The US Securities and Exchange Commission recently proposed new rules and amendments relating to initial public offerings by special purpose acquisition companies and to business combinations involving shell companies and private operating companies. While the proposed rules would enhance investor protections, it is possible they could have a cooling effect on the volume of such transactions or materially increase the costs of deal execution.
The US Securities and Exchange Commission (SEC) proposed new rules and amendments to certain rules and forms under the Securities Act and the Exchange Act on March 30, 2022 intended to enhance investor protections in initial public offerings (IPOs) by special purpose acquisition companies (SPACs) and in business combination transactions involving shell companies, such as SPACs, and private operating companies (collectively, the Proposed Rules).[1]
The Proposed Rules are the SEC’s response to the increased prevalence of SPAC IPOs and business combinations between SPACs and private operating companies (referred to as de-SPAC transactions) in the US public securities markets. While SPACs and de-SPAC transactions have served as an alternate vehicle for private operating companies to enter the US public securities markets since the 1990s, the more recent proliferation of these transactions has garnered significant scrutiny from multiple stakeholders, including the SEC. In this respect, market observers have expressed concern regarding the impact of certain structural aspects of SPACs and the adequacy of disclosures provided to investors.
Following the promulgation of informal guidance by the SEC on SPAC IPOs and related business combinations,[2] the Proposed Rules would, among other things, require increased disclosures regarding compensation paid to sponsors, conflicts of interest, dilution, and the fairness of business combination transactions.
In addition, the Proposed Rules address financial statement requirements for shell companies and questions regarding the use of projections, forward-looking statements, and safe harbors.
Enhanced Disclosure Requirements Through New Subpart 1600 of Regulation S-K
The Proposed Rules, through the proposed adoption of new provisions in Regulation S-K, would add the following key disclosure requirements in connection with SPAC IPOs and de-SPAC transactions.
SPAC sponsors, conflicts of interest, and dilution
The Proposed Rules would require additional disclosures regarding the experience, roles, responsibilities, and material interests of the SPAC sponsor and affiliates and the relationships between such parties; the nature and amount of total compensation earned by or paid to the sponsor and its affiliates with respect to the SPAC and de-SPAC transaction; detailed discussion of the conflicts of interest, including the potential benefits, risks, and effects for investors, as well as potential benefits for SPAC sponsors and other affiliates; and the potential for dilution in the SPAC IPO and de-SPAC transaction, the sources of dilution, and the possible disproportionate impact on non-redeeming shareholders.
The fairness of the de-SPAC transaction to the SPAC investors
The Proposed Rules would require a statement as to whether the SPAC reasonably believes that the de-SPAC transaction and any related financing transactions are fair or unfair to the SPAC’s unaffiliated security holders and a description of the bases for this statement. SPACs may seek a fairness opinion from a financial advisor to substantiate their “reasonable belief,” but the Proposed Rules do not require a SPAC to obtain such an opinion.
Aligning De-SPAC Transactions with IPOs
The Proposed Rules are also intended to align the treatment of private operating companies entering the public markets through a de-SPAC transaction with the liability and investor protection provisions applicable to an IPO. In this respect, the Proposed Rules include the following requirements.
A requirement that the private operating company be a co-registrant when a SPAC files a registration statement on Form S-4, or Form F-4 for a de-SPAC transaction
This requirement would expand liability for material misstatements and omissions in any registration statement on Form S-4 or Form F-4 filed in connection with a de-SPAC transaction to the target private operating company; its principal executive officer, principal financial officer, and principal accounting officer; and a majority of the board of directors (subject to a due diligence defense for all parties other than the SPAC and the target private operating company).
A redetermination of smaller reporting company status within four days following the consummation of a de-SPAC transaction
The Proposed Rules would require a redetermination of a post-business combination company’s smaller reporting company (SRC) status before its first SEC filing after the filing of its “Super Form 8-K” (i.e., a Form 8-K that includes Form 10 information) with its public float measured as of a date within four business days following completion of a de-SPAC transaction. Under this proposal, SPACs that initially qualified as SRCs and relied on scaled disclosure requirements would be required to produce more comprehensive disclosures following a de-SPAC transaction at an earlier time than under existing rules.
An amended definition of “blank check company” to make the liability safe harbor in the Private Securities Litigation Reform Act of 1995 (PSLRA) for forward-looking statements, such as projections, unavailable in filings by SPACs and certain other blank check companies
The proposed amendment to the definition of “blank check company” would eliminate the PSLRA safe harbor for forward-looking statements, such as projections, for filings by SPACs and certain other blank check companies. While the availability of the PSLRA to de-SPAC transactions has not previously been considered settled law, the elimination of this safe harbor, if adopted, could increase the exposure to potential liability of SPAC sponsors and target private operating companies in connection with the use of projections in marketing materials and disclosures relating to SPAC IPOs, de-SPAC transactions, and related financings, including private investments in public equity (PIPE).
In addition, the Proposed Rules also seek to require additional disclosures regarding projections in a de-SPAC transaction, such as the purpose for which they were prepared and the identity of the preparer, the material assumptions, and whether the projections still reflect the view of the board of the SPAC or the target company as of the date of filing.[3]
A rule that deems underwriters in a SPAC IPO to be underwriters in a subsequent de-SPAC transaction when certain conditions are met
Proposed Securities Act Rule 140a would clarify that a person who has acted as an underwriter in a SPAC IPO and completes steps to facilitate the de-SPAC transaction, or any related financing transaction, or otherwise participates (directly or indirectly) in the de-SPAC transaction will be deemed to be engaged in the distribution of the securities of the surviving public entity in a de-SPAC transaction within the meaning of Section 2(a)(11) of the Securities Act of 1933 (the Securities Act).
If adopted, liability under Section 11 of the Securities Act for the contents of a registration statement used in connection with a de-SPAC transaction would apply to any SPAC IPO underwriter who participates in the de-SPAC transactions. The SEC explains its position by describing the potential roles that SPAC IPO underwriters may play to actively facilitate de-SPAC transactions (e.g., financial advisor to the SPAC, identifying and engaging investors for and negotiating PIPE investments) and their financial incentive to ensure the successful consummation of de-SPAC transactions (e.g., deferred underwriting fees).
The Proposed Rules could result in changes to how SPAC IPO underwriters participate or engage in de-SPAC transactions to ensure the availability of the due diligence defense, reduce the willingness of some underwriters to participate in SPAC IPOs and de-SPAC transactions, and/or trigger changes to existing compensatory arrangements for their services.
A requirement that SPAC shareholders have adequate time to consider the information presented in a de-SPAC transaction
Noting the lack of a federally mandated dissemination period in a de-SPAC transaction, the Proposed Rules would require that prospectuses and proxy and information statements filed in connection with a de-SPAC transaction be distributed to shareholders at least 20 calendar days in advance of the shareholder meeting or the earliest date of action by consent, or the maximum dissemination period permitted under the applicable laws of the SPAC’s jurisdiction of incorporation or organization if less than 20 calendar days.
Business Combinations Involving Shell Companies
The Proposed Rules applicable to business combination transactions involving shell companies, including SPACs, would do the following.
Deem that a business combination transaction involving a reporting shell company and another entity that is not a shell company constitutes a sale of securities to the reporting shell company’s shareholders for purposes of the Securities Act
The Proposed Rules provide that in a business combination between a reporting shell company and a company that is not a shell company, the reporting shell company investors effectively exchange their securities representing an interest in the reporting shell company for new securities representing an interest in the combined operating company. It is the SEC’s view that under current securities laws, investors in a reporting shell company may not receive the disclosures and other protections afforded by the Securities Act in connection with a business combination that involves another entity that is not a shell company because the filing of a registration statement is not required in connection with such a business combination.
Proposed Securities Act Rule 145a would require the filing of a registration statement (subject to applicable exemptions) for business combinations between a reporting shell company and a company that is not a shell company and afford shareholders the full protections of the Securities Act’s disclosure and liability provisions. Proposed Rule 145a would have no impact on business combinations between two bona fide non-shell entities, and would not apply to reporting shell companies that are “business combination related shell companies,” as such term is defined in Securities Act Rule 405.
Align the required financial statements of private operating companies in transactions involving shell companies with those required in registration statements for IPOs
The Proposed Rules would amend the required financial statements to correspond to similar requirements in a traditional IPO. In this respect, the Proposed Rules address the number of years of financial statements required where the target business will be a predecessor to the shell company, including SPACs, and that the age of the financial statements of a private operating company as predecessor would be based on whether such private company would qualify as an SRC in an IPO. In addition, the predecessor to a shell company will be required to be audited by an independent accountant in accordance with the Public Company Accounting Oversight Board (PCAOB) to the same extent that a registrant would be audited for an IPO.
The Proposed Rules also address financial statement requirements regarding probable acquisitions of a target company (either prior to the business combination or pending probable acquisitions) in the same manner as the rules applicable to an IPO.
Additionally, the Proposed Rules seek to eliminate any distinction between a de-SPAC transaction that is structured as a forward acquisition or reverse capitalization by allowing a registrant to exclude the financial statements of a SPAC for the period prior to the de-SPAC transaction, once all the financial statements of the SPAC have been filed for all required periods through the de-SPAC transactions and the financial statements of the registrant include the period on which the de-SPAC transaction was consummated.
Status of SPACs Under the Investment Company Act
Proposed Rule 3a-10 would provide a safe harbor from the definition of “investment company” under Section 3(a)(1)(A) of the Investment Company Act of 1940 (the Investment Company Act) for SPACs that meet the conditions of the rule. SPACs would not be required to comply with the safe harbor, and the Proposed Rules clarified that failure to meet the safe harbor would not result in an automatic determination of investment company status.
To meet the proposed safe harbor, SPACs must comply with the following conditions, without limitation:
While many practitioners have not considered a SPAC to be an investment company under the Investment Company Act, the proposed safe harbor may complicate the issue depending on the complexity of a de-SPAC transaction and its overall timeline, which is impacted by multiple external factors. For example, stock exchange rules allow SPACs a maximum of 36 months to complete a de-SPAC transaction and SPACs may often seek shareholder approval to extend the time necessary to complete an announced de-SPAC transaction that needs additional time to be consummated.
The Proposed Rules reflect the potential for significant regulatory consequences to SPACs and de-SPAC transactions, such as the alignment of the legal obligations of companies and advisors in SPAC IPOs and de-SPAC transactions with those of traditional IPOs in addition to the increased disclosure obligations.
It is possible that the Proposed Rules could have a cooling effect on the volume of SPAC IPOs and de-SPAC transactions or materially increase the costs of deal execution due to newly instituted compliance measures and controls. While portions of the Proposed Rules codify existing SEC guidance and practice, and, as such, may help to standardize the scope and detail of disclosures, there were some notable additions, particularly with respect to underwriter liability and the proposed Investment Company Act safe harbor.
In response to the Proposed Rules, SEC Commissioner Hester M. Peirce issued a strongly worded dissent, warning that the proposal “seems designed to stop SPACs in their tracks” and “does more than mandate disclosures that would enhance investor understanding.”[4] Commissioner Peirce questioned whether, if adopted, the Proposed Rules would impose unduly significant burdens on the typical SPAC to change its operations, economics, and transaction timelines to comply with the rules.
For example, in response to the potential extension of underwriter liability on SPAC IPO underwriters for activities conducted at the de-SPAC stage, Commissioner Peirce predicts SPAC IPO underwriters will do all in their power to avoid being subject to the rule, including demanding up-front compensation to eliminate the perception of being a stakeholder or facilitator of related de-SPAC transactions. Commissioner Peirce also cautioned that the Proposed Rules are likely to affect non-SPAC-related business combinations.
Public comments on the Proposed Rules will be due on the later of May 31, 2022, or 30 days following publication of the proposing release in the Federal Register, and the proposing release seeks input on many specific issues. The SEC has not addressed the expected timing of adoption or whether there will be a transition period applicable to impacted registrants.
Given the breadth of the SEC’s current rulemaking agenda, we believe it is unlikely that the rules will be adopted in the next calendar quarter. Furthermore, we expect that there will be significant commentary and possible legal challenges to the extent the rules are adopted as proposed.
If you have any questions or would like more information on the issues discussed in this LawFlash, please contact any of the following Morgan Lewis lawyers:
Boston
Bryan S. Keighery
New York
R. Alec Dawson
Russell Franklin
Thomas P. Giblin, Jr.
Thurston J. Hamlette
Howard A. Kenny
Andrew L. Milano
Orange County
Todd A. Hentges
Philadelphia
Justin W. Chairman
James W. McKenzie
Kevin S. Shmelzer
Joanne R. Soslow
Pittsburgh
Celia A. Soehner
Princeton
David C. Schwartz
Silicon Valley
Albert Lung
Washington, DC
Leland S. Benton
Erin E. Martin
[1] See SEC Proposing Release No. 33-11048, Special Purpose Acquisition Companies, Shell Companies, and Projections (Mar. 30, 2022). SPACs were initially presented as an alternative to a “blank check company,” which is a development-stage company with no specific business plan or purpose other than to engage in a merger or acquisition with an unidentified company and that is issuing “penny stock.” See, e.g., Rule 419(a)(2) of the Securities Act of 1933 and Rule 3a51-1 of the Exchange Act of 1934. Blank check companies conduct offerings pursuant to Rule 419 of the Securities Act of 1933. SPACs are considered “shell companies,” which are registrants with (1) no or nominal operations and (2) either (i) no or nominal assets, (ii) assets consisting solely of cash and cash equivalents, or (iii) assets consisting of any amount of cash and cash equivalents and nominal other assets. See, e.g., Rule 405 of the Securities Act of 1933.
[2] See, e.g., SEC Division of Corporation Finance, CF Disclosure Guidance: Topic No. 11, “Special Purpose Acquisition Companies” (Dec. 22, 2020).
[3] The Proposed Rules would also amend Item 10(b) of Regulation S-K to clarify that any projected measures that are not based on historical financial results or operating history should be clearly distinguished from projected measures that do, and to present projections that are based on historical financial results or operating history with equal or greater prominence than those that are not. The proposed amendments also confirm the SEC’s intention that Item 10(b) guidance regarding financial projections is not limited to projections of the registrant included in a registration statement or proxy statement, but also applies to any target private operating company projections included in a registration statement or proxy statement filed by an acquiror.
[4] See SEC Commissioner Peirce, Statement, Damning and Deeming: Dissenting Statement on Shell Companies, Projections, and SPACs Proposal (Mar. 30, 2022).