Jumping on the SPAC train? Not so fast. Securities litigation is on the rise.
While the last two years will likely be remembered mainly for the COVID-19 pandemic ravaging the globe, many in the financial space will also remember this time as the rise of Special Purpose Acquisition Companies, more commonly referred to as SPACs. The number of SPAC initial public offerings (IPOs) rose exponentially from 59 in 2019 to 248 in 2020 to an astonishing 498 in 2021, raising over $120 billion this past year alone. SPAC IPOs now make up more than three-fifths of all IPOs in the United States. With this rise in popularity has come greater scrutiny by the SEC and an increase in securities litigation filed on behalf of shareholders. Despite the pace of new SPACs slowing mid-year, by the end of 2021 the market was booming once again and the wave shows no signs of cresting as 2022 begins.
In addition to their increasing popularity among institutional investors, SPACs have become a new status symbol for celebrities and financiers alike, drawing in a whole new crowd of interested participants, including retail investors. With SPACs being run by the likes of professional athletes like Alex Rodriguez and musicians like Jay-Z, it is easy to get caught up in the hype. There has been so much hype in fact, that the SEC had to issue a warning to “never invest in a SPAC based solely on a celebrity’s involvement.” While having name recognition and success in other fields, those promoting SPACs don’t necessarily have the financial savvy and experience to pick the most profitable companies.
So what are SPACs and why are they so popular? They’re essentially shell companies set up by investors for the sole purpose of raising money through IPOs to acquire or merge with other companies and take them public, usually within two years. SPACs have no underlying operating businesses and do not have assets other than proceeds from the IPOs. The founders of SPACs do not identify the targets of the acquisitions before the IPOs, which is why they are sometimes referred to as “blank check” companies. Investors do not know what companies they will ultimately end up investing in.
Once the SPAC acquires a target company, they merge in a process known as a “de-SPAC” transaction, after which they become an operating company with publicly traded shares. SPACs are popular because they frequently result in a large return on investment for the sponsors putting up the initial capital (usually a 20% interest in the SPAC that is converted to shares in the public company after the merger) and they can be easily created without having to comply with the regulatory requirements for traditional IPOs.
In a normal IPO process, a company going public must issue various disclosures about its financial records and history. Because a SPAC is not an operating business at the time of its IPO, it has very little financial information to report, and therefore it is easier to meet disclosure obligations. Further, companies with IPOs are barred from making projections about future earnings so as not to mislead investors with overly rosy forecasts of future success not based on underlying data. SPACs, however, are free to publish financial projections for themselves, which can be inflated and based on very little but hype.
With their quick rise in popularity, and little regulation, it was only a matter of time before there was an increase in litigation. In fact, at least thirty-five securities class action lawsuits relating to SPACs have been filed since 2019, with the number expected to keep rising each year. Last year, suits involving SPACs tripled. There are two main aspects of SPACs that make them particularly ripe for securities suits and will fuel continued litigation.
1. The SPAC structure and environment may encourage fraud.
SPACs are designed with systemic misalignments of incentives that create an environment conducive to fraud. The SPAC sponsors often contribute only a relatively small amount of assets to cover overhead before taking it public, but usually receive a 20% interest in the resulting company. Given the significant rise in the number of SPACs and deals in the last year, the market is flooded with potential buyers, resulting in a shrinking pool of profitable companies to acquire within the two-year time frame. As a result, many SPACs are overpaying for companies and receiving high valuations because of increased demand alone and not their actual value.
Further, the system provides significant incentives for sponsors to exaggerate or overinflate the value of the target company, which can cross the line from hype to fraud. In a speech on December 9, 2021, SEC Chair Gary Gensler noted that “SPAC sponsors may be priming the market without providing robust disclosures to the public to back up their claims. Investors may be making decisions based on incomplete information or just plain old hype.” The way SPACs are designed, even if the company ends up being an unprofitable acquisition, sponsors often walk away with a significant profit, frequently making several hundred percent on their original investments, while the return for retail shareholders is usually far less.
Additionally, sponsors may cut corners on due diligence because they are typically looking to merge within two years. SEC Chair Gensler has further noted that investors in SPAC IPOs should be afforded similar protections as those in standard IPOs, but that the “gatekeepers” behind SPACs, such as directors and officers, sponsors, financial advisers, and accountants “may not be performing the due diligence that we’ve come to expect.” Standard IPO due diligence practices can take time. Sponsors have an interest in making an acquisition quickly, regardless of the quality of the operating company they are purchasing, and with limited due diligence, in order to maximize their own profit and ensure an acquisition occurs within the required time frame. If they don’t meet the deadline, they need to refund investor money.
The SPAC’s underwriting banks also have reason to exaggerate the value of an acquired company and downplay any potential issues with the merger. SPACs are not required to disclose their banks’ fees in regulatory filings. But typically sponsors pay such banks a 5.5% fee for underwriting the IPO, part of which is paid upfront, with the remainder paid once a merger is complete. The underwriting banks therefore also have an interest in a merger going through, regardless of the value of the target company. This risk is further compounded by the fact that these same underwriting banks can sometimes earn even more fees if they represent the target company and assist the SPAC in raising additional capital for the merger.
Combine this potential for fraud with limited due diligence and you get the key ingredients for securities litigation. And while it is true that there are fewer registration requirements for SPACs, particularly at their IPO, there are still several disclosure requirements that must be complied with, the violation of which can be the basis for shareholder actions. In fact, as a merger vehicle, SPACs are uniquely susceptible to certain claims relating to proxy statements that are easier to prove than securities fraud claims.
2. Securities claims against SPACs may be easier to prove.
Securities class actions are brought under a variety of laws, chief among them Section 10(b) of the Securities Exchange Act of 1934 (“Exchange Act”) and Rule 10b-5 promulgated thereunder, which prohibit companies from engaging in several types of fraudulent behavior, including making material misstatements or omissions in connection with the sale of a security. To prove a Section 10(b) claim, a class must plead facts showing a strong inference that the company acted recklessly or with the intent to deceive, manipulate, or defraud. Proving intent, which is a state of mind, particularly of a corporation, can be exceedingly difficult and by its very nature can often only be proven through circumstantial evidence. The element of intent, therefore, presents a significant hurdle to successfully prosecuting cases.
With SPAC litigation, the plaintiffs can bring proxy claims under Section 14(a) of the Exchange Act and Rule 14a-9 promulgated thereunder. During the de-SPAC transaction, once a business has been identified for acquisition, the acquisition is put to a shareholder vote. As part of that process, the SPAC must issue a proxy statement through which it discloses detailed information about the target business, including its financial history, operational structure, and financial projections of its expected performance. Section 14(a) prohibits material misstatements and omissions in proxy statements that cause injury to a plaintiff. Unlike Section 10(b) claims, however, Section 14(a) claims only require plaintiffs to show that a company was negligent, not that it recklessly or intentionally lied or omitted key facts. To prove negligence, a plaintiff class needs to show that a company acted with less care than an ordinary company would have exercised under similar circumstances. It is a much lower bar to meet than proving intent and will no doubt result in an increase in securities class actions against SPACs.
The fact that the demand for target companies by SPACs has increased while the pool of quality companies for purchase has decreased will only further contribute to the filing of such actions. Plaintiffs’ counsel and frustrated SPAC investors could decide to file whenever an acquired company fails to perform well after the de-SPAC transaction. SPAC investors could then argue under Section 14(a) that the sponsors and SPAC made misrepresentations and omitted information regarding the financial conditions of the target company to convince shareholders to approve the transaction so that the sponsors could profit and the SPAC could meet the two-year deadline. They would then allege that the SPAC was negligent in doing so, e.g. that it failed to conduct sufficient due diligence, and that they relied on the SPAC’s false statements or omissions in the proxy statement to approve the transaction, suffering injury when the target company underperformed.
Pending securities class actions against SPACs have asserted Section 14(a) claims, as well as claims under a variety of additional securities laws, including Section 10(b) and others. As investors continue to pour more money into a system structurally primed for fraud, and some SPAC-purchased companies turn out to be poor acquisitions, more securities cases will inevitably follow.
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