End of the Checkbook May be Coming Soon for SPACs

Is there any clear sight for the future of special purpose acquisition companies (“SPACs”), which proliferated in the bull market of the pandemic? Amidst a bear market and increasing scrutiny from the Securities and Exchange Commission (“SEC”), SPACs have crashed as fast as they rose. (Lipschultz, Bloomberg Law). The features, such as their speed and lack of disclosures, that made SPACs so popular, are now causing their failure.

SPACs are publicly traded corporations with the purpose of merging with private companies, called “targets,” within 18-24 months of going public. (Bazerman & Patel, Harvard Business Review).  This process allows those private companies to go public and bypass the traditional initial public offering (“IPO”) process. Id.. SPACs take companies public faster than traditional IPOs, with the former taking approximately four months as opposed to the better part of a year or two in preparation for a traditional IPO. (Lipschultz & Burton, Bloomberg Law; Domonoske, NPR). While the recent boom in SPACs makes them seem like they are new, this is not the first time similarly organized companies have been the center of attention. (Lipschultz & Burton, Bloomberg Law).. In the 1980s, “blank check”  companies rose to prominence. Id. These entities issued penny stocks, or companies traded at less than $5 per share, as opposed to modern SPACs which typically list at $10 per share. (Id; Nussbaum, Bloomberg Law). Like SPACs, the blank check companies of the 1980’s only business operations were to merge with a private company, however modern SPACs raise more funds and consequently merge with higher quality targets than their predecessors did. (Bazerman & Patel, Harvard Business Review) The 1980’s practice led to widespread investor fraud cases and by the early 1990s cost investors more than $2 billion a year before Congress regulated blank check companies out of existence. (Id.; Lipschultz & Burton, Bloomberg Law). The regulations, including a two-year limit on holding funds and mandatory disclosures, created the modern SPAC. (Lipschultz & Burton, Bloomberg Law).

Despite their established presence, SPACs remained a risky investment in the years following the blank check boom, seemingly reserved for companies with weak financials who could not utilize a traditional IPO. (Goldstein, New York Times). However, the COVID pandemic created a perfect environment for SPACs to thrive. (Ye, American Bar). An increase in investors in the U.S. stock market and low interest rates encouraged investors to take bigger risks, and SPACs became a popular choice. (Goldstein, New York Times).

Modern SPACs changed focus to companies disrupting industries like consumer, technology, and biotech markets. (Bazerman & Patel, Harvard Business Review). Moreover, serious investors started to launch SPACs, and even celebrities, like the singer Ciara, joined in on the craze. Id. This encouraged participation in SPACs by many of the 20 million less-sophisticated retail investors who entered the U.S. stock market in 2020 and 2021. Id. During this boom, SPACs raised approximately $250 billion, with 295 created in the first quarter of 2021, compared to 59 in all of 2019. (Id.; Lipschultz & Burton, Bloomberg Law).

The recent proliferation of SPACs has created a spate of novel problems that SPACs now have to face. Firstly, there are now about 700 SPACs in the market searching for targets to merge with, many before the expiration of their two-year deadline. (Lipschultz & Burton, Bloomberg Law; Lipschultz, Bloomberg Law). Secondly, paralleling the prior “blank check” companies of the 1980s, companies that went public through SPACs have wiped out billions of dollars in value for shareholders after merging with targets that failed on their projections. (Lipschultz & Burton, Bloomberg Law). This was enabled in part by the fact that SPACs do not need to comply with many investment regulations intended to protect investors from such lofty projections. (Id.; Zanki, Law360). Most notably, SPACs have been able to take advantage of the Private Securities Litigation Reform Act’s (“PSLRA”) safe harbor provisions, which shield them from liability for prospective statements. (SEC). Many SPAC target companies have failed on their financial promises and have incurred little to no SEC liability due to the safe harbor provisions. (Karageorge, Huffman, & Lee, Law360). The provisions do not apply to traditional IPOs or blank check companies. (SEC). However, because the provisions define blank check companies specifically as companies issuing penny stocks, SPACs have been able to circumvent the blank check company exception. Id.  

In response, the SEC has begun taking a more proactive stance towards SPACs. Since 2020, the SEC has opened two dozen investigations of SPACs. (Satran, Reuters; Goldstein, New York Times). In March of this year, the SEC released proposed rules for SPACs which are designed to apply traditional IPO requirements to SPACs. (De Martino, National Law Review). The proposed rules would increase disclosure requirements, underwriter liability, and eliminate the PSLRA safe harbor provision for SPACs. (Zanki, Law 360; De Martino, National Law Review). While the enhanced disclosure requirements have garnered support from commenters such as the American Bar Association, which agreed investors are entitled to “robust disclosures,” other proposed rules have not. (De Martino, National Law Review). Investment bank, Cowen Inc., criticized the rules as being unclear on how underwriter liability would be determined, which they say would increase the risk of investing in a SPAC. (Zanki, Law 360).  The proposed rules would also make SPACs less profitableinvestments for underwriters, whose support played an integral part in SPACs boom, because they require underwriters to devote more resources to ensure compliance. (Goldstein, New York Times). The release has already begun to have a chilling effect on the SPAC market, with prominent underwriters like Goldman Sachs backing out because of the increased requirements. (Zanki, Law 360).

While the SEC’s actions have influenced the recent SPAC crash, commenters say the decline was foreseeable before SEC involvement. (Bernard, NY Times). Usha Rodrigues, a Professor of Law at the University of Georgia, suggested the fall of SPACs was inevitable because of the disproportionate ratio of SPACs to targets. (Lipschultz & Burton, Bloomberg Law). Additionally, higher interest rates may have contributed to the decline. (Goldstein, New York Times). Compared to 2020, when SPACs grew with the help of low interest rates, SPACs now face the Federal Reserve’s largest interest rate hike since 1994  with an equivalent one potentially coming. (Goodkind, CNN). Lastly, SPACs’ fall parallels that of reverse merger transactions that also grew too large for their own good and became a victim of their own success. (Naumovska, Harvard Business Review). Reverse merger transactions involve a private company merging with a failed publicly traded company. Id. These transactions saw a dramatic rise and fall in the mid-2000s. Id. As the number of reverse mergers grew, skepticism intensified as low-quality mergers discouraged higher quality firms from joining. Id.Similarly, as SPACs’ popularity grew, shareholders, put in motion by short sellers, voiced more concerns about the target companies, leading to a wave of securities class actions involving SPACs. Id.

While the SEC’s recent regulation of SPACs has played a role in cooling the market, the unsustainable growth of SPACs also contributed to their decline. The rapid proliferation of SPACs before a quick and unexpected recession ultimately caused their crash, more so than the SEC’s increased attention. However, the next embodiment of SPACs may also avoid the spotlight of SEC scrutiny  by forming in ways to circumvent the new regulations as they had before and weather the harsh market conditions to cause another sensational market boom.