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E-MailAndrew F. Tuch is Professor of Law at Washington University in St. Louis and Joel Seligman is President Emeritus and University Professor at the University of Rochester and Dean Emeritus and Professor of Law at Washington University in St Louis. This post is based on their recent paper.
Since at least the 1930s, when the federal securities framework was adopted, most companies undertaking initial public offerings (IPOs) have relied on firm-commitment underwriters to act as intermediaries between themselves and investors. The close relationship between IPOs and underwriting, governed by Section 11 of the Securities Act of 1933, is implicit in a regime that has proven successful over the years. Section 11 imposes near-strict liability on corporate insiders and certain secondary actors, primarily underwriters, incentivizing careful due diligence. Among other provisions of the Securities Act, Section 11 was instrumental in restoring confidence in US capital markets in the wake of the Great Depression and has helped them become the world’s deepest and most liquid. It is no surprise that investors, their interests guarded by underwriters acting in the role of gatekeepers, made the IPO the pinnacle event for emerging companies seeking capital for growth.
Today, traditional IPOs may be on the wane as firms turn to mergers with special purpose acquisition companies (SPACs) and direct listings, alternatives that provide routes to public markets entirely or partially without an underwriter or due diligence. SPAC mergers and direct listings dispense with nearly century-old techniques for capital raising, weakening investor protection. As a result, these IPO alternatives introduce new risks into financial markets. The shift in corporate activities has been permitted, indeed encouraged, by Congress and the Securities and Exchange Commission (SEC).
In a new paper, The Further Erosion of Investor Protection: Expanded Exemptions, SPAC Mergers, and Direct Listings, we critically examine SPAC mergers and direct listings, assessing their perceived benefits alongside the threats they pose to investor protection, arguing that many of the purported benefits of SPAC mergers and direct listings are overstated and, in any case, fail to justify the erosion of investor protection implicit in these transactions. SPAC mergers and direct listings enjoy significant regulatory accommodations, including accommodations allowing them to sidestep significant risk of underwriter liability, which is central to the efficacy of Section 11. We also suggest reforms governing SPAC mergers and direct listings.
We situate our analysis of SPAC mergers and direct listings in the context of a decades-long decline of Section 11, observing that decisions by the SEC and Congress have permitted the decline by substantially increasing the number and scope of exemptions from Securities Act registration. A result is that a significant majority of the capital raised in securities offerings today lie beyond the section’s reach. As an illustration, consider that in 1970, roughly 17 percent of funds raised in new corporate offerings relied on an exemption; by 2019, the corresponding figure was around 70 percent. We also take stock of other forces that have made experimentation with SPAC mergers and direct listings more appealing to those looking to take companies public.
In addressing SPAC mergers, we focus on the troubling incentives they create for certain transaction participants, the regulatory leniency they enjoy, and the high costs they impose. We are not the first to note problems with SPAC mergers, but our emphasis on their deal structures is novel. Focusing on structure provides a more nuanced understanding of the regulatory accommodations SPAC mergers enjoy and the risks they pose showing, for instance, that because structure drives the availability of safe harbors for forward-looking statements, some SPAC mergers fall outside safe harbor protections.
Because transaction structure shapes the extent of Section 11 liability, generally little risk of underwriter liability exists in SPAC mergers, significantly limiting the force of Section 11. This produces weaker incentives for all gatekeepers—not only investment banks but also auditors and legal counsel—to assure the accuracy of corporate disclosures, relative to the incentives surrounding traditional IPOs. Transaction participants have stronger incentives to consummate a proposed merger, even at a lofty price. Many SPAC mergers may also benefit from liability shields for certain forward-looking information that are unavailable for participants in traditional IPOs. Meanwhile, other factors give transaction participants incentives to act contrary to investor interests.
We assess the merits of underwriter liability in SPAC mergers by using traditional IPOs as a benchmark. This comparison shows that underwriter liability would generate benefits in SPAC mergers at least as great as those accrued to traditional IPOs, without imposing additional costs. Accordingly, the case for underwriter liability is at least as strong for SPAC mergers as it is for traditional IPOs. If underwriter liability is cost-justified for traditional IPOs, as we contend, the same is true for SPAC mergers.
We also assess the empirical evidence regarding SPAC mergers, highlighting salient areas of dispute among scholars. In particular, it is uncertain whether, at the time of a merger, the high costs of SPAC mergers fall on outside SPAC investors holding stock at the time of the merger or whether those costs fall on the companies with which SPACs merge—or on both parties. An appreciation of this uncertainty should limit any regulatory impulse to steer private companies toward traditional IPOs and away from SPAC mergers, although it does not alter our conclusions as to Section 11.
Regarding other potential reforms, we liken the position of SPAC mergers to going-private transactions, transactions in which participants often have misaligned incentives and are denied safe harbors protections. Federal securities law responds to going-privates by requiring the targets and its affiliates to disclose the transaction’s purposes and a written justification of its structure and, importantly, to attest that they reasonably believe the transaction is fair to shareholders and why this is so.
We also consider direct listings, examining their implications for investor protection. We question the purported advantages of these transactions, which are said to provide significant cost-savings over traditional IPOs, and suggest that, for the foreseeable future, the use of direct listings will be limited to a small proportion of companies able to successfully market their shares without the services of conventional underwriters. Nevertheless, direct listings raise basic concerns about investor protection arising primarily from the elimination of the traditional underwriting role. If the SEC reopens the direct listing NYSE and Nasdaq rules, it could engage in rulemaking on a more fully informed basis. On the other hand, failure to reopen the NYSE and Nasdaq rule approvals or otherwise review the need for underwriting in direct listings runs the risk of fortifying yet another exception to the 1933 Act’s near-strict liability requirements in public offerings.
We conclude by urging the Commission to undertake a comprehensive review of the Securities Act. The regulation of SPAC mergers and direct listings must be assessed alongside issues including the rise of private markets, the growth of exemptions, technological advances, and the mechanics of complying with provisions of the Securities Act.
The complete paper is available for download here.
