SPAC ATTACK – The SEC’s Proposed New Regulations

On March 30, 2022, the SEC released a sweeping proposal that would significantly increase the regulatory burden on de-SPAC transaction participants, with the stated goal of providing investors in these “going public” transactions with the same level of protection investors receive when companies conduct traditional IPOs. In the SEC’s view, “a private operating company’s method of becoming a public company should not negatively impact investor protection.” The long-foreshadowed proposal, which was drafted by staff in the SEC’s Divisions of Corporation Finance and Investment Management, was approved by a vote of three Commissioners to one.

We summarize below the four key focuses of the proposed rules relevant to de-SPAC transactions:

• Use of projections;
• Gatekeeper and private operating company responsibility;
• Heightened disclosure obligations; and
• SPAC status under the Investment Company Act of 1940.

The proposed rules also include provisions applicable to SPAC IPOs and other SPAC transactions but these are beyond the scope of this alert.

Projections

The perceived ability to include a private target company’s financial projections in de-SPAC registration and proxy statements as well as PIPE investor decks while enjoying the benefit of the safe harbor from securities law liability for forward-looking statements has been cited as a key advantage of the de-SPAC route of going public.^[1] Well-accepted liability concerns in IPOs generally make the use of projections in IPO registration statements a non-starter. The SEC’s proposed rules would clarify that securities law liability does indeed attach to forward-looking statements, such as projections, used in de-SPAC registration and proxy statements.^[2]

Where target company projections are included in de-SPAC registration and proxy statements despite the potential securities law liability (for example, to satisfy state law disclosure requirements in the context of shareholder votes on business combinations), the SEC’s proposed rules would require that^[3]:

Projected measures that are not based on historical financial results or operating history be clearly distinguished from projected measures based on such factors;

• Historical financial results and operating history be presented with equal or greater prominence than projections based on such historical information; and
• Projections that include non-GAAP financial measures be presented with a clear explanation of each non-GAAP measure, a description of the most closely related GAAP measures, and an explanation of why the non-GAAP measures were used instead of the GAAP measures.

The SEC’s proposed rules also would require a SPAC that includes the private operating company’s projections in its de-SPAC registration or proxy statement to disclose:

• The purpose for which the projections were prepared and the party that prepared the projections;
• All material bases of the disclosed projections and all material assumptions underlying the projections, and any factors that may materially impact such assumptions (including a discussion of any factors that may cause the assumptions to be no longer reasonable, material growth rates or discount multiples used in preparing the projections, and the reasons for selecting such growth rates or discount multiples); and
• Whether the disclosed projections still reflect the view of the board or management of the SPAC or target company, as applicable, as of the date of the filing; if not, then discussion of the purpose of disclosing the projections and the reasons for any continued reliance on the projections by management or the board.

Taken together, the SEC’s proposed rules regarding the use of projections in de-SPAC registration and proxy statements reflect the SEC’s uneasiness with the rigor with which projections used in de-SPAC transactions have been prepared and vetted. The SEC stated that its proposed rules regarding projections are intended to assist shareholders in assessing the rationale for and reliability of these projections.

Gatekeeper and Private Operating Company Responsibility

In order to address the SEC’s concerns regarding the amount of vetting de-SPAC registration and proxy statements receive, the SEC proposed a significant expansion of the securities law liability regime that currently applies to disclosures regarding de-SPAC transactions. If adopted as proposed, the SEC’s rules could have a chilling effect on the participation of sophisticated financial advisors and investors in de-SPAC transactions and would impact the due diligence process and review and approval of SEC filings regarding the de-SPAC transaction.

Underwriter Liability

Underwriters in traditional IPOs conduct thorough due diligence of issuers and their disclosures in order to protect themselves against securities law liability under Section 11 of the Securities Act, which provides an avenue for investors to hold issuers, officers and directors, underwriters, and others liable for damages resulting from material misstatements or omissions in registration statements. Unlike in IPOs, Section 11 liability does not currently attach to investment banks involved in facilitating de-SPAC transactions. The SEC’s proposed rules aim to motivate gatekeepers such as investment banks to conduct the same level of due diligence they conduct in IPOs in de-SPAC transactions by creating a similar liability structure for the banks. 

Underwriters of a SPAC’s IPO often participate in the subsequent de-SPAC transaction as financial advisors, assisting with the identification of targets, negotiation of merger terms, and structuring of concurrent financing transactions, such as PIPEs. In addition, a portion of the SPAC IPO underwriting compensation frequently is deferred, payable only upon the completion of a de-SPAC transaction, which incentivizes a SPAC’s IPO underwriters to facilitate the later de-SPAC transaction.

Proposed Rule 140a under the Securities Act would deem any SPAC IPO underwriter that facilitates the subsequent de-SPAC transaction (or any related financing transaction) or otherwise participates, directly or indirectly, in the de-SPAC transaction to be engaged in a distribution of securities and therefore to be an underwriter of the de-SPAC transaction. As an underwriter of the de-SPAC transaction, the IPO underwriter would be subject to liability under Section 11 of the Securities Act for disclosures in de-SPAC filings. Notably, the SEC alluded to the possibility that additional parties involved in the de-SPAC process, such as financial advisors and PIPE investors, may also be deemed underwriters of the de-SPAC transaction and consequently subject to a heightened standard of liability for misstatements or omissions in a de-SPAC registration statement.

Private Operating Company Liability

Currently, a de-SPAC registration statement is filed by the SPAC and signed only by SPAC executives and directors. Because a de-SPAC transaction effectively serves as the IPO of a private target, the SEC’s proposed rules would deem the private operating company to be treated as a co-registrant of the SPAC for purposes of Section 6(a) of the Securities Act, which sets forth required signatories of registration statements under the Securities Act. This would render the target company’s signatories (including its principal executive officer, principal financial officer, controller/principal accounting officer, and its directors) liable under Section 11 of the Securities Act for any material misstatements or omissions in the de-SPAC registration statement.

Heightened Disclosure Obligations

The SEC also proposed additional disclosure requirements specific to de-SPAC transactions. In large part, these disclosure requirements reflect a view that de-SPAC transactions are inherently conflicted because of the structure of the SPAC. The proposed rules borrow heavily from Regulation M-A disclosure requirements applicable to Rule 13e-3 going private transactions. 

De-SPAC Fairness and Key Additional Disclosure Requirements

Significantly, the SEC proposes to require disclosure in a de-SPAC registration or proxy statement regarding whether the SPAC reasonably believes the de-SPAC transaction and any related financing transactions are fair or unfair to unaffiliated security holders. This disclosure must include a reasonably detailed discussion of the material factors upon which the belief is based (which may include target valuations, fairness reports, and potential dilution) and, to the extent practicable, the weight assigned to each factor.^[4] If a SPAC or its sponsor receives a third-party report, opinion or appraisal regarding the fairness of a proposed de-SPAC or related financing transaction, it must disclose specified information about the report, opinion or appraisal and the document must be filed as an exhibit to the registration statement or included in the proxy statement.

Key additional proposed de-SPAC disclosure requirements include:

• Roles and responsibilities of the SPAC sponsor, its affiliates, and any promoters; arrangements regarding voting in favor of the de-SPAC transaction, redeeming outstanding securities, and lock-up restrictions; and compensation and reimbursement paid and payable to the SPAC sponsor, its affiliates, and promoters.
• Conflicts of interest between the SPAC sponsor, its affiliates, or any SPAC officers, directors or promoters, and unaffiliated SPAC security holders (including conflicts relating to contingent sponsor compensation and simultaneous involvement in multiple SPACs). Disclosure regarding the fiduciary duties owed by SPAC officers and directors to other companies would also be required.
• Potential dilution of SPAC security holders from the de-SPAC transaction and any related financing transactions, particularly if holders do not redeem their shares prior to the de-SPAC transaction. In a registration statement, the cover page would need to include tabular disclosure of anticipated dilution at varying potential redemption levels.
• Background, material terms and effects of the de-SPAC transaction and any related financing transactions.

The SEC noted that these rules would largely standardize the disclosures that most SPAC disclosure documents typically provide.

Alignment of de-SPAC Disclosure with Traditional IPO Disclosure

• Earlier Form 10 disclosure requirements: After a de-SPAC transaction, the surviving public company must file a “Super 8-K” containing all of the information that would be required in a Form 10 registration statement. The proposed rules would require this disclosure earlier in the de-SPAC transaction process in the registration or proxy statement, consistent with IPO registration statement disclosure requirements.
• Financial disclosures: Proposed Article 15 of Regulation S-X and related amendments to Regulation S-X would modify the financial statement disclosure requirements applicable to de-SPAC transactions to ensure consistency with traditional IPOs, including requiring that the de-SPAC target’s financial statements must be examined by an independent accountant in accordance with PCAOB standards.

Procedural Updates

• Minimum prospectus and proxy statement dissemination periods: SPACs will be required to deliver their de-SPAC prospectuses/proxy statements at least 20 calendar days prior to the shareholder vote unless applicable state law provides for a shorter period.
• Re-determination of smaller reporting company status: Companies that qualify as “smaller reporting companies” (“SRCs”) are eligible for scaled disclosure requirements. Post-de-SPAC companies may retain the SPAC’s SRC status until the first determination date after the de-SPAC transaction, which would be the end of the public company’s second fiscal quarter. The proposed rules would require a re-determination of SRC status within four business days after the closing of the de-SPAC transaction, which must be reflected in the public company’s first periodic report.

Investment Company Act Safe Harbor

Finally, the proposed rules seek to clarify the treatment of SPACs under the Investment Company Act of 1940. An “investment company” is an issuer that is or holds itself out as being engaged primarily, or proposes to engage primarily, in the business of investing, reinvesting, or trading in securities. To date, the SEC has not deemed any SPACs to be “investment companies” in connection with their IPOs (and in August 2021, over 55 law firms, including Covington, signed onto a statement rejecting the contention that SPACs are investment companies).

To provide more certainty for SPACs, the SEC proposed a safe harbor from the definition of “investment company” under Section 3(a)(1)(A) of the Investment Company Act for a SPAC that satisfies the following conditions:

• The SPAC’s assets prior to the de-SPAC transaction consist solely of government securities, government money market funds and cash items. These assets may not be acquired or disposed of for the primary purpose of recognizing gains or decreasing losses resulting from changes in market value.
• The SPAC must seek to complete a single de-SPAC transaction that would result in a surviving public company primarily engaged in the non-investment company business of the target company. The single de-SPAC transaction could involve business combinations with multiple target companies, but the SPAC must treat the multiple business combinations as a single de-SPAC transaction in its descriptions in SEC disclosure and reporting documents and the closing of all such transactions would need to occur contemporaneously. The surviving company must have at least one class of securities listed on a national securities exchange.
• The SPAC must announce a business combination agreement with a target within 18 months after effectiveness of the SPAC’s IPO registration statement, and the de-SPAC transaction must be completed no later than 24 months after IPO registration statement effectiveness. Following the de-SPAC transaction, assets that are not transferred to the target company in connection with the transaction must be distributed in cash to the SPAC’s investors as soon as reasonably practicable. A SPAC would also be required to distribute its assets to investors if it does not meet either the 18-month or 24-month deadline.

SPACs would not be required to rely on this Investment Company Act safe harbor, if adopted as proposed.

What Happens Next?

The public comment period for the SEC’s proposed rules will remain open until the later of 30 days after publication in the Federal Register or May 29, 2022. We expect comments to be mixed, with retail investors largely in support of the proposal and SPAC market participants disfavoring many of the proposed rules. In particular, the requirement for enhanced disclosures around the fairness of the de-SPAC transaction, and the related requirement to file any third-party fairness evaluation obtained by a SPAC, as well as the imposition of underwriter liability on financial advisors and other potential market participants in a de-SPAC transaction, could spur a number of comments in opposition to the proposed rule.

If you have any questions concerning the material discussed in this client alert, please contact the members of our Securities and Capital Markets and Mergers and Acquisitions practices.