Will the SEC Adopt New SPAC Regulations in 2022?

Will the SEC Adopt New SPAC Regulations in 2022?

One of the biggest questions facing special acquisition companies (SPACs) is whether the SEC will adopt new rules...

As we enter 2022, one of the biggest questions facing special acquisition companies (SPACs) is whether the Securities and Exchange Commission (SEC) will adopt new rules. Like most governmental regulatory agencies, the answer is that its procedural requirements of comment periods for the adoption of new rules means that new rules will come, well after their anticipated proposal in April 2022.  New rules are sorely needed to protect public investors and to shield public trading markets from inequities and improprieties that are presently subjects of privately brought litigations resulting from abuses that are now well known. It remains to be seen as to whether stricter SEC oversight will protect the public and cool the market.  SPACs will evolve in response to regulatory challenges, and continue to adapt, having been marketed in one form or another for decades.

As has been held in a number of leading court decisions, the SEC is required to perform significant analytic procedures regarding the economic consequences of regulations it proposes.  Any significant changes the SEC proposes will likely take additional time to become effective after their expected announcement in April 2022 and the comment period required pursuant to the Exchange Act’s direction that the public‘s interest, investor protection and maintaining fair and orderly markets be considered. So, after April 2022, there will likely be a comment period and further notices from the SEC.

The Basics of SPACs

As discussed in greater detail in my prior articles, a SPAC is a shell company with no operations. They are often referred to as “blank check” companies, a denomination in use for decades by our clients for similar blind pool structured IPOs. Today, a SPAC 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, provide the initial capital to form the SPAC and then seek to raise additional funds via an IPO through a brokerage firm underwriting the sale process. In the IPO, securities are offered at a unit price, usually $10, 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 price slightly higher than the offering price, usually $11.50. The funds raised through the SPAC’s IPO are placed in a trust, and that money is held until the SPAC identifies a potential merger or acquisition target. The sponsor’s initial capital is used to fund the limited costs of the search for a target company for a merger or acquisition by the SPAC.

Underwriters like this unit offering structure for the IPO because after the IPO, the SPAC usually allows for the detachment and separate trading of the low-priced warrants, with the unit shares trading separately around or slightly below the $10 offering price for the units, and the warrant trading for less than a dollar, yielding those investors in for a quick turn-around a small immediate profit, and the underwriter/market-maker and speculative traders a heavily traded, low-priced, volatile security.

After the IPO, to facilitate the sought for merger or acquisition, SPAC sponsors often raise additional capital through transactions known as private investments in public equity, or “PIPEs.” The merger or acquisition, often referred to as a “de-SPAC transaction,” is between the publicly traded SPAC and a private operating company, with the shareholders of the private company receiving shares of the SPAC and/or cash as consideration.  SPAC investors are 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 pro-rata return of the funds held in escrow. The less risky shares tend to trade around the initial offering price until a de-SPAC deal is announced.

SEC Making SPACs a Regulatory Priority

In 2021, 602 SPAC IPOs were filed, compared to 248 in 2020. Of those, more than 280 SPACs had announced targets by the end of December 2021. The booming SPAC market, the inherent speculative risks and some flagrant transgressions and flops triggered scrutiny by the SEC, which appears poised to level the playing field between SPACs and traditional IPOs.

At the end of March 2021, the Office of the Chief Accountant issued a statement entitled, Financial Reporting and Auditing Considerations of Companies Merging with SPACs and the Division of Corporation Finance issued a Staff Statement on Select Issues Pertaining to Special Purpose Acquisition Companies. In April 2021, additional SEC documents on the topic of SPACs were issued: SPACs, IPOs and Liability Risk under the Securities Laws and Staff Statement on Accounting and Reporting Considerations for Warrants Issued by SPACs.

In June, the SEC listed SPACs as a rulemaking priority. According to the agency’s regulatory agenda, the target date for issuing a proposal is April 2022. To date, the agency has not released any proposals. However, there is likely work going on behind the scenes.

Recommendations of SEC Investor Advisory Committee

In September 2021, the SEC Investor Advisory Committee (IAC) issued its recommendations for further SPAC oversight, focusing on the practical challenges SPAC investors face in fully assessing the risks and opportunities associated with these investment vehicles. The IAC recommended that the SEC regulate SPACs more intensively by exercising enhanced focus and stricter enforcement of existing disclosure rules under the Securities Exchange Act of 1934 (Exchange Act) in relation to the adequacy of disclosure around several areas, which included:

• Disclosure of the role of the SPAC sponsor (and/or insiders or affiliates such as celebrity sponsors/advisors), including disclosure of the sponsor’s appropriateness, expertise, and capital contributions, as well as an overview of any potential conflicts of interest;
• Plain English disclosure in the SPAC registration statement (beyond mere financial footnotes) around the economics of the various participants in a SPAC process, including the “promote” (e.g., “founder shares”) paid and their impact on dilution sufficient to enable a retail investor to make a meaningful comparison of the upside potential and downside risks of one SPAC transaction as compared to other SPACs, as well as other types of investment opportunities;
• Disclosure that includes a clear description (with diagrams or charts as appropriate) in the SPAC registration statement of the mechanics and timeline of the SPAC process;
• Disclosure in the SPAC registration statement regarding the opportunity set and target company areas of focus, including a clearer discussion of the boundaries of the search area and attributes of acceptable and unacceptable companies, with ground rules for any changes to the search area.
• Disclosure regarding the competitive pressure and risks involved in finding appropriate targets and reaching market acceptable prices for those companies, as well as disclosure regarding the absorption of expenses by the sponsor in the event there is not a successful de-SPAC transaction.
• Disclosure of the acceptable range of terms under which any additional funding (e.g., public investment in private equity “PIPEs”) might be sought at the time of acquisition/redemption .
• Disclosure regarding the manner in which the sponsor plans to assess the capability of potential targets to be a “‘34 Act company” from a governance and internal control perspective, and whether the sponsor will take any steps to ensure the target company can meet minimum preparedness/quality standards for operating as a public company.
• Disclosure about the minimum pre-de-SPAC diligence the sponsor will commit to regarding the accounting practices used by the target company, including audit history, use of GAAP and non-GAAP pro forma numbers, and audit committee (composition; communication between committee, auditor, and management).

In response, SEC Chair Gary Gensler asked SEC staff to “look closely at each stage of the SPAC process to ensure that all investors are being protected,” which included developing rulemaking recommendations to elicit enhanced disclosures and conducting economic analysis to better understand how investors are advantaged or disadvantaged by SPAC transactions.

Chair Gensler Offers Insight into Potential SPAC Rules

SEC Chair Gensler has been a vocal supporter of further SPAC oversight. In remarks at the virtual Healthy Markets Association Conference in December 2021, Gensler highlighted that “the investing public may not be getting like protections between traditional IPOs and SPACs.”

The SEC Chair specifically questioned whether the SEC is doing enough to mitigate conflicts of interest between sponsors and investors. “Due to the various moving parts and SPACs’ two-step structure, I believe these vehicles may have additional conflicts inherent to their structure,” he stated.

Gensler also addressed information asymmetries between early and late investors. He specifically noted that PIPE investors may gain access to information the public hasn’t seen yet, at different times, and can buy discounted shares based upon that information. In contrast, retail investors may not be getting adequate information about how their shares can be diluted throughout the various stages of a SPAC. “Thus, I’ve asked staff to serve up recommendations about how investors might be better informed about the fees, projections, dilution, and conflicts that may exist during all stages of SPACs, and how investors can receive those disclosures at the time they’re deciding whether to invest,” Gensler stated. “I’ve also asked staff to consider clarifying disclosure obligations under existing rules.”

With regard to the use of misleading or fraudulent information in marketing materials, Gensler noted that SPAC mergers often are announced with a slide deck, a press release, and even celebrity endorsements, which may result in investors making decisions “based on incomplete information or just plain old hype.” Accordingly, he has asked staff to make recommendations around “how to guard against what effectively may be improper conditioning of the SPAC target IPO market,” which could include providing more complete information at the time that a SPAC target IPO is announced.

Finally, Gensler also asked staff for recommendations about how the SEC can better align incentives between gatekeepers and investors, and address the status of gatekeepers’ liability obligations. In his remarks, the SEC Chair made clear that when it comes to liability, SPACs do not provide a “free pass” for gatekeepers, such as directors, officers, SPAC sponsors, financial advisors, and accountants.

What’s Next?

As the April 2022 target approaches, SEC staff are preparing proposals for the Commission’s consideration around issues raised by the IAC and Chair Gensler, among others. Based on what we know so far, it is likely that any new rules will seek to better align the legal treatment of SPACs and their participants with the investor protections provided in other IPOs, specifically with respect to disclosures, marketing practices, and gatekeeper obligations.  Given their popularity, volatility and risks, the numerous experienced securities litigation law firms are attentive to sudden downward price fluctuations in SPAC securities.  These private actors also serve as a guardrail and monitors of fraud on the market and have already been actively prosecuting federal court litigations on behalf of public and private investors.  More of this litigation activity can be expected, given the huge amounts of potential losses, the lack of adequate present regulatory control, and the growing competitive SPAC offering market as some SPACs fail to achieve their stated goals.

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.