SPACs: Regulatory Ramifications in the Current Business Environment

By: Tarquin McGurrin, Class of 2024

Special purpose acquisition companies (“SPAC”) are rapidly becoming the preferred way for management teams, private equity, and venture capital firms (“sponsors”) to take companies public.[1] SPACs are shell entities that raise capital through initial public offerings (“IPO”) to acquire existing private companies.[2] During the IPO process, investors receive one share of common stock and a fraction of a stock warrant, which constitutes 80% of the interest in the SPAC, while the remaining interest belongs to the management team with nominal invested capital.[3] Once this process is completed, proceeds are placed into a trust account, and the SPAC has approximately two years to identify and complete its merger with the specified target company. This is referred to as a “de-SPAC” transaction.[4] If the SPAC finds a suitable target, the SPAC will negotiate terms and conditions, file a proxy statement describing the proposed de-SPAC transaction with the Securities and Exchange Commission (“SEC”), and seek shareholder approval.[5] Conversely, the management team will liquidate the SPAC and return the IPO proceeds to the public shareholders if the SPAC cannot find a suitable target.[6]

In recent months, financial institutions have seen a positive correlation between the rise in SPAC transactions and increased SEC regulatory enforcement activity.[7] Gary Gensler, the Chairman of the SEC, stated that SPACs require close regulation because of SPACs failures to perform due diligence on acquisition targets, thereby misleading investors.[8] For example, In the Matter of Momentus, Inc., et al. involved a SPAC, Stable Road Acquisition Corporation, that prematurely merged with Momentus, a space technology company, prior to performing adequate due diligence.[9] Before the deal, Momentus’ CEO made numerous misrepresentations to Stable Road, investors, and the SEC regarding the efficacy and commercial value of its technology. Additionally, Momentus was unable to obtain government permission for its operations due to concerns about its CEO’s background.[10] In effect, the SEC charged the SPAC, its CEO, and its sponsors with various securities law violations for neglecting to perform their fiduciary duties.[11]

Moreover, SPACs have drawn the attention of Congress, including U.S. Senators who recently sent open letters to frequent investors in SPACs.[12] The letters cite concerns pertaining to the incentives of sponsors, who aim to quickly strike merger deals, regardless of quality, and earn profits derived from making hyperbolic, misleading claims about the target company.[13] Furthermore, the Private Securities Litigation Reform Act (“PSLRA”) currently provides SPAC sponsors with a “safe harbor” for forward-looking projections and evaluations.[14] Though it provides broad protection, the PSLRA excludes securities offerings made by three types of issuers: blank check companies, penny stock issuers, and IPOs.[15] Consequently, the U.S. House Committee on Financial Services recently conducted hearings to discuss legislation redefining “blank check companies” to include SPACs, which would effectively preclude SPAC sponsors from the benefits of the safe harbor provision in future dealings.[16]

Although the structural makeup of SPACs enables companies to avoid traditional IPO costs, these companies may suffer from increased litigation costs and penalties, unless necessary precautions are taken.[17] In anticipation of these concerns, SPAC sponsors should provide investors with comprehensive disclosures about material issues, perform sufficient due diligence on potential target companies, and ascertain the susceptibility of the proposed industry to litigation prior to engaging in a SPAC transaction to avoid repercussions.[18]

[1] PricewaterhouseCoopers, How special purpose acquisition companies (SPACs) work, https://www.pwc.com/us/en/services/trust-solutions/accounting-advisory/spac-merger.html#:~:text=A%20SPAC%20raises%20capital%20through,of%20executing%20its%20own%20IPO (last visited Apr. 1, 2022). [2] Id. [3] See Morgan Lewis, The Future of SPACs: Increasing Litigation and Regulation (Dec. 2, 2021), https://www.jdsupra.com/legalnews/the-future-of-spacs-increasing-8958513/ [4] PricewaterhouseCoopers, supra note 1. [5] Morgan Lewis, supra note 3. [6] See id. [7] See id. [8] See Elisha Kobre, SEC’s Recent Enforcement Actions a Sign of Increased Scrutiny of SPACs (Dec. 7, 2021), https://www.bradley.com/insights/publications/2021/12/sec-recent-enforcement-actions-a-sign-of-increased-scrutiny#:~:text=In%20August%202021%2C%20the%20SEC,the%20Akazoo%20and%20Momentus%20actions [9] See Morgan Lewis, supra note 3. [10] See Kobre, supra note 8. [11] See Morgan Lewis, supra note 3. [12] See id. [13] See John Vukelj, Hey, SPACs: Congress and the SEC Would Like a Word With You (Dec. 15, 2021), https://www.daypitney.com/insights/publications/2021/12/hlst-2-hey-spacs-congress-sec-would-like-word [14] See John Coates, SPACs, IPOs and Liability Risk under the Securities Laws (Apr. 8, 2021), https://www.sec.gov/news/public-statement/spacs-ipos-liability-risk-under-securities-laws [15] See id. [16] See Chris Prentice, U.S. Congress to hold hearing on SPACs, ramping up scrutiny (May 21, 2021), https://www.reuters.com/business/us-congress-hold-hearing-spacs-ramping-up-scrutiny-2021-05-21/ [17] See Roger Barton, Caution ahead: SPAC litigation trends provide a road map for directors and officers (Sept. 2, 2021), https://www.reuters.com/legal/legalindustry/caution-ahead-spac-litigation-trends-provide-road-map-directors-officers-2021-09-02/ [18] See id.