The pandemic brought a surprising boon to the U.S. public markets with special purpose acquisition companies, or SPACs. The question now is whether this bonanza is a bubble.
SPACs have breathed new life into U.S. markets following waves of de-listings in the wake of the enactment of the Sarbanes–Oxley Act of 2002. They have offered a number of structural advantages when compared to a traditional IPO, including the ability to present a pre-revenue investment thesis to retail investors and greater control over stock pricing when going public—thereby avoiding the IPO “pop” (i.e., the perceived underpricing of IPOs, arguably at the expense of issuers).
For the first time, retail investors have been given access to companies that otherwise would likely have gone through multiple rounds of additional venture capital funding prior to entering the public markets.
The SPAC surge has been fueled by central banks pumping funds into economies worldwide to combat pandemic-induced woes. SPACs are a desirable alternative to low interest rates for retail investors flush with cash.
The allure of SPACs, which give investors the option of redeeming their SPAC stocks (typically at or near the price of their investment) if they do not like the acquisition presented, is clear. Proponents argue that there is little downside to investing in these vehicles given current market conditions.
But we are potentially reaching an inflection point. Critics say that the market is oversaturated, with SPACs that often seem to be characterized more by hype than by substance. Given the sheer dominance of the vehicle, it is guaranteed that some portion will not live up to expectations.
The fact that SPACs typically target early-stage companies only heightens the risk. Already, some hedge funds are shorting select SPACs. S3 Partners LLC, a research firm that tracks short activity in U.S. markets, identified that short positions in SPACs, which totaled $724 million at the beginning of 2021, have jumped to $2.7 billion in less than three months.
The market may be poised for a backlash against its current darling. Set forth below are some potential catalysts which, in the face of poor stock price performance, may result in a dampening of the SPAC frenzy.
Unsurprisingly, the tsunami of SPACs drew regulatory attention. In 2020, the Securities and Exchange Commission focused on information transparency, raising comments and issuing guidance on SPAC disclosures.
Then-SEC Chairman Jay Clayton noted that while SPACs “actually create … competition around the way we distribute shares … to the public market,” and “competition to the IPO process is probably a good thing, for good competition and good decision making, you need good information.”
We now seem to have a new administration that is signaling that disclosure guidance is not enough and that SPACs will be an enforcement priority.
In recent weeks, the SEC (or staff thereof) issued three statementson SPACs: (a) two questioning the readiness of their targets to go public and (b) one calling into question the accounting treatment of warrants they issue.
On April 8, John Coates, acting director of the SEC’s Division of Corporate Finance, warned participants in acquisitions by SPACs (i.e., de-SPAC transactions) and their advisers that the Private Securities Litigation Reform Act, which provides issuers of securities a safe harbor for forward-looking statements in certain circumstances, only protects from private litigation—not SEC enforcement actions.
Coates also asked whether the SEC should “reconsider the concept of ‘underwriter’ in [de-SPAC transactions]”, perhaps signaling that a more expansive view that would place more of the stakeholders involved in these transactions in the cross hairs of Section 11, which provides for strict liability for certain persons for material misstatements or omissions in a registration statement for public offered securities. While this statement specifically disclaims being the views of the SEC, it provides insight into thoughts circulating at the SEC and is a clear warning to SPACs and their de-SPAC targets.
The SEC has also sent requests to several Wall Street banks for information on SPAC deal fees, volumes, and what controls the banks have in place to police the deals internally. Whether this is merely a prelude to a formal investigation and further what sort of investigation that might be (e.g., insider trading v. disclosure or process concerns) is yet to be determined.
Change in Law
Regulatory change would be even more damaging to SPACs than regulatory scrutiny and attendant enforcement actions.
One notable feature of de-SPAC transactions has been the inclusion of financial projections for the operating company being acquired. While projections are common in the private equity and venture capital context, many companies decline to include projections in their IPO disclosures due to the litigation risk associated with this information should anticipated results not materialize.
As a result, for the first time retail investors have been obtaining projections for companies that are effectively IPO-ing through SPACs.
The SEC has made clear that it is rethinking the liability framework that has facilitated the inclusion of financial projections and would like to treat de-SPAC transactions as “real” IPOs.
Rethinking the liability framework associated with SPAC acquisitions could drastically change the nature of the SPAC market. As it moves forward, we may see the SEC navigating the line between embracing the newfound dominance of SPACs along with the inflows to U.S. capital markets that it has brought and throttling the vehicle.
To date, the SPAC wave has not resulted in significant amounts of litigation. Nonetheless, the sheer number of SPACs combined with the historically litigious nature of U.S. public company M&A suggests that it is not a question of whether there will be a surge in litigation, but rather when such surge will come.
The plaintiff’s bar, which had to quickly update their playbook to respond to the recent slew of SPACs, can be expected to become increasingly sophisticated. The SEC’s new SPAC disclosure guidance may lay the groundwork for lawsuits in the coming months. SPACs will need to ensure that the disclosure in their proxies does not lose the rigor attendant to a traditional IPO.
SPACs must complete a de-SPAC transaction within a certain period, typically 18 to 24 months, or liquidate. Liquidation results in the SPAC sponsors losing their initial investment and any opportunity to realize value through the consummation of an acquisition.
This “do-or-die” nature of SPACs combined with the fact that SPAC sponsors typically acquire equity in the SPAC on more favorable terms than the public makes SPACs susceptible to claims of fiduciary breaches under state laws in relation to conflicts of interest.
While disclosure-based litigation is largely accepted as a cost of doing business in the U.S. market, if fiduciary duty-based claims prove successful, then the SPAC structure may become less attractive.
Ultimately, the longevity of SPACs as investment vehicles may be determined by their performance. A barrage of high-profile failures to meet sunny projections will make SPACs a target of regulators, courts, and plaintiffs. A weakening of the retail market or hiccups in the funding channels that guard against redemptions by SPAC shareholders (i.e., PIPEs) will make SPACs less attractive when compared to private funding.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Michelle R. Heisner is a partner in Baker McKenzie’s Global Corporate and Securities Practice group in New York.