Calls For New SPAC Rules And Hints At PSLRA Change

For months, the SEC Chairman Gary Gensler has expressed concern over the meteoric rise of SPACs and has dropped teasers about stepped-up enforcement to come. Now, the time for the main event is almost here. According to Chairman Gensler, the Commission’s guiding principle as it devises proposed rules for SPACs in the coming months should be—to borrow from Aristotle—to “treat like cases as like.” That is, the Commission should strive to align SPACs’ structure and regulatory obligations more closely with those of a standard IPO. 

Chairman Gensler identified three areas of interest: information asymmetries between early and late investors, the use of misleading or fraudulent information in marketing materials, and updating liability regimes to mitigate conflicts of interests among a SPAC’s sponsors and the investing public. As for how the Commission will achieve these goals, Chairman Gensler called on the SEC staff to develop new proposed rules by spring 2022 and expressed support for additional avenues for private litigation against SPAC “gatekeepers.” The latter of these changes could mean paring back the safe-harbor provisions of the Private Securities Litigation Reform Act (“PSLRA”), which has protected SPAC sponsors from civil liability for their forward-looking statements.

Chairman Gensler’s remarks offer the clearest vision yet of how the Commission will shape SPAC transactions going forward and suggest that Gensler would like to enlist both the SEC and private plaintiffs in that effort. Aristotle might have opined centuries ago that “the Law is Reason free from Passion,” but it seems that the SEC is growing more passionate (and specific) about the impending SPAC crackdown.

The Early Bird (Or Investor) Gets The Worm

As explained in my prior Article, ‘SPAC-Tacular’ Growth Means More Enforcement Ahead, SPACs are companies formed with no commercial operations whose purpose is to raise capital to acquire another company. Because the SPAC is little more than a name with a robust bank account, a SPAC can conduct an IPO with less regulatory friction than a traditional IPO. Once the SPAC has gone public through its streamlined IPO, it sets out on the next phase of its lifecycle: identifying and acquiring a private company—the so-called “target company.” If approved by the SPAC shareholders, the SPAC purchases the target company using the funds raised during its IPO, the companies merge, and—voila!—the newly created operating business is listed on a public exchange. Additionally, after the announcement of a merger, the SPAC must give its public shareholders the option to redeem their shares at the original price. In order to offset the potential deficit of operating capital following this redemption period, a SPAC will often shore up the balance sheet of the eventual operating company using a private investment in public equity—or “PIPE”—wherein the SPAC raises further capital through a sale of some of its public shares to institutions or wealthy individuals. Since arriving at the SEC in April 2021, Chairman Gensler has signaled that the Commission was concerned about protecting retail investors in the midst of the SPAC boom that resulted in SPAC deals worth $370 billion in 2021. 

A central aim of the SEC’s regulatory agenda is opening the spigot of information to retail investors who purchase shares later in the SPAC process. In December 2020, for example, the Commission released informal guidance regarding what it considered best practices for SPAC disclosures, which centered on giving retail investors more insight into the interests of a SPAC’s sponsors and how the SPAC evaluated the company it planned to acquire. The guidance instructs that at each stage of the SPAC’s lifecycle—from the SPAC’s IPO to the merger with the target company—the SPAC’s sponsors, directors, and officers should disclose their financial incentives (in particular any conflicts between their compensation and the interests of the SPAC’s shareholders), and explain the business rationale behind their selection of a target company. 

Chairman Gensler’s December 2021 remarks bring into focus the kinds of information asymmetries the SEC will seek to remedy, and identify a particular feature of SPAC financing as problematic—the PIPE transaction. Theoretically, the PIPE is intended to provide an infusion of cash that the SPAC can use to finance the new operating company. As Chairman Gensler sees it, however, the typical result of the PIPE transaction is a privileged class of investors. Often, the PIPE investors are large, wealthy institutions and the PIPE affords them the opportunity to purchase shares of the SPAC at a discount just before a splashy merger with the target company. This preferential access gives PIPE investors early access to information about the target company, which they can use to sell their shares just as the hype around the merger reaches its apex. PIPE investors can use this information advantage to reap a profit by offloading their shares, leaving the public investors with diluted positions.

Chairman Gensler has asked the SEC staff for recommendations for better disclosure “about the fees, projections, dilution, and conflicts that may exist during all stages of SPACs, and how investors can receive those disclosures at the time they’re deciding whether to invest.” Although the exact contours of the Commission’s posture will have to wait until the staff’s proposal, it is likely that the Commission will attempt to empower public retail investors with the same knowledge possessed by institutional PIPE investors through additional disclosures before small investors decide to purchase shares. 

Take Off Your Rose-Colored Glasses (In SPAC Marketing)

Chairman Gensler also noted that when announcing the proposed target company, SPACs often prime the market for its shares with sophisticated marketing practices. Often, Gensler explained, SPACs announce their Target with a glitzy slide deck, a bombastic press release, or the backing of a beloved celebrity or financier. Although these initial public statements make for eye-catching headlines, they fall short of the rigorous disclosures that the SEC considers crucial for informed investing. Indeed, SPACs’ use of high-profile endorsements or shiny press materials, Gensler explained, contravenes a core tenet of U.S. securities laws: that insiders in a company—here, the SPAC’s sponsors—should not be allowed to use incomplete marketing materials to drum up demand for stock before the required disclosures reach investors.

SPACs’ supposed use of incomplete marketing materials has been a consistent area of focus for the SEC in both the Commission’s interactions with specific SPACs and in general guidance released to the investing public. In March 2021, for instance, the SEC issued an investor warning against the dangers of assuming that a SPAC is a wise investment simply because of the glitz and glamour of celebrity involvement. In July 2021, the SEC torpedoed the SPAC spearheaded by Bill Ackman, the celebrity financier with a penchant for aggressive investing. Although the SEC did not offer specifics about its objections to the transaction, it surely noticed that the buzz around Ackman’s SPAC reached a fever-pitch among retail investors whenever Ackman hinted at a potential target. 

Now, the SEC appears ready to address what it considers to be SPACs’ improper use of marketing materials to juice demand for stock with concrete regulations targeted at SPACs as a class of investment vehicle. Gensler called on the SEC staff to develop a more comprehensive disclosure regime for SPACs when they announce their target acquisition. Based on Gensler’s comments, SEC regulations or guidance are likely to require a SPAC to make additional disclosures at the time it announces a target company, the hope being that a sober analysis of the long-term viability of the target acquisition will drown out the braggadocio of a SPAC’s sponsors, thereby allowing investors to make an investing decision without being swayed by a SPAC’s marketing hype. Practically, a more demanding disclosure regime would mean that SPACs will be compelled to perform more thorough due diligence on potential targets for acquisition and compile a more fulsome disclosure earlier in the process.

Batten Down The Hatches—SPACs Could Lose Safe Harbor Of PSLRA

An important adjunct to the SEC’s own enforcement is the use of private plaintiffs to combat securities fraud with lawsuits against SPAC sponsors. Although a few private plaintiffs have brought suit against SPACs for allegedly misleading statements about a target company or for improperly acting as an investment company, the plaintiffs’ bar has been quieter than one would expect thus far, given the explosion of SPACs in 2021. 

One reason that SPACs may have largely evaded securities class actions is that they currently fall under for the safe-harbor provision of the Private Securities Litigation Reform Act (“PSLRA”). Under the PSLRA safe harbor provision set forth at 15 U.S.C. § 77z–2, issuers in certain filings are immune from liability in civil litigation for forward-looking statements about a company’s prospects, as long as the projections are made in good faith and are accompanied by a warning that the projections are uncertain. Importantly, the PSLRA excludes from the safe harbor statements made in connection with an IPO or those made by “blank check companies.” SPACs, however, have not traditionally been considered to fall under either exclusion, and forward-looking statements by SPAC sponsors are thus protected by the safe harbor. 

The SEC has supported closing this apparent loophole. In April 2021, the then-Acting Director of the SEC Division of Corporation Finance, John Coates, argued the SPAC’s merger with a Target was akin to an IPO and that SPACs should not be immune from private litigation alleging material misstatements by finding cover under the PSLRA’s safe harbor provision. 

Coates’ statement included the standard language that his interpretation of the PSLRA was not a binding pronouncement of the SEC, but only his personal view. Chairman Gensler appears to share Coates’ assessment and may be ready to make it the formal view of the Commission. In his December 2021 remarks, Gensler warned that there “may be some who attempt to use SPACs as a way to arbitrage liability regimes.” The sponsors, accountants, and advisors behind a SPAC’s acquisition of a target company, Gensler suggested, should be subject to civil liability for inadequate due diligence or material misstatements just like underwriters of a traditional IPO. Gensler asked for recommendations from the SEC staff about how the Commission can “better align incentives between gatekeepers and investors, and how [it] can address the status of gatekeepers’ liability obligations.” In the end, the Commission would likely need Congress’s help to amend the PSLRA to exclude SPACs from its safe harbor provisions, and the House Committee on Financial Services released draft legislation that would do just that. Nevertheless, were the SEC to take a formal position that SPAC sponsors should face greater liability for their prospective statements regarding target companies, it would provide powerful momentum for a sea change in private securities litigation that would surely lead to more litigation against SPAC insiders. 

A Springtime SPAC Surprise

With the SEC targeting April 22, 2022 as the date by which it hopes to issue a proposed rule or guidance about SPACs, the investing public will not need to wait long before finding out exactly what the SEC has planned. If one reads the tea leaves of Chairman Gensler’s recent remarks, however, spring 2022 likely will see the Commission impose additional disclosure requirements on SPACs regarding their structure and potential conflicts of interest, curb inflated marketing strategies, and push for additional avenues for private litigants to sue a SPAC’s insiders for their forward-looking statements. Whether shifts in the Commission’s posture toward SPACs puts a dent in their popularity on Wall Street remains to be seen. If—to quote Aristotle one last time—“We are what we repeatedly do,” the SEC’s persistent focus on SPACs, culminating in Chairman Gensler’s recent comments, shows that the Commission intends to exert significant influence over the SPAC market in the coming months.

Anthony Sampson, an associate at the firm, assisted in the preparation of this blog.

To read more from Robert J. Anello, please visit www.maglaw.com.