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The Comeback of SPACs: Wall Street’s Hottest Investment Vehicle and its Potential Liability Risks

Published onAug 02, 2021
The Comeback of SPACs: Wall Street’s Hottest Investment Vehicle and its Potential Liability Risks

Special Purpose Acquisition Companies (“SPACs”) have become one of Wall Street’s most favored investment vehicles. In the first half of 2021, there has already been an unprecedented number of SPACs formed. These investment vehicles offer private companies a faster way to go public by avoiding the lengthy and cumbersome process of a traditional initial public offering (“IPO”). Well-known companies that have been taken public by SPACs include the online sports betting platform DraftKings and spaceflight company Virgin Galactic.

In the past, the number of annual SPAC IPOs has fluctuated, but recently there has been a significant surge in SPAC IPOs. For instance, in 2019, there were 59 SPAC IPOs, which raised over $13 billion in funding. By comparison, in 2021, there have already been 366 SPAC IPOs, which have collectively raised over $112 billion. The recent increase in Wall Street’s appetite for SPACs is unquestionable, which begs the questions: What are SPACs? Who invests in them? And what are potential liability risks for SPACs?

What are SPACs?

SPACs are shell corporations with no business operations. The sole purpose of a SPAC is to raise capital through an initial IPO and then to use those funds to acquire a private company to take public. SPACs are also known as “blank check companies” because they generally do not identify a merger target at the time of their IPO. In essence, investors provide the SPAC management team, the “sponsors,” with a blank check to use to find a private company to acquire and take public. Sponsors typically search for a target company in an industry of which they have extensive experience.

SPACs initially avoid some of the traditional IPO disclosure requirements since they are merely shell corporations with no commercial operations, making for a faster and more streamlined IPO process. However, once a SPAC acquires and merges with a private company in what is known as the “initial business combination” or the “de-SPAC transaction,” a SPAC must file additional disclosures. SPACs normally have a period of 18 to 24 months to find a target company and to complete an initial business combination. If a SPAC fails to execute an initial business combination during its specified period—and if its structure does not permit an extension—the SPAC will dissolve. If a SPAC dissolves, shareholders will receive their pro rata share from the SPAC’s interest-bearing trust account, which holds the funds raised from the SPAC’s initial IPO.

Who invests in them?

There can be a wide range of investors in SPACs, including institutional and everyday retail investors. SPACs typically search for institutional investors, such as private equity firms, before offering their shares to retail investors. The SPAC structure and the industry expertise of the sponsors are what often make SPACs attractive investment opportunities to investors. For instance, the SPAC structure allows investors to redeem their shares at the initial IPO price any time before the SPAC executes an initial business combination. Investors may also receive interest on their shares since the funds raised during a SPAC’s initial IPO remain in an interest-bearing trust account until the SPAC completes an initial business combination.

What are potential liability risks for SPACs?

SPACs, like all other investment vehicles, are not immune to risk. Some are predicting the surge in SPAC deals will be followed by an increase in SPAC litigation. There has already been a variety of claims asserted against SPACs and their sponsors. For instance, investors have sought to hold SPACs and their sponsors liable under securities laws for inadequate due diligence and disclosures, as well as false and misleading financial projections.

Moreover, liability risk in SPAC transactions is generally considered to be lower during a SPAC’s initial IPO. One reason for this lower initial liability risk is that at first, SPACs are only shell companies and thus avoid some of the traditional IPO disclosure requirements about business operations that can subject a company to liability for material misstatements or omissions under securities laws. However, SPACs could still be held liable during their initial IPO for material misstatements about their financial statements or a sponsor’s background and credentials.

Liability risk in SPAC transactions is thought to be highest when the SPAC merges with the target company during the de-SPAC transaction. During this phase, SPACs must file disclosures in connection with the de-SPAC transaction that subjects SPACs to heightened liability under securities laws. The de-SPAC transaction could give rise to liability under both federal and state law.

Under federal law, SPACs and their sponsors can become subject to liability under the Securities Act of 1933 (“Securities Act”) and the Securities Exchange Act of 1934 (“Exchange Act”). Under the Securities Act, SPACs and their sponsors may be held liable under Section 11 if the de-SPAC transaction involves a registered offering. In a registered offering, a SPAC files a Form S-4 registration statement and under Section 11, investors can hold SPACs and their sponsors liable for damages resulting from material misstatements or omissions made within an effective registration statement. Further, SPACs and their sponsors may also be held liable under Section 14(a) of the Exchange Act for material misstatements or omissions in proxy solicitation materials. A SPAC’s proxy solicitation materials, which often include a proxy statement and prospectus, disclose information about the SPAC’s target company and are filed in connection with the de-SPAC transaction.

In addition to the Securities Act and Exchange Act, the Private Securities Litigation Reform Act of 1995 (“PSLRA”) has also been a focal point of de-SPAC transaction liability risk. The PSLRA created a safe harbor that shields public companies from private litigation based on inaccuracies in forward-looking statements and projections. The safe harbor only applies if the forward-looking statements and projections are made in good faith (cannot be knowingly false or misleading) and include the necessary cautionary language.

The safe harbor does not apply to traditional IPOs, and SPACs have been operating on the presumption that it applies in the context of de-SPAC transactions. SPACs have relied on the safe harbor to protect themselves from private litigation based on forward-looking statements and growth projections. However, recently, regulators have questioned whether the safe harbor applies to de-SPAC transactions, and the House Financial Services Committee has released draft legislation that would prohibit SPACs from using the safe harbor to protect themselves from private litigation.

In addition to federal securities law, SPACs and their sponsors may also be held liable in connection with a de-SPAC transaction under state law. For instance, Delaware corporate law strictly applies fiduciary duties, including the duty of candor, in situations that involve conflicts of interest. Due to the SPAC structure, conflicts of interests are often inherent in de-SPAC transactions, therefore, subjecting SPACs and their sponsors to potential liability.

Furthermore, SPACs are subject to a variety of liability risks under both federal and state securities laws. As the number of SPACs continue to grow, the regulatory scrutiny and enforcement over the SPAC sector will likely increase as well. It is important that SPAC investors and sponsors become aware of the potential liability risks associated with these investment vehicles and that the necessary precautions are taken to avoid legal action.

Charles Jenkins is a third-year law student at Wake Forest University School of Law. He holds a Bachelor of Business Administration in Management and Integrated Strategic Communication from the University of Kentucky. Upon graduation, he intends to practice transactional law.

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