The Risks of Investing in SPACs
POMERANTZ MONITOR | MAY JUNE 2021
Special Purpose Acquisition Companies (“SPACs”) burst onto the Wall Street scene, seemingly from nowhere, as the COVID-19 pandemic swept the world by storm in 2020. Their rise to prominence has been so profound that it has garnered the attention of the SEC and the plaintiffs’ bar. The glamour of SPACs has even drawn superstar athletes, such as Serena Williams and Alex Rodriguez, as well as entertainers, such as Jay-Z and Ciera, to take on prominent roles as investors and advisors.
What is this seemingly newfound investment opportunity that everyday investors and celebrities alike have flocked to? A SPAC is a publicly traded company that is set up by investors with the sole purpose of raising money through an IPO to acquire an existing company. The SPAC itself does nothing at all. Typically, its only asset is the money raised through the IPO to fund a targeted acquisition.
These shell companies are usually formed by a team of institutional investors. At the time the shell company goes public, it is not certain what existing company it is seeking to acquire. After the money is raised through an IPO, it is placed in an interest-bearing account until the acquisition can be made. The SPAC generally has up to two years to identify a target company to acquire. Once a target company has been identified and an agreement is in place, the acquisition must be approved by the SPAC’s shareholders through a vote.
Once the acquisition is completed, shareholders are left with the choice of either converting their shares of the SPAC into shares of the acquired company or redeeming their shares and receiving their investment back plus the accrued interest. If the SPAC fails to identify a target company within the two-year time limit, the SPAC is liquidated, with all shareholders receiving their original investment back along with accrued interest.
Since SPACs have risen to prominence only recently, many investors assume they are new. In fact, SPACs have been around for decades but have scarcely been used. They became more prevalent recently due to the extreme market volatility caused by the COVID-19 pandemic. Existing companies looking to go public were left with a choice: either postpone their IPOs due to the uncertainty, or merge with a SPAC.
The benefits of merging with a SPAC are fairly straightforward. As Peter McNally, global sector lead at Third Bridge, a research firm, explains, “SPACs are giving management and boards of companies more options for quicker and more efficient ways to go public.” Registering an IPO with the SEC can take up to six months, while merging with a SPAC takes only a couple of months to complete, providing the acquired company with quicker and easier access to capital. Additionally, in theory, companies acquired by SPACs are not subject to the same scrutiny under the securities laws and by the SEC, as they were not introduced to the market through IPOs. As a result, SPACs have been more aggressive in making forward-looking statements, prior to targeted acquisitions being finalized, to draw investors in. These perceived benefits are also where the risks lie and are the reason why SPACs have become the focus of the SEC’s crackdown.
The risk of investing in a SPAC for everyday investors is significant. For starters, investors do not know which company the SPAC will seek to merge with. That uncertainty, in and of itself, creates risk. Further, SPACs do not seem to be exercising the same rigorous due diligence that is performed during a traditional IPO. The primary concern of a SPAC is to find a target company to acquire before the two-year time limit runs out. For that reason, SPACs are incentivized to find an acquisition that can close quickly rather than finding the best acquisition target based on performance and price.
Typically, being unable to access the hottest IPOs, an average retail investor’s ability to access a SPAC as soon as it goes public may tempt them to accept the risks.
Investors are not the only ones who bear some risk with their involvement in SPACs. Target companies run the risk of having the merger rejected by the SPAC’s shareholders. Once a company has been chosen for acquisition, the de-SPAC process, which is similar to that of a public company merger, begins. The SPAC, acting as the buyer, requires the approval of its shareholders. Generally, more than 20% of the voting stock approval is mandatory.
Given the recent surge in SPACs, it comes as no surprise that the SEC and the plaintiffs’ bar have taken notice. In a statement issued on April 8, 2021, John Coates, the SEC’s acting director of the Division of Corporation Finance, cautioned that de-SPAC acquisitions are similar to IPOs and should be treated as such under the securities law. Further, Coates warned, the perception that SPACs are subject to reduced liability is “overstated at best” and “seriously misleading at worst.”
Coates warned of the various dangers of forward-looking statements being issued by SPACs, such as their speculative, misleading, and sometimes fraudulent nature. Risk disclosures in SEC filings may serve as a “safe harbor defense” for public companies in securities litigation that arises from their statements to investors, in that predictions, projections and expectations in disclosure documents may not be construed as misleading if they contain sufficient cautionary language disclosing risks. Coates specifically questioned whether SPACs are excluded from the safe harbor under the PSLRA, given their similarity to IPOs, which are excluded. However, there is no definition as to what an IPO consists of in the PSLRA or any SEC rule, and case law interpreting what constitutes an IPO under the PSLRA is sparse. Coates stated that the SEC is considering making rules or providing guidance as to how the PSLRA safe harbors apply at the final stages of a SPAC transaction.
Given the uncertainty regarding whether the safe harbor applies to SPACs, they are expected to be more cautious about the forward-looking statements in their disclosures. This will diminish the appeal of SPACs to investors who have relied on these forward-looking statements to anticipate the type of acquisition targeted by a SPAC in which they invested. It is important to note that regardless of whether the safe harbor applies to SPACs, they are still prohibited from making false or misleading statements in their disclosures. With the SEC turning their attention to SPACs, the forward-looking representations issued are now under the microscope for such infractions.
Further, between September 2020 and March 2021, at least 35 SPACs were sued by shareholders in New York state courts. Generally, these lawsuits allege that SPAC directors breached their duties by providing inadequate disclosures regarding the proposed acquisition. Some of the lawsuits also claim that the SPAC itself, along with the target company and its board of directors, aided and abetted the SPAC directors’ breaches. Notably, all of these lawsuits are limited to state law tort claims and do not assert any state or federal securities claims. The lawsuits were all filed after the de-SPAC transactions were announced but before shareholders had voted on approving the transactions. As such, the lawsuits seek preliminary injunctive relief to prevent the acquisitions from being finalized.
Lawsuits against SPACs remain in their infancy. The only cases in New York state court that have been resolved are those where plaintiffs stipulated to voluntarily dismiss the action. The lawsuits, however, provide a clear indication that the plaintiffs’ bar is monitoring and pursuing SPACs. The Harvard Law School Forum of Corporate Governance anticipates there will be increased litigation in federal courts regarding SPACs, including claims under section 10(b) of the Securities Exchange Act. Given that SEC guidance and intervention appears to be on the horizon, it appears likely that more litigation will follow.
Will SPACs remain prevalent over the long haul, or fade into the background where they have resided for decades? The SECs intervention, or lack thereof, will play a large part in determining that. However, Paul Marshall, co-founder of the investment firm Marshall Wace, did not mince words in his criticism of the future outlook of SPACs, predicting that the phenomenon will “end badly and leave many casualties.” Unsurprisingly, based on his outlook on SPACs, Marshall is shorting them and betting on their eventual demise. Time will tell whether he is correct. However, the returns on SPACs have steadily declined, and it appears the phenomenon which blossomed as uncertainty flooded the market may already be fading as that same uncertainty begins to dissipate, the world begins to reopen, and a new normal is established.