New Rules for SPACs, Shell Companies, and De-SPAC Transactions

The SEC recently implemented new rules that are intended to enhance investor protections in deals involving special purpose acquisition companies (SPACs) and shell companies. The new rules, which go into effect July 1, 2024, impose enhanced disclosure and liability standards for (i) SPAC initial public offerings and (ii) initial business combinations involving a SPAC and a private target company that result in the private target company becoming a publicly listed company (de-SPAC transactions).

SPACs are publicly traded companies formed with the sole purpose of finding a private target company to merge with. SPACs raise large sums of money from investors in order to support such a business combination. SPACs are essentially shell companies with limited or no tangible assets, other than cash from investors, and they generally do not have active business operations. The result of the business combination is a new public company. De-SPAC transactions are a shortcut to the traditional IPO process for private companies seeking to enter the public markets.

Statutory Underwriter Liability in a De-SPAC Transactions

Prior to the adoption of the new rules, investment banks involved in bringing a target company public via a de-SPAC transaction were not deemed to be acting as underwriters. With the adoption of Rule 145a under the new rules, banks involved in de-SPAC transactions will be considered “statutory underwriters.” The definition of “statutory underwriters” captures anyone who is selling on behalf of the company or participating in the distribution of securities in the combined company.

In the context of a de-SPAC transaction, securities are being distributed to the SPAC’s investors and public market investors. Even though banks in a de-SPAC transaction do not engage in the typical activities of an underwriter like in an initial public offering, they are captured by the broad interpretation of the definition of statutory underwriters. By being considered underwriters, the banks participating in the distribution of securities could be found liable for any material misstatements or omissions in the registration statement under securities laws.

Co-Registrants

The new rules require both the SPAC and the private target company to be named as co-registrants in the Form S-4 registration statement. Previously, only the SPAC entity was treated the registrant in the Form S-4 registration statement. A Form S-4 registration statement is filed with the SEC by a public company seeking to undergo a merger or acquisition.

The implication of new requirement to have co-registrants named on the registration statement is that the target company, its Chief Executive Officer, Chief Financial Officer, Chief Accounting Officer, and its board of directors, are all subject to securities law liability for any material misstatements or omissions.

Forward-Looking Statements

Forward-looking statements are statements that evidence beliefs and contain projections about future business conditions. Such statements are common in public company SEC filings, earnings presentations, and earnings releases. Such statements can also make a company susceptible to securities litigation by plaintiffs who claim that a stock price drop was attributable to overly optimistic forward-looking statements made by a company.

A safe harbor for forward-looking statements was enacted under the Private Securities Litigation Reform Act of 1995 (PSLRA). The PSLRA safe harbor shields companies from liability in private actions under the Securities Act of 1933 or the Securities Exchange Act of 1934 based on a materially misleading statement or omission if (i) the forward-looking statement is identified as a forward-looking statement and (ii) the plaintiff fails to prove that the forward-looking statement was made with actual knowledge of being false or misleading.

The new rules going into effect on July 1, 2024 eliminate the availability of the PLSRA forward-looking statements safe harbor for SPACs and other blank check companies. This aligns the rules for de-SPAC transactions more closely with traditional IPOs, where the PSLRA safe harbor is also not available. The rationale behind the rule change is that company insiders and public market investors face an information asymmetry. The implication is that SPAC registrants will have to take extra precautions in preparing and presenting future projections.

Enhanced Disclosure Requirements

The new rules implemented a number of enhanced disclosure requirements for target companies in de-SPAC transactions. For example, a detailed description of the target company’s business must be included in the Form S-4 registration statement so that prospective SPAC investors have access to sufficient information about the target company prior to the closing of the business combination transaction. Previously, there was more discretion to defer disclosure about the target company’s disclosure until the closing Form 8-K filing.

Investment Company Status

The new rules provide guidance on the factors that could make the requirements of the Investment Company Act of 1940 applicable to SPACs. The Investment Company Act imposes strict regulations for companies deemed to be “investment companies” under Sections 3(a)(1)(A) and 3(a)(1)(C) of the Investment Company Act. The regulations are designed to protect investors and keep them informed of potential risks associated with investment companies.

A five criteria test is used to assess a company’s status as an “investment company”:

  • Assets in Investment Securities: A SPAC that owns or proposes to acquire 40% or more of its total assets in investment securities, it would likely qualify as an “investment company.” For example, a SPAC that invests in corporate bonds or acquires a minority interest in a company with the intention of being a passive investor is more likely to be required to register under the Investment Company Act.
  • Management Activities: If the executive officers and key employees of the SPAC are engaged in actively managing the SPAC’s portfolio of securities, and are dedicating disproportionately less time to searching for a private target company to merge with, the SPAC may be deemed to have a primary purpose of investing and trading securities. Such a finding would require the SPAC to register under the Investment Company Act and the sponsors of the SPAC may be deemed investor advisers.
  • Duration: If a SPAC operates without entering into a business combination agreement within the traditional timeframe of 12-18 months, it may raise concerns that the SPAC is actually an investment company. Following a SPAC IPO, a SPAC is generally expected to enter into a definitive agreement within 12-18 months and then to close the de-SPAC transaction within 24 months of the SPAC IPO. The longer this timeframe drags out, the more it raises concerns that the SPAC is not intending to fulfill its stated business purpose.
  • Holding Out: The way the SPAC holds itself out to investors factors into the analysis. If a SPAC is perceived as merely a fixed-income investment opportunity or a vehicle for getting exposure to a portfolio of securities, the SPAC may be deemed an “investment company.”
  • Business Combination with an Investment Company: If a SPAC were to merge with a company that is considered an investment company under the Investment Company Act, the SPAC itself is likely to be considered an investment company requiring registration under the Investment Company Act.