Tag: IPO

The events that occurred in 2020 drastically altered the world’s financial markets,[1] contributing to an increase in Initial Public Offerings (“IPOs”) of Special Purpose Acquisition Companies (“SPACs”).[2] In particular, 2020 was a year marked by numerous records within the SPAC market, including the highest number of SPAC IPOs (248), the highest amount of proceeds raised in SPAC IPOs ($83.3 billion), the highest average SPAC IPO size ($336.2 million),[3] and the largest SPAC IPO ever ($4 billion).[4] SPAC IPO activity continued at a record pace during the first quarter of 2021, as $111.9 billion was raised through 317 SPAC IPOs, which surpassed the annual records set in 2020 in a single quarter.[5] SPAC proponents argued that SPACs provided disruptive private companies with a viable route to access capital via the public markets.[6] Furthermore, and central to this Note, SPACs caught the attention of potential investors,[7] potential SPAC sponsors,[8] and the Securities and Exchange Commission (“SEC”).[9] SPACs have become subject to an increasing amount of regulatory scrutiny and litigation risk.[10] After two years of record-breaking activity in the SPAC market, the future of the SPAC’s role in the capital markets is clouded with uncertainty.[11]

A SPAC is a publicly-held shell company created to merge with a private company and bring the private company public.[12] A shell company is a development stage company that has no physical assets (other than cash and cash equivalents) and either has no business plan or its business plan is to merge or acquire another company or entity.[13] The “merger” between the shell company and private company is commonly known as a “de-SPAC transaction,”[14] and this Note uses the terms interchangeably. First, the SPAC sponsor (“sponsor”),[15] the financiers and managers running the SPAC deal, raise a war chest of capital with the intention of pursuing a de-SPAC transaction in a process similar to the typical IPO process.[16] The sponsor has a set time limit, typically two years (the “outside date”), to find a target company, negotiate a merger or purchase agreement, and take the company public through the de-SPAC transaction or the SPAC liquidates and returns its IPO proceeds to its investors.[17] During this process, the investment proceeds raised in connection with the IPO are held in a trust account.[18] Once the target company is identified, the de-SPAC transaction is subject to shareholder approval.[19] Even if the transaction is approved, SPAC IPO investors are able to opt out of the transaction by redeeming their shares at the time of the merger, receiving a pro rata share of the trust account (plus interest).[20] At the time of the SPAC IPO, potential SPAC IPO investors do not know which company the sponsor plans to merge the SPAC with, only finding out when the potential target company is proposed to them.[21] In light of the speculative nature of investments in SPAC IPOs emerges a nuanced question of whether or not potential SPAC IPO investors are provided with sufficient disclosure at the time of the SPAC IPO.[22] Secondly, SPAC commentators have argued that the SPAC’s compensation structure can incentivize sponsors to pursue a “losing” de-SPAC transaction at the expense of some investors.[23] This Note addresses these two key concerns potential SPAC IPO investors are faced with.

The first concern that potential SPAC investors are faced with is whether they are provided with sufficient disclosure at the time of the SPAC IPO and until the target company is announced. The primary purpose of federal securities law is to ensure that investors are provided with enough information to sufficiently evaluate the merits of investment opportunities themselves.[24] If the sponsor does not provide sufficient disclosure at the time of the SPAC IPO, potential SPAC IPO investors will be forced to make a misinformed decision about whether to invest in the SPAC.[25] This Note concludes that the current regulations and applicable exchange rules demand sufficient disclosure at the time of the SPAC IPO and before the de-SPAC transaction is announced. Going forward, the SEC should ensure that investors are provided with adequate disclosure when the target company is proposed and at the time of the de-SPAC transaction.

The second concern for potential SPAC IPO investors, and the focus of this Note, is whether the regulations governing SPACs and SPAC terms provide adequate protection against the partial misalignment of incentives between the sponsor and SPAC IPO investors that stem from the SPAC’s compensation structure.[26] The sponsor is either compensated with a twenty percent stake in the target company post-merger if the sponsor completes a de-SPAC transaction or is left uncompensated if the sponsor fails to complete a deal before the outside date.[27] SPAC IPO investors want the sponsor to complete a de-SPAC transaction that will increase the value of their shares post-merger.[28] The sponsor largely shares the same goal. A successful transaction is more profitable for the sponsor and can lead to future fundraising opportunities.[29] However, if the outside date is approaching and the sponsor has yet to complete a merger, the sponsor can be incentivized to complete a de-SPAC transaction that may be value-destroying to SPAC IPO investors,[30] creating an agency problem.[31] Sponsor compensation is not substantially tied to SPAC IPO investor compensation.[32] While the sponsor would prefer a merger in which the SPAC shareholders do well, as the outside date approaches, the sponsor will favor a merger that is bad for shareholders rather than no merger at all.[33] SPAC incentives could be better aligned if the SPAC’s compensation structure closely tied sponsor compensation to SPAC IPO investor compensation.

This Note concludes that while redemption rights largely protect SPAC IPO investors against the partial misalignment of incentives created by the SPAC’s compensation structure,[34] SPAC warrants can incentivize some SPAC IPO investors to exercise their redemption rights in self-serving ways at odds with the SPAC’s ultimate goal of completing a successful de-SPAC transaction.[35] A warrant is a contract to purchase additional shares of common stock at a later time for a pre-determined price.[36] The warrants incentivize investors to invest in the SPAC IPO by providing additional compensation to investors if the target company performs well post-merger.[37] However, the warrants do not encourage SPAC IPO investors to hold onto their shares after the IPO.[38] Rather, the warrants can incentive SPAC IPO investors to redeem their shares even if they believe the target company will be successful post-merger. By redeeming their shares, these investors guarantee that they receive their initial investment back (plus interest), while retaining the potential upside the warrants provide.[39] By acting on these incentives, redeeming SPAC IPO investors harm non-redeeming SPAC IPO investors and pose a threat to the SPAC’s long-term viability as an investment vehicle. The inefficiencies prevalent in SPACs today could be mitigated if there were an incentive for SPAC IPO investors to not redeem their shares outside the protective purpose that redemption rights serve.

This Note utilizes a case study of Pershing Square Tontine Holdings, Ltd. (“Pershing Square Tontine”), the largest SPAC IPO to date,[40] to analyze its claims. In March 2021, Pershing Square Tontine had just issued its SPAC IPO, and the SPAC was being praised by commentators for its “shareholder-friendly terms” and “strong alignment” of incentives.[41] Pershing Square Tontine made a bold attempt to align sponsor and SPAC IPO investor incentives with its compensation structure and warrant structure, which significantly departed from common SPAC terms at the time.[42] Pershing Square Tontine’s shares performed exceptionally well in the months following its SPAC IPO,[43] indicating that the market valued its innovative structure.[44] Unfortunately, Pershing Square Tontine proposed an excessively complex transaction that abandoned any resemblance to a typical de-SPAC transaction to acquire a ten percent stake in Universal Music Group (“UMG”).[45] Shortly after, Pershing Square Tontine issued a letter to its shareholders canceling the transaction, noting issues raised by the SEC and investors.[46] After the failed transaction, Pershing Square Tontine faced multiple challenges that will only be touched upon briefly in this Note.[47] In July 2022, after failing to complete a merger before its outside date, Pershing Square Tontine announced that it would liquidate and return all of its capital to its investors.[48] Pershing Square Tontine will be viewed as a failure. Nonetheless, commentators still view Pershing Square Tontine’s original terms as some of the most investor-friendly SPAC terms ever introduced,[49] noting that the sponsor’s “determination to innovate and reform SPACs” was “admirable.”[50] The entire SPAC market was left to wonder what would have happened had Pershing Square Tontine succeeded in completing a de-SPAC transaction.[51]

Since January 2021, the overall sentiment of the SPAC market has steadily declined due to SPAC’s “lackluster aftermarket performance,”[52] SPAC litigation threats, and increasing regulatory scrutiny within the SPAC market.[53] While we will likely never see the SPAC deal volume of 2020 to 2021 again, the flexibility of the SPAC’s structure may enable future SPACs to “carve out specific niches” within the capital markets.[54] But doing so would require addressing the inefficiencies that were prevalent in the SPACs of 2020–2021. An analysis of Pershing Square Tontine’s original terms provides a starting point for this discussion. Future SPACs should consider replicating some of Pershing Square Tontine’s original terms to mitigate the agency problem common in SPACs.

On March 30, 2022, the SEC proposed a sweeping new set of highly criticized rules regarding SPAC IPOs and de-SPAC transactions.[55] SEC Commissioner, Hester Peirce, opposed the proposed rules, stating in a hearing that they “seem designed to stop SPACs in their tracks.”[56] The proposed rules will likely face extensive comments and the final rules will “attract close scrutiny and potential legal challenges.”[57] Given that the scope and effect of the regulation is yet to be determined, this Note narrows its analysis to the SPACs and applicable regulation of 2020–2021 before the SEC proposed new rules. The focus on the SPAC market of 2020–2021 sheds light on an unprecedented time within the capital markets. The analysis that follows will be relevant regardless of how SPAC regulation evolves and its corresponding effects within the SPAC market. If the regulation is reasonable, the proposals set forth in this Note will serve as recommendations for future SPAC sponsors to adopt, as originally intended. Similarly, if certain proposed rules are adopted, commentators argue that there will be unintended consequences that will magnify the current SPAC criticisms addressed in this Note.[58] Alternatively, in a world in which excessive regulation kills the SPAC market, these proposals will serve as an alternative solution to addressing SPAC criticisms.

Part I sets out the offsetting costs and benefits faced by SPAC IPO investors and sponsors that form the core of the SPAC’s agency problem. Part II describes the typical SPAC transaction in detail, elaborating on the mechanisms that drive this partial misalignment of incentives. Part III compares a SPAC IPO to a traditional IPO, analyzes the advantages and recent popularity SPACs have had within the capital markets, and describes the incentives that underlie the SPAC IPO process. Part IV explores the fraudulent history of shell company offerings, providing a rationale for investors and regulators to be wary of SPACs. Part IV then depicts how Rule 419 and other securities laws and regulations helped mitigate concerns posed by shell company offerings, ultimately leading to the creation of the SPAC.[59] While regulation was necessary for shell company offerings, SPACs provide many of their protections through contractual obligations, thus the looming threat of excessive regulation will likely lead to the demise of this valuable alternative to a traditional IPO. Part V describes the SPAC boom (or bubble) of 2020 to 2021 and the original terms of Pershing Square Tontine. Part VI addresses the first concern posed to SPAC IPO investors, utilizing Pershing Square Tontine’s SEC filings to argue that there is sufficient disclosure at the time of the SPAC IPO. Part VII observes how SPAC sponsor compensation has resulted in a partial misalignment of incentives in the SPAC form and the effect that investor voting rights and redemption rights have had on balancing these incentives. In light of these findings, this Note proposes modifications to common SPAC terms. Future SPACs should consider adopting some of the novel terms Pershing Square Tontine introduced in an attempt to better align sponsor and SPAC IPO investor interests.