On August 30, 2021, more than 55 leading law firms, including Arnold & Porter, took the unusual step of issuing a collective Statement in response to a recent set of lawsuits that challenge the legality of special purpose acquisition companies (SPACs) and allege that SPACs should be considered investment companies under the Investment Company Act of 1940 (1940 Act). The law firms' Statement rejects the claims in these lawsuits on the grounds that SPACs are not investment companies. In this advisory, we discuss the Statement issued by the law firms, the recent lawsuits that prompted the Statement, and why plaintiffs' claims are contrary to the SEC's historical position on whether SPACs are investment companies under the 1940 Act.
Sponsors, target companies, their respective directors and officers, and their investment banks would be well advised to anticipate the likelihood of increasing and enhanced scrutiny of SPACs by the plaintiffs' bar and regulators. While there are serious flaws in the claims brought in these recent lawsuits, and there is hope that the application of the 1940 Act to SPACs will be rejected, these types of actions will continue to be filed until courts definitively rule on the issues and a judicial consensus is established.
Statement by More Than 55 Law Firms
The Statement begins by addressing the fact that certain derivative lawsuits recently filed by a purported shareholder of certain SPACs allege that the "SPACs are investment companies under the [1940 Act], because proceeds from their initial public offerings are invested in short-term treasuries and qualifying money market funds." The Statement explains that, under the 1940 Act, "an investment company is a company that is or holds itself out as being engaged primarily, or proposes to engage primarily, in the business of investing, reinvesting or trading in securities."
The Statement then distinguishes SPACs from investment companies, explaining that SPACs "are engaged primarily in identifying and consummating a business combination with one or more operating companies within a specified period of time." The Statement draws a further distinction between the two, namely that "[c]onsistent with longstanding interpretations of the 1940 Act, and its plain statutory text, any company that temporarily holds short-term treasuries and qualifying money market funds while engaging in its primary business of seeking a business combination with one or more operating companies is not an investment company under the 1940 Act."
As a result, the Statement concludes that "the undersigned law firms view the assertion that SPACs are investment companies as without factual or legal basis and believe that a SPAC is not an investment company under the 1940 Act if it (i) follows its stated business plan of seeking to identify and engage in a business combination with one or more operating companies within a specified period of time and (ii) holds short-term treasuries and qualifying money market funds in its trust account pending completion of its initial business combination."
Lawsuit Against Pershing Square Tontine Holdings
The law firms' Statement was issued in response to several recent lawsuits, including the complaint filed in Assad v. Pershing Square Tontine Holdings Ltd., 1:21-cv-06907 (SDNY August 17, 2021) against Bill Ackman's SPAC, Pershing Square Tontine Holdings Ltd. (PSTH). This complaint, which was filed by former SEC Commissioner Robert Jackson and Yale Law professor John Morley together with other plaintiffs' attorneys, has garnered significant media and industry attention given the high profiles of the players involved, not to mention the fact that its claims potentially challenge the fundamental structure of traditional SPACs.
The $4 billion PSTH is the largest SPAC in history. PSTH had an atypical investment plan, now abandoned, to invest the majority of its assets in a 10 percent stake in the common stock of Universal Music Group BV (UMG). This is a departure from the traditional SPAC model, which is to hold the SPAC's assets in a trust account and invest them in US Treasury and/or money market securities until the end of the SPAC life cycle, at which time those assets are then used to acquire 100 percent of an operating target company in a transaction known as a de-SPAC.
Under PSTH's proposed plan, PSTH would acquire and hold the UMG shares. Only after a public listing of UMG would PSTH investors receive a distribution of UMG shares. The SPAC would continue in existence, with $1.6 billion to invest at its discretion. While the SEC staff identified issues with this proposed plan, which prompted Ackman to revise the plan, the deal ultimately was not consummated.
Plaintiff alleges in this litigation that PSTH is an investment company under the 1940 Act for the following reasons: (1) PSTH invested its initial public offering proceeds in short-term government securities and money market funds for more than a year after the IPO; (2) now that the UMG deal has been abandoned, those proceeds will continue to be invested in these securities for up to an additional 17 months as PSTH "continues to search for a new way to deploy its billions of dollars of capital"; (3) PSTH's initial purpose was to further invest in securities of UMG; and (4) PSTH is "ultimately controlled" by its manager, Pershing Square Capital Management, which provides investment advisory services to PSTH in return for advisory fees, and therefore PSTH is effectively the manager's fund. Plaintiff concludes that the SPAC was therefore illegal because it did not register with the SEC as an investment company, and that the managers of the sponsor of PSTH violated the Investment Advisers Act of 1940 (IAA) by failing to register as investment advisers.
Plaintiff further alleges that PSTH's sponsor and directors breached their fiduciary duties because (i) the sponsor received payments "worth more than $800 million in exchange for a payment of just $65 million," (ii) the directors received payments "worth about $36.8 million in exchange for . . . investments of just $2,837,500," and (iii) these payments were for "just two to two-and-a-half years of work." Plaintiff argues that this "staggering compensation was promised at a time when the returns to the Company's public investors have starkly underperformed the rest of the stock market," and that this "is hardly the arms'-length bargain the [1940 Act] and IAA demand."
Jackson and Morley Strike Thrice, With Potentially More Suits To Come
Jackson and Morley have challenged not only PSTH, but also two other SPACs called E.Merge Technology Acquisition Corp. (E.Merge) and Go Acquisition Corp. (Go Acquisition), with the same purported shareholder serving as the plaintiff in all three actions. Assad v. E.Merge et al, 1:21-cv-07072 (SDNY August 20, 2021); Assad v. Go Acquisition Corp., 1:21-cv-07076 (SDNY August 20, 2021).
In the E.Merge and Go Acquisition cases, the SPACs were challenged for largely the same reasons as in the PSTH case, and all three complaints restate many of the same allegations. In all of them, plaintiffs seek rescission of the transactional arrangements underlying the SPACs and damages from the SPAC sponsors and directors for compensation purportedly paid in breach of their fiduciary duties.
Also, the plaintiffs' counsel group that includes Jackson and Morley might not be done. This group reportedly "is actively monitoring the SPAC sector to identify potential issues at other SPACs," with some sources saying that the "number of potential new lawsuits could end up being as high as 50," although another source indicated that "this estimate was incorrect and that no new legal action was imminent."
Plaintiffs' Claims In These Recent Suits Are Contrary to the SEC's Historical Position
Reacting to the PSTH complaint, Ackman noted in an August 19, 2021 letter to shareholders: "During [Jackson's] more than two-year term as Commissioner, the SEC reviewed and declared effective more than 100 SPAC IPO registration statements, and oversaw dozens of de-SPAC merger transactions. If Mr. Jackson is so sure that SPACs are in fact illegal investment companies, why didn't he take steps to shut them down while he was an SEC Commissioner?" Indeed, more than 1,000 SPAC IPOs have been reviewed by the SEC over two decades, and the agency has never suggested that those SPACs were investment companies subject to the 1940 Act.
As a legal matter, SPACs will likely be able to argue by analogy that they, like other "blank check" companies recognized by the SEC, are not subject to the 1940 Act. In 1992, the SEC adopted Rule 419 under the Securities Act of 1933. Among other things, the rule governs offerings of blank check companies that issue penny stock. In its adopting release, the SEC recognized that "in light of the purposes served by the regulatory requirement to establish such a [Rule 419] account, the limited nature of the investments, and the limited duration of the account, such an account will neither be required to register as an investment company nor regulated as an investment company as long as it meets the requirements of Rule 419." 57 Fed. Reg. at 18,040 (Apr. 28, 1992) (emphasis added).
While SPACs do not issue penny stock and therefore are not governed by Rule 419, they share many of the core features that led the SEC to determine that blank check companies are not required to register under the 1940 Act. Namely, both SPACs and blank check companies must (i) deposit a specified portion of their offerings in a trust account, (ii) only invest the trust proceeds in certain money market accounts or US treasury securities, and (iii) return the trust proceeds if the entity fails to complete a business combination within a limited period of time. Indeed, the first generation of SPACs was developed in the aftermath of the adoption of Rule 419 by managers who did not technically fall within the regulatory framework of Rule 419 but "voluntarily complied with most of the Rule 419 provisions in hopes of renewing investor confidence in blank check offerings." Daniel S. Riemer, Special Purpose Acquisition Companies: SPAC and SPAN, or Blank Check Redux?, 85 Wash. U. L. Rev. 931, 944 (2007).
The current SPAC lawsuits argue that the "courts and the SEC have said many times that both US government bonds and shares of common stock in money market funds are unambiguously 'securities,' not only under the [1940 Act] generally, but also specifically within the meaning of section 3(a)(1)(A)." This argument, however, ignores the exception in the language of Rule 3a-1 of the 1940 Act, which provides another reason why SPACs are not investment companies. Under Rule 3a-1, an issuer generally will not be deemed an investment company if no more than 45 percent of the value of its total assets, and no more than 45 percent of its net income for the last four quarters, derive from securities other than government securities (or certain other categories of securities). In addition, shares of money market funds that comply with Rule 2a-7 under the 1940 Act generally may be treated as cash items and therefore are also exempt from the 45 percent rule. See SEC No-Action Letter (Oct. 23, 2000).
Of course, if PSTH had executed its plan, more than 45 percent of its net income could have been derived from its 10 percent ownership of UMG. However, the plan was not executed-and, under the plain language of the 1940 Act, a company that derives all of its net income from government securities generally would be excepted from the definition of an investment company.1
As shown above, there are serious flaws in the recent claims that have been brought. It would be unwise, however, to believe that the legal challenges to SPACs will be short-lived. The sheer number and significant money involved in these transactions almost guarantees that SPACs will be the focus of plaintiffs' attorneys and regulators for the next few years. Unfortunately, this is often the price of inventiveness in the markets, but it should not be reason to abandon these structures. The key is to be guided by the parameters discussed above and to learn from the experiences of earlier transactions, feedback from regulators, and developing caselaw-just as occurs in any emerging market.
For additional details on private litigation and enforcement activity relating to SPACs from earlier this year, please see our previous advisory here. Arnold & Porter will continue to monitor and report on enforcement and litigation developments related to SPACs as well as develop best practices for our clients. If you are seeking advice on how to mitigate risks in connection with SPAC transactions, please reach out to any author of this advisory or your regular Arnold & Porter contact.
1. The SEC has stated that "special situation" investment companies are not excluded from the 1940 Act's definition of an investment company. Special situation investment companies are companies that secure control of other companies primarily for the purpose of making a profit in the sale of the controlled company's securities, whereas a traditional SPAC is consummated for the purpose of acquiring the target.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.