On April 12, 2021, the SEC effectively chilled SPAC activity by announcing that it had examined warrant accounting in several SPACs and found that the warrants were being erroneously classified as an asset. The SEC identified two accounting issues, one related to the private placement warrants and the other related to both the private placement and public warrants. These companies were required to restate previously issued financial statements to reclassify warrants as liabilities, and the ripple effect began. Overnight SPAC management teams, accountants and auditors were scrambling to determine if a restatement was required (in most cases it was) and in-process SPACs were put on hold or at least delayed while market participants tried to figure out the meaning of the SEC guidance and how to address it.
The timing of the statement was interesting as well; most calendar year end SPACs had just filed their Form 10-K for FYE 2020 requiring a slew of 8-Ks to disclose non-reliance on previously issued financial statements. Those that had filed a Form 12b-25 to obtain a 15-day extension scrambled to re-do the financial statements before filing and as such most were late in filing. Likewise, many companies that had recently completed business combinations with SPACs had to restate previously issued financial statements and/or delay reports.
The SEC statement specifically indicated that where warrants had been improperly characterized as assets instead of liabilities, a company should consider its obligation to maintain internal controls over financial reporting and disclosure controls and procedures to determine whether those controls are adequate. Further, a company needed to assess whether prior disclosure on the evaluation of internal controls over financial reporting and disclosure controls and procedures needs to be revised in the amended filings. As a result, most restated Exchange Act reports contained a disclosure that previously disclosed internal controls were not, in fact, effective due to a material weakness and added risk factors related to inadequate internal controls including litigation risks.
However, the industry was extremely motivated (with just under $90 billion raised in 2021 so far alone) and it appears that accounting firms and the SEC have agreed on a form of warrant that can classified as equity and not as a liability for financial reporting purposes. Despite the resolutions discussed below, the SEC has not issued any formal guidance or statements updating the April 12, 2021 statement. Many market participants do not feel they can confidently rely on these changes to be sure that the SEC will not find further issues and have called for lawmakers to add clarity.
The Accounting Standards Codification (“ASC”) provides rules and guidelines for when warrants can be classified as equity (and thus an asset) or treated as a liability. Under the rules, a warrant can only be classified as equity if the warrant is indexed to the company’s common stock. One of the features of indexing is that a warrant has a fixed strike price. In its review of SPAC warrants, the SEC found that some warrants included variables that would impact the exercise price and in particular, a variable exercise price depending on whether the warrant was held by the sponsor or a non-permitted transferee.
In a typical SPAC structure (see HERE) the private placement (sponsor) warrants have different features than the public warrants. For example, the private placement warrants are generally not redeemable and always have cashless exercise provisions. The public warrants, on the other hand, are almost always redeemable by the company if the stock trades at $18.00 or higher for 20 out of 30 trading days and only have a cashless exercise feature if there is no effective registration statement as to the underlying shares. Furthermore, both the private warrants and public warrants usually have provisions adjusting the exercise price in certain circumstances associated with the business combination transaction, with the private warrants being entitled to a greater adjustment than the public. The warrant agreement provides that once the private placement warrants are transferred to persons other than certain permitted transferees, they become public warrants and thus are treated differently depending on the holder of the warrant. The SEC took issue with potential variations in exercise price depending on holder of the warrant as not being consistent with the rules allowing indexing, and thus treatment as equity and not a liability.
The SEC staff and market participants have come up with two alternatives to address this issue. The first is to keep private placement warrants separate and distinct from public warrants with no possibility of changes to their terms regardless of transfer. That is, the concept of “permitted transferee” could be removed and all transfers would then be permitted. The issue is that the public warrants generally trade on a national exchange (or OTC Markets) and since the features of the private warrant are different, there would be no opportunity to sell such private warrants on the open market. Liquidity would only be had in a private transaction or upon exercise (which may or may not be in-the-money).
The second alternative is to remove the distinctions between the private and public warrants. Of course, this would change the economics significantly for the sponsor.
Another alternative, which is not a fix to the warrants but a different structure altogether, is to utilize rights instead of warrants. Many SPACs include rights as part of their offering structure, though generally in addition to, and not instead of, a warrant. A right entitles the holder to purchase a share of common stock for xx number of rights (such as one share of common stock for 10 rights). A right generally has a fixed exercise price and is a short-term instrument. Care would have to be given such that a Rights Agreement did not contain the same provisions that the SEC found problematic in the Warrant Agreement.
Forced Cashless Exercise
Some SPAC warrant agreements contain a provision that allows the company to force a cashless conversion (i.e., payment in net shares) if the stock price of the company equals or exceeds $10.00 for a period of time. The exercise price for these warrants is based on a warrant table that varies based on the current stock price and period of time remaining prior to expiration of the warrants. The formula is based on Black-Scholes and is meant to compensation warrant holders for lost value based on the forced exercise. As this provision causes the warrant exercise price to be variable, the SEC found that it precluded the warrants from being treated as equity and instead had to be treated as a liability.
SEC staff, together with accounting professionals, have reached the conclusion that if the warrant table is removed or modified, the warrants could be treated as equity. Removal of the table is straightforward. Modification would need to be in such a manner that the SEC no longer views the exercise price as variable.
I note that if the table is removed, a post business combination company could still proceed with a tender or exchange offer to entice warrant holders to exchange their warrants for cash and/or stock, but the company would no longer have an absolute right to force conversion.
Tender Offer Provisions
In addition to being properly indexed to common stock, in order to qualify for equity treatment, the warrant must allow the company to settle the warrant with shares. That is, GAAP accounting includes a general principle that if an event that is not within the entity’s control could require net cash settlement, then the contract should be classified as an asset or a liability rather than as equity. There is an exception to this rule if net cash settlement can only be triggered in circumstances in which the holders of the shares underlying the contract also would receive cash, such as in a complete change of control.
In its statement the SEC pointed out a fact pattern in which, if a company made a tender or exchange offer that was accepted by the holders of more than 50% of the Class A common stock, all holders of the warrants would be entitled to receive cash for their warrants. Since in the typical SPAC structure the sponsor’s Class B common stock represents 20% of the total issued and outstanding equity, there would not necessarily be a change of control of the company as a result of the tender offer, and thus the exception would not apply. In other words, in the event of a qualifying cash tender offer (which could be outside the control of the entity), all warrant holders would be entitled to cash, while only certain of the holders of the underlying shares of common stock would be entitled to cash. The SEC staff concluded that, in this fact pattern, the tender offer provision would require the warrants to be classified as a liability measured at fair value, with changes in fair value reported each period in earnings.
SEC Staff, together with accounting professionals, have reached the conclusion that if the language in the tender offer provisions is modified such that the tender offer triggering cash settlement of the SPAC warrants results in the maker of the tender offer holding more than 50% of the voting power of the company’s securities, the company would not be precluded from classifying the warrants as equity.