SEC Proposes Sweeping Regulations Regarding SPAC and De-SPAC Transactions that Could Have a Chilling Effect on SPACs and Other Market Participants

On March 30, 2022, the U.S. Securities and Exchange Commission (SEC) proposed new rules and amendments relating to special purpose acquisition companies (SPACs). The SEC indicated these proposals are meant to enhance investor protections for initial public offerings (IPOs) by SPACs and for subsequent business combination transactions between SPACs and private operating companies (de-SPACs). The public comment period will remain open for 60 days following publication of the release on the SEC website, which would be May 31, 2022, or for 30 days upon publication in the Federal Register, whichever is longer.

The proposals focus on:

• Aligning de-SPAC transactions with traditional IPOs, including by creating potential disclosure liability for additional parties and amending the definition of a “blank check company” to prevent the safe harbor under the Private Securities Litigation Reform Act of 1995 (PSLRA) for forward-looking information from applying to projections and other forward-looking information in filings by SPACs.
• Supplementing disclosure requirements, including by obligating SPACs to disclose whether a de-SPAC transaction or related financing transaction is fair to unaffiliated security holders, expanding disclosures as to dilution and conflicts of interest in respect of SPAC sponsors, and expanding current SEC guidance on the presentation of projections of future economic performance in filings for all issuers.
• Amending rules applicable to reporting shell companies, including what qualifies as a “sale” of securities under the Securities Act of 1933 (Securities Act) and financial statement requirements applicable to transactions involving reporting shell companies.
• Clarifying the status of SPACs under the Investment Company Act of 1940 by providing a safe harbor in the Investment Company Act allowing SPACs not to register as an investment company if they meet certain requirements.

Background

SPACs are a type of blank check company – the purpose of which is to raise money in a public offering, identify a suitable target for a business combination, and then consummate that business combination. SPACs generally target private companies and, accordingly, de-SPAC transactions represent an alternative to the traditional IPO for private companies seeking to go public. In recent years, SPAC IPOs have grown in popularity in part due to certain benefits, or perceived benefits, of de-SPAC transactions relative to traditional IPOs, including greater certainty in execution and valuation – although both execution and valuation certainty has diminished greatly in recent months – the relatively faster path to being public and, importantly, the belief that SPACs, unlike traditional IPOs, could more easily present financial projections. SPAC IPOs raised more than $83 billion in 2020 and $160 billion in 2021. SPACs conducted more than half of all IPOs completed in the years 2020 and 2021.[1] This spike raised some concerns with the SEC, which publicly questioned the premise that de-SPAC transactions were not subject to the same securities law disclosure obligations and statutory liability scheme applicable to traditional IPOs. After numerous SEC pronouncements during 2021 – most of which were akin to purposeful reminders to the market that SPACs are subject to robust disclosure and other obligations required for the protection of investors – SEC Chair Gary Gensler foreshadowed for the last several months that the SEC was contemplating ways to enhance investor protections by heightening disclosure requirements and aligning the de-SPAC process to be more similar to that of a traditional IPO.[2] This view reflects the SEC’s belief that the SEC’s disclosure obligations and the liability provisions of the federal securities laws should not differ solely as a result of the means by which a private company goes public.

Proposed Amendments to Align De-SPAC Transactions with Traditional Initial Public Offerings

Underwriter Status and Liability in Securities Transactions

The SEC’s proposed Rule 140a – perhaps the proposal that sent the biggest shockwaves through the market – would “deem anyone who has acted as an underwriter of the securities of a SPAC IPO and who takes steps to facilitate a de-SPAC transaction, or any related financing transaction or otherwise participates (directly or indirectly) in the de-SPAC transaction to be engaged in a distribution and to be an ‘underwriter’ in the de-SPAC transaction.”[3]

Congress defined the term “underwriter” to include “all persons who might operate as conduits for securities being placed in the hands of the investing public.”[4] The SEC interprets that definition broadly to include, in certain circumstances, “any person, including an individual investor . . . if that person acts as a link in a chain of transactions through which securities are distributed from an issuer or its control persons to the public.”[5] The SEC views such underwriters as intermediaries between the issuer and public investors, playing the critical role as “gatekeepers” to the public markets. While underwriters are not expressly required under the Securities Act to conduct a due diligence investigation, underwriters do have certain defenses to liability afforded to them by reasonable due diligence, and the SEC expressed that they nonetheless have an affirmative obligation to conduct reasonable due diligence, and the Commission’s proposals clearly signal the belief that investors would benefit from subjecting additional parties to such due diligence obligations.

The SEC has stated that there is nothing in the Securities Act placing a time limit on a person’s status as an underwriter, because the public has the same need for protection afforded by registration whether the securities are distributed shortly after their purchase or after a considerable length of time.[6] Typically, SPAC IPO underwriters are not retained to act as underwriters in a subsequent de-SPAC transaction, but in certain instances the SPAC will ask the IPO underwriters to facilitate the de-SPAC transaction by acting as a financial advisor or capital markets advisor, or by acting as a placement agent in a related financing transactions, such as a private investment in public equity (PIPE), a transaction that frequently accompanies a de-SPAC transaction to provide the target with additional cash. The proposed rule will classify parties who participate in a wide array of activities as underwriters. Such activities include: serving as a financial advisor to the SPAC and engaging in activities necessary to the completion of the de-SPAC distribution such as identifying potential target companies, negotiating PIPE investments, identifying PIPE investors, and negotiating merger terms. Additionally, the SEC would consider receipt of compensation in connection with the de-SPAC transaction as direct or indirect participation in the transaction. The scope of this proposed rule could even potentially apply to a SPAC IPO underwriter who receives its deferred underwriting compensation from the SPAC IPO – typically 3.5% of the gross proceeds from the SPAC IPO – at the consummation of the de-SPAC given that the fee is only deemed earned at that time.  Furthermore, the proposal leaves open the possibility that other parties involved in de-SPAC transactions, including financial advisors, placement agents and PIPE investors could be deemed statutory underwriters under certain circumstances, thereby subjecting them to liability under Section 11 of the Securities Act.

In some of these situations, underwriter liability is more than participants in SPAC transactions expected, and may lead some newly deemed “underwriters” to question if participating in the SPAC process is worth the risk. Anecdotally, we understand that some investment banks have suspended their participation as SPAC IPO underwriters and/or placement agents, and some have terminated existing engagements to act as PIPE placement agents and/or waived their entitlement to deferred IPO compensation relating to SPAC IPOs for which they served as an underwriter. Our view is that investment banks are taking these actions preemptively while they digest the implications of the proposed rules and, potentially, until final rules are adopted. Given the proposal’s expansive view of the parties who may constitute statutory underwriters, we expect comments to focus on narrowing, or at least clarifying, what direct or indirect participation will be sufficient to trigger underwriter status. Those exposed to underwriter liability will want to conduct robust due diligence akin to that of more traditional IPOs and surely will want to be compensated accordingly. Along with adding an additional expense, such diligence will also likely add time to the de-SPAC process, and might prompt unintended consequences for SPACs with deadlines to consummate deals.

Private Operating Company as Co-Registrant to Forms S-4 and F-4

The SEC also proposed an amendment that would change the signature instructions to Form S-4 and F-4 to state that, if a SPAC is offering its securities in a de-SPAC transaction that is registered on the form, the term “registrant” for purposes of the signature requirements of the form would mean the SPAC and the target company.[7]

In proposing this amendment, the SEC explained its concern that “a narrow approach to registrant status in de-SPAC transactions could undermine the statutory liability scheme that Congress applied to initial public offerings of securities,” as “it is the private operating company that, in substance, issues or proposes to issue its securities, as securities of the newly combined public company.” [8] The SEC assumes this proposal “could improve the reliability of the disclosure provided to investors in connection with de-SPAC transactions by creating strong incentives for such additional signing persons to review more closely the disclosure about the target company in these registration statements and to conduct more searching due diligence in connection with de-SPAC transactions and related registration statements.”[9]

The true impact of this proposal likely turns on this last statement regarding the potential impact on individuals who would be exposed to additional liability under the federal securities laws. In particular, this proposal appears to target directors and executive officers of the target company with the hope that they will be more rigorous in their review and approval of public disclosures made in connection with de-SPAC transactions to the same extent as would be appropriate in the context of a traditional IPO. Although target companies already expect to assume any federal securities law liability of the SPAC arising out of materially false or misleading statements in its public disclosures in a Form S-4 or F-4 used in connection with a de-SPAC transaction, target companies currently are not deemed to be “registrants” under the federal securities laws and, as a result, do not have direct liability exposure for such disclosures.

PSLRA Safe Harbor

As enacted, the PSLRA provides a safe harbor for forward-looking statements under the Securities Act and the Securities Exchange Act (Exchange Act). The SEC’s proposal would amend the definition of “blank check company” to include SPACs, thereby making the PSLRA safe harbor unavailable for forward-looking disclosures – including projections – in de-SPAC registration statements. In part, as a result of the unavailability of the safe harbor in a traditional IPO, private companies seeking to go public (who are subject to strict liability for material misstatements or omissions in their IPO disclosures) and underwriters and directors (who have an affirmative defense to such liability if they can demonstrate that, after “reasonable investigation,” they believed that the statements in the registration statement were free of material misstatements or omissions) are reluctant to present financial projections in registration statements relating to traditional IPOs due to the difficulty in performing such due diligence on projections. A significant perceived advantage of de-SPAC transactions relative to traditional IPOs was the ability to present projections with the benefit of the safe harbor. Although members of the SEC Staff and Chairman Gensler have attempted in prior public remarks to disabuse market participants of the belief that this perceived benefit was supported by the law, the proposed rule if adopted, would put to rest any question about the applicability of the safe harbor by amending the SEC’s definition of “blank check company” to include SPACs.

In light of the proposed rule change, SPACs, target companies and, if proposed Rule 140a is adopted, IPO underwriters (and potentially others, including placement agents and financial advisors), will confront the choice of either disclosing projections and other forward-looking information – which historically have been critical to the marketing of PIPE transactions and necessary to present a compelling investment thesis to SPAC stockholders in the hopes that they will not elect to redeem their shares – and taking on additional exposure to securities law liability, relying on the traditional notion of the “bespeaks caution” doctrine regarding the projections, assumptions and disclosure relating thereto, or omitting such projections and certain other forward-looking information in an effort to limit such exposure. If market participants choose the latter, the proposed amendment may have the presumably unintended consequence of reducing information that might otherwise be provided to investors.

To the extent that the proposed rules curtail the use of forward-looking information, including projections, many targets – particularly high-growth companies with historical losses, but significant projected growth – may find it more challenging to consummate de-SPAC transactions.

Non-Financial Disclosures of the Private Operating Company

The proposed rules provide that, if the target company is not subject to the reporting requirements of Section 13(a) or 15(d) of the Exchange Act, the SPAC would be required to provide disclosure in the registration statement or a schedule filed in connection with the de‑SPAC transaction with a description of the business, property and legal proceedings, changes in and disagreements with accountants, security ownership of certain beneficial owners and management, and recent sale of unregistered securities. While this information is already required to be included in a Current Report on Form 8-K filed within four days of the completion of the de-SPAC transaction, the purpose of this rule is to provide shareholders this information prior to voting, investing, or redeeming their shares. While the SEC acknowledges that many, but not all, Forms S-4 and F-4, along with Schedules 14A and 14C filed in connection with de-SPAC transactions, already contain information about the target company as proposed, their concern is that the added disclosure practice was not consistent across the SPAC space. The proposed amendments, if adopted, “would require that this information be provided in all de-SPAC transactions subject to the specialized disclosure requirements in Subpart 1600,”[10] which is described in more detail below.

Re-Test a Registrant’s Status as a “Smaller Reporting Company”

A “smaller reporting company” is currently defined as a company that is not an investment company, an asset-backed issuer or a majority-owned subsidiary of a parent that is not a smaller reporting company, and has (1) public float of less than $250 million or (2) annual revenues of less than $100 million during the most recently completed fiscal year for which audited financial statements are available and either had no public float or a public float of less than $700 million. The status of a smaller reporting company is determined at the time of filing an initial registration statement. Most SPACs qualify as smaller reporting companies, and, the rules as currently drafted allow the post-business combination company remaining following a de-SPAC to retain that status until the next annual determination.

The SEC’s proposed rules would require a re-determination of smaller reporting company status following the consummation of a business combination. Companies would be required to determine their public float within four business days after the consummation of the de-SPAC. The revenue requirement would be determined using the annual revenues of the private operating company as of the most recently completed fiscal year for which audited financial statements are available. The thresholds for such determinations would remain unchanged. 

Proposed Amendments Regarding Use of Projections

Item 10(b) of Regulation S-K currently applies to the use of projected financial information in SEC filings. As currently drafted, an issuer may provide projections of future performance if there is a reasonable and good faith basis for those projections and they include disclosure of the underlying assumptions and limitations of the projections. The proposed amendment, which would apply generally to all issuers, would require that the projected financial information be clearly distinguished between projections based on historical financial results or operational history and those that are not. Further, any non-generally accepted accounting principles (GAAP) projected financial information would need to include an explanation for why the most closely related GAAP measure was not used, however, the reference to the nearest GAAP measure would not require a reconciliation to that GAAP measure. These amendments would apply to any projections of persons other than the registrant, including the target company of a business combination transaction, that are included in the registrant’s SEC filings.

Additionally, the SEC is proposing Item 1609 of Regulation S-K, which would apply only to de‑SPAC transactions. This Item would require SPACs to disclose, among other items, the reason for which financial projections were prepared, material assumptions used in preparing the projections, and whether or not the projections still reflect the view of the board or management of either the SPAC or target company of the de-SPAC transaction regarding the financial outlook on the filing date.

Both the SPAC and target company should be mindful that the projections used may be cause for liability if the proposed amendment to the PSLRA, as described above, is approved. To prevent any risks of liability, SPACs and target companies should include in-depth disclosure covering as much material information and assumptions used as possible to best align with the obligations under these proposals as well as corporate laws and federal securities laws.

Proposed Amendments for Enhancing Disclosure Requirements

The SEC is proposing to add Subpart 1600 to Regulation S-K to house new disclosure requirements applicable to SPACs regarding certain areas such as the sponsor, potential conflicts of interest, dilution, and the use of fairness opinions in analyzing both de-SPAC transactions and related financial transactions. Many of these proposals are consistent with current market practice for SPAC IPOs and de-SPAC transactions.

• Item 1603(a) would provide additional disclosure requirements for a SPAC’s sponsor, its affiliates, and any promoter, including as to the experience and responsibilities of the sponsor, the arrangement between the sponsor and SPAC regarding redemption of outstanding securities, the controlling person of the sponsor, tabular disclosure of material terms for any lock-up agreements between the sponsor and its affiliates, and the nature and amount of compensation paid to the sponsor, its affiliates, and any affiliates.
• Items 1602(a)(4), 1602(c), and 1604(c) would require additional disclosure for material potential sources of additional dilution that non-redeeming SPAC shareholders may experience such as shareholder redemptions, sponsor compensation, underwriting fees, and PIPE transactions.
• Item 1603(b) proposes disclosure surrounding actual or potential material conflicts of interests between the SPAC sponsor, its affiliates, or the SPAC’s directors and officers and the SPAC’s unaffiliated shareholders. Similarly, Item 1603(c) proposes additional disclosure regarding the fiduciary duties that each SPAC director and officer owes to other companies.
• Items 1602(a) and 1602(b) call for additional disclosure on the prospectus cover page and prospectus summary regarding the time frame for a de-SPAC transaction, redemption rights, compensation rights of the sponsor, conflicts of interest and dilution risks, and a statement regarding the fairness of the de-SPAC transaction and related financing transactions.
• Item 1606(a) would require a statement from a SPAC as to whether it reasonably believes that the de-SPAC transaction and any related financing transaction are fair or unfair to the SPAC’s unaffiliated security holders, while also providing rationale for these statements. Under Item 1606(b), the SPAC would be required to discuss in reasonable detail the material factors upon which the reasonable belief regarding the fairness of a de-SPAC transaction or any related financing transaction is based, and the weight assigned to each factor.
• Item 1607 would require disclosure as to whether or not the SPAC or its sponsor received a fairness opinion from an outside party relating to the consideration offered to security holder surround a de-SPAC transaction.

The key takeaway from this set of proposals is the requirement for a statement regarding the fairness of a de-SPAC transaction or any related financing transactions. This requirement coupled with the elimination of the PSLRA safe harbor, the extension of underwriter status under proposed Rule 140a, and the proposed Rule 145a, discussed below, could discourage such transactions by subjecting not only the signatories of the registration statement but also the underwriters, experts, and auditors to potential liability. SPACs should consider whether to obtain fairness opinions for pending and future de-SPAC transactions. The proposed rules do not require that a SPAC seek out a third-party fairness opinion, rather; it only requires disclosure as to whether they received one. As a practical matter, however, some market participants – and particularly Boards of Directors of SPACs – may conclude that obtaining a third-party fairness opinion is necessary or desirable to support the disclosure of the SPAC’s reasonable belief as to the fairness of the transactions, the result of which would be to increase the costs of de-SPAC transactions. Of course, in certain cases, this may result in the determination that the transaction is not fair, from a financial point of view, to stockholders.

Proposed Amendments for Business Combinations Involving Shell Companies

Proposed Rule 145a

Citing concerns regarding the use of shell companies as a means of accessing capital markets, the SEC’s proposed rule would deem any business combination of a reporting shell company, including SPACs, and a non-shell company to involve a sale of securities to a reporting shell company’s shareholders. The proposed Rule 145a defines reporting shell company as a company that has:

• No nominal operations;
• Either:
  
  • No or nominal assets;
  • Assets consisting of solely cash or cash equivalents; or
  • Assets consisting of any amount of cash and cash equivalents and nominal other assets; and
• An obligation to file reports under Section 13 or Section 15(d) of the Exchange Act.

By deeming these transactions as a “sale” under the Securities Act, the SEC believes this would cure the potential disparities in the disclosure and liability protections available to reporting shell company shareholders, depending on the transaction structure used in the reporting shell company business combination. By deeming these transactions as a sale of securities to the SPAC’s shareholders, it appears that the SEC would be eliminating the ability of effecting certain de-SPAC transactions through a proxy statement without filing a registration statement, even where the SPAC is not the registrant or surviving public company in the transaction.

The proposed rule would have no impact on business combinations between two bona fide non‑shell entities, though any reporting shell company that is made to appear to have more than nominal assets or operations would still be subject to the proposed rule in a business combination transaction.

Financial Statement Requirements in Business Combinations Involving Shell Companies

The proposed rules include an amendment to Regulation S-X to align the required financial information of a private target company involved in a business combination with a shell company to the financial information required in a traditional IPO.

The modifications would require:

• the financial statements for a de-SPAC transaction where the target business will be a predecessor to the SPAC registrant to include the same financial statements for that business as would be required in a registration statement for a traditional IPO of that business;
• the audit of financial statements be conducted by an independent accountant in accordance with the standards of the Public Company Accounting Oversight Board for the purpose of expressing an opinion;
• the age of financial statements for a private operating company that would be the predecessor to a shell company in a registration statement would be based on whether the private operating company would qualify as a smaller reporting company if filing its own initial registration statement; and
• the financial statements of any other business, besides the predecessor, that have been or are probable to be acquired may be included in the registration statement.

In addition, the proposed rules would allow a registrant to exclude the financial statements of a SPAC for the period prior to the de-SPAC transaction if all financial statements of the SPAC have been filed for all required periods through the de-SPAC transaction and the financial statements of the registrant include the period on which the de-SPAC transaction was completed.

The SEC emphasizes that this proposal is merely the codification of current staff guidance relating to shell company transactions.

Proposed Amendments for Status of SPACs under the Investment Company Act Of 1940

The proposed rules include a safe harbor for SPACs under the Investment Company Act of 1940. The SEC reasons that these proposals aim “to assist SPACs in focusing on, and appreciating when, they may be subject to investment company regulation.”[11] The proposed Rule 3a-10 would provide a safe harbor in the definition of “investment company” under Section 3(a)(1)(A) of the Investment Company Act.

In order to qualify for the safe harbor, SPACs must comply with the following conditions:

• It must hold its assets solely in U.S. government securities and money market funds invested in U.S. government securities;
• It must pursue one de-SPAC business combination, however, the transaction could involve the combination of multiple target companies so long as the SPAC treats them for all purposes as part of a single de-SPAC transaction. Additionally, the de-SPAC transaction must result in a surviving entity engaged in the business of the target company and the surviving entity must have at least one class of securities listed for trading on a national securities exchange;
• The SPAC’s officers, directors, and employees must be primarily focused on activities related to seeking a target company, and the SPAC’s board of directors must adopt an appropriate resolution of this business purpose; and
• It must announce a business combination within 18 months of its IPO and complete a business combination within 24 months of its IPO.

SPACs are not required to rely on this safe harbor – i.e., if a SPAC does not meet the conditions listed, it will not automatically be considered an investment company. But the SEC’s Director of the Division of Investment Management cautioned that SPACs which do not satisfy the conditions of the safe harbor should consult with advisors and consider their compliance obligations as he would expect the SEC staff to be looking at the compliance of SPACs who do not qualify for the safe harbor.[12]

Next Steps

The SEC is seeking comments on 180 specific matters, which will be considered when drafting the final rules. Given the significant impact of the proposed rules on SPACs and other market participant involved in de-SPACs and related financing transactions, we expect the SEC will receive substantial feedback on the proposals.

There remains significant uncertainty among market participants surrounding these proposals, resulting in many interested parties, such as investment banks and SPAC sponsors, pausing their activities in the space until the there is greater clarity regarding the effects of the proposals – many of which we expect industry participants to address preemptively in their filings – and as new market practices develop. We are closely monitoring the status of the proposals and developments throughout this space and will provide updates as appropriate.

[1] SEC Release Nos. 33-11048; 34-94546; IC-34549; File No. S7-13-22 (Special Purpose Acquisition Companies, Shell Companies, and Projections) (“SEC Release”).

[2] See Chair Gary Gensler (SEC), “Testimony Before the Subcommittee on Financial Services and General Government, U.S. House Appropriations Committee,” May 26, 2021, and Chair Gary Gensler (SEC), “Remarks Before the Healthy Markets Association Conference,” Dec. 9, 2021.

[3] SEC Release at 20.

[4] SEC Release at 87.

[5] Id.

[6] SEC Release at 93-94.

[7] SEC Release at 76.

[8] SEC Release at 75-76

[9] SEC Release at 77.

[10] SEC Release at 69.

[11] SEC Release at 135.

[12] Director William Birdthistle, “Comments at the 3/30/22 SEC Open Meeting,” Mar. 30, 2022.