The IPO Alternative: Special Purpose Acquisition Companies Are Gaining Traction in Private Equity.

• Author: Geiss, Jay
• Position: Initial public offering

1. INTRODUCING SPECIAL PURPOSE ACQUISITION COMPANIES 235 II. BACKGROUND 237 A. History of Blank Check Companies and SPACs 237 B. The Traditional IPO Process 242 C. The SPAC IPO Process 242 III. ANALYSIS 244 A. SPACs Post-IPO and the Business 244 Combination (De-SPAC) Process B. The Advantages of SPACs Compared to Traditional IPOs 246 1. Advantages to the Target Company 246 2. Advantages to the SPAC Management Team 248 and Initial Sponsors 3. Advantages to the Average Public Investor 248 C. The Disadvantages of SPACs 249 1. Disadvantages to the Target Company 249 2. Disadvantages to SPAC Management 250 and Initial Sponsors 3. Disadvantages to the Average Public Investor 251 D. The SPAC Incentive Structure 254 IV. RECOMMENDATION 255 V. CONCLUSION 258 I. INTRODUCING SPECIAL PURPOSE ACQUISITION COMPANIES

   At its simplest, private equity is an investment in an entity that is currently not publicly listed on a major exchange such as the New York Stock Exchange ("NYSE") or NASDAQ. (1) As a result, private equity is often subjected to less scrutiny by the public and governing bodies compared to publicly traded securities. (2) Traditionally, private companies become publicly listed through an initial public offering ("IPO"), making them available for the common investor. (3) IPOs have been the go-to for private companies transitioning to public companies throughout history. However, the past decade has seen Special Purpose Acquisition Companies ("SPAC" or "SPACs") become increasingly popular alternatives year after year, with their own unique benefits and drawbacks. (4)

   SPACs are blank check companies--having no day-to-day operations--that go public with the intention of pooling capital through their IPO to acquire or merge with one or more unspecified companies or assets. (5) These targets are typically private companies and as a result become publicly traded. (6) The specific acquisition is usually not disclosed until after the SPACs IPO. (7) SPACs represent a low-risk opportunity for investors to enter what would typically be a private equity investment. (8) The average investor can purchase a share of a SPAC through their brokerage, close the position by selling the share back, or hold the share through the merger and own a share of the newly-public company. (9) The entry is often low-risk as "shareholders vote on whether to accept an acquisition, and individual investors have the right to reject the proposed business acquisition and can redeem their shares for full value." (10) In addition, "if the SPAC cannot find a target company in an agreed-upon and allotted time frame, generally 18 to 24 months, the SPAC vehicle is liquidated, and all funds are returned to shareholders." (11)

   The downside is that once an operating entity is acquired and merged with the SPAC, the Securities and Exchange Commission ("SEC") normally does not allow "the typical grace period for many areas of regulatory compliance"--meaning that the merged entity must immediately satisfy various SEC rules and regulations. (12)

   Many companies choose the SPAC route over traditional IPOs because of this simplicity. The traditional IPO process is long and difficult, taking between six months and a year. (13) But the SEC rarely asks extensive questions up front to SPACs, thanks to their simple purpose, their nonexistent financial history and assets, and their minimal business risk. This allows companies to go public in just a few short months. (14) Once the SPAC is in place, the process for a subsequent merger is much simpler than a full registration with the SEC. (15)

   SPACs, which were once a last resort, have become an increasingly popular option for companies looking to go public. Recently, the volume of SPAC deals has grown year after year, breaking the record in 2019 with about $13.6 billion in gross proceeds, rebreaking the record in 2020 with $83.35 billion in gross proceeds, and again in 2021 with $129 billion gross proceeds through September 2021. (16) About half of all IPO volume in 2020 came from SPACs. (17) This Note provides a comprehensive background of SPACs and their growth and argues that the current regulatory framework for SPACs creates discordant incentives between management and investors and should be reworked.

2. BACKGROUND

   1. History of Blank Check Companies and SPACs

      Blank check companies developed in the 1980s and garnered a poor reputation as a result of dishonest activity based on defrauding inexperienced investors utilizing penny stocks. (18) The 1990s saw a growing U.S. economy after the 1980s recession making IPOs an increasingly popular investment tool for sophisticated U.S. investors. (19) To protect investors from the blank check companies seen in the 1980s, Congress imposed strict regulations on blank check companies in the form of the Penny Stock Reform Act of 1990. (20) This act required brokers selling specific stock to obtain a written sales agreement from investors who did not usually purchase from that broker. (21)

      In addition to the Penny Stock Reform Act, the SEC required increased disclosure and management requirements through Rule 419 of the Securities Act of 1933. (22) SPACs arose in 1992 as a way for blank check companies to provide "sufficient investor protection... to gain the approval of the SEC." (23) To avoid Rule 419, early SPACs maintained more than $5 million in assets, meaning the stock issued was not defined as penny stock under [section] 3a51-1 of the Securities Exchange Act of 1934, a vital aspect of modern SPACs. (24) These first-generation SPACs typically complied with Rule 419 regulations to instill confidence in investors cognizant of blank check companies' questionable history. (25) Today, most SPACs continue to follow Rule 419 of their own volition, although the SEC should take steps to ensure compliance. (26) The initial generation of SPACs included many of the features a modern SPAC carries. For example, excluding the small portion of money used to cover operating expenses, most money raised through the SPAC IPO is held in a trust account. (27) These SPACs also included the right for shareholders to liquidate their shares upon the announcement of an undesired acquisition. (28) Unfortunately, this is one of the few rights that SPAC shareholders have regarding their relationship with the SPAC, as such this Note later discusses and argues for increased SPAC shareholder rights. (29)

      Despite the reasonable success of the early SPACs, increased regulation and a swell in traditional capital market activity by small capitalization ("small cap") companies (30) drove blank check companies to the brink of extinction in the 1990s. (31) In 2003, SPACs returned in a new regulatory era, one in which the Sarbanes-Oxley Act of 2002 required "sweeping auditing and financial requirements for public companies." (32) The 2000s saw a year-over-year increase in the total equity SPACs raised. (33) In 2005, the SEC adopted rules "that required SPACs completing a business combination to file with the SEC all of the information regarding the operating company that would be required had the operating company gone public by filing a traditional registration statement." (34) The SEC's stated goal was to "protect investors by deterring fraud and abuse in our securities markets through the use of reporting shell companies." (35) In addition, the American Stock Exchange ("NYSE Amex") in 2005 allowed SPACs to list without requiring operating histories. (36)

      The 2000s saw SPACs and private equity reach new heights. (37) SPACs reached their peak in 2007, accounting for nearly 22% of all IPOs that year. (38) SPACs--and the world economy--were subsequently crushed by the housing bubble burst and credit crunch. (39) In 2010, SPACs returned with many of the specific terms we see today. (40) For example, the NYSE Amex required SPACs to have at least 90% of their gross capital raised held in trust and the completion at least one merger or acquisition within three years of the IPO (valued at least 80% of the net value of the funds held in trust). The acquisition or merger must be approved by a majority of public shareholders, and shareholders disapproving of the business combination must be entitled to redeem their shares for a pro rata portion of the trust funds. (41) These requirements were very similar to the NYSE or NASDAQ SPAC listing requirements. (42) SPACs were further regulated in the 2010s. For example, in 2010 Congress enacted the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 ("Dodd-Frank" Act) in response to the 2008 financial crisis, increasing regulations on banks and implementing executive compensation requirements--the latter of which had negative implications on SPAC founder compensation structures. (43) This downside was somewhat alleviated in 2012 when Congress passed the Jumpstart Our Business Startups Act ("JOBS" Act) which created the emerging growth company ("EGC") provision, commonly known as the "IPO on-ramp." (44) The provision aimed to make it easier for companies to go public and has been a crucial aspect in allowing SPACs to IPO quickly. (45) The EGC provision was designed to encourage "small cap companies into going public by reducing the burdens of public disclosure and ongoing federal regulation," and is crucial for current SPACs to remain competitive. (46) EGCs were allowed more lenient financial reporting standards and regulatory communication restrictions, eased Dodd-Frank executive compensation requirements, and were exempted from the typical mandated post-IPO quiet period. (47) This easing of Dodd-Frank executive compensation requirements has created unique issues addressed later in this Note and ought to be reversed. (48) Consequently, the JOBS Act made it cheaper and easier for SPACs to go public via the IPO on-ramp by allowing them to file confidentially and avoid auditor verification of financial statements under Sarbanes-Oxley as well as executive...