What the SPAC?! Blank-Check Explosion Draws New Regulatory Scrutiny

Shareholder Advocate Spring 2021

April 22, 2021

By now even casual followers of financial news have heard of Special Purpose Acquisition Companies, or SPACs, blank-check companies that purportedly provide a smoother path for privately held companies to go public with less exposure to liability.

Initial public offerings of SPACs have exploded over the last several years, driven by market volatility, low interest rates, their own growing popularity, and the lucrative profits they can make for sponsors. But while the SPAC frenzy continues unabated, increased scrutiny from regulators may mean its days are numbered.

SPACs are shell companies that go public, usually priced at $10 a share, with the sole purpose of combining with an as-yet-undetermined private operating company within 18-24 months. Sometimes their barebones prospectuses specify a targeted industry or business, but that’s not required. If a deal materializes for the SPAC by the deadline, it merges with the private company to create a new publicly traded corporation in a business combination known as “de-SPACing.”

A total of 248 SPACs went public last year, accounting for 55% of U.S. IPOs and raising $83.34 billion—more capital than all previous SPACs combined, according to SPAC Analytics. And this year it took only three months to eclipse last year’s astounding total; as of this writing, 303 SPACs have raised nearly $98 billion this year, making up eight of ten U.S. IPOs and a staggering 70% of their proceeds.

SPACs have a mixed track record for investors. Those who buy in the original IPO get their money back with interest if there’s no merger or if they don’t approve of the acquisition. Still, they may end up receiving shares worth less than what they paid for their warrants. As for those who buy shares of the de-SPACed company on the secondary market, several studies show performance of de-SPACed companies lagged that of corporations that go through traditional IPOs.

In addition, some lawyers who advise on offerings say that SPACs actually may be a more expensive way to go public than traditional IPOs at the end of the day. Bloomberg columnist Matt Levine estimated they typically gobble up 25% of the money raised, “three or four times as much as you’d pay in an IPO, albeit better disguised.”

In contrast, SPACs all but guarantee big profits for sponsors—if they meet the de-SPAC deadline. In exchange for their expertise and a nominal investment, sponsors receive warrants worth 20% of the merged company, an outsized payoff that could tempt them to overpay for a target company, bring it public before it is ready, or ignore red flags.

Lured by the potential rewards, every financier, dealmaker, and industry expert seem to have sponsored a SPAC in the last couple of years. Lately they have been joined by celebrities like Fox Business commentator Larry Kudlow, former House Speaker Paul Ryan, musician Jay-Z, baseball great Alex Rodriguez, and basketball’s Shaquille O’Neal, whose venture was quickly dubbed the “Shaq SPAC.”

The misaligned incentives, celebrity sponsorship, and sheer number of SPACs have drawn the attention of the Securities and Exchange Commission, which is considering tighter regulations and increased disclosures regarding these blank-check IPOs.

On April 12, 2021, the SEC issued new guidance on the convertible warrants SPACs issue to their early investors, saying that some should be classified as liabilities for accounting purposes instead of equity instruments, as they currently are. The statement is the strongest in a series of what observers see as warnings to both SPAC issuers and target companies and may force some companies to restate their financial results, if the accounting change is deemed material.

The new guidance came just four days after John Coates, acting director of the SEC’s Division of Corporate Finance, issued a public statement saying the “unprecedented surge” in the popularity of SPACs was prompting “unprecedented scrutiny” and that it “may be time to revisit” the regulations governing them.

Mr. Coates cited a litany of troubling “concerns,” including “risks from fees, conflicts, and sponsor compensation, from celebrity sponsorship and the potential for retail participation drawn by baseless hype, and the sheer amount of capital pouring into the SPACs, each of which is designed to hunt for a private target to take public.”

In particular, the statement took issue with claims that SPACs provide “less securities law liability exposure for targets and the public company itself” than traditional IPOs. Mr. Coates questioned the idea, for example, that business projections contained in disclosures filed with de-SPAC transactions are shielded from liability under the “safe harbor” provision of the Private Securities Litigation Reform Act of 1995.

Material misstatements made in the registration statements that must be filed with the SEC as part of the de-SPAC are subject to Section 11 of the Securities Act, he said; material misstatements in connection with proxy statements trigger liability under Section 14(a) of the Exchange Act. Both sections offer plaintiffs an easier path to establish liability than Section 10(b) of the Exchange Act.

“Any simple claim about reduced liability exposure for SPAC participants is overstated at best, and potentially seriously misleading at worst,” Mr. Coates said. “Indeed, 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.”

The public statement came two weeks after a March 25 Reuters report that the Commission had begun an inquiry into SPACs, sending letters to Wall Street banks “seeking information on how underwriters are managing the risks involved.” Though the letters asked for the information to be provided voluntarily, Reuters reported, they were sent by the SEC’s Enforcement Division.

Mr. Coates was the second SEC official to issue a public statement on SPACs. On March 31, Acting Chief Accountant Paul Munter encouraged private companies to “consider the risks, complexities, and challenges related to SPAC mergers, including careful consideration of whether the target company has a clear, comprehensive plan to be prepared to be a public company.”

Mr. Munter’s statement flagged five areas of concern for target companies: the demands of going public on an accelerated timeline; their ability to comply with increased and heightened financial reporting requirements; the importance of maintaining internal control over financial reporting; the need for corporate board oversight, especially by the audit committee; and the shift to financial statements audited in accordance Public Company Accounting Oversight Board standards.

As SPACs have proliferated, so inevitably have shareholder lawsuits involving their offspring. Since 2019, 22 blank-check companies have been subject to securities class actions, according to the Stanford Law School Securities Class Action Clearinghouse.

These lawsuits, typically brought on behalf of investors who own shares in the merged company, asserting claims under the Exchange Act, focused on false statements after the merger, and the Securities Act, relating to the Registration Statement filed at the time of the merger. Few, if any, securities lawsuits are filed in connection with the original IPO, given the vague nature of most SPACs’ initial registration statements and investors’ ability to cash out.

A SPAC-related lawsuit filed April 2 against electric vehicle company Canoo, Inc. offers a cautionary tale of what can happen when a privately held company is not prepared to go public.

Canoo was formed in December 2020 through the merger of Hennessy Capital Acquisition Corp. and Canoo Holdings Ltd., a transaction that raised $600 in cash and valued the company at $2.5 billion. Electric vehicle and battery companies have been popular targets for blank-check companies over the last year, with at least 22 announcing deals to go public via SPACs, The Wall Street Journal reported. They have also drawn a number of securities lawsuits, whether or not they were formed via SPACs.

The August 18, 2020 news release announcing the planned merger said Canoo would rely on a “unique business model” based on three revenue streams: providing engineering services under contract to other vehicle makers; offering vehicles to consumers via a subscription service; and selling “last-mile” delivery vehicles to businesses.

The news release and accompanying presentation, which was filed with the SEC, said the consumer subscription service would be especially important, since it would be “more profitable and resilient” than selling new vehicles. In later public statements, the Canoo team continued to stress the three revenue streams. The company also touted a February 2020 agreement to provide contract engineering services to Hyundai Motor Group as an example of its experience and potential in that area.

But in its first post-merger earnings call on March 29, 2021, Canoo abruptly changed course, announcing the departure of its CFO, saying it would “deemphasize” the contract engineering services, and casting doubt on the future of the subscription service.

Adding to the confusion, the merged company’s CEO, who had co-founded and run Canoo as a privately held company, did not appear on the conference call, which was run by Executive Chairman Anthony Aquila, who had joined the company two months before the merger. As one analyst said, these were “significant surprises.” Soon after the call, The Verge reported the deal with Hyundai “appeared to be dead.”

Asked to explain the shift, Aquila pointed to the inexperience of the prior leadership team, which had been “a little more aggressive” and “presumptuous” than advisable in its public statements about business prospects and didn’t meet “our standard of representation to the public markets.”

“This comes back to having an experienced public company team,” Aquila said, referring to statements about potential engineering contracts with other manufacturers. “You’ve got to be careful of the statements you make.”

Well, yes. Canoo’s stock price fell 21% the next day.

With more than 400 SPACs on deadline to find targets, the pressure is only increasing on private companies to join the blank-check party—ready or not. Tighter regulations that gently let the air out of the SPAC bubble offer the best hope for a soft landing.