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Regulators Create Headwinds for SPACs

Firm Memoranda

The well-documented wave of Special Purpose Acquisition Companies (“SPAC” or “SPACs”) that lasted throughout 2020 and the first quarter of 2021 has started to show the first signs of retreat.[1]  Two major statements from SEC officials in the past couple of months may be contributing to the slow-down.  As of late April 2021, SPAC transactions had hit “a screeching halt.”[2]  Between 80 and 110 SPACs IPO’d each month in January, February, and March 2021.  As of April 21, 2021, just ten SPACs had IPO’d.[3]  SPACs and the private companies they merge with would be well-advised to consider their exposure to private litigation and public regulatory actions in light of recent statements from John Coates, Acting Director of the Division of Corporate Finance at the Securities and Exchange Commission, and Paul Munter, Acting Chief Accountant.

Forward-Looking Statements.

One common explanation for the appeal of SPACs is that they are not subject to the same securities law restrictions as would apply in a traditional IPO.  In a traditional IPO, the private firm that intends to go public is usually advised not to make “forward-looking statements,” i.e. any statements about the future, including expectations for revenue or growth.  Such statements are particularly important for private businesses whose valuation lies mostly in projected growth.

The reason for the divergence between SPACs and traditional IPOs lies in the 1995 Private Securities Litigation Reform Act (“PSLRA”).  The PSLRA enacted certain restrictions on private litigation under the securities laws.  One such restriction is for private litigation concerning “forward-looking statements,” such as, “We expect this product will be approved and come to market next year…” or “We anticipate that our revenue next year will grow by…”  By their nature, the character of these statements as true or false is more difficult to evaluate than straightforward statements of present or past conditions.  By the PSLRA, Congress enacted a categorical “safe harbor” for “forward-looking statements,” so that publicly-traded businesses that offer guidance into their expectations and be protected from the threat of private litigation on account of those statements.  There are, however, exceptions to this safe harbor, including an exception for forward-looking statements made during an “initial public offering.”

For this reason, then, businesses that are coming up on an IPO are commonly advised not to make forward-looking statements, such as projections of future earnings.  This advice stands in contrast to the common practice among existing public businesses of routinely giving guidance as to the business’s future financial condition.  This exception in the PSLRA creates a kind of black hole in which investors do not get the benefit of management’s projections for the future of the business; and management, for fear of litigation and liability, offers very little guidance about future plans and projections.

But there is no such exception to the safe harbor for mergers.  The attraction, then, of merging with a SPAC is in large part the safe harbor of the PSLRA.  De-SPAC mergers have not typically been regarded as an “initial public offering” and so a private operating company that merges into a publicly-traded entity will often be advised that it may make “forward-looking statements” to the prospective merger partner, such as a SPAC.  This is most important for businesses whose valuation lies mostly in their future growth.  “Going public via a SPAC is appealing because it lets private firms talk up their business.”[4] 

From one standpoint, then, merging with a SPAC achieves the same basic end result as a traditional IPO, underwritten by major banks.  In both instances, a private business ends up publicly-traded.  But from a securities law standpoint, the two paths to public markets have been treated as significantly distinct.

On April 8, 2021, John Coates, Acting Director of the SEC’s Division of Corporate Finance, published a statement in which he addressed the surge of interest in SPACs and pointed out two potential problems with “forward-looking statements” in the context of a “de-SPAC” transaction.[5]

First, he pointed out, the PSLRA only applies to private litigation – it does not protect businesses from enforcement actions brought by the Securities and Exchange Commission itself.  A business that makes forward-looking statements in the context of a de-SPAC merger may be exposed to enforcement actions brought by the regulator.

Second, and much more significantly, Coates asked whether a de-SPAC merger should be regarded as a kind of initial public offering.  “In simple terms, the PSLRA excludes from its safe harbor ‘initial public offerings,’ and that phrase may include de-SPAC transactions.  That possibility further calls into question any sweeping claims about liability risk being more favorable for SPACs than for conventional IPOs.”[6]

In support of this argument, Coates pointed out that the PSLRA does not define “initial public offering.”  “No definition [for initial public offering] can be found in the PSLRA, nor (for purposes of the PSLRA) in any SEC rule.”[7]  Market participants do not commonly refer to de-SPAC transactions as “an IPO” but the SPAC process is analogous to an IPO insofar as it begins with a private operating business and ends with that business’s shares traded on a public exchange.  “The economic essence of an initial public offering is the introduction of a new company to the public.”[8]

What made Coates’s remarks particularly noteworthy was that his proposal is not conditional on new rule-making by the SEC, nor did he suggest that judges “deem” the SPAC merger process to be analogous to an IPO and therefore outside the safe harbors.  He suggested, rather, that a de-SPAC transaction is already encompassed within the meaning of the term “initial public offering” as that term is used in the PSLRA.  A judge ruling on a motion to dismiss in a securities class action would not need to “deem” the procedure “equivalent to” an initial public offering.  On Coates’s view, a judge could hold—as early as tomorrow—that a de-SPAC transaction is categorically a kind of IPO.  This ruling would not require any action at all by the SEC or Congress.  (Reuters did report in late April, however, that the SEC was evaluating possible new guidance to clarify the conditions under which the safe harbor applies.[9]  Bloomberg followed in June 2021 with a report that rules pertaining to SPACs were on the SEC’s rule-making agenda, with a placeholder date for an announcement in 2022.[10])

Coates effectively invited every federal judge to hold that de-SPAC mergers are already initial public offerings, under existing law, and therefore the safe harbors of the PSLRA do not apply.  Even more significantly, this invitation would extend not only to SPAC transactions not yet completed but also to de-SPAC mergers that are already closed and in which the participants might have fully expected and believed themselves to be operating within the safe harbors of the PSLRA.

  The practical implications of Coates’s speech are that SPAC investors and management must be attentive to the litigation risk that attaches to forward-looking statements in a de-SPAC merger—and to previous de-SPAC mergers.  Coates has laid down the gauntlet.  Management and underwriters and the operating business itself (and by implication its investors) could be deprived of the protections of the PSLRA at any time.

In fact, Coates’s statement has already found its way onto federal dockets.  Waitr Inc., a food delivery business, merged with a SPAC in November 2018, before the wave of interest in SPACs began to rise in 2020 and 2021.  Waitr shares lost about 96% of their value in 2019, wiping out almost $1 billion of equity.  A class action purporting to represent shareholders in the SPAC is pending in federal district court in Louisiana.  Welch v. Meaux, 19-cv-1260 (TAD) (W.D. La.).  The complaint names directors of the SPAC, the business itself, and the Underwriters as defendants.  Dkt.. 37.  Even before Coates’s statement, the complaint already defined the de-SPAC merger as “the Going Public Transaction.”  Dkt. 37 at 2.  The defendants moved to dismiss, in part based on the PSLRA’s protections for forward-looking statements.  Dkt. 47-1 at 22-23; Dkt. 45-1 at 1, 3.  It can have been no surprise, therefore, that the Plaintiffs seized upon Coates’s statement and filed it on the docket to “supplement the record,” even though the Statement itself cautions that it “is not a rule, regulation, or statement of the SEC . . . does not alter or amend applicable law and has no legal force or effect.”  Dkt. 75, 75-1.

But the significance of Coates’s statement is that, on his view, there is no need to “alter or amend applicable law[.]”  He is arguing, rather, that existing law already provides a basis to deprive de-SPAC mergers of the protections of the PSLRA.  Market participants – including directors and officers of businesses merging into SPACs and investors in those businesses – should be cognizant of Coates’s view and of the possibility that federal judges may agree with his analysis.

Of course, there is scope to push back against John Coates’s views of the applicability of the PSLRA to SPACs.  Hester Peirce, an SEC Commissioner, announced in a Tweet on April 8, 2021 that she “appreciate[s] the work that the Corp Fin staff & Acting Director Coates have been doing on SPACs, but not necessarily his interpretation of legal liability around de-SPAC projections [citing to Coates’s statement].  I welcome others’ input as I think through the issue.”[11]  It remains to be seen on which side the Courts will come down.

New Accounting for Warrants.

On April 12, 2021, John Coates, along with Paul Munter, Acting Chief Accountant, released a Staff Statement on Accounting and Reporting Considerations for Warrants Issued by Special Purpose Acquisition Companies (the “Warrants Accounting Statement”).[12]  The Statement caused turmoil in the world of SPACs because it called into question how the SPACs themselves—which are publicly traded companies and subject to public accounting requirements—should classify warrants for their securities: as debt or equity.

Strictly speaking, the Warrant Accounting Statement pertained to how SPACs account in their financial statements for warrants they may issue for their securities.  But accounting has legal ramifications because publicly-traded entities are obligated to file true and accurate financial statements with the SEC.  Issuers such as SPACs are also obligated to correct any previous statements whenever they conclude that there has been a material error misstatement.

US GAAP includes guidance as to whether a contract that may be settled in a corporation’s own stock may be classified as equity of the entity or as an asset or liability.[13]  “An equity-linked financial instrument, such as a warrant, must be considered indexed to an entity’s own stock in order to qualify for equity classification.”[14]  When a SPAC issues warrants that provide for potential changes to the settlement amounts dependent upon the characteristics of the holder of the warrant, then the warrants are not “indexed to the entity’s stock, and thus the warrants should be classified as a liability measured at fair value, with changes in fair value each period reported in earnings.”[15]  Such warrants would not only need to be classified as a liability; they would need to be classified as a liability at fair value, with changes in fair value reported each period in earnings.

Likewise, GAAP requires that if a financial contract or instrument might require a cash settlement by reason of events that lie outside one party’s control, then the instrument should be classified as an asset or liability rather than as equity.  Some SPAC warrants include a provision that in the event of a tender or exchange offer made to and accepted by holders of more than 50% of the shares of a single class of stock, all holders of the warrants would be entitled to receive cash in return for their warrants.  A qualifying cash tender offer could be outside the control of the entity; and yet, all warrant holders would be entitled to receive cash.  OCA staff concluded that, on this fact pattern, the tender offer provision would likely require the warrants to be classified as a liability.

Publicly reporting issuers that may have previously classified such instruments as equities and which conclude that the instruments should be re-classified as liabilities may need to revise their  previously filed financial statements.  SPACs, private businesses that anticipate—or are—merging with a SPAC, and the resultant merged entities should review the terms of outstanding warrants in light of the Warrants Accounting Statement.

The problem of re-stating financials is compounded for SPACs because more than 90% of SPACs that IPO’d in the past six years have been audited by just two accounting firms: Marcum and WithumSmith+Brown.[16]  Re-stating the financials in keeping with new guidance from the SEC has resulted in a significant backlog of work: new SPAC issuances were crushed under a “paperwork logjam.”[17]  Even existing SPACs were affected, holding up their mergers until existing financial statements could be re-evaluated.[18]

For investors, whether in the original operating company or the SPAC, new guidance gives rise to the risk of litigation.  The Warrants Accounting Statement is premised in existing GAAP principles and so a plaintiff might argue that the warrants should always have been accounted for as liabilities rather than as equity and that it was a misstatement to account otherwise.  Some SPACs have already defended the practice on the grounds that their warrants are written so that a cash outlay is unlikely to happen: the tender offer to the warrant holders will be made below the redemption value, resulting in investors redeeming their warrants rather than accepting the cash payment.  “In reality, the company will never pay cash because the warrant holder will exercise and get the equity . . .That’s more valuable to them.”[19]  Warrants can be highly individualized and defenses specific by business may arise.  If the change in accounting proposed by Coates and Munter would not have a material effect on the valuation of certain warrants, perhaps because the cash redemption is improbably unlikely to occur, then materiality may be a valid defense to any private litigation that might ensue.

Conclusion

Market participants in the SPAC universe will need to be cognizant of changing regulations and even of the influence of the ongoing debate at the SEC regarding the use of SPACs as an alternative route for private companies to access public markets.  Coates’s statement on the reach of the PSLRA safe harbors has already been cited in federal court; and the joint statement by Coates and Munter practically stopped all work on new SPAC issuances in April.

In light of these statements by prominent regulators, market investors should consider evaluating forward-looking statements and warrants to assessing their litigation risk.

***

If you have any questions about the issues addressed in this memorandum, or if you would like a copy of any of the materials mentioned in it, please do not hesitate to reach out to:

Christopher Kercher
Email: christopherkercher@quinnemanuel.com
Phone: +1 212-849-7263 

Michael Liftik
Email: michaelliftik@quinnemanuel.com
Phone:  +1 202-538-8141

Ellison Merkel
Email: ellisonmerkel@quinnemanuel.com
Phone: +1 212-849-7362

Andrew Rossman
Email: andrewrossman@quinnemanuel.com
Phone: +1 212-849-7282

Robert Schwartz
Email: robertschwartz@quinnemanuel.com
Phone: +1 213-443-3675

Brian Timmons
Email: briantimmons@quinnemanuel.com
Phone: +1 213-443-3221

Brendan Carroll
Email: brendancarroll@quinnemanuel.com
Phone: +1 212-849-7129

 

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[1]   SPAC Excitement Fades as Historic Quarter Ends, Wall Street Journal (March 31, 2021).

[2]   SPAC Transactions Come to a Halt Amid SEC Crackdown, CNBC (April 21, 2021) available at https://www.cnbc.com/2021/04/21/spac-transactions-come-to-a-halt-amid-sec-crackdown-cooling-retail-investor-interest.html

[3]   Id.

[4]   SPACs Are the Stock Market’s Hottest Trend.  Here’s How They Work., Wall Street Journal (March 29, 2021).

[5]   SPACs, IPOs and Liability Risk Under the Securities Laws, John Coates, April 8, 2021, accessible at https://www.sec.gov/news/public-statement/spacs-ipos-liability-risk-under-securities-laws

[6]   Id. at 3 (emphasis added)

[7]   Id.

[8]   Id. at 3 (emphasis in original)

[9]   https://www.reuters.com/business/exclusive-us-watchdog-weighs-guidance-aimed-curbing-spac-projections-liability-2021-04-27/

[10]   https://news.bloomberglaw.com/securities-law/sec-proposals-on-climate-esg-disclosures-planned-for-october?utm_source=newsletter&utm_medium=email&utm_campaign=newsletter_axiosprorata&stream=top

[11]   https://twitter.com/HesterPeirce/status/1380300518963171338?s=20

[12]   https://www.sec.gov/news/public-statement/accounting-reporting-warrants-issued-spacs

[13]   Financial Accounting Standards Board Accounting Standards Codification (“ASC”) 815-40.

[14]   Warrants Accounting Statement at 2.

[15]   Warrants Accounting Statement at 2.

[16]   SPAC Transactions Come to a Halt Amid SEC Crackdown, CNBC (April 21, 2021) available at https://www.cnbc.com/2021/04/21/spac-transactions-come-to-a-halt-amid-sec-crackdown-cooling-retail-investor-interest.html

[17]   SPACs face a new regulatory roadblock, Axios (April 28, 2021) available at https://www.axios.com/sec-spac-guidance-limit-safe-harbor-4784c121-7d92-4513-bf45-865a6dce7dc9.html?utm_source=newsletter&utm_medium=email&utm_campaign=newsletter_axioscloser&stream=top

[18]   Id.

[19]   SPAC Warrants as Liability Called an Expensive Change, CFO Dive (April 19, 2021) available at https://www.cfodive.com/news/spac-warrants-liability-change-SEC-CFO-accounting-antoniades/598655/