By: Haodi Dong
Recently, a growing number of companies are choosing to go public by merging with Special Purpose Acquisition Companies (“SPACs”) instead of going through a traditional Initial Public Offerings (“IPOs”). This post discusses current SPAC regulations and explores why investors should think carefully before investing in SPACs.
The Year of SPAC
In 2020, 248 SPAC IPOs raised over $82 billion, which accounted for 55% of total U.S. IPOs and 46% of total U.S. IPO proceeds. However, from 2003 to 2019, the average number of SPAC IPOs per year was just 23, and SPAC IPOs have never raised more than 20% of total U.S. IPO proceeds in a given year. Based on this significant increase in both the number and capital raised of SPAC IPOs, many called 2020 “the year of SPAC”—and the enthusiasm remains strong this year as well. By June 12, 2021, a total of 339 SPAC IPOs have raised over $106 billion in funding, accounting for 72% of total U.S. IPOs and 61% of total U.S. IPO proceeds this year.
SPAC in a Nutshell
A SPAC is a shell company formed by a team of sponsor investors with the sole purpose of raising cash through a SPAC IPO before acquiring another operating company in the future—a process called a de-SPAC. After the SPAC IPO, the sponsors place the funds raised in a trust. If needed, the funds can be returned to public shareholders, with interest, if the SPAC fails to acquire a target company. Regulations also dictate that sponsors have a time limit of two years to complete the de-SPAC process, and SPAC shareholders also have redemption rights to get their investment back before the de-SPAC process. This way, companies can go public simply by merging with SPACs, effectively bypassing the prolonged traditional IPO process. However, since a SPAC’s operation is nothing more than acquiring a future target that is unknown during its IPO, SPACs are also referred to as “blank check companies.” Unsurprisingly, investors and media have expressed concerns over SPACs. However, under existing laws and regulations regarding SPACs, many of these concerns are unwarranted.
Existing SPAC Regulations Already Protect Investors Sufficiently
Most SPAC regulations deal with the two main steps of SPACs: (1) SPAC IPOs; and (2) de-SPACs. During step one, the same regulations and standards apply to both SPAC IPOs and traditional IPOs, such as filing registration statements with the Securities and Exchange Commission (“SEC”), clearing SEC comments, and conducting roadshows. Additionally, Section 11 of the Securities Act gives shareholders a cause of action based on material misstatements or omissions in a registration statement, and shareholders asserting Section 11 claims need not prove reliance. However, since SPACs are newly formed shell companies, SPAC sponsors do not have much information to disclose during step one.
After step one, SPAC sponsors need to search and identify a private company with which to merge. Once SPAC sponsors have identified a target company, step two—the de-SPAC process—begins. The more meaningful SPAC regulations occur at this step because as an operating company, the target company will have information of interest to SPAC shareholders such as prior transactions, assets, and liabilities. In order to initiate the de-SPAC process, the SPAC needs to obtain shareholder approval by providing proxy statements on Schedule 14A. Schedule 14A requires disclosure of important information which allows shareholders to make an informed decision. Any material misstatement or omission related to a proxy statement is subject to liability under Section 14(a) of the Exchange Act, J.I. Case Co. v. Borak. Additionally, within four business days of the de-SPAC process, the SPAC needs to file a special Form 8-K, called a Super 8-K. The Super 8-K must disclose information that describes any property, business, risks, financial information, directors, and executives officers, among other considerations.
After detailed information disclosure during both steps, SPAC investors are well-informed and protected against many concerns. As mentioned above, SPAC regulations also offer SPAC investors additional protection, for instance SPAC proceeds are held in a trust and shareholders have additional protections such as approval rights and redemption rights. In a paper published in November 2020, two law professors and a research assistant found “no evidence that SPACs are hotbeds of fraud or outright investor deception,” and suggested that “perhaps investor protection should be left to market forces.”
Beware: SPACs Are a Double-Edged Sword
Although current SPAC regulations provide investors with sufficient protection, investing in SPACs still might not be a good idea after all. In the same paper mentioned above, the authors found that SPAC investors “see post-merger share prices drop on average by a third or more.” This significant drop in post-merger share price might be partially explained by the type of companies using SPACs to go public and SPAC’s two-year limit to de-SPAC.
According to Marcus New, CEO of InvestX Capital, there are three types of companies that go public: (1) the best-quality market-leader companies which do not want, nor need, a SPAC; (2) the high-quality companies that may or may not use SPAC to go public faster; and (3) the lower quality companies which are being targeted by SPAC sponsors. In other words, many companies that use SPACs to go public are of lower quality.
Another reason for the post-merger share price drop would be the two-year limit to de-SPAC. Because of the two-year limit to de-SPAC, many SPAC sponsors are motivated to get the deal done as soon as possible. By rushing to de-SPAC, SPAC investors might not receive the best deal for their investment. Ironically, the two-year limit also helps SPAC investors secure a timely return on their investment since proceeds held in a trust return no significant profits. However, this dilemma comes within the structure of SPACs, and we should leave it to the investors and market to balance on a case-by-case basis.
SPACs are double-edged swords because on the one hand, average SPAC investors lose money after the merger. On the other hand, SPACs provide an alternative vehicle for companies to go public, inviting increased investment and a mobilization of the stock market. However, under the current regulations, so long as investors know and weigh the risks, SPACs can be relatively safe investments. However, amid the recent dramatic increase of SPACs, most under the two-year limit to de-SPAC, investors should contemplate how many high-quality companies are out there and actually willing to go public via SPACs.
Haodi Dong is a third-year law student at Wake Forest University School of Law. He holds a Bachelor of Science in Applied Mathematics and a Minor in Philosophy from the University of California, Davis. After graduation, he intends to practice business or intellectual property law.