Client Advisory: Nowhere to Hide as SEC Seeks Out SPACs with Adoption of Final Rules

Author: Susan Friedman, Esq.

At the starting gate

All engines were revved up on January 24, 2024 when, in a 3-2 neck-and-neck vote, the Securities and Exchange Commission (SEC) adopted its final rules mandating additional procedural and disclosure requirements in initial public offerings (IPOs) by special purpose acquisition companies (SPACs) and in subsequent business combination transactions between SPACs and their target private companies (the de-SPAC transaction).¹

Although SPACs have existed for decades, perhaps as the dark horse alternative to the traditional IPO (with the ability to bypass strict regulatory and disclosure requirements, benefit from better pricing certainty and be executed with speed), this financial maneuver had its heyday during the pandemic.

According to SPAC Analytics, in 2020 we saw 248 SPAC IPOs — only to be surpassed in 2021 with 613 SPAC IPOs, which then went off track with a decrease to 86 in 2022 and 31 SPAC IPOs in 2023 (at last count there were four SPAC IPOs by the end of February 2024).²

Subsequently, the SPAC sprint went from a gallop to a full stop as it encountered a challenged economy, increasing interest rates, difficulty finding Target private companies with which to merge, lackluster performance of SPAC-acquired firms and significant SEC scrutiny.

In his statement regarding the Final Rules, SEC Chair Gary Gensler commented that these regulations "will help ensure that the rules for SPACs are substantially aligned with those of traditional IPOs, enhancing investor protection through three areas: disclosure, use of projections, as well as issuer obligations." Although Gensler acknowledged the rapid decline in the volume of SPAC transactions, he explained that "...markets ebb and flow, and there could be a change in the future." As such, he maintained his rationale "[W]hether you are doing a traditional IPO or a SPAC target IPO, SPAC investors are no less deserving of our time-tested investor protections."³

In her dissenting statement, SEC Commissioner Hester M. Peirce advised "...the rule will exacerbate a problem — the shrinking pool of public companies — by closing down one road into public markets." Peirce continued that while certain aspects of SPACs required "fixing...the market was fixing them before the Commission proposed this rule." Peirce noted, "[T]he regulatory reaper came for SPACs and seems to have won. That outcome is disheartening."⁴ Peirce specifically commented that the final Rules impede the ability for small companies to enter the public market. In this regard, SEC Commissioner Mark T. Uyeda, in agreement with Commissioner Peirce, explained that the final Rules in effect will deter the formation of SPACs and will result in fewer private companies opting to participate in the transaction, which in turn means less opportunities for the investing public.⁵

Notably, however, these regulations have been two years in the making as the proposed rules were released in March 2022.⁶ During this two-year period, the market practices of SPACs have generally come around the bend to accommodate for the SEC's earlier proposed rules in anticipation of adoption.

Highlights of the SEC's final rules

The SEC's final rules set forth in 581 pages the regulator's original proposal from 2022 in terms of enhanced disclosure requirements in SPAC IPOs and business combinations between SPACs and Targets; the use of projections in de-SPAC and other registration statements; and business combinations involving shell companies, including SPACs.

Further, although the SEC did not specifically adopt rules on certain controversial topics, it did provide guidance to market participants with respect to underwriter liability in de-SPAC transactions, the use of projections and the safe harbor under the Investment Company Act of 1940.⁷

Below, we provide a snapshot of the final rules.

Enhanced disclosures and investor protection

In their registration statement, SPAC IPOs must disclose compensation paid to sponsors, conflicts of interest, dilution, the Target and any other information that's important to investors in SPAC IPOs and de-SPAC transactions, which includes. among others:

• The experience of the SPAC sponsor, including material roles and responsibilities of the parties in directing and managing the SPAC, as well as their involvement with other SPACs
• The identity of the controlling persons who have direct and indirect material interests in the SPAC sponsor
• Tabular disclosure of the material terms regarding any lock-up agreement entered into by the SPAC sponsor⁷

In terms of the de-SPAC transaction, the following must be disclosed in the de-SPAC registration statement, among others:

• The background, material terms and effects of the de-SPAC transaction
• Any agreements between the sponsor and the SPAC, its directors, officers, or affiliates in determining whether to proceed with the de-SPAC transaction
• If required by the law of the SPAC's jurisdiction, the board's determination that the de-SPAC transaction is advisable and in the best interests of the SPAC and its shareholders, and the material factors considered in their determination (including the valuation of the Target, any financial projections relied upon by the SPAC board, and any third-party reports, opinions or appraisals received by the SPAC board)
• Any transfers or arrangements related to the transfer of SPAC securities by the SPAC sponsor or others, which includes disclosing any payments or agreements between the SPAC sponsor and unaffiliated security holders of the SPAC regarding the redemption of SPAC securities
• A description of any material terms in agreements regarding restrictions of when the SPAC sponsor and its affiliates may sell SPAC securities
• Specifics as to the reasons the SPAC and the Target are engaging in the de-SPAC, including the reasons for the proposed structure and timing⁷

Additional requirements of the final rules include, among others:

• Under certain circumstances, the Target must be a co-registrant with the SPAC or another shell company on the registration statement used for the de-SPAC transaction and, in effect, assume responsibility (together with the Target's directors and officers who are required to sign the registration statement) for disclosures in the registration statement filed in connection with the de-SPAC transaction. Note that this requirement exposes the Target directors and officers to liability under Section 11 of the Securities Act of 1933, imposing strict liability for issuers where registration statements contain false or misleading statements or omissions of a material fact.
• A 20-calendar-day minimum dissemination period for prospectuses and proxy statements filed for de-SPAC transactions (or the maximum period allowable by the SPAC's jurisdiction of incorporation or organization if such a period is less than 20 calendar days).
• Re-determination of "smaller reporting company" status is required within 45 days following consummation of the de-SPAC transaction.
• Any business combination transaction involving a reporting shell company, including a SPAC, is deemed to be a sale of securities to the reporting shell company's shareholders.
• The SEC updated Regulation S-X, which governs financial statement requirements that apply to transactions involving shell companies and private operating companies, to generally align their disclosures with those for IPOs.⁷

Enhanced projections disclosure

The safe harbor for forward-looking statements, such as projections, under the Private Securities Litigation Reform Act of 1995 (PSLRA)⁸ is NOT available to SPACs. This safe harbor protects companies from liability for forward-looking statements and, without it, SPAC sponsors carefully need to assess potential legal risks when determining whether and how to use projections in the de-SPAC transaction:

• The SEC amended the definition of "blank check company" to include SPACs for purposes of the PSLRA.
• The unavailability of the safe harbor applies to statements regarding the projections of the Target in the de-SPAC transaction.

There are new disclosure requirements within Regulation S-K that apply only to the de-SPAC transaction regarding any projections contained in the filing. The mandated disclosure must include the purpose for which the projections were prepared and the party who prepared those projections, as well as the material bases and underlying assumptions of the disclosed projections and whether the disclosed projections reflect the view of the board of directors or management of the SPAC or the Target as of the date of filing.

Guidance

Underwriter status. The SEC refrained from adopting its proposed rule and, instead, provided guidance as to whether underwriters of a SPAC IPO who participate in a distribution of securities in the de-SPAC transaction should be classified as an underwriter in that de-SPAC transaction.

Citing Section 2(a)(11) of the Securities Act of 1933, the SEC advised "...the statutory definition of 'underwriter' itself encompasses any person who sells for the issuer or participates in a distribution associated with a de-SPAC transaction."The SEC advised that it will interpret the terms distribution and "underwriter" "broadly and flexibly....in view of the facts and circumstances of a particular transaction which includes de-SPAC transactions."⁷

Investment company status. In declining to adopt its proposed rules, the SEC noted that, depending upon the facts and circumstances, a SPAC could be an investment company under the Investment Company Act of 1940 at any stage of its operations.⁷

• Status as an investment company brings about additional regulations and disclosure requirements, yet the SEC didn't grant a safe harbor for SPACs, but rather provided guidance in determining whether a SPAC meets the definition of "investment company."⁷
• The SEC advised that in determining investment company status the following should be examined:
• The nature of the SPAC assets and revenue
• Management's activities
• The duration of the SPAC prior to entering into a de-SPAC agreement and closing the de-SPAC
• Whether the SPAC holds itself out in a manner that suggests investors should invest in its securities primarily to gain exposure to its portfolio of securities prior to the de-SPAC transaction
• Whether the SPAC merges with an investment company⁷

The SEC provided additional guidance on the use of projections by all issuers in SEC filings.⁷

The endgame for board directors and officers

We end at the beginning — that SPACs have been around for decades. Although the SEC seeks to level the playing field between SPAC offerings and traditional IPOs, private companies of all sizes and in all industry sectors will consistently consider going public for many decades to come.

Commentators suggest that this regulatory pit stop with the final rules and guidance may result in:

• Increased exposure to liability for board directors and officers
• Additional costs for SPAC IPOs and de-SPAC transactions to comply with the new disclosure requirement⁹
• Narrowing of the pool of transactions to larger SPACs with solid targets and established track records for earnings and performance¹⁰
• Disincentivizing participation in de-SPAC transactions for fear of an increase in the risk of being classified as an underwriter¹¹
• Deterring involvement of third parties who provide advice to SPAC participants due to an increase in costs (charged by the third parties) and disclosure requirements⁹
• Decreasing the use of projections in de-SPAC transactions due to the lack of safe harbor protection and heightened scrutiny¹⁰
• Diminishing the appeal of SPACs ⁴

Yet, companies with smaller market capitalization and some horsepower keep trotting to keep SPAC IPOs as a viable alternative method to enter public markets. Further, the serial SPAC sponsors and those with a history in this space have had two years (since late March 2022 with the release of the proposed rules) in the race for compliance to get ahead of the curve, and many have already done so.

To remain frontrunners and keep odds in their favor, given the robust regulatory requirements and the nuances associated with the SPAC/de-SPAC transaction, board directors and officers must examine their Directors and Officers Liability insurance. To protect personal assets and the corporate balance sheet, coverage needs to be available for all sides of the SPAC/de-SPAC equation that could result in any of the following:

• Regulatory investigations and enforcement actions
• Securities class actions alleging false or misleading statements, misrepresentations or omissions in registration statements
• Merger objection lawsuits brought by shareholders claiming inadequate consideration
• Shareholder derivative demands and derivative investigations
• Claims alleging breaches of fiduciary duties, conflicts of interest, breach of contract

And the list goes on.

As SEC Chair Gensler remarked, "...markets ebb and flow....".³ As long as there are private companies, SPACS will continue to exist as a staple of capital markets.

Robust due diligence and disclosures are required at all phases of the SPAC process to reduce the exposure to investigations, regulatory activity and litigation. Protection of all persons and entities involved in the SPAC IPO/de-SPAC transaction is paramount. Due to the complex nature of these transactions, the creation and maintenance of a first-in-class risk management program by coverage and industry specialists is critical. Using an insurance broker with significant expertise will assist in reaching the finish line and allow you to avoid signaling danger by "raising the red flag."

In the race for risk mitigation, a good bet is to engage Gallagher's Executive and Financial Risk practice specialists who always stand ready to assist.