Special purpose acquisition companies or SPACs have greatly increased in number over the past two years, far outpacing the number of IPOs—a phenomenon that’s due in part to private equity and venture capital firms being flush with cash. Will the SEC’s recent heightened scrutiny in the area chill the SPAC rush?
This blog post looks at special purpose acquisition companies (SPACs)—shell companies created for raising capital to buy an existing, privately held firm and take it public more quickly than would be possible by going the traditional initial public offering (IPO) route, and examines the SEC’s growing focus on their filings. SPACs are attractive because of the speed with which they can take a company public, and because less SEC regulation is involved as compared to a traditional IPO. There is less SEC regulation at least partially because the review process is considerably more streamlined given the absence of historical financial data and because SPACs, unlike IPOs, are thought to be able to take advantage of the safe harbor rules for forward-looking statements under the Private Securities Litigation Reform Act of 1995 (PSLRA).
With that said, SPAC investments do have their disadvantages, some of which are the focus of SEC scrutiny: concerns around due diligence disclosures, forward-looking statements, and warrant accounting. Before moving to the business impact of this scrutiny, let’s examine how a SPAC works.
SPAC shells, which have no operations of their own, are generally formed by a group of investors called sponsors, who raise money from other investors. The investors receive units in return for their investment, with each unit consisting of a share of common stock and a warrant to purchase more stock at a later date. Units of a SPAC’s IPO are registered under the Securities Act on a Form S-1 registration statement. After a SPAC goes public, it can take up to two years for it to pick and announce the company that it wants to acquire or merge with, a move that marks the start of the de-SPAC process. If the SPAC requires additional funds to complete the merger, it may issue debt or additional shares, such as a private investment in public equity (PIPE).
Once a SPAC acquires or merges with a target, it becomes subject to SEC rules and regulations governing public companies, including the requirement to file a Form 8-K (referred to as a “Super 8-K”) within four business days of closing that contains all of the information that would be required in a Form 10 registration statement filed by the target. If the SPAC doesn’t move in on a target company within the applicable timeframe, it is liquidated, and the funds raised are returned to investors. This provides a great incentive for the sponsors to find a target company, especially since they usually get an equity stake of approximately 20 percent in the target.
Bumps in the road
According to SPAC Research, during the first four months of 2021, more than 300 SPACs valued at nearly $100 billion were listed in the US, already surpassing the figure for all of 2020, which itself had been a record-breaking year, and 130 mergers worth almost $290 billion had completed. In contrast, fewer than 100 IPOs listed in the same time frame. This SPAC boom has undoubtedly caught the attention of the SEC, with Staff in the Division of Corporation Finance issuing CF Disclosure Guidance: Topic No. 11, Special Purpose Acquisition Companies, in late December 2020, followed by a series of Staff statements this year from the Office of the Chief Accountant and the Division of Corporation Finance (available on Thomson Reuters Checkpoint)—all of which highlight disclosure and accounting considerations for SPACs to bear in mind and which may result in slowing this frenzy considerably.
1. Inadequate due diligence disclosures
The SPAC process described above often translates into the due diligence not being as rigorous as that for a traditional IPO, which generally means that the related disclosures are inadequate. SEC Staff indicated that it’ll be looking closely at the adequacy of disclosures in offering documents in several areas to make sure that SPAC shareholders have the material information that they need to make informed decisions. (see, for example, SECPlus Filings Highlights (“Highlight”), Panacea Acquisition Expands Upon SPAC Disclosures in Response to SEC Comments, dated June 18, 2021, and Legacy Acquisition Faced With SEC Comments on Level of Diligence in SPAC Merger, dated February 25, 2021, available on Thomson Reuters Checkpoint).
One such area involves sponsor disclosures about conflicts of interest, because the economic interests of SPAC sponsors aren’t the same as those of SPAC investors and may even be at odds. Remember, since SPAC sponsors are generally tasked with finding a workable acquisition or merger within a couple of years and not necessarily the best possible deal, they aren’t really incentivized, for example, to avoid having the SPAC overpay for the target company.
Another focus area relates to sponsors’ obligations and commitments to parties other than the SPAC, like relationships between SPAC management and target management or any private investors, and how those allegiances may affect their evaluation of a business combination.
SEC Staff also indicated that it will be looking closely at whether the post-SPAC public operating company is following the rules and regulations that govern public companies. For example, public companies are generally required to assess the effectiveness of internal control over financial reporting annually and evaluate on a quarterly basis the effectiveness of disclosure controls and procedures. Target companies have to understand these requirements and put in place a compliance plan, as they may not have experience with annual or interim reporting nor with public companies’ accelerated adoption schedule for new accounting standards.
2. Confusion around safe-harbor statements
A statement by Acting Director of the Division of Corporation Finance John Coates in April 2021 hints that the safe harbor protections for forward-looking statements under the PSLRA–which already aren’t available for IPOs–may not necessarily be available for a de-SPAC transaction’s financial projections either, potentially taking away a key advantage that SPACs have over IPOs. In fact, Acting Director Coates argues that a de-SPAC transaction is, in substance, an IPO and should be regarded as such, and suggests that the SEC may carry out some rulemaking to clarify the scope of the PSLRA’s safe harbor protections. Losing that safe-harbor protection could deal a great blow, especially for early-stage companies who often don’t generate revenue or profits for quite some time, but instead rely heavily on market projections and forward-looking guidance to raise funding. Apparently, the House Subcommittee on Investor Protection, Entrepreneurship and Capital Markets is taking a page from Coates’ book, as it debated a draft bill in late May 2021 that would prevent SPACs from taking advantage of the safe harbor rules, potentially putting them on much the same footing as regular IPOs.
Even if the safe harbor rules continue to apply to SPACs, they only apply to private litigation and don’t provide protection from SEC action for false or misleading statements. A number of SPACs have been accused by the SEC of issuing statements that include only their more optimistic projections. Most recently, SPAC Stable Road Acquisition Company, its sponsor, merger target and CEOs were all charged by the SEC for making misleading claims about successfully testing the company’s propulsion technology in space.
3. Misapplication of new warrant accounting
Another issue raised concerns the accounting for warrants, contracts giving the holder the right to purchase a specific number of additional shares of common stock in the future at a certain price, often at a premium to the stock price at the time the warrant is issued. Warrants are covered under FASB ASC Topics 480, Distinguishing Liabilities from Equity, and 815, Derivatives and Hedging, which require companies to assess whether the warrants they issue should be classified as equities or liabilities. Warrants categorized as liabilities must be accounted for at fair value, and since changes in fair value between reporting periods run through the income statement, that introduces volatility into earnings. The SEC has indicated that some SPACs haven’t properly accounted for their warrants, and an increasing number have already issued financial restatements due to adjusted valuations of warrants (see Highlight, Canoo May Be Required to Restate Financials Per Recent SEC Guidance on SPACs, dated April 20, 2021). This increased scrutiny by the SEC could lead to even more restatements.
Although new SPACs are still forming and selecting targets on a regular basis, the accounting going forward likely will be more rigorous and subjected to stricter review. That, along with the above issues, should be enough to at least give pause to investors before jumping on the SPAC bandwagon.
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