An Economic Substance Approach to SPAC Regulation and the Implications of MultiPlan for SEC Rulemaking

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

Two seemingly unrelated topics have received a lot of attention recently. One is the rise of SPACs, shell companies that take private companies public by merging with them. The other is the economic substance approach in securities regulation. Over the past two years, SPACs have closed mergers with a total announced enterprise value of more than half a trillion dollars. While some observers have hailed SPACs as a welcome financial innovation, the SEC Chair recently expressed concerns (posted on this Forum) about the potential for regulatory arbitrage between SPACs and IPOs. Separately, when discussing rules for cryptocurrencies in December, the former and the current SEC Chair were in agreement that securities transactions should be regulated in accordance with their economic substance rather than their legal form.

In a new paper, I apply this economic substance approach in securities regulation to SPACs. As readers of this Forum know, when a SPAC merges with its target, SPAC shareholders are entitled to have their escrowed cash returned to them from a trust account. At that point, each shareholder makes an individual choice: walking away with their still risk-free cash or investing it in the target. The paper’s key insight for future regulation is that a SPAC shareholder’s decision to invest their escrowed cash in the target should be treated as the economic equivalent of purchasing target stock for cash. This allows for a better understanding of SPACs’ economic substance and more clearly identifies gaps in investor protection compared to IPOs. Most importantly, it offers a sound legal basis for crafting new rules that close these gaps. Along the way, the paper spells out the overlooked implications of the Delaware Chancery Court’s recent decision in the MultiPlan shareholder litigation for the future regulation of SPACs by the SEC.

Economic Reality of SPAC Mergers

Current regulation conceives of the merger as the transaction in which the SPAC invests the capital it raised in its IPO. This does not reflect economic reality. The SPAC’s role in the merger is to find investors, not to invest its own cash. In fact, the SPAC has no cash of its own, because all of the funds escrowed in its IPO are held by an independent trustee for return to redeeming shareholders. Before they decide whether to redeem, SPAC shareholders have merely parked their cash, not yet committed it. In economic substance, the merger is thus the transaction in which each nonredeeming shareholder, not the SPAC, invests their cash in the target. This is also the conclusion the Delaware Chancery court came to in MultiPlan, holding that “the public stockholders’ funds held in trust did not belong to [the SPAC] until those stockholders opted not to redeem but to invest in the post-merger combined entity,” consistent with my earlier post on this Forum.

This economic substance approach highlights regulatory differences between SPACs and IPOs that have previously not been analyzed. While some of its implications for future regulation may initially seem unexpected, they all follow quite naturally from regarding SPAC shareholders as making cash investment decisions and then simply applying our existing regulatory regime.

The original purpose of the escrowed cash feature was merely to protect against the uncertainty of investing in a blank check company. Its unintended effect, however, has been to cause what are effectively capital raising transactions to be regulated as business combinations. This has led to serious regulatory gaps by rendering inapplicable rules about disclosure liability, underwriter regulation and offering regulation, all of which play critical roles in protecting investors in IPOs.

SPAC Mergers Function as Stock Sales for Cash

In SPAC mergers, targets raise capital not from the SPAC, but from the public. Interestingly, this starts not with the SPAC’s initial investors, but in the secondary market. Most investors that buy in a SPAC’s IPO have no intention ever to invest risk capital in the target. They seek to sell their shares for more than their escrowed cash and will otherwise typically redeem. Redemption is profitable for these initial holders because in the SPAC’s IPO they also receive warrants that have value if the merger closes. SPAC and target therefore try to find new investors who replace those initial holders by buying their shares. Ideally, these new investors then elect not to redeem. SPAC shares thus effectively become target shares that can freely be sold to the public for cash.

SPACs act as intermediaries in this sale process, effectively selling target stock to public investors for a fee. They advertise target shares as an investment, validate target quality, and receive compensation only if the transaction closes. In other words, SPACs function as underwriters for target stock. They may utilize investment banks for support, but investors rely primarily on the SPAC’s due diligence, experience and reputation. The underwriting that SPACs provide does not come cheap, and empirical research has found that SPAC costs are largely borne by public investors.

Resulting Gaps in Investor Protection

The failure of existing rules to treat SPAC mergers as cash sales of stock has opened up wide gaps in regulation between SPACs and IPOs. The two regimes are alike in that they both require the eventual disclosure of information about the company going public. Where the regulation of SPACs differs dramatically from that of IPOs, however, is in all the other important rules that govern stock sales for cash, none of which apply in SPAC mergers.

In terms of disclosure obligations and liability, parties in SPAC mergers are not subject to the same standards as in IPOs. The paper demonstrates that this gap runs deeper than previously thought. The current federal regulation of SPAC mergers requires investors to establish fraud, not negligence, in order for them to recover damages under the securities laws for material misstatements or omissions; it applies a laxer liability standard for projections, even though the pressure to boost them may be great; and it eliminates gatekeeping incentives for investment banks involved in the transaction by shielding them from disclosure liability.

Furthermore, as the paper shows for the first time, SPACs effectively act as underwriters for target stock without being subject to any of the rules of underwriter regulation. In traditional public stock offerings, these rules prohibit excessive underwriting compensation that comes at the expense of public investors and creates unhealthy incentives; they require an independent review when an underwriter has a conflicting financial interest; and they ensure that all investors pay the same stated price by prohibiting secret side deals. These protections are completely absent in the stock sale that, in economic substance, takes place in SPAC mergers.

In addition, SPAC mergers suffer from material gaps in offering regulation that have so far received no or scant academic attention. Companies can induce or execute purchases of their own stock, thereby potentially inflating the price on which public investors rely when deciding to invest. They can also fan exuberance by conditioning the market with publicity. Finally, SPAC mergers promote sales of new stock that take place well before SEC-cleared disclosure.

Leveling the Playing Field Between SPACs and IPOs

Building on its functional analysis, the paper develops a blueprint for rules that close these gaps in investor protection and level the playing field between SPACs and IPOs. The SEC has clear authority to adopt these rules. The paper does not take a position on whether the regime for IPOs and other traditional capital raising transactions always strikes the right balance between investor protection and capital formation. It does, however, suggest that there is no policy rationale for the stark difference in regulatory treatment between SPACs and IPOs that currently prevails.

The heart of this blueprint is a new SEC rule that would treat a SPAC shareholder’s decision to invest their escrowed cash as equivalent to the purchase of stock for cash. This recognition of economic substance would allow the SEC to regulate SPAC mergers as stock sales and SPACs (and potentially their sponsors) as underwriters and, effectively, brokers that targets hire to sell their stock for transaction-based compensation. This proposal provides the most comprehensive framework for SPAC regulation to date and is fully grounded in our existing securities laws.

The complete paper is available for download here.

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