Although the U.S. Securities and Exchange Commission has taken steps through the JOBS Act and other legislation to remove roadblocks to capital formation generally, it has not taken a fresh look at special purpose acquisition companies, or SPACs, in over a decade. Operating companies that go public by merging with SPACs are saddled with unnecessary restrictions that prohibit them from accessing the capital markets efficiently. The reasons for this are largely historical and stem from their categorization as shell companies and the association of shell companies with penny stock fraud in the 1990s. Inefficient regulation of the SPAC market would not be a problem but for the fact SPACs accounted for approximately 20 percent of all 2018 initial public offerings by number and 17 percent of all IPO proceeds, and attracted over $10 billion in capital.
SPACs raise money in an IPO and, led by a management team of industry or private equity professionals, look to complete an acquisition of a target company within a specified period of time, or they must return the money raised to investors. Because SPACs hold no assets other than cash prior to completing an acquisition, they are “shell companies” under the SEC’s definition. Shell companies first found themselves in the SEC’s cross hairs in the 1990s due to the SEC’s finding that they were being used as vehicles for fraud and market manipulation in the penny stock market.
In the early 2000s, the first generation of SPACs came to market, raising fresh concerns regarding the adequacy of disclosure for companies going public through reverse mergers. In response, the SEC adopted rules in 2005 that required SPACs completing a business combination to file with the SEC all of the information regarding the operating company that would be required had the operating company gone public by filing a traditional registration statement. While the SEC’s shell company rules should have put to rest concerns that companies merging with SPACs presented a greater risk of disclosure abuses, SPACs found their reputation hard to shake.
The SEC adopted its sweeping “Securities Offering Reform” rules in 2005, the same week it adopted the shell company rules. Aimed at modernizing securities offerings, the rules greatly expanded the manner in which issuers can communicate with investors and provided for greater ease of access to the capital markets. For example, the SEC allowed certain large issuers with over $1 billion of public float to access the markets without SEC review by filing registration statements that went automatically effective upon filing, provided for a variety of safe harbors for communications with investors, and allowed issuers greater latitude to communicate in writing with investors through the use of so-called “free writing prospectuses.” However, the rule created a new category — ineligible issuers — considered too risky to be permitted to utilize the new rules.
The SEC included shell companies and blank check companies, which include SPACs, in the “ineligible issuer” category. SPACs are joined in this category by bankrupt companies, penny stock companies, delinquent filers, companies convicted previously of certain felonies and companies subject to cease and desist orders for violating the securities laws. Not only were shell companies put in the penalty box, but also any companies that had a predecessor that was a shell company at any time in the prior three years. An operating company that goes public through a business combination with a SPAC is therefore an “ineligible issuer” for three years, regardless of its public float and regardless of the fact it will have provided to the market all of the same information that would have been provided if it had done a traditional IPO.
Today’s SPACs are sponsored by some of the largest private equity firms in the U.S. and their IPOs are underwritten by top-tier investment banking firms. SPACs are regularly completing business combinations in transactions valued in excess of $1 billion. Continuing to lump companies that merge with SPACs in the same category as penny stock issuers and issuers subject to SEC cease and desist orders has resulted in an increasing number of newly public companies operating under the pre-2005 offering regime for at least three years after they go public.
The disfavored treatment of SPACs continued in 2007 when the SEC adopted amendments expanding the availability of Rule 144, an important resale safe harbor that allows holders of unregistered securities and affiliates to resell securities without registration. The amendments, among other things, reduced the required holding period for restricted securities. At the same time, the SEC expanded upon a prior interpretive position first taken in 2000 that Rule 144 is not available for promotors or affiliates of blank check companies. The amendments made Rule 144 unavailable for the resale of securities of an operating company that merges with a SPAC for one-year post-business combination, and imposed an ongoing requirement that a SPAC be current in its periodic reports in order for Rule 144 to be available.
The restriction on the use of Rule 144 by former SPACs has increasingly become an issue as the size of SPAC transactions has increased, leading to an increase in the number of SPACs issuing additional equity in private placements to finance their acquisition of an operating company. The “evergreen” current information requirement and the delay in Rule 144’s availability has unnecessarily hindered resale transactions by investors in former SPACs and increased costs to these companies by requiring that they maintain registration statements for resales of privately placed securities that would otherwise be permitted under Rule 144. Similarly, PE funds that hold restricted securities of former SPACs are not able to make a pro rata distribution of those securities to their partners without registering the distribution because the securities do not become freely tradeable under Rule 144, even after one year.
The SEC’s application of many of its rules to SPACs too often adheres to form over substance. The acquisition by the SPAC of an operating business is not so much a “business combination” — the term used by SPACs — as it is the IPO of an operating business. The SEC, however, treats the IPO of the SPAC as the IPO of the company, with the SPAC’s capital raise rather than the business combination starting the “clock” on the new public company for a variety of purposes. For example, because it often takes over a year to complete a business combination, SPACs often find themselves as “accelerated filers” prior to ever completing a business combination and having used up the phase-in periods designed to allow newly public companies to transition to full compliance with requirements such as Sarbanes-Oxley.
In addition, the SEC treats the length of the time the SPAC has been in existence as relevant to the number of years of audited financial statements that must be filed for the operating company. If a SPAC has filed its first annual report on Form 10-K with the SEC, any target company that completes a business combination with the SPAC will be required to provide three rather than two years of audited financial statements, notwithstanding the target company would be entitled to relief as an “emerging growth company” if it went public through a traditional IPO. As a result, operating companies that go public through a merger with a SPAC must hit the ground running without the benefit of certain provisions of the JOBS Act that would otherwise be available to “emerging growth companies” or the benefit of phase-in periods available to other newly public companies, thereby discouraging companies from undertaking these transactions.
SPACs have evolved since 2005 and the SEC’s regulation of these entities should evolve as well. The SEC should remove companies that have merged with SPACs from the definition of “ineligible issuers” and allow these newly public companies the benefit of all offering rules, transition periods and relief under the JOBS Act to which they would otherwise be entitled on the basis of their size, public float and reporting history. These steps would both encourage efficient capital formation beyond the traditional IPO and be consistent with investor protection.