On August 17, 2021, a purported shareholder of Pershing Square Tontine Holdings, Ltd. ("PSTH") filed a derivative lawsuit against PSTH, a special purpose acquisition company ("SPAC") sponsored by investment funds managed by Bill Ackman, as well as certain of PSTH's directors and certain other entities, alleging, among other things, that PSTH is an unregistered "investment company," as defined in the Investment Company Act of 1940, as amended (the "ICA").1
The lawsuit has garnered a significant amount of media attention, in part because the lawyers behind it include former SEC commissioner and current NYU Law professor Robert Jackson and Yale Law School professor John Morley, and the same purported shareholder, represented by the same lawyers, has subsequently filed lawsuits against other SPACs containing the same allegation. The claim that SPACs are investment companies is meritless, as it is based on a flawed portrayal of both the purpose of SPACs as well as the applicable provisions of the ICA. As the SEC has recognized for decades, a SPAC is a blank check company whose primary purpose, during its limited corporate lifespan, is to engage in a business combination with an operating company, and therefore is not an investment company governed by the ICA. The lawsuits, which contain no novel arguments or revelations that would affect that treatment, should fail.
What is an Investment Company under the ICA?
Section 3(a)(1) of the ICA defines an "investment company" for purposes of the federal securities laws. Sections 3(a)(1)(A) and (C) of the ICA provide that an investment company is a company that:
- is or holds itself out as being primarily engaged, or proposes to engage primarily, in the business of investing, reinvesting or trading in securities (sometimes called "orthodox" or "typical" investment companies); or
- is engaged or proposes to engage in the business of investing, reinvesting, owning, holding or trading in securities, and owns or proposes to acquire investment securities having a value exceeding 40 percentum of the value of such issuer’s total assets (exclusive of Government securities and cash items) on an unconsolidated basis (sometimes called "inadvertent" investment companies).2
SPACs Are Not Investment Companies
SPACs disclose their primary business purpose on the cover page of their initial public offering ("IPO") prospectus. A typical SPAC states that it is a blank check company whose purpose is to effect a merger, capital stock exchange, asset acquisition, stock purchase, reorganization or similar business combination with one or more businesses, and if it is unable to do so within a specified period of time (typically 18 to 24 months), it will liquidate and redeem the shares held by its public investors for cash.
The website of the SEC’s Office of Investor Education and Advocacy ("OIEA") explains that:
A blank check company is a development stage company that has no specific business plan or purpose or has indicated its business plan is to engage in a merger or acquisition with an unidentified company or companies, other entity, or person. … A type of blank check company is a "special purpose acquisition company," or SPAC for short. A SPAC is created specifically to pool funds in order to finance a merger or acquisition opportunity within a set timeframe. The opportunity usually has yet to be identified.3
Given that a SPAC’s primary business purpose is not investing, reinvesting or trading in securities, a SPAC is not an "orthodox" or "typical" investment company that falls within the scope of Section 3(a)(1)(A) of the ICA. Likewise, as described in more detail below, because the proceeds held in the SPAC’s trust account are not "investment securities" (as defined in the ICA), a SPAC is not an inadvertent investment company that falls within the scope of Section 3(a)(1)(C) of the ICA. Indeed, the plaintiff concedes that PSTH is not an inadvertent investment company, and accordingly, this Client Alert focuses only on the definition in Section 3(a)(1)(A).
Notwithstanding the fact that PSTH, like all SPACs, clearly articulated its purpose as identifying and consummating a business combination, and not investing, reinvesting or trading in securities, the complaint against PSTH (¶ 101) alleges:
The ICA defines an investment company as a company that invests in securities. And investing in securities is all the Company has ever done or proposed to do with the great majority of its assets.
The complaint misstates both the law and what PSTH, like all SPACs, proposes to do. As noted above, to be an investment company under Section 3(a)(1)(A) of the ICA, a company must do more than merely invest in securities. Investing in securities must be the company's primary business to fall within Section 3(a)(1)(A). The purported basis in the lawsuit for its allegation that PSTH's primary business is investing in securities is the fact that, prior to the consummation of a business combination or liquidation, PSTH, like all SPACs, is required to deposit all of the gross proceeds from its IPO into a trust account, which may only be invested in United States "government securities" or in certain money market funds which invest only in direct US government treasury obligations. This argument was rejected long ago by the SEC.
In 1992, the SEC adopted Rule 419 under the Securities Act of 1933, as amended (the "Securities Act"). Rule 419 governs blank check companies that issue "penny stock." When Rule 419 applies to an offering, it requires, among other things, that (i) a specified portion of the offering be deposited into either an escrow or trust account (the "Rule 419 Account"), (ii) the proceeds in the Rule 419 Account be invested only in certain money market funds or US treasury obligations, and (iii) the proceeds in the Rule 419 Account be returned to the company’s investors if the company has not completed an acquisition within 18 months after the effective date of the company’s registration statement for the offering.
In the Rule 419 adopting release,4 the SEC noted that the proposing release solicited comment regarding the registration of the Rule 419 Account as an investment company under the ICA. The SEC noted that "in light of the purposes served by the regulatory requirement to establish such an account, the limited nature of the investments, and the limited duration of the account, such an account will neither be required to register as an investment company nor regulated as an investment company as long as it meets the requirements of Rule 419." (emphasis added)
SPACs are not governed by Rule 419 because they do not issue penny stock.5 Nonetheless, the hallmarks of a blank check company cited in the SEC's Rule 419 adopting release as supporting the determination that blank check companies are not required to register under the ICA are all present in a SPAC, including (i) the requirement to deposit a specified portion of their offerings (typically 100 percent) in a trust account, (ii) the requirement to invest the trust proceeds only in certain money market accounts or US treasury securities, and (iii) the requirement to return the trust proceeds if the SPAC fails to complete an initial business combination within a limited period of time.
SPAC IPO prospectuses make clear that the trust account is intended as a holding place for funds pending the earliest to occur of either the completion of an initial business combination or the failure to complete a business combination within a limited period of time, and that the offering is not intended for persons who are seeking a return on investments in government securities or investment securities.
The lawsuit against PSTH (¶13) further alleges that:
the abstract intention to identify an operating business to acquire at some undefined time in the future is insufficient to allow an entity that otherwise qualifies as an investment company to avoid regulation under the ICA nd (sic) IAA.
This allegation fails because, as demonstrated above, PSTH, like all SPACs, does not otherwise qualify as an investment company, and of course, the intention to identify an operating business is more than abstract. A SPAC must do so or liquidate within a limited period of time, clearly demonstrating that its primary purpose is identifying and combining with an operating company, not investing in securities.6 Since 2003, only a small minority of SPACs have liquidated without consummating a business combination.
Since 2003, there have been over 1,000 SPACs that have undergone SEC review, completed their IPOs and operated without registration under the ICA. The SEC staff has issued comments from time to time in SPAC IPOs relating to the specific disclosure about the SPAC not being regulated as an investment company, and we are not aware of any case where the SEC staff prevented a SPAC IPO from proceeding on the basis that a SPAC was an unregistered investment company.
The UMG Transaction
The attorneys behind the lawsuits seem to have initially targeted PSTH because of a highly unusual transaction that PSTH recently proposed, and then abandoned. PSTH proposed to invest the majority of its assets in a ten percent stake in the common stock of Universal Music Group B.V. ("UMG"). In this unusual transaction structure, PSTH would have acquired its 10 percent stake in UMG as a stock purchase; in contrast, SPAC business combinations are typically structured as mergers in which the operating company merges with and into the SPAC or a subsidiary of the SPAC, with the SPAC being the going-forward public company, or as a merger in which the SPAC is acquired by either the target or a newly formed holding company.
If the only deviation from the typical SPAC structure would have been to effect the business combination as a stock purchase rather than a merger, that would have been a distinction without a difference, as the end result would have been that the SPAC’s shareholders would have owned a direct interest in an operating company, and the SPAC would have liquidated and dissolved. But that’s not what was initially proposed. The UMG transaction was originally structured so that the SPAC would acquire and hold the UMG shares and only distribute the UMG shares to its investors after a public listing of UMG on Euronext Amsterdam later this year. Moreover, the SPAC would continue in existence, with $1.6 billion to invest as it saw fit, without any of the restrictions and obligations that routinely apply to SPACs. (In addition, investors would have received the right to acquire a stake in a new vehicle known as a special purpose acquisition rights company, or SPARC; more about that below.) That structure, had it actually proceeded, raised the concern that, from and after the closing of the UMG investment, PSTH would have been an investment company, as a majority of its assets following the UMG stock purchase would have consisted of a minority position in UMG. Indeed, we understand that the SEC staff raised this issue, and in order to address it, PSTH revised the terms of the transaction to require PSTH to transfer the UMG shares into a liquidating trust for the benefit of PSTH’s shareholders pending the public listing of UMG. However, PSTH still proposed to continue on after the UMG stock purchase with $1.6 billion in cash and no restrictions, which the SEC staff believed was not permitted under New York Stock Exchange ("NYSE") listing rules. As a result, PSTH ultimately issued a press release stating that it decided to abandon the UMG deal, and instead focus on structuring its initial business combination as a conventional SPAC merger.7
Ironically, the takeaway from the proposed UMG transaction is not that SPACs are investment companies, but rather than when a SPAC proposes an unconventional transaction that includes features that deviate from the normal SPAC structure in a way that renders it an investment company, the SEC does not hesitate to raise the issue and thwart the SPACs ability to proceed. Instead, the plaintiff and his lawyers have used it as a springboard to bring the same spurious claim against other SPACs.
The lawsuits come in the backdrop of a number of SEC staff pronouncements regarding SPACs which have left some SPAC market participants on edge. However, as described above, it is clear that SPACs do not fit within the definition of an investment company under Section 3(a)(1)(A) of the ICA because they are not, and do not hold themselves out as, being engaged primarily, or do not propose to engage primarily, in the business of investing, reinvesting or trading in securities. SPACs seek to acquire or combine with one or more operating businesses. While there are various ways to structure business combination transactions, the result is that the SPAC’s shareholders become the shareholders of the combined company, which thereafter carries out the operating company’s business.
On August 19, 2021, Mr. Ackman issued a letter to PSTH’s shareholders,8 stating:
While we believe the lawsuit is meritless, the nature of the suit and our legal system make it unlikely that it can be resolved in the short term. Even if the case were dismissed expeditiously, the plaintiff can then appeal. As a result, the mere existence of the litigation may deter potential merger partners from working with PSTH on a transaction until the lawsuit is finally resolved.
He went on to say that PSTH is proceeding to seek SEC and NYSE approval for the SPARC structure, and if it is approved, PSTH would seek shareholder approval to return the $4 billion in its trust account, and the SPARC would seek to consummate a business combination.
One may speculate on Mr. Ackman’s motivation to pivot to the SPARC structure, in light of the challenges that PSTH seems to have had in deploying its $4 billion in a business combination, but the motivations of the lawyers behind the PSTH and other lawsuits are clear. "We think this is a space where everybody sees the need for reform," Professor Jackson said in an interview with Bloomberg published on August 17, 2021.
It is unfortunate that the lawyers are concocting spurious claims as a means of pursuing their agenda.
There are many investor protections in the Securities Act, the Securities Exchange Act of 1934, as amended, and the rules and regulations thereunder that apply to SPAC transactions, and the SEC has not hesitated to invoke them. Regulation as an investment company under the ICA, however, is not one of them. As a result, the claim that a SPAC is an investment company should fail.
1 Assad v. Pershing Square Tontine Holdings, Ltd. et al, Docket No. 1:21-cv-06907 (S.D.N.Y. Aug 17, 2021). The complaint is available here.
2 A third category of investment companies is defined in Section 3(a)(1)(B) of the ICA as an issuer that is engaged or proposes to engage in the business of issuing face-amount securities of the installment type, or has been engaged in such business and has any such certificate outstanding. SPACs are not engaged, and do not propose to engage, in the business of issuing face-amount securities of the installment type.
3 See here.
4 See here.
5 The definition of penny stock excludes, among other things, securities whose issuer has net tangible assets in excess of $5,000,000 or whose issuer is registered with a national securities exchange.
6 The listing rules of both the Nasdaq Stock Market and the New York Stock Exchange limit the period of time that a SPAC has to identify a target and complete its initial business combinations to 36 months.
7 See here.
8 See here.
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