Last year the market for SPACs or special acquisition companies experienced a boom. Nearly 250 SPACs raised more than $ 80 billion in initial public offerings (IPOs) in 2020. This trend did not let up in the course of the calendar year. SPACs raised more capital in January and February 2021 than in all of 2020. However, from April we saw a sharp decline in the number of SPACs. While around 320 SPAC IPOs took place in the first quarter of 2021, the numbers fell by 90 percent in April. The downward trend has largely continued since then.
One possible cause of the slowdown in the SPAC is the numerous announcements by the US Securities and Exchange Commission concerning concerns about the adequacy of disclosure to investors and potential conflicts of interest for management and sponsors. SPACs are typically viewed as a more seamless way to conduct an IPO compared to traditional IPOs, and given the tremendous popularity of these transactions in recent years, the SEC is signaling that more restrictions are needed to ensure investor protection.
Speaking to the House Appropriations Subcommittee on Financial Services and General Government in May, SEC Chairman Gary Gensler said he was concerned about whether SPAC investors are being adequately protected by the SEC and whether retail investors are getting accurate information about SPAC transactions. Additional rules and recommendations are being considered to protect SPAC investors, he said. In June, the SEC announced that its regulatory agenda would change the SPAC rules in April 2022.
SPACs are a unique investment vehicle
A SPAC, also known as a blank check IPO or shell company, is a company with no operations or assets. A SPAC is set up with the sole purpose of raising capital through an IPO in order to acquire a private operating company. These letterbox companies are set up by a management team, often made up of investors or sponsors with expertise in a particular industry. The management team typically holds sponsor shares in the SPAC, while the remaining shares are held by public shareholders. As SPAC becomes a publicly traded company, it must comply with SEC regulations. The securities issued by SPACs are typically a unit that includes a share and a fraction of a stock warrant. Investors do not know which private company the SPAC wants to merge with, as a target company is identified after the IPO phase. The SPAC typically has between 18 and 24 months to acquire a target company, which is commonly referred to as a de-SPAC transaction.
If SPAC does not complete a merger within the deadline specified in its registration declaration, it must liquidate and repay the proportionate share of the shareholders in the total amount that is still deposited in the escrow account. If the SPAC acquires a target company within the specified time frame, the de-SPAC transition can take place. Once the merger is complete, the target company will become a public company and must meet the disclosure and regulatory requirements of the SEC.
Disclosure will be tightened
The first indication of crackdown on SPACs came in December when the SEC’s corporate finance division issued Conflict of Interest Disclosure guidelines for SPACs. A SPAC IPO must disclose whether its sponsors, officers, directors or management team have interests in other companies that could conflict with their obligations to the SPAC. This includes organizations that might compete with the SPAC for merger opportunities or that have competing financial interests. Insiders are also required to disclose any disputes related to their SPAC compensation or financial incentives in order to complete the merger within a specified time.
There is a long list of disclosure recommendations, including the insider-controlled percentage of votes for the merger, whether the time to target and other actions can be taken without the consent of the shareholders, details of the past experience of the sponsors and other insiders, compensation agreements between the SPAC and the lead manager whether additional funding might be required and the terms of any forward purchase agreements.
The SEC also wants additional disclosure of de-SPAC transactions, including terms for additional funding, terms for converting convertible bonds, details of the selection process for a target company, conflicts of interest between SPAC insiders with the target company, whether additional services will be provided to SPAC by the lead manager of the IPO and a fairness opinion to assess whether the merger is in the best interests of the shareholders. (See the SEC’s December statement here.)
Better recording will be needed
In March, the SEC issued an employee statement reminding the SPACs that they must comply with the existing requirements to “keep books, records and accounts in reasonable detail that accurately and fairly reflect the transactions and dispositions of the issuer over its assets reflect … [and] advise and maintain a system of internal accounting controls. “According to the SEC statement, when a SPAC merges with a target company, the newly listed company must be able to comply with its public reporting obligations. (See the statement of the SEC here.)
SEC warns of potential legal liability
Then in April the SEC tightened its requirements even further, issuing a statement cautioning against believing that the SPAC process permits forward-looking statements that could not be made in a traditional IPO.
Based on a safe harbor provision in the Private Securities Litigation Reform Act, it was believed that de-SPACs would benefit from not being exposed to the same liability risk for forward-looking statements as they would with conventional IPOs. The SEC cautioned that such a safe haven does not apply to SEC enforcement actions and only applies to private litigation if certain conditions are met, including “significant warnings” and forward-looking statements that contain no omissions or misstatements. Probably the most important part of the statement is the uncertainty it created. As it stands, Safe Harbor only applies to de-SPACS – not initial public offerings, and the SEC warned it could change the definition of an IPO to include de-SPACs. (See the SEC statement here.)
Warrants can be liabilities, not equity
Just days later, the SEC announced that under generally accepted accounting principles (GAAP), warrants issued by SPACs may need to be accounted for as a liability rather than equity if there is a provision to change the settlement amount of the warrant or if the warrant holder is eligible to receive cash in an offer to buy, and holders of common stock do not have the same rights. For many companies, this could mean that previous financial statements have to be adjusted. (See the SEC statement here.)
SPACs remain viable
None of this means that investors or sponsors should absolutely shy away from SPACs, which remain a creative way to invest in undervalued companies. Many SPACs have a track record of starting profitable public companies, and stricter disclosure and other rules will not negate that success. Sponsors and organizers should assume, however, that SPACs will adhere to the higher disclosure, liability and accounting requirements under discussion and that they will need to be more closely and more attentive to conflict and regulatory details than they have been in the past in the initial stages of capital increases .