How to Regulate De-SPACs as IPOs

Harald Halbhuber is a Research Fellow of the Institute for Corporate Governance & Finance and New York University School of Law.

On April 8, 2021, John Coates, the Acting Director of the SEC’s Division of Corporation Finance, issued a statement on “SPACs, IPOs and Liability Risk under the Securities Laws” (discussed on the Forum here). It thoughtfully raises several important questions regarding the future regulation of SPACs. One such question is whether the SEC should treat the “de-SPAC” transaction through which a SPAC takes a private company public as the “real IPO.”

This post does not address whether de-SPACs should be regulated as IPOs. Such regulation could come from Congress or from the SEC, where it would require new rulemaking. Instead, I describe how the SEC could adopt such a rule under its existing authority, if it decides that doing so would be in the public interest. As I discuss below, one way the SEC could do this is by focusing on the decision that SPAC shareholders make to release their cash in the trust account when the SPAC acquires its target. Blunt application of IPO rules to de-SPACs may ultimately not be the right answer, but the decision-based framework suggested here can help guide the SEC’s approach. This post is based on a larger project on SPACs that I plan to present in a forthcoming paper.

The SEC’s Potential Policy Concerns

The question of whether de-SPAC transactions should be treated as IPOs is not about the required content of the SEC disclosure document, which is substantially identical across both transaction structures. Inaccurate or misleading disclosure can result in liability in either case, although details vary. Rather, the SEC appears concerned that the quality of the information provided to investors in de-SPACs may be affected by the absence of conventional underwriters that function as gatekeepers in IPOs, and perhaps also by a somewhat more deal-driven rather than disclosure-focused culture and speed of execution.

In addition, there are things companies can do when going public via a SPAC that are prohibited when selling shares in an IPO: conditioning the market with publicity before the SEC disclosure document is available; having trading in the stock of the new public company commence based on nothing more than a PowerPoint deck, before the SEC disclosure document is available and before the SEC has completed its review; and purchasing stock themselves in the market, which could drive up the price, while the deal is being marketed to investors. The SEC may be analyzing whether some of the investor protection and market integrity concerns that animate prohibiting these practices in IPOs may also be present in de-SPACs.

The SPAC Shareholders’ Decision

When a SPAC acquires its target in the de-SPAC transaction, it requests the approval of its shareholders in a vote. Recent research shows, however, that the outcome of this vote is a foregone conclusion. SPAC shareholders approve even bad deals to preserve value in their warrants.

The more significant decision shareholders make at the de-SPAC is whether to redeem their shares. Redeeming shareholders put their shares back to the SPAC for their portion of the risk-free cash in the trust account. Non-redeeming shareholders simply let their redemption rights lapse, the trustee releases their portion of the cash to the SPAC for use in the acquisition, and when the SPAC closes the acquisition, they become shareholders of the post-acquisition company owning the target.

The Scope of the Securities Act

Traditional IPOs are regulated by the Securities Act. That statute is designed to protect investors by providing them with information necessary for informed investment decisions. This raises the question of why it does not apply to the de-SPAC redemption decision of SPAC shareholders.

The answer lies in the scope of the Securities Act, which applies only to transactions in which issuers or their affiliates sell securities to public investors. Traditional IPOs involve such sales of securities, de-SPACs do not. An investor’s decision not to sell a security it owns back to the issuer is not a purchase, and therefore not a sale by the issuer. This explains why securities with embedded puts that entitle holders to sell them back to the issuer, such as the redemption right of SPAC shareholders, do not implicate the Securities Act when holders decide not to exercise those puts.

The narrow scope of the statute reflects a deliberate policy choice. Imposing its rigorous and, in some ways, restrictive regime on issuers whenever investors make decisions would not be practicable. By limiting this regime to issuer sales, it focuses on transactions with heightened incentives for issuers to underdisclose negative information to raise capital and transfer risk to public investors. It considers investors as most in need of protection when they are parting with their money and placing it at risk in new investments that benefit issuers or their affiliates and are thus especially exposed to information asymmetry.

SEC Regulation Based on the Redemption Decision

While the principles that keep the scope of the Securities Act narrow are sensible, their strict application can be at odds with the statute’s policy objectives. Transactions that are not legally sales of securities can create similar incentives for issuers raising capital and comparable exposure for investors placing capital at risk. The SEC has broad authority, however, to adopt rules that regulate transactions based on their economic substance rather than their legal form. The exercise of that authority is especially appropriate when new evidence becomes available that suggests the need for rulemaking to protect investors.

The SEC could analogize the economic substance of the decision that SPAC shareholders make to the following non-SPAC hypothetical. A sponsor (again, no SPAC here) approaches potential co-investors for a yet-unidentified target business opportunity. It asks them to pre-fund into escrow the future purchase price for their shares in the company that the sponsor set up to acquire the target. Investors are not finally committed, however, until the sponsor has presented the target to them. They can then still decide whether they are “out” or “in.” Investors that are “out” receive their deposit back. For investors that are “in,” the sale of the shares in the company owning the target occurs when they authorize the use of their deposit for that purpose.

In adopting a new rule for SPACs, the SEC could take the view that by deciding not to redeem their shares, SPAC shareholders are effectively making the same decision as investors in the above hypothetical that elect to be “in.” Compared to the hypothetical, the default election is reversed in SPACs, with investors deemed to be “in” unless they notify the SPAC otherwise prior to the de-SPAC. The SEC could conclude, however, that this does not change the decision investors are faced with, or the information necessary to make that decision. In either case, they are effectively placing previously risk-free capital at risk in a new enterprise, with the associated information asymmetry. The fiduciary duties of SPAC directors may improve the position of investors compared to the non-SPAC hypothetical, but the SEC may determine that those state law duties are no effective substitute for the rigors and restrictions of the federal securities law regime. As such, the SEC could, in a new rule, treat the non-redemption in a de-SPAC as a sale of securities.

In support of such a rule, the SEC may also point to the fact that in de-SPAC transactions the issuer has, in principle, a capital-raising incentive to underdisclose similar to the one that exists for issuers in traditional securities offerings, whether or not they act on it. After all, the SPAC has no access to the cash in the trust account until redemption rights have expired. In fact, the incentive to underdisclose may be even greater in de-SPACs due to the SPAC sponsor’s pay-off profile. It pairs the potential for outsize returns from an acquisition with the risk of total loss for the sponsor’s upfront investment if the SPAC fails to acquire any target and has to liquidate.

In theory, the initial cash deposit into the SPAC’s trust account could serve to ensure liquidity to fund the acquisition. But the almost complete turnover in the shareholder base at the time of the de-SPAC reported by recent research casts doubt on that rationale. Liquidity, it seems, is coming not from the initial deposit, but from a completely new set of shareholders buying into the stock. The SEC might rely on this to support rulemaking that treats the SPAC as raising the capital for its acquisition not in its IPO, but at the time of the de-SPAC.

Finally, the SEC has traditionally been more inclined to subject transactions to the Securities Act when they resulted in the creation of a public trading market for a previously private company. This was the case with shell company spin-offs, where private companies would go public by selling themselves to a public shell corporation that would then distribute the private company’s shares to the public corporation’s shareholders as a dividend. It is also the case for de-SPACs.

Distinguishing Non-SPAC Redemptions

There are non-SPAC redeemable securities that entitle holders to put them back to the issuer at certain times or upon the occurrence of certain events. Those non-SPAC embedded puts, however, are fundamentally different in nature. There, holders placed capital at risk initially and are then given an opportunity to evaluate whether to keep it at risk when the risk/return profile may have changed since the initial investment.

That contrasts with the risk-free position of initial SPAC shareholders. By deciding not to redeem, SPAC shareholders are placing their capital at risk, not keeping it there. An SEC rule that deems a SPAC shareholder’s redemption decision to involve a sale could be written without affecting the regulation of other redeemable securities.

Precedent for Similar Rulemaking

There is precedent for SEC rulemaking that deems transactions to be sales. In the late 1950s, the SEC was concerned about another structure where companies raised capital without legally selling new securities. It involved so-called assessable stock that enables the issuer to levy assessments requiring holders to pay in additional capital or give up their stock. Dormant companies with assessable stock were using assessments to finance the purchase of securities of other companies, effectively letting those other companies raise capital from public investors. Since there was no sale of new shares, there was no SEC registration, and shareholders received insufficient information.

To address this concern, the SEC eventually issued a rule, still on the books today, that deems an assessment call to constitute an offer for sale of securities to the holders of the assessable stock and deems that sale to occur when a holder pays the assessment. The SEC explained that holders, in considering and meeting an assessment call, were making an additional investment in the enterprise that presented the same need for investor protection as a new investment.

The SEC could do something similar today if it determined that, for policy reasons, treating a SPAC shareholder’s non-redemption decision as a sale of securities was in the public interest. Like holders of assessable stock, SPAC shareholders are already shareholders, not buying new shares, but are faced with a decision whether to place capital at risk for the issuer’s benefit and stand to lose their existing shares if they do not.

Like the rule for assessable stock, such a new rule for de-SPACs would dovetail with another SEC rule, this one on the books since 1933. It deems an issuer, the chief part of whose business consists of the purchase of the securities of another issuer, and the sale of its own securities, to furnish the proceeds with which to acquire the securities of such other issuer, to be engaged in the distribution of the securities of such other issuer. If a SPAC were treated as selling its shares at the de-SPAC to fund its acquisition of the target, this rule would then automatically deem that to involve a sale of securities of the target. The SEC may find this result consistent with a policy objective of treating the de-SPAC as, effectively, the IPO of the private target company. It would make the target a co-issuer in the deal and impose IPO-level liability on the target and its directors, signatory officers and control persons.

Conclusion

In this post, I have suggested how the SEC could regulate de-SPACs as IPOs through rulemaking if it decides to do so. The suggested approach would focus on an identifiable decision by investors to place capital at risk for the benefit of the issuer. By focusing on the proceeds to the issuer, it avoids tension with the regulation of reverse mergers, which also involve shareholder turnover but no capital raising. I hope this suggestion contributes to the important ongoing debate about the future of SPACs.

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