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The Securities and Exchange Commission released proposed rules for special purpose acquisition companies (SPACs), shell companies, and projections (the Release). In a comment letter I filed with the SEC, I provide a critical assessment of this proposal.
The Commission proposed far-reaching changes intended to enhance investor protections and align disclosure and liability rules in de-SPACs more closely with those in traditional IPOs. An under-appreciated feature of the proposed reforms is that they would subject de-SPACs to provisions closely modeled on Rule 13e-3 of the Exchange Act, which applies to going-private transactions, including management buyouts. Intended to tackle potential conflicts of interest and other abuses, Rule 13e-3 requires extensive disclosures about the substantive fairness of going-private transactions and must be carefully navigated by transaction planners. Although I discuss other aspects of the proposed reforms in my comment letter, I focus here on the proposed rules modeled on Rule 13e-3.
Of these rules, proposed Items 1606 and 1607 are the most important. They would require SPACs to state whether they reasonably believe the de-SPAC and any related financing transaction are fair to the SPAC’s unaffiliated security holders and to discuss the material factors upon which such belief is based (Item 1606). They would also require SPACs to state whether the SPAC or SPAC sponsor has received any report, opinion, or appraisal from an outside party relating to the transaction and summarize that third party opinion, among other matters (Item 1607).
In the Release, the Commission briefly justifies its recourse to Rule 13e-3 by reference to the risk of conflicts of interest in de-SPACs. These transactions suffer from “the same potential for self-interested transactions … as in going-private transactions.” Moreover, “the conflicts of interests and misaligned incentives inherent in going-private transactions are similar to those often present in de-SPAC transactions.”
Below I assess the analogy between going-privates and de-SPACs. First, I question whether the analogy between de-SPACs, as defined in the Release, and going-private transactions subject to Rule 13e-3 justifies the application of provisions modeled so closely on Rule 13e-3. Second, I question whether de-SPACs ought to be subject to such extensive rules when, under the proposal, de-SPACS would also be subject to enhanced Section 11 liability. This concern goes to the cumulative deterrent effect of Section 11 liability and provisions modeled on Rule 13e-3. Third, I draw attention to conflicts and uncertainties in the empirical evidence on de-SPACs, an understanding of which should limit regulation designed to steer private companies toward traditional IPOs and away from de-SPACs. Finally, drawing on a study of all fairness opinions delivered in de-SPACs since January 2019, I identify problems with proposed Item 1606, which will encourage, if not practically require, the use of fairness opinions in de-SPACs. In conclusion, I suggest that Items 1606 and 1607 either should not apply to de-SPACs or should apply only to those de-SPACs raising heightened concerns about conflicts of interest.
Below is a more detailed account of my analysis.
An Analogy with Going-Private Transactions
SPAC mergers and traditional IPOs are close analogs in an important respect. As Professor Joel Seligman and I argued in The Further Erosion of Investor Protection: Expanded Exemptions, SPAC Mergers and Direct Listings, key participants in both types of transactions have opportunities and incentives to engage in self-dealing, to the detriment of unaffiliated security holders. For de-SPACs, these securities holders are public SPAC shareholders unaffiliated with the sponsor; for going-private transactions subject to Rule 13e-3, they are public shareholders in the target company unaffiliated with the acquirer. In both transactions, countervailing forces limit the potential for self-dealing: in going-privates, the requirement for target shareholders’ approval disciplines conflicted target managers; in de-SPACs, the right of SPAC shareholders to redeem their shares may deter sponsors and directors from proposing value-decreasing deals, since widespread redemptions may leave a SPAC with insufficient cash to proceed with a de-SPAC.
These parallels invite recourse to Rule 13e-3 because of its evident concern with mitigating the risk of conflict in going-privates. Nevertheless, the proposed rules modeled on Rule 13e-3 run into problems.
Consider first how de-SPACs, as defined in the Release (proposed Item 1601), and going-private transactions subject to Rule 13e-3 compare in exposing unaffiliated security holders to the risk of conflict. By definition, going-private transactions subject to Rule 13e-3 will create severe conflicts of interest for corporate fiduciaries. The provision applies to a “Rule 13e-3 transaction,” defined, in part, as any transaction or series of transactions between a target and an “affiliate” that have the purpose or effect of taking the target private. So defined, going-private transactions subject to Rule 13e-3 suffer from a structural conflict since the same individuals owing fiduciary duties, often managers of the target company, are on both sides of the deal.
In de-SPACs, corporate fiduciaries (SPAC sponsors and SPAC directors) typically face conflicts of interest. These conflicts result from compensation arrangements under which SPAC sponsors and SPAC directors receive SPAC shares that have value only if the SPAC undertakes a de-SPAC. Since they pay almost nothing for these shares, sponsors and directors may profit from a value-decreasing de-SPAC, giving them incentives to undertake a de-SPAC even if it harms unaffiliated security holders. (See Klausner, Ohlrogge & Ruan; and Gahng, Ritter & Zhang). SPAC underwriters also have interests in tension with those of unaffiliated security holders.
Even accepting this analogy between de-SPACs and going-privates subject to Rule 13e-3, Rule 13e-3 applies only to going-privates that suffer from severe conflicts of interest, while the proposed rules need not apply to de-SPACs suffering from conflicts. Under definitions in the proposal, neither of the terms a special purpose acquisition company or de-SPAC is defined to assure the existence of a conflict of interest. For instance, neither definition refers to sponsors’ or directors’ compensation or other factors that may lead to conflict. Nor do the proposed definitions of SPAC sponsor and target company suggest a close analogy with going-private transactions subject to Rule 13e-3.
Under the proposal, SPACs will be subject to rules modeled on Rule 13e-3 regardless of the conflicts of interest they pose. The proposed rules therefore do not countenance the possibility that de-SPACs will evolve to minimize the risk of conflict between the interests of corporate fiduciaries and those of unaffiliated security holders. Recent suits are already creating incentives for reforms to market practices. (Consider, for instance, a SPAC board comprised of a majority of directors who are independent of the SPAC sponsor and are not compensated with founder shares). The proposed rules may therefore be, or become, over-broad since they would apply to transactions raising none of the concerns about conflicts that motivated the rules.
This concern about the breadth of the definition of de-SPACs is all the more serious since Rule 13e-3 does not apply to all going-private transactions. Under Rule 13e-3, questions arise as to whether a party is an “affiliate” or “engaged in” a relevant transaction, which creates room for deal planners to structure going-privates to avoid the application of Rule 13e-3, minimizing the risk of conflict.
A response to this definitional problem would be to ensure that the relevant provisions only apply to de-SPACs creating severe risks of conflict. That might involve restricting the de-SPACs to which proposed Items 1606 or 1607 apply or not applying these provisions at all.
Cumulative Deterrent Effect of Proposal
The second question is whether the proposal would subject de-SPACs to heavier regulatory burdens than those applicable to either going-private transactions subject to Rule 13e-3 or traditional IPOs. I suggest it does since, in addition to subjecting de-SPACs to rules modeled on Rule 13e-3, the proposal would subject SPAC transaction participants to enhanced Section 11 liability under the Securities Act of 1933. In contrast, transaction participants in going-private transactions subject to Rule 13e-3 rarely face Section 11 liability. This matters because Section 11, the most potent liability provision in the federal securities regulatory arsenal, strongly deters misconduct by transaction participants, including corporate directors, performing a similar function to provisions modeled on Rule 13e-3. A heavier regulatory burden on de-SPACs is not justified by analysis in the Release or by other evidence of which I am aware.
De-SPACs may also face tougher regulation under state corporate law than going-private transactions subject to Rule 13e-3, although courts have had few opportunities to articulate any differences. In In Re Multiplan Corp. Stockholders Litigation, the Delaware Court of Chancery suggests that corporate fiduciaries will be assessed under the rigorous entire-fairness standard. In contrast, corporate fiduciaries’ conduct in going-private transactions typically enjoys more deferential BJR protection due to the use of cleansing mechanisms, including the use of fully informed and uncoerced votes of disinterested stockholders. It is unclear from MultiPlan whether the use of cleansing mechanisms by corporate fiduciaries in de-SPACs will provide BJR protection to corporate fiduciaries. If cleansing devices lack similar protection, Delaware’s fiduciary law will have a greater deterrent effect on transaction participants in de-SPACs than it does on corporate fiduciaries in going-private transactions subject to Rule 13e-3.
The proposal would also impose heavier regulatory burdens on de-SPACs than those applicable to traditional IPOs, despite the expressed objective to “align more closely the treatment of private operating companies entering the public markets through de-SPAC transactions with that of companies conduct traditional [IPOs]” and “to provide investors with disclosures and liability protections comparable to those that would be present if the private operating company were to conduct a traditional firm commitment [IPO].” Traditional firm commitment IPOs do not face the requirements of Rule 13e-3, even though founders and promoters in IPOs have interests in conflict with those of IPO investors. In determining the IPO offer price, for example, founders’ interests are in tension with those of public IPO investors. It is this conflict of interest that scholars and others point to in justifying gatekeeper liability, including Section 11 liability. Although I regard Section 11 liability as justified in the context of de-SPACs (as I explain in my comment letter), the imposition of such liability must be accounted for in determining the extent to which de-SPACs are subject to rules modeled on Rule 13e-3.
In short, the proposal would leave de-SPACs more heavily burdened by regulation than either going-private transactions subject to Rule 13e-3 or traditional IPOs. It would be better were it to account for the deterrent threat of Section 11 and give transaction planners incentives to avoid conflicts. To rectify this, the Commission might impose proposed Items 1606 and 1607 more selectively, to those de-SPACs raising heightened risks of conflicts, or not impose them at all. If applied more selectively, Items 1606 and 1607 might apply to SPACs lacking cleansing mechanisms such as independent boards or board committees to review and approve transactions.
Empirical Evidence on the net costs of De-SPACs
Much of the empirical evidence on de-SPACs points to needed reform (See, e.g., Rodrigues & Stegemoller; Spamann & Guo). However, even some of the most critical evidence of de-SPACs suggests that de-SPACs have created net collective gain (See Klausner, Ohlrogge & Ruan). There are also points on which scholars disagree. There is dispute as to whether de-SPACs are more or less expensive from the target companies’ perspective than traditional IPOs. Scholars dispute the extent of any benefits that de-SPACs offer target companies over traditional IPOs. On this point, if de-SPACs are more expensive than traditional IPOs for target companies, as some scholars claim, we can infer that target companies have undertaken de-SPACs because they offer significant benefits not provided by traditional IPOs. It follows that traditional IPOs are not necessarily more desirable than de-SPACs as a matter of policy, and no basis exists for reforms designed to channel private companies intending to “go public” away from one type of transaction to the other. (For a more detailed discussion, see here and here) Nevertheless, by apparently failing to weigh the cumulative effect of Section 11 liability and provisions modeled on Rule 13e-3, the proposed reforms subject de-SPACs to greater regulatory burdens than those faced by either traditional IPOs or going-private transactions, steering private companies away from de-SPACs and toward alternatives.
Concerns about proposed Item 1606
Proposed Item 1606 would require SPACs to state whether they reasonably believe the de-SPAC and any related financing transaction are fair or unfair to the SPAC’s unaffiliated security holders and to discuss the material factors upon which such belief is based. Although framed as a disclosure provision, the proposed rule requires a SPAC’s board to make a reasonable determination as to fairness, a requirement that, if adopted, would likely lead many boards to engage financial advisors to provide fairness opinions, to substantiate the reasonableness of their beliefs as to a transaction’s fairness to unaffiliated security holders.
Fairness opinions provided in response to proposed Item 1606 are likely to confront major obstacles. These opinions would need to opine on the fairness of a de-SPAC to unaffiliated security holders, an opinion that is far from routine. As the Commission highlights in the Release, the structure of SPACs dilutes the financial interests of unaffiliated security holders primarily due to the grant of founder shares to sponsors for nominal consideration. By convention, parties to a de-SPAC refer to an “implied” enterprise value based on an assumed $10 price per SPAC share. However, due to dilution, the value that each SPAC share represents at the time of the de-SPAC on a net cash basis is often significantly lower than $10. Confirming the importance of net cash per share, econometric research has established that the value of SPAC shares has tended to fall over the 12 months following a merger. (See Klausner, Ohlrogge & Ruan and Gahng, Ritter & Zhang). This dilution makes it possible, if not inevitable, that the interests of unaffiliated SPAC investors will diverge from those of the SPAC.
A de-SPAC may nevertheless be fair to unaffiliated security holders for either or both of two reasons. First, the target shareholders—rather than public SPAC shareholders—may bear the effects of dilution. This is possible, although well-advised target companies are aware that the $10 value a convention. Second, the SPAC merger may promise to create significant value, such as that arising from public company status or from the expertise that sponsors may bring to the post-combination company. (See Klausner, Ohlrogge & Halbhuber). This reason seems more likely (but still far from certain or even probable) than assuming ignorance or weak bargaining on the part of target companies.
Whether a proposed merger will create enough value to overcome the dilution embedded in the typical SPAC structure is uncertain. The greater the dilution, the greater these gains would need to be to make a de-SPAC fair to unaffiliated security holders. To conclude that a transaction is fair to unaffiliated security holders, a financial advisor must find that the value of the combined company would be at least $10 per share. Conceptually, to give such an opinion, a financial advisor would need to consider first, the extent of dilution inherent in the transaction, and second, whether sources of value exist to overcome that deficit from the perspective of unaffiliated security holders. Practically, the financial advisor need to estimate the total value of the combined company, using that figure to determine the expected value per share. The analysis would need to adjust for warrants and any rights and would be contingent, since the total number of shares also depends on the extent of redemption, which would not be known when the fairness opinion is given. This analysis adds dimensions of complexity to the valuations typically required of financial advisors in mergers.
As explained further below, financial advisors giving fairness opinions have generally not disclosed analyses addressing the fairness of a de-SPAC to unaffiliated security holders. In de-SPACs, SPACs have obtained fairness opinions sparingly, typically when a target company is affiliated with a sponsor. In all but a small handful of de-SPACs, these opinions opined on the fairness of a transaction to the SPAC, rather than to unaffiliated security holders. These opinions therefore overwhelmingly avoided the issue that proposed Item 1606 would require SPACs to address.
In the 330 de-SPACs completed from January 1, 2019 to June 8, 2022 (identified using data from Deal Point Data), SPACs obtained fairness opinions from a financial advisor in 40 (or 12.1 percent) of the transactions. I reviewed each of these fairness opinions. In 37 (or 92.5 percent) of these 40 opinions, the opinion stated, without more, that the consideration paid was fair from a financial point of view to the SPAC. In two (or 5 percent) of these fairness opinions, the financial advisor opined that the transaction was fair to unaffiliated security holders. These fairness opinions were given by Scalar Group and Mediabanca. One other opinion opinion—given by ThinkEquity LLC—stated simply that the transaction was fair, without stating to whom.
All 40 opinions were provided by small or “boutique” advisors rather than major investment banks. Moelis & Company, Duff & Phelps, and Houlihan Lokey were the most frequent authors of these letters, giving them in 10, 6, and 5 de-SPACs, respectively. Other financial advisors that gave fairness opinions (and the number of de-SPACs for which they did so) were BTIG (1), Cassel Salpeter (2), Craig-Hellum Capital Group (1), Guggenheim Securities (2), Lake Street Capital Markets (1), Mediabanca (1), Northland Capital (1), Northland Securities (1), Primary Capital (1), Rothschild (2), Scalar Group (1), SVB Leerink (1), ThinkEquity LLC (3), and Vantage Point Advisors (1).
Major investment banks advised on many of the de-SPACs for which fairness opinions were given. These included Goldman Sachs, Morgan Stanley, Credit Suisse Securities, Deutsche Bank Securities, Banc of America Securities, and Citigroup Global Markets. But none of these firms provided a fairness opinion for in a de-SPAC.
Financial advisors were generally careful to avoid any interpretation that they were opining as to fairness to SPAC shareholders. Again, all but three of these letters opined only on fairness to the SPAC, an entirely different question since a SPAC’s interests can be expected to diverge from those of unaffiliated security holders. Many of these opinions also stated that they were giving no opinion as to the value of shares to SPAC shareholders and/or were assuming, for purposes of their analysis, that each SPAC share was valued at $10, an assumption that sidesteps the issue of dilution.
For example, the fairness opinion provided by Moelis & Company in the 2021 merger between Gores Metropoulos II, Inc., a SPAC, and Sonder Holdings Inc, stated that the opinion “does not address the fairness of the [SPAC merger] or any aspect or implication thereof to, or any other consideration of or relating to, the holders of any class of securities, creditors or other constituencies of the [SPAC] or Target.” The opinion provided by Houlihan Lokey in the 2021 merger between Auror Innovation, Inc and Reinvent Technology Partners Y assumed a value per share of $10 and expressly disregarded the dilutive impact of founder shares. Of course, the opinions were also careful to avoid lending weight to the projections they used as inputs in their valuation analyses, noting that these projections were supplied by management and had not been independently verified.
Only three transactions might be interpreted as opining that the relevant de-SPAC was fair to unaffiliated security holders. In the combination of Petra Acquisition, Inc. and Revelation Biosciences, Inc. and that of Investindustrial Acquisition Corp. and Ermenegildo Zegna Holditalia S.p.A, the financial advisors opined that the transaction consideration was fair to unaffiliated SPAC shareholders. In another transaction, the combination of FG New American Acquisition Corp. and Opportunity Financial, the financial advisors failed to state from whose perspective the merger consideration was fair, leaving open the possibility, at least based on its concluding statement of opinion, that it was speaking to the perspective of unaffiliated security holders.
Analysis of these opinions underscores concerns about the limits of SPAC fairness opinions in addressing substantive fairness concerns. Despite their concluding opinions, none can reasonably be taken to provide unaffiliated security holders with assurance about the relevant merger’s fairness. This is not to say that appropriate opinions cannot be given; in principle, they can. Rather, opinions given to date would not be responsive to proposed Item 1606.
Consider first the Revelation Biosciences de-SPAC, in which Scalar Group provided an opinion that the merger consideration “is fair, from a financial point of view, to [the SPAC] and [the SPAC’s] unaffiliated stockholders”. The letter demonstrates no explicit basis for this opinion. The letter compares the target company with selected comparable public companies in the biotech and pharmaceutical industries, allegedly chosen for the similarity of their operations to those of the target. The opinion applies numerous adjustments to determine “a range of selected implied equity values” for the target of $43 million to $126 million, which “compares to the equity consideration of $106 million to be issued to [the target’s] shareholders per the Business Combination Agreement.” Next, the financial advisor reviews de-SPACs and IPOs involving certain selected healthcare companies, listing their transaction prices and providing summary statistics. Based on these analyses, the fairness opinion concludes that the merger consideration is fair to the SPAC and its public stockholders from a financial point of view.
What is missing is any analysis of the dilution caused by the founder shares, warrants and expenses or any examination of where these costs fall or how they are apportioned between unaffiliated security holders and the target. The disclosed opinion fails to consider whether unaffiliated security holders bore the effects of this dilution, as we would expect if the target bargained hard, aware of the dilution inherent in the conventional de-SPAC structure. And the opinion is devoid of any consideration of the possibility of uplift coming from public company status or the sponsor’s ongoing role in advising the target. The opinion also fails to consider how redemption would affect dilution. The opinion thus provides no apparent basis for its conclusion regarding fairness to unaffiliated security holders. Rather, its valuation analyses broadly mirror those of fairness opinions that expressed no opinion regarding fairness to unaffiliated security holders.
The de-SPAC between Ermenegildo Zegna Holditalia and Investindustrial Acquisition Corp. Financial advisor Mediobanca opines that the merger consideration is “fair, from a financial point of view, to the holders of the ordinary shares of [the SPAC].” This letter also fails to disclose any firm basis for such an opinion. First, the financial advisor “assumed that the value of each Ordinary Share is equal to $10.00 per share,” sidestepping the core issue of a lack of a market price for the SPAC stock, stripping the opinion of meaning. Second, as with the Revelation Biosciences de-SPAC, the valuation analyses fail to speak to the fairness or otherwise of the merger consideration to unaffiliated security holders. Again, what is missing is any analysis of the dilution caused by the founder shares, etc., or where these costs fall.
Neither of these opinions provides real comfort that the relevant transactions were fair from a financial point of view to unaffiliated security holders—despite their concluding statements.
In the combination of FG New American Acquisition Corp., ThinkEquity opined that the merger consideration paid by the SPAC “is fair from a financial point of view,” without saying to whom. This opinion, and the accompanying proxy statement disclosures, disclose scant valuation analyses. Nothing in it assesses the value of SPAC shares in the merger to unaffiliated security holders, and so this opinion, too, could not reasonably bear much weight in demonstrating fairness to unaffiliated security holders. Moreover, the letter discloses conflicts; this is a rare deal in which the financial advisor also served as an underwriter in the SPAC IPO and in connection with the IPO, received both common stock and warrants in the SPAC that would be worthless if no merger occurred within the defined investment window. This conflict undermines the force of the letter’s expressed opinion. Despite the apparent breadth of the opinion, it fails to address the issue of substantive fairness to unaffiliated security holders.
In short, only three of the fairness opinions given in de-SPACs since January 1, 2019 state an opinion that, on its face, may address fairness to unaffiliated security holders. On deeper inspection, none of these opinion letters can reasonably be regarded as addressing substantive fairness concerns for unaffiliated security holders. These fairness opinions lack convincing analyses and include statements undermining the force of their concluding opinions. None were provided by a major investment bank, even though these banks advised SPACs on many of the deals.
In view of this evidence, I make two recommendations. First, any fairness opinions provided in de-SPACs must be required to clearly state that they study fairness from the perspective of unaffiliated security holders. Opinions should grapple with the dilutive effects of the transaction. To buttress the required board opinion, fairness opinions might state the net cash per share at the time of the de-SPAC and precisely why the financial advisor considers the de-SPAC fair to unaffiliated security holders. Opinions should not assume a SPAC value of $10 per share for purposes of their analysis. Without such analysis, a bald statement as to fairness, even such a statement speaking to the position of unaffiliated security holders, lacks credibility and should not be regarded as allowing SPAC boards to satisfy their obligation under proposed Item 1606.
Second, consistent with my arguments above, proposed Item 1606 should be reserved for those de-SPACs in which conflict concerns are the most serious. Opinions by financial advisors addressing fairness to unaffiliated security holders are tough to give. Whether financial advisors will be willing to give them is doubtful; to date, no major investment bank has done so, and the small handful of opinions that appear to address the issue would seem to lack supporting analyses. For de-SPACs that have already adopted effective measures to mitigate severe conflicts, imposing proposed Item 1606 (incentivizing the use of fairness opinions adequate to assessing fairness to unaffiliated security holders) would be unduly burdensome.
For the complete comment letter, including footnotes and a critique of other proposed reforms, see here.