The Death of the SPAC and What It Means for the IPO Process

On Jan 24, 2024, the Securities and Exchange Commission (SEC) adopted a new resolution to limit the use of Special Purpose Acquisition Companies (SPACs). A SPAC is a type of company with no commercial operations that is formed strictly to raise capital through an initial public offering (IPO) for the purpose of acquiring an existing company. SPACs are also known as “blank check companies” since investors in SPACs are essentially writing a blank check to the company’s management to pursue a merger or acquisition with an unspecified business entity within a certain timeframe, typically 18 to 24 months.

The SEC’s new rules are expected to severely limit the SPAC’s role in the market, and help to reestablish the traditional Initial Public Offering (IPO) process as the primary means of taking a business public in the United States. This splash of cold water will land on the entrepreneurs and business owners looking to take a company public in the summer of 2024, when the new rules go into effect. 

The SPAC was born in the United States and lived prosperously for several decades. A SPAC is essentially a shell corporation designed specifically to raise capital through a special IPO for the express purpose of acquiring an existing company. Although similar mechanisms (such as a reverse merger) existed earlier, the modern form of SPACs as we know them today began to take shape in the 1990s.

The term “Special Purpose Acquisition Company” itself was coined in the early 2000s. Before this, entities similar to SPACs were often referred to as “blank check companies,” a term that is still used interchangeably with SPACs but has a broader meaning. “Blank check company” refers to any development stage company that has no specific business plan or purpose or has indicated its business plan is to engage in a merger or acquisition with an unidentified company or companies.

SPACs exploded in popularity during the pandemic. Between 2019 and 2021, Statista reported a tenfold increase in the volume of SPAC IPO activity in the United States. This rapid expansion of the SPAC’s role in the market allowed certain high profile companies such as Virgin Galactic and Lucid Motors to offer shares to retail investors without providing the same level of rigorous, independently audited financial documentation that the firm would have to provide under the traditional IPO model. While this model is advantageous to the business itself, it is detrimental to the flow of information into the public, and the SPAC boom has largely transitioned into a bust as a result. Post-SPAC outcomes for companies that went public using this mechanism during the pandemic left 90% of their investors with a net loss at the end of 2023.

The SEC’s new rules seek to address concerns over the aforementioned disclosure inadequacies, the responsible use of projections in an IPO declaration, and general investor protection in the IPO and de-SPAC transaction process. The complexity of these transactions and the potential for conflicts of interest, misleading information, and asymmetries in the information available to investors prompted the SEC to take action to ensure that SPACs provide investor protections comparable to those in traditional IPOs.

Traditionally, companies undertaking IPOs have been subject to stringent disclosure standards, requiring a thorough vetting of financial statements, business models, and risk factors. The introduction of the SEC’s new rules narrows the disclosure gap between SPACs and traditional IPOs, pushing SPACs to match the level of transparency that has been expected of IPOs. This comparative increase in disclosure requirements is a clear signal from the SEC that the path to public markets through a SPAC must be paved with the same level of investor protection and informational integrity as the traditional route.

Under the new regulatory landscape, the role of auditors, legal advisors, and underwriters—often referred to as the ‘gatekeepers’ of the public markets—should regain some of the significance that was eroded by the emergence of the SPAC. These entities are now tasked with ensuring that SPACs meet the enhanced disclosure requirements, effectively acting as safeguards against misleading financial projections and unfounded business valuations. By placing a heavier responsibility on these gatekeepers, the SEC is leveraging their expertise and authority to prevent the dissemination of inaccurate or overly optimistic information that could mislead investors.

The new rules require SPACs to disclose more comprehensive information about conflicts of interest, compensation of SPAC sponsors, potential dilution effects, and other details crucial to investors. This includes information on the nature and amount of compensation for services provided to the SPAC, details on securities issued, and material interests of the SPAC sponsors and their affiliates​. The rules also make the Private Securities Litigation Reform Act of 1995’s safe harbor for forward-looking statements unavailable to SPACs, tightening the standards for the use of projections.

The use of projections in a public offering is one of the unique benefits of the SPAC structure, and the SEC identified this benefit as a particularly juicy target for regulation for good reason. Projections allow companies going public through SPACs to present a forward-looking view of their financial health, growth potential, and operational milestones. This is especially appealing to investors who are looking for opportunities with significant upside and are willing to assume the associated risks, but they also enable unscrupulous behavior that can obfuscate those risks. 

The accuracy of these projections can vary widely, and overly optimistic forecasts can mislead investors. The recent SEC rules aim to address these concerns by enhancing disclosure requirements and limiting the use of certain legal protections for forward-looking statements, thereby aiming to strike a balance between providing valuable information to investors and protecting them from potential misinformation.

Before the introduction of the new SEC rules, litigation around SPACs often centered on allegations of misleading financial projections and inadequate disclosures, particularly during the de-SPAC process when a SPAC merges with a target company to take it public. A notable case study that illustrates the status quo of SPAC-related litigation involves the electric truck company Nikola Corporation, which went public through a SPAC merger in June 2020.

The Nikola case became a focal point for discussions around SPAC litigation due to allegations of fraud around the company’s core technology, capabilities, and its partnerships. Shortly after Nikola went public, a report by a short-selling firm accused the company and its founder of making exaggerated claims about the readiness of Nikola’s technology and its progress toward producing zero-emission trucks. These allegations led to significant market volatility for Nikola’s shares and drew the attention of federal regulators and investors alike.

Investors filed lawsuits alleging that Nikola, its executives, and the SPAC that facilitated Nikola’s public listing made false statements in violation of securities laws. The plaintiffs argued that the defendants failed to adequately disclose material information about the company’s technology and business prospects, leading to inflated stock prices that subsequently crashed once doubts about the company’s claims were made public. In the end, the courts held Nikola founder Trevor Milton responsible for $165 million in damages and sentenced him to 4 years in prison due to the extent of the firm’s malfeasances. 

The Nikola case underscores the issues at the heart of SPAC-related litigation: the reliance on aggressive financial projections, the adequacy of disclosures to investors about the risks and the underlying business of the target company, and the potential conflicts of interest among the SPAC sponsors, executives, and other insiders. These issues highlight the challenges investors face in assessing the value and veracity of companies that go public through SPAC mergers, often based on optimistic future projections rather than historical financial performance.

This backdrop of litigation concerns, exemplified by cases like Nikola, prompted the SEC to introduce new rules aimed at enhancing investor protections by improving the transparency and reliability of disclosures in SPAC transactions, thereby addressing some of the key areas that have led to legal disputes in the past.

The SEC’s new rules should cool down the heated IPO market, aiming to temper the frenzied speculation and prevent repeats of situations like the Nikola saga. During the pandemic, the SPAC boom was partly fueled by a market environment flush with liquidity and a quest for quick gains, where the allure of futuristic technologies and growth stories often overshadowed the fundamentals of due diligence and sound financial disclosure. Nikola’s case, where the excitement over electric vehicles and zero-emission technologies led investors to overlook critical gaps in disclosure and due diligence, serves as a cautionary tale.

The SEC’s regulatory response is designed to cool off this exuberance by ensuring that companies going public through SPACs adhere to more stringent disclosure requirements, similar to those faced by traditional IPOs. By mandating detailed disclosures about conflicts of interest, financial projections, and the underlying business fundamentals of the target companies, the rules aim to provide investors with a clearer, more comprehensive view of their potential investments. This enhanced transparency is crucial for enabling investors to make more informed decisions, thus reducing the likelihood of getting caught in the hype without understanding the risks.

Furthermore, the elimination of the safe harbor for forward-looking statements for SPACs, which previously allowed companies to present overly optimistic financial projections without as much legal risk, acts as another layer of protection for investors. It means that companies must now be more circumspect and realistic about their future prospects, providing only projections that they can reasonably justify. This shift encourages a more cautious approach among investors, prompting them to scrutinize the financial health and operational viability of companies more closely rather than getting swept up in speculative fervor.

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