Since I wrote about the SPAC IPO boom in June 2020 (HERE), the trend has not waned. However, as soon as celebrities like Jay-Z, Shaquille O’Neal, A-Rod and astronaut Scott Kelly jumped in, I knew the tide was shifting, and recent SEC alerts bring that to light. To be clear, SPACs have been used as a method for going public for years and will continue to do so in the future. In fact, I firmly believe that going public through a SPAC will continue and should continue to rival the traditional IPO. With so much SPAC money available in the market right now (an estimated $88 billion raised in 2021 so far already exceeding the estimated $83.4 billion raised in all of 2020) and the Dow and S&P beating historical records, SPACs are an excellent option as an IPO alternative.
However, SPACs should not be viewed as the trendy investment of the day and both investors and potential IPO targets should be aware of the reality behind the hype and make informed business decisions considering all available information. At the end of the day, there are some fundamental differences between a traditional IPO and going public via a merger with a SPAC, both at the onset of the process and for a few years following the transaction. Moreover, although most SPACs are structured very similarly (more on that below), the SPAC sponsor team is integral to the success of a deal and to providing strategic assistance to the IPO target following the transaction. Some celebrities have vast business success and experience, but no one should complete an IPO transaction or invest in a company just because a celebrity is attached to the deal.
On March 10, 2021, the SEC issued an investor alert warning of celebrity-backed SPACs and more recently on March 31, 2021, the SEC issued two statements on SPACs. One highlighted certain issues, including relating to shell status, and the other on financial reporting and audit considerations. Then again on April 8, 2021 the SEC issued another statement on SPACs, this time from John Coates, Acting Director of the Division of Corporation Finance. As discussed below, Coates statement is compelling and thoughtful, clearly targeting the rise in over-valued targets in the de-SPAC process. In addition to discussing the SEC statements, this blog will delve a little further into SPAC structures as well.
SEC Investor Alert on Celebrity Involvement in SPACs
On March 10, 2021, the SEC issued an investor alert warning investors not to make investment decisions related to SPACs based solely on celebrity involvement. As obvious a statement as this seems, with the influx of celebrity-backed SPACs, the SEC thought it necessary to remind the investment community. In an interesting choice of words, the SEC continues, “[C]elebrities, like anyone else, can be lured into participating in a risky investment or may be better able to sustain the risk of loss.”
The investor alert points out that a sponsor may have a conflict of interest and always has a different economic position than shareholder investors. Although the SEC doesn’t get into details, as discussed further below, a sponsor receives founder shares for a fixed price of $25,000 which founder shares will typically represent 20% of the total issued and outstanding capital stock immediately following the closing of the SPAC IPO. The sponsor must also invest enough capital to cover the IPO costs, ongoing SPAC upkeep legal and accounting fees, and costs associated with the de-SPAC transaction (locating and conducting due diligence on a target and transaction costs associated with the merger), which is generally approximately 5% of the total IPO amount. However, the terms of this sponsor PIPE are also more favorable than the IPO terms.
The investor alert suggests (i) checking the background, including registration or license status of anyone recommending a SPAC; (ii) investing the SPAC sponsors background, experience and financial incentives, how the SPAC is structured, the securities being offered, the risks of the investment, plans for a business combination and other shareholder rights; and (iii) consider the investments costs, risks and benefits in light of an individual’s risk tolerance and investment objectives.
SEC Statement on Particular Issues Related to SPACs
On March 31, 2021, the SEC issued a statement on certain legal specifics associated with a SPAC, some of which differ from a traditional IPO and can follow the SPAC target for years after a transaction.
Shell Company Status
The first point raised by the SEC is one I’ve touched about in a prior blog related to SPACs (see HERE), and that is that a SPAC is a shell company and as such carries all of the legal effects of a company that is or once was a shell company.
- Financial statements and Form 10 information for the acquired business must be filed within four business days of the completion of the business combination in a Super 8-K (financial statements for an acquired business by a non-shell are not due until 71 days following the filing of the initial closing 8-K).
- A SPAC will be an ineligible issuer for three years following completing a business combination and, as such, (i)is not entitled to use a free writing prospectus in its IPO or subsequent offerings; (ii) cannot qualify as a well-known seasoned issuer (WKSI); (iii) may not use a term sheet free writing prospectus available to other ineligible issuers; (iv) may not conduct a road show that constitutes a free writing prospectus, including an electronic road show (see HERE for more on road shows and eligibility considerations); and (v) may not rely on the safe harbor of Rule 163A from Securities Act Section 5(c) for pre-filing communications made more than 30 days prior to the filing of the registration statement (see HERE for more on gun jumping).
- A SPAC does qualify to use incorporation by reference in Exchange Act reports, proxy or information statements, or Form S-1 (including forward incorporation by reference) until three years after completing a business combination (see HERE for more on incorporation by reference).
- After completing the IPO and until it completes a business combination, the SPAC must identify its shell company status on the cover of its Exchange Act periodic reports.
- A SPAC cannot use a Form S8 to register any management equity plans until 60 days after completing a business combination and filing Form 10 information.
- A SPAC may not file an S-3 in reliance on Instruction 1.B.6 (the baby shelf rule) until 12 months after it ceases to be a shell and has filed “Form 10” information (i.e., the information that would be required if the company were filing a Form 10 registration statement) with the SEC reflecting its status as an entity that is no longer a shell company. See HERE on S-3 eligibility. More recently, the SEC issued a C&DI extending the 12 months post-shell status eligibility requirements to Instruction 1.B.1 (the full shelf rule) and as such, a SPAC may not use S-3 for a shelf registration until 12 months following its business combination.
- Although not pointed out in the SEC alert, holders of SPAC securities may not rely on Rule 144 for resales of their securities after the SPAC completes a business combination until one year after the company has filed current “Form 10” information with the SEC reflecting its status as an entity that is no longer a shell company and so long as the SPAC remains current in its SEC reporting obligations.
Books and Records and Internal Controls
Although applicable to all companies, whether going public via a SPAC or IPO, the SEC reminds these companies that they have obligations associated with being subject to the Exchange Act reporting requirements. These obligations include maintaining books and records in reasonable detail such that they accurately reflect the company’s transactions and disposition of assets. The second if to maintain internal controls and procedures over financial reporting (ICFR), have management assess such ICFR, and file CEO and CFO certifications regarding such assessment.
An ICFR system must be sufficient to provide reasonable assurances that transactions are executed in accordance with management’s general or specific authorization and recorded as necessary to permit preparation of financial statements in conformity with US GAAP or International Financial Reporting Standards (IFRS) and to maintain accountability for assets. Access to assets must only be had in accordance with management’s instructions or authorization and recorded accountability for assets must be compared with the existing assets at reasonable intervals and appropriate action be taken with respect to any differences. These requirements apply to any and all companies subject to the SEC Reporting Requirements, including SPACs and the post-business-combination entity.
Likewise, all companies subject to the SEC Reporting Requirements are required to provide CEO and CFO certifications with all forms 10-Q and 10-K certifying that such person is responsible for establishing and maintaining ICFR, have designed ICFR to ensure material information relating to the company and its subsidiaries is made known to such officers by others within those entities, and evaluated and reported on the effectiveness of the company’s ICFR. As the company grows, it will be subject to additional internal control requirements as set out in the Sarbanes Oxley Act (see HERE ).
Exchange Listing Standards
Both Nasdaq and the NYSE have initial and continued listing standards as well as ongoing compliance obligations, which I’ve written about many times. See HERE and HERE for some information on Nasdaq listing requirements and HERE for basic NYSE listing standards). During the SPAC IPO process, it was required to meet the initial listing standards, and thereafter to comply with the continued listing standards.
Unlike in an IPO process where certain corporate governance requirements may be phased in (such as having a majority of the board of directors be independent), as part of the merger process, the combined SPAC and target entity must meet all of the initial listing requirements of the national exchange. As part of the process, an application for approval of the listing of the combined entity must be filed with the exchange, and again, all of the initial listing standards must be met at the outset.
The SEC points out that the de-SPAC business combination process can impact the listing qualifications. For example, a company must have at least 300 round lot shareholders, holding freely tradable securities and there must be at least 1,000,000 shares in the public float. In addition, of the 300 holders, at least 151 of them must own securities valued at $2,500 or more. If the SPAC loses round lot holders through redemptions prior to the business combination, the combined company might not meet the round lot holder requirement upon consummation of the business combination, in which case it could be delisted.
Likewise, all corporate governance standards must be in place at the time of the closing the SPAC business combination, including a majority of independent board of directors, an independent audit committee, and independent compensation and nomination committees. A company must also have a code of conduct, whistleblower policy and insider trading policy.
Statement on Financial Reporting and Auditing Considerations
On March 31, 2021, Paul Munter, Acting Chief Accountant of the SEC, issued a statement on financial reporting and auditing considerations associated with SPAC transactions. The majority of the statement was the usual rhetoric regarding how important reliable financial statements are to our public markets. Mr. Munter rightfully points out the accelerated timeline to complete a SPAC transaction as opposed to a traditional IPO and the fact that the target company must be fully loaded and ready for public company regulatory compliance from day one. Target companies need to ensure they have the staff with associated expertise to comply with SEC reporting requirements, exchange compliance requirements and internal controls over financial reporting (ICFR).
Statement on SPACs, IPOs and Liability Risk under the Securities Laws
On April 8, 2021, John Coates, Acting Director of the Division of Corporation Finance issued a statement expressing concern with the “unprecedented surge in the use and popularity” of SPACs. Mr. Coates makes it clear that the SEC is carefully reviewing filings for appropriate disclosure including related to the sponsor fees and promote, conflicts of interest, other fees and the target (including valuation).
Coates goes on to talk about SPAC structures in general and the potential liability in a SPAC transaction. As discussed below, SPACs generally rely on projections and other valuation materials that are not used in a traditional IPO and as such valuations of a target company are generally higher than in a traditional IPO. One of the reasons for the is a belief that the Private Securities Litigation Reform Act (PSLRA) safe harbor for forward-looking statements provides protection from liability during the de-SPAC process. Coates warns that the belief in reduced liability in a SPAC transaction is “overstated at best, and potentially seriously misleading at worst.” He continues “in some ways, liability risks for those involved are higher, not lower, than in conventional IPOs, due in particular to the potential conflicts of interest in the SPAC structure.”
In particular, any material misstatement in or omission from an effective Securities Act registration statement as part of a de-SPAC business combination is subject to Securities Act Section 11. Any material misstatement or omission in connection with a proxy solicitation is subject to liability under Exchange Act Section 14(a) and Rule 14a-9, under which courts and the SEC have generally applied a “negligence” standard. Any material misstatement or omission in connection with a tender offer is subject to liability under Exchange Act Section 14(e). De-SPAC transactions also may give rise to liability under state law. Delaware corporate law conventionally applies both a duty of candor and fiduciary duties more strictly in conflict of interest settings (see HERE for more on a board of directors responsibilities in a merger transaction).
Coates also attacks reliance on the PSLRA pointing out that it only protects against civil litigation, not SEC enforcement actions, provides no protection for knowingly false and misleading statements, and only applies to forward looking statements, not current information on valuation. As an example if a company has multiple sets of projections that are based on reasonable assumptions, Coates believes there could be liability if it only disclosed favorable projections and omitted disclosure of equally reliable but unfavorable projections.
He also questions the PSLRAs applicability in total to a de-SPAC transaction. The PSLRA specifically excludes statements made in connection with an offering of securities by a blank check company, a penny stock issuer, or in connection with an initial public offering (for more on the PSLRA and other protections that can be afforded forward looking statements, including common law protections, see HERE ). Although the terms “blank check company” and “penny stock issuer” (see HERE) are clearly defined in the federal securities laws, “initial public offering” is not nor is there any dicta or case law on point.
Perhaps foreshadowing a new SEC perspective (including by enforcement), Coates believes that a de-SPAC transaction could be considered an initial public offering. Although not a conventional IPO, a de-SPAC transaction is a method for a private company to go public and as part of that process the initial SPAC shareholders have a right to redeem or sell their shares. Moreover, generally new money is raised, and that new money may involve a registration. Coates notes that at the time of the passing of the PSLRA, a going public transaction generally only involved an IPO but today there are many options including direct listings and SPAC transactions.
Further “[T]he economic essence of an initial public offering is the introduction of a new company to the public.” Coates makes a good argument that the purpose of the disclosure laws in an IPO, and the added liability, should apply in a de-SPAC transaction as well. Coates view is that regardless of the structure, an IPO should encompass any transaction wherein the public first learns about a private company, including financial information, and that results in that private company being a public company. Coates calls on the SEC to clarify the applicability of the PSLRA in all forms of going public transactions either through rulemaking or guidance. He also suggests that the term “underwriter” may need to be revisited, hinting that a sponsor may be acting in such a role.
More on SPAC Structure
A special purpose acquisition company (SPAC) is a blank check company formed for the purpose of effecting a merger, share exchange, asset acquisition, or other business combination transaction with an unidentified target. Generally, SPACs are formed by sponsors who believe that their experience and reputation will facilitate a successful business combination and public company. SPACs are often sponsored by investment banks together with a leader in a particular industry (manufacturing, healthcare, consumer goods, etc.) with the specific intended purpose of effecting a transaction in that particular industry. However, a SPAC can be sponsored by an investment bank alone, or individuals without an intended industry focus.
SPACs follow substantially the same structure. A sponsor receives founder shares for a fixed price of $25,000, which founder shares will typically represent 20% of the total issued and outstanding capital stock immediately following the closing of the SPAC IPO. The sponsor must also invest enough capital to cover the IPO costs, ongoing SPAC upkeep legal and accounting fees, and costs associated with the de-SPAC transaction (locating and conducting due diligence on a target and transaction costs associated with the merger), which is generally approximately 5% of the total IPO amount. This amount is referred to as the sponsor PIPE, and the terms of the sponsor PIPE is more favorable than the IPO terms. The sponsor PIPE may involve a different class of stock, warrants or a combination of both.
The sponsor entity generally conducts its own private placement, within the sponsor entity, to raise the capital necessary to fund the sponsor PIPE. Generally, one or more of the sponsor investors will also commit to participate in a closing PIPE as part of the business combination, assuming they agree with the target choice and valuation. Sponsor capital is at risk – sponsors do not make money unless a successful business combination is completed, and the value of their ownership increases enough to justify the time and capital commitment of acting as a sponsor.
The common stock and warrant received by a sponsor are generally the same as those sold in the IPO with a few key differences. The sponsor common stock is not redeemable in a business combination transaction (i.e., it stays at risk) and agrees to vote in favor of any business combination approved by the board of directors. The sponsor common stock converts into regular common stock on a one-for-one basis upon completion of the business combination but is subject to a 12-month lock-up period thereafter (though the lock-up may be released upon achieving certain trading price milestones). Sponsor warrants usually are not callable and contain cashless exercise provisions.
A SPAC IPO is usually structured as one share of common stock and either a whole, half or quarter warrant for a unit price of $10.00. The unit may sometimes also contain an additional “right” (similar to a warrant). Whereas a warrant has an exercise price, a right is usually just exchanged for a new security. For example, a SPAC unit may include a right to receive 1/10th of a share of common stock upon completion of a business combination, and so holders of 10 rights could exchange those rights for a share of common stock. The exercise price for a warrant is almost always $11.50 with a call option by the company if the stock trades at $18.00 or higher for 20 out of 30 trading days. Warrants sometimes have a downward adjustment on exercise price for if the SPAC trades below $9.20.
A SPAC generally has 24 months to complete a business combination; however, it can get up to one extra year with shareholder approval. If a business combination is not completed within the set period of time, all money held in escrow goes back to the shareholders and the sponsors will lose their investment.
The value of the SPAC is negotiated by the sponsor, the target and any investors that are putting in new money at the closing (the closing PIPE) and as a result, the valuation of a target entity may be higher in a SPAC transaction. In a traditional IPO, neither the underwriter nor the IPO company rely on future growth projections and same are almost never included in a registration statement or as part of a road show. The reason is that the Securities Act imposes the stricter Section 11 liability standard on a company and its underwriters in an IPO process. Although a new Securities Act registration statement may be filed as part of the de-SPAC process, it is not a necessary component.
There is also a belief that the Private Securities Litigation Reform Act (PSLRA) provides coverage from liability based on forward looking statements. However, as discussed above, the coverage is not iron clad. Of course, as pointed out by John Coates, the general federal anti-fraud provisions still apply to all aspects of the transaction, including the proxy materials in connection with voting on the merger.
The SPAC IPO process is the same as any other IPO process. That is, the SPAC files a registration statement on Form S-1 that is subject to a comment, review, and amend process until the SEC clears comments and declares the registration statement effective. Concurrent with the S-1 process, the SPAC will apply for listing on a national exchange.
At the time of its IPO, the SPAC cannot have identified a business combination target; otherwise, it would have to provide disclosure regarding that target in its IPO Registration Statement. Moreover, most SPACs (or all) will qualify as an emerging growth company (EGC) and will be subject to the same limitations on communications as any other IPO for an EGC. See HERE related to testing the waters and public communications during the IPO process.
When trading commences, investors can trade out of their shares, choosing to attempt to make a short-term profit while the company is looking for a business opportunity. Likewise, buyers of SPAC shares in the secondary market are generally either planning to quickly trade in and out for a short-term profit or betting on the success of the eventual merged entity. If a deal is not closed within the required time period, holders of the outstanding shares at the time of liquidation receive a distribution of the IPO proceeds that have been held in escrow.
Upon entering into an agreement for a business combination, the SPAC will file an 8-K regarding same and then proceed with the process of getting shareholder approval for the transaction. The SPAC must offer each public shareholder the right to redeem their shares and request a vote on whether to approve the transaction. Shareholder approval is solicited in accordance with Section 14 of the Exchange Act, generally using a Schedule 14A, and must include delineated disclosure about the target company, including audited financial statements.
Upon approval of the business combination transaction, the funds in escrow will be released and used to satisfy any redemption requests and to pay for the costs of the transaction. Target companies generally require that a certain amount of cash remain after redemptions, as a precondition to a closing of the transaction, or as talked about above, that a simultaneous PIPE transaction provide the needed cash. The exchanges all require that the newly combined company satisfy their particular continued listing requirements.