At an open meeting on March 30, 2022, the Securities and Exchange Commission proposed far-reaching changes to the regulations of special purpose acquisition companies, or SPACs, that could eliminate many of the advantages the vehicles have enjoyed over traditional IPOs.
SEC Chair Gary Gensler stated that the new rules would offer investors “protections similar to those in traditional IPOs” by enhancing the disclosure investors receive, discouraging potentially deceptive marketing practices, and reinforcing the accountability for gatekeepers and issuers for the information provided to the public.
In a blistering dissent, Commissioner Hester Peirce accused the SEC of overreach, saying that the new rules "seems designed to stop SPACs in their tracks" and would "damn, diminish, and discourage” adoption of a popular alternative path to public status.
The SEC had signaled last May that it was considering a range of reforms to how SPACs are regulated. The 372-page document outlining the proposed rules would profoundly change current business practices in the mergers between SPACs and private companies, otherwise known as the de-SPAC process.
- Strict Liability for Projections – The new rules specifically exclude SPACs from relying on the “safe harbor” for forward-looking statements that many have relied upon when they provide extensive financial projections for the target companies in SPAC mergers. Gensler made it clear that de-SPAC transactions would be subject to the same level of liability as IPOs, which rarely provide public projections.
- More Disclosure on Conflicts and Dilution – The new rules would require that registration statements provide substantially more information about the SPAC sponsor, potential conflicts of interest, and the dilution that will result from a SPAC merger and related financings. The SEC notes that according to one study when the dilutive impact of sponsor compensation, underwriting fees, warrants, and rights are combined, the median dilution was equal to 50% of the cash raised in a SPAC IPO. By requiring clear tables outlining all the potential sources of dilution, the Commission believes investors can make better-informed decisions.
- Fairness Opinion – The SPAC would now be required to state if the de-SPAC transaction and related financings are fair or unfair to investors. In reaching this determination, the SPAC is to consider the private company's valuation, financial projections, any third-party report or appraisal, and the dilutive impact of the de-SPAC transaction and PIPE financing on investors who do not redeem. Practically, this will mean that directors will likely require an independent fairness opinion to provide a reasonable basis for the statement of fairness in these complex transactions.
- Target Liability – The SEC proposes that the private operating company be deemed a co-registrant on the S-4 or F-4 registration statement in any SPAC merger. Practically, this will mean that the private company and its senior officers and directors have full liability for the disclosures made to investors during the de-SPAC process.
- Underwriter Liability – The SEC would dramatically extend the liability of underwriters for any untrue statements or material omissions during the de-SPAC process by deeming SPAC underwriters who participate in any way in the de-SPAC transaction or PIPE financing to be an underwriter of the de-SPAC as well. Being deemed an underwriter would impose a duty to provide extensive due diligence on the SPAC merger transaction, comparable to a traditional IPO. The SEC believes this will reinforce the role of investment banks as “gatekeepers” to the public markets.
- Registration Required for Shell Mergers – In addition to the rules on SPAC mergers, the SEC proposes that all mergers by operating companies into publicly reporting shell companies to be required to file a registration statement with the SEC. Such transactions, also known as "reverse mergers," previously only needed a super 8-K disclosure within four days after the merger was completed. Shell mergers would instead be viewed as a sale of securities to the shell companies’ shareholders and be subject to formal review by the SEC in advance of being consummated.
- Investment Company Act – The rules also address the somewhat obscure argument that SPACs that fail to close on a merger within one year should be treated as an investment company. The rules will create a safe harbor if SPACs meet specific duration, asset composition, and business purpose tests. Notably, the new rules would establish an 18-month deadline to announce a merger target and 24 months to complete the business combination.
Key Considerations
For the past 12 months, it was evident that the SEC was concerned with the explosive growth of the SPAC format. In 2021, 613 SPACs raised over $160 billion, significantly outstripping the number of traditional IPOs by operating companies. As of April 1, 2022, there were 717 SPACs with $188 million in trust that are seeking merger partners and another 107 live de-SPAC transactions with $25 million in trust seeking to close their deals.
The SEC notes that due to this unprecedented growth in SPAC IPOs, “it is likely that a significant proportion of companies in the coming years that enter the U.S. public securities market will do so through de-SPAC transactions.” SPACs have simply become too successful at raising capital for the Commission to ignore.
The SEC has also made it clear that its staff is far more comfortable with the process through which traditional IPOs are marketed and disclosed to investors than with their SPAC brethren's more free-wheeling and continuously evolving practices. The proposed rules are designed to make the de-SPAC process more closely conform to traditional IPOs in several essential respects.
Whether their combined effect will "strengthen investor confidence in the SPAC market," as Chairman Gensler predicted, or will drastically diminish SPACs’ appeal, remains to be seen. We expect market participants to actively weigh in on the potential intended and unintended consequences during the comment period for the proposed regulations.
Is Forward-Looking Information Helpful or Hype?
One of the most dramatic differences between how SPAC mergers and IPOs communicate to investors is that SPACs often provide detailed projections about the expected financial performance of the private companies with which they are proposing to merge. Often, SPAC sponsors have made very aggressive growth forecasts for pre-revenue companies stretching out many years in the future.
To some observers, this was a welcome democratization in how aspiring public companies communicate since it theoretically put retail investors on an even playing field with the institutional investors who purchased large slugs of stock through a PIPE transaction based on confidential information.
By contrast, traditional IPOs rarely issue projections, relying instead on sell-side analysts to develop their “independent” models that are then shared selectively with institutional accounts, leaving retail investors in the dark.
The downside to this democratic innovation is that many SPACs have turned out to be wildly optimistic about the ability of their private companies to scale up revenues and earnings. To quote physicist Niels Bohr, “Prediction is very difficult, especially if it is about the future.” Predicting whether a disruptive, commercially unproven technology will overcome its technical hurdles and be embraced by the marketplace on a defined timetable is a particularly precarious endeavor.
Will the SEC’s new rules result in de-SPACs providing more cautious, nuanced, and substantive forecasts? Or will they quash all discussions of future performance expectations by imposing crippling legal liability for projections that are inherently uncertain?
The proposed rules contain sensible guidelines for when companies choose to communicate their expectations about the future. Companies should be clear if the projections are rooted in prior financial performance and if so, present them side-by-side with the historical results. They should disclose who authored the projections and for what purpose, and they should reveal the assumptions underlying the projections and what might cause actual results to diverge from those assumptions. And if the projections use non-GAAP financial metrics, the company would be required to explain that choice.
While these disclosure guidelines appear to promote “new and improved” projections, the imposition of strict “Section 11” liability on participants in the de-SPAC process seems more likely to eliminate their use altogether. Heretofore, SPAC managers have operated under the belief that they enjoyed the protections in the "safe harbor" for forward-looking statements that are available to existing public companies, including when they disclose the expected performance of planned acquisitions. As long projections have a reasonable basis and are provided in good faith, it is difficult to prevail in a lawsuit absent evidence of an intent to defraud.
But with Section 11 liability, which is the standard imposed on IPOs by statute, it is enough to prove that the company made an untrue statement of a material fact or an omission of a material fact that the investor relied upon in purchasing the shares. Given that the future is inherently unknowable, will management and directors want to assume such liability? The SEC appears to admit it is unlikely when they note that the “heightened litigation risks associated with providing forward-looking statements, may have created a chilling effect given that, in staff experience, projections are almost never provided to the public in connection with an IPO.”
How would removing the ability to provide projections alter the attractiveness of SPAC mergers as a means for late-stage venture companies to access growth capital? And how would reducing such companies' access to public markets impact American innovation and economic competitiveness? More broadly, does the provision of forward-looking information, including projections, reduce the information asymmetry between insiders and institutions and the broader market? Or are projections inherently prone to abuse and little more than “marketing hype?”
Is the Market Fair?
While most of the proposed new rules seek to align de-SPAC transactions with traditional IPOs, the requirement to opine if the transaction is “fair" to outside shareholders is an outlier. When investment banks develop their valuation models for an IPO, the relevant question is, "What are investors likely to be willing to pay for a stake in the company?” Not, “Is it fair that they pay that price?”
The question gets even more convoluted because to opine what a company is worth — especially a young company aspiring to shake up its industry — you need to make some educated guesses about the market acceptance and growth of its products and services. In other words, projections. And the basis, assumptions, and forecasts underlying a fairness opinion will all presumably be disclosable. So, while double barring the front door against speculative financial projections, the SEC is essentially welcoming them in through the back door.
Should a SPAC merger be regulated more like a traditional merger – where fairness opinions are used 85% of the time, according to the SEC – or like an IPO, where they are unheard of? To put it another way, should the valuation in a de-SPAC be determined by what is "fair" or by what the market will bear?
Everyone is Liable When de-SPACs Go Wrong
In addition to increasing the stakes for inaccurate disclosure during a de-SPAC transaction, the new rules would extend Section 11 liability to a wide range of participants. The private target company would be deemed a co-registrant with the SPAC. Underwriters of the IPO who provide advice on a merger or act as a placement agent for a PIPE or defer part of their compensation to the completion of the merger would all now be deemed underwriters of the de-SPAC as well.
Financial advisors, placement agents, and PIPE funds are all at risk of being deemed statutory underwriters of the de-SPAC—ditto for experts whose opinions are cited in the registration statement. The list of potential statutory underwriters will “include every accountant, engineer, or appraiser, or any person whose profession gives authority to a statement made by him, who has with his consent been named as having prepared or certified any part of the registration statement or certified any report or valuation which is used in connection with the registration statement,” according to the SEC.
The SEC intends that investment banks who take SPACs public be incentivized to engage in deep due diligence on private companies in de-SPACs, which the SEC calls “central to the integrity of our disclosure system.” But it is by no means clear that SPAC IPO underwriters will be comfortable assuming this liability, especially if de-SPACs continue to provide projections to investors that may well turn out to be inaccurate.
Will investment banks increase the size of their underwriting discount to reflect the increased work and liability associated with this expanded role? Or will they instead do everything possible to avoid being deemed a de-SPAC underwriter and insist on all their compensation upfront?
Given that SPAC underwriters currently defer 60-70% of their IPO commissions until the de-SPAC is completed, such changes could profoundly impact the economic viability of the format.
Despite their complexity and potential for conflicts of interest, the recent explosion of SPACs has reversed the disturbing long-term trend of fewer public companies listing on the American markets. It is unclear if the net impact of the new rules, as proposed, will be to reform SPACs as a sustainable and flexible alternative to traditional IPOs.
We anticipate that market participants will take advantage of the comment period to help the Commission thoroughly think through alternatives to achieving both adequate investor protections and the broadest range of investable growth companies for investors to choose from.
