SPACs: A Fast Track to Fast Cash?

You may have heard of an initial public offering (“IPO”), but what about a special purpose acquisition company (“SPAC”)? Once viewed as a “sketchy Wall Street arcana,” a SPAC is a publicly traded shell company created for the sole purpose of merging with or acquiring a private company so the target company can forgo much of the traditional IPO paperwork. (Heather Perlberg, Bloomberg; Julie Young, Investopedia; Camila Domonoski, NPR). In recent years, SPACs have increased in popularity to the extent many famous individuals, such as baseball legend Alex Rodriguez, professional-basketball-superstar-turned-DJ Shaquille O’Neal, and former House of Representatives Speaker Paul Ryan, are now creating them. (Heather Perlberg, Bloomberg). In 2020, U.S. SPACs raised $83.3 billion, up from $13.6 million in 2019. Id. This year, SPACs have already generated $73 billion and make up around 70% of the IPO market. Id. How did SPACs become so popular and how do they work?  

SPACs have many built-in advantages; they are quickly created, and they provide less uncertainty for founders and more control than traditional IPOs. (Camila Domonoski, NPR). In a traditional IPO, a company announces its intention to go public. Id. It then provides investors information about its business. Id. Next, investors buy shares of that company—the company is provided with capital, and the investor gains ownership. Id. SPACs operate in a reverse manner. Investors buy into a newly created shell company—a company without active business operations or significant assets—without a meaningful understanding of the company they are investing in. (Id.; Will Kenton, Investopedia). The SPAC is able to avoid lengthy Securities and Exchange Commission (“SEC”) disclosures because “a pile of money doesn’t have any business operations to describe.” (Camila Domonoski, NPR). The SPAC (at this point a publicly-traded shell company) then seeks out another company with business operations and assets to merge with. Id. Consequently, the target company is able to be traded on stock exchanges much faster than with a traditional IPO. Id. SPACs typically have around two years to find a company to merge with or acquire. (Anna-Louise Jackson and Benjamin Curry, Forbes Advisor). If a SPAC does not meet the deadline, money will be returned to shareholders. Id.

In addition to the built-in advantages for investors, SPACs provide a fast track to fast cash. For example, Luminar, a company that develops light detection software for self-driving cars, went public through the SPAC method in December 2020. (Weston Blasi, Market Watch). Luminar merged with SPAC Gores Metropoulos, instantly creating a market cap of $8.1 billion and a 25-year-old billionaire. (Id.; Cromwell Schubarth, Silicon Valley Business Journal).

As investors realized the ease of creating a SPAC and the large cash returns that can follow, more hopped on the bandwagon, creating a “meteoric rise” in SPAC formation. (Camila Domonoski, NPR). When powerful, influential individuals create SPACs, others follow suit and give SPACs a chance. Id. Alex Rodriguez’s Slam Corp SPAC invests in startup companies. (Reuters Staff, Reuters). Shaquille O’Neal, along with one of Martin Luther King Jr.’s sons and some former Disney executives, created Forest Road Acquisition Corporation, a SPAC that will acquire media and technology companies. (Kori Hale, Forbes). Paul Ryan’s SPAC has not yet selected a target industry but is being led by notable individuals including Tagg Romney, the son of former 2016 presidential candidate, Mitt Romney. (Renaissance Capital, NASDAQ).  

But financial bubbles eventually burst. While SPACs are trendy and rather unregulated compared to traditional IPOs, the SEC is developing new guidance for potential conflicts, potential disclosure requirements, and other structural issues. (Heather Perlberg, Bloomberg). When SPACs near the end of their two-year period to find a target company and are faced with the pressure of finalizing a deal, SPAC founders will be pressured to lock down any deal that gets them to the finish line rather than return money to investors, thus incentivizing cutting corners on due diligence. Id. One Equity Partners of JPMorgan Chase notes that because of the pressure of nearing their two-year period, much of the SPAC market will be washed out, ending the era of easy money. Id. Heather Perlberg notes: “Many SPAC buffs predict a kind of Biblical deluge, with an Ark only big enough for Wall Street A-listers. SPACs, many say, will once again fade into the background, overshadowed by IPOs or whatever shiny new thing comes along.” Id.

In the meantime, SPACs carry risks for investors. If the combined company performs poorly, SPAC investors may file a securities lawsuit challenging a misstatement in the SEC registration statement. (Priya Cherian Huskins, ABA). Shareholders typically learn of the “shabbiness” of the target company after the merger, triggering this type of lawsuit. Id. For example, shareholders sued Heckman—a SPAC—in 2010, arguing that Heckman failed to inform investors of risk by misstating China Water’s—the acquired company—financial statements and failed to diligently inquire about China Water’s internal controls and management, constituting Section 10(b) fraud under the Securities Exchange Act of 1934. Id. Heckman ultimately settled for $27 million—capital that could have been reinvested in the company or returned to investors. Id.

Bankruptcy and shareholder lawsuits may also occur. Id. In 2005, Paramount Acquisition Corp. (“Paramount”) acquired Chem Rx. Id. 18 months later, Chem Rx violated a financial covenant in one of its loan agreements. Id. Chem Rx subsequently filed for bankruptcy and unsecured creditors and shareholders filed claims against Paramount’s board of directors arguing that the board of directors breached their fiduciary duties by acquiring Chem Rx. Id. As in the case of Paramount and Chem Rx, shareholders can file a lawsuit under the duty of care legal doctrine alleging a breach of fiduciary duties. Under the duty of care doctrine, directors are required to act in the best interest of the company by not putting personal interests ahead of the company. (Latham & Watkins). Directors and officers of companies are typically granted an extra layer of protection from lawsuits via the business judgment rule—courts will not intervene in decisions made by officers of a company if the decisions are made in the good faith belief that the decision was in the best interest of the company and not self-interested. (Legal Information Institute).

However, in the case of Paramount, the business judgment rule did not apply because the directors had an economic interest in the acquisition of Chem Rx making it a self-interested transaction. (Cherian Huskins, ABA). This eliminated the business judgment rule’s protection, opening up the company to legal liability and increasing risk for investors. The National Law Review notes that “certain structural terms of . . . SPACs . . . may make it more challenging for the business judgment rule to apply to decisions by SPAC directors to enter into agreements for business combination transactions.” (McDermott Will & Emery, National Law Review).

To protect against risk, loss of capital, and potential lawsuits, investors should diversify their investment portfolios. Investors can also protect themselves by engaging in diligent research to ensure that the SPAC is operating in a manner that will produce long-term profits and results.