SPACs and Risk Management
December 01, 2021
By Nicholas Zurzolo
Special purpose acquisition companies, known as SPACs, rapidly grew the U.S. IPO market in the past few years. The need to accurately assess the risks associated with leveraging a SPAC to tap into the public markets and apply sound risk management practices to mitigate them is paramount. While there are a slew of risks SPAC investors face, regulatory, financial, and post-transaction risk are three areas SPACs should focus on where they should demonstrate robust risk management, ultimately fostering greater confidence in the marketplace.
Notably, SPACs face the same regulatory reporting requirements as any other public company. This begins and continues throughout the lifecycle of a SPAC from inception through the de-SPAC. During the de-SPAC phase, regulatory obligations consist of proxy requirements, filing a Super 8-K within four business days of a consummations of a transaction, and quarterly and annual financial reports.
While the SEC has issued guidance and statements where SPACs are concerned, there is still room for clarification.
In April, the SEC indicated that some SPAC warrants should be classified as liabilities instead of equity instruments. This caused hundreds of SPACs to refile 10-Ks and 10-Qs. More recently, in late September, the SEC privately advised auditors that “redeemable” shares issued by SPACs must be treated as temporary equity, against the traditional permanent equity. The implications of the SEC ruling of temporary equity may cause most SPACs to list on NASDAQ’s Global Market tier, which lacks an equity requirement. While the implications of the listing change are currently unclear, some analysts believe it could be a step toward harsher regulation for the SPAC market. 1 As noted by FINRA, the Financial Industry Regulatory Authority, the SPAC “may attract ‘hot’ sectors or business models that may be only short-term fads instead of viable long-term businesses.”2 With the temporary equity regulation, as well as the potential for additional SEC crackdown, forming SPAC investments with more volatile companies can prove to be disastrously costly, so the priority of finding a stable and responsible company that can go public must be number one.
Within the past few months, the conversation has continued to shift as to whether SPACs should be registered as investment companies. SPACs have been under fire from certain lawyers who are accusing the acquisition firms of operating illegally by not registering as investment companies, while some law firms are highly critical of the litigation against SPACs. SPACs are frequently referred to as “blank-check” companies; however, recent lawsuits have called into question how they could be considered investment companies under the Investment Company Act of 1940, and therefore should be regulated as such. An example includes a recent lawsuit title Assad v. Pershing Square Tontine Holdings. Investors sued William Ackman, alleging that the SPAC he created did not register as an investment company in order to illegally compensate insiders through generous security terms. The lawsuit has already made a stark impact on William Ackman’s SPAC, as he originally had dismissed the lawsuit, but later admitted that there was legal ambiguity behind his company. As a result, Ackman proposed liquidating his SPAC and replacing it with a SPARC, an acronym for special purpose acquisition right company.3 While these lawsuits are targeting SPACs, to counter, more than 60 law firms disagree and have condemned the actions of the lawyers and are looking for rules and regulations to dictate the operations of SPACs, not lawsuits.4 5 To avoid their financial purpose being put into question, SPACs should maintain clear, concise, and well-documented financial histories and disclosures. FINRA has a similar mindset, as they are currently conducting a widespread “exam” spanning three years of various SPACs’ histories, surveying training, financials, policies, and procedures.6
Once the de-SPAC transaction completes, the target company becomes the publicly listed entity. The risks post-close primarily pertain to the expectations of operating as a public company. For example, shareholder lawsuits that have occurred are related to omissions or misstatements during the acquisition as well as lawsuits involving conflict of interest. The risk management for post-close requires due diligence and the ability to clearly state all aspects of the SPAC merge to shareholders, in order to prevent misstatements.
Similarly, some target companies, once public, do not perform as intended, are unable to scale, and are more volatile than expected. According to Bloomberg Law, the average depreciation in the value of the 24 out of 36 total de-SPACed entities that went public after January 1, 2019 is 26%, with two outliers over 60%. To contrast, the 12 positive entities only averaged appreciation of 20% with one outlier over 50%.7 The risk management for post-close performance would be to closely monitor the performance of the public company, instill proper governance, and produce financials that can withstand PCAOB scrutiny.
1 EXCLUSIVE U.S. SEC cracks down a second time on SPAC equity accounting treatment - sources | Reuters
2 Guest view: SPAC investors face six key risks
3 Lawyers suing Bill Ackman's SPAC plan up to 50 more lawsuits against blank-check firms, sources say
4 A SPAC Counterattack
5 Over 60 of the Nation’s Leading Law Firms Respond to Investment Company Act Lawsuits Targeting the SPAC Industry | Ropes & Gray LLP (ropesgray.com)
6 SPAC Sweeps: FINRA Releases Guidance After Announcing Its Latest Series of Targeted Exams
7 YTD Post-Merger SPAC Performance is Mostly Negative