Bates Research | 09-23-21
Regulators Turn Up the Heat on SPACs with More Enforcement and Potential Rulemaking
Regulators have moved from statements to guidance to alerts and now to enforcement and rulemaking in their efforts to gain some degree of control over the exuberant Special Purpose Acquisition Company (“SPACs”) marketplace. As highlighted in our white paper, published in late April 2021, the SEC had been prolific in stating its concerns about SPACS. There were warnings by the SEC Office of Investor Education and Advocacy (“OIEA”) to investors concerning the complexities of these financial vehicles and not to make decisions on SPAC investing based on celebrity endorsements; guidance issued by the SEC Division of Corporation Finance (“DCF”) on SPAC disclosures related to risks associated with fees, conflicts of interest, sponsor compensation; more guidance by DCF on SPAC accounting, financial reporting and governance responsibilities; and several important clarifying statements by DCF leadership on SPAC liability risk under the securities laws, and reporting considerations for warrants issued in connection with SPACs.
FINRA also weighed in by producing a guide for investing in SPACs (which highlighted the potential for conflicts of interest and the risk of fraud associated with the target company) and highlighting emerging concerns about anti-money laundering risks.
Given this ongoing attention, it was not surprising when FINRA President Robert Cook announced in July 2021 at a SIFMA conference that FINRA would pursue a regulatory sweep on SPACs. That effort dovetails with beefed up SEC enforcement action. Heightened scrutiny and litigation also underscore SEC Chair Gary Gensler’s publicly stated intention for strengthening SPAC regulations with forthcoming rulemakings. The Chair announced that he directed the SEC staff to look closely at each stage of the SPAC process to ensure that all investors are being protected.
Here we review the issues raised in some of the early enforcement efforts and where new SEC rules may be headed based on draft recommendations from the SEC Investor Advisory Committee and recent testimony by Mr. Gensler.
SPAC Enforcement Activity
According to the Stanford Law School Securities Litigation Clearinghouse, as of August 27, 2021, there were 22 filings of SPAC related federal class action lawsuits this year. Only four were filed in 2020 and six in 2019. Those types of lawsuits are often referred to as “stock drop” cases because the share values often experience dramatic price fluctuations when investors allege that they were misled by company statements.
Federal Class Action Lawsuits against SPACs
Prominent among the suits was the announced settlement of an SEC action against the Stable Road Acquisition Corp. (the SPAC) and its merger target Momentus (“the target”), a privately held company seeking to offer “space infrastructure services.” The SPAC engaged in a private placement of shares securing $175 million in investment commitments.
The SEC determined that the respondents repeatedly told investors that [the target] had “successfully tested its propulsion technology in space when, in fact, the company’s only in-space test had failed to achieve its primary mission objectives or demonstrate the technology’s commercial viability.” The SEC claimed that in registration and other public statements that the target and its former CEO made materially false statements, omissions, and engaged in other deceptive conduct, and that the SPAC “also engaged in negligent misconduct by repeating and disseminating [the target’s] misrepresentations in Commission filings without a reasonable basis in fact.” (In addition, the SEC found failures to disclose to investors, that the Committee on Foreign Investment in the United States (“CFIUS”) issued divestment orders related to the target’s CEO, or that the Department of Commerce denied the target CEO’s application for an export license for national security reasons.) As a result, the SEC alleged that the SPAC failed to engage in adequate due diligence as well as violated reporting and proxy solicitation provisions. The SEC also charged the target and its CEO with fraud and with causing the SPAC to engage in securities law violations.
To settle the case (and allow the de-SPAC transaction to proceed), the SPAC agreed to pay $1 million, the target agreed to pay $7 million, and the SPAC’s CEO agreed to pay $40,000. (The target’s former CEO did not settle and the SEC’s case against him is proceeding.) The SPAC and the target also agreed to provide investors with “the right to terminate their subscription agreements prior to the shareholder vote to approve the merger.” The target also agreed to enhance its disclosure controls, to form an independent board committee, and retain an internal compliance consultant for a period of 2 years.
On the settlement, Chair Gensler remarked: “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.”
The Stable Road Acquisition Corp. case is not unusual as an SEC legal strategy. Most of the federal suits concern similar charges for fraud or misrepresentations regarding material facts in the sale of the securities and the due diligence obligations of sponsors. But those are not the only types of cases being brought. New lines of legal attack are being pursued as well. Recent reports highlight lawsuits whose main purpose is to reinterpret SPACs as investment companies that should fall under the regulatory authority provided by the Investment Company Act of 1940. If successful, regulators will have additional tools to scrutinize SPACs (including, for example, over issues of compensation) under Investment Company Act regulations.
That effort is meeting resistance. On August 27, 2021, 60 prominent financial law firms published an unusual joint letter decrying the assertion that SPACs are investment companies, and arguing that any such interpretation would be contrary to “longstanding interpretations of the 1940 Act, and its plain statutory text.” Further, the firms highlighted the fact that “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.”
Whether or not the courts countenance such a change, it remains unclear whether such targeted use of enforcement is changing behavior in the market. There are many reports of SEC investigations, including on the adequacy of the disclosures of SPACs covering everything from health care technology to online betting. Some observe that the suits are having little to no effect. They cite research to show that while “the pace of listings has slowed, it is running much higher than before the boom began last summer—25 SPACs have gone public this month … with “more than $100 billion worth of SPAC mergers … announced in July alone.” Other analysts suggest that the market has been “spooked” not only by the regulatory crackdown led by the SEC over inadequate disclosure, but also by “many SPACs’ poor financial performance.”
Looking for a Bigger Stick; Regulators Start Talking about SPAC Rulemaking
On September 9, 2021, the SEC Investment Advisory Committee (“IAC”) adopted draft recommendations “focusing on the practical challenges SPAC investors face in fully assessing the risks and opportunities associated with these investment vehicles.” The IAC focused in on disclosure risk and proposed conducting an analysis of the “players in the various SPAC stages, their compensation, and their incentives.”
As to disclosure, the IAC recommended eight areas over which the Commission could enhance its focus and enforcement. They include clearer disclosure (i) concerning sponsors (including any potential conflicts of interest … and any divergence of the sponsor’s financial interest relative to that of the retail investors); (ii) using plain English in registration statements, particularly around “founders” compensation, and “their impact on dilution;” (iii) in the registration statement of the instruments, mechanics, and timeline of the SPAC process; (iv) in the registration statement of the target company areas of focus and the search parameters to be employed; (v) on the risks involved in finding target companies and “reaching market acceptable prices for those companies;” (vi) on terms under which any additional funding might be sought at the time of acquisition/redemption; (vii) on how the sponsor plans to assess the capability of potential targets to govern as a public company; and, (viii) on the minimum pre-de-SPAC due diligence including audits, accounting measures, and practices used by the target company.
In remarks before the IAC, Chair Gensler commended the recommendations, in particular the discussion around founders’ compensation and dilution. He referred to a report cited by Committee members concluding that “SPAC sponsors generate significant dilution and costs for investors.” He stated that he directed his staff to conduct “economic analysis to better understand how investors are advantaged or disadvantaged by SPAC transactions. That comment suggests that the Chair may be considering a far more ambitious rulemaking. The IAC, for its part, has also left options on the table, stating that “as more data emerges, the IAC intends to revisit the issue of SPAC governance in [the] future and may offer additional suggestions for reform in that area.”
The regulators have had SPACs in their sights for some time now. They responded to the exploding market phenomenon by publishing guidance and issuing warnings that raised awareness of the risks—particularly for retail investors—that the SPAC structure presents. The regulators then announced their intention to enhance enforcement efforts and followed up, primarily with disclosure and due diligence related actions. The next few months will reveal FINRA-related efforts. It may be too early to assess the impact of the enforcement efforts. It is unclear whether the targeted use of enforcement is curbing behavior or slowing the pace of SPAC mergers in the marketplace (despite much punditry and analysis on the subject).
The preliminary recommendations of the IAC and the continuing references to looming rulemakings focus on disclosure and due diligence. However, both the Chair and the Committee left the door open for more. Bates will keep you apprised
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 On August 30, 2021, FINRA issued more guidance on SPACs, adding to SEC warnings on warrants and urging investors to fully understand terms of what they are purchasing and how the redemption process works. Notably, FINRA stated that it was particularly concerned about retail investor exposure that had “increased substantially as a result of retail investors’ interest in the Initial Public Offerings (IPOs) of many SPACs.”