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How SPACs Can Manage the Risks of White Collar Scrutiny

Notwithstanding the economic difficulties following the pandemic, 2020 saw a huge increase in initial public offerings ("IPOs") and merger activity relating to "SPACs" (Special Purpose Acquisition Companies). The number of SPAC IPOs in 2020 (242) was four times the number in 2019, and the average transaction size in 2020 ($335 million) was almost 50 percent higher than the average in 2019. Since the start of 2021, 228 more SPACs have filed to go public.1

While SPAC mergers have become a popular vehicle for private companies going public on US markets, SPAC transactions present some risks for government scrutiny. Government regulators may critically examine these deals for, among other things, insider trading, material conflicts of interest between the SPAC management and investors, and misleading disclosures or omissions in SEC filings made in connection with the transaction. All of these risks, however, can be managed through strong policies and procedures, as well as enhanced disclosures.

 

What is a SPAC?

A SPAC is a blank check company with no operations that raises capital—generally hundreds of millions of dollars—in an IPO and places the proceeds into a trust account for subsequent use in acquiring one or more businesses. Following the SPAC's IPO, the SPAC's management team, or "sponsors," will identify acquisition targets and attempt to complete a business combination transaction (the "deSPAC-ing" transaction). Sometimes, the SPAC may require financing in addition to the proceeds from its IPO to complete the deSPAC-ing transaction. The SPAC sponsors may provide this financing in the form of a forward purchase commitment at the time of the IPO, and/or the SPAC may solicit interest from private investment in public equity ("PIPE") investors.

SPACs typically must complete the deSPAC-ing transaction within a specified time frame (often 24 months) after the IPO. If the SPAC fails to meet this deadline, the SPAC must liquidate and distribute the proceeds to the public shareholders. Investors also have the option to redeem their SPAC shares at the time the deSPAC-ing transaction is proposed if they do not like the terms.2 After the deSPAC-ing transaction, the combined company continues as a public company.

As compared to an IPO, the regulatory environment for private companies that choose to go public through a SPAC differs in at least two respects. First, in a typical IPO, more than just the private company is focused on ensuring that disclosures to investors are adequate. Under the Securities Act of 1933, underwriters face potential liability for misstatements in the offering materials. As there is no underwriter in a deSPAC-ing transaction, the responsibility for the accuracy and completeness of the disclosure largely falls on the SPAC, and this can open the SPAC up to second-guessing. Second, because financial projections made in connection with most IPOs are not protected by the safe harbor of the Private Securities Litigation Reform Act ("PSLRA"), and underwriters would face liability if such projections were made, companies typically do not make such projections when launching an IPO. The same projections, however, are protected in a deSPAC-ing transaction if properly identified as forward-looking and completely accurate. Additionally, as noted above, there is no underwriter that would have liability. As a result, SPACs often make such projections, which will likely lead to government scrutiny of whether the SPAC and the individuals who signed the SEC filings exercised reasonable care in ensuring the accuracy thereof.3

 

White Collar Risks

The recent surge in interest and publicity surrounding SPACs is sure to draw increased attention from securities regulators. In their view, the unique process by which SPACs take private companies public may present risks for securities fraud—but the good news for participants in the transactions is that such risks can be managed.

First, there is a heightened risk of insider trading. Because the SPAC is a publicly traded company prior to the deSPAC-ing transaction, there is a risk that individuals will purchase the SPAC securities after learning of the proposed deSPAC-ing transaction target and other potentially material information, but before that information is publicly announced. Particularly if the deSPAC-ing transaction requires PIPE financing, the group of individuals who are aware of the target can be quite large, and this can lead to leaks that will raise suspicions of insider trading.

We expect the Financial Industry Regulatory Authority ("FINRA"), the US Securities and Exchange Commission ("SEC"), and the US Department of Justice ("DOJ") to critically examine trading in SPACs' securities ahead of the deSPAC-ing transactions to identify unlawful insider trading. In light of this, SPACs and target companies should ensure that they have robust policies and procedures to prevent insider trading of the SPAC securities, and should consider instituting a trading blackout period for SPAC and target insiders or require pre-clearance of trades ahead of the deSPAC-ing transaction. In addition, they should carefully respond to any inquiries from FINRA regarding who was aware of the transaction before it was announced and assume that any responses will be shared with the SEC and the DOJ.

Second, there is a risk that the SEC or the DOJ will question whether a SPAC has adequately disclosed potential conflicts between the sponsors' interests and the interests of the public shareholders.4 The economic interests of the SPAC sponsors in a deSPAC-ing transaction may differ from the interests of that SPAC's shareholders, thereby leading to conflicts of interest. For instance, SPAC sponsors may have other business activities that the government may think affect their selection and valuation of the potential target. To avoid government scrutiny, SPAC sponsors should disclose any economic interests in the potential target and any other financial incentives that differ from the incentives to SPAC shareholders to complete the deSPAC-ing transaction. This could include compensation to sponsors that is contingent on that transaction. In addition, if a SPAC requires additional financing, such as PIPE investments, to complete the deSPAC-ing transaction, the SPAC should disclose the terms of such financing so the investors understand whether the financing will dilute their ownership interest.

Notably, the government might investigate whether the deadline for completing a deSPAC-ing transaction pressured sponsors to complete an acquisition that is not in the best interests of the SPAC shareholders in order for the sponsors to avoid liquidation. The government might also investigate whether sponsors have less leverage to negotiate favorable acquisition terms because the target is aware of the deadline. To avoid such issues, sponsors should explain whether there was any time pressure, along with explaining any procedures for extending the deadlines.

The SEC has already made it clear that it plans to focus on these types of potential conflicts. In October and November, then-SEC Chairman Jay Clayton said that shareholders should understand the incentives to the sponsors in the deSPAC-ing transaction and that SPAC sponsors may not be making adequate disclosures.5 Shortly thereafter, in December, the SEC's Division of Corporation Finance issued "Disclosure Guidance for SPACs" in which they spelled out all of the potential conflicts between sponsors and SPAC investors that should be disclosed.6 In addition, the SEC's Office of Investor Education issued investor guidance to ensure investors understand the "financial interests and motivations of the SPAC sponsors and related persons" and to caution investors that celebrity involvement in a SPAC does not mean that the investment is appropriate.7 Further, the acting Chairman of the SEC recently stated that they are looking into "the structural and the disclosure issues" of SPACs.8 One can reasonably expect that after all of these warnings, the SEC's Division of Enforcement is not far behind and will start evaluating SPAC disclosures.

Third, the government may believe that SPACs bring private companies into the public markets without the same level of vetting that occurs with an IPO, thereby risking that the SPAC is acquiring an entity that has undisclosed baggage.9 The IPO process includes statutorily encouraged due diligence and evaluations of disclosures by underwriters and the SEC before a company can complete an IPO. DeSPAC-ing transactions similarly include due diligence of the target, but because the process is conducted largely by the SPAC and may also face the time pressure of the deSPAC-ing deadline, the government may view it skeptically.10 In fact, it appears that the SEC is currently investigating at least one SPAC for failing to adequately disclose to investors, during a recent deSPAC-ing transaction, that the target/company acquired was the subject of an active DOJ investigation, and the SEC and DOJ are examining a SPAC target and its CEO's potential misrepresentations in connection with a second deSPAC-ing transaction.11

Finally, while the PSLRA's safe harbor for forward-looking statements may provide some protection to SPACs when they issue financial projections during the deSPAC-ing transaction, this protection is not ironclad and such projections still draw scrutiny from the SEC. For example, in 2019, the SEC sued the founder and CEO of a SPAC, the target of its deSPAC-ing transaction, and the target's Chief Executive Officer and Chief Technology Officer for, among other things, misstated financial projections in connection with that transaction.12 The SEC alleges in its actions that the pressure the SPAC was under to complete the transaction led them all to lie to SPAC shareholders about the transaction.13 With respect to the founder and CEO of the SPAC, the SEC found that he did not exercise reasonable care in ensuring the statement made to shareholders that the SPAC had "conduct[ed] a thorough due diligence review" was accurate because the SPAC had not conducted third-party due diligence to ensure that certain financial projections on the target's backlog and pipeline of customer orders were accurate, nor did he disclose material facts that contradicted these projections.14 With respect to the target and its officers, the SEC alleged that the target's officers had authority over the content of the proxy statement by virtue of the terms of the deSPAC-ing agreement and the central role they played in that transaction. Further, the SEC's allegations against the officers survived a motion to dismiss.15

 

Conclusion

As the SPACs enter into their deSPAC-ing transactions, they can expect the SEC and DOJ to be watching. These investigations will likely involve not only the SPAC and SPAC sponsors, but also the acquisition target, its directors and officers, and any party who was aware of the target before the deSPAC-ing transaction was publicly announced.16 To limit such scrutiny, SPACs should, at a minimum, ensure that they: (i) have robust policies and procedures to prevent insider trading; (ii) carefully craft responses to FINRA requests; (iii) ensure that all disclosures are complete and accurate; (iv) conduct in-depth due diligence on the target, including third-party due diligence; and (v) ensure that any financial projections are both identified as forward-looking and reasonable.

 

1 "SPACDex: Return Compared to S&P 500," SPAC INSIDER, (last visited Mar. 22, 2021).
2 The SPAC typically files a proxy statement with the SEC for the purpose of soliciting proxies from its shareholders. This proxy statement should contain all material information for the shareholders to determine whether to redeem their SPAC shares or approve the business combination. If there are misstatements in the proxy materials, the SEC can charge the SPAC, the target and the individuals responsible for the proxy statement with, among other things, violations of the anti-fraud provisions (Section 17(a) of the Securities Act of 1933 and Section 10(b) of the Securities Exchange Act of 1934 ("Exchange Act")) and violations of the proxy solicitation provision (Section 14(a) of the Exchange Act).
3 At least one expert has recently encouraged the SEC to make the regulations for SPACs and IPOs consistent, including the safe harbor for financial projections. See Tom Zanki, "Regulatory Edge Benefiting SPACS Should End, Panel Told," LAW360 (Mar. 11, 2021).
4 The SEC is also focused on conflicts of interest for financial advisors to the transactions.
5 Soyoung Ho, "SPACs are Hot but SEC is Watching," THOMSON REUTERS (Oct. 26, 2020). See also "SEC Chairman Jay Clayton on disclosure concerns surround going public through a SPAC," CNBC (Sept. 24, 2020, 9:46 AM).
6 "CF Disclosure Guidance: Topic No. 11," SEC DIVISION OF CORPORATION FINANCE (Dec. 22, 2020),
7 "What You Need to Know About SPACS — Investor Bulletin," SEC OFFICE OF INVESTOR EDUCATION AND ADVOCACY (Dec. 10, 2020). See also "Celebrity Involvement with SPACs — Investor Alert," SEC OFFICE OF INVESTOR EDUCATION AND ADVOCACY (Mar. 10, 2020).
8 Isabelle Lee, "SPAC Returns Don't Warrant the 'Hype' They're Getting, SEC Chair Says," BUSINESS INSIDER (Mar. 11, 2021).
9 Tom Huddleston Jr., "What is a SPAC? Explaining one of Wall Street's hottest trends," CNBC (Jan. 30, 2021, 9:00 am), ("While the SPAC merger process does require transparency regarding the target company, former Goldman Sachs CEO Lloyd Blankfein told CNBC that the due diligence of the SPAC process is not as rigorous as a traditional IPO.").
10 Recently, PIPE placement agents have begun to more actively engage in due diligence in connection with the private placement of the PIPE.
11 Jonathan Ponciano, "Chamath Palihapitiya's Clover Health Discloses New SEC Investigation and Responds to Short-Seller's Scathing Allegations," FORBES (Feb. 5, 2021, 11:54 am). See Michael Wayland, "Nikola Admits Ousted Chairman Misled Investors as Legal Costs Mount," CNBC (Feb. 25, 2021, 6:12 pm). See also Matt McFarland, "Nikola Motor Reveals It Received Subpoenas from DOJ, SEC," CNN (Nov. 10, 2020, 2:39 pm).
12 Benjamin H. Gordon, Exchange Act Release No. 86164, File No. 3-19210 (June 20, 2019) (finding that a SPAC sponsor had failed to take reasonable steps to ensure shareholders received accurate information during the deSPAC-ing transaction). See also SEC v. Hurgin, No. 1:19-cv-05705, 2020 U.S. Dist. LEXIS 162447 (S.D.N.Y. Sept. 4, 2020) (denying motions to dismiss by target company and its principals).
13 Benjamin H. Gordon, supra note 12 (stating that the SPAC was required to return investors' capital if it did not complete a merger by December 2015 and the merger was proposed on December 22, 2015). See also Complaint at ¶ 21, SEC v. Hurgin, No. 1:19-CV-05705 (S.D.N.Y. June 18, 2019) (alleging "with the December 23, 2015 deadline fast approaching, [the SPAC] had still not yet identified a target with which [the SPAC's] shareholders would vote in favor of merging").
14 Benjamin H. Gordon, supra note 12.
15 SEC v. Hurgin, 2020 U.S. Dist. LEXIS 162447 at *38.
16 The SEC has also sued broker-dealers and their principals for fraud where they found a broker-dealer was aware of material misstatements by a SPAC. See United States SEC v. Spartan Sec. Grp., Ltd., No. 8:19-cv-448-T-33CPT, 2020 U.S. Dist. LEXIS 242637 (M.D. Fla. Dec. 28, 2020) (denying broker-dealer and its principals' motions for summary judgment because a jury could find they were aware certain statements were untrue). Further, there have been private lawsuits against SPACs and targets for similar alleged misconduct.

 

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