The Fast Rise and Possible Fall of the Special Purpose Acquisition Company (SPAC)

Alarm about the surge in recent SPAC-funded deals has prompted increased scrutiny and new accounting guidance by the SEC 

Key takeaways:

• A SPAC is a funding vehicle that provides an attractive alternative to traditional IPOs. 
• The SPAC market exceeded its record-breaking total $83.4 billion issuance of 2020 in just the first three months of 2021.
• Announcements of increased oversight by the SEC have slowed the SPAC trend.
• Changes to an accounting rule regarding SPAC warrants may have widespread implications for hundreds of companies involved in SPAC deals. 

The SPAC market, which exceeded its record-breaking total $83.4 billion issuance in 2020 in just the first three months of this year, will face many challenges. Not the least of these is increased SEC oversight.

A funding vehicle that rose to prominence amid the volatility of 2020, the SPAC provides an attractive alternative to the traditional initial public offering (IPO). In an Investor Bulletin from December 2020, the SEC noted that “certain market participants” believe that a SPAC transaction offers more certainty over deal terms such as pricing and control than IPOs.

But the ease and flexibility offered by SPACs is now the subject of review by the US’s top market regulatory body. The SEC seeks clearer disclosure for SPAC participants, citing concerns with “fees, conflicts, and sponsor compensation.” Celebrity sponsorship, which has accounted for much of the “meteoric” rise in popularity of SPACs, is among the issues posed by the SPAC structure. 

A brief introduction to today’s SPACs 

The SPAC can be traced back to the 1980s, when “blank check” companies and “penny stock” offerings proliferated until being brought under control and then nearly eliminated by the consequences of SEC’s Rule 419. The “modern” SPAC surfaced in the 1990s as a form of “blank check” vehicle for an IPO but incorporating the investor protections of Rule 419.

SPAC transactions reached a peak in 2007 and then virtually disappeared in the aftermath of the Great Recession. The use of SPACs has increased dramatically since 2016 and made up approximately half of the total US IPO market in 2020.

The recent SPAC trend has been fueled by celebrity involvement and enthusiasm from market heavyweights Goldman Sachs, JP Morgan, and Bill Ackman, whose $4 billion Pershing Square Tontine Holdings SPAC deal was 2020’s largest. The SPAC IPO is particularly suited to an investment environment with an “increased focus on growth over value,” according to Goldman Sachs. 

SPAC advantages and risks

As a “blank check” company, a SPAC can ease the transition of a private company to a public company. This goal is typically accomplished by using the public SPAC to make an acquisition (or “reverse merger”) with a privately held target. When the SPAC goes public, it is a shell company and has no underlying operating business and assets other than cash and the limited investments related to the IPO.

The advantages of SPACs vary according to market participants. 

• SPAC sponsors (the management team that creates the SPAC and brings it to market) achieve easier access to capital and more flexibility investing it than using private equity or venture capital funding. 

• SPAC investors can realize large gains with a successfully completed transaction, and virtually risk-free conditions pre-transaction (IPO funds are placed in an interest-bearing trust account, to be returned with modest gains if no merger or acquisition occurs).

• Private companies can find an easier route to becoming a publicly-traded company than a traditional IPO: no roadshow, minimal paperwork, and no worry about fluctuations in the company’s valuation.

All SPAC participants benefit from the stability of an agreed-upon valuation before any deal. SPAC deals also “typically price higher” than both traditional IPOs and private transactions. 

An investor buying shares in a SPAC during the IPO stage is dependent upon the judgment of the SPAC’s sponsors. He or she is betting on the sponsor’s ability to initiate and execute an attractive merger within two years. 

SPAC sponsors are not required to pursue the target business or industry specified in the SPAC IPO. Because the SPAC has no operating history itself, the backgrounds of its sponsors and their proposals are what investors are buying. And the minimal reporting requirements can leave investors lacking critical information for making fully informed decisions about potential risks.

As a part of the SPAC IPO, investors usually receive shares plus warrants, which give the investors the right to buy additional shares at a fixed price in the future. If other investors exercise their warrants, the original investors may find their percentage of ownership diluted. The two-year maximum timeframe for the SPAC-funded transaction may also prove too lengthy for less liquid investors.

Regulatory red flags and market vulnerabilities 

The widespread unease of market watchers caused the SEC to issue two public statements that effectively chilled the SPAC market at the beginning of April. 

On April 8, 2021, John Coates, SEC’s Acting Director, Division of Corporation Finance, released a public statement putting SPAC sponsors and investors on notice that the SEC is paying attention and tightened regulations may follow. At issue in the Coates memo was the idea that SPACs are inherently less risky than traditional IPOs. 

The SEC is concerned with the quality of protection afforded to investors in the current SPAC structure. Coates questioned if “current liability provisions give those involved—such as sponsors, private investors, and target managers—sufficient incentives to do appropriate due diligence on the target and its disclosures to public investors.” 

In a related statement days later, the SEC announced revisions to the financial reporting rules of SPACs. The guidance concluded that SPAC warrants “should be classified as a liability measured at fair value, with changes in fair value each period reported in earnings.” Previously, SPAC warrants were classified as equity instruments.

If the guidance becomes law, registrants in violation of the accounting guidelines—those companies that filed financial reports with warrants misclassified—will need to assess the “materiality” of the error to determine what amendments must be made. Hundreds of companies involved in SPAC deals could be facing the considerable expense and consequences of restating their financial statements.

Implications for future growth

The SEC announcements slowed the SPAC market at least temporarily, as evidenced by the sharp decline in filings at the time of this writing. And market watchers believe that increased SEC oversight will remove many of the incentives SPACs hold for investors. Bank of America analysts reported that retail investors “may be returning back to their traditional roots” and choosing established companies over more speculative securities. 

A wave of recent SPAC-related lawsuits, beginning with 35 filed in New York State, suggests that “the plaintiffs’ bar is actively monitoring and pursuing SPACs.” As both financial oversight and lawsuits increase, the allure of SPACs—even those with celebrities attached—could fade rapidly.

The attorneys at Johnston Clem Gifford routinely advise companies on issues related to securing capital and regulatory compliance. Our Financial Services teamworks with the world’s largest institutions as well as smaller and middle-market firms. Contact us online or by calling (214) 974-8000.