Hey, SPACs: Congress and the SEC Would Like a Word With You

Special purpose acquisition companies (SPACs) have been all the rage since early 2020. Although new SPAC registrations have declined in recent months, attention from Congress and the U.S. Securities and Exchange Commission (SEC) is on the rise. Both bodies are demanding that SPACs—and their sponsors and creators—answer questions over perceived conflicts of interest, rosy financial projections, and thoroughness of investigation into their merger targets.

A brief primer on SPACs: a SPAC is an alternative to a traditional initial public offering (IPO). At the outset, the SPAC "sponsor"—often a prominent investor, but sometimes a celebrity—raises capital through an IPO for a shell company. The now-public shell company (i.e., the SPAC) then has two years to acquire or merge with a private company (in what is called a "de-SPAC" transaction). The private company goes public as a result of the de-SPAC, and the sponsor stands to be compensated handsomely. But if no de-SPAC is consummated within the two-year period, the SPAC must return all funds to investors.

Members of Congress and representatives of the SEC are saying that the peculiarities of SPAC transactions incentivize sponsors to cut corners and pursue de-SPAC transactions with untested targets that are bound to underperform, to the detriment of retail investors.

In late September, a group of Democratic Senators sent six serial SPAC creators a letter raising questions about their SPAC-related activities. Sen. Elizabeth Warren wrote in her press release: "We are concerned about the misaligned incentives between SPACs' creators and early investors on the one hand, and retail investors on the other." The release warns that sponsors have "incentives to quickly strike merger deals, regardless of the quality," and "sponsors and early investors profit from hyperbolic, pre-merger claims about" the target company. The legislators claim SPACs have generated "astonishing reports of abuse and market dysfunction." They "asked" the SPAC creators to provide detailed information about their SPAC transactions and related compensation and financial incentives.

For its part, the SEC has issued a series of statements highlighting concerns about disclosure of SPAC investment terms; sponsors' and board members' alleged conflicts of interest; and the readiness of the private companies (or de-SPAC entities) to meet accounting, financial reporting, and governance requirements. It has warned that SEC staff "will continue to be vigilant about SPAC and private target disclosure so that the public can make informed investment and voting decisions about these transactions."

The SEC's focus can be seen clearly in its widely-publicized enforcement action this past summer against a SPAC, its sponsor, CEO, the target, and the target's former CEO. The SEC alleged, among other things, that the target, an early-stage space transportation company, made misleading disclosures about its capabilities and that the SPAC repeated them without adequate investigation. The case highlights regulators' concern that some SPACs and their sponsors may be hasty in finding a de-SPAC target, regardless of warning signs that should be explored during due diligence into the target and its operations.

All told, more than 400 SPACs are still in search of a business acquisition target, and the clock is ticking. The anticipated crush of de-SPAC activity only confirms that increasing scrutiny from legislators and regulators is not going away anytime soon.

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