Fairness Opinions and SPAC Reform

Under the emerging regulatory framework for special purpose acquisition companies (SPACs), mergers of SPACs, known as de-SPACs, must be “fair” to public (or unaffiliated) SPAC shareholders, and transaction participants face heightened liability risk for disclosure errors. This framework is a product of the SEC’s reform proposal for SPACs (SPAC Reform Proposal) and recent decisions of the Delaware Court of Chancery. In this environment, third-party fairness opinions have been regarded as a de facto requirement for de-SPACs.

In a paper available here, I examine the emerging regulatory landscape by analyzing the significance of third-party fairness opinions and the proposed disclosure-oriented reforms. These opinions typically assess whether the consideration paid in a transaction is fair, from a financial point of view, to a party or group. The assessment of fairness opinions sheds light on the difficulties associated with evaluating and demonstrating a de-SPAC’s value for public shareholders. The heightened risk of disclosure liability adds to the stakes, given the transaction value’s materiality to public shareholders and the potential ramifications of any misstatement or omission for those involved.

The evidence suggests that a low quality market emerged for fairness opinions. SPAC fiduciaries obtained opinions that provided virtually no substance from less reputationally sensitive financial advisors and disclosed these opinions to public investors in an apparent effort to give assurance as these investors decided whether to exercise redemption rights

The Distinct Interests of Public Shareholders

The SEC’s and Court of Chancery’s concern for public shareholders recognizes that these shareholders’ interests diverge from those of SPAC fiduciaries (sponsors and boards) and those of the SPAC as an entity itself. Public shareholders have the right to redeem their shares for cash if a de-SPAC is consummated; redemption typically occurs at the purchase price of $10—plus interest, thereby guaranteeing initial investors at least a nominal return. However, the conventional SPAC structure undermines this protective right. SPAC sponsors and directors are compensated only if de-SPAC occurs, receiving heavily discounted “founder” shares. The structure creates incentives for SPAC fiduciaries incentives to consummate a de-SPAC, even if it is unfavorable to public shareholders. It also discourages shareholders from exercising their redemption rights, as high redemption rates may jeopardize a de-SPAC’s viability. Moreover, the structure dilutes the interests of public shareholders, reducing the net cash backing each SPAC share. Consequently, it becomes less likely that a public shareholders will be better for continuing with a de-SPAC rather than exercising their redemption right. (See Klausner, Ohlrogge & Ruan; and Gahng, Ritter & Zhang).

Fairness to Public Shareholders

Given these threats to public shareholders, the SEC and Delaware courts rightly focus on de-SPACs’ fairness to these investors. In this environment, commentators emphasize the importance of third-party fairness opinions. For example, a prominent law firm regards the SEC proposal as “creating a de facto requirement for obtaining a fairness opinion . . . in a manner consistent with market practice in Rule 13e-3 transactions.” Other firms agree.

While the notion of fairness is susceptible to alternative interpretations, the SPAC Reform Proposal offers no guidance on its meaning. In the context of de-SPACs, determining the whether a de-SPAC is fair from a financial point of view to public shareholders, one must consider shareholders’ alternatives at the time when the SPAC undertakes a business combination. Public SPAC shareholders may elect to redeem their shares in connection with a de-SPAC at $10 per share, plus interest. In the absence of a de-SPAC, public SPAC shareholders will receive a liquidation of approximately $10 per share. Based on these alternatives, for consideration in a de-SPAC to be fair from a financial perspective to public shareholders, the de-SPAC should represent value to these shareholders of at least $10 per share. Otherwise, public shareholders would be better off redeeming their shares.

To assess the fairness of a de-SPAC to public SPAC shareholders, I argue, a fairness opinion must estimate the value of the post-merger entity, taking into account the position of public shareholders. This analysis would require a comparison of public shareholders’ $10 redemption option with the per share value in the post-merger company, adjusting for dilution. Since the business combination and related transactions has yet to occur, the latter calculation must be performed on a pro forma basis considering various possible scenarios and generating a range of possible outcomes.

However, financial advisors face significant difficulties applying this criterion for fairness. The required analysis deviates from the standard fairness opinion template for public M&A where buy-side opinions assess whether the transaction consideration paid by the buyer (here, the SPAC) is fair to the buyer. Additionally, the lack of a reliable pre-merger guide for transaction consideration (Rodrigues & Stegemoller; Spamann & Guo) would lead financial advisors to assume a value for SPAC shares for analytic purposes. If financial advisors follow SPAC parties’ convention of assuming a value of $10 per share, they would likely be overstating the value of transaction consideration, making it harder to consider it fair in comparison with estimates of the target’s value. This overstated value can be expected to lead target companies to inflate their values. (See Klausner, Ohlrogge & Halbhuber).

Even if a financial advisor concludes that the (likely inflated) transaction consideration is fair to the SPAC, such a conclusion, accepted at face value, offers no assurance of fairness to public shareholders, the analysis shows. Dilution in the conventional SPAC structure means that the de-SPAC may still provide less than $10 per share value to public shareholders, rendering the transaction unfair to them. The underlying notion is that even if a target is worth $10 per share, combining it with a SPAC worth less than $10 per share may result in a post-merger company worth less than $10 per share. This reasoning undermines any argument that the use of a conservative valuation assumption (to overstate consideration) necessarily provides comfort to public shareholders.

Empirical Evidence

An empirical analysis of all fairness opinions used in de-SPACs completed since 2019 shows that these opinions suffer from profound methodological problems and fail in their intended purpose (See also Tuch). Since the SEC put forward its SPAC Reform Proposal on March 30, 2022, almost two-thirds of announced de-SPACs have obtained such opinions, compared to only 13% before. However, few opinions purported to address fairness to public shareholders, thereby avoiding the thrust of judicial and regulatory attention. Those that purported to address fairness to public shareholders, with one exception, failed to provide supporting analyses relevant to these shareholders or to adjust for SPAC dilution. These opinions misleadingly concluded that the consideration was fair to these shareholders while their analyses failed to address the question. Other opinions were ambiguous or obviously mistaken. Financial advisors providing opinions generally borrowed from the public M&A playbook, assessing the fairness of transaction consideration to the SPAC rather than to the public shareholders.

In providing opinions, financial advisors almost universally borrowed from the public M&A playbook, assessing the fairness of transaction consideration to the SPAC rather than the public shareholders. Moreover, advisors generally followed convention by assuming a $10 value for SPAC shares. Buoyed by optimistic estimates of target value, the financial advisor for each of these de-SPACs concluded that the transaction consideration was fair. These opinions appear dubious since they suggest that financial advisors may have valued targets more highly than did targets’ own managers. In any case, they provide no comfort regarding fairness to public shareholders.

Notably, only smaller and lesser-known financial advisors provided fairness opinions in de-SPACs, while major investment banks took on other roles in the same or related transactions. This apparent reluctance by large firms to give fairness opinions may reflect the challenges advisors face in addressing fairness to public shareholders. Ultimately, advisors addressing the position of public shareholders must determine whether the de-SPAC can generate sufficient value to offset the dilution that is inherent in the conventional SPAC structure and find certainty in the face of incomplete information, which is a tall order. All advisors face these challenges, but smaller firms have less at stake reputationally, and in some cases have given implausible and apparently unsubstantiated opinions. There is more to the story, however, as major investment banks have not even given opinions addressing fairness to SPACs, even as these opinions are conceptually more straightforward to give.

Disclosure-Oriented Reforms

The paper argues that the SEC’s proposed reforms are necessary from a policy perspective. The reforms would deem SPAC IPO underwriters and certain other participants to be de-SPAC underwriters, make target operating companies co-registrants with SPACs, and deem any business combination of a reporting shell company involving another non-shell company to be a “sale” of securities to the reporting shell company’s shareholders. Additionally, the reforms would limit the application of the PSLRA safe harbor to de-SPACs. These measures would address the preferential treatment that SPACs currently receive relative to traditional IPOs. They would also help prevent disparities in regulation for transactions that are similar in economic substance but vary in legal structure (See Halbhuber; Tuch & Seligman). Inevitably, these protections will fall short in some ways. The article discusses the potential shortcomings and suggests modifications that will better account for distinctive features of de-SPACs.

Implications

The SEC and courts are right to emphasize fairness to public shareholders, but transaction participants are wrong if they believe that fairness opinions have provided an effective response. Overwhelmingly, opinions have failed to address fairness to public shareholders, and those purporting to do so have generally failed to provide supporting analyses. None have undertaken the rigorous analysis required to assist boards attempting to satisfy their fiduciary responsibilities by assessing whether a de-SPAC represents value to public shareholders.

These results corroborate concerns by legal scholars citing the subjectivity and conflicts inherent in fairness opinions. (See, e.g., Bebchuk & Kahan) The results also align with a body of empirical research examining the role of investment bank quality, finding poorer outcomes for lower-tier investment banks. Although systematical empirical evidence is inconclusive as to whether buy-side fairness opinions have informational content, this study suggests they do not in the de-SPAC setting.

The analysis also bears on the information public shareholders need to decide whether to exercise their redemption rights, valued at $10, or else invest in the post-merger company. The key from the standpoint of public shareholders is the value per share of the post-merger entity. It is shares in this entity that these shareholders will receive if they choose not to redeem. That value turns not only on the cash the SPAC brings to the merger but also on the value the target brings and any non-cash sources of value. Only when post-merger shares are worth more than $10 per share will a de-SPAC be fair from a financial perspective to public shareholders.

Reputation-conscious financial advisors may be reluctant to provide opinions addressing fairness to public shareholders. The required analyses may not support a conventional conclusion as to fairness to public shareholders, given the contingencies involved, the consequential breadth of the valuation ranges, and the possible extent of dilution. Nevertheless, presentations of such analyses would be more useful to SPAC boards than are the fairness opinions they have obtained to date.

Finally, it is doubtful that investment banks, SPAC sponsors, and target companies will stand behind de-SPACs in their current form with stronger incentives under Section 11 for complete and accurate disclosures. As a result, transaction terms and structures must undergo significant change in response to fairness-seeking reforms.

The full paper is available here.