Blank-check companies, also known as special purpose acquisition companies (SPACS), are booming. In early October, a record eight SPACs went public in one day, netting $3.25 billion in proceeds.
The hot market for blank-check SPAC companies is attracting the attention of brokerages and investors alike, with both groups hoping to cash in on the boom. Not surprisingly, the Securities and Exchange (SEC) is also taking notice.
Key Features of SPACs
A special purpose acquisition company is created exclusively to raise capital through an IPO and then use those funds to acquire or merge with an existing private company. Provided its net tangible assets exceed $5 million, a SPAC is exempt from regulation as a blank check company under Rule 419, which prohibits trading until an acquisition occurs. Indeed, the post-closing trading of the offered securities is heated and dynamic, particularly the trading of the warrants typically included in the SPAC offerings.
As discussed in greater detail in a prior article, sponsors, often the management team, provide the initial capital to form the SPAC. During the IPO, securities are typically offered at a unit price, often $10 per unit. Each unit represents one or more shares of common stock and one or more warrants exercisable for one share of common stock typically exercisable at $11.50 a share. Units may also include a “right,” typically the right to receive one-tenth of one share upon the completion of a subsequent merger with an operating company – known as the “de-SPAC” process. Since the SPAC entity has no performance history, no revenue, and the business plan is to acquire an unknown business, the prospectus focuses almost exclusively on the SPAC sponsors and may include information about the specific industry and geographic area the SPAC plans to target.
The funds raised through the SPAC’s IPO are placed into a trust, except for a small portion to pay filing and professional fees and administrative expenses during the search period for a merger entity. The money is held until the SPAC identifies and closes on a merger or acquisition target. Once the IPO is completed, the management of the IPO has a set amount of time to complete a merger or acquisition, usually 18 to 24 months, and must use at least 80 percent of its net assets for any such acquisition. Investors who vote against an acquisition are entitled to a pro rata return of the funds held in escrow. In addition, should the SPAC fail to come to terms with a private company within the specified timeframe, the IPO revenues are returned to investors in pro rata shares.
Rising Popularity of SPACs
Blank-check companies got a black eye in the 1980s after some were used to perpetrate penny stock schemes and other forms of investment fraud. However, since many blank-check offerings were very successful, and the opportunities for fraud were subsequently reduced by safer structural requirements, greater regulation, and restrictive oversight requirements placed upon sponsors, they have been steadily gaining popularity and legitimacy over the past decade. Top tier underwriters have more recently jumped aboard, having recognized the profitability of the unit structure, the trading profits and commissions in post-IPO open market transactions, the customer interest and the improved safety in the trust fund and other restrictions. The imprimatur on SPACs as a legitimate investment structure is now well established.
In 2019, 59 SPACs went public via IPOs, raising a record $13.5 billion. The volatility caused by COVID-19 has fueled further growth of the market in 2020, with many companies leery of conducting traditional IPOs. Notable companies that went public through mergers with SPACs this year include electric-truck maker Nikola Corp. and online sports-betting company DraftKings Inc.
SEC Addresses Blank Check Companies
The SEC has taken notice of the surge in SPACs. In recent remarks at The SEC Speaks in 2020, Commissioner Allison Herren Lee addressed both the risks and benefits.
To start, Commissioner Lee acknowledged that blank-check companies “have the potential to bring private issuers into the public market more quickly than would be possible in a traditional IPO.” She also noted that “the entry of established firms in this space may benefit SPAC investors by offering experienced management at the helm of the SPAC in both identifying a worthwhile target and as a potential advisor or executive in the post-merger operating company.”
As with other innovations, the SEC is keeping a close watch to determine if additional regulations are needed to protect investors. In her remarks, Commissioner Lee highlighted the importance of disclosures, recommending that the SEC focus on how SPACs disclose the relevant risks and sponsor compensation. “As a special purpose vehicle, initial investors in a SPAC rely heavily on the sponsor’s experience and expertise in identifying a target that will provide meaningful investment returns,” she stated. “In the short term, a SPAC investment acts largely as a blank check, so it is critical that the offering documents clearly disclose the material risks involved, as well as the ways in which the sponsor will be compensated for its services.”
Commissioner Lee also stated that the SEC should consider whether there are ways to further align the interests of sponsors and investors to ensure that sponsors are incentivized by the quality of any potential target. According to Lee, the requirement that SPACs return capital to investors if a target is not identified within 18 to 24 months of raising capital, along with the fact that significant source of the sponsor’s compensation is comprised of shares in the post-acquisition operating company, can create a conflict-of-interest. “The requirement to return capital to investors, therefore, may create an incentive for sponsors to pursue a less-than-ideal acquisition in order to secure that compensation,” she stated. “While the Commission’s rules currently require certain holding periods and SPAC governing documents may impose additional terms on sponsors, I hope to hear from investors about whether the Commission should consider additional protections for investors in this space.”
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If you have any questions or if you would like to discuss these issues further,
please contact Dan Brecher or the Scarinci Hollenbeck attorney with whom you work, at 201-896-4100.