New SEC rules on Spacs shut the barn door after horses have bolted

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“And it’s too late, Baby, now it’s too late.” As Carole King sings in her iconic 1971 hit, sometimes you take too long to fix a situation and the damage is done. “Something inside has died, and I can’t hide and I just can’t fake it.”

Last week the US Securities and Exchange Commission issued final rules for special purpose acquisition companies (Spacs). A Spac is a blank-cheque vehicle that offers private companies an alternative route to a stock exchange listing. Once the Spac raises money, its sponsors have usually two years to combine it with an operating company.

The new SEC rules are long and detailed, but the basic gist is to align the procedures for initial public offerings (IPOs) with mergers of companies with listed Spacs (aka “de-Spacs”). The key features are:

• More detailed disclosure on Spac sponsors, including the conflicts of interest and the dilution

• Subjecting the operating company merging into the Spac to the same liability standards as a regular IPO issuer

• Axing the safe harbour for projections and forward-looking statements

• Providing “guidance” around circumstances where an investment bank working on the de-Spac might have underwriters’ liability

• Tightening various other loopholes to put de-Spacs on a similar footing to an IPO

According to SEC Chair Gary Gensler, the rules “will strengthen protections for investors in [Spacs].” 

To be sure, the rules could have strengthened investor protections if they had been issued in a timely manner. But now? Three years after Peak Spac Frenzy? When the Spac market is catatonically kaput?

With the new Spac rules, the SEC is closing the barn door long after the horses have bolted. And those fleeing horses weren’t always thoroughbreds and stallions. A fair number of donkeys romped on to the Elysian Fields of the equity capital markets, too, leaving a pile of stinky manure in investor portfolios.

It’s easy to forget the scale and intensity of Spac-mania. The number of Spac IPOs rose more than tenfold from 59 in 2019 to 613 in 2021, with proceeds soaring from $12 billion to $162 billion, as markets got high on a Covid-era cocktail of central bank stimulants and fiscal amphetamines. Everyone was getting into the act of sponsoring Spacs: private equity firms, venture capitalists, entrepreneurs, dealmakers, gurus, sports stars, influencers, celebrities. Spacs accounted for 63 per cent of all IPOs in the US in 2021.

Inevitably, there was some sloppiness and even more sharp practice. Given their 20 per cent “promote”, Spac sponsors could make a lot of money from merging with an even a poorly-performing target company, and so they had a strong incentive to puff up the prospects of their proposed business combinations. And the rules for going public via a de-Spac have until now meant you could get away with “outlandish” projections in a way you couldn’t when listing via the normal IPO route.

The Spac craze crescendoed in early 2021, and it has been carnage ever since. Share prices of de-Spac’d companies have collapsed amid missed forecasts, nosebleed valuations, overhyped expectations, wayward execution, and even bankruptcies. Some early Spac promoters walked away with windfall profits, but chastened investors have responded in kind: over the past two years the vast majority — often 90 per cent or more — of Spac shares were redeemed for cash in lieu of being tendered in the de-Spac proposal. This has either made it impossible to take the target operating company public via the Spac or forced the target to reverse into an empty listed shell with almost no cash, assets or free float. 

And what about investment banks? They were feasting on chunky fees from these deals. But in early 2022 the bulge-bracket firms were spooked by the hint of liability — and the reputational risk — from associating with de-Spac’d companies whose shares were cratering dramatically. As a result, they pulled back from advising and underwriting these transactions, and by mid-2022 the Spac market had ground to a halt.

And yet only now has the SEC issued 581 pages of rules to regulate Spacs. It’s too late, baby.

SEC Chair Gensler is correct that there’s no good reason to hold de-Spacs to a lower disclosure standard than IPOs, since they both involve listing new companies on the stock exchange. However, after incurring huge losses, the market had already — if belatedly — taken action to address the disparity in treatment by shutting down de-Spacs as a viable channel for going public. 

The SEC has its reasons for taking so long. It’s complicated to issue regulations already on top of a complex code, and the agency is required to jump through a lot of procedural hoops, such as giving notice and considering public comments. And the SEC has been busy working out its framework for crypto and ESG, among other pursuits.

But the agency’s tardiness shows that regulation often addresses the problems of the past well after the fact. It can take a long time — and a lot of damage — before watchdogs rouse themselves to close gaps, loopholes and inconsistencies in their rules. Until then, highly interested parties have the time and space to (legally) exploit these lacunae, potentially at the expense of the parties who are supposed to be protected. It’s often up to the market to resolve these issues well before the regulators can get around to it.

If and when Spacs return, the market will likely demand structural enhancements, including more money in escrow and more stringent share price performance benchmarks before sponsors can get paid their promote. Those tougher terms will put off the flakier folks from promoting a Spac. In short, the self-healing medicine of the market will go down quicker than 581 pages of rulemaking.