In a recent aggressive and ground-breaking decision, the Securities and Exchange Commission announced enforcement actions against a special purpose acquisition company (SPAC) known as Stable Road Acquisition Corp. (SRAC); its sponsor, SRC-NI; the CEO of SRAC; the target company; and the target company’s former CEO.
This represents the very first time that the SEC has sanctioned a SPAC, its sponsor, and the target company before a shareholder vote on the merger. All parties reached a settlement with the SEC with the exception of the target’s former CEO, who continues to litigate the matter.
With this decision, the SEC has made clear that SPAC sponsors must conduct adequate due diligence in connection with a merger, and that SPAC transactions will draw increased regulatory scrutiny by the SEC under the Biden administration.
The SPAC transaction at issue involved a proposed merger between SRAC and a space infrastructure company. According to the SEC and unbeknownst to SRAC, the proposed target allegedly misrepresented having “successfully tested” its propulsion system in space and omitted or made misstatements concerning the U.S. government’s national security concerns relating to its former CEO.
The SEC further stated that, although SRAC had engaged a space technology consulting firm to conduct due diligence, the firm allegedly failed to investigate claims regarding the testing of the propulsion system in space. The SEC contended that SRAC failed to independently investigate the national security concerns despite allegedly knowing that the government had required the same CEO to divest from a similar company.
Nonetheless, in public disclosures with the SEC and proxy materials intended for investors, SRAC included the target company’s alleged material misstatements about its purportedly successful tests in space and omitted to mention the national security concerns surrounding the target company’s CEO. On that basis, the SEC charged SRAC with violations of Sections 17(a)(2) and (3) of the Securities Act, Section 14(a) of the Exchange Act, and Rule 14a-9, and Section 13(a) of the Exchange Act and Rules 12b-20 and 13a-11 thereunder.
SRAC agreed to pay a penalty of $1 million, it’s CEO a penalty of $40,000, and the target company a penalty of $7 million.
Implications for SPAC Enforcement
The implications of the SEC’s enforcement action are far-reaching.
First, the SEC charged the SRAC’s sponsor with causing SRAC to violate Section 17(a)(3) of the Securities Act. Under the settlement, the sponsor agreed to forfeit 250,000 founders’ shares and give PIPE investors the opportunity to terminate their subscriptions.
This settlement remedy is particularly aggressive, especially considering the SEC’s acknowledgment that the respondents cooperated, and it likely could become part of future SPAC-related settlements. Accordingly, sponsors of SPACs can no longer rely solely on a target company’s representations, and diligence conducted by consulting firms must be reasonable and of adequate scope.
Second, the SEC brought its enforcement action before SRAC’s Form S-4 became effective and the proxy statement had been delivered to investors. The SEC’s charges against SRAC were brought at the preliminary proxy statement stage, when the SEC could have still given SRAC the opportunity to amend. Despite the preliminary proxy stage posture of the transaction, the SEC’s settlement still included significant penalties—yet another indication that future SEC penalties in the SPAC market could be even higher.
Third, the Biden administration is pressing the SEC to engage in more vigorous oversight of SPAC deals, and the SEC is listening. This enforcement action confirms that SEC statements made last year about scrutinizing SPACs were not merely empty words and reflects the SEC’s intent on implementing aggressive methods of scrutinizing and regulating SPACs.
Moreover, the SEC brought the action against SRAC in only eight months after opening the Order of Investigation, as opposed to the SEC’s typical 24-month timeline.
Preventive Measures for Market Participants
SPACs already have and certainly will continue to face new and increasing regulatory obstacles and should not move too hastily to market without sufficient legal advice. The “safe harbor” rules of the Private Securities Litigation Reform Act will not provide protection in this context. Robust, fully independent due diligence that does not simply rely on the target’s representations is a legal imperative.
Market participants should consider the following preventive measures:
Due Diligence. SPAC sponsors should hire reputable third-party investigators and top notch audit firms, implement fairness opinions, and use extreme caution when relying on unverified statements from proposed merger targets. They should document all diligence efforts undertaken in connection with mergers and err on the side of more comprehensive disclosures.
Accounting. SPACs must prepare their internal accounting controls, so that the post-merger publicly-traded company will meet the SEC’s reporting demands.
Litigation Preparation. To limit litigation risks, market participants should ask experienced litigation counsel, rather than relying solely on their usual corporate counsel, for input on the documents being prepared, relied upon, and disseminated. Litigation counsel should also weigh in on the recommended strategic approach in managing litigation risk, and can also provide input on insider trading risks that the post-merger company may face.
Conflicts. SPACs must also consider all potential conflicts of interests and whether their public disclosures adequately disclose them. SPACs must be particularly cognizant of conflicts with the ultimate de-SPAC M&A targets and misaligned incentives with sponsors that are more keen on completing the merger (especially if they are bumping up against the two-year statutory time frame) than conducting adequate due diligence.
By following these measures, market participants can avoid or, at the very least, minimize the chances of facing an adverse outcome of SEC investigations and/or enforcement actions (and related follow on or concurrent securities class actions and/or shareholder derivative actions) based on allegations of improper or inadequate due diligence, among other things.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Perrie M. Weiner is the partner in charge of Baker McKenzie’s Los Angeles office and chair of the firm’s North America Securities Litigation Group.
David Sverdlov is a member of the North America Litigation & Government Enforcement Practice Group in Baker McKenzie’s Los Angeles office. He has represented clients in enforcement actions brought by the DOJ, SEC, and CFTC relating to securities and commodities trading.
Desirée Hunter-Reay is a junior associate in the North America Litigation & Government Enforcement Practice Group in Baker McKenzie’s San Francisco office and a member of the firm’s North America Trade Secrets Practice Group.