About the authors: Vishesh Gupta and Aashna Shah are fourth-year undergraduate law students from Nirma University in Gujarat, India.
Photo by Scott Beale, available here.
In recent years, there has been a meteoric rise in publicly listed companies through special purpose acquisition company (SPAC) initial public offerings (IPOs) rather than through traditional IPOs. This popularity is due to the perceived low-risk and low-cost advantages that SPACs offer to investors. However, these benefits are substantially outweighed by underappreciated risks, and a comprehensive risk management framework should be developed to protect investors.
An Overview of SPACs
A SPAC is a shell company with no operating history. The SPAC’s creators (SPAC sponsors) may purchase 20% of the SPAC’s shares at a steep discount before publicly listing the company through an IPO. Once the SPAC sponsors list the company on the public market, investors can buy shares, and these funds finance the acquisition of an operating company. This acquisition is called a de-SPAC transaction, in which the sponsors decide on a target company, and the shareholders vote to approve or reject the proposed acquisition.
Experts have claimed that SPAC IPOs are low-risk investments compared to traditional IPOs. This is primarily due to the redemption right, which allows investors to sell the shares they purchased during the SPAC IPO back to the SPAC and requires the SPAC to accept the sale. The redemption right thus functions as a “money-back guarantee”; if a shareholder is dissatisfied, then they may recoup their investment.
Despite these shareholder protections, SPACs present substantial risks to shareholders. A recent study published by Harvard University found that although SPAC shares are valued at $10 at the time of merger, for the median SPAC, only $6.67 per share is backed by cash. This substantially reduces the investment value for shareholders. Additionally, the chairman of the United States Securities Exchange Commission (SEC) stated that claims regarding reduced liability for SPAC participants are overstated and misleading.
Risks Associated with SPACs
1. Conflict of Interest
A sponsor’s main goal is to enter a de-SPAC transaction with a target company irrespective of whether it is the most profitable option. Sponsors’ profit depends on the completion of a de-SPAC transaction. If a de-SPAC transaction does not materialize, then all shareholder investments are returned and sponsors receive no remuneration. In contrast, shareholders’ interests are best served if the sponsors acquire a lucrative company. These conflicting economic interests give rise to the risks illustrated in the merger between MultiPlan Corp and Churchill Capital Corp III. In this merger, the post-merger company’s share price dipped and the shareholders faced losses, but the SPAC sponsors made millions in profits. Because the sponsors bought their shares pre-IPO at such a steep discount, any post-merger losses fell more heavily on the shareholders who bought shares at face value.
The case of Franchi v. MultiPlan Corp. further demonstrates the conflict of interest issue in SPAC listings. The plaintiff claimed that the SPAC sponsors breached their fiduciary duties by not conducting the fairness standard of review for the proposed merger. They prioritized their own interests of completing the proposed business combination rather than the shareholders’ interests of acquiring a profitable firm.
To counter such risks, some jurisdictions, such as India and Singapore, have proposed interesting laws. The draft regulations released by the International Financial Services Centre Authority for SPAC listings (IFSCA) mandate a freeze of the sponsors' shares until 180 days after the completion of the deal. Similarly, the Singapore Exchange (SGX) consultation paper proposes a six-month lock-in period. Such a moratorium on share trading would encourage sponsors to choose target companies according to their economic potential and not as short-term investment vehicles.
Additionally, recognizing the importance of minimizing conflict of interests, the SEC released CF Disclosure Guidance: Topic No. 11 guidelines. The guidelines suggest that disclosures include any conflicts of interest arising from sponsors’ and investors’ divergent economic interests, including related party transactions, financing terms, evaluation mechanisms for identifying potential targets, and the total ownership interest of the SPAC management.
Moreover, conflicts of interest create the risk of price determination. Whereas the market determines the price of an IPO, SPAC sponsors wield sole responsibility in valuing the price of a target company. In the Kwame Amo v. MultiPlan Corp. complaint, plaintiffs alleged that the sponsors breached their fiduciary duty by acquiring the target through an unfair process that resulted in mispricing. Mispricing the transaction harms investors’ interests because it can dilute their investments.
The SEC, in the CF Disclosure Guidance: Topic No. 11, noted the importance of disclosing the valuation method for the target company to its shareholders. The UK consultation paper and the IFSCA draft regulations also suggest disclosure of valuation methodology. The consultation paper released by the SGX on SPACs proposes a novel policy requiring the appointment of an independent valuer to value the target company in a de-SPAC transaction. In theory, an independent valuation would give shareholders an unbiased value of the target company, which they can then use to decide whether to approve the transaction.
2. Fraud/Misconduct in Disclosures
Dissemination of accurate information by SPAC sponsors is essential for upholding investor protection because of the unique structure of SPACs, which scholars allege to be filled with conflict and misconduct. There is no operating history in terms of profit-loss and revenue-expenditure. Therefore, the investors bet on the sponsors to make profitable decisions.
Sponsors, who have a high pecuniary interest in completing the de-SPAC transaction, disseminate every piece of information related to the SPAC and the target company to shareholders. These high pecuniary interests give sponsors sufficient incentive to indulge in misconduct. For instance, in the US, SPAC sponsors provide information to investors through a proxy statement filed in Form S-4. This is a key source of information that assists the shareholders in making decisions regarding the proposed transaction. It includes information about the proposed target company, its audited financial statements from the previous two to three years, forward-looking financial statements post-business combination, and the terms of the acquisition.
This gives sponsors an opportunity to window dress the financial statements or conceal relevant information to make the target company look more impressive, luring the investors into approving the merger. Risks of fraud are not mere apprehensions. In the recent merger between Momentus and Stable Road Acquisition Corp., the SEC charged the SPAC for providing misleading statements to its shareholders and for not conducting adequate due diligence despite its claims that it had. In the SEC’s complaint against Momentus and its founder, the SEC chair stated that the merger reflected the inherent risk of misconduct in SPAC transactions.
Misconduct by target companies is also a pressing issue, as they also have incentives to window dress their accounts. Target companies can create an illusion of financial stability that gives it an advantage over other prospective target companies. In 2019, a de-SPAC transaction took place between Akazoo and Modern Media Acquisition Corp. Before the merger, Akazoo claimed to be the leading music streaming service in multiple countries. However, a 2020 report claimed that Akazoo had committed fraud by overstating its subscribers, revenue, and profits. The report also revealed that the materials provided by Akazoo for due diligence were misleading. This shows that despite having laws for disclosures, the inherent scope of fraud and misconduct persists in the SPAC structure.
Inherent Risks of SPAC Transactions May Outweigh the Redemption Right
Multiple studies have claimed that despite the risks to investors in SPAC transactions, the advantages overpower the disadvantages because of the redemption right. However, this claim does not factor in various risks that can disable the benefits of the redemption right. Even if the shareholders ultimately have the option to back out, misleading information in the proxy statement may deceive shareholders into not withdrawing their investment.
Additionally, as in the cases of Nikola and Akazoo, the price of post-merger shares declined after fraud was discovered, leading to shareholder losses. In Nikola, the target company made false statements about its product. The fraud was discovered post-merger, resulting in an 80% dip in share prices from their peak. Likewise, in Akazoo, Akazoo’s stock prices plummeted when fraud was discovered, and the post-merger company’s stock price fell below the stock price of the pre-merger SPAC.
Proposed Regulations
The risks of listing through SPACs are overlooked. Advantages such as low cost and low risk are misleading because investors ultimately bear the costs. The risks of misconduct and fraud in disclosure requirements can reduce the protection provided by the redemption right to the investors.
For SPACs to be sustainable investments, it is imperative that countries improve their investor protection regulations. Considering the current need for investor protection, we propose two suggestions:
Appoint an independent valuer to value the target company. The valuer shall be appointed through a majority shareholder vote. Further domestic regulations should establish qualification criteria to ensure the independence of the valuer. This will make it more likely that the valuation method is free of manipulation.
Appoint an independent advisor who analyzes the proposed business combination and provides their opinion. This is essential for retail investors who do not conduct thorough due diligence on the target company. This independent advisor’s opinion shall assist the investors in their decision and minimize any risks due to conflict of interests.