Also, during this period, at least the more sophisticated sponsors began to realize that all of the SPACs being brought to market would be competing with each other for a limited pool of targets. While there are thousands of private companies that, in principle, might go public, many are owned by founders and families with no interest in going public. Many other private companies are more suited for a premium acquisition by a strategic buyer or for the professional management support offered by a private equity firm. Of those companies that are interested in going public, the C-IPO market was also at all-time highs, and direct listings—faster, cheaper, and easier for companies than SPACs and CIPOs alike—have begun to be used by some of the most well-known private firms.
The disruption of the SPAC boom of 2021 was most likely attributable to regression to the mean, recognition of market overreach, and market-driven deflation of a bubble. The disruption may also have been attributable, in part, to an increase in litigation over SPACs and sheer professional service market overload. As much as this former SEC staffer would like to think the public listens to the SEC staff, the slowdown had only modestly to do with SEC or SEC staff statements about the risks of SPACs. I am confident that it had nothing to do with any deliberate effort by the SEC to slow SPACs down. That is simply a myth.
F. SPACs Are Indisputably Not Investment Companies
According to a final legal myth, SPACs are indisputably not “investment companies.” As discussed in Parts I and II, SPACs, in their first phase, function economically like mutual funds—a type of investment company. As discussed in Part II.D, nothing in the ICA itself nor SEC rules promulgated thereunder clearly exempts SPACs from the ICA. And, as discussed below, it is at least plausible that SPACs are investment companies subject to the ICA. To be clear, the myth is not “SPACs should not be treated as investment companies”—a type of qualified opinion that an advocate might reasonably advance. Rather, the myth is “SPACs are indisputably not investment companies under existing law.” The myth inheres in the understatement of legal risk.
Despite the legal uncertainty of whether SPACs are subject to the ICA, a remarkable statement signed in August 2021 by more than sixty law firms opined: “[T]he assertion that SPACs are investment companies [is] without factual or legal basis and [we] believe that a SPAC is not an investment company . . . .” The statement contains no reasoning beyond the bare assertion that the “plain text” of the ICA resolves the question because SPACs are designed to attempt to acquire an operating company, so (goes the reasoning of the statement) the “primary business” of a SPAC is that acquisition. “Plain text” arguments in the face of contrary interpretations commonly fail to persuade, and in prior transient investment company disputes, the companies involved were also arguendo pursuing similar acquisitions, which did not end those disputes. Indeed, it is hard to see how such an argument could be the last word on the question, or resolve the issue as a matter of law, because such an interpretation of the ICA would invite never-ending evasions covered by the claim that the company involved would get around to buying an operating company someday, and would ignore the necessarily factual nature of the ICA’s use of contestable terms such as “primarily,” “holds … out,” and “business.” Indeed, the uncertain nature of the ICA was the reason the SEC adopted Rule 3a-2’s more bright-line exemptive safe harbor.
Despite alluding to “longstanding interpretations” of the ICA, the statement cites no authorities at all, and never attempts to engage the implications of Rule 3a-2 and prior court and SEC staff no-action positions that a one-year limit is the maximum period that a SPAC could remain outside the ICA. The statement’s only specific point is that more than one thousand SPACs have gone public without registering under the ICA. Similar reasoning has been adopted by a few readers of a draft of this article. The reasoning seems to be: If a legal issue is unclear, and the SEC does not bring an enforcement action to enforce the unclear law, the law is somehow liquidated, and no future private or SEC action can be brought based on the uncertain law. Or perhaps the argument may be: The SEC should simply resolve all legal uncertainties in favor of capital formation. Would that be a sensible approach to the legal uncertainty of SPACs under the ICA?
Not noted in the law firms’ statement is that the vast majority of those SPACs explicitly noted ICA-related risk in their offering documents, and none (to my knowledge) ever disclosed having obtained a legal opinion that the ICA does not, in fact, apply to SPACs. If the issue were as clear as the law firms’ statement makes it seem, one would think that at least one of those law firms would have been willing to risk its reputation and malpractice exposure by providing a legal opinion to one of its clients. If SPACs were arguably—but not clearly—investment companies subject to the ICA, then what would we expect the SEC staff in the Division of Corporation Finance who were reviewing filings by these SPACs to do, except include a comment in a review letter asking for a risk factor? If the SPAC included the risk factor, and made no affirmative statement about its legal status other than in the form of “we believe,” should the staff have held up the offering?
Does the claim, then, reduce to one that a regulatory agency with a limited budget should be held to have legally ceded authority by not initiating an enforcement action over an issue regarding a “backwater” corner of the market? How, indeed, is this any different from the teenager complaints of Part III? In any event, however one thinks about what the SEC staff should have done in the past, it remains unclear whether typical SPACs are covered by this part of the ICA. Any such finding would impose limits and costs beyond those anticipated by typical SPAC structures, and as a result would effectively force typical SPACs to either liquidate or find another exemption on which to rely.
Another rule—Rule 3a-2, which was adopted by the SEC in 1981—might provide a possible escape route for SPACs. But that rule is limited to companies for a one-year “transient” period. As noted in Parts I and II, most SPACs specify a SPAC period of longer than one year, and many SPACs have taken longer than one year to complete their de-SPACs. In the release adopting Rule 3a-2, the SEC suggested a company would be running a serious risk if it exceeded the one-year limit. Of course, any time limit is arbitrary, and Rule 3a-2 may not be viewed as establishing by negative implication a one-year limit on SPACs, given other aspects of the SPAC structure and their marketing. But absent a new SEC exemptive rule or a persuasive appellate court holding on point, the longer the SPAC period for a given SPAC, and the greater the flexibility the SPAC contracts and corporate documents provide for extensions beyond the initially stated period, and the longer a given SPAC continues to not achieve a de-SPAC, the greater the risk it may be found to be an inadvertent investment company.
Relevant to that risk, outside the SPAC context, courts have addressed the permissible length of the time between the sale of a non-securities business and the acquisition of another such business, without falling afoul of the ICA by being deemed to be “primarily” engaged in holding securities (despite pursuing an operating company acquisition). In the most prominent of those lawsuits, the court also used a one-year period as part of an overall fact-specific evaluation of the company’s situation. The SEC staff also has used one year as a guideline in granting no-action relief when requested by transient investment companies. Although not binding on courts, the analysis and precedents of those no-action positions may be persuasive authority on this question.
Regardless of how the pending litigation on this question is resolved, the ICA is likely to limit innovation in the SPAC space. SPAC structures that explicitly contemplate a permanent or “evergreen” company pursuing a series of acquisitions over time, such as the one proposed by Bill Ackman during 2021, would be even more likely to fall afoul of the ICA, even if SPACs are permitted to endure for more than a year. By design, any such company would continue to hold securities beyond its initial acquisition, making it much more vulnerable to being viewed as “primarily” engaged in a business other than pursuing that initial acquisition.
In sum, it is a myth that the ICA clearly or inarguably does not apply to SPACs. A plausible “as applied” reading of the ICA would sweep in SPACs that last for more than a year without engaging in a de-SPAC, and a plausible “on its face” reading of the ICA would sweep in SPACs that, by the terms of their offering documents, have SPAC periods lasting more than year. The law firms’ statement notwithstanding, the issue is legally unresolved. SPACs’ own disclosure documents clearly acknowledge this risk. As between the deal-activity-enhancing and self-serving law firms’ statement, and the under-fraud-threat disclosures of SPACs advised by those same law firms, the latter is a more reliable source of legal advice on this point—but it is rarely noticed or reported by business journalists and is likely not being made clear to either SPAC sponsors or de-SPAC targets. In the end, the main significance of the law firms’ statement is to show how broadly the SPAC product spread during the bubble of 2021, and how invested major law firms and their clients in the SPAC industry became in struggling to maintain the status quo underlying that bubble and the related fee streams it was producing.
The SPAC industry continued to repeat these demonstrable myths long after the SPAC bubble burst. The industry players continued to assert that only in SPACs can companies talk about the future; they continued to claim that the PSLRA safe harbor clearly applies to de-SPACs and that SPACs generally give rise to lower liability risk for participants; they continued to claim that SPACs enjoyed a faster SEC registration process than C-IPOs, even as they also claimed that the SEC has changed accounting rules and its processing program in order to slow SPACs down; and they continued to dismiss ICA concerns about SPACs as if they were trivial. In reality:
- Companies are legally permitted to talk about the future in C-IPOs, and in fact do so through their underwriters on their roadshows.
- The PSLRA safe harbor may—but just as likely may not—apply to de-SPACs, and, in any event, de-SPACs are subject to offsetting or even higher liability risks than C-IPOs because they include a “deal” (the de-SPAC), which under Delaware law may fairly be seen as giving rise to conflicts of interest subject to heighted judicial scrutiny because of the control exerted by sponsors over the SPAC.
- The SEC has yet to make rule changes in response to the SPAC surge of 2021, and the staff has only done what it has always done—provide its views on accounting and legal questions when asked.
- The SEC has not slowed down its reviews of SPAC filings, and difficulties SPACs may be finding as they work through the disclosure process are at least as often due to choices and mistakes they and their professionals continue to make.
- The application of the ICA to SPACs remains very much a live legal issue as of this writing.
Many of these myths may have been believed by people who repeated them, which is why they were “myths” and not simply lies. In fact, they may have had greater influence if they were repeated frequently and confidently by celebrity financiers and business market commentators, who believed what they were told by lawyers.
But to the extent those repeating these myths knew what they were doing, they were engaged in a type of “deep fraud,” akin to the buying and selling of “doubt” about science. The fraud was “deep” because it did not directly elicit money from deceived strangers. Its effects were general, indirect, insidious, and downstream. It played on beliefs about over-regulation that are widespread, if unfounded, and relied on elements of classic “cons” by encouraging people to believe that they are the ones getting away with something—by evading the risk of litigation that is portrayed relentlessly by political actors as opportunistic, and by avoiding strict regulations that conflict with common sense (no talking about the future!), even when those regulations do not, in fact, exist. The “deep fraud” pointed at familiar scapegoats (overzealous civil servants) to distract from poor financial returns and professional incompetence. It conditioned market participants to believe that an overall package of contracts and structures was better than it truly was.
To be clear, the point is not that SPACs themselves are fraudulent, although some notoriously were fraudulent. Nor is the claim that anyone involved in a particular SPAC was relying specifically on this market conditioning in a way that would be actionable under conventional fraud law. Rather, the point is that, by repeating continuously these myths, the professionals repeating them made it more likely that they would generate rents in future SPAC deals.
SPAC professionals did so by creating information conditions in which it was easier to convince entrepreneurs—who of course are not typically lawyers, and who depend on lawyers to supply the credence good that is legal advice—that the SPAC product was better than it was from a legal point of view. They pulled in overoptimistic sponsors who failed to account for sponsors’ historic failure rate to find sustainable targets—greater than 90 percent, as established by market data for the second half of 2021 and the first half of 2022. They used the myths to curry favor with potential clients predisposed to believe myths with a political tint. Most of all, however, they contributed to a breathless meta-narrative for business journalists to suck up and repeat, blinding resurgent retail investors with technical complexity and tales of regulatory overreach, to fall first for an overall financial product, and only second for the specific pre-revenue version of that product, armed with hockey-stick projections that would be laughed out of a C-IPO roadshow.
SPAC professionals could only do this, to be sure, if they worked for and alongside legitimate SPACs sponsored by professional, experienced managers drawing in sophisticated private equity funding to acquire real targets and generate good, if normal, returns. Sweepingly bad products die. SPACs did appear to have genuine advantages over C-IPOs—just not the bogus ones touted in the myths reviewed above. These apparent genuine advantages primarily involve disintermediating the fairly concentrated banking industry (as well as venture capitalists) from their dominant roles as underwriters and pre-public-owners in the going public process. They thereby may enhance competitive pressure on entrenched C-IPO professionals to service companies who are looking to go public. They may also facilitate the “matching” among potential investor/managers seeking to run a public company, and private company owner/managers seeking to both list and partner with new managers without giving up a full equity stake, as they would have to do to sell to private equity. When PIPEs are involved, SPACs also give companies seeking to go public a greater degree of control over who their shareholders will be post-listing. But if they have these benefits, they are not dependent on the mythical regulatory arbitrage that many SPAC promoters continue to tout as the best reason to choose the SPAC path.
The myths about SPACs make plausible a broader claim: Financial-legal innovation can permit promoters to exploit the credence good character of professional advice, perpetuate deep fraud about complex financial products, and distort markets and asset prices longer than conventional theory assumes. Proving (as opposed to suggesting) these claims remains a task for ongoing research. In future studies, it would be worth reviewing ways in which other complex financial-legal products have been promoted with persistent myths, as well as how and when “markets” learn better, if ever, and the role that conventional forms of securities regulation (disclosure mandates, gatekeeper requirements, and liability rules) play in helping markets to function efficiently.
In the short run, however, the type of deep fraud documented here supplies a reason for two sorts of regulatory responses. First, the SEC’s pending proposals should be finalized. They will reduce legal uncertainties in several ways. They will remove any doubt that the PSLRA safe harbor does not apply to de-SPACs, even as issuers remain able to provide cautionary language that will no doubt assist in reducing liability risk under the judicially developed “bespeaks caution” doctrine. As a result, companies will have to be more careful in presenting—and before that, in developing—projections. Some claim that the removal of the PSLRA safe harbor is somehow inconsistent with the requirement that companies present projections if they are used by a target board to approve a de-SPAC merger. But the only inconsistency involved is the apparent expectation of some SPAC industry participants that multiyear projections of a kind that would never be actually relied upon by a serious and well-advised board of directors could be publicly disclosed without meaningful caveats and also without any risk of liability when they turn out rapidly to have been consistently over-optimistic—not “projections” so much as “stretch goals” used to motivate rather than inform.
The proposals will also bring certainty to the ICA issues identified in Part IV.F. SPACs could rest comfortably outside the ICA but only if the conditions to the proposed safe harbor are met. While the shortening of the SPAC period in the proposal will chill some SPAC activity, the market has already demonstrated a decreased appetite for long SPAC periods, in line with a recognition that two years is just too long a period for investors to remain in limbo while sponsors engage in speculative search. Some may think that even the extension beyond the one-year limit period in the current exemption may be too “loose” of a policy. From my perspective, the choice between one year or eighteen months falls in a range of reasonable judgment, and, as long as the SEC revisits the question periodically, the benefits of experimentation are worth some risk-taking.
Finally, the proposals will elicit more and better disclosure about SPACs—both their economics and their legal attributes. Better understanding of the true costs of SPACs, as well as whether their sponsors have engaged in a traditional process to obtain a “fair” deal for investors, and if so, on what basis they conclude that the result is likely to be fair, can only help investors and markets appropriately price specific de-SPAC deals. The opaque elements of SPAC incentives and costs—the potential for self-interested but suboptimal target selection and pricing, and the typical, but not always easy to estimate, amount of dilution—will be easier to understand if the SEC’s proposals are approved and effectively enforced.
Even after these regulatory reforms, however, SPACs will remain a highly complex product, both legally and financially. Economically, they bundle the sale of equity with a fixed income product and several different kinds of derivatives. Legally, they vary significantly in their terms (despite their reliance on boilerplate in many aspects), and the details of various kinds of contracts and ongoing uncertainties about corporate law’s application to the standard SPAC process mean that, even with clear disclosures, SPACs will remain hard to evaluate from an all-in legal perspective. Regulators must continue to speak publicly and clearly about SPACs’ ongoing uncertainties to moderate market-and-pricing distortions that tend to emerge in the presence of such complexity. Information wars are won by persistent communication of truth. Authoritative speakers matter. Regulatory voices do not always drive out myths, but they can complicate the tasks of those who speak to exploit them, and weaken or shorten the duration of their power. The need for such speech extends beyond conventional and worthwhile efforts to educate retail investors. It extends to more sophisticated participants, whose sharpened skepticism about (for example) conventional business salesmanship may lull them into not realizing how vulnerable they may be to myths about law.
Detailed Summary of SPAC Law and Governing Contracts
1. SPAC Listing Standards
Most SPACs commit to adhere to a stock exchange’s listing standards. Before the modern SPAC was fully developed, many SPACs traded on the over-the-counter markets, but the greater liquidity of listed SPAC shares, the greater size of SPACs in 2021, and the greater attractiveness to investors of SPACs subject to listing standards, made listings an expected part of the SPAC process during the 2021 surge. Listing standards are sometimes fairly understood to be regulatory in nature, and for SPACs, they track the kinds (but not the details) of investor protections in SEC Rule 419, which was adopted in 1992 and which was initially aimed at SPAC-like companies—“blank check companies.” As one initial misunderstanding among investors, Rule 419—which would intuitively be of first-order importance for SPACs given that SPACs are “blank check companies” in the ordinary English language sense—is actually not applicable to most modern SPACs. The scope of Rule 419 is limited to “penny stocks.” Few SPACs in the 2021 boom were small enough to have issued penny stocks. Few SPACs, as a result, were required to comply with the investor protections in Rule 419. Instead, the listing standards provide key investor protections particular to SPACs.
Contrary to common understanding, listing standards are not private-law equivalents to SEC regulations. The remedy for breaching listing standards is delisting, not an SEC enforcement action. Nonetheless, once listed, companies are loath to risk delisting, so in practice many effective investor protections are contained in listing standards.
Taking the NYSE listing standards as an example, a SPAC must hold 90 percent of the proceeds of its IPO in a trust account until it has located a target for a de-SPAC that will use at least 80 percent of the amount held in trust (net of amounts provided to the target, such as for working capital). The NYSE also sets numerical minimums for non-affiliated initial SPAC investors along with other structural and qualitative requirements. Among them is a limit on the length of the SPAC period. The NYSE permits the SPAC period to run up to three years—not the two-year period typically seen in SPACs in 2021, or the fifteen-to-eighteen-month period seen in most SPACs in 2022—and provide for delisting at the end of that period. The NYSE listing standards also require independent board approval of the de-SPAC and require initial SPAC underwriters to waive the right to collect any deferred underwriter discount if the SPAC liquidates. They also importantly mandate redemption rights, which (when supplemented with other elements of the SPAC structure) give initial SPAC investors an effective fixed income security, with an option to hold onto (or through warrants, discussed below, increase) their equity stake at the de-SPAC stage. This package means that initial SPAC offerings consist of low-risk investments, at least for those sophisticated enough to exercise the rights they provide.
2. Initial SPAC Contracts
In connection with the initial SPAC offering, a SPAC enters into a suite of formal agreements with its sponsor, its initial underwriters, and sometimes other investors. A basic “SPAC agreement” among the sponsor, the SPAC, and the SPAC executives includes a commitment from the SPAC not to do a de-SPAC without consent of the sponsor, a waiver by the sponsor and the executives to their redemption rights, and their agreement that they have no claim on the trust. In the basic agreement, too, the executives commit to vote for the de-SPAC identified by the sponsor, and the sponsor agrees to liquidate (or redeem or both) if no de-SPAC is done in the SPAC period. The basic agreement also may contain “lock-up” restrictions on the sponsor and other SPAC founders, limiting when and how they can sell their equity stakes in the SPAC, the terms of which can vary across SPACs and for different participants in a given SPAC, and for different securities held by the same participant. The basic agreement also typically stipulates that neither the sponsor nor founding executives will receive any compensation from starting and running the SPAC, or from finding and completing a de-SPAC, other than that disclosed in the SPAC’s prospectus. The agreements commonly cap sponsor ownership at 20 percent of the SPAC.
Along with the basic agreement are side agreements with some or all initial investors that commit not to redeem their shares and/or to vote in favor of any or a specified de-SPAC. The material terms of these agreements, such as consideration investors receive for not redeeming, are not always disclosed, although the legality of their omission from the public record is unclear. Other initial SPAC agreements may include:
- an initial securities purchase or subscription agreement between the SPAC and sponsor through which the sponsor obtains its basic equity ownership of the SPAC in return for a nominal investment, typically $25,000,
- a promissory note to the sponsor to fund start-up costs, typically up to $300,000,
- a registration rights agreement designed to secure liquidity for the SPAC securities acquired by the sponsor,
- indemnity agreements to enable the recruitment of SPAC directors,
- one or more forward purchase agreements between the SPAC and affiliates of the sponsor (or other third parties) committing them (or giving them an option) to help fund the de-SPAC,
- office sharing agreements, transitional service agreements, or intellectual property licenses between the SPAC and the sponsor or an affiliate to support the operations of the SPAC in the SPAC’s initial period, and
- financial consulting service agreements, sometimes with affiliates of the sponsor, effectively increasing the size of the sponsor’s promote.
All of these SPAC agreements are in addition to those that typically accompany any public offering, such as underwriting agreements, syndicate agreements, and agreements regarding comfort letters, legal opinions, and officers’ certificates. SPAC contracts are collectively more complex than contracts that accompany a typical C-IPO.
3. SPAC Warrants
Warrants and rights make up an unusually large and variable contingent set of equity claims in SPACs. Some SPACs have omitted warrants, but in most SPACs, they represent a significant part of the capital structure. Their terms are important to how SPACs function. Among varying terms are when warrants are exercisable and for how long, at what strike price, for how many shares, whether and on what terms the warrants are subject to redemption (commonly upon closing of a de-SPAC), when they expire (commonly thirty days after the closing of a de-SPAC, but some have longer durations), and how they may be adjusted to reflect dividends on the SPAC’s common shares. These terms are often set out in lengthy warrant agreements and certificates. Typically, the warrants sold to the public in a SPAC’s initial offering trade as a “unit” with the common shares, but not all SPACs address this issue identically.
SPAC warrants come in several varieties. SPACs commonly sell warrants to the public in the SPAC’s initial offering (“public warrants”), sell other warrants, on different terms, to the sponsor in a private placement (“private warrants”), sell still other warrants (“forward purchase warrants”) to investors affiliated with the sponsor or the SPAC in connection with forward purchase commitments to fund the de-SPAC, and commit to issue still other warrants (“working capital warrants”) in the event the sponsor or the SPAC managers loan the SPAC funds to stand up its post-de-SPAC operations and wish to convert those debt obligations in whole or in part to equity. Further complicating matters is the fact that SPACs often have side contracts with their sponsors or other subsets of shareholders regarding voting, and with warrant holders regarding their redemption and other rights, which create further variations in governance and ownership entitlements. Due to these variations, SPAC capital structures are more complex than is typical for a C-IPO.
Due to the listing standards described above, another key (but variable) set of terms specify redemption rights. These rights give initial SPAC investors the ability to redeem their shares for cash up to the closing of the de-SPAC transaction, and also commonly mandate redemption at the end of the SPAC period. Due to redemption rights, a SPAC, in its initial, pre-operating-stage, is functionally similar to a mutual fund (whose investors are able to redeem their shares at net asset value at any time). But unlike a mutual fund, SPAC redemption rights effectively die after its initial phase—so that, after the closing of the de-SPAC, a SPAC effectively converts from having the economics of a mutual fund to those of a conventional operating company.
4. GAAP Financials, PCAOB Audits, and Accounting for Warrants and Redeemable Equity
SPACs—as with all public companies—are required to include financial statements compliant with GAAP and audited by an independent audit firm subject to oversight by the PCAOB. For the most part, accounting and auditing initial SPACs is relatively simple, as they have no operating businesses, which typically generate the greatest number of choices and judgments in accounting and auditing.
A. Redeemable Shares as Mezzanine Equity
One SPAC-specific accounting question is the classification of securities as equity or debt. As noted above, SPACs issue redeemable shares to the public in their initial phase. The accounting guidance from the FASB on this classification is simple in concept: If the shares are redeemable at the option of the holder, or upon the occurrence of an event that is not “solely” within the control of the issuer, the security should be recognized “temporary” equity. Sometimes labeled “mezzanine” equity, such shares are not properly included in total (permanent) shareholder equity. This accounting treatment dates back to the 1970s when the SEC staff addressed the appropriate accounting treatment of redeemable preferred securities.
As applied to SPACs, the accounting is seemingly straightforward, and would be quite salient, given that redeemable equity is one of the core features of SPACs that distinguish them from other public companies. Standard redemption triggers—the occurrence of a de-SPAC or failure to engage in an acquisition within the SPAC period—are clearly not “solely” within the control of the SPAC, because they require negotiation with third parties and are subject to a number of customary conditions. Many SPACs, accordingly, accounted for the redeemable shares as temporary equity.
Some SPACs, however, have specified in their charters that de-SPAC-related redemptions would not occur to the extent they would bring the SPAC’s net tangible equity below $5 million. This term has reportedly been included for two reasons: The SEC’s Rule 419 may apply to SPACs if they have less than $5 million of net tangible assets, and because Nasdaq’s listing standards require listed companies to have that much net tangible equity, as “demonstrated on the … most recently filed audited financial statements filed with, and satisfying the requirements of, the [SEC].” Based on the idea that some portion of every share was subject to this $5 million limit on redeemability, many SPACs (and their auditors) took the view that $5 million of the shares could be classified as regular or “permanent” equity.
However, this condition to the redemption rights is not linked to any particular set of redeemable shares, because one cannot identify precisely which (or whether any) of the shares will not be redeemable due to the $5 million qualification. More importantly, all shares remain potentially redeemable under conditions that are not “solely” within the control of the company—in effect, the $5 million qualification simply specifies a possible reason that redemption might be deferred or delayed, but the qualification does not eliminate the possibility that the shares will be redeemed under circumstances not “solely” within the issuer’s control. And still more importantly, SPAC shares also typically include a separate right—not subject to the $5 million qualification—that they be redeemed if the SPAC has not achieved a de-SPAC prior to the end of the SPAC period. As a result, all such shares should be accounted for as “temporary equity.”
B. Warrant Contracts as Liabilities
Another prominent and material feature of SPACs—warrants—also raise accounting questions. As derivative contracts, warrants are not straightforwardly accounted for as common equity, because warrant terms vary, and some warrants produce returns that are closer to fixed income returns than to equity returns. As a result, warrants have long been treated differently under GAAP, depending on their terms. As with mezzanine equity, authoritative statements by the FASB on warrant accounting were included as part of FASB’s 2009 codification of GAAP. But the content of those statements—including the fact that warrants receive varying treatment depending on their terms—is older and was discussed repeatedly as part of Emerging Issue Task Force Issue No. 00-19 over fifteen years, from 1987 through 2002.
The content of that guidance is complex. Warrant accounting turns on the precise terms of the warrants, which vary from SPAC to SPAC. Specifically, at the risk of some simplification, ASC-815-40-15 provides that warrants should be accounted for as equity if they are “indexed” to equity. To be “indexed,” their settlement amount must equal the difference between the fair value of a fixed number of equity shares and a fixed price—a so-called “fixed for fixed” amount. If adjustments are made to such an amount, the warrants can only be accounted for as equity if the “only variables that could affect the settlement amount would be inputs to the fair value of a fixed-for-fixed forward or option on equity shares.” That general conclusion holds even if the warrants may be settled in cash, but only if all shareholders generally receive cash in the same circumstances and the event is not within the issuer’s control. The same guidance treats transactions that do not involve a change of control as being within the issuer’s control—thus, tender offers for all of a company’s shares would qualify, but tender offers for only one class of a company’s shares, not causing a change of control, would not qualify. The basic concepts under the qualifications to those two points—a limit on alternative inputs to the calculation of the shares underlying the warrant, and carefully limiting when warrants can be cashed out by the issuer—are intuitive. If the formula for what warrant exercise produces for the holder (and for what the company must issue to that holder) deviates from a standard option model, then the warrant contract economics deviate from holding (or having issued) equity itself. If the exercise of a warrant yields cash, rather than equity, then the warrant is not really an equity equivalent.
While intuitive in concept, those conditions on equity treatment are not always simple to apply. Specifying when an event falls within when an issuer’s control is not always clear, and estimating the “fair value” of an option is not a simple task. Standard option models vary. Nonetheless, with respect to the elements of fair value, the FASB’s guidance prescribes limits. It lists the fair value inputs for an equity option (share price, term, dividends, cost of borrowing stock, interest rates, share price volatility, the issuer’s credit spread, and the ability to maintain a standard hedge position). It does not list other factors. Similarly, the limit on cash payouts (even if other shareholders are to receive cash) applies only to events outside the issuer’s control, and while “control” is not always self-defining, it seems clear that a tender offer for less than a majority of all of a company’s classes of equity would not be “beyond” an issuer’s control.
More specifically, with respect to standard SPACs, warrants do not necessarily provide for cash settlement simply because the holders received cash for their equity, and they commonly settle differently depending on the identity of their holders. Specifically, a typical SPAC warrant agreement allows for forced redemption of “public warrants” for a nominal amount if certain conditions are met (commonly if the stock price reaches $18 or higher for twenty out of the previous thirty trading days). Effectively, holders are forced to exercise their public warrants upon notice of redemption. However, warrants held by the SPAC sponsor or other designated parties are not subject to the same forced redemption. As a result, the redemption price may not be the same for all outstanding warrants, even though they were initially placed at the same time and subject to the same agreements. Because the identity of the holder is not an input to a fair value model for options, this differential treatment in warrant agreements takes them out of equity treatment, and they must be accounted for as liabilities.
Likewise, in a typical SPAC public warrant agreement, a “tender offer” clause allows for a cash settlement of the warrants in the event of a tender or exchange offer made to and accepted by holders of more than 50 percent of the outstanding shares of a single class of common stock. If there are multiple classes of stock (as is typical for SPACs, because founder shares and public shares are typically different classes), such a clause would allow for a cash settlement even in cases where there has been no change in control of the company. Given such a clause and such a capital structure, the public warrants would fall outside an exception that would otherwise be available, because cash payments could be made to settle the warrants without a change in control. Such warrants must be accounted for as liabilities. Whether the FASB’s strict treatment of this issue is reasonable could be debated, but the rule can only be read reasonably in one way. SPACs with warrants having such provisions that initially accounted for them as equity have, since the SEC staff statement, typically restated their financial statements to account for them as liabilities.
5. Corporate “Contracts”
In keeping with the acronym, a SPAC typically consists of a corporation that is an empty shell company with minimal or no assets that is intended to seek out an acquisition target. The charter and bylaws (and the background corporate statute and common law) provide a set of foundational components to SPAC law, as with any other form of corporate organization. Among key corporate law attributes of a SPAC are its capital structure and the voting, liquidation, and redemption rights of its owners. Corporate law also imposes fiduciary duties on the board and officers of the SPAC—open-ended standard-like obligations that are the subject of substantial ongoing litigation in the Delaware courts, as of this writing.
For a SPAC, corporate law functions more like a contract than for a non-SPAC firm, because a SPAC is not an operating company, over which a board exercises discretionary business judgment—a fundamental feature of corporate law and critical to governance regarding non-contractible or hard-to-contract-about contingencies. Instead, SPAC corporate law largely reduces to the terms of the charters and bylaws, which vary from SPAC to SPAC. For example, about 20 percent of SPACs have dual or multi-class structures and others a more conventional one-share/one-vote structure, either in the initial SPAC stage or in the de-SPAC stage or both.
Voting rights were once important in SPACs, because they affected the process through which initial investors could and did participate in approving the de-SPAC. Prior to 2010, de-SPAC voting rights were linked to redemptions, much as corporate statutes link appraisal rights to dissenting votes regarding a merger. Only if a SPAC investor voted against a proposed de-SPAC could they redeem their shares, and if they did vote against the de-SPAC, their shares would be redeemed. This redemption right created the risk of a “hold-up,” where concentrated and sophisticated initial-stage investors could threaten to vote against a de-SPAC deal, even a good one, to extract side payments. SPACs now typically decouple the voting and redemption rights. This may create its own problems, however, as argued by Professors Rodrigues and Stegemoller.
6. SPAC Trust Agreements
To back up redemption rights, and to comply with listing standards, a SPAC settles a trust with a third-party bank, into which proceeds of the initial SPAC offering are placed and held separate from the SPAC’s assets, pending use in the de-SPAC or to pay redemptions, subject to specific exceptions, such as SPAC taxes. Redemptions leading up to the closing of the de-SPAC (or redemptions upon expiration of the de-SPAC period) are paid out of the trust. The trust agreement is designed to prevent SPAC sponsors or managers from absconding or misusing the proceeds of the initial SPAC offering while the SPAC hunts for a target.
As is typical for third-party trusts, such trust agreements are highly standardized, and create an almost-auto-pilot way for trustees to know when and how much to distribute from the trust with form instructions attached to the trust agreement to use in the event of specified payout contingencies. To keep SPAC costs low, the trustee earns a grand total of roughly $15,000 for its services if the de-SPAC is completed within one year. Nonetheless, because the trust agreements cross-reference the SPAC’s charter, its agreements with the SPAC underwriters and sponsor, and (implicitly) the terms of the SPAC securities (including variations created by agreements with sponsors), their effective terms are also variable. SPAC trusts are useful, but add to the overall complexity of the SPAC path to a listing.
Most if not all SPACs raise additional funds as they approach an identified de-SPAC acquisition. They do so to increase their acquisition capacity and amass capital to infuse into the target, but also to counteract redemptions of shares by initial investors, the precise amount of which cannot be known with certainty by the SPAC or the target in advance. These additional funds are typically raised through private placements, which, because the SPAC is already a public company, fall into the category of capital transaction traditionally called PIPEs. Unlike traditional PIPEs, however, SPAC-PIPEs are negotiated as part of the lead-up to the SPAC acquiring an actual business, which is effectively going public through the de-SPAC. As a result, typical SPAC-PIPE processes, economics, and contract terms differ from conventional PIPEs, and add still more complexity to the SPAC universe.
In terms of process, ordinary PIPEs are commonly sought from a limited number of potential investors, partly to keep the fact of a potential securities sale confidential and partly to speed up the investments, permitting them to be completed in two weeks or less from initiation. While some SPAC-PIPEs also target one or two investors, SPAC sponsors have increasingly been broadening the set of potential PIPE investors beyond a set of specialized institutions, e.g., BlackRock, Fidelity, T. Rowe, and are now reportedly conducting mini-“road shows” leading up to a PIPE, akin to what is done in a C-IPO, over many weeks or even months. SPAC sponsors now reportedly approach as many as a hundred or more potential PIPE investors to obtain the desired funding.
Complete data on the number of investors who are offered, or even those who are sold, PIPE securities are not available, because current SEC rules do not require disclosure of such details, unless a given private placement triggers specific regulations, e.g., public disclosure following the acquisition of more than 5 percent of target securities. SPACs typically have incentives to disclose the identity of prominent or well-regarded PIPE investors, because doing so “certifies” the merits of the SPAC. Many SPACs thus voluntarily disclose the identities of the investors who actually purchase PIPE securities. Others, however, do not, which may, in some cases, involve spurious or fake PIPE announcements, designed to manipulate the SPAC’s stock price or increase its bargaining power in advance of a de-SPAC negotiation.
In terms of economics, ordinary PIPEs are more commonly conducted by smaller and mid-sized companies, which often face hurdles when raising money. Professors Lim, Schwert, and Weisbach reported that 90 percent of non-SPAC-PIPEs involved issuers under $1 billion in market capitalization and the median book value of the issuers was $51 million. SPAC targets are sometimes small or mid-sized, but PIPEs are also being used in de-SPACs when the targets are large—commonly in excess of $1 billion. Non-SPAC-PIPEs routinely involved discounts, as do SPAC-PIPEs, but SPAC-PIPEs have commonly involved discounts that would be large (if not unheard of ) in non-SPAC-PIPEs.
As for legal terms, in an ordinary PIPE, the company issuing the private securities is, by definition, already a public company, so the investors conduct a due diligence investigation on that public company, subject to a confidentiality agreement. In a SPAC-PIPE, the company that enters into a securities purchase or subscription agreement with the investor is often the SPAC itself, in cooperation with the de-SPAC target, and the investors conduct a due diligence investigation on both the SPAC (including all of the financial and legal arrangements sketched above) but more importantly the target (which has an operating business). This requires a three-way negotiation and legal commitments from the to-be combined SPAC/target, including (as typical in a PIPE) registration rights. Also, unlike a typical PIPE, the SPAC-PIPE investor and the SPAC and its sponsor agree to support the de-SPAC deal.
Collectively, PIPEs are an important part of the SPAC process that nonetheless add significant complexity and variation in SPAC terms, both legal and economic.
8. The 1933 Act and Related Regulations
With so much complexity embedded in the private and quasi-private law governing SPACs, it may come as something of a relief that the primary law governing the first phase of a SPAC is comparatively simpler than in a C-IPO. Both initial SPAC offerings and C-IPOs are governed by the 1933 Act and related regulations. Both require the filing of a registration statement with the SEC and amendments thereto that respond to staff comments. (The staff traditionally reviews all IPOs. Through the initial part of 2021, that tradition of all IPO filings included SPAC offerings. Starting in the spring of 2021, staff review of initial SPAC filings was curtailed to free up resources to review de-SPACs, which were beginning to surge. Both initial SPAC filings and C-IPOs require audited financial statements.
Unlike C-IPOs, however, the initial SPAC has no business to describe, and, as a result, its financial statements are comparatively simple. The SEC’s Form S-1 requires disclosure of the SPAC agreements and underwriting contracts, as well as the corporate charter and bylaws and capital structure of the SPAC, including SPAC warrants. However, the bulk of the disclosures could be produced by borrowing boilerplate from prior SPACs. The timing of an initial SPAC offering, moreover, would not be complicated by selling an operating company’s shares through a conventional roadshow. Instead, SPAC underwriters face the comparatively simply task of assembling a potentially small group of hedge funds and SPAC enthusiasts to buy the initial SPAC shares, which have both downside protection (redemption rights), a guaranteed return (due to the trust and the contracts described above), and optionality as to a target company hoped to be acquired in a future de-SPAC (the ability to continue as investors, or even buy more shares via the public warrants).
As a result, the typical initial SPAC underwriting has taken no longer than the process for C-IPOs, and many have taken less time. All of the initial SPAC offerings on Form S-1 filed in January 2021, for example, were declared effective and the offerings completed within three to four weeks, and previously filed confidential draft registration statements were cleared for filing on Form S-1 within four to six weeks of final effectiveness. C-IPOs filed in 2020 and early 2021, by contrast, took no less time (a month) to move from Form S-1 filing to effectiveness, and the time between the DRS filings and Form S-1 filings typically taking a month more, for an effective processing period roughly double that for SPACs. This is not surprising—a review of SEC staff comments on SPAC initial offerings shows them to include relatively few, if any, comments, which typically focused on redemption rights and potential extensions of the SPAC period.
Of course, this timing advantage is not the central point for comparing SPACs to C-IPOs. From the eventual SPAC target’s perspective, the more important timing component is the length of the period from the decision to proceed with the de-SPAC to the completion of the de-SPAC deal. As discussed in Part IV, the SEC’s review process is not materially longer for C-IPOs than for de-SPACs.