The frenzy that made Special Purpose Acquisition Companies (SPACs) the latest gold rush on Wall Street has quieted down for the moment. So it is time to take a dispassionate look at this latest maneuver from the financial industry. For the last several years, it was touted as the hot alternative to the traditional initial public offering (IPO), in which a company sells its stock for the first time to general investors.
The SPAC process works like this. Promoters set up a shell corporation without any assets or business, with its insiders getting stock at a deep discount. It then raises capital, selling its shares in an IPO that is registered with the Securities and Exchange Commission (SEC), the federal agency that protects investors from fraud.
The SPAC’s avowed purpose is to search for a private company to merge with so its owners will have a public market for their stock, making it a liquid asset. When that combination is proposed, the SPAC’s original shareholders can have their stock redeemed, typically for a good profit, rather than continue as shareholders of the surviving public company.
SPACs gained momentum over the last several years, and by fall 2020 there were 290 of them in some form of development holding $86.5 billion. They were said to be a cheaper and faster way for a private company to go public than by an SEC registered offering. Unlike that highly regulated procedure, SPACs allegedly allowed those firms to give investor projections about their prospects. Their promoters also claimed that they were the “poor man’s private equity” offering “mom and pop investors” early access to the best IPOs.
Yet they were just an updated way of “going public through the back door,” an old end-run around the carefully constructed registration process designed to safeguard investors from questionable deals. Even worse, some of them seemed to resemble classic stock manipulations using shell corporations to pump up share prices so insiders could dump their stock on unsuspecting investors.
But after holding back for some time, SEC officials came out this spring with a series of strong warnings about SPACs. They first cautioned the public not to be taken in by celebrity sponsors of these ventures, some of whom were prominent professional athletes. They next admonished SPAC organizers to be aware of specific accounting and disclosure rules governing them because they were nothing more than “blank check” companies with no real history of operations.
And in a telling statement, a leading SEC officer announced that his government agency would fully review these offerings before they could be sold. Just as in a traditional IPO, he said, outsider investors need that protection because they lack meaningful information about the operation of those firms that had made no previous public disclosures. The SEC followed up with more stringent accounting regulations requiring SPACs to expense certain preferential rights given to their promoters for future stock purchases.
Then an even more telling blow to the SPAC industry came from an academic study by distinguished scholars at Stanford and NYU. They did a detailed analysis of their structure and costs, finding that while SPAC promoters usually make out quite well, their post-merger shareholders typically see a substantial dilution in their investments. In effect, those ordinary investors are subsidizing the target companies that use them to go public.
The study also refuted claims that SPACs are cheaper and offer more effective pricing than fully registered offerings. Concluding that all those assertions were overstated, it debunked much of the hype about SPACs and appears to have at least temporarily burst their bubble.
In addition, a day of reckoning may be awaiting some SPAC promoters in court. The powerful shareholder law firm Robbins, Geller, Rudman & Dowd has put together a SPAC Task Force to investigate wrongful conduct there. It has already won a significant legal victory in a case in which the projections made by an energy company in a SPAC merger were fraudulent. Some of the stock sales by organizers of these ventures may also have involved unregistered securities and therefore been done in violation of the law.
The SPAC story is a troubling tale of how Wall Street tried to exploit a crack in the structure of the securities laws. Those were set up to prevent harm to investors and oversee the honesty of our capital markets. Legislation has been introduced in Congress to tighten up that regulatory process. Even if it fails to become law, the SEC’s current response to the SPAC mania now seems to be tamping down the threat it has posed to the integrity of our financial system.
Daniel J. Morrissey is a professor and former dean at Gonzaga University Law School.