SEC Adopts Final Rules On SPACS, Shell Companies And The Use Of Projections – Part 1

On January 24, 2024, the SEC adopted final rules enhancing disclosure obligations for SPAC IPOs and subsequent de-SPAC business combination transactions.  The rules are designed to more closely align the required disclosures and legal liabilities that may be incurred in de-SPAC transactions with those in traditional IPOs.  The new rules spread beyond SPACs to shell companies and blank check companies in general.

The SEC is specifically requiring enhanced disclosures with respect to compensation paid to sponsors, conflicts of interest, dilution, and the determination, if any, of the board of directors (or similar governing body) of a SPAC regarding whether a de-SPAC transaction is advisable and in the best interests of the SPAC and its shareholders.  The SEC has also adopted rules that deem any business combination transaction involving a reporting shell company, including a SPAC, to involve a sale of securities to the reporting shell company’s shareholders, and has amended several financial statement requirements applicable to transactions involving shell companies.

In addition, the new rules require that a private operating company be a co-registrant when a SPAC files an S-4 or F-4 registration statement associated with a business combination; minimum dissemination periods for the distribution of shareholder de-SPAC communications; require a re-determination of smaller reporting company status within four days following the consummation of a de-SPAC transaction; and amend the definition of a “blank check company” to make the liability safe harbor in the Private Securities Litigation Reform Act of 1995 for forward-looking statement such as projections, unavailable in filings by SPACs and other blank check companies. Although the SEC did not adopt proposed rule that would deem underwriters in a SPAC IPO to be underwriters in a de-SPAC transaction, they have provided guidance under the current rules which could result in the same conclusion.  Moreover, the rules provide guidance on investment company determinations which impact all public companies.

On March 30, 2022, the SEC published the proposed rules.  At the time I wrote a six-part in-depth review of the proposed rules which can be read here – Part 1- HERE; Part 2 – HERE; Part 3 – HERE; Part 4 – HERE; Part 5- HERE; and Part 6 – HERE.  Similarly, I am writing a multi-part deep dive blog series into these highly impactful new rules.

Background

A special purpose acquisition company (SPAC) is a blank check shell company formed for the purpose of effecting a merger, share exchange, asset acquisition, or other business combination transaction with an unidentified target, within a set period of time.  The business combination transaction is commonly referred to as a “de-SPAC” transaction.

SPACs are formed by sponsors who believe that their experience and reputation will facilitate a successful business combination and public company. SPACs are often sponsored by investment banks together with a leader in a particular industry (manufacturing, healthcare, consumer goods, etc.) with the specific intended purpose of effecting a transaction in that particular industry. However, a SPAC can be sponsored by an investment bank alone, or individuals without an intended industry focus.

SPACs follow substantially the same structure.  A sponsor receives founder shares for a fixed price of $25,000, which founder shares will typically represent 20% of the total issued and outstanding capital stock immediately following the closing of the SPAC IPO (the “promote” or “founder’s shares”).  The sponsor must also invest enough capital to cover the IPO costs, ongoing SPAC legal and accounting fees, and costs associated with the de-SPAC transaction (locating and conducting due diligence on a target and transaction costs associated with the business combination), which is approximately 5% of the total IPO amount.  These funds are usually invested via a private placement referred to as the sponsor PIPE.  The terms of the sponsor PIPE are more favorable than the IPO terms.  The sponsor PIPE may involve a different class of stock, warrants or a combination of both.  The founder shares and sponsor PIPE often result in a sponsor owning 25% or more of the post IPO SPAC.

The SPAC IPO process is the same as any other IPO process. That is, the SPAC files a registration statement on Form S-1 or F-1 that is subject to a comment, review, and amendment process until the SEC clears comments and declares the registration statement effective. Concurrent with the S-1/F-1 process, the SPAC will apply for listing on a national exchange.  Differing from traditional IPOs, the underwriter typically only charges 5-5.5% of the offering proceeds (traditional IPO fees are closer to 7%) and usually a significant portion of those fees – around 3% – are conditioned on the completion of a de-SPAC transaction.  Following its IPO, the SPAC places all or substantially all of the IPO proceeds into an escrow account pending completion of a business combination transaction.  The funds in the escrow account are usually invested in treasury or similar securities which has resulted in questions as to whether a SPAC operates as an investment company.

A SPAC generally has 24 months to complete a business combination; however, it can get up to one extra year with shareholder approval. If a business combination is not completed within the set period of time, all money held in escrow goes back to the shareholders and the sponsors will lose their investment. Accordingly, sponsor capital is at risk – sponsors do not make money unless a successful business combination is completed.  Also, since the sponsor’s investment is at much better terms than the IPO investors (20% off the top for a nominal amount), the sponsor has incentives to complete a de-SPAC transaction on terms that are less favorable than they otherwise might consider.  This dynamic creates an inherent conflict of interest between the sponsor and the SPAC shareholders.

Upon entering into an agreement for a business combination, the SPAC will file an 8-K or 6-K then proceed with the process of obtaining shareholder approval for the transaction.  In addition to approving the de-SPAC transaction, the shareholder approval usually includes several changes to the constituent documents including a name change, authorization of additional securities, possibly a reverse split, etc.).   Prior to the closing of the de-SPAC transaction, the shareholders of the SPAC have the opportunity to either: (i) require the SPAC to redeem their common shares and receive a pro rata share of the amount in the IPO proceeds held in the escrow account, or (ii) remain a shareholder of the surviving company after the business combination.   A SPAC shareholder may vote “yes” on the business combination and still redeem their common shares.  Moreover, regardless of the common share redemption choice, the shareholder may keep their warrants to ride any potential upside in the transaction.  To offset redemptions, a SPAC often raises new money through a PIPE.

The value of the de-SPAC transaction is negotiated by the sponsor, the target and any investors that are putting in new money at the closing (the closing PIPE) and as a result, the valuation of a target entity may be higher in a SPAC transaction than a traditional IPO.  In a traditional IPO, neither the underwriter nor the IPO company rely on future growth projections and projections are almost never included in a registration statement or as part of a road show.  The reason is that the Securities Act imposes the stricter Section 11 liability standard on a company and its underwriters in an IPO process.  Among other issues, the new rules address this disparity.

Although a de-SPAC is structured as a merger or acquisition transaction, the SEC rightfully views it as the functional equivalent to an initial public offering as the transaction results in the target company going public and having access to capital markets funding from the initial SPAC IPO investors and/or new investors.

In 2020 and 2021 SPAC popularity reached an all-time high with 248 and 613 SPAC IPOs respectively.  The previous high was 50 SPAC IPOs in 2019.  In addition to publishing the proposed rules that precipitated these final rules, the SEC chilled SPACs beginning in April 2021 when it questioned SPAC warrant accounting causing a temporary standstill on transactions followed by a slew of accounting restatements (see HERE). On March 10, 2021, the SEC issued an investor alert warning of celebrity-backed SPACs and on March 31, 2021, the SEC issued two statements on SPACs. One highlighted certain issues, including relating to shell status, and the other on financial reporting and audit considerations.  Then again on April 8, 2021, the SEC issued another statement on SPACs, that time from John Coates, then Acting Director of the Division of Corporation Finance (see HERE).

In addition to regulatory issues, SPACs have been plagued with post de-SPAC shareholder litigation and class action lawsuits.  In 2023 there were only 31 SPAC IPOs and many SPACs dissolved without completing transactions.  Regardless the SEC pushed forward with the new rules noting that “[W]hile we recognize that the number of SPAC IPOs has declined since 2021, the investor protection concerns regarding SPACs and the hybrid nature of the de-SPAC transaction identified in the Proposing Release do not depend on market fluctuations.”

Summary of New Rules

The final new rules add new Subpart 1600 to Regulation S-K which will: (i) require additional disclosures about the sponsor of the SPAC, potential conflicts of interest, and dilution; (ii) require additional disclosures on de-SPAC transactions, including that the SPAC disclose (a) whether law of the SPAC organizational jurisdiction requires the board of directors to determine whether the de-SPAC is advisable and in the best interests of the SPAC shareholders or make a comparable determination, and to disclose that determination, and (b) whether the SPAC or SPAC sponsor has received any outside report, opinion, or appraisal relating to the de-SPAC transaction and certain disclosures pertaining to such report, opinion or appraisal; and (iii) require certain disclosures on the prospectus cover page and in the prospectus summary of registration statements filed in connection with SPAC IPOs and de-SPAC transactions.

The SEC has also adopted amendments to align disclosures and legal obligations with a traditional IPO.  In particular, the new rules: (i) amend the registration statement forms and schedules filed in connection with de-SPAC transactions to require additional disclosures about the target company; (ii) provide that the target company in a de-SPAC transaction is a co-registrant on the registration statement used for a de-SPAC transaction, such that the target company and its signing persons would be subject to liability under Section 11 of the Securities Act as signatories to the registration statement; (iii) require a re-determination of smaller reporting company status following the consummation of a de-SPAC transaction; and (iii) amend the definition of “blank check company” to encompass SPACs and certain other blank check companies for purposes of the Private Securities Litigation Reform Act of 1995 (PSLRA) such that the safe harbor for forward-looking statements under the PSLRA is not available to SPACs, including with respect to projections of target companies seeking to access the public markets through a de-SPAC transaction.

The new rules are not limited to SPACs but also encompass all shell companies that complete reverse acquisitions.  The SEC has adopted new Securities Act Rule 145a that deems any business combination of an Exchange Act reporting shell company with another entity that is not a shell company, to involve the sale of securities to the reporting shell company’s shareholders.  For purposes of new Rule 145a, the term “reporting shell company” is defined as a company, other than an asset-backed issuer as defined in Item 1101(b) of Regulation AB, that has: (i) no or nominal operations; (ii) either: (a) no or nominal assets; (b) assets consisting solely of cash and cash equivalents; or (c) assets consisting of any amount of cash and cash equivalents and nominal other assets; and (iii) an obligation to file reports under Section 13 or Section 15(d) of the Exchange Act (for more on reporting obligations see HERE).

The implications of this new rule are astounding.  The rules already require the filing of financial statements and Form 10 information for the acquired business in a Form 8-K within four business days of the closing of a transaction (see HERE/); however, this new rule will require a shell company to file a registration statement on Form S-4 or F-4 or determine the availability of a registration exemption for its existing shareholders prior to the closing of a transaction.  My belief is that it would be difficult if not impossible to find an available exemption and as such, every reporting shell company business combination will require a registration statement.

The SEC has also adopted new Article 15 of Regulation S-X, to more closely align the financial statement reporting obligations in a business combination involving a shell company and a target company with those in traditional IPOs.  In May 2020, the SEC amended the financial statement and disclosure requirements related to the acquisitions and dispositions of businesses in an effort to reduce the complexity and compliance costs associated with these transactions for reporting companies (see HERE).  Those rules apply across the board to all companies, whether a shell or not.

In essence, if a company is a shell, any acquisition would be significant and audited financial statements and Form 10 information on the target company would be required in a Form 8-K within four business days of closing.  The new rules would not only amend portions of the May 2020 amendments, but would also clarify the requirements in the closing 8-K.  Since Form 8-K allows for incorporation by reference, and since under the new rules a full S-4 or F-4 would have been filed prior to closing, presumably, in practice a Super 8-K would become a relatively short document incorporating the S-4 or F-4 prospectus.

The SEC has also provided guidance regarding potential underwriter status under Section 2(a)(11) of the Securities Act in de-SPAC transactions.

Finally, the SEC has issued guidance regarding the status of SPACs under the Investment Company Act of 1940 (’40 Act).  The proposed rules provided for a limited exemption under the ’40 Act for SPACs which the SEC determined not to adopt.  Rather, the SEC has issued guidance to help determine whether a SPAC is acting as an investment company based on individual facts and circumstances.

Effective Date

The new rules are effective 125 days following publication in the Federal Register.