It seems everyone is getting in on the SPAC craze lately. The latest numbers from SPACInsider show that 138 SPACs went public in 2020 through the first week of October 2020, raising a record $53.7 billion. SPACs are so hot that even the Oakland A's Billy Beane and former chief economic advisor Gary Cohn are riding the SPAC train.
As a reminder, special purposes acquisition companies, or SPACs, raise capital in an IPO with the intention to acquire or merge with a private operating company that ends up being a publicly traded company as result of the merger. SPACs themselves are not operating companies. While the concept is not new, their recent gain in popularity has been explosive.
The recent popularity of these SPACs makes it worth examining the litigation risks for directors and officers of SPACs. I've written in the past about how more SPACs means more private litigation by shareholders.
Now the Securities and Exchange Commission is sharpening its focus on SPACs as well.
The SEC and SPAC Disclosure
In September 2020, SEC Chairman Jay Clayton made remarks about the agency's focus on SPACs. For clarity, there was no handwringing about SPACs as a financial vehicle per se. Reflecting positively on SPACs as a concept, Chairman Clayton noted that the concept "actually creates competition around the way we distribute shares to the public market," and "competition to the IPO process is probably a good thing."
He went on to say, however, that "for good competition and good decision making, you need good information." Thus, it is not surprising that his concern is chiefly that the incentives and compensation of SPAC sponsors is clear and that disclosures are both accurate and easily understood by SPAC shareholders.
You can hear the SEC Chairman talk about this in the interview below. In that interview, Chairman Clayton declared that "at the time of the transaction, when [shareholders] vote," the SEC wants to make sure "they're getting the same rigorous disclosure that you get in connection with bringing an IPO to market."
Chairman Clayton's remarks send a clear message that the SEC is watching the SPAC trend closely.
SEC Enforcement Action Against a SPAC
Chairman Clayton's current remarks, however, should not be taken to mean that the SEC has been ignoring SPACs before now.
In 2019, the SEC accused and settled with Benjamin Gordon, the CEO of Florida-based SPAC Cambridge Capital Acquisition Corp., for failing to take "reasonable steps and conduct appropriate due diligence to ensure that Cambridge shareholders voting on the merger were provided with material and accurate information concerning" the target company's prospects.
Mr. Gordon participated in the filing of a proxy statement to solicit the shareholders of Cambridge Capital Acquisition Corp. to vote in favor of the proposed merger with Ability Computer & Software Industries, Ltd. Unfortunately, the proxy statement turned out to be woefully deficient with respect to its description of the assets and business prospects of Ability.
A summary of the case by the SEC:
The order finds that Gordon [the CEO of Cambridge] negligently failed to take reasonable steps and conduct appropriate due diligence to ensure that Cambridge shareholders voting on the merger were provided with material and accurate information concerning Ability's business prospects, including Ability's purported ownership of a new, game-changing cellular interception product, ULIN, Ability's so-called backlog of orders from its largest customer, a police agency in Latin America, Ability's lack of actual purchase orders backing its backlog, and Ability's pipeline of possible future orders from customers.
Of course, it is unlawful to solicit shareholders by means of a proxy statement that contains materially false or misleading statements.
The SEC's order describes in unsparing detail the SEC's view of Mr. Gordon's lack of diligence. In its order against Mr. Gordon, the SEC notes that the proxy statement made representations as to Cambridge's "thorough diligence" of various aspects of Ability, notwithstanding that many of the "facts" in the proxy statement were misleading if not outright falsehoods.
The SEC specifically notes the absence of any third-party due diligence on the intellectual property ownership of certain assets of Ability or its purported backlog and revenue figures. Ultimately, the SEC finds that the "claim that Cambridge had conducted 'thorough due diligence' was false and misleading."
Several months after Cambridge shareholders voted in favor of acquiring Ability and the merger closed, the shareholders learned the ugly truth through the filing of Ability's annual report. The news caused the company's stock price to fall 33%. The SEC ordered a cease and desist for violating Section 17(a)(2) of the Securities Act of 1933 and Section 14(a) of the Securities Exchange Act of 1934 and Rule 14a-9 thereunder.
Mr. Gordon agreed to pay a fine of $100,000. He also agreed to a yearlong suspension from associating with any broker, dealer, and investment advisor or participating in the offering of any penny stock.
The principals of the target company were also pursued by the SEC. The SEC charged this Israel-based company, its wholly owned subsidiary, and two top executives with defrauding shareholders.
The SEC summarizes that case here:
To convince shareholders to vote in favor of the merger proposal, the defendants allegedly lied to SPAC shareholders about Ability's business prospects, including Ability's purported ownership of a new "game-changing" cellular interception product, ULIN, Ability's so-called backlog of orders from its largest customer, a police agency in Latin America, Ability's lack of actual purchase orders backing its backlog, and Ability's pipeline of possible future orders from customers.
While shareholders lost $60 million in the deal, the two executives profited a total of $30 million. The SEC charged the executives with violations of the antifraud and proxy statement provisions of the federal securities laws.
The timeline is also important. It is notable that SPACs that run into trouble often do so as they attempt to complete a transaction at the end of their pre-agreed life. In this case, Cambridge's sponsors formed it in October 2013 with an $81 million public offering. They had until December 2015 to acquire a company or return the IPO proceeds. The proxy statement in question was provided to shareholders in early December 2015, and the transaction closed later that month.
All things considered, the SEC does not make it a practice to pursue directors and officers merely because deals do not work out. That is, after all, the risk of business. The SEC is very interested, however, in good disclosure, because, in Chairman Clayton's own words from above, "for good competition and good decision making, you need good information."
The Cambridge debacle as well as Chairman Clayton's recent remarks provide some clear guidelines for directors and officers of SPACs:
- Diligence is not to be approached in a cavalier way or to be taken lightly. The SEC will not be sympathetic to a SPAC's sponsors for having been fooled by a target's management. Instead, the SEC expects that if the proxy says that the sponsors conducted thorough diligence, the sponsors will have, in fact, done this.
- Thorough diligence at a minimum includes using third parties to validate things like the ownership of intellectual property and other assets as well as the veracity of things like backlog and pipeline.
- Pay special attention and do not cut corners if an acquisition will end up taking place at the very end of a SPAC's life.
- Ensure that the compensation and incentives of the SPAC sponsors, both at the time of the SPAC IPO as well as at the time of the merger transaction, are clearly disclosed to shareholders.
- Be sure to purchase good D&O insurance.
This last point is critical. One of the reasons SPACs purchase D&O insurance is to ensure that there is money for a good defense lawyer should the SEC or shareholders decide to sue the directors and officers of a SPAC.
As noted in Woodruff Sawyer's Guide to Insurance for SPACs, the insurance issues for SPACs can be complex and nuanced and ought to be addressed before issues arise.