SPACs and Corporate Disclosure

The Securities and Exchange Commission has published fresh guidance detailing how special-purpose acquisition companies — those corporate contraptions designed to go public first and then acquire other operating businesses later — should disclose conflicts of interest, financial incentives for management, acquisition strategies, and related issues.

SEC staff released the guidance on Dec. 22 as a “CF Disclosure Topic” — not legally binding like a formal SEC rule, but advice that shouldn’t be ignored, either. So compliance professionals working with special-purposes acquisition companies (SPACs) would do well to read the guidance and keep its points in mind as you prepare the SPAC’s filings or counsel senior executives about how to conquer the world without picking up an enforcement action along the way.

For those unfamiliar with SPACs, they are just what the name suggests: investment vehicles that go public first, without any actual operations. They then hold investors’ cash in escrow accounts and go on the hunt to acquire other businesses within a set period of time. Those acquired businesses then get rolled into the SPAC’s financial statements like any business that might integrate an acquisition into the quarterly reports.

There are, of course, lots of ways a SPAC’s behavior could go awry. What if it tells investors it will only acquire life science companies, and then grabs a defense contractor? What if the SPAC’s board approves an acquisition where the CEO has an ownership stake in the target? And so forth and so on. 

Moreover, SPACs have been sprouting like weeds this year. According to financial data firm Calcbench, the number of SPACs filing statements with the SEC more than doubled from Q3 2019 to Q3 2020, and most of that surge happened in the middle of 2020. Seventy-six SPACs that formed within the last year have more than $100 million in assets.

That’s a lot of cash gushing into a high-growth sector brimming with disclosure risk. No wonder the SEC decided to release some guidance to keep everyone on the straight and narrow.

Disclosure Duties at the Beginning

The SEC guidance begins with a look at disclosure concerns SPACs will face when going public, and conflicts of interest among the SPAC’s senior executives was a primary theme. For example, the chief executive of the SPAC might also serve on the board of another company, where both businesses could be hunting for similar acquisition targets. 

So how do you disclose a conflict like that to investors? The SEC offered a few questions for self-reflection. 

Have you clearly described the sponsors’, directors’ and officers’ potential conflicts of interest?  Have you described whether any conflicts relating to other business activities include fiduciary or contractual obligations to other entities; how these activities may affect the sponsors’, directors’ and officers’ ability to evaluate and present a potential business combination opportunity to the SPAC and its shareholders; and how any potential conflicts will be addressed?

There’s more. SPACs typically promise investors that they will acquire operating businesses within a set timeframe (say, 18 or 24 months) or else return their cash to investors. So as a SPAC approaches that deadline and is under more pressure to put that cash to work, it’s in a weaker position to bargain with acquisition targets. Even better: the SPAC executives might have bonus compensation tied to closing such deals, and the price might not always align with investors’ interests.

Back to the SEC guidance: 

Have you clearly described the financial incentives of SPAC sponsors, directors and officers to complete a business combination transaction? Have you disclosed how these incentives may differ from the interests of public shareholders? Have you disclosed the amount of control that SPAC sponsors, directors and officers and their affiliates will have over approval of a business combination transaction?

The guidance also includes questions about how a SPAC might change its governance rules — say, the process for amending the SPAC’s acquisition deadline, or for amending the authority an executive would have to approve or deny a deal. As usual, the actual processes or discretion aren’t the issue here; it’s how the SPAC discloses that power to change the rules to its investors that matters to the SEC. 

And Duties During Acquisitions

OK, let’s say your SPAC answered those IPO-related questions (and many, many more I didn’t mention here), and now the SPAC is ready to pounce on a target. What disclosure obligations come next? The SEC identified three categories of concern.

First, the SPAC should disclose any additional financing that’s necessary for the proposed acquisition. If that financing involves issuing new securities for sale, the SPAC needs to explain the structure of that secondary offering and how it compares to the original securities offering at the IPO.

Second, the SPAC should disclose how its executive officers evaluate acquisition targets. That includes details such as which party approached the other about a potential acquisition, how the SPAC decided on a purchase price, and why the SPAC selected its actual target rather than other potential targets that it might have been considering. 

The third category of concern was potential conflicts of interest during an acquisition, and the SEC devoted a lot of attention to it. For example:

Have you clearly described any conflicts of interest of the sponsors, directors, officers and their affiliates in presenting this opportunity to the SPAC and how the SPAC addressed these conflicts of interest? If the SPAC had a policy to address conflicts of interest and waived any provisions of that policy, have you disclosed the waiver and the reasons therefor? Have you described any interest the sponsors, directors, officers or their affiliates have in the target operating company, including, if material, the approximate dollar value of the interest, when the interest was acquired and the price paid? 

More questions follow about payments that executives might receive as part of an acquisition, the ownership stakes that executives will have in the SPAC after closing, and other potential conflicts of interest. 

In other words, the SEC has extensive expectations for what SPACs disclose about potential conflicts of interest. And given the nature of SPACs — that they raise gobs of cash and then go on acquisition sprees — those potential conflicts are likely to come up over and over. 

So it would behoove SPACs to implement a disciplined, systematic approach to disclosing and managing conflicts of interest, long before any specific acquisition comes along that might color executives’ objective judgment. That might not be what SPAC managers want to hear just as they prepare to conquer the world, but it beats dealing with an SEC regulatory probe later.