What could Aristotle possibly have to say about SPACs? In remarks on Thursday before the Healthy Markets Association, SEC Chair Gary Gensler shared his thoughts on the regulation of SPACs with a theme drawn from antiquity: Aristotle's maxim that we must "treat like cases alike." That concept, in Gensler's view, should apply as finance evolves in response to new technologies and new business models. Take SPACs, for example—a type of transaction that, while not exactly new, has really "taken off in the last couple of years." A SPAC, he said, is really an alternative method of conducting an IPO. The question addressed by Gensler in his remarks is how "this competitive market innovation [should] be treated under our public policy framework," in effect, giving us a preview of what we may see in SPAC rulemaking, possibly next year.
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The concept of treating like cases alike is not new is the SPAC context. In April, then-Acting Corp Fin Director John Coates questioned the common assertion that SPACs involve lower securities law liability risk than traditional IPOs, raising the fundamental issue of whether the level of liability should be determined by the form of the IPO pathway, rather than the substance of the entire transaction. In other words, shouldn't like activities be treated alike? (See this PubCo post.) Similarly, at a separate House hearing, the witnesses agreed that, to prevent regulatory arbitrage, all IPO vehicles, whether traditional IPOs or SPACs, should operate on a level playing field and be subject to the same type of regulation of disclosure and liability. (See this PubCo post.)
According to Gensler, in 2021, there were 181 SPAC target IPOs, or de-SPAC transactions, with a total deal value of $370 billion, a substantial increase from just 26 SPAC target IPOs in 2019. Given this surge in SPAC activity, "which principles and tools do we use to ensure that like activities are treated alike?"
With regard to principles, Gensler points to three: leveling out information asymmetries; guarding against misleading information and fraud; and mitigating conflicts among parties that may have different incentives. To address these issues, Gensler highlights several policy tools for public offerings that were adopted back in the 1930s but remain central, including the need to provide full and fair disclosure on a timely basis, prohibiting the use of sales tactics to "condition the market" before the required disclosure reaches investors, imposing obligations on various gatekeepers (such as auditors, brokers and underwriters) "to stand behind and be responsible for basic aspects of their work," and creating the SEC to serve as the "federal cop on the beat."
In the context of SPACs, Gensler believes that a de-SPAC transaction is functionally "akin to a traditional IPO." If we are going to treat like cases alike, then "investors deserve the protections they receive from traditional IPOs." Yet Gensler is concerned that, whether at the time of the initial SPAC blank-check IPO or the de-SPAC merger, information asymmetries, fraud and conflicts are not being adequately mitigated and that SPAC investors are not receiving "the protections they would get in traditional IPOs, with respect to disclosure, marketing practices, and gatekeepers."
For example, SPACs may involve even more conflicts than traditional IPOs, such as the conflict between the investors who vote and then redeem their shares to cash out and those who stay through the transaction. Do they have the same incentives in the deal? Could potentially misaligned incentives result in enrichment of some parties at the expense of others?
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At a September hearing before the Senate Committee on Banking, Housing and Urban Affairs, Gensler was asked about SPACs. Senator Sherrod Brown expressed concern that many of the institutional investors in SPACs were not in it for the long term and that workers would be hurt as a result. He focused on a particular Ohio manufacturer that he believed some outside investors viewed, not as a long-term investment in a community with a proud manufacturing heritage and talented workforce, but as a way to realize a quick return with no follow-through. In a situation like that, he said, when investors pull out, companies break promises and workers and communities pay the price. Should we be encouraging risky financial mechanisms? Gensler confirmed that, in this context, many of the institutional investors do sell and leave much of the dilution and other risk to retail investors. He reported that he had asked the staff to develop a proposal to address the issue. (See this PubCo post.)
Gensler indicates that, "to reduce the potential for such information asymmetries, conflicts, and fraud," he has "asked staff for proposals for the Commission's consideration around how to better align the legal treatment of SPACs and their participants with the investor protections provided in other IPOs, with respect to disclosure, marketing practices, and gatekeeper obligations." (The SEC's reg-flex agenda identifies 4/22 as the target date for issuance of a proposal on SPAC regulation. (See this PubCo post.))
Disclosure. Gensler maintains that the level of disclosure can vary significantly among the different parties to the SPAC transaction. For example, Gensler contends, "PIPE investors may gain access to information the public hasn't seen yet, at different times, and can buy discounted shares based upon that information," while "retail investors may not be getting adequate information about how their shares can be diluted throughout the various stages of a SPAC." Are retail investors adequately advised that the 20% of the equity that typically goes to SPAC sponsors if they complete a de-SPAC transaction "largely falls on the 'remainers,' not those who cash out after the vote"? Gensler has asked the staff for recommendations for better disclosure "about the fees, projections, dilution, and conflicts that may exist during all stages of SPACs, and how investors can receive those disclosures at the time they're deciding whether to invest. [He has] also asked staff to consider clarifying disclosure obligations under existing rules."
Marketing practices. Gensler suggests that, with slide decks and press releases available at announcement, and even celebrity endorsements, "SPAC sponsors may be priming the market without providing robust disclosures to the public to back up their claims. Investors may be making decisions based on incomplete information or just plain old hype." Staff recommendations for rulemaking will likely include approaches to prevent improper conditioning of the de-SPAC target market, such as requiring "more complete information at the time that a SPAC target IPO is announced."
Gatekeeper obligations. Who are the gatekeepers for the de-SPAC merger process? In traditional IPOs, investment banks are considered the "underwriters," but, Gensler reminds us, the law "takes a broader view of who constitutes an underwriter." Gensler expresses concern that there "may be some who attempt to use SPACs as a way to arbitrage liability regimes. Many gatekeepers carry out functionally the same role as they would in a traditional IPO but may not be performing the due diligence that we've come to expect. Make no mistake: When it comes to liability, SPACs do not provide a 'free pass' for gatekeepers."
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According to Reuters, analysts think the SEC has been "worried about how much due diligence is performed by SPACs before acquiring assets, and about disclosures to investors," and SEC officials have previously expressed concerns about the adequacy of due diligence on proposed merger targets. The adequacy of due diligence on SPAC targets was also an issue raised at a House subcommittee hearing in June. At that hearing, a law professor introduced the metaphor of a wedding, comparing the traditional wedding to the traditional IPO, with all the prep and long-term planning that goes into both: with an IPO, the company starts out many months ahead in selecting bankers who vet the company, preparation of a prospectus, working through the SEC comment process and going on a roadshow. A SPAC, however, was more like a Las Vegas wedding—a quick wedding that ends up in marriage, to be sure, just like the SPAC process ends up in a publicly traded company, but without the same level of preparation and vetting. As a result, she supported extending potential Section 11 liability and eliminating the safe harbor for forward-looking statements for SPACs. (See this PubCo post.)
Citing John Coates, then-Acting Director of Corp Fin, Gensler repeats Coates' contention that "[a]ny simple claim about reduced liability exposure for SPAC participants is overstated at best, and potentially seriously misleading at worst." Accordingly, it appears that we can expect to see rulemaking that seeks to "better align incentives between gatekeepers and investors" and to "address the status of gatekeepers' liability obligations."
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For example, Coates questioned the widespread belief that SPACs retain the protection of the safe harbor for forward-looking statements in the PSLRA. In that case, he asked, "[d]o current liability provisions give those involved...sufficient incentives to do appropriate due diligence on the target and its disclosures to public investors, especially since SPACs are designed not to include a conventional underwriter at the de-SPAC stage?" Further, he maintained, there is no "free pass for material misstatements or omissions" in de-SPAC transactions. Material misstatements in or omissions from the de-SPAC registration statement, he said, are still subject to liability under Section 11 and the related proxy statement is subject to liability under Section 14(a) and Rule 14a-9, which has typically been assessed under a "negligence" standard. And about that thorny question of PSLRA protection? Don't be so sure, Coates contends. Specifically excluded from the safe harbor are statements made in connection with an offering of securities by a blank check company, those made by a penny stock issuer and those made in connection with an initial public offering. But there is no definition provided for "initial public offering" and, in Coates's view, "that phrase may include de-SPAC transactions.... To be sure, an 'IPO' is generally understood to be the initial offering of a company's securities to the public, and the SPAC shell company initially offers redeemable equity securities to the public when it first registers to raise funds in order to look for and later acquire a target. However, it is also commonly understood that it is the de-SPAC—and not the initial offering by the SPAC—that is the transaction in which a private operating company itself 'goes public,' i.e., engages in its initial public offering." Isn't it really a question of economic substance over form? (See this PubCo post.)
Cop on the Beat. The Enforcement Division, according to Gensler, is the "cop on the beat." Here he notes Enforcement's charges brought in July against a SPAC, its sponsor, its CEO and the merger target and its CEO.
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In that case, a private company that aspired "to provide space infrastructure services" was seeking to go public through a SPAC transaction. Among other things, the SEC order charged, the SPAC's due diligence failures compounded the misrepresentations and omissions of the target and its CEO and resulted in the dissemination of materially false and misleading information to investors. Gensler weighed in—a rare comment on a litigation settlement, perhaps signaling the significance of the case: "This case illustrates risks inherent to SPAC transactions, as those who stand to earn significant profits from a SPAC merger may conduct inadequate due diligence and mislead investors....Stable Road, a SPAC, and its merger target, Momentus, both misled the investing public. The fact that Momentus lied to Stable Road does not absolve Stable Road of its failure to undertake adequate due diligence to protect shareholders. Today's actions will prevent the wrongdoers from benefitting at the expense of investors and help to better align the incentives of parties to a SPAC transaction with those of investors relying on truthful information to make investment decisions." (See this PubCo post. For a different case also involving securities fraud and a SPAC, see this PubCo post.)
It's worth noting that, in the end, not only does Gensler believe that SPAC investors deserve the same protections as investors in traditional IPOs, he also may be hinting at future recommendations, observing that "these innovations around SPAC target IPOs remind us that there may be room for improvements in traditional IPOs as well."
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