underwriters in the de-SPAC transaction. Lee also raised the question for commenters of whether other participants in the de-SPAC transaction could also be subject to statutory underwriter liability if they participated in the distribution. She also questioned whether the proposal has taken the right approach on the ’40 Act safe harbor. Ultimately, she favored the proposal, contending that it is “tailored to address investor protection gaps in the existing regime, which should increase investor confidence in SPACs and help ensure their continuing viability as a pathway to the public market.”
Commissioner Caroline Crenshaw also voted in favor of the proposal, remarking that, while she was “supportive of companies having greater access to the public markets through a variety of avenues, the current SPAC boom highlighted a process with significant conflicts of interest and a host of misaligned incentives. The result is a process that can extract fees and compensation at the expense of shareholders. And, a process that may overvalue the prospective public company to the detriment of the public markets and investors.” The complex structure of SPACs, she said, can lead to concerns about conflicts of interest arising, for example, because compensation to SPAC sponsors and to SPAC IPO underwriters is contingent upon completion of a de-SPAC transaction, leading to the possibility that they “may prefer a sub-optimal deal over no deal at all.” The proposal seeks to address these issues with improved disclosure and accountability measures, such as making the PSLRA safe harbor for forward-looking statements inapplicable (as in IPOs) to de-SPAC transactions.