SEC explores tighter investor protection around SPAC transactions
31 March 2022 US
Image: AdobeStock/ qingwa
The US 色花堂and Exchange Commission (SEC) has proposed reforms designed to improve investor protection relating to business transactions conducted through special-purpose acquisition companies (SPACs) and shell companies.
The past two years have witnessed an unprecedented rise in the use of SPAC vehicles as an alternative means of public listing, according to the SEC. SPAC IPOs generated more than US$160 billion in 2021, a fifteen-fold increase on 2020, according to Commissioner Allison Herren Lee.
The SEC has reacted to this trend with a package of measures targeted to promote greater transparency and accountability in the SPAC market.
SPACs typically work through two key transactions. A SPAC sells shares in a shell company to generate funds with the intention of merging with or acquiring a 鈥榯arget鈥� private operating company. The shell company does not have independent operations, but does have a group of professionals that are responsible for organising and managing the SPAC.
In the second transaction, or 鈥榙e-SPAC鈥�, the shell company merges with a private company (a company that does have existing business operations) to form a public company listed on a national securities exchange.
If, however, the SPAC does not identify and complete a merger transaction (the 鈥榙e-SPAC鈥� phase identified above), then the funds raised by the SPAC IPO (the fund raising phase identified above) will be returned to shareholders.
The SEC notes that, in practice, SPAC transactions can be highly complex and are typically governed by regulations designed for oversight of more traditional IPO structures.
This complexity of SPAC structures and their rapid proliferation has prompted the Commission to ask questions regarding whether shareholders have appropriate insight into the compensation channels, incentives and potential conflict of interests relating to SPAC sponsors.
The SEC raises concerns about whether a lack of traditional investor protection and liability leaves shareholders vulnerable, particularly in terms of how these are applied in the de-SPAC stage. It voices fears that, in some circumstances, retail shareholders may be 鈥渓eft holding the bag on an ill-advised or underperforming business鈥� after sponsors have taken their compensation and insiders have cashed out their shares.
Commenting on the proposal, SEC chair Gary Gensler notes that, from an economic perspective, the SPAC target IPO (the 鈥榙e-SPAC鈥�) is being used as an alternative means to conduct an IPO. With this in mind, investors require the level of protection that they receive from traditional IPOs relating to information asymmetry, fraud and conflicts of interest. They should also expect consistency across these mechanisms from the standpoint of disclosure, marketing practices, gatekeepers and issuers.
Indeed, almost 90 years ago, Congress introduced protection for investors when companies raise public money through IPO channels.
Specifically, companies raising money through IPOs are required to provide full and fair disclosure at the time when investors are making key decisions to invest. Consistent standards must be applied to the marketing practices used to promote IPOs, whereby parties to the transaction should not use 鈥渙verly optimistic language or over-promise future results in an effort to sell investors on the deal鈥�.
Also, gatekeepers and other third parties involved in the sale of the securities (including auditors, lawyers and underwriters) should police fraud and ensure the accuracy of disclosure to investors 鈥� and they should be expected to stand behind this work after the event.
The SEC aims to align standards across SPAC IPOs and traditional IPO channels. It proposes enhanced reporting and disclosure standards to investors, ensuring that investors are better informed about the functioning of this method for accessing public markets and the factors that determine the value of their SPAC investments.
This will include disclosures relating to the potential for dilution of shares, the sponsor鈥檚 experience, any material relationships that the sponsor has with other entities, along with a summary of key terms in the prospectus.
Significantly, the proposal will amend some existing rules and may lead to the introduction of new rules to regulate SPAC-based IPOs. This may include measures to enable underwriter liability and Private 色花堂Litigation Reform Act (PSLRA) liability to apply to de-SPAC transactions, ensuring that the SPAC and its advisers engage in effective due diligence on target companies and provide relevant disclosures.
鈥淏y clarifying that liability attaches [to the disclosures and forward-looking statements relating to de-SPAC transactions] serves to ensure that these forward-looking statements are as accurate and careful as they would be in other similar contexts,鈥� says SEC Commissioner Caroline A Crenshaw.
The SEC proposal aims to establish a 鈥渘ew safe harbour鈥� for SPACs which comply with its key investor protection conditions. This will help investors to identify SPACs which meet the proposed investor protection requirements, subject to the expectation that the SPAC announces a target IPO transaction within 18 months and it completes this transaction within 24 months.
The past two years have witnessed an unprecedented rise in the use of SPAC vehicles as an alternative means of public listing, according to the SEC. SPAC IPOs generated more than US$160 billion in 2021, a fifteen-fold increase on 2020, according to Commissioner Allison Herren Lee.
The SEC has reacted to this trend with a package of measures targeted to promote greater transparency and accountability in the SPAC market.
SPACs typically work through two key transactions. A SPAC sells shares in a shell company to generate funds with the intention of merging with or acquiring a 鈥榯arget鈥� private operating company. The shell company does not have independent operations, but does have a group of professionals that are responsible for organising and managing the SPAC.
In the second transaction, or 鈥榙e-SPAC鈥�, the shell company merges with a private company (a company that does have existing business operations) to form a public company listed on a national securities exchange.
If, however, the SPAC does not identify and complete a merger transaction (the 鈥榙e-SPAC鈥� phase identified above), then the funds raised by the SPAC IPO (the fund raising phase identified above) will be returned to shareholders.
The SEC notes that, in practice, SPAC transactions can be highly complex and are typically governed by regulations designed for oversight of more traditional IPO structures.
This complexity of SPAC structures and their rapid proliferation has prompted the Commission to ask questions regarding whether shareholders have appropriate insight into the compensation channels, incentives and potential conflict of interests relating to SPAC sponsors.
The SEC raises concerns about whether a lack of traditional investor protection and liability leaves shareholders vulnerable, particularly in terms of how these are applied in the de-SPAC stage. It voices fears that, in some circumstances, retail shareholders may be 鈥渓eft holding the bag on an ill-advised or underperforming business鈥� after sponsors have taken their compensation and insiders have cashed out their shares.
Commenting on the proposal, SEC chair Gary Gensler notes that, from an economic perspective, the SPAC target IPO (the 鈥榙e-SPAC鈥�) is being used as an alternative means to conduct an IPO. With this in mind, investors require the level of protection that they receive from traditional IPOs relating to information asymmetry, fraud and conflicts of interest. They should also expect consistency across these mechanisms from the standpoint of disclosure, marketing practices, gatekeepers and issuers.
Indeed, almost 90 years ago, Congress introduced protection for investors when companies raise public money through IPO channels.
Specifically, companies raising money through IPOs are required to provide full and fair disclosure at the time when investors are making key decisions to invest. Consistent standards must be applied to the marketing practices used to promote IPOs, whereby parties to the transaction should not use 鈥渙verly optimistic language or over-promise future results in an effort to sell investors on the deal鈥�.
Also, gatekeepers and other third parties involved in the sale of the securities (including auditors, lawyers and underwriters) should police fraud and ensure the accuracy of disclosure to investors 鈥� and they should be expected to stand behind this work after the event.
The SEC aims to align standards across SPAC IPOs and traditional IPO channels. It proposes enhanced reporting and disclosure standards to investors, ensuring that investors are better informed about the functioning of this method for accessing public markets and the factors that determine the value of their SPAC investments.
This will include disclosures relating to the potential for dilution of shares, the sponsor鈥檚 experience, any material relationships that the sponsor has with other entities, along with a summary of key terms in the prospectus.
Significantly, the proposal will amend some existing rules and may lead to the introduction of new rules to regulate SPAC-based IPOs. This may include measures to enable underwriter liability and Private 色花堂Litigation Reform Act (PSLRA) liability to apply to de-SPAC transactions, ensuring that the SPAC and its advisers engage in effective due diligence on target companies and provide relevant disclosures.
鈥淏y clarifying that liability attaches [to the disclosures and forward-looking statements relating to de-SPAC transactions] serves to ensure that these forward-looking statements are as accurate and careful as they would be in other similar contexts,鈥� says SEC Commissioner Caroline A Crenshaw.
The SEC proposal aims to establish a 鈥渘ew safe harbour鈥� for SPACs which comply with its key investor protection conditions. This will help investors to identify SPACs which meet the proposed investor protection requirements, subject to the expectation that the SPAC announces a target IPO transaction within 18 months and it completes this transaction within 24 months.
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