On Wednesday, March 30, 2022, the Securities and Exchange Commission (SEC) proposed new rules and amendments to enhance disclosure and investor protection in initial public offerings (IPOs) and in business combination transactions, or de-SPAC transactions, by special purpose acquisition companies (SPACs).
These proposed rules came out as a result of the SEC’s long-term effort to tighten its regulations over SPACs since the significant increase in the use of SPACs to effect listings by private entities. Although the SPAC structure has existed since the 1990s, its recent boom and the increasing use of de-SPAC transactions as a way for private companies to go public in the U.S. market without facing much of the same regulatory scrutiny surrounding a traditional public offering has concerned certain market observers.
Below is a summary of the SEC’s proposed rules.
- Require specialized disclosure regarding the SPAC sponsor, including detailed disclosure regarding compensation paid, potential conflicts of interest, dilution and steps taken to ensure the fairness of the de-SPAC transaction.
- Require that disclosure documents in de-SPAC transactions be disseminated to investors at least 20 calendar days in advance of a shareholder meeting or the earliest date of action by consent, or the maximum period for disseminating such disclosure documents permitted under the laws of the jurisdiction of incorporation or organization if such period is less than 20 calendar days.
- Deem a private operating company in a de-SPAC transaction to be a co-registrant of a registration statement on Form S-4 or Form F-4 when a SPAC files such a registration statement for a de-SPAC transaction.
- Amend the definition of “Smaller Reporting Company” to require a redetermination of Smaller Reporting Company status following the consummation of a de-SPAC transaction.
- Amend the definition of “blank check company” to clarify that the statutory safe harbor in the Private Securities Litigation Reform Act (PSLRA) is not available for forward-looking statements, such as projections, made in connection with de-SPAC transactions involving an offering of securities by a SPAC.
- Require that any projections not based on either financial results or operational history be clearly distinguished from those that are based on financial results and operational history.
- Extend Section 11 underwriter liability to SPAC underwriters who also (directly or indirectly) “participate” in the de-SPAC transaction, when certain conditions are met.
- Better align the required financial statement of private operating companies in transactions involving SPAC IPOs, including the disclosure of three years of audited statements of comprehensive income, changes in stockholder’s equity and cash flow.1
- Propose a new safe harbor under the Investment Company Act of 1940 that would provide that a SPAC that satisfies the conditions of the proposed rule would not be deemed an investment company and therefore would not be subject to regulation under that act.
Implications
The proposed rules have significant implications in a variety of areas.
Use of Projections. For years, many practitioners in the SPAC space have taken the view that the PSLRA safe harbor is generally available for the use of projections in connection with de-SPAC transactions. The proposed rules specifically eliminate the PSLRA safe harbor for forward-looking statements, such as projections, for filings by SPACs. The explicit clarification by the SEC that the use of any arguably afforded protections under the PSLRA does not insulate the combined company from potential investor litigation post de-SPAC will chill the very use of those projections in such registration statements for the very reasons issuers do not include projections in IPO registration statements. Excluding SPACs from the safe harbor liability protections of the PSLRA may lead to increased litigation with respect to the information provided in the de-SPAC transaction, which in and of itself should be expected to compel SPACs to either include less comprehensive projections or exclude them altogether. SPAC participants may argue that this “inability” to include such projections will result in a higher rate of redemptions at the time of the de-SPAC; however, with current redemption rates at historically high levels and with many deals funding the combined company at the time of the de-SPAC with either a PIPE (private investment in public equity) or convertible financing, this is not a likely outcome.
Underwriter Liability. The impact on underwriters who take SPACs public with the implicit understanding that they will “assist” or “participate” in the de-SPAC transaction is more significant. The proposed rules would deem an underwriter of a SPAC’s IPO that takes steps to facilitate a de-SPAC transaction or any related financing transaction or otherwise participates (directly or indirectly) in the de-SPAC transaction to be engaged in a “distribution” and to be an underwriter in the de-SPAC transaction. Unlike with a traditional IPO, there are no underwriters of securities in connection with a de-SPAC transaction. Investment banks either assist as placement agent to fund a private placement of securities to a limited group of sophisticated investors or convertible deal or act as financial advisors to the SPAC or the private operating company. Under the proposed rules, an underwriter for the SPAC IPO that acts only as a placement agent in the PIPE in connection with the de-SPAC transaction would have potential liability not only to PIPE investors but also to all SPAC stockholders in connection with the Form S-4 or Form F-4 registration statement for the de-SPAC transaction. In such an instance, the Staff believes that as with a traditional IPO, investors would benefit from the rigor and diligence exercised by SPAC underwriters in connection with the de-SPAC transaction. It appears the staff is taking the view that since cash in trust is subject to redemption, and redemptions have trended to historically high levels, de-SPAC transactions with PIPEs that involve the same underwriter as the SPAC IPO are effectively an initial public offering for the combined company by that same underwriter. The staff notes in a footnote to the proposed rules that “the staff has observed that for the vast majority of PIPEs associated with de-SPAC transactions, the closing of the PIPE financing is crossconditioned on the closing of the de-SPAC transaction.” Curiously, it would appear that neither a financial advisor to the target company nor an investment bank that acts as a financial advisor to the SPAC or a placement agent to the SPAC or target that was not part of the SPAC IPO underwriting syndicate would be deemed an underwriter.
In addition, the proposed rules note that acting as a financial advisor to the SPAC, assisting in identifying potential target companies, negotiating merger terms or receiving compensation in connection with a de-SPAC could constitute underwriter participation in the transaction. While that financial interest in the outcome of the de-SPAC transaction alone may not be sufficient to deem the IPO underwriter an “underwriter” in the de-SPAC transaction, the proposed definition is very broad and picks up numerous roles that advisors typically play in de-SPAC transactions. The extension of Section 11 liability2 in connection with any participation in the de-SPAC deal will dramatically raise the bar for such bankers in the diligence of the private company in a de-SPAC. This may chill the anticipated participation of such bankers in the de-SPAC, which could adversely affect existing SPACs that counted on such banker involvement in the de-SPAC to either fund or provide assistance in connection with the de-SPAC or those seeking to go public with a banker that promises that in the de-SPAC. It is reasonable to expect that SPAC IPO underwriters would take roles in connection with the de-SPAC transaction only if they are able to conduct a due diligence exercise consistent with an IPO of the target company in the de-SPAC transaction and are appropriately compensated. The expense and cost of involvement of such bankers in the de-SPAC will dramatically rise, with the SPAC bearing the cost burden of reimbursement as a condition to such involvement.
Fairness of De-SPAC Transactions. The proposed rules will require that a SPAC, in connection with a de-SPAC transaction, make a statement in the Form S-4 or Form F-4 as to whether the SPAC reasonably believes that the de-SPAC transaction (and any related financing transaction) is fair or unfair to the SPAC’s unaffiliated security holders. The SPAC would be required to discuss the factors upon which a reasonable belief regarding the fairness of a de-SPAC transaction and any related financing transaction is based and, to the extent practicable, the weight assigned to each factor. These factors would include but not be limited to the valuation of the private operating company; the consideration of any financial projections; any report, opinion or appraisal obtained from a third party; and the dilutive effects of the de-SPAC transaction (and any related financing transaction) on non-redeeming shareholders. This will provide further incentive to SPACs to seek fairness opinions to substantiate their “reasonable belief” as to the fairness of the transaction. Of note is that IPO underwriters of the SPAC that render such an opinion in connection with the de-SPAC transaction would be deemed “statutory underwriters” under the proposed rule.
Co-Registrant Liability. The provisions of the proposed rule treating the private operating company as a co-registrant to Form S-4 or Form F-4 does nothing more to extend liability to those who should bear the liability for material misstatements or omissions made on Form S-4 or Form F-4 registration statements during the de-SPAC transaction. This is in line with the current thinking of practitioners in the space and should not affect transactional volume.
In summary, the proposed rules affecting SPAC issuers should not come as a significant surprise to those that practice in the SPAC market. The proposed expansions of liability to bankers may indeed adversely affect the IPO market for SPACs as well as the de-SPAC market.
SEC Comment Period
The public can comment on these rule proposals by May 31, 2022, or 30 days after publication of the proposing release in the Federal Register, whichever period is longer.
Electronic comments shall be submitted via https://www.sec.gov/regulatory-actions/how-to-submit-comments, or you can send an email to rule-comments@sec.gov and include “File Number S7-13-22” on the subject line. The SEC also receives comments via mail. You can find the mailing information from the SEC’s rule proposal via the link provided above.
We are closely monitoring these rule proposals and will keep you updated on the progress and implications.
1 For a company that has Emerging Growth Company status, the proposed rule permits it to include two years of audited financials.
2 Under Section 11(a) of the Securities Act of 1933 (15 U.S.C.A. § 77k), an underwriter is liable at law or in equity if any part of the registration statement “contained an untrue statement of a material fact or omitted to state a material fact required to be stated herein or necessary to make the statements herein not misleading.”