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Why SPACs face a regulatory crackdown

Posted by Shivali Anand

September 15, 2021 | 5-minute read (884 words)

Special purpose acquisition companies have been on a tear in recent months with a slew of IPOs. But they’ve also had to deal with several class-action lawsuits and other regulatory hurdles.

An overview of SPACs

With a SPAC deal, investment firms construct shell companies to obtain money via an initial public offering to buy another company. One example is Diamond Eagle Acquisition Corp.’s establishment as a SPAC at the end of 2019. Diamond Eagle merged with SBTech, a gambling tech company, and DraftKings, a fantasy sports platform. The acquisition was completed in April when DraftKings became a publicly traded company.

Technically, a SPAC is not a business entity. It does not sell or manufacture anything. According to the Securities and Exchange Commission, a SPAC's only asset is the proceeds from its first public offering. A group of investors often backs a SPAC. Some well-known Wall Street executives and high-profile CEOs, like Richard Branson and other billionaires, have jumped on board and created their own SPACs.

Typically, when a SPAC seeks funds through an IPO, the investors who purchase the IPO are unaware of the acquiring firm. Institutional investors with a track record of enormous success can easily persuade individuals to participate in their untested IPOs. This is why SPACs are dubbed "blank check" companies.

Almost all SPAC IPOs have a set price of $10 per share. The money is sent to an interest-bearing trust account once the business raises the share capital. It will stay there until the business's management or founders discover a private company ready to go public through acquisition. Following the purchase, the SPAC's investors can exchange their original shares for combined company shares or redeem them for their initial capital and interest.

Sponsors of SPACs have a deadline they must meet to obtain a favorable contract. This normally occurs two years after the IPO. If they don't, the SPAC will be liquidated, and the team will be reimbursed for their money plus interest.

More about SPACs

Even though these businesses have been utilized as an alternative investment option for some years, their popularity has increased as a simple way to take private companies public while avoiding the market volatility risk of an IPO. SPAC IPOs set a new high last year, and 2021 looks to be even better.

According to spacinsider.com, 248 initial public offerings were completed in 2020, with 298 expected in 2021. But a rise in shareholder litigation has accompanied the spike in SPAC IPOs. Most of these cases are brought after mergers are announced. According to data, shareholders have filed 19 class-action lawsuits in federal court pertaining to SPACs so far this year, compared to five in 2020.

Why are lawsuits against SPACs becoming more common?

The Securities Act of 1933 defines the liability of a SPAC IPO. Once the SPAC is publicly traded, it must comply with the Securities Exchange Act's periodic reporting obligations. Liabilities can emerge from various sources, including omissions in periodic filings, significant misstatements, and even proxy statements issued.

The SEC's Division of Corporation Finance issued guidelines on SPAC-related problems in December 2020. Most of these issues are similar to those raised in today's class-action lawsuits. Conflicts of interest between the management team or firm that formed the SPAC and the SPAC's directors, affiliates, shareholders, and officers are highlighted as being of special concern in the advice.

SPACs should carefully review their disclosure requirements under federal securities legislation, according to Corp Fin. The SPAC sponsor, for example, does not have much time to find a suitable acquisition target and close the deal. The sponsor's options limit as the SPAC's period approaches extinction, and the acquisition target obtains substantial bargaining power.

A rift between the sponsor's economic interests and the interests of the shareholders might result because of such an occurrence. The sponsor wants to complete the transaction before the deadline, while shareholders want a fair offer at a reasonable price.

While considering a business combination deal, Corp Fin advises SPACs to make sure they clearly define the financial motivations of the officers, sponsors, and directors. To avoid class-action lawsuits, they should be explicit about how these incentives vary from the interests of shareholders. SPACs should also declare if the time restrictions were extended before purchasing a company, according to Corp Fin. The possible financial impact of a failed purchase must be disclosed to SPAC's directors, officers, and sponsors.

If more funding is required to complete the combined transactions, another possible conflict with a SPAC arises. SPACs should explain how the extra funding arrangements may affect public shareholders, according to Corp Fin. Will it include the issuance of securities, and if so, how do the conditions and pricing of such securities compare to those offered in an initial public offering (IPO)?

In the review and selection of acquisition candidates, there might be potential conflicts. The SPAC should specify the amount and type of the consideration it will pay to combine with this acquiring business and how it arrived at this figure. The board of directors should also explain what substantial reasons it considered before approving the deal.

Leaving a lasting impression

Unless some of these concerns are addressed by their sponsors, SPACs will continue to be the subject of class-action litigation. Every party concerned must be always kept up to date.

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Startup

Why SPACs face a regulatory crackdown

An overview of SPACs

More about SPACs

Why are lawsuits against SPACs becoming more common?

Leaving a lasting impression

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