SEC SPAC Enforcement: Disclosure Requirements and Risks

SEC SPAC Enforcement: Disclosure Requirements and Risks

Special purpose acquisition companies, or SPACs, have become an increasingly popular way for companies to go public in recent years. However, the SEC has raised concerns about the risks to investors from inadequate disclosures and conflicts of interest. This article will examine the SEC’s efforts to enhance disclosure requirements and investor protections relating to SPACs.

What are SPACs?

A SPAC is a company that raises money through an initial public offering (IPO) in order to acquire or merge with an existing private company and take it public. The SPAC does not have any actual business operations itself – its sole purpose is to find and acquire a target company. The money raised by the SPAC in its IPO is held in a trust account until a merger target is identified. If no deal is made within the specified timeframe, usually 2 years, the SPAC is dissolved and the money returned to investors. Some key advantages of a SPAC merger over a traditional IPO include:

• Faster timeline – SPAC mergers can happen much more quickly than a regular IPO process
• Known valuation – The valuation is set at the time the merger is announced, vs an IPO where the price is determined on the first day of trading
• Less uncertainty – There is more certainty that the listing will be completed since the SPAC already has secured financing

While SPACs have been around for decades, they surged in popularity in 2020 and 2021. In 2021 alone, over 600 SPAC IPOs raised a total of $160 billion, up from 248 SPAC IPOs and $83 billion raised in 2020.

SEC Concerns Over SPAC Disclosures

In March 2022, the SEC proposed new rules aimed at improving disclosures from SPACs during the IPO process as well as disclosures made to investors in connection with a proposed merger or acquisition. The goal is to provide investors with information comparable to what they would receive during a traditional IPO process. As SEC Chair Gary Gensler stated:

“Functionally, the SPAC target IPO is being used as an alternative means to conduct an IPO. Thus, investors deserve the protections they receive from traditional IPOs, with respect to information asymmetries, fraud, and conflicts, and when it comes to disclosure, marketing practices, gatekeepers, and issuers.”

Some of the key new disclosure requirements proposed by the SEC include:

• Enhanced disclosures during the IPO stage about the SPAC sponsors, structure, fees, conflicts, and share dilution.
• Disclosures about the process for searching and selecting a merger target, including any contacts or discussions that have already taken place.
• Projected financial information for the target company, including key assumptions and sensitivities.
• Disclosures about the background of directors and officers of the target company, as well as any regulatory issues they may have been involved in.

The proposed rules would also amend the safe harbor for forward-looking statements under the Private Securities Litigation Reform Act as it applies to SPACs. This would make it easier for investors to recover damages if a SPAC makes unrealistic projections about the future combined company.

SPAC Liability Risks

In an April 2021 public statement, SEC officials raised concerns about whether liability protections for investors are sufficient given the way some SPACs promote themselves:

“Are current liability protections for investors voting on or buying shares at the time of a de-SPAC sufficient if some SPAC sponsors or advisors are touting SPACs with vague assurances of lessened liability for disclosures?”

They noted that private companies going through a SPAC merger often have no more track record of disclosures than those doing a traditional IPO. Yet SPACs are sometimes marketed as having less liability risk compared to an IPO. This raises investor protection concerns if those representations are overstated or misleading.

Some of the key liability risks involved with investing in a SPAC include:

• Securities Act Section 11 liability – This covers material misstatements or omissions in a SPAC’s registration statement, such as an unrealistic valuation or inadequate risk disclosures.
• Exchange Act Rule 10b-5 liability – Makes it illegal to engage in manipulative or deceptive conduct in connection with the purchase or sale of securities.
• Securities Act Section 12(a)(2) liability – Creates liability for material misstatements in oral or written communications related to selling or offering securities.
• Exchange Act Section 14(e) liability – Covers material misstatements or omissions in connection with a tender offer, including a de-SPAC transaction.

While SPACs do involve certain liability safe harbors, such as the PSLRA safe harbor for forward-looking statements, investors may still have remedies if a SPAC makes false or misleading statements. The SEC has cautioned that SPACs should not overstate any purported liability advantages they may have over traditional IPOs.

SEC Enforcement Actions

The SEC has already brought enforcement actions against some SPACs for misleading disclosures and misrepresenting facts to investors:

• In July 2022, the SEC charged Digital World Acquisition Corp with failing to disclose that it had talks with Trump Media & Technology Group about a merger before DWAC’s own IPO as a SPAC. DWAC also misled investors about diligence it had performed on the social media company.
• In December 2021, the SEC charged Nikola Corp for misleading investors about its products, technical advancements, and commercial prospects in the run-up to its merger with a SPAC. Nikola’s founder Trevor Milton was charged for making false statements directly to investors.
• In July 2021, the SEC charged Stable Road Acquisition Corp for misleading claims about due diligence done on Momentus Inc, the space transportation startup it acquired via a SPAC merger.

These enforcements show that SPACs are firmly on the SEC’s radar. SPACs must take care to provide full and accurate disclosures to investors about their operations, prospects, risks, and diligence processes. Otherwise they are at risk of facing SEC charges with potentially serious penalties.

Accounting and Reporting Issues

The complexity of certain financial instruments and arrangements in SPAC deals can also lead to accounting and reporting issues if not properly handled. In April 2021, the SEC highlighted challenges with properly accounting for warrants, which are often included as part of the units issued in a SPAC IPO.

Warrant agreements often include terms like price-based anti-dilution provisions that require complex derivative accounting under GAAP. In some cases, SPACs did not properly account for warrants as liabilities, resulting in material misstatements of net income in their financials. The SEC has pushed SPACs to properly evaluate the accounting implications of warrant terms and correct any errors in prior reporting.

Other common accounting problem areas for SPACs include:

• Incorrectly accounting for redemptions of shares as equity transactions rather than liabilities
• Not appropriately classifying convertible debt, which may require bifurcation and derivative accounting
• Improperly netting different classes of shares on the balance sheet
• Flawed analysis of effective control leading to incorrect consolidation conclusions

SPACs involve very complex transactions, with terms and deal structures evolving quickly. The SEC expects SPACs to maintain robust accounting policies and processes to ensure financial reporting is compliant with all requirements.

Investor Implications

For investors evaluating investment opportunities in SPACs, the SEC recommends carefully reading through the IPO prospectus, merger proxy statements, and other SEC filings by the SPAC. This will help ascertain the true economics, dilution, risks, and potential conflicts involved. Areas of focus include:

• Sponsor compensation – The SPAC’s founders often receive 20% or more of the shares for a minimal investment.
• Redemption rights – Understand the impact if a substantial number of investors redeem their shares.
• Dilution – Estimate the potential future dilution from warrants, earn outs, and convertibles.
• Conflicts – Look for disclosures on affiliate transactions and conflicts in the de-SPAC process.
• Projections – Scrutinize the reasonableness of any financial projections and how they were developed.

The SEC advises investors to go beyond the hype and scrutinize SPAC deals just as they would for any investment opportunity. While SPACs can offer advantages, they do not represent a free pass on performing due diligence. As with any investment, understanding the risks and downsides is just as important as the potential rewards.