The Securities & Exchange Commission is stepping up its warnings about special purpose acquisition companies, with a new statement today walking through the internal control and governance concerns that SPACs and the private businesses they acquire are obligated to meet. 

SPACs, also known as blank-check companies, are all the rage on the capital markets these days. They are publicly traded shell companies, which raise gobs of money from investors first and then go hunting for private operating companies to acquire. Usually the SPAC has a certain investing them — say, only medical businesses, or only women-led firms, or only ESG-related businesses — and some SPACs hire celebrity “advisers” to help raise the SPAC’s profile.

Of course, despite all the glam around some of these capital contraptions, SPACs are supposed to go about the business of acquiring private companies and take those companies public, typically within two years. If the investment money isn’t spent by then, the SPAC is required to — gasp! — return its money to the investors. 

So the concern is that SPACs will be under pressure to scoop up private businesses as quickly as possible, and will toss good governance and internal control concerns over the side. Which is a risk to investors that the SEC does not want, and hence the SPAC statement today.

Indeed, this is the third time the SEC has spoken about SPACs in four months. It first published guidance on Dec. 22 about the possible conflicts of interest that SPACs should consider and disclose to investors. Then came an investor alert on March 10 about celebrity advisers to SPACs, whose ranks include Shaquille O’Neal, Steph Curry, Serena Williams, and Ciara. (Disclosure: I had to look up who Ciara is. Apparently she’s a singer.) 

So what did today’s statement cover? Let’s take a look.

Internal Control Requirements

First, like any good publicly traded firm, the SPAC and its operating businesses will need to maintain adequate books and records; and meet Sarbanes-Oxley Act requirements for effective internal control over financial reporting. 

That includes management’s duty to establish and maintain adequate ICFR, as well as disclosure controls and procedures. Management aso has to evaluate and disclose its assessment of ICFR every year, as required under Section 404(a) of SOX; and do the same for disclosure controls and procedures every quarter. The books-and-records provisions are important for compliance with the Foreign Corrupt Practices Act and to reduce the risk of accounting fraud. 

One important point is that in most cases, the books-and-records and ICFR provisions will apply to the SPACs and their acquisition targets from the day the merger is complete, and the previously private business is now part of a publicly traded SPAC. So the SPAC and its targets need to straighten out these internal control questions before they complete the merger. (In a few special circumstances where management can’t assess the state of ICFR in the year the deal closes, you might be able to stall until the second year, but the SEC staff does expect such occasions to be rare.)

Another wrinkle here is that some new accounting standards might apply to public businesses but not yet to private ones, so the SPAC’s targets might not have tooled up their financial processes for those new standards yet. Again, the SEC expects the SPAC to bring the private business up to public company standards before the deal closes, not after. 

Overall, the SEC had this to say about ICFR and financial reporting issues:

The combined company will need the necessary expertise, books and records, and internal controls to provide reasonable assurance of its timely and reliable financial reporting. A private operating company may have viewed the necessity for those capacities differently prior to the business combination, and may not be able to develop those capacities without advance planning and investment in resources.

Don’t let the stilted language here fool you. The SEC is warning SPACs and their private company targets to figure out potential ICFR time bombs before going public, rather than leave those bombs explode in a 10-K or 10-Q several years down the road where investors are the ones who suffer. 

SPACs and Governance Concerns

The SEC also warned SPACs that they will need to meet listing standards to trade on U.S. exchanges, which means corporate governance standards such as a board with a majority of independent directors; a fully independent board audit committee; a Code of Conduct applicable to all employees; and independent director oversight of executive compensation. 

“There is a risk that a private operating company that has not prepared for an initial public offering and is quickly acquired by a SPAC may not have these elements in place in order to meet the listing standards at the time required,” the SEC warned. “Advance planning may be necessary to identify, elect, and on-board a newly-constituted independent board and audit committee, and for them to adequately oversee the preparation and audit of the company’s financial statements, books and records, and internal controls.”

My question is how this point about independent corporate boards will square with businesses owned by venture capital or private equity firms. I’m sure the folks at VC or PE firms would love to talk with SPACs about a cash-out opportunity for one of their portfolio companies, but said portfolio companies often have numerous board directors who are partners at the VC or PE firm — meaning, they’re not independent. So how will the SPAC looking to acquire and the PE firm looking to sell reconstitute the board of the portfolio company, especially if they’re looking to close a deal quickly? Where are all these qualified independent directors supposed to come from? 

SPACkling Over the Weaknesses

Clearly the SEC has concerns about SPACs, and for good reason. The total number of these things soared in 2020, and they show no sign of abating in 2021. Some SPACs are making headlines for deals that are theoretically possible, but on paper they sound flat-out nuts. 

Case in point: the news last week that WeWork — you know, the shared office space startup that lost $3.2 billion last year; and canceled its IPO in 2019 amid conflict of interest questions about founder Adam Neumann — is preparing to go public via a SPAC that lists Shaquille O’Neal among its advisers. I mean, what could go wrong? 

According to data from Calcbench, 91 SPACs were filing quarterly reports at the end of 2020. In total they had assets of $19 billion, and $16.9 billion of that amount was listed as “non-current assets held in trust.” That’s the cash SPACs are holding for investment and must use within two years, or else the dough goes back to investors. 

How much damage can these firms do with $16.9 billion, and probably more raised in Q1 2021? I don’t know, but the longer they wait to do a deal, the more pressure they’ll face to do a deal. Which means they’ll offer higher prices to those private businesses, and that has a funny habit of making executives say, “Our ICFR? Ummm, yeah, sure; that stuff is fine. When can you send the wire?” 

My fear is that by 2023 or so, we’ll see a boomlet of accounting scandals proving that such promises made today were baloney. I don’t know that it will be as bad as the massive frauds 20 years ago that led to SOX, but even a shorter, lamer sequel to that period will not be a fun time. No wonder the SEC wants to avoid it.

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