Statement on the SPACs Proposal
March 30, 2022
I’d like to thank the staff, my fellow Commissioners, and the Chair. The staff’s work is, as always, the reason we are here today and I am grateful for, and deeply rely, on their expertise, acumen, and dedication.
A special purpose acquisition vehicle (“SPAC”) is a company that has no commercial operations and is formed solely to raise capital so it can acquire a private operating company and take that private company public. These vehicles are not new. They have existed for decades.[1] But in 2020 and 2021, we witnessed a sudden SPAC boom with more than $80 billion raised in 2020 and more than $160 billion raised in 2021. In 2019, by comparison, SPACs raised less than 9% of what they raised in 2021.[2] And while I am, of course, supportive of companies having greater access to the public markets through a variety of avenues, the current SPAC boom highlighted a process with significant conflicts of interest and a host of misaligned incentives. The result is a process that can extract fees and compensation at the expense of shareholders.[3] And, a process that may overvalue the prospective public company to the detriment of the public markets and investors.[4] I am hopeful that today’s proposal will lead to rules that help mitigate some of the issues with SPACs while preserving an alternative and viable path for companies to go public.
To understand some of the concerns the SPAC markets raise for regulators, it’s important to think about the way SPACs work. Generally speaking, SPACs have two key transactions. First, a SPAC sells shares in a shell company to raise funds for a transaction with a yet-to-be identified private operating company.[5] This shell company, as noted above, does not have operations, but does have a group of professionals who are responsible for organizing and managing the SPAC.[6] The second transaction is a “de-SPAC,” where the shell company merges with a private company, that has operations and prospects for future success, to form a public company listed on a national securities exchange.[7] If the SPAC does not identify and consummate a merger, the funds raised at the SPAC IPO are returned to shareholders.[8]
A typical SPAC is a complex structure. It can include several sophisticated participants with differing and sometimes competing incentives,[9] contingent compensation and fee structures, [10] offerings with a mix of equities and derivatives in the form of warrants or rights,[11] rights that allow investors to redeem their shares but still vote in favor of a merger,[12] and later-stage capital infusions.[13] Those characteristics can, and often do, raise conflict of interest concerns, among others.[14] For example, sponsors do not retain their compensation unless a de-SPAC is completed.[15] Similarly, SPAC IPO underwriter compensation, in part, is contingent upon completion of the de-SPAC.[16] Meaning that if a de-SPAC does not occur, people forfeit their compensation and may prefer a sub-optimal deal over no deal at all.[17]
The proposal seeks to address these issues in at least two ways. First, the proposal contemplates enhanced reporting and disclosures so investors are better informed about the complexities of this method for accessing public markets, and the factors that impact the value of their SPAC investment.[18] For example, the proposal, among other things, would require tabular disclosures relating to the potential for dilution,[19] a required summary of various key terms in the prospectus,[20] detailed disclosure regarding the sponsor’s experience and material relationships with other entities, [21] disclosure about financing negotiated before the de-SPAC,[22] and enhanced disclosures relating to projections.[23]
Second, the proposal amends existing rules, offers guidance, and contemplates new rules. One example, among others, is to bring some protections afforded to investors in traditional IPOs to de-SPACs. More specifically, the proposal would provide assurance that the Private Securities Litigation Reform Act (“PSLRA”)[24] and section 11 underwriter liability apply to de-SPACs. [25] This is important because underwriter liability and potential PSLRA liability help to ensure the SPAC and its advisors engage in quality due diligence and carefully considered disclosure.[26] Companies at the de-SPAC stage may make disclosures involving forward-looking statements about the prospective merged company’s future performance. To the degree companies and individuals can’t be held accountable for those statements, it is possible that some of those projections will be a bit more positive, and potentially less accurate, than they ought to be. Clarifying that liability attaches serves to ensure that these forward looking statements are as accurate and careful as they would be in other similar contexts.
All this said, the proposal also includes a “safe harbor” from the Investment Company Act, which necessarily implies SPACs might otherwise be operating as investment companies.[27] Among other things, the conditions would require de-SPACs to happen within a specific timeframe.[28] I am curious whether the period of time allotted provides appropriate protections for investors.
Thank you again to the staff, particularly the staff in the Divisions of Corporation Finance, Office of the Chief Accountant, Division of Economic and Risk Analysis, the Division of Investment Management, and Office of the General Counsel for all you’re hard work, and I look forward to reviewing all the comments on this proposal.
[1] See, e.g., Special Purpose Acquisition Companies, Shell Companies, and Projections, Release Nos. 33-11048; 34-94546; IC-34549 at 9 (proposed Mar. 30, 2022) [hereinafter the Release].
[2] See, e.g., Release at 8, n. 7, n. 8.
[3] See Michael Klausner, Michael Ohlrogge & Emily Ruan, A Sober Look at SPACs, 39 Yale J. on Regul. 228, 247 (2022) (noting that sponsor compensation via a “promote” creates two dysfunctional incentives – the sponsors stand to make money even if they enter into a “value destroying” transaction and the incentive to merge is “overwhelming” because if there is no merger the SPAC must liquidate and the sponsors will lose their initial investment and that sponsor compensation via the promote).
[4] Recent academic research suggests that the costs embedded in SPAC structure are subtle, opaque and are higher than the cost of an IPO. See Klausner et al. at 246 (defining costs in a SPAC IPO and de-SPAC as value extracted by parties other than the SPAC shareholders and the target and its shareholders and finding that “the costs embedded in the SPAC structure are far higher than costs associated with traditional IPOs” because such costs reduce the amount of cash per share that a SPAC will contribute in its merger, additional costs stem from the dilution from the sponsor’s promote, warrants given to SPAC-IPO investors, underwriting fees, and redeeming shareholders). While traditional IPOs raise some dilution concerns, choosing a SPAC over an IPO for cost-savings may be illusory or cost-shifting rather than eliminating. See, e.g., Allison Nathan, Top of Mind: The IPO SPAC-tacle, 95 Goldman Sachs Macro Research at 4 (Jan. 28, 2021) (interviewing Professor Jay Ritter who notes that “given the dilution risk from the sponsor promote as well as other aspects of the SPAC structure, it is unclear whether SPACs are cheaper on average than a conventional IPO, and they’re certainly not cheaper for all IPOs”).
[5] See Release at 9-15.
[6] See id.
[7] See Release at 9.
[8] See Release at 10.
[9] See, e.g., John Coates, SPAC Law and Myths (“SPACs build in divergences (i.e., conflicts) of interests among (a) sponsors (who effectively control the SPAC in the period leading up to the deal, and who by design are able to benefit from doing deals that harm other pre-de-SPAC investors), (b) the target, which sits at the bargaining table and negotiates with the sponsor (and possibly with PIPE investors), (c) PIPE investors, who invest on terms that differ from terms offered to other shareholders (typically investing at a discount), and (d) the public shareholders and other shareholders. Add to this mix the significant overhang of contingent equity in the form of warrants, the terms of which differ across public warrants, private warrants, and (in some SPACs) other warrants, and the possibility – often a reality – that many voting shareholders will redeem and exit the SPAC shortly after they vote on a deal, creating a close analogue of “empty voting.””).
[10] Release at, 98-99 (“While SPAC IPO underwriting fees—those fees the SPAC IPO underwriters earn for their efforts in connection with the initial offering of SPAC shares to the public—generally range between 5% and 5.5% of IPO proceeds, a significant portion (typically 3.5% of IPO proceeds) is deferred until, and conditioned upon, the completion of the de-SPAC transaction.”).
[11] Warrants allow holders to purchase in the future at set price, but does not impose an obligation to do so. See Release at n. 15, 187-87.
[12] See, e.g., Release at 175 (“[I]n cases where the SPAC is structured so that the shareholders are able to vote in favor of a merger but also redeem their shares, this could present a moral hazard problem, in economic terms, because these redeeming shareholders would not bear the full cost of a less than optimal choice of target.”); Usha Rodrigues & Michael Segemoller, Redeeming SPACs (Research Paper No. 2021-09) (noting that SPAC shareholders can vote for a business combination even while redeeming shares “in effect, they can vote for an acquisition while walking out the door…permit[ting] corporate transactions that do not accurately reflect the true economic preferences of shareholders” and noting that retail investors investing in SPACs alongside hedge fund investors “renders these [retail] investors uniquely vulnerable”). Further, research indicates that 54.2% of SPAC shares are redeemed on average, and news reports recent redemptions reaching more than 80%. Id.
[13] See, e.g., Release at section IX.B.2.c
[14] See, e.g., Release at 33-34 (identifying some conflicts of interest as the contingent nature of SPAC sponsor’s compensation where the sponsors and its affiliates have “significant financial incentives to pursue a [de-SPAC] even though the transaction could result in lower returns for public shareholders than liquidation of the SPAC or an alternative transaction”; SPAC sponsors hold financial interests in or have obligations to other entities; or when the de-SPAC target is a private company affiliated with the sponsor, the SPAC, the SPAC’s founders, officers, or directors; SPAC’s officers who work at other companies); Klausner et al. at 232 (finding that SPAC structure is “designed to support a circuitous two-year process from IPO to merger—entails costs that are subtle, opaque, and far higher than previously recognized.”); Rodriguez et al. at 4-5 (“[e]very major player in the SPAC is incentivized to find a target and take it public, even if it is a value-destroying transaction. The SPAC’s founders, termed sponsors, receive a significant payoff it—and only if—they complete an acquisition. The investment banks pocket deferred underwriting fees if—and only if—an acquisition occurs. The SPAC IPO investors, largely hedge funds, hold warrants that have value if—and only if—they complete an acquisition. The target firm itself—and private investors that often invest during the merger—has decided that the transaction is beneficial (in terms attractive to it… not necessarily to the retail SPAC investors). Thus, all the major players in the SPAC are deeply incentivized to see the deal pushed forward. In other words, SPACs lack a gatekeeper. And that means SPAC targets can be let loose on the market even if they are not ready for prime time.”).
[15] See Klausner et al. at 247 (noting that sponsor compensation via the promote creates two dysfunctional incentives – the sponsors stand to make money even if they enter into a value destroying transaction and the incentive to merge is “overwhelming” because if there is no merger the SPAC must liquidate and the sponsors will lose their initial investment);
[16] See, e.g., Release at 98-99, n. 203.
[17] See, e.g., supra notes 9, 14, 15, 16.
[18] See Release at sections II, IV.B, V.
[19] See id. at section II.D.
[20] See id. at section II.E.
[21] See id. at section II.B.
[22] See id. at section II.F
[23] See id. At section V.B.
[24] The benefit of the PSLRA safe harbor is the ability to make forward-looking statements without the potential for liability to private-rights of action under the PSLRA. See Release at section II.E. The PSLRA notes that statements related to “initial public offerings” are not eligible for the safe-harbor, presumably because at the initial launch stage, forward looking statements are of heightened importance as there is no corporate history or current performance to assess. See id. Thus, traditional IPOs and SPAC IPOs are not able to benefit from the safe harbor, however, it is a separate question as to whether de-SPACs are able to use it. See id. It is important to note that the PSLRA does not provide safe harbor from the SEC’s ability to enforce the securities laws. See Coates at 6. While it is important to give management the ability to speak frankly about future performance without fear of unnecessary litigation, the de-SPAC stage is when the operations that will underlie the future public company are evaluated and disclosed. During the first stage, the SPAC IPO, there are no such operations to evaluate – there are no cash flows, revenues, or a financial track record to assess because the operating company has not yet been identified. Today’s release amends the relevant rules so that forward looking statements made at the de-SPAC stage would not be covered by the safe harbor.
[25] See Release at 15, n. 34 (noting “the lack of a named underwriter in [de-SPAC] transactions that would typically perform traditional gatekeeping functions, such as due diligence, and would be subject to liability under Section 11 of the Securities Act for untrue statements of material facts or omissions of material facts”); Coates at 7 (“One of the possible advantages (to sponsors and target managers) of the SPAC’s two-stage structure is that by separating the initial offering – with conventional underwriters involved – from the de-SPAC – when no formal underwriters are involved, SPACs have had at least the promise of lowering the overall legal exposure of the investment banks working on the deals.”) See also Release at 104 (SPAC IPO underwriters typically are not retained to act as firm commitment underwriters in the de-SPAC transaction, they nevertheless typically participate in activities that are necessary to that distribution. For instance, it is common for a SPAC IPO underwriter (or its affiliates) to participate in the de-SPAC transaction as a financial advisor to the SPAC, and engage in activities necessary to the completion of the de-SPAC distribution such as assisting in identifying potential target companies, negotiating merger terms, or finding investors for and negotiating PIPE investments. Furthermore, receipt of compensation in connection with the de-SPAC transaction could constitute direct or indirect participation in the de-SPAC transaction.”)
[26] See, e.g., Release at 84-85 (noting that some market participants “are of the view that the PSLRA safe harbor for forward-looking statements is available in de-SPAC transactions…thus may not exercise the same level of care in preparing forward-looking statements, such as projections, as in a traditional initial public offering”); Usha et al. at 5 (noting that because the chief gatekeeper in an IPO, the investment bank, faces liability under section 11, banks scrutinize a company’s initial disclosure documents for accuracy “but because the de-SPAC is technically not an IPO, banks do not fact the same liability”).
[27] See Release at 137 (“We are concerned that SPACs may fail to recognize when their activities raise the investor protection concerns addressed by the Investment Company Act. To assist SPACs in focusing on, and appreciating when, they may be subject to investment company regulation, we are proposing Rule 3a-10.”
[28] See id.