{"id":3514,"date":"2021-02-22T20:47:54","date_gmt":"2021-02-22T20:47:54","guid":{"rendered":"https:\/\/live-journal-of-law-and-public-policy.pantheonsite.io\/?p=3514"},"modified":"2021-02-22T20:47:54","modified_gmt":"2021-02-22T20:47:54","slug":"spacs-avoiding-volatility-evading-regulation","status":"publish","type":"post","link":"https:\/\/publications.lawschool.cornell.edu\/jlpp\/2021\/02\/22\/spacs-avoiding-volatility-evading-regulation\/","title":{"rendered":"SPACs: Avoiding Volatility, Evading Regulation"},"content":{"rendered":"\n

(Source<\/em><\/a>)<\/em><\/p>\n\n\n\n

The American economy shattered records in 2020. In April, the unemployment rate rose<\/em><\/a> to 14.7%, the highest rate in the history of the data. By June, national debt had increased<\/em><\/a> by twenty-five percentage points since the end of 2019, the strongest surge in history. In July, the Bureau of Economic Analysis found that U.S. gross domestic product fell<\/em><\/a> 31.4% during the second quarter, representing the biggest recorded contraction of that figure. Two-thousand twenty was a record-breaking year for Wall Street, too. On March 16, the Dow lost<\/em><\/a> 2,997.10 points, a larger one-day percentage slide than the one on Black Monday in 1929. However, by August, the Dow had erased<\/em><\/a> all of its 2020 losses and the S&P 500 closed at an all-time high<\/em><\/a> after its severe plummet earlier in the year. <\/p>\n\n\n\n

There was another source of record-breaking activity on Wall\nStreet last year. Special-purpose acquisition companies, or \u201cSPACs,\u201d have\nentered the market in unprecedented numbers. In 2020, SPACs conducted 248<\/em><\/a> initial public offerings\n(\u201cIPOs\u201d) and raised over $83 million. By contrast, 2019 \u2013  also an unprecedented year for SPACs \u2013 saw\nonly fifty-nine SPAC IPOs and $13.6 million raised. <\/p>\n\n\n\n

SPACs<\/em><\/a> are public companies formed for the purpose of merging with private companies. SPACs typically operate like blank-check companies, holding limited assets and having no operating history. A SPAC raises funds through an IPO and holds that money in escrow. It typically then has two years following the IPO to merge with a target company or else face liquidation\u2014to find a date to the prom, as it were. Interestingly, SPACs must use at least 80% of their net assets to fund their ultimate acquisition. When the SPAC finds its target, it submits proxy materials to shareholders, soliciting their approval of the proposed merger. If the merger fails, shareholders are given a pro rata share<\/em><\/a> of the money held in escrow<\/em><\/a>; that amount typically constitutes a significant portion of the initial investment. Moreover, SPACs give shareholders redemption rights<\/em><\/a> as additional exit options. Although the word \u201cacquisition\u201d is in the name, SPACs \u201cacquire\u201d targets through reverse mergers<\/a><\/em> <\/a>in which the target sells its common stock to the SPAC. Following the merger, the target company assumes the SPAC\u2019s public listing; for that reason, reverse mergers between public and private companies are sometimes deemed \u201creverse IPOs<\/em><\/a>.\u201d <\/p>\n\n\n\n

Private targets experience significant regulatory breaks when SPACs bring them public through reverse mergers. While the newly-formed public company is required<\/em><\/a> to report the merger in a Form 8-K <\/a> <\/em>filing for material events, it does not face the same requirements under the Securities Act of 1933<\/em><\/a> because the SPAC already met those requirements during the initial IPO, well before the reverse merger. The Securities Act requirements, especially the Section 5 \u201cgun-jumping\u201d<\/em><\/a> laws, are formidable. In a traditional IPO<\/em><\/a>, the issuer must file a lengthy registration statement with the SEC and wait for it to become effective prior to selling any securities. At each stage of the IPO, the issuer\u2019s communications\u2014and particularly those of non-reporting issuers\u2014are highly regulated. During the pre-filing period, the issuer may not \u201coffer\u201d any security for sale. Section 2<\/em><\/a> of the Act broadly defines \u201coffer,\u201d and subsequent SEC interpretive releases<\/em><\/a> have expanded the definition to include almost any communications that could conceivably condition the market<\/em><\/a> to anticipate purchasing the issuer\u2019s securities ahead of the offering. In the \u201cwaiting period\u201d after the issuer has filed the registration statement but before the SEC has declared the statement effective, the issuer can begin marketing its securities but only through oral communications at roadshows and written communications in statutory prospectuses meeting the requirements of Section 10<\/em><\/a> of the Act. Even after the SEC declares the registration statement effective, the issuer still must abide by the statutory prospectus requirement and ensure that such prospectuses are \u201cdelivered\u201d with the sale of each security. Section 11<\/em><\/a> imposes civil liability for material misrepresentations in the registration statement, and Section 12<\/em><\/a> imposes civil liability for violating the Section 5 gun-jumping laws. Notably, the issuer is not the only one who has to worry about these liabilities, as underwriters, accountants, and other offering participants can also be held liable for not following these regulations. Of course, all of these requirements are also subject to various exemptions<\/em><\/a> and safe-harbor rules<\/em><\/a>. Nevertheless, the entire process demands precise attention to detail, requiring issuers to work closely with lawyers and investment bankers\u2014two classes of professionals not known for charging low hourly rates. <\/p>\n\n\n\n

For all of those regulatory breaks, do SPACs offer any\nbenefits in return? Attorney Brandon Schumacher argues<\/em><\/a>\nthat SPACs provide advantages for all relevant parties. Reverse mergers between\nSPACs and targets can provide significant returns for SPAC investors. Moreover,\nSPAC shares offer a degree of safety, as investors are returned their initial\ninvestments if the SPAC fails to merge with a target company. SPACs offer\nmanagers new funds for conducting investment activity, and SPAC management\noften benefits from the merger as they typically receive an interest in the\nSPAC\u2019s shares as compensation for their work. <\/p>\n\n\n\n

Furthermore, SPACs shield the target companies from timing issues<\/em><\/a>\nintroduced by market volatility. Volatility increases the risk that shares will\nquickly lose value; when the market is volatile, investors demand shares at\ndiscounted prices to account for that risk, forcing issuers and underwriters to\nlower the offering price or delay the IPO. Lowering the offering price\ndecreases the amount of capital the issuer can raise, and delaying the IPO can\nresult in reputational harm to both the issuer and the underwriters. Indeed,\nsome commentators maintain<\/em><\/a>\nthat the 2020 SPAC boom is caused in part by market volatility resulting from\nthe coronavirus pandemic. Merging with SPACs allows private companies to go\npublic without directly offering shares to investors in the market. Since the\nacquisition price is determined between the SPAC and the private company, both\nparties avoid the threats posed by volatility in the broader stock market. <\/p>\n\n\n\n

SPACs might even offer more benefits besides making investors rich. Some SPACs, such as the Sustainable Opportunities Acquisition Corporation<\/em><\/a>, seek to create a broader social benefit by targeting private companies in the sustainability sector. Allowing those companies to grow and flourish could constitute a valid way of combatting the urgent problem of climate change and other global issues.<\/p>\n\n\n\n

On the other hand, SPACs are not entirely spectacular\n(SPACtacular?). Jay Ritter, a finance professor at the University of Florida,\nonce pointed\nout<\/em><\/a> the potential misalignment of management and investor interests in\nSPAC mergers. Since the SPAC\u2019s managers are assigned shares of the company\nfollowing the merger, and since the managers have a limited amount of time to\nfind a target, they may push for mergers with less-than-ideal targets. Additionally,\nbecause SPACs must spend 80%<\/em> of their net assets in the purchase, they\nmay overpay<\/em><\/a>\nfor certain targets. Yet, if investors are unsatisfied with the proposed\nmerger, they can simply vote against the merger and exercise their redemption\nrights<\/em><\/a>. Shareholders who exercise their redemption rights receive a pro\nrata share of the IPO proceeds held in escrow, typically equal to about $10 per\nshare. <\/p>\n\n\n\n

Maybe SPACs constitute fine investment vehicles. But is the\nSPAC boom truly a positive development in the capital markets? One way of\nlooking at the boom places it within the broader context of gradual securities\nderegulation. Daniel Morrissey, a law professor at Gonzaga, writes<\/em><\/a>\nthat businesses have always been wary of securities regulation. Many\nderegulation proponents assert that free-market forces alone would incentivize\nissuers to make truthful and accurate disclosures as they compete for capital. Contemplating such competition<\/em><\/a>,\nthe SEC and Congress have relaxed many registration requirements for certain\nissuers. For example, in 2005 the SEC created automatic\nshelf-registration<\/em><\/a> for well-known seasoned issuers (\u201cWKSIs\u201d), effectively\nallowing WKSIs to offer securities without waiting for SEC review. In 2012,\nCongress passed the JOBS\nAct<\/em><\/a>, exempting emerging growth companies (\u201cEGCs\u201d) from the Section 5\nrequirements when they \u201ctest the waters\u201d with qualified institutional buyers\n(\u201cQIBs\u201d) or accredited investors . In 2019, the SEC expanded<\/em><\/a>\nthat exemption to all issuers in promulgating Rule 163B. <\/p>\n\n\n\n

The new rules fall far short of abolishing the registration\nrequirement, but they indicate the markets\u2019 deregulatory momentum. As more and\nmore companies go public through reverse IPOs with SPACs, that momentum could\npick up force. The Securities Act\u2019s drafters meticulously\ncrafted it<\/em><\/a> (over the course of one weekend) in the wake of the stock\nmarket crash of 1929 to protect the investing public. The drafters, assuming a\nphilosophy of robust\ndisclosure<\/em><\/a>, intended for the laws to prevent fraudulent activity by\nrequiring issuers to provide investors with all material information prior to\ntheir actual investment decision. Significantly, disclosure has likely played a\nrole in improving standards of conduct at reporting companies. Contrary to what\nthe free-market proponents suggest, substantial deregulation could be\nproblematic for the capital markets, as free-market market forces do not offer\nthe same\nguarantee<\/em><\/a> of investor protection that stringent registration\nrequirements provide. Moreover, even as sophisticated actors like QIBs and accredited\ninvestors remain the focus<\/em><\/a>\nof deregulation efforts, it would be wrong to assert that those actors only\nplay ball with rich folks\u2019 money\u2014plenty of those investors are, for example, pension plans<\/em><\/a> deploying\nthe money of the \u201cunsophisticated\u201d public. <\/p>\n\n\n\n

SPACs will probably continue to proliferate as long as the\nmarkets remain volatile. Nevertheless, when the volatility subsides, investors\nshould think hard about investing in SPACs in light of the potentially adverse\neffects they may have on protective regulations. <\/p>\n\n\n\n

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\n

About the Author: Nicholas Swan is a J.D. candidate in the class of 2022 at Cornell Law School. He graduated from Cornell University in 2019. He is interested in issues of federal income taxation and securities regulation.<\/p>\n<\/div><\/div>\n\n\n\n

Suggested Citation: Nicholas Swan, SPACs: Avoiding Volatility, Evading Regulation<\/em>, Cornell J.L. & Pub. Pol\u2019y: The Issue Spotter (Feb. 22, 2021), https:\/\/live-journal-of-law-and-public-policy.pantheonsite.io\/spacs-avoiding-volatility-evading-regulation\/<\/a>. <\/p>\n","protected":false},"excerpt":{"rendered":"

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