SPACs: Litigation risk considerations from an underwriting perspective

Here’s how those associated with special purpose acquisition companies can guard against.

Contributors of this article are: Arpi Lal (Partner), Steven Muller (Manager), and Olivia Sondler (Senior).

In brief

• The SEC has mostly placed emphasis on SPAC sponsors’ and associated directors’, officers’ and affiliates’ economic interests.
• The SEC has ratcheted up due diligence on conflicts of interest and disclosures of possible conflicts of interests around underwriters’ role and compensation.

Underwriters may assume various roles through the special purpose acquisition company (SPAC) process.¹ Under processes where services are provided, underwriters are eligible to receive a percentage of the offering price for equity or a percentage of the principal amount of debt, formally known as the “underwriting discount.”² This discount should be disclosed to the SPAC’s board of directors for conflict of interest concerns arising out of any of the underwriter’s continued roles.

The SEC has largely focused on the economic interests of SPAC sponsors and associated directors, officers and affiliates, often differing from those of public shareholders. The SEC has increased its emphasis on performing conflict of interest due diligence and disclosure of potential conflicts related to underwriters’ role and compensation, including deferred compensation.³

In addition to increased scrutiny, the SEC has previously charged the parties involved, including in 2019, for example, when sponsors convinced shareholders to vote in favor of a merger by fabricating the target’s business prospects and ownership of “game-changing” products.⁴

Benefits to underwriters

The way a company is taken public through a SPAC vs. a traditional initial public offering (IPO) varies in many ways. A SPAC, often referred to as a “blank-check company,” allows for increased IPO efficiency given that the entity has no operations, assets or financial history.⁵

As such, the SPAC IPO process benefits underwriters and sponsors in the following four ways, among others:

1. A SPAC IPO has fewer SEC hurdles regarding the IPO prospectus, which in turn allows for faster issuance by the underwriter and sponsor in comparison with a traditional IPO process.⁶
2. SPACs can provide forward-looking financial projections in the de-SPAC process, which are not allowed in the traditional IPO process under SEC regulations. The use of projections reduces the risk that an underwriter or sponsor omitted material information or made inaccurate disclosures; however, the risk that the underwriter or sponsor remains responsible for inflated projections is not to be discounted.⁷
3. In a traditional IPO process, it may be difficult to address doubts about a company and its business model or other operating functions to mutual funds, pension managers and other institutional investors as a result of the required road show process.⁸,⁷
4. Compared with the de-SPAC process, a company may circumvent addressing existing operating issues that would have been discussed in depth during the road show. It is important to note, however, that a de-SPAC process still requires many of the same disclosures and documentation produced by underwriters and sponsors of a traditional IPO process, inclusive of audited financial statements and disclosure items of the target.⁹

Litigation and regulatory scrutiny

Given the acceleration in issuance of SPACs, lawsuits and regulatory scrutiny have increased significantly. Proxy disclosures have been challenged at both the federal and state level with a focus on disclosures related to the acquisition process, financial analyses, projections and potential conflicts of interest.¹⁰ If shareholders believe a proxy statement lacks adequate disclosures, impacting their ability to make an informed decision, they may challenge the disclosures under Section 14(a) of the Securities Exchange Act of 1934. The Department of Justice (DOJ) will also play a role in scrutinizing whether a SPAC has adequately disclosed potential conflicts of interest.¹¹

Going forward, the DOJ and SEC may enhance their regulatory focus on whether completing the de-SPAC process within the allotted two-year time frame pressures sponsors and underwriters to complete a process not in the best interest of shareholders in order to avoid liquidation.

Former SEC Chairman Jay Clayton has stated the commission’s intention to focus on “the incentives and compensation to the SPAC sponsors. How much of the equity do they have now? How much of the equity do they have at the time of the IPO-like transaction? What are their incentives?”¹² To do so, the SEC will scrutinize the “the initial (equity) distribution of the SPAC to the market and … when the transaction takes place with the operating company. We want to make sure [investors are] getting the same rigorous disclosure that you get in bringing an IPO to market.”¹³

SEC Chairman Gary Gensler further stated that “the agency was taking a closer look at some of the hottest trends in investing – SPACS and retail trading apps – out of concern that smaller investors are getting a raw deal.”¹⁴ The heightened monitoring by the SEC on the SPAC process comes with increased issuance to bring targets public.¹⁵

During the SPAC-IPO process, underwriters and sponsors are responsible for the accuracy and completeness of due diligence and the evaluation of disclosures. Though this responsibility falls heavily on the SPAC itself in the de-SPAC process, it does not remove the negative reputational impact on a SPAC-IPO underwriter or sponsor if inaccurate or incomplete information is uncovered.

Within the past year, there has been significant litigation surrounding material misstatements or omissions under Section 10(b) of the Securities Exchange Act and false and misleading statements in connection with proxy solicitations under Section 14(a). One such example is that of a food ordering and delivery business that pursued a merger with a blank-check firm. The largest investors backing the blank-check company were taken to court in a class-action lawsuit claiming they had misled shareholders on the risks of the target business.

Reputational harm for underwriters

Needless to say, SPACs and their underwriters and sponsors will begin to see an uptick in litigation related to adequacy of registration statements and IPO and de-SPAC disclosures involving potential conflicts of interest with sponsor affiliates and terms of SPAC insider investments and financing transactions. Additionally, SPAC directors can face litigation on the basis of breach of fiduciary duty with regard to business combination transactions and stock price declines following the de-SPAC process.¹⁶

However, given that shareholders are able to redeem their investment in the SPAC upon announcement of the proposed de-SPAC transaction, it would make awarding damages difficult in court. Nevertheless, underwriters and sponsors must consider the above SPAC litigation and the indirect impact on the financial institution’s reputation given its involvement in the transaction.