The Scorching SPAC market will increase the chance of SEC investigations and litigation

The market has seen a boom over the past two years for emerging companies that have gone public through the use of Special Purpose Acquisition Companies (SPACs). SPACs are an attractive means of giving a private company faster access to public capital and avoiding the traditional initial public offering (IPO). A SPAC starts out as a public company through a traditional IPO, but has no business activity. The SPAC raises public funds provided that it uses those funds to find a private target company to invest in. Once the target is identified, the SPAC goes through a business combination transaction (known as a de-SPAC transaction) in which the SPAC and the private target conduct a merger transaction, with the result that the target survives as a private company.

However, the recent dramatic increase in the use of SPACs has been scrutinized. More recently, this trend has drawn the attention of the US Securities and Exchange Commission, as well as the plaintiffs’ class action law firms. Directors and Officers (D&O) insurance carriers are also adjusting their premiums and terms and conditions to address these increased risks when using SPACs. Such growing concerns are only heightened by recent news of gaps in certain deals between returns for insiders and eventual investors who suffer losses after a company is listed on a SPAC.

This post highlights the recent SPAC-related issues raised by the SEC and litigation filing, including potential disputes with SPAC sponsors, accounting controls for targets, and the financial projections companies use to provide support for a SPAC Receive transaction. SPAC sponsors and potential SPAC target companies should be aware of these developments when considering the booming SPAC market. Despite this headwind, it is likely that the SPAC market (especially the De-SPAC market) will continue to be strong in 2021 as valuations remain attractive and given that so many SPACs are competing for targets in the market .

SPAC sponsor conflicts

In late 2020, the SEC’s corporate finance division (Corp Fin) issued guidance on its views on certain disclosure considerations for SPACs in connection with their IPOs and subsequent business combinations. In the guidance, Corp Fin noted that the economic interests of insiders forming a SPAC (sponsors, officers, directors, and affiliates of a SPAC) often differ from the economic interests of public shareholders, which can create conflicts of interest. See SEC Corporate Finance Division, CF Disclosure Guidance: Issue # 11 (December 22, 2020).

Corp Fin emphasized the importance of a SPAC’s management team clearly disclosing such potential conflicts of interest when deciding to recommend SPAC targets to shareholders. Corp Fin gave SPAC sponsors several examples of questions to consider when disclosing a SPAC’s initial public offering and additional disclosures about possible business combinations. Such recommended disclosures include details of whether the SPAC will “pursue a business combination with an objective in which [the SPAC’s] Sponsors, directors, officers, or their affiliates have an interest. “

Corp Fin also addresses the proper disclosure of how the SPAC sponsors control the approval of a business combination transaction, as well as how the SPAC “assessed the identified transaction and decided to propose it” and select “the target company”.

De-SPAC transaction problems

SEC officers recently raised concerns about adequate disclosures about the target company in the De-SPAC process. The SEC’s acting director of corporate finance, John Coates, issued a series of warnings reiterating that the SEC “will continue to be vigilant about SPAC and private target disclosures so that the public can make informed investment and voting decisions about these transactions.” See SEC Department of Corporate Finance, SPACs, IPOs, and Liability Risk under Securities Acts (April 8, 2021).

Acting Director Coates specifically warned SPAC Insider that the safe haven under the Private Securities Litigation Reform Act (PSLRA) may not apply to forward-looking statements regarding financial projections of a target. The Acting Director stated that the PSLRA’s safe haven does not apply to IPOs and the statute is written so that a De SPAC transaction can be considered an IPO. He then took the view that the “liability risks” for SPAC participants are “higher and not lower than for conventional IPOs, in particular due to the potential conflicts of interest in the SPAC structure”.

To counter these higher litigation risks, Acting Director Coates emphasized the need for adequate disclosures in registration statements and proxy inquiries in a De-SPAC business combination under Section 11 of the Securities Act of 1933 and Sections 10 (b), 14 (a), 14 (e) and Rules 10b-5 and 14a-9 under the Securities Exchange Act of 1934. Additionally, he noted that De-SPAC transactions may result in state liability, such as Delaware’s duty to be open and on fiduciary duties in the event of conflicts of interest.

Acting Director Coates also cautioned that the SEC’s enforcement process would not have a safe haven for forward-looking statements (even if the courts determine that the PSLRA applies to de-SPACs), and that a safe haven would not apply to a statement that having given actual knowledge about it was wrong at the time. In conclusion, he said SPAC participants should “treat the De-SPAC transaction as a” real IPO “and provide” appropriate safeguards “with” potentially problematic forward-looking information “.

SPAC accounting for warrants

To raise capital, SPACs often issue warrants. SPAC warrants give investors the right to buy more shares at a preset price in the future. While SPACs typically classified warrants as equity on their balance sheet, SEC officials recently issued a public statement advising that in many cases these warrants should be classified as liabilities. See SEC Corporate Finance Department, Employee Declaration on Accounting Considerations and Reporting for Warrants Issued by Special Purpose Acquisition Companies (“SPACs”) (April 12, 2021).

The SEC warned that accounting errors can occur if a SPAC incorrectly classifies its warrants as equity, asset, or liability. In certain warrant terms issued by a SPAC, “Warrants should be classified as a fair value liability, with fair value changing for each period reported in earnings.” The terms of the SPAC takeover offer may create the same liability classification based on the facts of the deal. If a billing error occurs and is deemed material, the company would have to file an adjustment of all affected previously published financial statements and submit a Form 8-K.

SPAC litigation risks

As control increases, SPACs and SPAC targets increase, so SEC inquiries and shareholder actions increase. Private plaintiffs may seek ways to bring claims not only against the SPAC, but also against the Target and the Target’s Board of Directors for allegedly supporting and facilitating the SPAC Directors’ violations of their governmental obligations. If there are conflicts or forecasts differ from those reported, legal disputes are likely to include claims under state law for conflicting transactions and securities fraud under federal securities laws. SPAC targets with controlling shareholders could also be exposed to control claims if those who control the target receive a different consideration than others in the de-SPAC transaction. In this situation, the target should introduce additional procedural protection right from the start in order to decide whether to approve a deal.

Important takeaways when considering SPAC transactions

These three recent SEC alerts highlight the increasing awareness of SPAC transactions, and nursing sponsors and boards of directors must be vigilant throughout the SPAC transaction process, from the initial public offering of the SPAC to the de-SPAC transaction. SPAC sponsors and targets should carefully and fully disclose a target’s financial projections and potential conflicts with insiders.

In making any forecast, the Ziel and SPAC insiders should carefully consider what to disclose, as well as appropriate disclaimer language to warn investors. If companies only share certain forecasts, they also need to be able to justify why a certain forecast was publicly shared and why another was not. This requires careful planning and design considerations for disclosure so that investors can adequately consider the risks of the De-SPAC transaction. Additionally, the SEC alerts highlight the importance of having good finance teams in place at the SPAC target before it goes public and subject to financial reporting requirements.

Vigilant bodies can help avoid SEC inquiries and shareholder lawsuits by providing accurate and meaningful information and putting in place all necessary corporate governance processes to protect potential insider-shareholder conflicts.