An article from the KPMG SPAC Intel Hub.
The SPAC boom is attracting closer scrutiny from regulators and investors alike. This year (2021), the Securities and Exchange Commission has issued a flurry of statements on SPACs, while several SPAC deals have caught the attention of federal investigators. SEC Chair Gary Gensler told Congress in May that the agency is “closely looking” at SPAC transactions. Investors have noticed, and new SPAC IPOs have slowed from the torrid pace at the start of 2021. As they pursue their transaction, parties in a SPAC deal need to keep abreast of these developments and manage regulatory and other risks down the line.
SEC statements and actions
During the past several months, the SEC and some of its senior officials have spelled out their views on a variety of issues:1
Testimony before the Subcommittee on Financial Services and General Government, U.S. House Appropriations Committee2
- “The surge of SPACs raises a number of policy questions,” said Gensler. “First and foremost, are SPAC investors being appropriately protected? Are retail investors getting the appropriate and accurate information they need at each stage—the first blank-check IPO stage and the second target IPO stage?”
- “How do SPACs fit into our mission to maintain fair, orderly, and efficient markets? It could be the case that SPACs are less efficient than traditional IPOs. One recent study shows that SPAC sponsors generate significant dilution and costs.”
SPACs, IPOs and liability risk under the Securities Laws3
- “It is not clear that claims about the application of securities law liability provisions to de-SPACs provide targets or anyone else with a reason to prefer SPACs over traditional IPOs,” John Coates, Acting Director, Division of Corporation Finance, wrote. “Any simple claim about reduced liability exposure for SPAC participants is overstated at best, and potentially seriously misleading at worst. Indeed, in some ways, liability risks for those involved are higher, not lower, than in conventional IPOs, due in particular to the potential conflicts of interest in the SPAC structure.”
Financial reporting and auditing considerations of companies merging with SPACs4
- SEC Acting Chief Accountant Paul Munter gave an overview of key considerations related to “the unique risks and challenges of a private company entering the public markets through a merger with a SPAC.” He cited market and timing considerations; financial reporting considerations; internal control considerations; corporate governance and audit committee considerations; and auditor considerations.
Staff statement on select issues pertaining to Special Purpose Acquisition Companies5
- This staff statement from the Division of Corporation Finance addressed “certain accounting, financial reporting and governance issues that should be carefully considered before a private operating company undertakes a business combination with a SPAC,” including: shell company restrictions; books and records and internal controls requirements; and initial listing standards of national securities exchanges.
Celebrity involvement with SPACs – Investor alert6
- The SEC’s Office of Investor Education and Advocacy (OIEA) cautioned “investors not to make investment decisions related to SPACs based solely on celebrity involvement.”
In March 2021, Reuters reported that the SEC Division of Enforcement had sent letters to some Wall Street banks seeking voluntary information on their SPAC dealings.7 Sources said that the SEC wanted information on SPAC deal fees, volumes, internal controls, compliance and reporting.
Flashing yellow lights
Key areas of SPAC transactions that may result in exposure to fraud, misconduct, compliance and other investment risks include:
Inadequate disclosures
- Fiduciary or contractual obligations of SPAC sponsors, directors and officers who may not work exclusively on behalf of the SPAC to identify acquisition targets. These may lead to conflicts of interest, including conflicts involving entities that may compete with the SPAC for business combination opportunities.
- Detailed information on how SPAC sponsors, directors, officers or their affiliates will benefit from the transaction and on their financial incentives to complete a business combination.
- Financial incentives of SPAC sponsors, directors, officers and their affiliates that may differ from public shareholders. Differences may result from securities ownership, compensation arrangements or relationships with affiliated entities and may lead to conflicts of interest when evaluating potential business combination.
- Information about how SPAC sponsors, directors and officers evaluated and decided to propose an identified transaction. SPAC sponsors, who are mostly tasked with finding a workable acquisition within two years and not necessarily the best possible deal, are not incentivized to avoid having the SPAC overpay for the target company.
- Material factors the board of directors considered in its determination to approve the identified transaction.
- Fees that the underwriter of the SPAC’s IPO will receive upon completion of the business combination transaction, such as fees for advisory services, including the amount of fees that is contingent upon completion of a business combination transaction.
Earnings management through forward-looking statements and due diligence
- SPACs often make forward-looking projections, which may lead to government scrutiny of whether the SPAC and the individuals who signed the SEC filings exercised reasonable care in determining the accuracy of any forward-looking statements.
- Many private companies going public through a SPAC merger do not yet have revenue but promote their growth prospects by touting anticipated revenue figures—something that companies in IPOs don’t do.
Insider trading
- Heightened risk of insider trading due to the various parties involved in the transaction that have access to material non-public information (e.g. sponsors, investors, target companies, those involved in PIPE financing).
PIPE financing
- Is there adequate disclosure of any conflict of interest?
Lack of internal controls and governance structures
- Younger, private companies may be forced to quickly adopt stricter regulatory, accounting and governance systems for public companies and fail in the implementation.
Compensation arrangements for sponsors
- SPAC sponsors may receive 20 percent of IPO shares as a “promote,” and the first-stage investors may redeem when the SPAC finds a target. However, this may leave the non-redeeming and later investors to bear the brunt of that dilution.
How to manage the risks
A well-designed process put in place as part of the transaction execution can help manage downstream risks.
- develop policies and procedures for SPACs (e.g. insider trading, conflicts of interest, disclosures requirements, document retention, etc.)
- compliance and corporate governance due diligence of target companies
- internal controls and reporting requirements for SPAC owners
- obtain a fairness opinion on the terms of the business combination agreement.
Bottom line
The SPACs phenomenon has become too big to avoid 360-degree scrutiny. Rushing to close deals in a competitive market is likely to only heighten risks. More than ever, this is time for all SPAC participants to go the extra mile, asking the right questions and promptly addressing any concerns to ensure the success of the deal—and more importantly, that of the merged company.
Footnotes
1 The SEC’s earlier statements included:
- “CF Disclosure Guidance: Topic No. 11” on conflict of interest, December 22, 2020. The Guidance provides the Division of Corporation Finance’s views about certain disclosure considerations for SPACs, in connection with their initial public offerings and subsequent business combination transactions.
- “What You Need to Know About SPACs – Investor Bulletin,” December 10, 2020. This alert provides a brief overview for investors of important concepts when considering investing in a SPAC, both (1) when the SPAC is in its shell company stage and (2) at the time of and following the initial business combination.
2 SEC, “Testimony Before the Subcommittee on Financial Services and General Government, U.S. House Appropriations Committee,” May 21, 2021.
3 SEC, “SPACs, IPOs and Liability Risk under the Securities Laws,” April 8, 2021.
4 SEC, “Financial Reporting and Auditing Considerations of Companies Merging with SPACs,” March 31, 2021.
5 SEC, “Staff Statement on Select Issues Pertaining to Special Purpose Acquisition Companies,” March 31, 2021.
6 SEC, “Celebrity Involvement with SPACs – Investor Alert,” March 10, 2021.
7 Jody Godoy and Chris Prentice, Reuters, “U.S. regulator opens inquiry into Wall Street’s blank check IPO frenzy-sources,” March 25, 2021.
