New in the world of SPACs: arks, sharks and SPARCs

November 2021 | SPOTLIGHT | FINANCE & INVESTMENT

Financier Worldwide Magazine

November 2021 Issue

Special purpose acquisition companies (SPACs) have been one of the success stories of recent years. They have attracted huge volumes of investment as professional and retail parties invest through an initial public offering (IPO) in a ‘cash shell’ company with a mandate to find a suitable unlisted acquisition target. The company then typically merges (often by a reverse takeover) with its target in a de-SPAC transaction, creating a new listed business.

Arks

In recent volatile years, SPACs have been presented as arks for all parties involved – safe havens for capital, offering opportunity and flexibility. They allow sponsors to raise funds and then negotiate the taking public de-SPAC with money in hand. Sponsor shares (the ‘promote’) entitle the sponsor to a significant percentage of the new business after the de-SPAC.

In turn, under both US and UK law, investors have the right to have their funds returned if no suitable target is located, the ability to vote on the end acquisition and can chose to have their shares redeemed on closing. Theoretically, they invest on the basis of the reputation of the sponsor as deal‑finders and dealmakers, thereby getting access to such expertise.

Both sides stand to benefit from the differences compared to a traditional IPO or reverse takeover.

Following recent changes to UK listing rules to align more closely to the approach already in place in the US, trading is not suspended in the SPAC’s shares upon announcement of the acquisition (the default UK position for a reverse takeover). Instead, investor protection is addressed by new disclosure rules on the information to be given to shareholders about an acquisition and by continued liaison with the UK’s Financial Conduct Authority (FCA).

In the US, SPAC mergers have different regulatory requirements from traditional IPOs. One key difference is that the target company is permitted to make public projections about its expected future business prospects, which are not allowed in an IPO. This permits the target company and, by association, the SPAC’s sponsor, to take advantage of enhanced publicity around the SPAC, though as recent actions by the Securities and Exchange Commission (SEC) have shown, not without risk.

Sharks

There are signs that the security and mutual benefit of the SPAC structure has been overplayed, as SPACs are increasingly becoming targets for litigation challenges.

Critics warn of the risks of the inherent conflicts of interest, from potential misalignment of the management team with the target management and arising from overexuberant dealmaking as demand for de-SPAC opportunities outstrips suitable targets. We would also add the risks inherent from the application and interpretation of new and developing regulation. None of these issues is new to investors but the popularity of SPACs has made them a focal point for such concerns.

One novel issue that has arisen is the question of whether SPACs are truly ‘acquisition companies’ at all or whether they are investment companies (at least under US regulation). SPACs typically have a limited period of two years to spend the cash raised, otherwise they must return it to shareholders and liquidate. While searching for the acquisition target, the company must act as a responsible custodian of the funds raised and so these are often invested in government securities and suitable money market funds.

In the high-profile case of Assad v Pershing Square Tontine Holdings, currently before the US District Court for the Southern District of New York, it is alleged that this results in SPACs becoming subject to the Investment Company Act of 1940 (ICA), with the claim that compensation paid to sponsors, including the sponsor shares, is accordingly illegal.

On one side, claimants accuse sponsors of regulatory corner cutting and eye-wateringly high and illegal compensation. On the other, sponsors accuse such claimants of bringing opportunistic lawsuits against a legitimate investment structure, pointing out that SPACs’ entire business purpose is not to invest in securities and therefore is outside the scope of the ICA, but expressly to combine with an operating company.

There are some special circumstances in the Pershing case, namely that the SPAC in question had previously unsuccessfully sought to structure the deal as a traditional de-SPAC (a merger in which it would convert its shares into a minority stake in Universal Music) so instead had planned a straight share purchase of Universal’s shares to be distributed in short order to its own shareholders. This has not stopped the instigation of several similar lawsuits against other SPACs, however, as well as increasing interest in US structures from the SEC.

For example, on 13 July 2021, the SEC announced an enforcement action against SPAC Stable Road Acquisition Company, sponsor SRC-NI, chief executive Brian Kabot, target company Momentus Inc., and Momentus’s former chief executive Mikhail Kokorich, all related to a proposed SPAC transaction with Momentus, a privately owned space-transportation company. The action is significant because charges were brought against Kabot in his individual capacity, not only the SPAC and target-company entities.

This activity has given rise to a sense among participants that all SPACs are now a litigation target and, as a result, to a joint statement, issued on 27 August 2021 by over 60 leading law firms in the US, saying that the assertion that SPACs are investment companies is without factual or legal basis.

Whichever way you look at it, there are sharks in the water and traps for the unwary, which risk a chilling effect on the market, at least in the US.

The position is somewhat different in the UK, where the FCA has confirmed that the new listing rules should not themselves bring SPACs within scope of the UK’s Alternative Investment Fund Managers (AIFM) regime. It characterises the short-term investments by SPACs typically as protection of cash raised, not investment activity (although each SPAC must consider the position on an individual basis).

SPARCs

Every novel challenge gives rise to a novel solution. In this case, the newcomer is the SPARC – a special purpose acquisition rights company.

The crucial ‘R’ (rights) works in this way: SPARCs raise no cash on day one. Instead, shareholders in the SPARC are issued rights (warrants or similar instruments) rather than shares and so have the right (but not obligation) to invest when a target has been identified. This sidesteps the need for short-term investment of funds, and so the question of investment fund regulation. Neat though it seems, this structure faces practical issues (how and to whom to give free rights) as well as regulatory ones.

Both the SEC and the New York Stock Exchange are currently deciding whether to allow this structure to move forward, in the context of Pershing. In the UK, each SPARC would need to be assessed on a case-by-case basis, to ensure it is not an alternative investment fund and that it complies with, or is exempt from, financial promotion and prospectus rules.

In conclusion, while SPACs have been around for more than two decades, the rapid growth throughout 2020 and into 2021 has brought about increased scrutiny from regulators and investors. The ark is still afloat, but the sharks are circling. A SPARC may be a lifeboat, but it is too soon to tell.

Margaret Dale and Dorothy Murray are partners at Proskauer Rose LLP. Ms Dale can be contacted on +1 (212) 969 3315 or by email: mdale@proskauer.com. Ms Murray can be contacted on +44 (0)20 7280 2055 or by email: domurray@proskauer.com.

Margaret Dale and Dorothy Murray

Proskauer Rose LLP