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SPACS - An In-Depth Guide

The popularity of SPACs, their effect on the capital markets and the levels of investment in them make them one of the most significant issues of recent years. 

The possibility of swifter returns has led to SPACS being viewed as an attractive option. With SPACs being created with the sole purpose of acquiring another company and using a process that differs from a traditional initial public offering (IPO), they have come to be seen by many as the way to invest.

The resulting rise of SPACs is having an effect on the behaviour of both investors and some regulators.

What is a SPAC?

A SPAC is a particular means of acquiring another company in a way that can bring swifter returns for investors than more conventional company acquisitions. This is part of the reason for the increased popularity of SPACs.

Under a traditional initial public offering (IPO), a company is audited and it files a registration statement with the appropriate exchange commission, such as the US Securities and Exchange Commission (SEC) or the UK’s FCA. Arrangements are then made to list its shares on a stock exchange.

Use of a SPAC, however, involves a different process. A SPAC is created by a team of investors in order to acquire another company.  Once incorporated, the SPAC undertakes an IPO and its shares are listed on a public stock exchange. While a SPAC raises money through its own IPO, it has no commercial operations and no assets other than the money it raises through the IPO. Once this money has been raised, it is placed in an account until those running the SPAC identify a private company that is seeking to go public via an acquisition. 

When a SPAC’s founders establish the company, they invest in it in exchange for preferred shares or “founder shares”. This initial investment may fund some or all of the IPO, and usually leads to the founders keeping a 10-20% stake of the company when the IPO is completed. Founder shares also usually entitle founders to a percentage of the increase in value of the company after the acquisition.

Founders will usually be on the SPAC’s board of directors and will be involved in identifying acquisition targets. This identification is based on them using their existing contacts and industry-specific knowledge. The chances of conflicts of interest arising due to any connections that the founders have with such contacts or with acquisition targets or related parties can be minimised by seeking appropriate undertakings from the founders and, if necessary, the issuance of independent fairness opinions.

When a target has been identified, the acquisition process will begin. The acquisition is, in effect, a reverse takeover for the SPAC. When the acquisition is completed, the listing of the SPAC’s shares is cancelled. For the SPAC listing to be maintained, it has to publish a prospectus or AIM admission document so that the enlarged group can be re-admitted to trading. Once the acquisition is complete, investors in the SPAC can either swap their shares for shares in the acquired company or cash in their shares for what they paid for them plus any interest accrued.

A SPAC must complete an acquisition within a set period of time. If a company is not acquired within this period – usually two years after the SPAC’s IPO – the SPAC is liquidated and investors have their money returned.

Recent Trends in SPACs

The sudden increase in the popularity of SPACs is the result of a number of factors, all of which have made them a more attractive proposition. The market for traditional IPOs has tightened as a result of the uncertain economic environment that resulted from the COVID-19 pandemic, which has accelerated the reassessment of the traditional IPO process by many in the financial markets. This, in turn, led to many seeking different routes - such as those offered by SPACs and, to a lesser extent, direct listings. 

SPACs are also attractive because they allow investors to co-invest with founders, who have the requisite industry knowledge, expertise and access to potential acquisition targets that may not otherwise be available through the public markets. Low interest rates and the potential for taking advantage of distressed markets are also reasons why SPACs have become increasingly appealing to investors. They offer a stable route to the public markets that does not lead to investors facing some of the obstacles they will encounter with an IPO.

In the first half of 2021, there were more than 400 SPACs scrutinising the US markets for targets. Such a SPAC-heavy presence in the US is likely to lead many of them to turn their attentions to Europe in search of possible acquisitions.

The FCA’s changes to the SPAC rules

In April 2021, the FCA set out proposals for a more flexible listings regime that would bring the UK closer to the approach being taken by its major financial rivals. The ultimate aim was to lure SPACs (special purpose acquisition companies) to the City. 

The FCA recognised that changes needed to be made to the UK Listing Rules if there was to be any chance of creating a market environment here that was conducive to SPACs. It published a consultation that detailed its proposed investor protection measures for listed SPACS. Its proposals came after recommendations made by Lord Hill following his review of UK listings.

In his review, Lord Hill said the current Listing Rules presumption that trading in a SPAC’s shares should be suspended when an acquisition is announced was a key deterrent to potential investors. Investors in SPACS are unable to sell their shares during the suspension period - which can be lengthy – even if they wanted to. They may disagree with the SPAC’s acquisition target but cannot remove themselves from it – and sell their shares in it – because of the suspension period.

The US and a number of other leading SPAC markets do not require there to be a suspension. US SPACs can contain certain protections for investors, such as allowing shareholders to vote for or against an acquisition before it is completed. The FCA proposed removing the Listing Rules presumption that suspension of trading in a SPAC’s shares was necessary when there was an announcement of an acquisition - providing the SPAC complied with certain conditions. These conditions included granting SPAC shareholders redemption rights and requiring approval from the SPAC’s public shareholders before the acquisition can go ahead. If a SPAC did not comply with these requirements, it would remain subject to the current rules. 

In July 2021, following consultation on the proposals, the FCA announced its new rules.

These were:

  • SPACS HAVING TO RAISE A MINIMUM OF £100 MILLION AT INITIAL LISTING.  This can only be used to fund an acquisition. If that does not happen within the time limits mentioned below, it should be returned to shareholders. The FCA believes such a minimum – which excludes sponsors’ investment - will mean that high-level institutional investment would be needed, which would ensure due diligence being conducted on both the SPAC and its managers. It also believes this will encourage both proper scrutiny of the proposed investment and the involvement of experienced management.
  • MONEY FROM PUBLIC MARKETS BEING RING-FENCED TO PROTECT INVESTORS FROM MISAPPROPRIATION OF FUNDS. Money raised from public shareholders will be kept solely to fund an acquisition. If no acquisition is made, the money should be returned to investors, minus any sums that were used for the SPAC’s running costs, which have to be detailed to investors in the prospectus at the IPO.
  • A TWO-YEAR TIME LIMIT FOR MAKING AN ACQUISITION. Money should be returned to investors if no acquisition has been made by the end of this period. This two-year proposal reflects US market practice. But the FCA has introduced an option where, if a SPAC has identified a target by the end of the two years but the acquisition has not been completed, the two-year, time-limited operating period (or three-year period, if shareholders have approved a 12-month extension) can be extended by six months, without needing to obtain shareholder approval. The additional six months will only be available in limited circumstances and is intended to provide more time for a SPAC to conclude a deal where a transaction is well advanced.
  • ANY PROPOSED ACQUISITION TO REQUIRE SHAREHOLDER APPROVAL. Any acquisition would require a majority vote of public shareholders, as is the case with many US SPACs. The sponsors of the SPAC would not be able to take part in the vote.
  • A FAIR AND REASONABLE STATEMENT FROM THE DIRECTORS. If any of the SPAC’s directors have a conflict of interest regarding the acquisition target, a statement would have to be published by the board (reflecting advice from a qualified, independent adviser) saying that the proposed transaction is fair and reasonable as far as the SPAC’s public shareholders are concerned.
  • INVESTORS TO BE ALLOWED TO LEAVE THE SPAC. SPACs would have to give investors redemption rights so that they can leave the SPAC before any acquisition is completed if they dislike either the terms or the target of the deal. This exit would be conducted at a pre-arranged price – either a set amount or a fixed, pro rata share of the ring-fenced IPO proceeds minus agreed running costs. This is an approach that is similar to US market practice.
  • ADEQUATE PUBLIC DISCLOSURE. There would be a requirement to disclose information at all appropriate stages in the SPAC’s development, from listing through to either an acquisition or its dissolution. This disclosure would cover the SPAC’s structure, its strategy, the IPO arrangements and relevant information when the announcement of an initial acquisition is made; including updates on any new information that arises before the shareholder vote.
  • SUPERVISORY APPROACH. A SPAC would still have to contact the FCA before announcing an acquisition. In order to avoid a suspension, it would need to indicate to the FCA that it has met the relevant criteria from IPO and will do so until completion of the acquisition. If there is a leak, the FCA says the presumption of suspension will still apply, although this would be lifted if the issuer can show it meets the relevant criteria. The FCA has emphasised that it will not indicate at the time of listing whether it is satisfied that a suspension at a future date will not be necessary. This can only be done when a SPAC notifies the FCA about a potential acquisition. In announcing its rules, the FCA said it was modifying its supervisory approach to provide more comfort prior to admission to listing that an issuer is within the guidance, which sees the presumption of suspension disapplied.

The final rules, which the FCA announced would come into effect on 10 August 2021, aim to give larger SPACs more flexibility. This flexibility is offered, says the FCA, “provided they embed certain features that promote investor protection and the smooth operation of our markets’’. Private companies listing in the UK via a SPAC will still be subject to the full rigour of the FCA’s listing rules and transparency and disclosure obligations. The FCA will still look to apply any Market Abuse Regulations and the general suspension powers that it has at its disposal.

Risks of Investing in SPACs 

While the appeal of SPACs is, as we have said, on the increase there are also risks with such investment.

A failure to complete an acquisition within a SPAC’s lifetime leads to it being closed, meaning there is no gain for those who invested in it. There is the possibility that the limited life of a SPAC could create a pressure to complete a deal within the timescale. This could lead to the acquisition of a less than ideal company or an acquisition on unsuitable terms. Either of these could result in poor performance, leading to weak returns or losses for investors.

The level of disclosure provided to SPAC investors has also raised concerns. As the SPAC is effectively a shell, it has no history and the information about it that is available is limited to it acquisition strategy, its financing and those who have created it. While there is more disclosure once an acquisition target has been identified, this is only done after the IPO, by which time investors are already committed. Investors in SPACS are also heavily reliant on the founders, who use their market experience and contacts to seek the best possible company to acquire. But this can produce conflicts of interest.

The fact that a SPAC’s founders can also retain what amounts to a controlling stake after the acquisition can mean that their interests (and possible gains) are not always identical to those of the other investors. This can result in differences of opinion and a lack of unity in the newly-merged company, which could prove damaging to its chances of success and even lead to litigation between the parties.

Litigation

While there are features of SPACs that make them attractive, there are also aspects of them that could prompt litigation if some of those involved do not believe the process has been conducted as they believe it should have been. 

Some of the most likely grounds for litigation are:

  • Filings and disclosures by SPACs and acquisition targets. Material misstatements in company registration statements or omissions from them could be grounds for legal action brought by shareholders.
  • Breach of fiduciary duty. A SPAC’s shareholders could sue its officers and directors for breach of fiduciary duty. Shareholders in the company that is the acquisition target could also take this course of action.
  • Shares sale and investment fraud. SPAC shareholders could sue for this.
  • Litigation due to poor performance. If, for whatever reason, the company created as a result of the SPAC acquisition performs so poorly it has to go into bankruptcy, its creditors -which could include its shareholders – may sue. 
  • Unsuccessful negotiations. The SPAC and the acquisition target could sue each other for breach of contract or breach of the duty to negotiate in good faith, if negotiations are not concluded. 
  • Statutory and contractual rights. Shareholders in the acquisition target company could bring legal action to exercise their rights of statutory appraisal, while those against the acquisition may look to the law to exercise contractual rights.

Legal Issues with SPACs  

Regardless of whether any of the previously mentioned circumstances put a SPAC’s chances of success at risk or prompt litigation, there are serious legal issues surrounding their operation. While the SPAC process has many enthusiastic supporters and has been behind many recent major, high-profile mergers, their use touches on a number of areas of law.

Misleading statements and misleading impressions

One of the most immediately obvious legal areas relevant to SPACs is that regarding misleading statements and misleading impressions.

Misleading statements is covered by s89 of the Financial Services Act 2012. It applies where someone:

  • makes a statement which a person knows to be false or misleading in a material respect
  • makes a statement which is false or misleading in a material respect, being reckless as to whether it is, or
  • dishonestly conceals any material facts whether in connection with a statement made by a person or otherwise

Misleading impressions comes under s90 of the Financial Services Act 2012. It contains an offence of knowingly or recklessly creating a false impression for the purpose of (or with the knowledge that it is likely to lead to) personal gain, or the purpose of causing (or with the knowledge that it is likely to lead to) a loss to another person (or exposing that person to risk of loss).

Market Abuse and SPACs

Any conduct in relation to SPAC creation, promotion and subsequent activities will have to comply with the FCA’s Market Abuse Regulation. The Market Abuse Regulation (MAR), introduced in 2016, aims to protect investors by ensuring there is transparency in the financial markets.

MAR outlines three main forms of market abuse:

  • Insider Dealing: Using inside information to make, change or cancel deals to obtain an advantage or to encourage a third-party to do so using this knowledge.
  • Unlawful disclosure of inside information: Releasing inside information to another person without having permission to do so.
  • Market manipulation: Actions that distort the performance of the market by misleading the market through a particular activity that manipulates the price. It is detailed in Article 12 of MAR, while Annexe l of MAR lists all activities that could indicate market manipulation.

MAR also regulates (via its Article 11) the practice of market sounding; where information is communicated before the announcement of a transaction in order to gauge the scale of possible interest from investors. 

While MAR relates to the UK, SPACS based in the United States face similar responsibilities. Section 204A of the Investment Advisers Act of 1940 imposes obligations regarding the use of insider information and the prevention of insider trading, while SEC Rule 10b5 makes it an offence to use any measure to defraud, mislead the market or conduct business operations that would deceive another person regarding transactions involving stock and other securities.  

Any SPAC, therefore, has to ensure it discloses and records all inside information in a compliant way while also having in place procedures to make sure that market abuse can be identified and reported.

Investment fraud

Provisions relating to fraud exist in the US’s Securities Exchange Act 1934, the Securities Act 1933 and the Sarbanes-Oxley Act 2002. In the UK, investment fraud is an offence under the Fraud Act 2006. Activities relating to SPACs could possibly fall under fraud by false representation (Section 2), fraud by failure to disclose information when there is a legal duty to do so (Section 3) or fraud by abuse of position (Section 4). In each case, the conduct must be dishonest and the intention must be to make a gain or cause loss or risk of loss to another.

The Section 2 offence requires a defendant to have made a false representation, knowing that it was or might be untrue or misleading. Fraud by failing to disclose information (Section 3), involves a defendant failing to disclose information to another person when he was under a legal duty to disclose that information. The Section 4 offence of fraud by abuse of position relates to a defendant occupying a position in which they were expected to safeguard - or not to act against - the financial interests of another person but abused that position.

All three offences could be relevant to SPACs if they become a reality in the UK. One other area of concern could be accounting fraud, if the capital raised in the SPAC is distorted.

Conclusion

For the reasons that we have outlined, SPACs are enormously popular at present. It is this popularity that has prompted the FCA to produce proposals that would give the UK a stronger chance of gaining a slice of the multi-billion SPAC market.

But while SPACs are currently attracting unprecedented levels of investment, it is vitally important that anyone considering becoming involved in them knows everything possible about the SPAC process and the risks associated with it. 

The rise of SPACs is the newest exciting development in investments. But, as with any investment opportunity, anyone considering becoming involved needs to know all the potential pitfalls as well as the possible gains.

Syedur Rahman C 09551

Syedur Rahman

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syedur.rahman@rahmanravelli.co.uk
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Syedur Rahman is known for his in-depth experience of serious fraud, white-collar crime and serious crime cases, as well as his expertise in worldwide asset tracing and recovery, civil recovery, cryptocurrency and high-stakes commercial disputes.

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