The Evolving Landscape of SPACs

A Special Purpose Acquisition Company (“SPAC”) is a publicly traded blank check company created to take a private company public through a merger. At its core, a SPAC is a form of regulatory arbitrage in which market participants capitalize on the varying liability exposure of taking a company public. A SPAC typically has two years to identify a target company and complete the business combination, often referred to as a “de-SPAC” transaction, or liquidate and return the proceeds from the IPO to the shareholders. When a SPAC proposes a merger, the shareholders have the option to participate in the merger or redeem their shares at the initial IPO price with accrued interest. Typically, SPAC sponsors receive a “promote”—founder shares in the form of 20% convertible securities of the SPAC’s equity for a nominal price as compensation.

Increased private litigation, enhanced regulatory scrutiny, and changing market dynamics have called into question the utility of SPACs. Critics argue that SPACs are rife with conflicts of interest, erode investor protection, and are incredibly dilutive. Conversely, proponents aver that the investment vehicle improves market efficiency, helps reverse the trend of technology companies remaining private, and allows retail investors to participate in the upside of early-stage high growth companies. To the extent SPACs continue to provide financial incentives to market participants, and enjoy less liability exposure than conventional IPOs, SPACs will remain a relevant component of our capital markets. As such, market participants most adroit at navigating the evolving landscape will obtain a competitive advantage in the marketplace.

Private Litigation Developments

Private litigation against SPACs has increased and is expected to escalate. Lawsuits have targeted each step of the SPAC lifecycle, from the IPO process, to proxy solicitation, to the post–de-SPAC transaction. Of particular interest, on March 25, 2021, plaintiffs filed a class-action lawsuit against Multiplan Corp., the surviving entity from a de-SPAC transaction in the Delaware Court of Chancery (“DCC”).

The plaintiffs allege that the board of directors and the SPAC sponsor breached their fiduciary duty during the de-SPAC merger. The claims stem from a director’s duty to act loyally and disclose material information when seeking shareholder action. Specifically, the plaintiffs claim the defendants failed, disloyally, to disclose information necessary for plaintiffs to exercise their redemption rights knowledgeably. On January 3, 2022, the DCC denied the defendants’ motion to dismiss, allowing the plaintiffs’ case to move forward except for two named defendants.

In re Multiplan Corp. Stockholder Litigation (“In Re Multiplan Corp.”) is likely to have broad-reaching implications, as it is the first time a Delaware court has had an opportunity to apply Delaware corporate law to SPACs’ unique characteristics. Of note, Vice Chancellor Lori W. Will opined, given the mechanics of a SPAC, plaintiffs’ claims are direct, not derivative, and “[t]he entire fairness standard of review applies due to inherent conflicts between the SPAC’s fiduciaries and public stockholders in the context of a value-decreasing transaction.”

Momentously, barring an appeal, In re Multiplan Corp. establishes that features common in SPACs are enough to rebut the presumptive protection of the business judgment rule and trigger an entire fairness review in Delaware court. Specifically, a sponsor’s promote in the form of founder shares at a nominal price creates a unique benefit to the sponsors that competes with the interest of public stockholders. The windfall founder shares’ beneficiaries would receive even in a value-decreasing transaction is misaligned with public stockholders’ interest to redeem their shares unless the value of the post-merger entity is greater than the full value of their investment with interest. Stated succinctly, the potential conflict between the SPAC sponsors and public stockholders resulting from their different incentives in a bad deal versus no deal is sufficient to rebut the business judgment rule.

In re Multiplan Corp. provides guidance for lawyers to structure SPACs in a manner that helps fiduciaries meet their standard of conduct under Delaware law and maintain the protection of the business judgment rule as a standard of review. Presumably, SPACs that structure their sponsors’ promote to align the financial incentives of SPAC sponsors with that of public stockholders will help mitigate conflicts of interest in de-SPAC transactions and maintain the protection of the business judgment rule in the pleading stages of litigation. Additionally, as Vice Chancellor Will points out, “one can imagine a different outcome if the defendants provided public stockholders all material information about the target.” Consequently, one can expect much more robust disclosure in de-SPAC transactions.

Regulatory Developments

Along with an increase in private litigation, the Securities and Exchange Commission (“SEC”) has shown a keen interest in the proliferation of SPACs in the capital markets. On December 22, 2020, the Division of Corporation Finance of the SEC released a Disclosure Guidance for SPACs. The SEC staff emphasized that a SPAC preparing to conduct an IPO or present a de-SPAC transaction to shareholders “should consider carefully its disclosure obligations under the federal securities laws as they relate to conflicts of interest, potentially differing economic interests of the SPAC sponsors, directors, officers and affiliates and the interests of other shareholders and other compensation-related matters.” Additionally, on April 8, 2021, Acting Director of the Division of Corporation Finance of the SEC John Coates opined that the Private Securities Litigation Reform Act (“PSLRA”) safe harbor for forward-looking statements might not apply to de-SPAC transactions. Of note, the PSLRA safe harbor and associated reduced §§ 11, 12 liability exposure in private litigation are the primary source of regulatory arbitrage opportunity of SPACs over conventional IPOs.

Subsequently, on April 12, 2021, the SEC published a joint statement by Acting Director Coates, and Acting Chief Accountant of the SEC Paul Munter, on Accounting and Reporting Considerations for Warrants Issued by SPACs (“Statement”). The Statement indicates that certain warrants commonly issued by SPACs contain terms that should be classified as a liability rather than equity under U.S. GAAP. The Statement had a chilling effect on the SPAC market, as numerous registrants had to restate or amend their filings.

As anticipated, the SEC is starting to crack down on perceived abuse in the SPAC market with enforcement actions. On July 13, 2021, the SEC announced charges against Stable Road Acquisition Company (“SRAC”), its sponsor, its CEO Brian Kabot, the SPAC’s proposed merger target Momentus Inc., and Momentus’s founder and former CEO Mikhail Kokorich. All parties have settled with the SEC except Kokorich, against whom the SEC has filed a separate complaint. Under the terms of the settled order, the settling parties agreed to pay more than $8 million in aggregate, tailored investor protection undertakings, and forfeiture of the promote the sponsors would have received if the merger were ultimately approved.

According to the settled order, Momentus’s multi-billion-dollar revenue projections were premised on misleading statements about Momentus’s development of commercially viable space propulsion technology. Additionally, the order asserts SRAC “engaged in negligent misconduct by repeating and disseminating Momentus’s misrepresentations in Commission fillings” and to investors without proper due diligence. In a statement, SEC Chair Gary Gensler stated in part, “[T]his 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…the fact that Momentus lied to Stable Road does not absolve Stable Road of its failure to undertake adequate due diligence to protect shareholders.” The case imposes gatekeeper-related obligations on SPAC sponsors and signifies a significant escalation in the SEC’s activity in the SPAC market.

In a speech on December 9, 2021, Gensler reiterated his trepidation of the proliferation of SPACs in the capital markets and touted his regulatory philosophy that like activities should be treated alike. He expressed his concerns that SPAC investors are not benefiting from the protection they would otherwise get from securities laws in traditional IPOs. Accordingly, he has asked the staff for rule proposals for the Commission’s consideration to mitigate information asymmetry, conflicts, and fraud in SPAC transactions.

Undoubtedly, the SEC will have a tremendous impact on the evolution of SPACs, especially if Gensler’s public comments materialize in the form of SEC rules on disclosure, marketing practices, and gatekeeper obligations. As the SEC develops its approach to regulating SPACs, the Commission will have to balance policy goals and underpinning principles with an evolving financial market–for instance, finding the proper balance between investor protection, democratizing finance, and maintaining an efficient market.

Market Developments

Litigation risk, regulatory activities, and market dynamics have curtailed SPAC market activity. However, as SPAC market participants obtain regulatory clarity, process litigation risks, and calibrate market dynamics, SPACs are likely to evolve with innovative deal structures. On November 24, 2021, Pershing Square Capital Management filed a registration statement with the SEC for the subscription warrants of its special purpose acquisition rights company (“SPARC”). A SPARC has features similar to a SPAC; however, amongst other things, a SPARC has an opt-in rather than an opt-out financing structure. A SPARC does not raise capital in its IPO, but instead issues warrants exercisable into the common stock of the SPARC if the SPARC enters into a binding agreement for an initial business combination transaction. Proponents of SPARCs maintain that SPARC features are more protective of investors than those of SPACs, by minimizing conflicts and aligning the interests of the sponsors with those of the general investing public.

Of particular note, a SPARC eliminates the opportunity cost for investors as their funds from a conventional SPAC IPO sit idle in a trust account while a SPAC seeks a target company. Additionally, a SPARC mitigates the time pressure associated with conventional de-SPAC transactions, often a source of leverage against a SPAC during merger negotiations and a liability hotbed. A central claim in litigations against SPACs often includes allegations that the SPAC sponsors were pressured to accept any deal within the two-year time limit to avoid liquidating the SPAC and forfeiting the sponsor’s promote. It remains to be seen if the SEC will declare the PSTH SPARC registration statement effective, or if the SEC will approve the NYSE proposed rule change to allow PSTH SPARC warrants to trade on the NYSE. Nonetheless, SPACs are becoming increasingly adaptive and provide transactional lawyers tremendous flexibility to structure deals, as market-driven SPAC structures are helping to shape the evolution of the SPAC market.

Conclusion

Accessing the public market through a SPAC or a variation thereof is fraught with litigation, regulatory, and market risks. As SPACs continue to evolve to mitigate their associated risks while capitalizing on their benefits, a convergence of conventional and innovative deal structures will ensue with corresponding pros and cons. For instance, a SPARC opt-in feature is analogous to a conventional Independent Sponsor Model (IDM) in which a sponsor identifies a target company then seeks investors to finance the deal. Like an IDM and a conventional private equity deal, a SPARC will have a higher level of uncertainty that the sponsor will be able to raise the funds and close the deal than would a conventional SPAC. However, like an IDM, a SPARC helps eliminate the opportunity cost of idle capital. Understanding the trend lines and parallel structure between conventional and emerging investment vehicles will be very helpful to navigate the evolving landscape.

Interestingly, the legal system, regulators, and market forces are converging to address the drawbacks of SPACs—particularly, conflicts of interests and information asymmetry. As SPACs continue to evolve, policymakers should consider who ought to be at the forefront driving these changes. As the complexities of the evolution of SPACs continue to unfold, transactional attorneys will need a deep understanding of the policy priorities of key regulators, litigation trends, market dynamics, deal structures, and economic drivers to best serve the needs of their clients. Not to mention, ingenuity and forethought will be at a premium.