The Proposed Rules contain new rules and amendments to the Securities Act of 1933 (Securities Act), the Securities Exchange Act of 1934 (Exchange Act), Regulations S-K (Reg. S-K) and S-X (Reg. S-X), governing reporting requirements, and the Investment Company Act of 1940 (Investment Company Act) that would increase transaction costs for de-SPAC transactions and expose participants in de-SPAC transactions to potential liability under, among other provisions, Section 11 (imposing liability for omissions and misstatements in registration statements) and Section 12 (imposing liability for omissions and misstatements in communications related to the offering or sale of securities) of the Securities Act. In light of the aggressive enforcement environment and SPAC shareholder activism, market participants are advised to fall back on familiar tools to limit liability: thorough diligence, comprehensive disclosures, effective internal controls, and reasonable, defensible forecasts.
I. Clarified Key Definitions and Increased Disclosure Regarding Sponsors, Their Conflicts of Interest, and Their Compensation
a. Sponsor conflicts of interest
The 2020 and 2021 surge in transactions taking private operating companies public through SPACs has drawn scrutiny from regulators and investors alike. Substantial attention has been directed toward sponsors – the entities who plan and form the SPACs – and their potential conflicts of interest. For example, a sponsor may simultaneously create multiple SPACs and pursue multiple de-SPAC transactions. In such case, actual or perceived conflicts may arise if a target company meets the investment criteria of multiple SPACs formed by the same sponsor. Further, the SEC Chair has publicly stated that the SEC is “particularly focused” on the “incentives and compensation to the SPAC sponsors.” Sponsors typically receive equity in the SPAC, called the “promote,” often equal to 20 percent of the number of shares sold to the public during the SPAC’s IPO. However, if a de-SPAC transaction is not consummated, the SPAC must liquidate and return the money raised to investors, rendering the promote worthless. Regulators are concerned that this structure may incentivize sponsors to rush into de-SPAC transactions that are unfavorable to investors.
Citing these concerns with the sponsor’s potential conflicts of interest, the SEC’s Proposed Rules require disclosure of:
- The roles and responsibilities of the sponsor, its affiliates, and any promotors of the SPAC, including any agreement or understanding between the sponsor and the SPAC, its executive officers, directors or affiliates in deciding whether to proceed with a de-SPAC transaction and regarding the redemption of outstanding securities.
- The identities of any controlling persons of the sponsor and any persons who have a direct or indirect material interest in the sponsor, any material terms of lock-up agreements between the sponsor and its affiliates and the provision of a structure chart showing the relationship between the SPAC, its sponsor, and the sponsor’s affiliates.
- The amount of compensation and reimbursement that has or will be paid to the sponsor, its affiliates and any promoters in connection with the completion of a de-SPAC transaction.
- Any actual or potential material conflict of interest between (i) the sponsor or its affiliates or the SPAC’s officers, directors, or promoters and (ii) unaffiliated stockholders, with particular emphasis on disclosure of conflicts of interest in deciding whether to complete a de-SPAC transaction and the manner of compensation of the SPAC’s sponsor or its officers and directors, as well as disclosure regarding the fiduciary duties each officer and director of a SPAC owes to other companies (including other SPACs).
- Any differences in rights of stockholders following the de-SPAC transaction.
This additional disclosure would emphasize that a sponsor and its affiliates may benefit from a de-SPAC transaction regardless of whether the proposed transaction benefits public stockholders. Another effect of the increased disclosure requirements is that such disclosure may itself mitigate the risk of potential lawsuits under Section 14(a) of the Exchange Act, which provides SPAC stockholders the ability to challenge the adequacy of disclosures in connection with a de-SPAC transaction and based on state law breach of fiduciary duty claims, because stockholders would be more informed about their SPAC investment.
b. Fairness of de-SPAC transaction to public stockholders
In the same vein, the SEC also proposed rules which would mandate disclosure of the procedures the SPAC followed (if any) to ensure the transaction was fair to unaffiliated stockholders, including whether:
- The approval of a majority of unaffiliated stockholders is required for the de-SPAC transaction or any related financing.
- The non-employee SPAC directors retained an unaffiliated representative to act on behalf of unaffiliated stockholders for purposes of negotiating the terms of the de-SPAC and/or preparing a report concerning its fairness.
- The de-SPAC transaction was approved by a majority of the non-employee SPAC directors.
- The SPAC reasonably believes the de-SPAC transaction and any related financing transaction are fair to the SPAC’s unaffiliated stockholders, including the material factors upon which the fairness belief is based, such as: the valuation of the private operating company, consideration of any financial projections, any report, opinion, or appraisal from a third party, and the dilutive effects of the de-SPAC and any related financing transactions on non-redeeming stockholders.
- Any director voted against, or abstained from voting on, approval of the de-SPAC transaction or any related financing and the reasons for such disapproval or abstention.
Commissioner Heister Piece noted in dissent that while these rules do “not require a SPAC board to hire third parties to conduct analyses and prepare a fairness opinion, [they] clearly contemplate that this is the likely outcome.” In 2021, only 15 percent of de-SPAC transactions were supported by fairness opinions. These rules, if enacted, could spark a major shift in the de-SPAC process and impose additional compliance costs.
c. Conflicts of interest
Supplementing the above, the Proposed Rules would address other potential conflicts of interest by mandating disclosure of:
- The background of the de-SPAC transaction including description of any contacts, negotiations, or transactions that have occurred concerning the de-SPAC transaction.
- Any related financing transaction, including payments from the sponsor to investors.
- The reasons behind engaging in the particular de-SPAC transaction, its structure, timing, and any related financing transaction.
- A simplified disclosure table presenting an estimate of the remaining pro forma net tangible book value per share at 25 percent, 50 percent, 75 percent, and maximum redemption scenarios. If there is an over-allotment option, the table would be required to include separate rows showing the remaining pro forma net tangible book value per share with and without the exercise of the over-allotment option.
- Any material potential source of additional dilution that non-redeeming stockholder may experience in the SPAC lifecycle, such as shareholder redemptions, sponsor compensation, underwriting fees, warrants and other convertible securities, and private investment in public equity (PIPE) financings, including a sensitivity analysis in tabular format describing the amount of potential dilution under a range of reasonably likely redemption levels and quantifying the impact of dilution on non-redeeming stockholders as redemptions increase.
II. Rule Changes to Align de-SPAC Transactions More Closely with Traditional IPOs
A major objective of the SEC’s Proposed Rules is to minimize the degree to which there are differences in the public disclosure for a company being taken public through the traditional IPO process versus by a SPAC in a de-SPAC transaction (this discrepancy has been termed by some as a form of “regulatory arbitrage”).
a. PSLRA safe harbor for forward-looking statements will no longer be available in de-SPAC transactions involving an offering of securities
The targets of many de-SPAC transactions are early-stage companies with limited current revenues or profits, but with substantial “upside” projections. Under the current regime, companies going public via de-SPAC transactions are subject to lower standards with respect to the use of forward-looking statements and thus face lower risk of liability. The Private Securities Litigation Reform Act (PSLRA) provides issuers and others a safe harbor from private liability under the Securities Act and the Exchange Act if forward-looking statements are (i) identified as such and are either immaterial or accompanied by meaningful cautionary statements or (ii) not made with actual knowledge of their falsity. Absent the safe harbor, issuers, underwriters, or persons acting on their behalf may be held liable for any “untrue statement of a material fact or omission of a material fact necessary to make the statement not misleading.” The PSLRA safe harbor does not apply to any statements made in connection with an IPO or in connection with an offering of securities by a “blank check company.”
As de-SPAC mergers are not considered IPOs, and SPACs presently are not “blank check companies,” SPACs have taken advantage this safe harbor and freely made projections in their de-SPAC filings (subject to the above limitations). However, the Proposed Rules amend the definition of “blank check company” to include virtually all SPACs with the effect of treating forward-looking statements made in connection with de-SPAC transactions involving an offering of securities on par with statements made in connection with traditional IPOs. Considering that such projections are almost never provided in connection with IPOs, the Proposed Rules may chill the use of financial projections going forward and may dissuade SPACs from targeting early-stage private operating companies that do not have significant revenues but nonetheless have a promising product and need access to significant amounts of capital to bring it to the market.
Prior to the issuance of the Proposed Rules, stockholders were already challenging the PSLRA’s protection of financial projections they claimed had no reasonable basis. The significant increase in exposure to potential liability upon exclusion of SPACs from the PSLRA safe harbor underscores the importance of conducting and documenting critical review of financial projections to ensure that they are expressly forward-looking, provide cautionary language disclosing known risks, and are fundamentally reasonable and defensible (for example, do not overstate the likelihood of achieving any predicted results or the quality of the assumptions and data on which the projections are based).
Notwithstanding the proposed amendments to the PSLRA, participants in de-SPAC transactions may find protection from private liability (but not from federal or state enforcement actions) in the common law “bespeaks caution” doctrine. This doctrine may shield participants from liability if the forward-looking statement in question is accompanied by meaningful cautionary disclaimers (i.e., disclaimers that are substantive and narrowly tailored to the statement), the disclaimers are both conspicuous and extensive enough to put a reasonable investor on notice that the forward-looking statement is speculative, and, in some circuits, the forward-looking statement is made with no awareness of any facts undermining its accuracy.
b. Pre-merger disclosures would mirror the disclosures required prior to an IPO
Under the existing regulatory framework, a company going public through a de-SPAC transaction may not be required to make certain disclosures that would be required in an IPO prior to consummating the IPO. The Proposed Rules attempt to bridge this gap by requiring the target to include in the registration statement or schedule filed in connection with the de-SPAC transaction certain disclosures already required by Reg. S-K, including: Item 101 (description of business); Item 102 (description of property); Item 103 (legal proceedings); Item 304 (changes in and disagreements with accountants on accounting and financial disclosure); Item 403 (beneficial ownership); and Item 701 (recent sales of unregistered securities). Under the current rules, this disclosure must be made within four days of the consummation of the de-SPAC transaction in the “super 8-K” filed after the de-SPAC transaction, so the practical effect of this rule is simply to require this disclosure prior to the de-SPAC transaction. Still, by requiring this disclosure prior to the consummation of the de-SPAC transaction, investors are provided potentially material information prior to their voting, investment, or redemption decisions. Moreover, by requiring disclosure of this information in a registration statement, the registrant would be subject to liability under Sections 11 and 12 of the Securities Act for material misleading disclosures provided in a registration statement on Form S-4 or F-4, akin to the treatment for disclosures in Form S-1 or F-1 for a traditional IPO.
c. The target operating company must be a co-registrant with the SPAC on Form S-4 and Form F-4
The Proposed Rules take other steps to close the perceived gap between the rules governing de-SPAC transactions and traditional IPOs. Under Section 11 of the Securities Act, issuers are strictly liable for material misstatements and omissions in a securities offering registration statement, such as the Form S-4 or F-4 filed in connection with mergers and other business combinations involving an offering of securities. The current rules require only the SPAC, its principal executive officer (PEO), principal financial officer (PFO), principal accounting officer (PAO), and a majority of its board of directors to sign the registration statement. The proposed amendments to Forms S-4 and F-4 would require that the SPAC and the target company to sign the registration statement filed in connection with the de-SPAC transaction. Consequently, the additional signatories to the registration statement (i.e., the target operating company’s PEO(s), PFO, PAO, and a majority of its board of directors or persons performing similar functions) would be strictly liable for any material misstatements or omissions in the Form S-4 or F-4.
III. SPAC IPO underwriters could be treated as underwriters in registered de-SPAC transactions and liable for material misstatements under Section 11 and Section 12(a)(2) of the Securities Act
The Proposed Rules also aim to decrease the differences between a traditional IPO and a de-SPAC transaction by seeking to impose liability on underwriters that aid SPACs in their de-SPAC transaction. The Securities Act defines “underwriter” as “any person who has purchased from an issuer with a view to, or offers or sells for an issuer in connection with, the distribution of any security, or participates or has a direct or indirect participation in any such undertaking, or participates or has a participation in the direct or indirect underwriting of any such undertaking.” In the traditional IPO context, an underwriter is liable for any material misstatements or omissions under Section 11 and Section 12(a)(2) of the Securities Act in the same manner as the signatories to the registration statement (including the company’s PEO, PFO, PAO, and directors), subject to a due-diligence defense. In practice, exposure to liability incentivizes underwriters to scrutinize the issuer and its disclosures before agreeing to underwrite an offering. Underwriters thus act as a gatekeeper to screen-out companies that are unsuitable for an IPO.
Under the current rules, the underwriter of a SPAC’s IPO is not liable for the statements or omissions of the future target private company taken public through the SPAC’s de-SPAC transaction. Proposed Rule 140a would clarify that an underwriter in a SPAC’s IPO that participates in the distribution of the target company’s securities by taking steps to facilitate the de-SPAC transaction, or any related financing transaction, or otherwise participates directly or indirectly in the de-SPAC transaction, will be deemed to be engaged in the distribution of securities of the surviving public entity in a de-SPAC transaction. Thus, the underwriter of the SPAC IPO would have the same liability for the private operating company SPAC target as it would otherwise have for the issuer in a traditionally underwritten IPO in the event it participates in the de-SPAC transaction. This proposal has already impacted the market, as the prominent investment bank Citigroup, Inc. has paused its SPAC underwriting operation until it receives further clarity on these rules.
Of particular note, the SEC’s Proposed Rules explicitly state that the clarified definition of “underwriter” is “not intended to provide an exhaustive assessment of underwriter status in the SPAC context, and neither is it intended to limit the definition of underwriter for purposes of Section 2(a)(11) of the Securities Act.” Depending on the circumstances, the SEC indicated that it may consider PIPE investors and financial or other advisors to be underwriters in connection with a de-SPAC transaction if they purchase from an issuer “with a view to” distribution, are selling “for an issuer,” and/or are “participating” in a distribution.
IV. The Proposed Rules would impose a 20-calendar day dissemination period
In addition to the notable proposals above, the rulemaking would also require that registrants observe a minimum 20-calendar day dissemination period for prospectuses and proxy and information statements, or the maximum dissemination period permitted in a jurisdiction whose laws have an applicable provision that is less than 20 calendar days. The reporting company following a de-SPAC transaction must reevaluate its filer status prior to making its first non-Form 8-K filing containing Form 10 information (i.e., “super 8-K” filing) with the SEC, measuring the public float as of a date within four business days after the consummation of the de-SPAC transaction and revenue as of the most recently completed fiscal year for which audited financial statements are available. The Proposed Rules would also codify a staff position that a Schedule TO filed in connection with a de-SPAC transaction should contain substantially the same information about the target private operating company that is required under the proxy rules, making it consistent with the information required by the proposed rule amendments to Forms S-4, F-4, and Schedule 14A.
V. Treating Any Business Combination of a Shell Company Involving a Non-Shell Company as Involving a Sale of Securities
a. Business Combinations would be deemed a sale of securities to shell company stockholders
The Proposed Rules address other perceived discrepancies in the disclosure requirements for a company being taken public through the traditional IPO process versus by a SPAC organized as a reporting shell company in a de-SPAC transaction. Historically, business combinations with reporting shell companies (including SPACs) have been subject to a different disclosure regime because they were not construed as involving the “sale” of securities, which would require registration. The shell company investors were treated as having exchanged their securities in the reporting shell company for securities in the combined operating company. Proposed Rule 145a that would deem any business combination of a reporting shell company involving another entity that is not a shell company to involve the sale of securities to the reporting shell company’s stockholders. The effect of Rule 145a is to expose the transaction to Securities Act liability arising from the same registration form and informational disclosure requirements applicable to traditional IPOs.
b. Alignment of financial statement requirements for business combinations involving shell companies to those for traditional IPOs
The Proposed Rules also create new provisions of Article 15 of Reg. S-X, as well as related amendments addressing the disclosure of historical financial information. Currently, historical financial information reporting requirements differ based on whether a company was taken public through a business combination transaction involving shell companies versus the traditional initial public offering process involving Securities Act registration statements. Under the current rules, a registrant on Form S-4 or F-4 can provide two years (instead of three) of the target’s audited income statements, cash flows, and changes in stockholders’ equity if (i) the target company would be an emerging growth company (EGC) and (ii) the registrant is an EGC that has not yet filed or been required to file its first annual report, even if the target would not be a smaller reporting company. With the newly proposed Rule 15-01(b) of Reg. S-X, the SEC is proposing eliminating condition (ii), potentially reducing the number of years required when the target company would be an ECG without regard to a registrant’s annual report. These rules are consistent with the objective of treating de-SPACs like traditional IPOs.
Additionally, proposed Rule 15-01(a) would require a target private operating company to comply with Article 2 of Reg. S-X as if it were filing an initial public offering for its audited financial statements, codifying existing staff guidance. Proposed Rule 15-01(c) would provide that, for a private operating company that would be the predecessor to a shell company in a registration statement or proxy statement, the number of years of financial statements required would be based on whether the private operating company would qualify as a smaller reporting company if filing its own initial registration statement. If the private company qualifies as a smaller reporting company, Rule 8-08 of Reg. S-X (17 C.F.R. § 210-8-08) sets the number of years of financial statements required. Otherwise, Rules 3-01(c) (17 C.F.R. § 210.3-01(c)) and 3-12 of Reg. S-X (17 C.F.R. § 210.3-12) apply.
VI. Restricting Projections
Use of financial projections by SPACs has become popular in part due to the safe harbor available to SPACs under the PSLRA’s current definition of “blank check company,” (as discussed above). While disclosure of such projections was not required by federal securities laws, it served the interest of the disclosing company by increasing the probability that investors would approve a de-SPAC transaction and by facilitating compliance with state or foreign corporate law requirements to disclose the reasons behind board approval of a business combination. However, regulators and investors have raised concerns that such projections are often misleading, obsolete, overly optimistic or otherwise lack a reasonable basis. In some cases, projections are disclosed even if they are so outdated at the time of filing that the SPAC and its directors and officers are not considering them when voting to approve a particular business combination. To address these concerns, the SEC has proposed amending Item 10(b) of Reg. S-K (which contains SEC guidance on the use of projections) to ensure it applies to projections made by SPAC targets.
The proposed amendments to Item 10(b) additionally require registrants to clearly distinguish any projected measures that are not based on historical financial results or operational history from projected measures that are based on historical financial results or operational history. The rule would require that historical measures or operational history be presented with equal or greater prominence than any projections based on those historical measures or operational history. This is comparable requirement to Item 10(e)’s requirement that equal or greater prominence be given to GAAP financial measures when non-GAAP financial measures are also disclosed. Under the proposed amendments to Item 10(b), projections that include a non-GAAP financial measure must include a clear definition or explanation of the measure, a description of the most closely related GAAP financial measure and an explanation of why the non-GAAP measure was used instead of the GAAP measure. No requirement to include a reconciliation to the applicable GAAP measure was proposed.
Going further, the rulemaking proposes a new Item 1609 of Reg. S-K (which only applies to SPACs) that would require disclosure of the purpose for which financial projections were prepared, the party that prepared the projections, all material bases and assumptions of the projections and any factors that may materially impact such assumptions. Notably, the registrant must disclose whether the projections still reflect the view of the board or management of the SPAC or target company as of the date of the filing. If the projections no longer reflect the view of the board or management of the SPAC or target company, then new Item 1609 of Reg. S-K would require disclosure of the purpose of the use and disclosure of such projections and the reasons for any continued reliance by the management or board on the projections.
VII. Investment Company Act Safe Harbor for SPACs
The structure of SPACs – which are generally formed to acquire a target company, yet ordinarily invest all their assets in securities while they seek a suitable target – has raised the issue of whether SPACs are “investment companies” under the Investment Company Act. Recent high-profile litigation has asserted that SPACs qualify as “investment companies,” however, the allegations in these cases (with pending motions to dismiss) have yet to be decided by the courts, and no prior case has addressed the issue. The Proposed Rules would create a safe harbor based on features that the SEC indicates “align with the structures and practices that it preliminarily believe[s] would distinguish a SPAC” raising Investment Company Act concerns from those that would not.
The Investment Company Act relies on two tests to determine if an issuer is an investment company. Under the “objective test,” an issuer is an investment company if it is in the business of “investing, reinvesting, owning, holding, or trading in securities” and “investment securities” comprise at least 40 percent of the issuer’s assets. Cash and government securities are excluded from the definition of assets. Under the “subjective test,” an issuer is an investment company if it is “engaged primarily…in the business of investing, reinvesting, or trading in securities.” The litigants have argued that SPACs are investment companies under the subjective test. Nearly all SPACs invest their assets into treasuries prior to an acquisition. Treasuries are not “investment securities” under the objective test, but they are “securities” under the subjective test. Because SPACs invest 100 percent of their assets into securities while they search for a target, some have argued that they engage primarily in investing in securities prior to any acquisition.
The SEC acknowledged this ambiguity and proposed a non-exclusive safe harbor under Proposed Rule 3a-10 to the Investment Company Act that SPACs can use to shield themselves from the subjective test. Under the non-exclusive safe harbor, a SPAC will not be considered an investment company if it satisfies the following conditions:
- The SPAC’s assets must consist solely of cash, “Government Securities,” and “Government Money Market Funds” (which excludes securities issued by state, local, and foreign governments).
- The SPAC seeks to complete only a single de-SPAC transaction in which the surviving public entity will be primarily engaged in the business of the target company.
- Following the de-SPAC transaction, at least one class of surviving company securities would trade on a national securities exchange.
- The SPAC’s business purpose must outwardly demonstrate its intent to acquire an operating company in a de-SPAC transaction and also be evidenced by a resolution passed by its board of directors in addition to the activities of its directors, officers, and employees. The SPAC may not hold itself out as being primarily engaged in the business of investing or trading in securities.
- Upon completion of a de-SPAC transaction, the SPAC would immediately return any cash not used to execute the de-SPAC transaction to stockholders.
- The SPAC will liquidate and distribute all assets in cash to stockholders if the SPAC (i) has not announced on Form 8-K an agreement to purchase a target within 18 months of the effectiveness of its IPO registration statement or (ii) has not consummated an acquisition within 24 months of the effectiveness of its IPO registration statement.
Many of these requirements reflect current market practice. Still, some of these Proposed Rules would push SPACs into unfamiliar territory. For instance, while many SPACs have a self-imposed deadline to consummate a transaction within 24 months (or less), this deadline usually can be extended with approval from stockholders. Under the Proposed Rules, they would be required to comply with the deadline or lose the protection offered by the safe harbor. While many SPACs have been able to complete their de-SPAC transaction within this timeframe, practitioners have commented that de-SPAC transactions may become more difficult in the future because the availability of suitable target companies has decreased and the number of SPACs seeking suitable targets has increased. The population of suitable private operating company targets is likely to be further reduced by the previously discussed rule proposals creating Securities Act liability for SPAC underwriters, as well as the heavily amended disclosure regime. Under the proposed regulations, SPACs will have significantly less wiggle room if they fail to find a target and consummate the de-SPAC transaction within 24 months.
VIII. Rule Effectiveness and Comment Period
Comments to the Proposed Rules must be submitted to the SEC by the later of May 31, 2022 or 30 days following the publication of the Proposed Rules in the Federal Register. Market participants should strongly consider sharing their perspectives with the SEC as the agency considers the Proposed Rules. After considering public comments, we expect the SEC will proceed expediently to adopt the final rules. As a result, SPACs that are considering de-SPAC transactions and companies that are considering a de-SPAC business combination with a SPAC, as well as their advisors, should consider the Proposed Rules. The Proposed Rules do not indicate the effect of any such rules, if adopted, on pending de-SPAC transactions, nor do they indicate whether there will be a transition period prior to the full implementation of the rules.