Last week, John Coates, the Acting Director of the SEC’s Division of Corporation Finance (“Corp Fin”), released a statement discussing liability risks in de-SPAC transactions.

The statement focused in particular on the concern that companies may be providing overly optimistic projections in their de-SPAC disclosures, in part based on the assumption that such disclosures are protected by a statutory safe harbor for forward-looking statements (which is not available for traditional IPOs). Director Coates’s statement questions whether that assumption is correct, arguing that de-SPAC transactions may be considered IPOs for the purposes of the statute (and thus fall outside the protection offered by the statutory safe harbor). He therefore encourages SPACs to exercise caution in disclosing projections, including by not withholding unfavorable projections while disclosing more favorable projections.

The statement has received considerable media attention and is plainly part of a broader effort by the Commission staff to identify potential securities law and policy concerns with the growing SPAC market. In addition to statements by staff in the Division of Corporation Finance, the effort includes:

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Introduction

Not far behind the dramatic increase in the use of special purpose acquisition companies (SPACs) is a corresponding increase in the number of shareholder lawsuits and increased activity at the US Securities and Exchange Commission (SEC). In recent days, Reuters reported that the SEC opened an inquiry seeking information on how underwriters are managing the risks involved in SPACs, [1] and the SEC’s Division of Corporation Finance (Corp Fin) and acting chief accountant have issued two separate public statements on certain accounting, financial reporting and governance issues that should be considered in connection with SPAC-related mergers. [2] This increase in activity by SEC staff comes on the heels of nearly two dozen federal securities class action filings, several SEC investor alerts and earlier guidance from Corp Fin. [3] The surge in litigation and regulatory interest is likely to continue and expand throughout 2021 and beyond.

In Depth

A SPAC is a company with no operations that raises funds from public investors through an initial public offering (IPO). The proceeds from the IPO are placed in a trust or escrow account for future use in the acquisition of one or more companies. A SPAC will typically have a two-year period to identify and complete a business transaction. If the SPAC fails to do so during the specified period, then it must return the funds in the account to its public shareholders on a pro rata basis and then dissolve.

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Following these ten steps will prepare SPAC boards, sponsors, and advisors for the likely shareholder suits and potential regulatory investigations that are increasingly becoming part of the SPAC landscape.

If 2020 was the “year of the SPAC,” 2021 may be the year of SPAC litigation. SPACs—Special Purpose Acquisition Companies—are publicly traded companies launched as vehicles to raise capital to acquire a target company. Often called blank-check companies, SPACs are companies in which shareholders buy shares without knowing which company the SPAC will target and acquire. Investors place their faith in the sponsor: the entity or management team that forms the SPAC. The SPAC generally has around twenty-four months to seek out and acquire a target, or else must liquidate and return the capital.

Hundreds of new SPACs were launched in 2020 alone. Booming M&A or other transactional activity in any sector can invite litigation driven by plaintiffs’ attorneys, and SPACs are no exception. In just the first three months of 2021, more than 40 suits targeting SPACs have been filed. The nature of these claims evidence growing sophistication, as lawyers used to challenging traditional M&A transactions begin to tailor their claims to the unique characteristics of the SPAC lifecycle. And with SPACs going mainstream—and attracting attention from outside the usual financial circles—regulators are closely examining transaction disclosures and other aspects of SPAC deals. [1]

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Introduction [1]

In a recent statement, Acting Chief Accountant Paul Munter highlighted a number of important financial reporting considerations for SPACs. [2] Among other things, that statement highlighted challenges associated with the accounting for complex financial instruments that may be common in SPACs. Additionally, CF staff also issued a recent statement [3] highlighting key filing considerations for SPACs.

We recently evaluated fact patterns relating to the accounting for warrants issued in connection with a SPAC’s formation and initial registered offering. While the specific terms of such warrants can vary, we understand that certain features of warrants issued in SPAC transactions may be common across many entities. We are issuing this statement to highlight the potential accounting implications of certain terms that may be common in warrants included in SPAC transactions and to discuss the financial reporting considerations that apply if a registrant and its auditors determine there is an error in any previously-filed financial statements.

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Stock-market short-termism—stemming from rapid trading and activists looking for quick cash—is, a widespread view has it, hurting the American economy. Because stock markets will not support corporate long-term planning, the thinking goes, companies fail to invest enough, do not do enough research and development, and buy back so much of their stock that their coffers are depleted of cash for their future.

This widespread view has induced proposals for remedy. One proposal is for corporate “loyalty shares,” whereby stockholders who own their stock for longer periods would get more voting power than those who trade their stock quickly. In the proponents’ vision, executives would appeal to loyal, longer-term, stockholders for votes against activists and traders and, by investing for the long run, would obtain the loyalty share votes. The longer-run stockholders, with extra votes, would elect like-minded boards and support longer-term corporate business policies. The affected companies would profit more and the American economy would prosper.

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Over the past six months, the U.S. securities markets have seen an unprecedented surge in the use and popularity of Special Purpose Acquisition Companies (or SPACs). [1] [2] Shareholder advocates—as well as business journalists and legal and banking practitioners, and even SPAC enthusiasts themselves [3]—are sounding alarms about the surge. Concerns include risks from fees, conflicts, and sponsor compensation, from celebrity sponsorship and the potential for retail participation drawn by baseless hype, and the sheer amount of capital pouring into the SPACs, each of which is designed to hunt for a private target to take public. [4] With the unprecedented surge has come unprecedented scrutiny, and new issues with both standard and innovative SPAC structures keep surfacing.

The staff at the Securities and Exchange Commission are continuing to look carefully at filings and disclosures by SPACs and their private targets. As customary, and in keeping with the Division of Corporation Finance’s ordinary practices, staff are reviewing these filings, seeking clearer disclosure, and providing guidance to registrants and the public. They will continue to be vigilant about SPAC and private target disclosure so that the public can make informed investment and voting decisions about these transactions.

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I am very grateful to Mr. Evans for his thoughtful reply to my prior post on the Forum. His reply raises important interpretive issues that I hope that the SEC and FINRA will directly address.

In connection with U.S. initial public offerings (IPOs), underwriters usually trade in the issuer’s stock for their own principal accounts, including by short selling the issuer’s stock and by exercising a green shoe option. I have argued that applicable U.S. law permits underwriters, subject to certain compliance measures, to monetize the value of their principal trading positions.

Mr. Evans’s reply post makes the empirical claim that underwriters do not use the green shoe option to profit from IPO stock pops. Mr. Evans asserts this empirical claim on the basis of deductive logic. According to Mr. Evans, Regulation M permits underwriters to pick one and only one of the following two activities: (1) making a market in an issuer’s stock as soon as exchange trading begins, and (2) profiting from IPO stock pops. Since we observe underwriters making markets once exchange trading begins, Mr. Evans concludes, underwriters do not use green shoe options to profit from IPO stock pops.

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The combination of record-level SPAC issuance and a flood of non-SPAC M&A has created a supply-demand imbalance in the event-driven asset class. With SPACs garnering most of the limelight, we believe investors are missing an excellent opportunity to deploy capital into “other” event-driven investments, most prominently merger arbitrage.

A Wild Year

It’s certainly been an interesting 12 months in the event-driven asset class. From soft catalyst event situations upended by the onset of COVID in Q1 2020, to the March 2020 “Arbageddon” widening in merger arbitrage spreads, to countless instances of hedge fund repositioning causing atypical volatility in typically boring share class arbitrage. It’s been a truly wild ride.
The combination of Q1 2020 performance challenges for the asset class and slow-to-recover new merger volume last spring and summer led to the perception that there was “nothing to do” in event-driven. The record issuance of SPACs in 2020 and early 2021, accompanied by some high-profile bouts of outperformance in former SPACs like Nikola, amended that narrative slightly. Recent commentary has been willing to stipulate that there was nothing to do in event-driven, apart from SPACs.

The Current Opportunity

As experienced event-driven investors, we’ve often chafed at the notion that event-driven’s attractiveness waxes and wanes as much as commentators would suggest. Indeed, our team mantra is “there’s almost always something to do,” and our historical results have supported this claim’s veracity.

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Introduction

2020 marked an incredible surge in the prevalence of Special Purpose Acquisition Company (“SPAC”) initial public offerings and business combinations (“deSPAC transactions”). In 2020, there were 248 SPAC IPOs (raising total gross proceeds of over $83 billion) and 66 deSPAC transactions, as compared with 2019’s 59 SPAC IPOs (raising approximately $13.6 billion in gross proceeds) and 28 deSPAC transactions. [1] And the pace continues to skyrocket in 2021 with 160 SPAC IPOs in the first two months of the year and 13 completed deSPAC transactions. [2] This spectacular rise, and the related profits, has unsurprisingly garnered attention from both the United States Securities and Exchange Commission (“SEC”) and plaintiffs’ law firms. Most recently, the SEC’s Division of Corporation Finance released guidance [3] (the “SEC’s SPAC Guidance”) concerning disclosure obligations for SPAC IPOs and deSPAC transactions, highlighting many process and disclosure-related issues that plaintiffs’ lawyers typically raise and have focused on in recent SPAC lawsuits. As we anticipate that plaintiffs’ firms will continue to hone in on SPAC-related litigation in 2021 (likely using the SEC’s SPAC Guidance as its new and more tailored playbook), SPAC sponsors, their boards of directors, and the directors and officers of acquisition targets should all be focused on key steps to limit litigation risks and minimize costs associated with these risks.

Disclosure-Based Claims and the SEC’s SPAC Guidance

Given that SPAC transactions have not historically been the subject of significant litigation, particularly as compared to traditional IPOs and public-to-public M&A transactions, plaintiffs’ firms played catch-up in this area during 2020, largely recycling their traditional M&A playbook. Accordingly, following the filing of the initial Form S-4 in connection with the deSPAC transaction, plaintiffs’ firms have alleged disclosure-based claims under Section 14(a) of the Exchange Act, claiming that the proxy statements issued are deficient due to the failure to disclose financial projections for the SPAC entity, immaterial details relating to negotiations or pursuit of other potential acquisition targets, reasoning for not hiring a financial advisor, or financial analyses that the SPAC board considered. See Wheby v. Greenland Acquisition Corp., C.A. No. 1:19-cv-01758 (D. Del. Sept. 19, 2019) (basing Section 14(a) action on alleged failure to make disclosures related to line items and reconciliations underlying financial statements, the target’s financial projections, terms of a non-disclosure agreements and letters of intent with potential targets, the basis for not hiring a financial advisor, and communications regarding future employment of the SPAC sponsors). More recently, however, plaintiffs’ firms are couching such pre-closing disclosure-based claims as breach of fiduciary duty claims, often filing in New York state courts, and are honing in on the unique aspects of SPACs and deSPAC transactions.

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Professor Corrigan offers a new theory about why some IPO stocks pop and others suffer steep drops—underwriters are to blame. His “principal trading theory” maintains that, contrary to accepted wisdom, overallotments and green shoe options in IPOs are used to maximize trading payoffs for underwriters. His theory is wrong. Matt Levine, in his Bloomberg column, Money Stuff, agrees.

As a matter of market practices and because of the SEC’s Regulation M, underwriters must complete their sales, including overallotments, before the IPO stock starts trading in the market. They cannot, for these reasons, hold back and sell more shares at higher prices in the aftermarket.

Establishing a new and vibrant trading market where one never existed is a challenging task. The investors that a company doing an IPO and its underwriters seek as shareholders have lots of competing ways to invest their money. Even in the same industry as the IPO company, there are competitors with established trading markets a track record of being a public reporting company.

Transforming a privately-held venture into a NYSE- or Nasdaq-traded company involves considerable art as well as science. Underwriters are asking the investors to take on some of the risk of that launch into the unknown of public trading. The dynamics of supply and demand for the shares can influence the success or failure of the company’s entering into the public markets.

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In academic and public commentary, entrepreneurial finance is usually portrayed as a quintessential American success story, an institutional structure whereby expert venture capitalists with strong reputational incentives channel much-needed equity to deserving entrepreneurs, then subject them to intense monitoring to assure they stay on the path to hoped-for success in the form of an initial public offering or public company acquisition. Yet, in recent years there have been gross embarrassments and allegations of outright criminality, at companies like Uber, Theranos, and the subject of our paper, WeWork. In short, we argue, fiduciary deficits and rent-seeking behaviors abound and the costs are borne not just by the venture capitalists or other investors.

Although we do not quarrel with the historical record of success, we are focused on the changes in the market for start-up capital that may well have contributed to the recent bouts of rent-seeking and extreme. Indeed, our title’s reference to corporate adolescence underscores the ever-lengthening period of time that high-tech start-up companies have before undergoing the so-called rites of passage to public adulthood. We argue that the private privileges allow for a build-up of bad choices and testy behaviors commonly observed in human adolescents, e.g., risk-taking and rule-breaking, thereby embedding in the firm’s habits and culture problems that may later be hard to fix.

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Thank you, Reni [Saula] for that introduction. It is a pleasure to be with all of you today. I will start with the usual disclaimer that my views are my own and not necessarily those of the Securities and Exchange Commission or my fellow Commissioners. The momentous market events of several weeks ago are relevant to the theme of this year’s conference—regulating the digital economy—and thus motivate my remarks.

The market events to which I am referring are, of course, the Reddit-threaded run-up in the prices of a number of meme stocks, the subsequent run-down in prices, and the many attendant colorful stories. At the top of the non-financial news feed were the market volatility, trading volumes, regular Joe-to-riches stories, hedge fund losses, short squeezes, gamma squeezes, glee at sticking it to the “suits,” anger at trading limitations, a jumble of emotions as stock prices fell from their highs, and debates about the intricacies of market structure. Movies to elucidate these events are on their way. [1]

The Securities and Exchange Commission, along with other regulators and market watchers, is still sorting through the many layers of those events, so I cannot give you a definitive assessment of what took place, let alone whether any significant regulatory changes or enforcement actions will result. Instead, I will offer some musings on the challenges that lie before the Commission as we decide whether and how to react to these events with new or modified regulations and, more generally, as we think about stepping up our game as a regulator of the digital economy.

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Last year, in particular the second half of the year, saw a vibrant market for initial public offerings (“IPOs”) of special purpose acquisition companies (“SPACs”). Coming out of this surge in SPAC offerings, the Division of Corporation Finance of the Securities and Exchange Commission (the “Staff”) published new disclosure guidance on December 22, 2020. [1] With the publication of this guidance, the Staff sought to remind SPAC sponsors, underwriters and other market participants of key concerns they have noted in their comment letters for SPAC filings in connection with IPOs and business combination transactions.

This guidance is particularly focused on the potential conflict of interest between a SPAC’s public shareholders, on the one hand, and a SPAC’s sponsor, directors, officers and their affiliates (the “insiders”), on the other hand. The insiders’ economic interests in the SPAC often differ from the economic interests of public shareholders in a number of important ways. As the Staff notes, this difference may lead to conflicts of interest, in particular as the insiders evaluate potential targets for the SPAC’s initial business combination.

The Staff notes that, unlike in the traditional IPO process where a private operating company’s securities are valued through market-based price discovery, the SPAC insiders are solely responsible for deciding how to value potential targets. While this is often cited as a reason why SPACs provide greater certainty for private companies considering a traditional IPO, the Staff points out that this can lead to potential conflicts of interest and risks for the public shareholders of the SPAC. Therefore, the Staff repeatedly emphasizes the importance of clear disclosure regarding these potential conflicts of interest and the nature of the insiders’ economic interests in the SPAC.

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In April 2020, the NYSE initially adopted, and the SEC approved, a temporary waiver (“NYSE Waiver”) of certain NYSE stockholder approval rules set forth in Section 312.03 of the NYSE Listed Company Manual (“NYSE Manual”) in order to lessen the hurdles companies face when seeking to raise capital, as many needed to do during the COVID-19 pandemic. [1]

After a series of extensions of the NYSE Waiver (the latest through March 31, 2021), the NYSE is proposing to officially amend Section 312.03 of the NYSE Manual. The proposed rule change will now go through a notice and comment period, but, if adopted, will make permanent the following.

Rule 312.03(b) — The Related Party Stockholder Approval Rule, as amended, would:

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Shortly before the end of his tenure as Chair of the Securities and Exchange Commission (SEC), Chair Jay Clayton presided over the SEC as it considered and approved the New York Stock Exchange’s (NYSE) proposed rule change modifying the NYSE’s rules in order to permit, as described below, primary issuances in connection with a direct listing of a class of the issuer’s equity securities on the exchange. As summarized in the timeline, the SEC’s consideration of the NYSE’s proposed rule change and the proposed rule change includes a number of twists and turns.

NYSE Proposal Approval Timeline

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Initial public offerings (IPOs) are set to rocket out of the gates again in 2021. Recently, we have witnessed some big pops (for example, Airbnb, 113 percent first-day return) and some steep drops (Wish, negative 16 percent).

With all this pricing variability following IPOs, what role is underwriter price stabilization playing? Relatedly, what role do overallotments and green shoe options play?

Overallotments are sales by the underwriting syndicate in excess of the number of shares the syndicate is obligated to purchase to underwrite the offering. A green shoe option is the right of the underwriters to purchase an amount of shares in addition to and at the same price as the base shares in the IPO.

Leading academic theories claim that underwriters use overallotments and green shoe options to help stabilize an issuer’s stock price following an IPO.

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Emerging companies have historically been backed by venture capital funds, but as Europe’s startup scene matures, involvement by more traditional private equity investors is growing, particularly in the tech, consumer, and digital health sectors. The number of PE investments in emerging companies has increased year on year, with investments in companies such as Wolt, Moonbug Entertainment, Zwift, Klarna, Epic Games, and Oatly demonstrating the range of opportunities available to PE sponsors in this space. While PE investors are increasingly familiar with VC deal dynamics, they are also pushing to align growth-deal terms more closely with traditional buyout concepts.

Relinquishing Control

Investors typically invest in a growth company as a minority investor at the top of a stack of existing institutional investors, meaning they are unable to exert the level of control usually seen in buyout deals. One board seat and a limited set of reserved matters are likely to be the limits of their influence. Alignment with fellow investors is therefore an important dynamic, and something that we are seeing deal teams consider at the outset of the transaction.

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While the popular media focuses on Bitcoin reaching record highs, there is something else happening in the crypto space that is largely under the radar screen. It is called DeFi or Decentralized Finance, and we examine its structure, opportunities and risks in our recent paper, DeFi and the Future of Finance.

Consider the state of our financial system. Around the world, 1.7 billion are unbanked. Small businesses, even those with a banking relationship, often must rely on high-cost financing, such as credit cards, because traditional banking excludes them. High costs also impact retailers who lose 3% on every credit card sales transaction. These total costs for small businesses are enormous by any metric. The result is less investment and decreased economic growth.

Decentralized finance, or DeFi, poses a challenge to the current system and offers a number of potential solutions to the problems inherent in the traditional financial infrastructure. While there are many fintech initiatives, we argue that the ones that embrace the current banking infrastructure are likely to be fleeting. We argue those initiatives that use decentralized methods—in particular blockchain technology—have the best chance to define the future of finance.

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Special Purpose Acquisition Companies (SPACs) have exploded in popularity. These so-called “blank check” companies are used as vehicles to take companies public without going through a traditional IPO process. In the life cycle of a SPAC, a management team forms a new public company (the SPAC) for the express purpose of identifying and acquiring an existing (but unspecified) private operating company and the SPAC sells shares of stock in the SPAC to the public (the SPAC IPO). Later, the SPAC’s management team identifies a private operating company for acquisition and then merges the target and the SPAC to create a continuing public entity that is the successor to the target’s business (the de-SPAC transaction). The year 2019 saw a record $13.6 billion raised across 59 SPAC IPOs. In 2020 through December 14, the value of SPAC investments has more than quintupled with $77.5 billion raised across 230 IPOs.

Although SPAC-related litigation has been relatively infrequent to date, that is likely to change given 2020’s explosion in SPAC IPOs. Tellingly, the price of D&O insurance for SPACs has reportedly nearly doubled in recent months, with insurers reducing their maximum exposure limits from $10 million to $5 million but continuing to charge similar premiums. In this climate, SPAC sponsors, investors and targets should be mindful of litigation risks presented by the SPAC process. In particular, any litigation filed after the de-SPAC transaction is complete will almost inevitably embroil all three of these constituencies and could prove a significant distraction to the continuing public entity that is the successor to the target’s business. Risks include litigation based on: (1) SPAC IPO registration statements; (2) de-SPAC proxy statements; (3) potential de-SPAC registration statements; (4) financial projections—which significantly distinguish SPAC disclosures from those made in traditional IPOS; (5) redemption of SPAC shares; (6) de-SPAC deadlines; and (7) post-SPAC public status.

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Today [Dec. 23, 2020], the Commission approved a new listing rule from the New York Stock Exchange (“NYSE”) which fundamentally shifts how companies can access the public markets. [1] The new listing standard will allow primary direct listings of companies seeking to go public and, importantly, raise capital outside of the traditional initial public offering (“IPO”) process. [2] NYSE’s proposal represents what could have been a promising and innovative experiment. Unfortunately, the rule fails to address very real concerns regarding protections for investors. As a result, we are unable to support this specific approach. [3]

Before delving into the specifics, we believe it is important to acknowledge that the current IPO process is far from perfect. Among other things, the structure often imposes relatively high fees on issuers. Market participants and the Commission should continue to explore ways to innovate and modernize the IPO process, but it need not be at the expense of fundamental investor protections.

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