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The SPAC-tacular Rise and Fall of Blank Check Companies

Imagine being able to bypass the complexities and expenses of a traditional Initial Public Offering (IPO), opting instead for a faster, more cost-effective route to take a company public. Special Purpose Acquisition Companies (SPACs) offer just that. With a record-breaking surge in 2020 and 2021, these so-called “blank check” companies took the financial world by storm, facilitating over $100 billion in public listings, accounting for over half of all IPOs during this period. 


From a modest tally of 59 SPACs in 2019, the number skyrocketed to 248 and 613 in the next two years. Yet, as quickly as they surged, enthusiasm for SPACs have since fizzled out. By 2023, the SPAC market saw a dramatic contraction with only 31 new launches, a stark decline from its peak. This downturn has been attributed to a series of factors: underwhelming returns, class action lawsuits, and a myriad of bankruptcies. Now, what may be the final nail on its head, the recent rollout of new Securities and Exchange Commision (SEC) regulations looms large, potentially spelling the end of the short-lived SPAC era.


Demystifying SPACs: A Closer Look

At their core, SPACs are public shell companies created for the sole purpose of pooling funds to acquire or merge with targeted private entities enabling them to go public (de-SPAC transaction). This innovative mechanism was first invented in 1993 by investment banker David Nussbaum and lawyer David Miller. Their vision was simple: create a vehicle that allows private companies to tap into the public equity market encompassing everyday investors. 


The process begins with underwriters and institutional investors who establish the SPAC, pooling funds to serve as the financial backing necessary for its operation. The SPAC subsequently secures additional funding, raised through its own IPO, earmarking the capital for future acquisitions. All capital raised from the IPO is channeled into an interest-bearing trust which has a singular purpose: to finance the acquisition of a promising emerging company. Typically, SPACs have a window of eighteen to twenty-four months to find a target business and complete the acquisition. If a SPAC fails to fulfill this objective, the SEC forces its liquidation, resulting in the forfeiture of any potential gains for the initial investors. 


Because SPACs themselves go through the traditional IPO process, they must comply with both the SEC and the Financial Industry Regulatory Authority (FINRA) regulations. Despite this, SPACs and their targets have historically benefitted from a more lenient approach with respect to disclosure requirements. In part, this luxury has been afforded by the Private Securities Litigation Reform Act (PSLRA) and its Safe Harbor Protection, which provides liability exemptions for “forward looking statements'' concerning a company’s projected financial earnings and market success. At first glance, it would appear this exemption does not apply because it specifically excludes “blank check” companies. However, the PSLRA defines a blank check company in a manner that includes issuers of “penny stock.” As SPACs can be structured to avoid the issuance of penny stocks, they have managed to navigate the regulatory landscape with ease.


Because of this, SPACs enable targeted companies streamlined access to the public market, piggybacking off the SPACs own established public standing, thereby circumventing traditional hurdles associated with the standard IPO process.


SPAC Turmoil

Despite their promising nature, the landscape of SPACs has not been without its controversies, including legal battles with the SEC, high-profile bankruptcies, and many notable failed deals. 


Unlike traditional IPOs, which are subject to stringent financial audits, companies acquired by SPACs are not subject to the same level of financial scrutiny. To further compound the issue, Marcum, a prominent accounting firm known as the go-to auditor of SPACs—responsible for over 400 audits of SPACs during the peak years of 2020 and 2021—was penalized $10 million by the SEC and an additional $3 million by the Public Company Accounting Oversight Board (PCAOB). The fine was levied following an investigation that revealed a failure rate of 25%–50% of the audits reviewed. 


This leniency in oversight, combined with the volatility in the financial market, may have contributed to a wave of financial instability, evidenced by the twenty-one de-SPACed companies that filed for Chapter 11 bankruptcy in 2023—many of them less than two years post acquisition. Among these, WeWork stands out as a cautionary tale. After its initial $47 billion IPO attempt faltered in 2019, WeWork instead opted to go public through a SPAC merger in 2021 at a significantly reduced valuation of approximately $9 billion. Two years later, it succumbed to the collapse of the commercial real estate sector. However, WeWork was not alone. Other notable bankruptcies included Bird electric scooters, Proterra Inc., and Lordstown Motors, all of which encountered similar fates to the tune of billions of lost investor capital. 


Credit: Andriy Blokhin | AdobeStock


Emergence of New SEC Rules

In response to the precipitous rise of SPAC transactions, the SEC took a series of decisive actions amid growing concerns over credibility and falling investor confidence; most notably, the massive $125 million crackdown on electric vehicle maker Nikola for defrauding investors. While subsequent fines, such as those levied against Hyzon Motors and Spruce Power, totaling $25 million and $11 million respectively, were less severe, the message was clear: the SEC was determined to clamp down on malpractices within the SPAC domain. 


Recognizing the need for comprehensive regulatory reform, in 2022 the SEC unveiled a proposal for a new set of rules, marking a pivotal shift toward more rigorous oversight in addressing the myriad of concerns surrounding SPACs. Two years later, on January 24, 2024, the SEC’s vision came to fruition as new rules were formally adopted. Designed with the specific goal of safeguarding investors, these regulations sought to mitigate SPAC risks by addressing information asymmetries, deceptive practices, and conflicts of interest in both SPAC and subsequent de-SPAC transactions. Among the many changes, key provisions tackle the reclassification of business combinations and enhanced disclosure requirements.


Reclassification of Business Combinations and PSLRA Changes:

The SEC has redefined business combinations involving SPACs to be considered sales of securities, bringing them under the purview of the Securities Act of 1933. This reclassification subjects SPACs to the same level of scrutiny as traditional IPOs, which essentially levels the playing field. Moreover, this redefinition also tightens the rules around how the PSLRA applies to financial projections. Specifically, the new rules clarify that SPACs can no longer rely on the PSLRA safe harbor for forward looking statements making them more accountable for the projections presented to investors. This change is designed to curb the overly optimistic and speculative forecasts. Moreover, the increased liability risk may lead to a shift to more conservative financial projections potentially affecting the attractiveness of SPACs


Enhanced Disclosure Requirements: 

The revamped rules also mandate detailed disclosures around the compensation of SPAC sponsors, potential conflicts of interest, and economic incentives driving the SPAC. In doing so, the disclosure requirements aim to shed light on complex financial structures typically underlying SPAC deals enhancing protections for investors. In addition, SPACs are also required to provide disclosures on the fairness of a proposed business combination, particularly focusing on the dilutive effects on shareholders. 


Potential Impacts and Future Prospects

The SEC’s reforms clearly aspire to align the regulatory treatment of SPACs with that of traditional IPOs. Consequently, the unique benefits SPACs offered will likely be tempered making them less attractive to sponsors and investors. It is likely the market’s reception to SPACs under the new regulations will waver, potentially paving the way for a resurgence of  traditional IPOs and mergers and acquisitions.


However, despite these constraints, the SEC’s reforms have potential benefits for SPACs including enhancing credibility, improving investor confidence and reducing the risk of failed mergers or underperforming investments due to more rigorous due diligence processes. In doing so, SPACs may have a path leading to long-term viability. 


Conclusion

SPACs present a compelling alternative to traditional IPOs, offering several advantages to address the needs of private companies seeking public capital. By providing a more direct pathway to capital—especially when markets are volatile—SPACs lower transaction fees and shorten the IPO process for their target companies.


Yet, the introduction of stricter SEC regulations threatens to render SPACs a thing of the past. Despite these hurdles, there exists a silver lining. There is growing sentiment that the new regulations could in fact bolster SPACs in the long run by decreasing bankruptcies, increasing transparency and ultimately elevating credibility among investors. 


As the financial landscape adapts to these regulatory shifts, it is almost certain that the new rules will usher in a new wave of investment strategies. Although the rules are still in their early days, the potential for further regulatory changes will likely depend on the SECs continued scrutiny of the SPAC market and whether these new changes achieve the desired results in establishing a more equitable playing field between IPOs and SPACs. In this evolving context, the future trajectory of SPACs remains uncertain.


*The views expressed in this article do not represent the views of Santa Clara University.


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