SEC’s proposal on SPACs would better protect investors as financiers profit regardless

The Securities and Exchange Commission’s (SEC) proposals on Special Purpose Acquisition Companies (SPACs) provide retail investors with much greater investor protections, which is welcome news to AFR, as we have been urging such changes for more than a year. SPACs are publicly traded companies created for the sole purpose of acquiring or merging with an existing company. SPACs, often referred to as “blank check companies” have been lucrative for the issuers who put them together and for early institutional investors – frequently hedge funds -, but this comes at the expense of subsequent retail buyers. Retail investors have lost significant amounts of money from SPAC investments in recent years.

Unlike traditional stock offerings, buyers blindly buy into a SPAC, which is initially just an empty shell company, hoping that the SPAC issuer can eventually find and merge with a good private company. While many SPAC issuers have touted SPACs as unique opportunities to get into rapidly growing private companies at an early stage, the reality is that many investors end up buying into heavily hyped duds that lose them lots of money. All of that has been enabled by the lack of basic investor protections in SPACs as compared to those of a traditional stock offering. The SEC’s proposals address many of those glaring gaps. 

Currently, after a SPAC has raised money from investors, it has a certain amount of time in which it must identify and arrange a takeover of a company, or else it must return that money back to the investors. When the SPAC finds a takeover target, shareholders of the shell company are provided with the financials of the target company.

However, since the financials provided during this merger process (often referred to as the “de-SPAC) are not technically an offering of shares, such as in an Initial Public Offering, de-SPACs are not subject to the Private Securities Litigation Reform Act of 1995. That act ensures that the accuracy of forward-looking projections are subject to legal liability. We need this kind of protection for SPACs, because currently, many SPAC targets with no revenues but highly hyped business models draw in thousands of investors who see billions of dollars of projected revenues five years from the merger. The SEC is proposing to close this loophole so SPAC forward projections are held to the same standards as those in IPOs.

AFR has been calling out the dangers of investors buying into these inflated forward-looking projections. And unfortunately, the Wall Street Journal found earlier this year that half of the SPACs issued over the past two years have already traded down 40% from the industry standard initial offering price of $10/share. In some cases, some especially hyped companies spanning electric vehicles, space exploration, and deep sea mining that rose many multiples to over $60/share have instead lost anywhere from 70-90% of their value. 

Speculative businesses normally fail at high rates, but in the case of SPACs, many of the issuers and early investors have managed to find a “tails I win, heads you lose” type arrangement. SPACs are unique in that they have a built in a compensation scheme for issuers where upon successful completion of a merger, the issuer receives 20% of the shares of the combined company for practically free. On a $100 million merger, this means the sponsor receives at least $20 million in free shares. 

This incentive structure creates significant issues around poor corporate governance. SPACs typically have about 2 years from raising money to merge with a company, and given such compensation structure, desperate issuers may resort to acquiring any company at any inflated price to be able to collect their 20% fee (often referred to as a promote).

The SEC’s proposals address these corporate governance concerns by requiring SPAC issuers to provide greater disclosures around any potential conflicts-of-interests, the dilutive effects of a merger on the value of the SPAC’s shares, and justification whether internally or from a third-party on whether they believe a merger is fair to investors.

Aligning the rules for SPACs with those in place with traditional stock offerings, combined with greater disclosures on conflicts and downside risks, will better protect future investors in SPACs.