SPAC to basics (V): calls for reform

Fred Halbhuber

This series has considered both whySPACs have become such an alluring investment vehicle as well as how the advantages of SPACs may come at the cost of post-merger investors[1] and lower transparency.[2] This instalment of ‘SPAC to basics’ considers how SPACs and the broader IPO market may be improved to address these concerns. First, the origins of SPACs will be explored to evaluate why it is that SPACs have taken on the capital structure that they have; key similarities and distinctions between SPACs and original blank check companies will be considered. Second, a number of key concerns with SPACs will be evaluated; it will be argued that the current operation of SPACs creates a dangerous distinction between how SPACs are perceived (and portrayed)in the literature and media and how they operate in practice. Finally, proposed avenues for change will be evaluated, both through reform of the SPAC route toIPO and through modifications to the traditional IPO process.

 

Origins

In order to understand how best to reform SPACs (if at all), it is necessary first consider why it is that SPACs have taken on their current form. Why is it that SPACs almost ubiquitously list at $10.00 per share? Why do all SPACs offer a redemption option on common shares? Why do SPAC IPOs offer units comprising common shares and warrants?Answering these questions will help to explain the disconnect between divesting and non-divesting investors discussed elsewhere in this series[3] and, ultimately, why there is such a stark disconnect between how SPACs operate in theory and how they operate in practice.

 

Although the terms “SPAC” and “blank check company” are often used interchangeably,[4] the two terms are not wholly synonymous. This use, however, is imprecise. As will be explored further in this section, the term “blank check company” encompasses a wider range of companies than “SPAC”.

 

The original blank check companies made a name for themselves in the 1980s as a shady vehicle to take those companies public who lacked the ability to go public via the traditional route.These blank check companies brought penny stocks[5] to the public market, but were quickly subject to extensive regulatory control. The SEC adopted Rule 419[6] with the intent of defining and limiting the operation of these blank check companies. Rule 419 was limited in scope to blank check companies,[7]defined as a company that:[8] (i)is a development stage company that has no specific business plan or purpose or has indicated that its business plan is to engage in a merger or acquisition with an unidentified company or companies, or other entity or person; and (ii)is issuing “penny stock”.[9]Among the most damning of the new rules imposed on these blank check companies is the requirement that at least 90% of IPO proceeds be placed in an escrow account unavailable to the blank check sponsors and management team: this prevented personal exploitation of these funds. The right of the shareholders to have their pro rata share of the trust returned if they disapproved of the proposed merger also incentivised management teams to find actually suitable targets and undermined the popular pump-and-dump scheme. This was further achieved by barring the trading of the blank check securities prior the closing of the merger. These rules largely defeated the “utility” of blank check companies as a means of taking companies public: from 1987 to 1990, 2,700 blank check companies went public; the similar period in the early 1990s saw lessthan fifteen offerings.[10]

 

How did today’s active SPAC market evolve from these ruins? In short, the first SPACs avoided Rule 419 by not issuing penny stocks,[11]thereby avoiding classification as “blank check companies” in the strict sense.In an effort to shake the stigma associated with the industry[12] and avoid the scrutiny of the SEC,[13]many of these SPACs adopted the same stringent requirement put in place by Rule419, even though they were not bound to so at law.[14] Indeed, SPACs have held an increasingly higher share of IPO proceeds in a trust account in an effort to attract investor attention and confidence.[15]

 

Notwithstanding the extent of this voluntary compliance with Rule 419, a few key distinctions must be noted.First, SPACs tend to operate with a longer lifespan than the original blank check companies. While the latter’s time to acquire a target is capped at 18months before automatically liquidating, SPACs typically have 24 months to find and merge and this can be extended up to 36 months.[16] Second, and most importantly, SPACs shares are not restricted from trading prior to the merger:shares can be traded immediately post-IPO and trading is not put on hold when a merger is announced.[17]

 

Concerns: disconnect between theory and practice

With less-than-assuring beginnings, we must ask ourselves whether these “new and improved” blank check companies have in fact left behind their old ways. It is argued that, while public perception has changed, the risks associated with the current capital structure of SPACs have gone unappreciated. Therefore, there is a growing disconnect emerging between how SPACs are perceived (and are being advertised to retail investors) and how SPACs actually operate in practice.

 

First, has public perception of these blank check companies changed? There has certainly been an increase in the number of big name sophisticated investors in SPACs over the past few years; most prominent among these is hedge fund billionaire Bill Ackman, who recently IPO’d the largest SPAC in history.[18] There has also been a parallel rise in the number of reputable firms willing to take the SPAC route to the public markets; Nikola, DraftKings and Virgin Galactic, whose business models span across three very different industries, have all recently gone public through SPACs.

 

This is not to say that all reporting has been positive: the FT recently published its findings that SPACs have, over the past five years, generally underperformed the market and that the majority of SPACs are now trading below their IPO price.[19]Such findings notwithstanding, the widespread view remains that SPACs have been refined since their penny stock beginnings. In part driven by the heavy involvement of sophisticated investors, the improved “quality of acquisitions that SPACs have been able to secure, as well as the quality of management going into creating these firms” has been frequently touted.[20]

 

This view also finds support in the academic literature.[21]Derek Heyman, writing on the evolution of SPACs, summarises as follows:

 

While it is true that in the 1980s, [blank check] companies were frequent vehicles for defrauding unsophisticated investors, the modern SPAC is a post-regulation vehicle with many built-in safety features. Its primary investors are among the most sophisticated — hedge funds — and it appears to have taken its place atthe table of legitimate means of raising capital.[22]

 

While Heyman is surely right to note that the “modern SPAC” introduces greater safety features than its penny stock-focused predecessor, the above assertion overlooks the stark differences between divesting and non-divesting investors discussed elsewhere in this series.[23]This is well illustrated by analysing holdings of SPACs which merged in 2020[24](the “2020 SPACs”) by the ten hedge funds with the largest SPAC investments[25](the “Top Ten”). The Top Ten sold or redeemed, on average, their full shareholder interest in 72% of targets within three months of the merger.Within four months post-merger this average increased to 78% and within six months to 82%.[26] In other words, in relation to their holdings in 82% of the 2020 SPACs, the TopTen had dumped their skin in the game in less than half a year.

 

Therefore, these hedge funds are not quite the “primary investors” which they may initially appear. Although 13F-filers[27]represent a large portion of those investors between IPO and De-SPAC, these investors usually have little intention of remaining invested in the target long term. The majority liquidate their assets, either by redemption or by sale, shortly before or after the merger.

 

The way in which Heyman refers to hedge funds—immediately following discussion of SPAC’s as a “postregulation vehicle” with new “built-in safety features”—is potentially illustrative of a misunderstanding of the role played by these hedge funds. It is not the Top Tenand other sophisticated institutional investors who are placed at risk, but rather the retail investors who buy at the date of the merger. This is because the SPAC’s new “built-in safety features” do not extend beyond the date of the merger; indeed, the safety features end abruptly at the De-SPAC when investors are given the final chance[28] to redeem their shares. For investors acquiring thereafter, no “safety net”remains. It is strongly recommended that interested readers look into Klausner and Ohlrogge’s article, “ASober look at SPACs”, which this piece has taken much inspiration from.

 

Proposals for reform

These shortcomings have led some to call for reform of SPACs. Some of these calls have been issued from industry leaders themselves. Bill Ackman, for example, underscored some of the major concerns surrounding SPACs by setting up a SPAC[29] (Pershing Square TontineHoldings) which departed significantly from SPAC industry standards. The most relevant of these departures was the decision not to give the standard 1/3warrant per unit; instead, investors acquired only 1/9 share but had the opportunity to obtain a further 2/9 if they did not redeem their shares. This helped to keep investors committed for the long term, rather than encourage them to follow the common pump and dump scheme often adopted by pre-merger investors.[30] In fact, Pershing Square consistently traded at 115% the IPO price post-merger.

 

Other commentators[31]have advocated using particular forms of the traditional IPO to replace theSPAC. Klausner and Ohlrogge have suggested a “sponsored IPO”, in which a sponsor searches for a suitable private company looking to go public, assists the company in the process by investing themselves and by lining up third party investors; in exchange, the sponsor acquires an equity holding in the pre-IPO company. This, Klausner and Ohlrogge suggest, would help to realign the skewed incentive in a SPAC where the sponsor is driven to close any merger they can within 24 months so as to avoid liquidation and, therefore, their 20% founders take. Similar “contingent IPOs” already exist: here, third party investors commit themselves prior to the date of the public offering to purchase a certain number of shares.[32]


[1] See ‘SPAC to basics (II): investor perspective’.

[2] See ‘SPAC to basics (III): target perspective’.

[3] See‘SPAC to basics (II): investor perspective’.

[4] Indeed, SPACs typically refer to themselves as blank checkcompanies in their registration statements. See, for example, the 2018-filedS-1 Form of Boxwood Merger Corp.: “We are a blankcheck company incorporated as a Delaware corporation formed for the purposeof effecting a merger, share exchange, asset acquisition, stock purchase,reorganization, recapitalization or other similar business combination with oneor more businesses” (emphasis added). Boxwood Merger Corp., having listed at$10.00 a unit (as set out in their preliminary prospectus), is, necessarily, aSPAC. For the S-1 filing of Boxwood Merger Corp., see:https://www.sec.gov/Archives/edgar/data/1751143/000161577418011368/s113457_s1.htm.For curious readers it may further be noted that Boxwood completed its merger(with Atlas Technical Consultants) in February of this year (2020).

[5] Typically stocks offered for under $5/share. The definitionof “penny stock” can be found in SEC Rule 3a51-1.

[6] Relevant changes to Section 7 of the Securities Act of 1933were made pursuant to the Securities Enforcement Remedies and Penny StockReform Act of 1990. Section 508 of the 1990 Act proposed the introduction of“special rules with respect to registration statements filed by any issuer thatis a blank check company.”

[7] § 230.419(a)(1). For regulatory context, see:https://www.law.cornell.edu/cfr/text/17/230.419.

[8] § 230.419(a)(2)(i) and (ii).

[9] As defined in Rule 3a51-1 under theSEA of 1934.

[10] Derek K. Heyman, “From Blank Check to SPAC: the Regulator'sResponse to the Market, and the Market's Response to the Regulation”,Entrepreneurial Business Law Journal, vol. 2, no. 1 (2007), 531-552, availableat: https://kb.osu.edu/bitstream/handle/1811/78301/OSBLJ_V2N1_531.pdf?sequence=1&isAllowed=y.

[11] Usually because the filing company had more than $5 millionin assets.

[12] Congressional investigation into blank check companiesexposed the extent of the fraud that plagued the industry.

[13] David Nussbaum, Chairman of GKN Securities and one of themasterminds behind the modern SPAC, noted in an ICR call with regulators thatthese securities were being made as “un-abusable” as possible: Daniel S.Riemer, “Special Purpose Acquisition Companies: SPAC and SPAN, or Blank CheckRedux?”, Washington University Law Review, January 2007, available at:https://openscholarship.wustl.edu/cgi/viewcontent.cgi?article=1160&context=law_lawreview.

[14] Enforced via contractual agreements between theparticipating parties and the charter of the shell company.

[15] While Rule 419 requires that 90% of IPO proceeds be held ontrust, modern SPACs typically so hold 100% or more (owing to sponsor capital):Ramey Layne and Brenda Lenahan, “Special Purpose Acquisition Companies: AnIntroduction”, Harvard Law School Forum on Corporate Governance, 6 July, 2018,available at:https://corpgov.law.harvard.edu/2018/07/06/special-purpose-acquisition-companies-an-introduction/.See also David N. Feldman, “Reverse Mergers: Taking a Company Public without anIPO”, Bloomberg Press, 2006, at 187.

[16] For SPACs listed on the NASDAQ, the listing rules set thiscap at 36 months: NASDAQ Rule IM-5101-2(b).

[17] As it is in the UK, pending the release of an FCA-approvedprospectus.

[18] Pershing Square Tontine Holdings Ltd. See further:Debevoise & Plimpton, “Bill Ackman and Pershing Square Launch Largest SPACTo Date: A Harbinger of Things to Come?”, 24 July, 2020, available at:https://www.debevoise.com/insights/publications/2020/07/bill-ackman-and-pershing-square-launch-largest#:~:text=On%20July%2022%2C%202020%2C%20Bill,breaking%20year%20for%20SPAC%20activity.

[19] Ortenca Aliaj, Sujeet Indap and Miles Kruppa, “Can Spacsshake off their bad reputation?”, Financial Times, 13 August, 2020, availableat: https://www.ft.com/content/6eb655a2-21f5-4313-b287-964a63dd88b3.

[20] William Freedman, “Surging SPACs: The New Normal?”,AlphaSense, available at: https://www.alpha-sense.com/insights/spacs. See alsothe view expressed by Mayer Brown: “Today, SPACs have higher quality sponsors,more blue-chip investors, bulge bracket underwriters, and better sponsorinvestor alignment structures than the past”, in “Special Purpose AcquisitionCompanies (SPACs)”, available at:https://www.mayerbrown.com/-/media/files/perspectives-events/publications/2020/08/whats-the-deal--spacs.pdf.Also note the view expressed by Benjamin Kwasnick, the founder of SPACResearch: “Great deals have brought in higher quality sponsors who in turn arestrong candidates to source and finance their own high quality transactions”:Sophie Kunthara, “2020 Is The Year Of The SPAC”, Crunchbase, 11 September,2020, available at:https://news.crunchbase.com/news/2020-is-the-year-of-the-spac/. A similar viewis expressed on SPAC Research: “There's been a flywheel effect in SPACs overthe past couple years. Exciting business combinations delivered great returnsto front-end investors and attracted higher quality sponsors, who then canbring more exciting companies to the table”: Newsletter of 7 December, 2020,available at: https://www.spacresearch.com/newsletter.

[21] Contrast, however, Klausner and Ohlrogge, “A Sober look at SPACs”.

[22] Heyman, “From Blank Check to SPAC”.

[23] See ‘SPAC to basics (II): investor perspective’.

[24]  Up to the mostrecent 13F filing date: 30 September, 2020.

[25] Based on 13F filings as of 30 September, 2020. See SPACResearch, “13F Portfolio Leaders”, available at:https://www.spacresearch.com/holder.

[26] All data employed in these calculations has been compiledin a spreadsheet available here:https://universityofcambridgecloud-my.sharepoint.com/:x:/g/personal/fh384_cam_ac_uk/Efl_z5vhp0BDiiwyExsWlBkBOnxLdNx7DFriDcgu92aviA?e=nFQ295.The data used is drawn from 13F filings between 31 March, 2018 and 30September, 2020. The full EDGAR advanced search system made available by theSEC can be accessed here: https://www.sec.gov/edgar/search/.

[27] 13 Filings require disclosures from institutions with atleast $100 million in securities and natural persons with at least $100 millionin securities investing on behalf of another.

[28] “Final” because investors may have been given a chance inthe interim following an extension request.

[29] In fact, the largest SPAC in history.

[30] See the second installment in this series: ‘SPAC to basics(II): investor perspective’.

[31] Klausner and Ohlrogge, “A Sober look at SPACs”.

[32] See, for example, PayPal’s commitment to purchase $500,000Uber shares if the IPO closed.