SPAC Mergers, IPOs, and the PSLRA’s Safe Harbor: Unpacking Claims of Regulatory Arbitrage

Amanda M. Rose is Professor of Law at Vanderbilt University Law School and Professor of Management at Vanderbilt University Owen Graduate School of Management. This post is based on her recent paper.

Merging with a SPAC has become a viable alternative to a traditional IPO as way for private companies to go public. Regulators are concerned. Fueling this concern are recent empirical studies (see here and here) showing outstanding average returns earned by SPAC IPO investors who redeem their shares or sell them on the secondary market after a deSPAC transaction is announced, and very poor average returns for SPAC investors who do not redeem or who purchase shares on the secondary market after the announcement (collectively, “deSPAC period investors”). The former group consists overwhelmingly of institutional investors, including a collection of repeat-player hedge funds referred to as the “SPAC mafia,” whereas as the latter group skews retail. These studies suggest that deSPAC period investors are systematically overvaluing SPAC shares, with the SPAC mafia and other institutional investors the primary winners and retail investors the primary losers. There are many possible reasons why deSPAC period investors may be overvaluing SPAC shares, and the SEC and Congress are considering a variety of fixes. In SPAC Mergers, IPOs, and the PSLRA’s Safe Harbor: Unpacking Claims of Regulatory Arbitrage, I focus on one possibility that has garnered significant attention: the public availability of management forecasts.

While commentators often assert that public disclosure of management forecasts is not allowed in traditional IPOs, but is allowed in deSPAC mergers, that is not technically correct. After filing a registration statement, companies doing an IPO may publicly release management forecasts, but they uniformly choose not to. This is because communications in connection with IPOs are excluded from the safe harbor for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995 (PSLRA), a provision that makes it harder for investors to win a lawsuit brought under the federal securities laws alleging that forward-looking statements were misleading. When SPACs share their target’s growth projections with investors, by contrast, those projections do enjoy the safe harbor’s protection.

Although it is unclear how often the PSLRA’s safe harbor plays a decisive role in private companies’ chosen path to publicness, the divergent application of the PSLRA’s safe harbor is often characterized as a troubling opportunity for “regulatory arbitrage.” SEC officials and other lawmakers have thus called for law reform that would exclude communications in connection with a deSPAC transaction from the safe harbor, which would purportedly place deSPACs on a “level playing field” with traditional IPOs as it concerns forward-looking statements and enhance retail investor protection. My paper interrogates the wisdom of such reform. The analysis suggests that lawmakers would likely do better to eliminate the safe harbor’s IPO exclusion than to extend it deSPAC mergers.

The Purpose of the IPO Exclusion

Before extending the IPO exclusion to capture deSPAC transactions, policymakers should pause to understand the exclusion’s purpose. The legislative history of the PSLRA contains very little on the various safe harbor exclusions, and scant attention has been paid to them by academics. Professor John Coates, while serving as Acting Director of the SEC’s Division of Corporation Finance earlier this year, sketched a rationale for the IPO exclusion that seemingly applies equally to the economic realities of a deSPAC transaction. He explained that when a private company is first introduced to public investors heightened information asymmetries are present, warranting heightened judicial scrutiny of projections. The unstated premise is that without such scrutiny, company officials would exploit the information asymmetry by offering overly optimistic projections, something that the specter of heightened judicial review will help deter. Other academics have similarly assumed that the IPO exclusion, as well as the other safe harbor exclusions, target situations where potential defendants are more likely to commit fraud.

This account is over-simplified. To see why, it is necessary to step back and consider the purpose of the safe harbor itself. While much of the PSLRA was aimed at curbing perceived nuisance litigation, the safe harbor had a different motivation. It was designed to encourage otherwise reluctant companies to share their forecasts with investors. Shielding such statements from liability risk was necessary to encourage voluntary disclosure. In an earlier era, the SEC was happy to let liability risk chill corporate release of forward-looking information. Indeed, the SEC affirmatively prohibited the inclusion of forward-looking information in SEC filings. The SEC’s position was based on a fear that unsophisticated investors would place undue reliance on even non-fraudulent forward-looking information, leading them to make poor investment decisions. Reasonable investors rallied against the SEC’s paternalistic position, emphasizing the importance of forward-looking information to their investment decisions and their ability to discount management forecasts for bias. The SEC in the 1970s began to listen, and seemingly changed position: instead of prioritizing the interests of unreasonable investors who might overreact to management forecasts, it began to take steps to encourage companies to share their forecasts for the benefit of reasonable investors. Toward this end, the SEC adopted two regulatory safe harbors from liability for forward-looking statements. After these safe harbors proved ineffective at encouraging disclosure, Congress stepped in with the more robust PSLRA safe harbor.

The PSLRA safe harbor, however, does not reach all forward-looking statements. It contains a hodgepodge of exclusions that have heretofore gone undertheorized. Some can easily be justified as advancing goals orthogonal to those that motivated the safe harbor’s adoption. In this category are a variety of “bad boy” disqualifiers that apply to companies that have violated certain provisions in the securities laws in the past three years; such disqualifiers appear in many places throughout the securities laws and are meant to deter and punish the underlying offense. A second category of exclusions cover situations—like tender offers, roll-up and going private transactions—where companies are compelled by law to share projections with investors; in such situations there is no risk that liability will chill disclosure and the safe harbor exclusion can be understood as an effort to increase the accuracy of such disclosures. The remaining exclusions each cover situations where a company is not compelled to share projections with investors. The IPO exclusion falls in this category, as do the exclusions for communications by investment companies and communications by blank check companies and penny stock issuers in connection with an offering, among others.

What ties the situations covered in this third category together? Perhaps they involve a heightened risk of fraud due to greater information asymmetries. But, at least in situations where liability risk is meaningful (and hence the safe harbor’s applicability of significance), denying voluntary management forecasts the protection of the safe harbor does not merely deter dishonest forecasts, it operates to silence all forecasts. Reasonable investors are capable of recognizing managers’ biases and adjusting for them. They would rather suffer the occasional unremedied fraud by a bad actor than be denied access to valuable forward-looking information by all companies.

A better answer is that these exclusions each involve cases where the potential defendant’s securities are unlikely to trade in an efficient market. As Holger Spamann has observed, efficient markets provide a critical “indirect investor protection” to unreasonable investors (see here). Unreasonable investors are just as likely to overweight management projections in connection with a seasoned offering as with an IPO, but in the former case competition between the smart money will set the price the investor pays, protecting the investor from his or her own foolishness. In the latter case, by contrast, unreasonable investors’ undue reliance on management forecasts may cause them real harm.

When understood in this light, these exclusions reveal that the safe harbor’s seeming prioritization of the informational needs of reasonable investors is in fact very circumscribed: the safe harbor operates to encourage the release of forward-looking statements for the benefit of reasonable investors only when unreasonable investors are unlikely to be harmed; in situations where they may be harmed, the safe harbor continues to prioritize unreasonable investor protection at the expense of reasonable investors—using the cudgel of liability risk to silence corporate forecasts.  It has succeeded brilliantly in the case of IPOs. Much to the chagrin of reasonable investors who would find such information extremely useful, IPO issuers never issue projections publicly. In the pre-filing period, this is dictated by the gun-jumping rules, but in the waiting and post-effective periods it is the byproduct of liability risk and the PSLRA safe-harbor exclusion for communications in connection with an IPO.

This more nuanced account of the IPO exclusion sharpens the analysis that is required to assess whether a similar exclusion should be created for deSPAC mergers. To assess whether the economic realities of deSPAC mergers present the same regulatory concern that animates the IPO exclusion, policymakers should assess the efficiency of the market for SPAC shares around the time of a deSPAC merger. Because that market is likely to be inefficient (see here), unreasonable SPAC investors could be harmed by forward-looking statements just like unreasonable aftermarket IPO investors. But unlike companies doing an IPO, SPACs are compelled by a combination of federal securities regulation and state corporate law to share target projections with shareholders. Thus, excluding deSPAC mergers from the safe harbor would not operate to silence projections the way the IPO exclusion does, although it might operate to foster more accuracy in their presentation (or on the margins to discourage deSPAC transactions). To truly place deSPAC transactions on a “level playing field” with IPOs as it concerns forward-looking statements, the SEC would have to change its disclosure demands in connection with deSPAC transactions and somehow override the state fiduciary obligations that compel disclosure of projections.

The Wisdom (or Not) of the IPO Exclusion

Assuming this could be done, should it? To state the question more broadly: is it sound public policy to de facto prohibit management forecasts in inefficient, retail-accessible markets? This may protect unreasonable investors, but it works to the detriment of reasonable investors. Is this distributional effect justified, on either fairness or efficiency grounds? Would more systemic approaches better protect unreasonable investors, given that they are likely to be harmed through their participation in these markets even in the absence of forward-looking disclosures? If there is uncertainty as to the wisdom of this policy, can the SEC learn something about the efficacy of the safe harbor exclusion by allowing the divergent treatment of IPOs and deSPAC mergers to persist? Finally, if silencing forward-looking statements in inefficient, retail-accessible markets is sound policy, is the safe harbor exclusion the best way to accomplish that goal?

The paper offers my views on the answers to these questions, but it’s more important contribution is to clarify that these are the questions that policymakers should be, but are not currently, asking.

The complete paper is available for download here.

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