Will the SEC Issue New Disclosure Rules for de-SPAC Transactions?

The SEC is keeping a close eye on special purpose acquisition companies (SPACs)...

The Securities and Exchange Commission (SEC) is keeping a close eye on special purpose acquisition companies (SPACs). When it looks to determine whether additional regulations are needed, one area of concern will likely be disclosures made in connection with de-SPAC transactions.

Hot SPAC Market Triggers SEC Scrutiny

As discussed in greater detail in prior articles, a SPAC is a shell company with no operations. In most cases, it is created for the sole purpose of raising capital through an initial public offering (IPO) and using those funds to acquire or merge with an existing private company.

In the first phase, sponsors, often the management team and private investors, provide the initial capital to form the SPAC, and then seek to raise additional funds via an IPO. During the IPO, securities are offered at a unit price, with each unit representing one or more shares of common stock and one or more warrants exercisable for one share of common stock at a slight increase over the offering price. The funds raised through the SPAC’s IPO are placed into a trust, and that money is held in trust for the SPAC IPO investors until the SPAC identifies and completes a potential merger or acquisition with a target company.

The second phase, often referred to as a “de-SPAC transaction,” involves a merger between the publicly traded SPAC and a private operating company, with the shareholders of the private company receiving securities of the SPAC and/or cash as consideration. SPAC investors are generally sent proxy materials regarding the acquisition and have a say in whether the deal should be consummated. Investors who vote against an acquisition are entitled to a return of funds held in escrow. 

The SPAC market has exploded over the past few years. While SPACs can be effectively used in a variety of transactions, they have become an increasingly popular means of transitioning a company from a closely held private company to a publicly held company whose securities are listed and traded on an exchange, often NASDAQ. Between 2016 and 2019, a total of 104 de-SPAC transactions were announced. By comparison, in the 15-month period from January 1, 2020, to March 31, 2021, a staggering 197 de-SPAC transactions were announced.

The hot SPAC market caught the attention of the SEC. On April 8, 2021, John Coates, Acting Director of the SEC’s Division of Corporation Finance, issued a Public Statement regarding the liability risks associated with SPACs. Coates specifically addressed the application of securities law liability provisions to de-SPACs. “Any simple claim about reduced liability exposure for SPAC participants is overstated at best, and potentially seriously misleading at worst,” he wrote. “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.”

Coates also discussed whether the definition of “initial public offering” encompasses de-SPAC transactions for purposes of the Private Securities Litigation Reform Act (PSLRA) safe harbor for forward-looking statements. The PLRSA precludes civil liability against public companies based on certain forward-looking statements. However, it specifically excludes from the safe harbor statements made in connection with an offering of securities by a blank check company, those made by a penny stock issuer, and those made in connection with an initial public offering.

As Coates noted, the assertion that the safe harbor applies in the context of de-SPAC transactions but not in conventional IPOs, is one of the reasons many believe SPACs are a better alternative. However, he raised concerns about the accuracy of that assertion, noting that it is “commonly understood that it is the de-SPAC—and not the initial offering by the SPAC—that is the transaction in which a private operating company itself ‘goes public,’ i.e., engages in its initial public offering.”

Given the lack of clarity and the growth of the SPAC market, Coates noted that “there may be advantages to providing greater clarity on the scope of the safe harbor in the PSLRA.” He went on to suggest that the SEC consider the following:

For example, the Commission could use the rulemaking process to reconsider and recalibrate the applicable definitions, or the staff could provide guidance explaining its views on how or if at all the PSLRA safe harbor should apply to de-SPACs. If the Commission or staff pursue that route, however, it would be important to keep the practicalities of SPACs in mind, in addition to other aspects of SPAC structures, relative to conventional IPOs as well as to other forms of achieving dispersed ownership, such as direct listings. Should the SEC reconsider the concept of “underwriter” in these new transactional paths? Is guidance needed about how projections and related valuations are presented and used in the documents for any of these paths?

Lordstown Motors Facing Liability Over de-SPAC

In addition to the SEC scrutiny, SPACs also face a growing litigation threat related to their disclosures (or lack thereof). This threat has now materialized in filed litigations, and more can be expected given the plethora of law firms on the lookout for sharp stock drops on negative announcements or short-seller pronouncements as to any publicly traded securities.  Once the de-SPAC process is completed, the disclosure rules that cover publicly traded companies apply. However, in advance of the de-SPAC merger closing, there has, until recently, been some notable abuses of the freedom perceived by the SPAC issuers to provide expansive, and too often indefensible, projections that would not be permitted in an IPO.

For instance, when Lordstown Motors pitched its de-SPAC merger in August 2020, it said that it would not need any additional capital to take its electronic vehicles to market. Now the company is struggling, which has led investors and the SEC to question whether its previous disclosures were misleading.

A March 2021 report from short-seller Hindenburg Research maintains that Lordstown did mislead investors, citing, among other issues, that the company had undisclosed production challenges. “Lordstown is an EV SPAC [special-purpose acquisition company] with no revenue and no sellable product, which we believe has grossly misled investors on both its demand and production capabilities,” Hindenburg wrote.

Lordstown launched an internal investigation in response to the report and several top executives have subsequently resigned. In June, Lordstown acknowledged its financial troubles in an amended SEC filing. According to the company, it will need to raise additional capital in order to move forward with its business plan: “Our ability to continue as a going concern is dependent on our ability to complete the development of our electric vehicles, obtain regulatory approval, begin commercial-scale production, and launch the sale of such vehicles,” the filing states.

Lordstown is facing shareholder lawsuits and a reported SEC investigation. The company’s stock price recently dropped precipitously from $30 down to its present trading range near its $10 SPAC launch price.

Key Takeaway

SPAC financial projections and related disclosures are a likely target of both litigation and SEC regulation. Equating a de-SPAC merger with an IPO with regard to disclosure requirements would rein in the expansive public statements and overly hyped projections issued by some SPACs in connection with communications to SPAC shareholders, and to the trading markets for the SPACs, in advance of effecting the closing of the de-SPAC transaction. The SEC has also issue statements concerning treatment of the SPAC warrants, both the public’s and the Sponsor’s warrants, in the SPAC financial statements. SPACs are adjusting their warrant rights and descriptions to head off what would be a major problem. At this point, it is unclear if and when the SEC’s concerns will result in new regulations or if the increased scrutiny will dampen the SPAC market. Nonetheless, private companies contemplating SPACs should stay apprised of legal updates and be mindful that the transactions may become more complex in the near future. We continue to watch these developments closely.

If you have questions, please contact us

If you have questions or if you would like to discuss the matter further, please contact me, Dan Brecher, or the Scarinci Hollenbeck attorney with whom you work, at 201-896-4100.