SPAC 101: Why SPACs are running into lawsuits and regulatory hiccups

For the better part of 2021, special purpose acquisition companies have been on the rise, with more and more IPOs sealed. SPACs, also known as blank check companies, have become a darling to Wall Street. But in recent days, these entities have come to face an array of class-action lawsuits and other hiccups.

Understanding SPACs

A SPAC is a shell company created by investors to raise funds via an IPO to acquire another company. For example, Diamond Eagle Acquisition Corp. was established as a SPAC in December 2019. The company then reported a merger with gambling tech platform SBTech and fantasy sports platform DraftKings. The deal was sealed in April, when DraftKings was able to trade as a public firm.

Technically, a SPAC does not involve commercial operations. That means it does not sell any merchandise or make any products. According to the Securities and Exchange Commission, the only asset a SPAC has is the money from its IPO. Typically, a SPAC is sponsored by a team of investors. Some highly regarded Wall Street professionals and high-profile CEOs such as Richard Branson, among other billionaires, have joined the bandwagon and formed their own SPACs.

Usually, as the SPAC raises money via an IPO, the investors purchasing the IPO do not know what the acquisition company will be. Institutional investors with records of huge success are able to easily convince people to buy their IPOs in the unknown. That is why these firms are known as blank check companies.

Almost all SPAC IPOs have a standard price of $10 for every share. After the company raises the share capital, this money is wired to an interest-bearing trust account. It remains there until the company’s management or the founders find a private company that is ready to go public via acquisition. After the purchase, the investors who initiated the SPAC can swap the original shares for the merged company shares or redeem them to acquire their initial investments and the interest.

SPAC sponsors have a time line in which they must find a favorable deal. Usually, that is around two years after the IPO. If they do not, the SPAC is liquidated, and the team will receive their money back plus interest accrued.

More insights on SPACs

Even though these companies have been used for several years as an alternative investment opportunity, their popularity has risen as an easy way to take private companies public in a way that mitigates the market volatility risk of an IPO. Last year, was a record-breaker for SPAC IPOs, and 2021 seems even better.

According to spacinsider.com, 248 IPOs were completed in 2020, while in 2021, the number has shot to 298. Accompanying the surge in the SPAC IPOs is an increase in shareholder lawsuits. Most of these lawsuits are filed after the announcement of mergers. Data shows that shareholders have filed 19 class-action lawsuits relating to SPACs in federal court so far this year versus five in 2020.

Why the increase in class-action lawsuits?

A SPAC IPO’s liability is captured in the Securities Act of 1933. Once the SPAC is public, it must undergo periodic reporting requirements as stipulated in the Securities Exchange Act. Liabilities may arise from several things, such as omissions in the periodic filings, material misstatements, or even the proxy statements filed.

In December 2020, the SEC’s Division of Corporation Finance released guidance about issues that touch on SPACs. Most of these issues are consistent with allegations found in the class-action suits filed today. The guidance highlights conflicts of interest among the management team or company that created the SPAC and the SPAC’s directors, affiliates, shareholders and officers as of particular concern.

Corp Fin tells SPACs to carefully look at the disclosure obligations as per federal securities law. For example, the SPAC sponsor does not have much time to get an acquisition target and seal off the business combination. As the time frame of the SPAC draws near extinction, the sponsor’s options narrow, and the acquisition target gains significant leverage on the negotiating table. 

Such an instance may cause a schism between the sponsor’s economic interests and the shareholders’ interests. The sponsor is looking to close the deal before time runs out, but shareholders’ interests demand a fair deal at a favorable price.

Corp Fin urges SPACs to ensure they delineate the financial incentives of the officers, sponsors and directors while going for the business combination transaction. They should be clear about how these incentives may differ from shareholders’ interests to avoid class-action lawsuits. Corp Fin also advises SPACs to disclose whether the time limit can be extended before acquiring a firm. Directors, affiliates, officers and sponsors of the SPAC must be apprised of the potential financial impact of a failed acquisition.

Another potential conflict with a SPAC is if additional financing is needed to complete the combination transactions. Corp Fin urges SPACs to disclose how the additional financing terms may affect the public shareholders. Will it entail issuing securities and if so, how do the terms and prices of those securities compare to the securities sold in an IPO? 

Potential conflicts could also arise in the evaluation and selection of acquisition candidates. The SPAC should state the amount and the nature of consideration it will pay to merge with this acquisition company, and how this was derived. The board of directors should also explain the material factors it looked at to approve the transaction.

Parting shot

SPACs will continue to be the subject of class-action lawsuits unless some of these issues are addressed by their sponsors. Every party involved must be well-informed of everything that is happening at every stage in a transparent way.