The market has seen a boom in the last two years for emerging companies going public through the use of special-purpose acquisition companies (SPACs). SPACs are attractive vehicles for allowing a private company to gain quicker access to public capital and avoid the traditional initial public offering (IPO) process. A SPAC starts as a public company through a traditional IPO but has no operations. The SPAC raises public funds under the premise that it will use those funds to find a target private company in which to invest. Once the target is identified, the SPAC goes through a business combination transaction (called a de-SPAC transaction) whereby the SPAC and private target engage in a merger transaction, with the result being the target survives as a public company.
The recent dramatic increase in using SPACs, however, has faced increased scrutiny. More recently, this trend has raised the attention of the U.S. Securities and Exchange Commission (SEC) along with plaintiff stockholder class action law firms. Directors and officers (D&O) insurance carriers are also adjusting their premiums and policy terms to account for these increased risks in using SPACs. Such rising concerns are only heightened by recent news reports of gaps in certain deals between returns for insiders versus later investors who suffer losses after a company becomes public via a SPAC.
This post highlights recent SPAC-related issues raised by the SEC and litigation filings, including potential conflicts with SPAC sponsors, accounting controls for targets, and the financial projections companies use when attracting support for a SPAC transaction. SPAC sponsors and potential SPAC target companies should be aware of these developments as they consider the booming SPAC market. Notwithstanding these headwinds, it is likely the SPAC market (particularly the de-SPAC market) will continue to be strong in 2021 as valuations continue to be attractive and given the reality that so many SPACs are in the market competing for targets.
SPAC Sponsor Conflicts
At the end of 2020, the SEC’s Division of Corporation Finance (Corp Fin) released guidance related to its views about certain disclosure considerations for SPACs in connection with their IPOs and subsequent business combination transactions. In the guidance, Corp Fin stated that the economic interests of insiders forming a SPAC (sponsors, officers, directors, and affiliates of a SPAC) often differ from the economic interests of public shareholders, which can lead to conflicts of interests. See SEC Division of Corporation Finance, CF Disclosure Guidance: Topic No. 11 (Dec. 22, 2020).
Corp Fin stressed the importance of a SPAC’s management team clearly disclosing such potential conflicts of interest as they decide on recommending SPAC targets to shareholders. Corp Fin gave SPAC sponsors several examples of questions to consider when making disclosures for a SPAC’s IPO and additional disclosures for possible business combination transactions. Such recommended disclosures include details regarding whether the SPAC “will pursue a business combination with a target in which [the SPAC’s] sponsors, directors, officers or their affiliates have an interest.”
Corp Fin is also concerned with proper disclosures surrounding SPAC sponsors’ control of approving a business combination transaction, and how the SPAC “evaluated and decided to propose the identified transaction” and select “the target company.”
De-SPAC Transaction Concerns
SEC Senior Staff also recently expressed concerns about having adequate disclosures surrounding the target company in the de-SPAC process. The SEC’s Acting Director of Corporation Finance, John Coates, provided a number of cautions in reiterating that the SEC “will continue to be vigilant about SPAC and private target disclosures so that the public can make informed investment and voting decisions about these transactions.” See SEC Division of Corporation Finance, SPACs, IPOs and Liability Risk under the Securities Laws (April 8, 2021).
Acting Director Coates specifically cautioned SPAC insiders that the safe harbor under the Private Securities Litigation Reform Act (PSLRA) might not apply to forward-looking statements regarding financial projections of a target. The Acting Director noted the PSLRA’s safe harbor does not apply to IPOs, and the statute is written in a way that a de-SPAC transaction could be considered an IPO. He then opined that “liability risks” for SPAC participants “are higher, not lower, than in conventional IPOs, due in particular to the potential conflicts of interest in the SPAC structure.”
To combat these higher litigation risks, Acting Director Coates stressed the need for adequate disclosures in registration statements and proxy solicitations as part of a de-SPAC business combination under Section 11 of the Securities Act of 1933, and Sections 10(b), 14(a), 14(e), and Rules 10b-5 and 14a-9 under the 1934 Securities Exchange Act. Additionally, he observed de-SPAC transactions may give rise to liability under state law, such as Delaware’s duty of candor and fiduciary duties in conflict of interest settings.
Acting Director Coates also cautioned that SEC enforcement proceedings do not have any safe harbor for forward-looking statements (even if courts determine the PSLRA applies to de-SPACs), and any safe harbor would not apply to a statement made with actual knowledge that it was false at the time made. In closing, he said SPAC participants should “treat the de-SPAC transaction as the ‘real IPO,’” and provide “appropriate safeguards” with “potentially problematic forward-looking information.”
SPAC Accounting for Warrants
To raise capital, SPACs often issue warrants. SPAC warrants give investors the right to purchase more shares at a preset price in the future. While SPACs have typically classified warrants on their balance sheets as equity, the SEC Staff recently issued a public statement where they indicated these warrants in many cases should be classified as liabilities. See SEC Division of Corporation Finance, Staff Statement on Accounting and Reporting Considerations for Warrants Issued by Special Purpose Acquisition Companies (“SPACs”) (April 12, 2021).
The SEC cautioned that accounting errors can occur if a SPAC wrongly classifies its warrants as equity, an asset, or a liability. In certain warrant provisions issued by a SPAC, “warrants should be classified as a liability measured at fair value, with changes in fair value each period reported in earnings.” The SPAC’s tender offer provisions can create this same liability classification, depending on the facts of the deal. If an accounting error occurs and is considered material, the company would then need to file a restatement of any impacted previously-issued financial statement and file a Form 8-K.
SPAC Litigation Risks
With increased scrutiny, SPACs and SPAC targets are seeing a rise in SEC inquiries and stockholder lawsuits. Private plaintiffs may try to find ways to assert claims against not only the SPAC, but also the target and the target’s board of directors for allegedly aiding and abetting the SPAC directors’ breaches of their state law duties. If any conflicts exist or projections turn out differently than reported, lawsuits will also likely allege claims under state law for conflicted transactions and securities fraud under the federal securities laws. SPAC targets with controlling stockholders could also face controller claims if those in control of the target receive different consideration than others in the de-SPAC transaction. In this situation, the target should implement added procedural protections at the very beginning in deciding whether to approve a deal.
Key Takeaways When Considering SPAC Transactions
These three recent SEC alerts highlight the increased attention on SPAC transactions, and the care sponsors and boards need to take throughout the SPAC transaction process—from the SPAC’s IPO to the de-SPAC transaction. SPAC sponsors and targets should provide careful, complete disclosures surrounding a target’s financial projections and any possible conflicts with insiders.
When making forecasts, the target and SPAC insiders should carefully consider what to disclose as well as appropriate disclaimer language to caution investors. Additionally, if companies choose to only share certain forecasts, they need to be able to justify why a particular forecast was publicly shared and why another one was not. This takes careful planning and drafting considerations of what to disclose so investors can adequately consider the risks of the de-SPAC transaction. Additionally, the SEC alerts show the importance of having good financial teams already in place at the SPAC target before it enters the public market and becomes subject to financial reporting requirements.
Vigilant boards can help avoid SEC inquiries and stockholder lawsuits by making careful and meaningful disclosures along with putting in place any necessary corporate governance processes to protect potential conflicts between insiders and stockholders.
If you have questions about SPACs and SEC inquiries, please contact the authors or any member of our Corporate & Securities Practice for more information.