SPACs: Avoiding Volatility, Evading Regulation
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The American economy shattered records in 2020. In April, the unemployment rate rose to 14.7%, the highest rate in the history of the data. By June, national debt had increased by twenty-five percentage points since the end of 2019, the strongest surge in history. In July, the Bureau of Economic Analysis found that U.S. gross domestic product fell 31.4% during the second quarter, representing the biggest recorded contraction of that figure. Two-thousand twenty was a record-breaking year for Wall Street, too. On March 16, the Dow lost 2,997.10 points, a larger one-day percentage slide than the one on Black Monday in 1929. However, by August, the Dow had erased all of its 2020 losses and the S&P 500 closed at an all-time high after its severe plummet earlier in the year.
There was another source of record-breaking activity on Wall Street last year. Special-purpose acquisition companies, or “SPACs,” have entered the market in unprecedented numbers. In 2020, SPACs conducted 248 initial public offerings (“IPOs”) and raised over $83 million. By contrast, 2019 – also an unprecedented year for SPACs – saw only fifty-nine SPAC IPOs and $13.6 million raised.
SPACs are public companies formed for the purpose of merging with private companies. SPACs typically operate like blank-check companies, holding limited assets and having no operating history. A SPAC raises funds through an IPO and holds that money in escrow. It typically then has two years following the IPO to merge with a target company or else face liquidation—to find a date to the prom, as it were. Interestingly, SPACs must use at least 80% of their net assets to fund their ultimate acquisition. When the SPAC finds its target, it submits proxy materials to shareholders, soliciting their approval of the proposed merger. If the merger fails, shareholders are given a pro rata share of the money held in escrow; that amount typically constitutes a significant portion of the initial investment. Moreover, SPACs give shareholders redemption rights as additional exit options. Although the word “acquisition” is in the name, SPACs “acquire” targets through reverse mergers in which the target sells its common stock to the SPAC. Following the merger, the target company assumes the SPAC’s public listing; for that reason, reverse mergers between public and private companies are sometimes deemed “reverse IPOs.”
Private targets experience significant regulatory breaks when SPACs bring them public through reverse mergers. While the newly-formed public company is required to report the merger in a Form 8-K filing for material events, it does not face the same requirements under the Securities Act of 1933 because the SPAC already met those requirements during the initial IPO, well before the reverse merger. The Securities Act requirements, especially the Section 5 “gun-jumping” laws, are formidable. In a traditional IPO, the issuer must file a lengthy registration statement with the SEC and wait for it to become effective prior to selling any securities. At each stage of the IPO, the issuer’s communications—and particularly those of non-reporting issuers—are highly regulated. During the pre-filing period, the issuer may not “offer” any security for sale. Section 2 of the Act broadly defines “offer,” and subsequent SEC interpretive releases have expanded the definition to include almost any communications that could conceivably condition the market to anticipate purchasing the issuer’s securities ahead of the offering. In the “waiting period” after the issuer has filed the registration statement but before the SEC has declared the statement effective, the issuer can begin marketing its securities but only through oral communications at roadshows and written communications in statutory prospectuses meeting the requirements of Section 10 of the Act. Even after the SEC declares the registration statement effective, the issuer still must abide by the statutory prospectus requirement and ensure that such prospectuses are “delivered” with the sale of each security. Section 11 imposes civil liability for material misrepresentations in the registration statement, and Section 12 imposes civil liability for violating the Section 5 gun-jumping laws. Notably, the issuer is not the only one who has to worry about these liabilities, as underwriters, accountants, and other offering participants can also be held liable for not following these regulations. Of course, all of these requirements are also subject to various exemptions and safe-harbor rules. Nevertheless, the entire process demands precise attention to detail, requiring issuers to work closely with lawyers and investment bankers—two classes of professionals not known for charging low hourly rates.
For all of those regulatory breaks, do SPACs offer any benefits in return? Attorney Brandon Schumacher argues that SPACs provide advantages for all relevant parties. Reverse mergers between SPACs and targets can provide significant returns for SPAC investors. Moreover, SPAC shares offer a degree of safety, as investors are returned their initial investments if the SPAC fails to merge with a target company. SPACs offer managers new funds for conducting investment activity, and SPAC management often benefits from the merger as they typically receive an interest in the SPAC’s shares as compensation for their work.
Furthermore, SPACs shield the target companies from timing issues introduced by market volatility. Volatility increases the risk that shares will quickly lose value; when the market is volatile, investors demand shares at discounted prices to account for that risk, forcing issuers and underwriters to lower the offering price or delay the IPO. Lowering the offering price decreases the amount of capital the issuer can raise, and delaying the IPO can result in reputational harm to both the issuer and the underwriters. Indeed, some commentators maintain that the 2020 SPAC boom is caused in part by market volatility resulting from the coronavirus pandemic. Merging with SPACs allows private companies to go public without directly offering shares to investors in the market. Since the acquisition price is determined between the SPAC and the private company, both parties avoid the threats posed by volatility in the broader stock market.
SPACs might even offer more benefits besides making investors rich. Some SPACs, such as the Sustainable Opportunities Acquisition Corporation, seek to create a broader social benefit by targeting private companies in the sustainability sector. Allowing those companies to grow and flourish could constitute a valid way of combatting the urgent problem of climate change and other global issues.
On the other hand, SPACs are not entirely spectacular (SPACtacular?). Jay Ritter, a finance professor at the University of Florida, once pointed out the potential misalignment of management and investor interests in SPAC mergers. Since the SPAC’s managers are assigned shares of the company following the merger, and since the managers have a limited amount of time to find a target, they may push for mergers with less-than-ideal targets. Additionally, because SPACs must spend 80% of their net assets in the purchase, they may overpay for certain targets. Yet, if investors are unsatisfied with the proposed merger, they can simply vote against the merger and exercise their redemption rights. Shareholders who exercise their redemption rights receive a pro rata share of the IPO proceeds held in escrow, typically equal to about $10 per share.
Maybe SPACs constitute fine investment vehicles. But is the SPAC boom truly a positive development in the capital markets? One way of looking at the boom places it within the broader context of gradual securities deregulation. Daniel Morrissey, a law professor at Gonzaga, writes that businesses have always been wary of securities regulation. Many deregulation proponents assert that free-market forces alone would incentivize issuers to make truthful and accurate disclosures as they compete for capital. Contemplating such competition, the SEC and Congress have relaxed many registration requirements for certain issuers. For example, in 2005 the SEC created automatic shelf-registration for well-known seasoned issuers (“WKSIs”), effectively allowing WKSIs to offer securities without waiting for SEC review. In 2012, Congress passed the JOBS Act, exempting emerging growth companies (“EGCs”) from the Section 5 requirements when they “test the waters” with qualified institutional buyers (“QIBs”) or accredited investors . In 2019, the SEC expanded that exemption to all issuers in promulgating Rule 163B.
The new rules fall far short of abolishing the registration requirement, but they indicate the markets’ deregulatory momentum. As more and more companies go public through reverse IPOs with SPACs, that momentum could pick up force. The Securities Act’s drafters meticulously crafted it (over the course of one weekend) in the wake of the stock market crash of 1929 to protect the investing public. The drafters, assuming a philosophy of robust disclosure, intended for the laws to prevent fraudulent activity by requiring issuers to provide investors with all material information prior to their actual investment decision. Significantly, disclosure has likely played a role in improving standards of conduct at reporting companies. Contrary to what the free-market proponents suggest, substantial deregulation could be problematic for the capital markets, as free-market market forces do not offer the same guarantee of investor protection that stringent registration requirements provide. Moreover, even as sophisticated actors like QIBs and accredited investors remain the focus of deregulation efforts, it would be wrong to assert that those actors only play ball with rich folks’ money—plenty of those investors are, for example, pension plans deploying the money of the “unsophisticated” public.
SPACs will probably continue to proliferate as long as the markets remain volatile. Nevertheless, when the volatility subsides, investors should think hard about investing in SPACs in light of the potentially adverse effects they may have on protective regulations.
About the Author: Nicholas Swan is a J.D. candidate in the class of 2022 at Cornell Law School. He graduated from Cornell University in 2019. He is interested in issues of federal income taxation and securities regulation.
Suggested Citation: Nicholas Swan, SPACs: Avoiding Volatility, Evading Regulation, Cornell J.L. & Pub. Pol’y: The Issue Spotter (Feb. 22, 2021), https://live-journal-of-law-and-public-policy.pantheonsite.io/spacs-avoiding-volatility-evading-regulation/.