SPAC MERGERS, IPOS, AND THE PSLRA'S SAFE HARBOR: UNPACKING CLAIMS OF REGULATORY ARBITRAGE.

• Author: Rose, Amanda M.

INTRODUCTION

The year 2020 was memorable for many reasons, one of the brighter being the explosive growth in initial public offerings (IPOs) in the United States. IPOs more than doubled in number and amount of capital raised relative to 2019. (1) In 2021, the number of IPOs more than doubled again, with proceeds growing 187 percent relative to 2020's record high. (2) A big part of this story concerns the astronomical rise of IPOs by special purpose acquisition companies (SPACs). In 2020, the number of SPAC IPOs more than quadrupled, and proceeds from SPAC IPOs increased more than sixfold relative to 2019 (the previous high-water mark since the NASDAQ and NYSE first began listing SPAC securities in 2008). (3) In 2020, there were 248 SPAC IPOs (versus 202 traditional IPOs) that collectively raised over $83 billion (versus $96 billion for traditional IPOs). (4) SPAC IPOs in 2021 shattered 2020's figures, numbering at 613 (versus 355 traditional IPOs) and collectively raising over $162 billion (versus $172 billion for traditional IPOs). (5)

SPACs are shell companies organized by sponsors. (6) They sell units in an IPO with the stated intention of finding a private operating company to combine with, typically within a two-year period.' SPAC units are typically sold for $10 and consist of a common share in the SPAC and a warrant, or fraction of a warrant, to buy additional shares at a set price (often $11.50); (8) soon after the IPO. the warrants trade separately, but they cannot be exercised until a business combination has been consummated. (9) The capital invested in SPACs by public investors is held in escrow while SPAC sponsors search for an acquisition target. (10) If a SPAC fails to complete a business combination in time, it is liquidated (unless an extension is obtained), and the sponsor gets nothing for its efforts; if the SPAC succeeds, the target company becomes a listed reporting company by virtue of its combination with the SPAC, and the sponsor typically gets a significant equity stake in the merged entity--referred to as the "promote." (11) In connection with the so-called "de-SPAC transaction," SPAC investors have the option to redeem their shares in exchange for their pro rata stake in the escrow account; most do, unless selling on the secondary market is more profitable. (12) SPAC sponsors seek to fill the funding shortfall created by redemptions by selling new SPAC shares to themselves and other private investors (an example of private investment in public equity, or PIPE, financing). (13)

Given their number and size, SPACs today offer private companies a meaningful alternative to the traditional IPO as a pathway to publicness. (14) According to commentators, one of the features that makes a combination with a SPAC attractive relative to a traditional IPO concerns differences in disclosure-based liability exposure. (15) One such difference that has garnered significant attention concerns the applicability of the safe harbor for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995 (PSLRA), a provision that makes it harder for investors to win a lawsuit alleging that forward-looking statements were misleading. When SPACs share their target's growth projections with investors, those projections may enjoy the protection of the PSLRA's safe harbor, whereas any projections shared by a company doing a traditional IPO would fall within an exclusion from the safe harbor. (16)

Although it is unclear how often the PSLRA's safe harbor has played a decisive role in private companies' chosen path to publicness, (17) the divergent application of the PSLRA's safe harbor is often characterized as a troubling opportunity for "regulatory arbitrage." (18) SEC officials and other lawmakers have thus called for law reform that would exclude communications in connection with a de-SPAC transaction from the safe harbor, which would purportedly place de-SPACs on a "level playing field" with traditional IPOs (at least as it concerns forward-looking statements). (19) As part of a broad package of proposed rules designed to "[a]lign[] [d]e-SPAC [t]ransactions [w]ith [i]nitial [p]ublic [o]fferings," the SEC in March answered these calls. (20) The proposed rules would, among other things, redefine terms in the PSLRA safe harbor such that the safe harbor "would not be available to SPACs, including with respect to projections of target companies seeking to access the public markets through a de-SPAC transaction." (21) Whether such reform is a good idea is a complicated question that this Article seeks to unpack.

This Article is both narrow and broad in its ambitions. It is narrow insofar as it does not take a position on the social value of SPACs. This should not be interpreted as endorsement: SPACs clearly raise a host of investor protection concerns, which I outline in Part LA. This Article is broad in two senses. First, it offers a framework for analyzing claims of regulatory arbitrage that can usefully be applied in other settings. Second, this Article brings into sharp focus the contestable policy choices that undergird the IPO exclusion to the PSLRA's safe harbor. Even if SPACs disappear tomorrow, this analysis will therefore remain important as policymakers consider adjustments to the regulatory framework for traditional IPOs.

How should charges that de-SPAC mergers allow companies to "arbitrage" liability rules be evaluated? The federal securities laws impose a web of different disclosure and liability standards that attach in different circumstances. Although these provisions are technically mandatory, in reality there is a large degree of optionality built in because companies can adjust their circumstances in a variety of ways to avoid the reach of particular rules. (22) Whether this optionality is normatively problematic requires a detailed analysis. Such an analysis must begin with an understanding of the "evaded" rule's purpose. What problem is it designed to solve? If companies can avoid the rule by structuring their transaction in an alternative way and the economic realities of that alternative do not present the same problem, then the differential regulatory treatment may be of no concern. (23) If the economic realities of the alternative do present the same problem, then the wisdom of the evaded rule should be considered before it is extended. Opportunities for regulatory arbitrage can be destructive when they allow companies to avoid optimal regulations, (24) but they can also serve a valuable function by alerting policymakers to potentially deficient regulations and prodding review--similar to sunset provisions. (25) Such review may lead to the conclusion that the evaded rule is indeed optimal and should be extended. It may reveal that the rule is suboptimal and should be changed. Or it might raise doubts about the optimality of the evaded rule, in which case allowing the divergence to persist might allow for regulatory learning. (26) The assumption here is not that companies will necessarily self-select the socially "better" regulatory regime in a virtuous race to the top but rather that observing the two contexts may provide useful data to policymakers as they seek to improve regulations.

Concluding that disclosures in connection with de-SPAC transactions should be excluded from the PSLRA's safe harbor thus requires significant analysis that has not been conducted to date. As a threshold matter, understanding what purpose the IPO exclusion serves is necessary. The legislative history of the PSLRA contains very little on the various safe harbor exclusions, and scant attention has been paid to them by academics. While serving as Acting Director of the SEC's Division of Corporation Finance, Professor John Coates sketched a rationale for the IPO exclusion that seemingly applies equally to the economic realities of a de-SPAC transaction. He explained that when a private company is first introduced to public investors, heightened information asymmetries are present, warranting heightened judicial scrutiny of projections. (27) The unstated premise is that without such scrutiny, company officials would exploit the information asymmetry by offering overly optimistic projections, something that the specter of heightened judicial review will help deter. Other academics have similarly assumed that the IPO exclusion, as well as the other safe harbor exclusions, target situations where potential defendants are more likely to commit fraud. (28)

This account is oversimplified. To see why, it is necessary to step back and consider the purpose of the safe harbor itself. While much of the PSLRA was aimed at curbing perceived nuisance litigation, the safe harbor had a different motivation. It was designed to encourage otherwise reluctant companies to share their forecasts with investors. (29) Shielding such statements from liability risk was necessary to encourage voluntary disclosure. In an earlier era, the SEC was happy to let liability risk chill corporate release of forward-looking information. Indeed, the SEC affirmatively prohibited the inclusion of forward-looking information in SEC filings. (30) The SEC's position was based on a fear that unsophisticated investors would place undue reliance on even nonfraudulent forward-looking information, leading them to make poor investment decisions.' (1) As you might imagine, reasonable investors rallied against the SEC's paternalistic position, emphasizing the importance of forward-looking information to their investment decisions and their ability to discount management forecasts for bias. (32) The SEC in the 1970s began to listen, and seemingly changed position: instead of prioritizing the interests of unreasonable investors who might overreact to management forecasts, it began to take steps to encourage companies to share their forecasts for the benefit of reasonable investors. (33) (As explained more fully in Part II...