‘SPAC-Tacular’ Growth Means More Enforcement Ahead

A once-derided investment vehicle, the SPAC is surging as investors turn the traditional IPO process on its head to streamline the public offering process and leverage a booming stock market. A company’s decision to assume the sometimes substantial undertaking to make an initial public offering (“IPO”) opens the floodgates to a deluge of regulatory obligations and disclosures about the details of its business operations. The payoff, however, can be vast; once the Company hits public markets, it has unparalleled access to capital and a bump in prestige.

SPACs are becoming a popular way to skip the heavy lifting of an IPO. Once relegated to the shadowy margins of the financial markets, SPACs are squarely in the mainstream. By one analysis, in 2020, SPACs raised as much capital in initial IPOs as they had in every IPO during the preceding decade. In the same year, roughly 25% of the IPOs reviewed by the SEC’s Division of Corporate Finance were SPACs. SPAC sponsors are no longer only lower-end market participants; they are attracting big-name investors such as Bill Ackman, former Yankee Alex Rodriguez, and Shaquille O’Neal. Investment Banks and other institutional players are also taking notice, bulking up their SPAC teams to take advantage of the growing opportunity.

Investors, however, are not the only ones watching. With an explosion of interest in these investment vehicles comes more regulatory scrutiny. In December 2020, the U.S. Securities and Exchange Commission released guidance regarding its enforcement posture for SPACs’ disclosure obligations. Enforcement is sure to follow. As more SPACs are formed and target promising companies for acquisition, regulators are poised to bring enforcement actions against SPACs that it perceives as running afoul of securities laws. Because most SPACs must make an acquisition within two years of formation, it is only a matter of time before SPACs are at the center of major securities litigation.

What’s a SPAC, anyway?

The basic idea is simple: what if instead of investing in a private company through a lengthy and expensive IPO, investors first pooled their money in a shell corporation that was already public (the SPAC) that later merged with a private company? Because a SPAC has no real business operations, it can go public with less paperwork than is required in a typical IPO. Then the SPAC sets out in search of a private company that is ready to be listed on the stock market but would rather avoid full disclosure of its structure or operations. The target company gets a name on the stock market and a quick infusion of cash. The target company can hit the market with the expertise of the SPACs’ presumably savvy management team. The SPACs’ investors, meanwhile, now own stock in an actual operating company. This dynamic has led some commentators to call SPACs a “poor man’s private equity” – retail investors can marshal their money behind sophisticated financial managers who see private companies that are ripe for public trading.

Despite this simple premise, the current generation SPACs are a relatively recent invention, having existed only since the mid-2000s. Behind today’s relatively sophisticated investments lies a checkered past. SPACs trace their ancestry to the so-called “blank-check companies” of the 1980s and 90s. These companies garnered harsh criticism; they regularly failed to acquire a target company, leaving the SPACs’ investors holding the bag. Congress and the SEC responded with legislation and regulations intended to curb the most rampant abuses of blank-check companies. In theory, today’s SPACs are more than a shell company; they carry enough capital to make a real acquisition and are backed by managerial expertise to identify profitable investment opportunities. Modern SPACs also afford investors additional safeguards such as downside protections up to the value of their initial investment. Prior to an acquisition, the SPACs’ shareholders hold a vote on the merger and may be able to redeem their shares in the SPAC. In a typical arrangement, the SPAC must make an acquisition with two years of its IPO or liquidate their assets and return investors’ money.

Because investors do not know which company will be the target of an investment, they must put immense faith in the experience and reputation of the management team. As one would expect, then, SPACs with the backing of established investment banks have flourished. Goldman Sachs has formed two SPACs, raising more than $1 billon in the process. Former heads of major banks such as Credit Suisse and Deutsche Bank have set out to leverage their name recognition to raise hundreds of millions of dollars via SPACs.

An early SPAC acquisition illustrated the promise of this investment vehicle. In 2007, a SPAC called Endeavor Acquisition Corp. purchased the up and coming, trendy fashion company American Apparel. At the time of the acquisition, American Apparel’s controversial CEO Dov Charney touted SPAC-acquisition as a way to raise capital without the scrutiny of a traditional IPO. The Company experienced rapid growth after the going public via a SPAC, only to be undone by Charney’s poor leadership and a series of sexual harassment allegations, including against Charney himself. The American Apparel acquisition nevertheless signaled the willingness of an aggressive private company to use SPACs as an entrée to public markets while short circuiting the normal IPO disclosure process. Other household names have followed suit, companies such as Burger King and Richard Branson’s Virgin Galactic have gone public using a SPAC.

Regulatory Scrutiny on the Horizon

In light of SPACs’ provenance and recent rise in the size and popularity, it is no surprise that Government regulators have looked askance at their surge in popularity. Although SPACs have proliferated in recent years, as more of these companies run up against the typical two-year deadline by which they must make an acquisition or liquidate their assets, regulatory enforcement and litigation is likely on the horizon.

Recent SEC enforcement actions make clear that the Agency’s principal concern is opening the flow of information to SPACs’ investors and avoiding conflicts of interest. In 2019, the SEC brought administrative charges  against a SPAC called Cambridge Capital Acquisition Corporation. The charges centered around the due diligence the company conducted prior to acquiring a technology company. The Agency alleged that Cambridge’s management team failed to provide its investors with accurate information about the target company including its current and future business prospects. The action resulted in civil penalties against the SPACs’ CEO and suspensions on Cambridge’s ability to trade. SPACs’ management teams must therefore be careful to evaluate both the quantity and quality of information they collect and disseminate to investors; skimping on either is likely to put a SPAC acquisition under the SEC’s microscope.

Regulators have not, however, taken the position that SPACs are inherently abusive. In September 2020, then-SEC Chairman Jay Clayton stated that SPACs “create[] competition around the way we distribute shares to the public market,” and affirmed that “competition to the IPO process is probably a good thing.” This, of course, does not mean a return to the Wild West days of blank-check companies. The Agency has, however, emphasized in recent months that a SPAC “is not a short cut there through the SEC process.” Indeed, while a SPACs’ initial IPO may be faster because the company has no operations, the so-called “deSPACing” – when the SPAC purchases a private company – will be subject to scrutiny. Of particular importance to regulators are issues related to SPACs’ sponsors, the experienced management team that forms and governs the SPAC. Because investors put their money in SPACs blindly, they are reliant on the sponsors market savvy and experience. The SEC has signaled that it will evaluate features such as the sponsors’ compensation and the risk disclosures made to investors to ensure that sponsors are pursuing viable companies. For instance, because sponsors are compensated through shares of the acquired company, regulators have expressed concern that SPACs may make a hasty acquisition rather than be forced to liquidate, or that sponsors will cut side deals with reluctant shareholders.

The Agency’s December 2020 Guidance document is perhaps the most helpful predictor of the enforcement priorities to come. Broadly, the Guidance can be understood in connection with the typical lifecycle of a SPAC, with an emphasis on potential conflicts of interest between a SPACs’ directors and sponsors and its shareholders.

• At the time of the SPACs’ IPO, the SEC encourages the SPACs’ sponsors, directors, and officers to disclose any potential conflicts of interest or other business entities to which they may owe fiduciary or contractual duties, and whether the SPAC may seek to acquire a target with which a sponsor or director is involved. Likewise, sponsors, directors, and officers should disclose other securities interests they hold and how those may conflict with the interest of the SPACs’ shareholders. Sponsors, directors, and officers should make clear how they will be compensated if the SPAC successfully acquires a private company. Lastly, a SPACs’ management should be transparent about whether sponsors and public shareholders have different classes of shares in the SPAC and the respective rights of both classes.
• The next crucial point in time for a SPAC is the deadline by which it must acquire a company or liquidate and redistribute shareholders’ interests. Here, the SEC encourages SPACs’ sponsors, directors, and officers to disclose what their role will be in approving a proposed acquisition. Likewise, those individuals should be clear about their own financial incentives to avoid liquidation – e.g., if they will be compensated with shares of the target company. As this deadline approaches, a SPACs’ management should also make clear whether, and on what terms, the management team can amend the SPACs’ governing instrument to allow for more time.
• The SEC’s Guidance encourages SPACs to make a series of disclosures in connection with a deSPAC-ing transaction. Sponsors, directors, and officers should inform shareholders of whether any additional financing will be needed to complete the acquisition and, if so, under what terms. The management team should also disclose how it evaluated the target company and negotiated the terms of the acquisition. More particularly, sponsors, directors, and officers should disclose any interest they may have in the target company and the total percentage share they will own once the transaction is complete. 
• Lastly, if there was an underwriter for the SPACs’ IPO (as is common), the SPAC should disclose whether the underwriter will provide any additional services after the SPAC IPO, such as target evaluation, private placement services, or arranging debt financing. If the underwriter’s compensation is to be deferred until after an acquisition, the SPAC should disclose any financial incentive the underwriter has in the acquired company.

What Tomorrow Will Bring

If the explosion of SPACs is any indication, they are here to stay. As the current wave of SPAC formation crests, deadlines by which these vehicles must make an acquisition loom. Public comments and administrative guidance suggest that the proliferation of SPACs is high on the SEC’s list of enforcement priorities, with a special focus on the tension between the interests of sponsors and shareholders. With SPACs’ acquire-or-liquidate deadlines in sight, sponsors may be tempted to cut deals with shareholders to encourage them to approve a suboptimal acquisition or take advantage of loopholes in the SPACs’ shareholder agreement to buy more time. Lest SPACs find themselves on the wrong end of an SEC enforcement action, the entity’s sponsors, officers, and directors should be careful to be transparent and thorough as they look for hidden gems to bring public.

Anthony Sampson, an associate at the firm, assisted in the preparation of this blog.

To read more from Robert J. Anello, please visit www.maglaw.com.