With a record-breaking number of SPAC deals happening over the past year and half, there is bound to be some duds with paltry or negative return on investment. Duds, of course, make investors unhappy.
While it was inevitable that there will be a wave of SPAC lawsuits, one recent suit brought by investor George Assad against Bill Ackman’s Pershing Square Tontine Holdings, Ltd. (PSTH) has gotten the most attention not only because it was the largest SPAC created but also because of the arguments made by the plaintiff. One of the lawyers representing Assad is former SEC Commissioner Robert Jackson, who is currently a law professor at New York University.
Their argument is that the SPACs and their sponsors are violating the Investment Company Act of 1940 (ICA) because they are investment companies, not operating companies. And this could have far-reaching implications.
The complaint was filed on August 17, 2021, in the U.S. District Court for the Southern District of New York in Manhattan. Since then, Assad has filed other similar reform lawsuits.
At least for one legal expert, William Birdthistle, a professor at Chicago-Kent College of Law of Illinois Institute of Technology, this lawsuit against the billionaire hedge fund manager will send a chilling effect through new deals and may even be the death knell of SPACs.
A simple SPAC—Special Purpose Acquisition Company—is a shell company without operations that raises capital publicly for the sole purpose of identifying and merging with a target private operating company. The merger transaction infuses the target company with capital that it might otherwise raise in a traditional initial public offering (IPO).
There are two stages to a SPAC deal.
First, a SPAC registers redeemable securities for cash, sells them to hedge funds and other institutions, and puts the proceeds in a trust for a future acquisition of a private operating company. The next step is “de-SPAC” or a merger with a private operating company. A SPAC has 18 to 24 months to complete the merger, and this is one reason why SPACs have been popular. The process is faster than a traditional IPO.
Some critics like Jackson and the suit’s co-counsel Yale law professor John Morley believe there should be greater regulation of SPACs.
The complaint says that Ackman’s SPAC is the product of Pershing Square Capital Management, L.P. (PSCM), and it is the company’s latest fund product. The management company qualifies as the SPAC’s investment adviser under the Investment Advisers Act of 1940 (IAA). This SPAC fits the definition of an investment company, but it was not registered with the SEC. It was also not structured to meet an exemption from registration.
“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 PSTH has ever done,” the complaint states. “From the time of its formation, PSTH has invested all of its assets in securities. And it has spent nearly all of its time negotiating a transaction that would have invested those assets in still more securities.”
“By telling the world that PSTH is not an ‘Investment Company’ as that term is defined in the ICA, Defendants have structured PSTH so as to charge its public investors what amounts to hundreds of millions of dollars in compensation,” the suit said. “Under the ICA and IAA, the form and amount of this compensation are illegal.”
Birdthistle believes that coming from legal heavy hitters like Jackson and Morley gives gravitas to the case.
“Every business with an interest in going public or raising capital on Wall Street is going to need an answer to this litigation before they can move forward with their plans,” he said.
“The SPAC industry was already under increasing scrutiny from the SEC; if there is now a compelling new theory for why SPACS are violating federal law, that could be their death knell,” added Birdthistle. “The SEC has killed off other capital raising schemes before, with a relatively minor regulatory touch, like Initial Coin Offerings.”
Not So Fast, Other Legal Experts Say
As is usually the case, there is another argument.
In the view of Dave Brown, a partner with Alston & Bird LLP based in Washington, there are two parts to the lawsuit story.
“Although I do not think that the lawsuit has much merit, it does cause some deal and transaction uncertainty, which in turn can cause delays,” Brown said. “The SEC has looked at SPACs for decades with a skeptical eye and has never called them an investment company. I think the lawsuit is an ill-advised attempt to force the SEC into a change in policy that is not consistent with the regulations.”
Forty-nine of the nation’s leading law firms issued a joint statement on August 27, saying that the assertion that SPACs are investment companies is without factual or legal basis. These law firms have plenty of former SEC officials, including chair, commissioner, and staff.
An investment company is primarily engaged in the business of investing. SPACs, on the other hand, are primarily engaged in identifying and executing a merger with one or more operating companies in a specified period of time.
“Consistent with long-standing 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,” the statement reads. “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.”
In the meantime, in a long August 19 letter to PSTH shareholders, Ackman wrote that Jackson and Morley should very well know as law professors, holding cash and government securities while seeking a business combination does not make PSTH an illegal investment company.
“While we believe the lawsuit is meritless, the nature of the suit and our legal system make it unlikely that it can be resolved in the short term,” he wrote. “Even if the case were dismissed expeditiously, the plaintiff can then appeal. As a result, the mere existence of the litigation may deter potential merger partners from working with PSTH on a transaction until the lawsuit is finally resolved.”
Thus, he is trying to get a registration approval from the SEC for Pershing Square SPARC Holdings, Ltd. (SPARC). He would liquidate PSTH.
“We are hopeful that SPARC’s favorable investor protection features will facilitate a timely approval,” the letter states. “The principal benefit of SPARC is that it would not hold investors’ money while we are looking for a target. This eliminates the substantial opportunity cost of capital that burdens all SPAC investors.”
“I think Ackman’s actions in response to the lawsuit are more about deal certainty than any merit the lawsuit may have,” Alston & Bird’s Brown said.
This article originally appeared in the August 30, 2021 edition of Accounting & Compliance Alert, available on Checkpoint.
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