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ANALYSIS: SPACs Go Splat; I-Banks Refuse to Write Blank Checks

May 18, 2022, 9:00 AM

The SPAC industry boomed but it’s now gone bust in the face of market forces and a proposed SEC rulemaking that’s “designed to stop SPACs in their tracks,” according to SEC Commissioner Hester M. Peirce.

SPACs have declined from 298 IPOs in the first quarter of 2021 to 55 in the first quarter of this year, and have notched only 13 IPOs through May 15 of the current quarter. Although most of that decline is market-based, the proposed rules and amendments issued by the Securities and Exchange Commission March 30 are already having an outsized effect and are more likely to permanently harm the SPAC market than the current adverse market conditions.

Proposed SEC Rule 140a Driving I-Bank Re-Think

Of the many proposed rules addressing special purpose acquisition companies, Securities Act Rule 140a may prove the most problematic for SPACs. It would make an underwriter for a SPAC’s IPO also liable as an underwriter for the de-SPAC transaction if certain conditions are met—generally, if the underwriter does anything that might be construed as facilitating the de-SPAC transaction or any related financing transaction.

The proposal is causing investment banks such as Goldman Sachs, Bank of America, and Citigroup, which underwrite securities offerings, to rethink their SPAC business. Those underwriters are balking at the prospect of their potential liability—already significant—being extended beyond a SPAC’s initial IPO to subsequent financings conducted by a SPAC, including the de-SPAC merger, even if their later involvement was minimal.

The underwriters’ reaction was predictable and should have been expected by the Commission. Banks that underwrite a SPAC’s initial public offering—a relatively simple deal—don’t want to be on the hook for misstatements made by the SPAC in a more complicated de-SPAC transaction they didn’t underwrite.

In all likelihood, the Commission’s majority was counting on underwriters to refuse to assume the extra and, at present, indefinable legal exposure. The proposed new legal standard wouldn’t require proof that the SPAC or its target intended to deceive investors. Investment banks involved in underwriting SPACs would simultaneously be forced to comply with the rules for both IPOs and reverse mergers. Simple negligence—such as an incorrect post-merger revenue projection in the offering documents—would be sufficient for liability. And that liability could be enormous.

A Possible Solution for Underwriters?

Bloomberg Opinion columnist Matt Levine suggests that banks may be able to hack these proposed SEC rules by essentially creating a deal wall between the IPO and de-SPAC transactions. Underwriters might avoid running afoul of the additional liability by strictly adhering to working on one side of the wall or the other for a given SPAC. In other words, an underwriter that worked on a SPAC’s IPO would stay away from de-SPAC work for that SPAC, and only underwriters not involved in the SPAC’s IPO would work on the later de-SPAC. It’s a fairly straightforward solution once the fee structure is adjusted, and promises to get the lucrative SPAC fee gravy train moving again for banks.

Unfortunately for SPACs and investment banks, the SEC and its chairman, Gary Gensler, don’t appear to be in the mood to accommodate that outcome. Gensler spoke with Bloomberg on May 10, and indicated that he wants underwriters to act more as gatekeepers by vetting deals and ensuring their fulsome disclosure in the public SPAC’s SEC filings. According to Gensler, an underwriter’s duty to get investors accurate information puts them on the hook for misstatements by the SPACs they underwrite.

Previously, Gensler has made clear that he believes a SPAC’s reverse-merger deal should undergo a higher level of scrutiny by his agency, similar to that received by operating companies seeking to IPO, and the deal should be constrained in how it touts a proposed merger’s benefits (forward-looking statements, in SEC parlance).

In a speech last December discussing the problems he perceives with SPACs, Gensler warned that SPACs shouldn’t be able to arbitrage the rules. That sentiment presumably extends to a SPAC’s sponsors and financial advisers, including its underwriters. Gensler wants the due diligence expertise that underwriters are perhaps in the best position to exercise to inform and protect investors, even if the liability that goes with that role risks driving underwriters away. The situation presents a difficult quandary for the Commission.

Recent Curious Moves by the SEC

Underscoring the shift in the SEC’s regulatory approach, John Jenkins of reported in his blog last month about the curious case of SEC staff declining to act on a routine acceleration request by Alberton Acquisition Corp. This inaction scuttled the SPAC’s deal with its target, SolarMax Technology, Inc., and drove Commissioner Peirce to make an extraordinary, if not unprecedented, public statement condemning the staff’s decision.

The decision not to act on Alberton’s routine acceleration request, after the parties spent months exchanging comments on it, is akin to Lucy pulling the football away at the last moment on Charlie Brown. Although not unprecedented by the agency (see, e.g., early cannabis company IPO filings that never went into effect), it’s a troubling development by a regulatory agency.

The key qualities that have made our legal system and capital markets so successful have been their predictability and relative transparency. Decisions have been based on publicly available rules, not on undisclosed policies or policies that may change with little or no notice.

Separately, the Commission has been receiving considerable criticism for setting too short a public comment period for complex and significant proposed rules that would affect many industries and investors. The SEC recently relented, extending comment periods for three major proposals, including private funds and the far-reaching ESG rules.

Comment periods—like the economic analysis performed to assess the likely regulatory burden imposed by a major rule change—shouldn’t be check-the-box, pro forma exercises by the government. Feedback from stakeholders is an essential part of the democratic process and a crucial step toward improving regulation and minimizing unnecessary burdens on the regulated. Rushed rulemaking will inevitably result in inferior public policy and diminished respect for our institutions.

Bloomberg Law subscribers can find related content on our In Focus: Special Purpose Acquisition Companies (SPACs) page, our Equity Deal Analytics and on our Securities Practice Center resource.

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