As I wrote about last week, the SEC has had a very busy rule-making few weeks. In addition to issuing six new compliance and disclosure interpretations (C&DI) for merger and acquisition transactions, most of which directly impact SPAC business organization transactions, it also proposed new rules on SPACs and all shell companies in a 372-page release. The new C&DI were the topic of last week’s blog (HERE) and in a multi-part blog series, I am delving into the proposed new SPAC rules.
On March 30, 2022, the SEC proposed rules enhancing disclosure requirements associated with SPAC initial public offerings (IPOs) and de-SPAC merger transactions; requiring that a private operating company be a co-registrant when a SPAC files an S-4 or F-4 registration statement associated with a business combination; requiring a re-determination of smaller reporting company status within four days following the consummation of a de-SPAC transaction; amending the definition of a “blank check company” to make the liability safe harbor in the Private Securities Litigation Reform Act of 1995 for forward-looking statement such as projections, unavailable in filings by SPACs and other blank check companies; and deeming underwriters in a SPAC IPO to be underwriters in a de-SPAC transaction when certain conditions are met.
The proposed rules would require specialized disclosure with respect to compensation paid to sponsors, conflicts of interest, dilution and the fairness of business combination transactions. Further disclosures will also be required in connection with the use of projections. The SEC is also proposing a rule that would deem any business combination transaction involving a reporting shell company, including a SPAC, to involve a sale of securities to the reporting shell company’s shareholders and is proposing to amend a number of financial statement requirements applicable to transactions involving shell companies.
On the positive side, the SEC is proposed a new safe harbor under the Investment Company Act of 1940 (’40 Act) that would provide that a SPAC that satisfies the conditions of the proposed rule would not be an investment company and therefore would not be subject to regulation under the ‘40 Act.
A special purpose acquisition company (SPAC) is a blank check shell company formed for the purpose of effecting a merger, share exchange, asset acquisition, or other business combination transaction with an unidentified target. In the past two years, the U.S. securities markets have experienced an unprecedented surge in the number of initial public offerings by SPACs, with SPACs raising more than $83 billion in in 2020 and more than $160 billion in 2021. In 2020 and 2021, more than half of all IPOs were conducted by SPACs.
Generally, SPACs are formed by sponsors who believe that their experience and reputation will facilitate a successful business combination and public company. SPACs are often sponsored by investment banks together with a leader in a particular industry (manufacturing, healthcare, consumer goods, etc.) with the specific intended purpose of effecting a transaction in that particular industry. However, a SPAC can be sponsored by an investment bank alone, or individuals without an intended industry focus.
SPACs follow substantially the same structure. A sponsor receives founder shares for a fixed price of $25,000, which founder shares will typically represent 20% of the total issued and outstanding capital stock immediately following the closing of the SPAC IPO. The sponsor must also invest enough capital to cover the IPO costs, ongoing SPAC upkeep legal and accounting fees, and costs associated with the de-SPAC transaction (locating and conducting due diligence on a target and transaction costs associated with the merger), which is generally approximately 5% of the total IPO amount. This amount is referred to as the sponsor PIPE, and the terms of the sponsor PIPE are more favorable than the IPO terms. The sponsor PIPE may involve a different class of stock, warrants or a combination of both. The founder shares and sponsor PIPE often result in a sponsor owning 25% or more of the post IPO SPAC.
The sponsor entity generally conducts its own private placement, within the sponsor entity, to raise the capital necessary to fund the sponsor PIPE. Generally, one or more of the sponsor investors will also commit to participate in a closing PIPE as part of the business combination, assuming they agree with the target choice and valuation. Sponsor capital is at risk – sponsors do not make money unless a successful business combination is completed, and the value of their ownership increases enough to justify the time and capital commitment of acting as a sponsor.
The common stock and warrants received by a sponsor are generally the same as those sold in the IPO with a few key differences. The sponsor common stock is not redeemable in a business combination transaction (i.e., it stays at risk) and agrees to vote in favor of any business combination approved by the board of directors. The sponsor common stock converts into regular common stock on a one-for-one basis upon completion of the business combination but is subject to a 12-month lock-up period thereafter (though the lock-up may be released upon achieving certain trading price milestones). Sponsor warrants usually are not callable and contain cashless exercise provisions.
A SPAC IPO is usually structured as one share of common stock and either a whole, half or quarter warrant for a unit price of $10.00. The unit may sometimes also contain an additional “right” (similar to a warrant). Whereas a warrant has an exercise price, a right is usually just exchanged for a new security. For example, a SPAC unit may include a right to receive 1/10th of a share of common stock upon completion of a business combination, and so holders of 10 rights could exchange those rights for a share of common stock. The exercise price for a warrant is almost always $11.50 with a call option by the company if the stock trades at $18.00 or higher for 20 out of 30 trading days. Warrants sometimes have a downward adjustment on exercise price for if the SPAC trades below $9.20.
The SPAC IPO process is the same as any other IPO process. That is, the SPAC files a registration statement on Form S-1 that is subject to a comment, review, and amend process until the SEC clears comments and declares the registration statement effective. Concurrent with the S-1 process, the SPAC will apply for listing on a national exchange.
At the time of its IPO, the SPAC cannot have identified a business combination target; otherwise, it would have to provide disclosure regarding that target in its IPO Registration Statement. Moreover, most SPACs (or all) will qualify as an emerging growth company (EGC) and will be subject to the same limitations on communications as any other IPO for an EGC. See HERE related to testing the waters and public communications during the IPO process.
When trading commences, investors can trade out of their shares, choosing to attempt to make a short-term profit while the company is looking for a business opportunity. Likewise, buyers of SPAC shares in the secondary market are generally either planning to quickly trade in and out for a short-term profit or betting on the success of the eventual merged entity. If a deal is not closed within the required time period, holders of the outstanding shares at the time of liquidation receive a distribution of the IPO proceeds that have been held in escrow.
A SPAC generally has 24 months to complete a business combination; however, it can get up to one extra year with shareholder approval. If a business combination is not completed within the set period of time, all money held in escrow goes back to the shareholders and the sponsors will lose their investment.
The value of the de-SPAC transaction is negotiated by the sponsor, the target and any investors that are putting in new money at the closing (the closing PIPE) and as a result, the valuation of a target entity may be higher in a SPAC transaction. In a traditional IPO, neither the underwriter nor the IPO company rely on future growth projections and same are almost never included in a registration statement or as part of a road show. The reason is that the Securities Act imposes the stricter Section 11 liability standard on a company and its underwriters in an IPO process. Although a new Securities Act registration statement may be filed as part of the de-SPAC process, it is not a necessary component.
There was historically also a belief that the Private Securities Litigation Reform Act (PSLRA) provided coverage from liability based on forward looking statements. However, as discussed below, the proposed rules would eliminate that coverage. Of course, the general federal anti-fraud provisions apply to all aspects of the transaction, including the proxy materials in connection with voting on the merger.
Upon entering into an agreement for a business combination, the SPAC will file an 8-K regarding same and then proceed with the process of getting shareholder approval for the transaction. The SPAC must offer each public shareholder the right to redeem their shares and request a vote on whether to approve the transaction. Shareholder approval is solicited in accordance with Section 14 of the Exchange Act, generally using a Schedule 14A, and must include delineated disclosure about the target company, including audited financial statements. If a SPAC or the target company is registering an offering of its securities (or the securities of a new holding company) to be issued in the de-SPAC transaction, then a registration statement on Form S-4 or F-4 is filed. If no registration statement or proxy or information statement is required, then the SPAC disseminates a tender offer statement (Schedule TO) for the redemption offer to its security holders with information about the target company.
Upon approval of the business combination transaction, the funds in escrow will be released and used to satisfy any redemption requests and to pay for the costs of the transaction. Target companies generally require that a certain amount of cash remain after redemptions, as a precondition to a closing of the transaction, or as talked about above, that a simultaneous PIPE transaction provide the needed cash. The exchanges all require that the newly combined company satisfy their particular continued listing requirements.
From the target company’s perspective, there are other perceived benefits of going public via a merger with a SPAC. Some of those benefits include: (i) greater pricing certainty in merger negotiations; (ii) a relatively shorter time frame in becoming a public company; (iii) the perceived freedom to use projections in connection with de-SPAC transactions, with reduced liability exposure; (iv) an infusion of capital from the SPAC; and (v) potentially greater share liquidity for the post-business combination company based on the existing trading market for the SPAC’s securities.
However, SPACs have faced criticism and regulatory concerns. On April 12, 2021, the SEC effectively chilled SPAC activity by announcing that it had examined warrant accounting in several SPACs and found that the warrants were being erroneously classified as an asset. An accounting resolution was soon achieved with most warrants being classified as liabilities from that time forward (see HERE). On March 10, 2021, the SEC issued an investor alert warning of celebrity-backed SPACs and on March 31, 2021, the SEC issued two statements on SPACs. One highlighted certain issues, including relating to shell status, and the other on financial reporting and audit considerations. Then again on April 8, 2021, the SEC issued another statement on SPACs, that time from John Coates, then Acting Director of the Division of Corporation Finance (see HERE).
More recently, on January 3, 2022, the Delaware Court of Chancery denied a motion to dismiss a shareholder lawsuit against a SPAC’s sponsor, its directors, and financial advisor claiming among items, breach of fiduciary duty. The facts supporting the claim mirror common factual scenarios in SPAC and de-SPAC (acquisition transaction) transactions (see HERE).
In addition to the regulators and litigation, commentators in the market have been vocal about concerns as well, including related to (i) the amount of sponsor compensation and other costs and dilution to SPAC shareholders; (ii) sponsor conflict of interests, especially as the time to complete a transaction starts running thin; and (iii) inadequate disclosures.
Proposed New Rules – Summary
The proposed new rules would add a new Subpart 1600 to Regulation S-K delineating specialized disclosure requirements in connection with SPAC IPOs and de-SPAC transaction. New Subpart 1600 would: (i) require additional disclosures about the sponsor of the SPAC, potential conflicts of interest, and dilution; (ii) require additional disclosures on de-SPAC transactions, including that the SPAC disclose (a) whether it reasonably believes that the de-SPAC transaction and any related financing transaction are fair or unfair to investors, and (b) whether it has received any outside report, opinion, or appraisal relating to the fairness of the transaction; and (c) require certain disclosures on the prospectus cover page and in the prospectus summary of registration statements filed in connection with SPAC initial public offerings and de-SPAC transactions.
I’ll delve into the granular requirements; however, in my experience SPACs already disclose whether they have received a fairness or third-party opinion relating to a de-SPAC transaction. Moreover, it seems axiomatic that no transaction would or should be approved by the board of directors and recommended to shareholders if it was unfair to investors – and basic fiduciary obligations already dictate this standard. However, by reiterating the obligation in a disclosure rule, the SEC is broadening the potential liability of SPAC sponsors and directors and, in the case of an S-4 or F-4, expanding that liability to the target company directors as well.
The proposed new rules would also align disclosure obligations with the reality that a de-SPAC transaction is a going public transaction for a private company and should be treated equally with an old-fashioned IPO. In particular, the new rules would: (i) amend the registration statement forms and schedules filed in connection with de-SPAC transactions to require additional disclosures about the private operating company; (ii) 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; (iii) 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, such that the private operating company and its signing persons would be subject to liability under Section 11 of the Securities Act as signatories to the registration statement; (iv) amend the definition of smaller reporting company to require a re-determination of smaller reporting company status following the consummation of a de-SPAC transaction; and (v) propose a definition for “blank check company” that would encompass SPACs and certain other blank check companies for purposes of the Private Securities Litigation Reform Act of 1995 (PSLRA) such that the safe harbor for forward-looking statements under the PSLRA would not be available to SPACs, including with respect to projections of target companies seeking to access the public markets through a de-SPAC transaction.
In addition, the proposed new rules would add new Securities Act Rule 140a that would deem anyone who has acted as an underwriter of SPAC securities, who is involved in the de-SPAC transaction, any related financial transaction, such as a PIPE, or otherwise participates in a de-SPAC transaction either directly or indirectly, to be deemed an underwriter. The new Rule would impose Section 11 liability on underwriters in connection with the de-SPAC transaction.
The new rules are not limited to SPACs but also encompass all shell companies that complete reverse acquisitions. The SEC is proposing new Securities Act Rule 145a that would deem any business combination of an Exchange Act reporting shell company with another entity that is not a shell company, to involve the sale of securities to the reporting shell company’s shareholders. For purposes of proposed Rule 145a, the term “reporting shell company” is defined as a company, other than an asset-backed issuer as defined in Item 1101(b) of Regulation AB, that has: (i) no or nominal operations; (ii) either: (a) no or nominal assets; (b) assets consisting solely of cash and cash equivalents; or (c) assets consisting of any amount of cash and cash equivalents and nominal other assets; and (iii) an obligation to file reports under Section 13 or Section 15(d) of the Exchange Act (for more on reporting obligations see HERE).
The implications of this new rule could be astounding. The rules already require the filing of financial statements and Form 10 information for the acquired business in a Form 8-K within four business days of the closing of a transaction (see HERE); however, this new rule will require a shell company to file a registration statement on Form S-4 or F-4 or determine the availability of a registration exemption for its existing shareholders prior to the closing of a transaction. My belief is that it would be difficult if not impossible to find an available exemption and as such, if this rule passes as written, every reporting shell company business combination would require a registration statement.
Generally, an acquisition is completed by the issuance of new securities of a public company to the target company shareholders and as such, a registration statement or exemption is only necessary as to the target company shareholders. As most private target companies have a small number of shareholders, and those shareholders are generally accredited investors, an exemption is usually available. On the contrary, public companies are widely held, with shareholders in the float that are either not accredited or as to which accreditation would be impossible to determine. Moreover, the SEC is clear that the exemption in Section 3(a)(9) would not be available for these transactions. This new rule would add significant time and costs to reverse merger transactions.
The SEC is also proposing new Article 15 of Regulation S-X to more closely align the financial statement reporting requirements in business combinations involving a shell company and a private operating company with those in traditional initial public offerings. In May 2020, the SEC amended the financial statement and disclosure requirements related to the acquisitions and dispositions of businesses in an effort to reduce the complexity and compliance costs associated with these transactions for reporting companies (see HERE). Those rules apply across the board to all companies, whether a shell or not.
In essence, if a company is a shell, any acquisition would be significant and audited financial statements and Form 10 information on the target company would be required in a Form 8-K within four business days of closing. The new rules would not only amend portions of the May 2020 amendments, but would also clarify the requirements in the closing 8-K. Since Form 8-K allows for incorporation by reference, and since under the new rules a full S-4 or F-4 would have been filed prior to closing, presumably, in practice a Super 8-K would become a relatively short document incorporating the S-4 or F-4 prospectus.
Finally, the proposed new rules will provide for a limited exemption to the Investment Company Act of 1940 (’40 Act) for SPACs. In the time period between an IPO and a de-SPAC transaction, the public offering proceeds are held in a trust account and conservatively invested to earn interest. Generally, these investments are in treasury securities. However, recently, the plaintiff’s bar has been asserting that this investment activity makes the SPAC an investment company required to register under and comply with the rules and regulations of the ’40 Act. The exemption would limit a SPAC’s duration, asset composition, business purpose and activities.
Securities attorney Laura Anthony and her experienced legal team provide ongoing corporate counsel to small and mid-size private companies, OTC and exchange traded public companies as well as private companies going public on the Nasdaq, NYSE American or over-the-counter market, such as the OTCQB and OTCQX. For more than two decades Anthony L.G., PLLC has served clients providing fast, personalized, cutting-edge legal service. The firm’s reputation and relationships provide invaluable resources to clients including introductions to investment bankers, broker-dealers, institutional investors and other strategic alliances. The firm’s focus includes, but is not limited to, compliance with the Securities Act of 1933 offer sale and registration requirements, including private placement transactions under Regulation D and Regulation S and PIPE Transactions, securities token offerings and initial coin offerings, Regulation A/A+ offerings, as well as registration statements on Forms S-1, S-3, S-8 and merger registrations on Form S-4; compliance with the Securities Exchange Act of 1934, including registration on Form 10, reporting on Forms 10-Q, 10-K and 8-K, and 14C Information and 14A Proxy Statements; all forms of going public transactions; mergers and acquisitions including both reverse mergers and forward mergers; applications to and compliance with the corporate governance requirements of securities exchanges including Nasdaq and NYSE American; general corporate; and general contract and business transactions. Ms. Anthony and her firm represent both target and acquiring companies in merger and acquisition transactions, including the preparation of transaction documents such as merger agreements, share exchange agreements, stock purchase agreements, asset purchase agreements and reorganization agreements. The ALG legal team assists Pubcos in complying with the requirements of federal and state securities laws and SROs such as FINRA for 15c2-11 applications, corporate name changes, reverse and forward splits and changes of domicile. Ms. Anthony is also the author of SecuritiesLawBlog.com, the small-cap and middle market’s top source for industry news, and the producer and host of LawCast.com, Corporate Finance in Focus. In addition to many other major metropolitan areas, the firm currently represents clients in New York, Los Angeles, Miami, Boca Raton, West Palm Beach, Atlanta, Phoenix, Scottsdale, Charlotte, Cincinnati, Cleveland, Washington, D.C., Denver, Tampa, Detroit and Dallas.
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