A ruling in In re Multiplan Corp. Stockholder Litigation accepting the relevance of misstatements in a Special Purpose Acquisition Company (“SPAC”) transaction continues to highlight the role of information disclosure in corporate financing. SPACs are blank-check public companies whose purpose is to acquire a privately held company within a given time period. This business combination (known as the “de-SPAC”) effectively allows the private company to become publicly traded. In denying motions to dismiss, the Delaware Chancery Court considered the allegation that the SPAC’s fiduciaries (including its sponsor and board of directors) misstated certain information about the business combination. The SPAC investors, the Court argued, would have been “substantially likely to find this information important when deciding whether to redeem [their shares ahead of a proposed acquisition].” As I will explain further below, the redemption right alluded to by the Court is a typical feature of SPACs.
The Chancery Court’s decision is related to commentary and research on the role of information disclosure in SPACs. Some have argued that an advantage of SPACs over IPOs stems from the view that the Private Securities Litigation Reform Act (“PSLRA”) safe harbor for forward-looking statements applies to SPACs as opposed to IPOs. The logic is that under this safe harbor protection, SPACs are able to provide forward-looking statements to investors that make the business combination more attractive, compared to IPOs.
However, even if this perceived advantage did contribute to the rise in SPACs in 2020–21, others are skeptical about such advantage. Among them is the SEC’s former Acting Director of the Division of Corporation Finance John Coates, who, in a statement delivered while in office, argued that “liability risks for those involved [in SPACs] are higher, not lower, than in conventional IPOs.” Mr. Coates went on to contend that this is particularly true due to “the potential conflicts of interest in the SPAC structure.” A March 2022 SEC proposal along the same lines would require companies to increase disclosure related to conflicts of interest, compensation, and dilution costs related to SPAC transactions.
This article provides economic and financial insight to help frame the role of information in SPAC transactions.
Information Asymmetries in Corporate Finance
Information disclosure serves a clear economic purpose, which is to help alleviate the asymmetry of information between investors and company insiders. Nobel prize recipient George Akerlof used the term “market for lemons” in the used car sales market to illustrate the harm that information asymmetries cause to the market. Akerlof argued that sellers of used cars have more knowledge about the quality of a used car than potential buyers. Because buyers cannot tell cars’ quality apart, the price at which these cars sell must be the same irrespective of true quality. But then the seller of a good quality car cannot receive the true value of the car. He concludes that “bad cars drive out the good because they sell at the same price as good cars.” If left unattended, the market breakdown caused by asymmetric information results in less commerce.
The same issue arises in corporate finance. Investors typically know less about the quality of a given asset compared to those who manage it. To solve information asymmetries and alleviate their cost, a host of contractual solutions, economic institutions, and regulations exist. For example, the IPO underwriting process provides a certification role that entices investors to participate in the IPO even when they have less information than the company insiders. Similarly, in the context of mergers and acquisitions, the acquiring company conducts exhaustive due diligence before completing the acquisition of its target. Finally, regulation and government agencies establish disclosure requirements and monitoring aimed at alleviating the cost of information asymmetries.
Information asymmetries are relevant because the two sides of the trade have different objectives. Going back to Akerlof’s example of a used car, its seller wants to obtain the highest price whereas a prospective buyer wants to pay the lowest price possible. Investors and company insiders might have misaligned incentives as well. For example, CEOs might undertake extravagant investments or engage in self-dealing behavior. This is why a CEO’s compensation package often includes stock options. A CEO only benefits from public stock options when the company’s stock reaches a certain level. To the extent that shareholders prefer a higher stock price, stock options can contribute to aligning CEO and shareholder incentives. I next explain how misalignments between investors and company insiders might apply in the context of SPACs, specifically between SPAC sponsors and investors.
The Roles of Information Disclosure in SPACs
SPACs are not immune to the asymmetry of information and diverging interests that exist in financial markets. First, SPAC investors likely have less information about acquisition prospects in general, and the ultimate target company specifically, compared to SPAC sponsors. This is so because the SPAC target is a privately held company often in a nascent industry. And this is more likely to be true if investors are relatively “unsophisticated” (i.e. retail investors compared to institutional investors). Partly because of this, investors can redeem their shares (at the price paid, plus interest) before the completion of the acquisition. This redemption right provides a hedge against pre-acquisition risk as it allows the SPAC investor to cash the shares and recover the full investment irrespective of the market price of the SPAC share at the time. Furthermore, a recent feature of the last wave of SPACs decouples the acquisition vote from the redemption decision. That is, the SPAC investor can redeem her shares and vote “yes” to the acquisition, if she wishes to do so. Klausner et al. report an average redemption rate of 58% for their 2019–20 merger cohort, indicating that a majority of SPAC shares are redeemed before the acquisition is completed.
Second, existing literature posits that conflicts of interest between SPAC sponsors and SPAC investors are also likely to exist. Initially, SPAC sponsors typically hold 20% to 30% of the SPAC’s equity (the “promote”) in the form of common shares. However, they pay less than SPAC investors for these common shares. While having skin in the game typically helps alleviate differing interests between investors and SPAC insiders (as I have argued above with the use of stock options in publicly traded companies), the fact that SPAC sponsors acquire their equity stake at a significantly lower price than SPAC investors can create conflicts. Two observations are worth mentioning here. First, if the SPAC finds no acquisition target, the SPAC is liquidated and the funds raised in the SPAC’s IPO, which sit in a trust, are returned to investors (with interest). Because the promote has no redemption rights, SPAC sponsors can only make a profit if the business combination is completed. Second, because SPAC sponsors pay less (per share) than SPAC investors, there is a range of acquisition prices for which SPAC investors earn negative returns whereas SPAC sponsors’ returns are positive. The evidence provided below indicates that this scenario might not be uncommon.
Thus, in the presence of information asymmetries and diverging interests, the role of (credible) information disclosure can play an important role. The safe harbor debate introduced at the beginning of this article can be analyzed in this context. Any credible information about the acquisition proposed by SPAC sponsors is likely to help investors decide to vote in favor of or against the business combination, and whether to redeem the SPAC shares. Forward-looking projections provided in the acquisition prospectus are part of this information set. The evidence summarized below indicates that indeed this information is relied upon by those investors more likely to suffer a bigger information gap vis-à-vis SPAC sponsors.
What Do Current Studies Tell Us About SPACs and the Role of Information Disclosure?
Several studies have calculated annualized returns, a common measure of performance, for SPACs. For purposes of this article, I focused on studies that include the latest wave of SPAC transactions. Table 1 below provides average returns reported in three studies. These returns correspond to common shares and do not include returns stemming from any warrants or rights. Moreover they are adjusted by the returns on a comparable basket of securities, that is, they are calculated as the SPAC’s excess return over a comparable index.
As shown in Table 1, all studies show that pre-de-SPAC returns are on average positive. In contrast, these studies show average negative de-SPAC returns. In other words, a SPAC investor who redeemed their shares before the acquisition would have more than recovered their investment (consistent with SPAC’s redemption rights), whereas an investor holding onto their common shares past the completion of the acquisition would have, on average, lost money during the first year.
