Introduction
SEDA Experts has been closely monitoring the developments in the Special Purpose Acquisition Companies (SPACs) market, specifically in the litigation context. We reviewed the outstanding complaints in connection with SPAC litigation matters and identified some of the most common claims across the complaints filed so far. There are currently over 45 lawsuits filed in connection with SPAC transactions, and this number keeps growing.[1]
In this article, SEDA Experts analyze the structures of the Special Purpose Acquisition Companies (SPACs) transactions, the potential conflicts of interest, and the motivations of the various market participants involved throughout the various stages of a SPAC transaction, including to its board of directors, sponsor, target company directors, and investors.
Finally, we identify what market participants should be paying attention and making sure is in place when structuring and closing a SPAC transaction, with special attention to misrepresentation, incomplete disclosers, lack of internal controls and policy and procedures, and conflict of interests in light of the bulletins and statements from the Securities and Exchange Commission.
Market Overview
As of December 30, 2021, there were 1,331 active SPACs including pre-IPO, after IPO, totaling approximately $292 billion in terms of trust value, averaging $265 million per trust (SPAC) for 2021 SPCAs.[2]
SPACs number have been growing dramatically in the past 12 years. SPACs IPOs have been increasing at an extremely fast pace starting in 2009. In little over 10 years SPAC IPOs went from 1 (one) to 248 SPAC in 2020 and 613 in 2021. Together with such growth, comes a higher level of scrutiny by regulators and investors.
Between 2009 and 2021, 1087 SPAC concluded IPOs, 27 of them were ultimately liquidated, meaning that either no target company was acquired within the 12-24 months acquisition period, or other reasons triggered the SPACs liquidation; 368 IPO SPACs completed the acquisition of a target company, 117 announced the acquisition of a target company, and 575 IPO SPACs are still searching for potential target company to be acquired.[3]
SPAC Transaction
Participants and Capital Structure
SPAC transactions involve multiple participants throughout the various stages of the transaction i.e., incorporation, pre-IPO, IPO, target company acquisition and business combination.
SPAC sponsors play a key role during the whole SPAC and de-SPAC process. Sponsors retain the lead or managing underwriter, auditors, counsel, other advisors, and ultimately choose the senior management of the SPAC.
Sponsors also fund the early stages of the SPAC pre business combination, representing around 5% to 7% of the gross proceeds from the IPO, and in exchange receive 20% of the SPAC IPO shares in the form of Founders Shares. SPAC sponsors typically are not compensated, and proceeds resulting from the IPO are held in a trust account. This is also a way for sponsors to show commitment to the SPAC and have skin in the game, prior to the business combination occurs.
It is important to understand the capital structure and ownership of a SPAC before and after the business combination (de-SPAC), because some of the issues raised in SPAC litigation cases are related to conflicts of interest arising from ownership and investors incentives.
Units sold by the SPAC take the form of a share of common stock, and warrants, and are comprised by Founders Shares (shares purchased and help by Sponsors and Management), and Public Shares (shares purchased by retail and institutional investors). It is common to have a SPAC capital structure in which public investors hold 80% of the Common Stock and Warrants, and founder investors hold 20% of the common stock and warrants issued by the SPAC at its IPO. Unlike -With most PE or hedge funds, sponsor ownership is typically “earned” upfront and not after outside investors receive a profit.
The capital structure of a SPAC is originally comprised of common stock and warrants held by both founders and public investors. Common stock is issued at a purchase price of $10 per unit, warrants that range from a ¼ to multiple warrants, meaning, option to buy shares at $11.5 expiring within 5 years of the business combination.
Public investors can trade common shares and warrants, and enjoy the rewards of redemption protection, meaning that they can redeem their common shares at the original purchase price of $10 if they choose not to participate in the business combination.
SPACs typically take 18-24 months to identify a target company to acquire or merge (business combination). The process of transitioning from a SPAC to a merger and combination with a private company is often called de-SPACing. During the de-SPACing process, a new type of investors may be asked to step in to add capital. There Private Investment in Public Equity (PIPE) investors participate to the de-SPAC process to supplement the capital needs of the SPAC usually following the redemption right exercised by the initial public SPAC investors or because additional capital injection is required to conclude the business combination with the target company.
Finally, owners of the target company also become shareholders of the public company during and after the de-SPACing process. Ultimately, the combined public company capital structure is comprised of original public investors, founders’ investors, PIPE investors, and target company investors.
In summary, the three main participants in SPACs, the Sponsors, which own the Founder Shares, the Pre-Business Combination Investors, which own Public and PIPE shares, and the Target Company investors, which are the target company owners that will also own shares in the business combination company, are ultimately the SPACs owners.
Other participants include service provides such as advisors, auditors, underwriters, and lawyers.
Potential Conflicts of Interests
Different types of shares, founders’ shares, public shares, PIPE shares, warrants etc., all with different provisions and rights.
As explained earlier in this paper, SPAC capital structures are diverse and comprise several types of shares which in turn are issued with different features and provisions that can ultimately create conflicts of interest among the different shareholders.
For example, Founders shares usually come with anti-dilution provision but usually include redemption waivers, as opposed to common shares, that can be diluted but enjoy the benefit of a redemption option.
The Investment Advisory Committee recommends:
“Disclosure of the acceptable range of terms under which any additional funding (e.g., public investment in private equity “PIPEs”) might be sought at the time of acquisition/redemption.”[4]
Sponsor and Management lose their founders shares (common stock and warrants) and is not compensated if the merger/acquisition does not occur within the 24 months. This is a potential source for misalignment of interests (asymmetry of information and incentives) between the sponsor and other investors
The provision that establishes a timeframe i.e., typically 24 months, for Sponsors to identify a target company and finalize the business combination, can potentially misalign economic interests between sponsor and public investors, as the sponsor is not typically compensated if the business combination does not occur, as opposed to public investors that will see their investment held in escrow at the trust returned at face value. In addition, if the Sponsor does not complete a merger, it loses its entire investment.
As the SPAC approaches the 24 month after IPO, and no target company was identified or nor business combination has occurred, the Sponsor may feel tempted to rush the purchase of a target company, overlooking the target company financials, performing weak due diligence on the target company, be short on disclosure regarding the target company, as well as any conflict of interest between sponsor, management team, board of directors, underwriter with the target company and its executive and board. Sponsors will suggest that the existence of the redemption feature enjoyed by public investors negates this conflict.
The Investment Advisory Committee recommends:
“Disclosure regarding the competitive pressure and risks involved in finding appropriate targets and reaching market acceptable prices for those companies (i.e., disclosure beyond mere risk factors in the risk factor section of the SPAC registration statement), as well as disclosure regarding the absorption of expenses by the sponsor in the event there is not a successful de-SPAC transaction.”[5]
Target Company economic interests, including the desire to be acquired to obtain funding and fresh capital from investors by merging with a SPAC, is a potential source of conflict of interest
Target Company during the de-SPACing process, has the responsibility and duty to fully disclose its financial statements, projections, internal policy and procedures or lack of thereof, external and internal audit findings and recommendations, as well as any other relevant information not reflected in formal statements and reports.
A target company may be tempted to avoid full disclosure and or inflate its financial condition and projections in order to secure the purchase by the SPAC, and also to allow a better negotiation and acquisition price at the time of the business combination with the SPAC. Sponsors would say that this is similar to the funding risk inherent in all transactions.
The Investment Advisory Committee recommends:
“Disclosure regarding the manner in which the sponsor plans to assess the capability of potential targets to be a “34 Act company” from a governance and internal control perspective, and whether the sponsor will take any steps to ensure the target company can meet minimum preparedness/quality standards for operating as public company.”[6]
SEC Concerns and Request for Information on SPACs May Shed a Light on Potential Sources of Litigation.
In line with the previous topic above, the SEC has been requesting and defining the necessary forms, registrations, and statements as well as information to be included in those same regulatory documents, that SPAC management, boards and Sponsors (and target companies) must include in such statements and registrations.
The SEC acknowledged potential conflicts of interests (economic conflicts) between SPAC sponsors, directors, officers and affiliates, and its public shareholders, as early as December 2020 when it issued a Bulletin named “CF Disclosure Guidance Topic No. 11”.
The SEC calls for SPAC participants and affiliates to fully disclose in advance their own economic interests in the SPAC and the terms thereof as well as in the Business Combination.
The SEC is clearly looking to make sure sponsors, directors and officers avoid or at least adequately disclose conflicts of interests with each other and other service providers such as underwriters, and target companies as well as with investors.
The SEC emphasizes the fact that economic interests in SPACs differ whether you take on the role of a sponsor, management, officers and directors, or public investors, which may ultimately lead to potential conflicts of interest. Clear and transparent disclosure of the various economic interest and their specific terms and conditions by parties involved in the SPAC and more importantly the ones responsible for choosing and negotiating with target companies and business combinations, is paramount.
The Investment Advisory Committee recommends the Commission regulate SPACs more intensively by exercising enhanced focus and stricter enforcement of existing disclosure rules under the Securities Exchange Act of 1934 (“Exchange Act” or “‘34 Act”) in relation to the adequacy of disclosure, such as:
The SEC lists several questions to provide guidance to SPAC participants, helping them to understand whether their disclosure obligations are being met. Example of such questions and guidelines are listed below:
Sponsor Related Questions:
“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?”[7]
“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 quantified, to the extent practicable, information about the losses the sponsors, directors and officers could incur if the SPAC does not complete a business combination transaction?”[8]
“Is it possible that you will pursue a business combination with a target in which your sponsors, directors, officers or their affiliates have an interest? If so, have you disclosed how you will consider potential conflicts of interest?”[9]
“If the underwriter of your IPO may provide additional services such as identifying potential targets, providing financial advisory services, acting as a placement agent in a private offering or underwriting or arranging debt financing, have you described those potential services and disclosed the fees you may pay for those services and whether you may pay those fees in other than cash? Have you disclosed any conflict of interest the underwriter may have in providing such services given any deferred IPO underwriting compensation?”[10]
“Have you disclosed whether and how you may compensate your sponsors, directors, officers and their affiliates for services to the SPAC? Will any payments be contingent on the completion of the business combination transaction? Have you quantified known amounts?”[11]
“Have you disclosed the total percentage ownership interest the SPAC sponsors, directors, officers and affiliates may hold in the combined company, including through the exercise of warrants and conversion of convertible debt?”[12]
“Have you disclosed the fees that the underwriter of your IPO will receive upon completion of the business combination transaction, including the amount of fees that is contingent upon completion of a business combination transaction?”[13]
The Investment Advisory Committee recommends:
“Disclosure of the role of the SPAC sponsor (and/or insiders or affiliates such as celebrity sponsors/advisors), including disclosure of the sponsor’s appropriateness, expertise, and capital contributions, as well as an overview of any potential conflicts of interest on the part of the sponsor and other insiders or affiliates, and any divergence of the sponsor’s financial interest relative to that of the retail investors in the SPAC.”[14]
Registration Statement Disclosure
The Investment Advisory Committee recommends
“Disclosure that includes a clear description (with diagrams or charts as appropriate) in the SPAC registration statement of the mechanics and timeline of the SPAC process, including the precise nature of the instrument being purchased, the events required in the next two years for value appreciation of that instrument, and the details of the shareholder approval process at the time of de-SPAC (e.g., whether shareholders are permitted to vote for a deal while simultaneously redeeming their shares).”[15]
“Plain English disclosure in the SPAC registration statement (beyond mere financial footnotes) around the economics of the various participants in a SPAC process, including the “promote” (e.g., “founder shares”) paid and their impact on dilution sufficient to enable a retail investor to make a meaningful comparison of the upside potential and downside risks of a SPAC transaction compared to other SPACs as well as other types of investment opportunities. To the extent particulars cannot be determined and disclosed because they are subject to future negotiation at the time of the “deSPAC” transaction (described below), the Commission should consider ways to encourage disclosure around “guardrails” or ranges of acceptable terms.”[16]
“Disclosure in the SPAC registration statement regarding the opportunity set and target company areas of focus, including a clearer discussion of the boundaries of the search area and attributes of acceptable and unacceptable companies and the ground rules for any changes to the search area.”[17]
Analysis of Current SPAC Litigation Claims
After reviewing current claims as well as other industry papers, we found that many of the issues and allegations against defendants in SPAC matters, are often related to failure to properly disclose necessary information at the various stages of the SPAC, De-SPACing, and post-Merger/Acquisition, in the various regulatory statements i.e., IPO offering materials, proxy statements, and registrations statements.
As per Stanford Litigation Database, as of December 31, 2021, there are 45 claims outstanding related to SPACs. These could all generate potential business in the litigation and dispute space in which expert witnesses will be needed to issue opinions and testimony.[18]
Based on a general review of the claims and allegations made across the complaints filed between 2019 and 2021 above, we find, as one might expect, that claims are mainly filed against the Sponsor, Management and or Board of Directors of the respective SPACs, or against the target company and its officers.
In terms of the nature of the allegations, they tend to be related to alleged misrepresentation, failure to disclose potential conflicts of interest, omission and or inflation of the true financial condition of the target company by manipulation of financial statements and or omission of important factors that impact the ultimate valuation of the target company. (i.e., proxy statements, lack of due diligence before and during target company acquisition).
Our experts reviewed the Complaints for the 45 claims recently filed in court and have a good understanding of the main allegations and claims, as well as defendants being targeted by plaintiffs. This analysis and review provide useful insights on what will be the expertise needed by both the Plaintiffs and Defendants involved in litigation disputes, and how SEDA Experts could assist parties involved with its in house expertise across the various experts with relevant knowledge and industry experience.
Below are some examples of common claims across the complaints filed in connection with SPAC transactions:
Deceiving the public investors, inflating and manipulating the market price of the target company securities and so cause the purchasing of the securities at artificially inflated price. Specifically, by making false and/or misleading statements and/or failed to disclose that: (i) target company had deficient internal controls; (ii) as a result, the SPAC had misrepresented, inter alia, its operations’ size and regulatory compliance.
The target company’s management knew the adverse non-public information about the target company’s misstatements and have failed in their duty to disseminate accurate and truthful information with respect to the target’s financial condition and results of operations, and to correct promptly any public statements issued by the target which had become materially false or misleading.
The sponsor of the IPO, either directly or indirectly through their affiliates, established the SPAC, selecting its management and the members of the Board, granted themselves substantial benefits in the IPO and the Merger, participated in the identification of target companies to be acquired by the SPAC, and influenced and controlled the drafting of the Proxy.
SEDA Experts View of the SPAC Litigation Context
SEDA Experts look at the recent slowdown in the underwriting of new SPACs as being due to increased regulatory scrutiny, which in our opinion will potentially result in additional claims and lawsuits being filed against outstanding SPACs as well as those which will soon be newly formed.
SEDA Experts understands the challenges of the SPAC world as well as its complexity, which ultimately demand several areas of expertise to work together in a litigation and dispute context. SEDA has in house expertise among its experts and across the key subject areas traditionally involved in SPAC transactions such as, board of directors and management for public companies, and more specifically for SPACs, underwriting experience, accounting and valuation, as well as investment and capital markets.
LIST OF COMPLAINTS FILED ON SPACs.
See below list of complaints filed related to SPAC claims, including claims of alleged federal securities law violations, and or breach of fiduciary duties.
Sources:
[1] https://securities.stanford.edu/filings.html. [2] SPAC TRACK at https://spactrack.net/activespacs/. [3] https://spacinsider.com/stats/ [4] Recommendations of the Investor as Purchaser and Investor as Owner Subcommittees of the SEC Investor Advisory Committee regarding Special Purpose Acquisition Companies, August 26, 2021, SEC at [5] https://www.sec.gov/spotlight/investor-advisory-committee-2012/draft-recommendation-of-the-iap-and-iao-subcommittees-on-spacs-082621.pdf. [6] Recommendations of the Investor as Purchaser and Investor as Owner Subcommittees of the SEC Investor Advisory Committee regarding Special Purpose Acquisition Companies, August 26, 2021, SEC at https://www.sec.gov/spotlight/investor-advisory-committee-2012/draft-recommendation-of-the-iap-and-iao-subcommittees-on-spacs-082621.pdf. [7] https://www.sec.gov/corpfin/disclosure-special-purpose-acquisition-companies. [8] Id. [9] Id. [10] Id. [11] Id. [12] Id. [13] Id. [14] Recommendations of the Investor as Purchaser and Investor as Owner Subcommittees of the SEC Investor Advisory Committee regarding Special Purpose Acquisition Companies, August 26, 2021, SEC at https://www.sec.gov/spotlight/investor-advisory-committee-2012/draft-recommendation-of-the-iap-and-iao-subcommittees-on-spacs-082621.pdf. [15] Id. [16] Id. [17] Id. [18] Source: https://securities.stanford.edu/filings.html.
TEAM
Mitchell I. Gordon
Mitchell Gordon has over 30 years of industry experience as a C-suite executive, as a partner at private equity firms, and as a senior investment banker. He has extensive experience in Special Purpose Acquisition Companies (SPACs) as President and CFO, and he brings significant expertise in Investment Banking, M&A, and restructuring transactions. Click here for his bio
Richard Marin
Richard Marin as a former finance senior executive with over 40 years of industry experience, and as a former clinical professor at Cornell University is a world-class testifying expert in asset management, alternative investments, private equity investments, securities lending, retirement and pensions, and real estate/project financing. He was previously the Chairman and Chief Executive Officer at Deutsche Bank and Bear Stearns, and a senior executive at Bankers Trust Company. Click here for his bio
Damiano Colnago
Damiano Colnago is a Managing Partner at SEDA Experts, specializing in complex structured products. Mr. Colnago demonstrates intricate focus, knowledge, and expertise with regard to securities operations and reconciliation, custody and trustee services, collateral administration, and funds operations. His expertise includes damage calculations related to financial instrument defining lost profits, performing disgorgement analysis, and event study analysis. Click here for his bio
Sergio C. Godinho
Sergio Godinho is a senior professional with diversified experience in both the financial services industry, as well as providing advice in litigation, dispute resolution, mediation, and business consulting matters, including class actions and class certifications. He works closely with senior experts in establishing causation, liability, and damages across a vast array of dispute matters. Click here for his bio
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