Bates Research | 06-09-22
Regulatory and Legislative Action on SPACs Gaining Momentum: SEC Rule Proposal and Senate Legislation Introduced; Class Actions Growing
It has been clear for some time that regulators are targeting special purpose acquisition companies (“SPACs”) for increased scrutiny, tighter rules, and aggressive enforcement. (See Bates White Paper.) The SEC has responded to the market phenomenon over the past few years by publishing guidance, issuing frequent warnings on the inherent risks of these structures, and ramping up its compliance investigations and enforcement actions (See previous Bates post). On March 30, 2022, the agency took the next step by proposing rules on SPACs. The amendments would enhance disclosure in SPAC initial public offerings (“IPOs”) and business combination transactions involving shell companies.
SPACs have been on the radar of legislators as well. In September, 2021, Senators Warren (D-Mass.), Sherrod Brown (D-Ohio), Tina Smith (D-Minn.), and Chris Van Hollen (D-Md.) sent letters to prominent SPAC “creators” seeking information about potential abuse by insiders who “are taking advantage of legislative and regulatory gaps at the expense of ordinary investors.” In November, Senator Warren asked the SEC to investigate potential securities violations (i.e. failures to provide material information and other filing omissions) related to one SPAC’s plan to merge with former President Trump’s Media and Technology Group. Based on these and other reported concerns, Senator Warren released a report in May titled: The SPAC Hack: How SPACs Tilt the Playing Field and Enrich Wall Street Insiders. The Report is intended to serve as the basis for her proposed legislation: the “SPAC Accountability Act of 2022.”
This regulatory and legislative activity comes amid poor overall SPAC performance and volatility. As a result of all this attention, the market for SPACs has recently soured. In this article, we review the proposed SEC regulation, Senator Warren’s SPAC report, the anticipated legislation, and current conditions.
SEC Proposal on SPACs, Shell Companies, and Projections
In a fact sheet, the SEC stated that the new rule on SPACs was needed due to (i) the “unprecedented surge in the number of initial public offerings,” (ii) “heightened investor protection concerns about various aspects of the SPAC structure,” (iii) the “increasing use of shell companies as mechanisms for private operating companies to become public companies,” and (iv) projections and forward-looking statements by private operating companies that may lack a reasonable basis. The proposed rules are intended, therefore, to provide additional investor protections in initial public offerings by SPACs and in de-SPAC transactions.
The 372-page rule proposal responds to concerns in several ways, first and foremost by requiring specialized disclosure on compensation paid to sponsors, conflicts of interest, sources of dilution, and business combination transactions. The proposal would amend financial statement requirements on transactions involving shell companies and includes new guidance on such disclosure. Further, the proposal would require additional disclosure in Commission filings on any use of projections of future economic performance.
The proposal also expands the definition of SPACs as “investment companies” under the Investment Company Act, thus ensuring agency oversight by “deem[ing] any business combination transaction involving a reporting shell company, including a SPAC, to involve a sale of securities to the reporting shell company’s shareholders.”
Under the proposal, a SPAC would have a safe harbor from registration as an investment company if it “fully complies with the rule’s conditions,” by (i) maintaining certain types of assets (cash items, government securities, and certain money market funds); (ii) “seek[ing] to complete a de-SPAC transaction after which the surviving entity will be primarily engaged in the business of the target company,” and (iii) agreeing to engage in a de-SPAC transaction within 18 months after its IPO and complete its de-SPAC transaction within 24 months.
The comment period closes on June 13, 2022.
Senator Warren’s SPAC Report
Senator Warren’s Report is an indictment on the use of SPACs as a vehicle to avoid the requirements placed on traditional IPOs. Her investigation consisted of a review of responses received from the Senators’ letters to SPAC creators, contributions from the SEC, and other public disclosures. The resultant Report “finds that the structure of SPACs routinely rewards serial SPAC creators and Wall Street backers while leaving retail investors at risk from SPACs’ convoluted structure and incentives for dilution, fraud, and abuse.”
Senator Warren draws several conclusions:
- SPAC “sponsors’ incentives and outcomes do not align with retail investors;” the Report found that “from 2019 to 2021, SPAC sponsors received average returns of 958 percent, even as companies taken public by SPACs consistently underperformed the market and retail investors took losses.”
- SPAC “shortcuts give institutional investors and Wall Street insiders opportunities that dilute shares for retail investors and put companies at risk;” the Report found that “institutional investors are given early access to information and discounted stock before retail investors can participate on the open market.” These “shortcuts” include the ability to participate - at a discounted rate - in private investment in public equity (so-called “PIPES,”) and access to redemption rights that can insulate institutional investors from any risk or long-term investment in the public company.
- Financial institutions can charge excessive and hidden fees; the Report states that financial institutions charge fees that outstrip those of a traditional IPO, including an underwriter fee, a PIPES placement agent fee, and a financial advisor fee.
- SPACs incentivize inadequate and fraudulent disclosures; the Report states that SPACs are “rife” with disclosures where companies “used inflated information about their financials, their future business, or even their underlying technology.”
- SPACs allow rampant self-dealing at the expense of retail investors; the Report states that the flawed regulatory rules allow SPAC sponsors to “pay advisory fees to companies they are associated with, participat[e] in PIPEs and private investment rounds despite their clear insider knowledge, and even choos[e] their own companies as acquisition targets.”
The Report concluded that regulation and legislation is necessary to protect retail investors and the integrity of the markets. Senator Warren acknowledged that the SEC proposed rules would address many of the issues her office identified. She noted, among other things, that the proposed SEC amendments would cover “dilution of SPAC shares, inadequate disclosures, and the use of forward-looking statements to make overblown or even fraudulent projections.” She also highlighted that the SEC’s proposal would give teeth to enforcement, increasing the legal liabilities for involved parties in a de-SPAC transaction by expanding the definition of underwriters to anyone who acted as an underwriter for the initial SPAC offering. That said, the Senator recommended legislative action to strengthen the SEC’s authority to crack down on SPAC malfeasance.
Legislation on the Horizon
The Report previewed the senator’s anticipated legislation: the SPAC Accountability ACT of 2022. The bill would, purportedly, “close regulatory loopholes” (as to the current use of the existing safe harbor provisions) and “codify the [SEC’s] amended definitions [on ‘investment companies,’ ‘underwriters’ and ‘blank check’ companies] into law.” The intention of the bill, according to the Report, is to enhance investor disclosure, “to require SPAC sponsors and underwriters to have a greater stake in their merged companies’ futures,” and to impose “greater liability during the SPAC IPO and de-SPAC process.” The Report states that the expanded definition of “underwriter” would increase the liability of SPAC sponsors and financial institutions, and the bill would also require SPAC sponsors’ shares “to remain locked-up until the company has projected bringing in revenue in forward-looking statements.”
Regulatory and legislative attention to SPACs is a direct result of their proliferation. Senator Warren cited the numbers: “In 2019, 59 SPACs raised more than $13 billion… In 2021, there were 613 SPAC listings raising a total of $145 billion.” Federal civil actions also reflect the increase in attention. (e.g., Stanford Law School’s Class Action Clearinghouse is now tracking 63 filings since January 30, 2019. These are primarily cases where investors allege that they were misled by company statements.)
Beyond the historical data cited by the Report, the market has not been kind to SPACs during this recent period. The New York Times reported the following: “around 600 SPACs that went public in the past couple of years are still trying to complete deals … seven SPACs have folded since the beginning of the year ... 73 SPACs that were waiting to go public have shelved their plans … and a fund that tracks the performance of 400 SPACs is down 40 percent over the past year.” The Wall Street Journal reported that “about 90% of the companies that completed SPAC mergers during the boom that started in 2020 now trade below the SPAC’s initial listing price … some investors expect many SPACs to pursue low-quality companies to take public at improper valuations to stave off possible losses… and analysts say many SPACs won’t find mergers because there simply aren’t enough companies that will want to complete SPAC deals in time.”
Whether regulator warnings, guidance, enforcement actions (primarily related to disclosure and compliance failings) and now proposed rules and anticipated legislation protect retail investors and rectify problems on the use of SPACs as an investment vehicle is yet unknown. The market volatility may preempt the conversation. Bates will keep you apprised.