Special Purpose Acquisition Companies exploded in popularity in recent years as a means to take private companies public, given executives perceived these shell companies as a faster and less regulatorily burdensome means to access public capital.
The U.S. Securities and Exchange Commission took notice, warning investors last April that purported advantages of the SPAC process, like reduced legal liability, could prove illusory if tested in the courts.
The SEC could go further during a meeting Wednesday, when it will vote on whether to propose new rules that would clarify that there is no legal safe harbor protecting companies from liability for making misleading projections of financial performance when taking a company public via SPAC.
The rule, if proposed and later adopted, would also require enhanced disclosure to prospective investors about potential conflicts of interest between SPAC sponsors and the companies they target, as well as better information about how an investor’s interest in a SPAC can be diluted as it takes a company public.
In a statement supporting the rule proposal, SEC Chairman Gary Gensler said it would “strengthen disclosure, marketing standards, and gatekeeper and issuer obligations by market participants in SPACs, helping ensure that investors in these vehicles get protections similar to those when investing in traditional initial public offerings.”
The issue of dilution is of particular concern to retail investors as the processes by which a SPAC investment can be made less valuable as it takes a company public can be opaque, according to SEC officials who briefed reporters on the proposal.
SPACs raise cash through an initial public offering that typically prices shares at $10, after which the shell company has two years to use the raised funds to purchase a private company, thereby making that company public. Investors in the SPAC IPO have the right to redeem their shares for $10 each, plus interest, if they don’t want to remain invested in the target company after it is announced.
A recent analysis of SPAC transactions by Michael Klausner and Emily Ryan of Stanford University and Michael Ohlrogge of NYU found that investors who stick with a SPAC through its acquisition of a target company end up with median net cash per share of just $5.70.
The reason the value of these shares are diluted is because SPAC sponsors typically earn a 20% fee to establish and support the SPAC and underwriters earn 5.5% of the IPOs total proceeds, according to the analysis. Finally, initial investors in a SPAC are promised interest on their initial $10 per-share investments and other inducements that enable them to reap healthy returns when they redeem their cash prior to the SPAC merger.
Despite these dilutive dynamics, SPACs have become an increasingly popular means for going public in recent years, with a record 617 SPAC going public globally in 2021 worth a combined $172.2 billion, according to data from Dealogic. Meanwhile, SPAC IPOs rose to account for more than 60% of all IPOs in 2021, while SPAC mergers accounted for more than 30% of all going-public deals last year.
Michael Klausner, Emily Ryan and Michael Ohlrogge
There are signs that the market is cooling however, as 314 of those SPAC IPOs occurred in the first quarter of last year, before the SEC and Congress began telegraphing their concerns over these trends.
The SEC proposal would standardize, simplify and make more prominent disclosures related to potential sources of dilution, requiring sponsors to present dilution scenario analysis in a tabular format on a prospectus cover page, SEC officials said.
One of the more high profile SPACs to go public in recent years is Digital World Acquisition Corp.
which announced plans to merge with and take public former President Donald Trump’s company Trump Media, creator of the Truth Social app.
Digital World Acquisition Corp. has said that regulators are investigating it following reports that it may have run afoul of securities laws by discussing the possibility of merging with Trump Media with company representatives before the SPAC went public last September.