Not far behind the dramatic increase in the use of special purpose acquisition companies (SPACs) is a corresponding increase in the number of shareholder lawsuits and increased activity at the US Securities and Exchange Commission (SEC). In recent days, Reuters reported that the SEC opened an inquiry seeking information on how underwriters are managing the risks involved in SPACs,[i] and the SEC’s Division of Corporation Finance (Corp Fin) and acting chief accountant have issued two separate public statements on certain accounting, financial reporting and governance issues that should be considered in connection with SPAC-related mergers.[ii] This increase in activity by SEC staff comes on the heels of nearly two dozen federal securities class action filings, several SEC investor alerts and earlier guidance from Corp Fin.[iii] The surge in litigation and regulatory interest is likely to continue and expand throughout 2021 and beyond.
A SPAC is a company with no operations that raises funds from public investors through an initial public offering (IPO). The proceeds from the IPO are placed in a trust or escrow account for future use in the acquisition of one or more companies. A SPAC will typically have a two-year period to identify and complete a business transaction. If the SPAC fails to do so during the specified period, then it must return the funds in the account to its public shareholders on a pro rata basis and then dissolve.
Although SPACs have been used for decades as alternative investment vehicles, they have recently increased in popularity as a way to transition private companies into public companies in a manner that mitigates the increased market volatility risk of a traditional IPO. Indeed, 2020 was a record-breaking year for SPAC IPOs and 2021 has already crushed that record. According to spacinsider.com, SPACs completed 46 IPOs in 2018 and 59 IPOS in 2019.[i] These numbers increased dramatically over the last 15 months, with spacinsider.com reporting a total of 248 IPOs in 2020 and 298 IPOs so far in 2021 – a stark contrast to the 121 total SPAC IPOs from 2009 through 2017.
With this extraordinary increase in the use of SPACs comes an increase in SPAC shareholder lawsuits filed soon after announcements of mergers between SPACs and their target companies. According to data compiled by Stanford University, shareholders have filed 21 securities class actions lawsuits involving SPACs since 2019, with eight of these filings occurring in 2021.[ii]
Why the Increase in Litigation and Regulatory Interest?
There are a number of issues associated with SPACs that make them a prime target for potential litigation and enforcement action under the federal securities laws. The SPAC IPO is a public offering from which liability arises under the Securities Act of 1933 (Securities Act). After the SPAC goes public, it is subject to the periodic reporting requirements of the Securities Exchange Act (Exchange Act). Liability (including liability under sections 10(b) and 20(a) of the Exchange Act) can arise from material misstatements or omissions in the SPAC’s periodic filings, as well as proxy statements filed in connection with proposed acquisitions.
On December 22, 2020, Corp Fin issued guidance that describes some of the issues specific to SPACs.[iii] These issues are echoed in many of the allegations in the class actions filed to date. Corp Fin highlights the possible conflicts of interest between the entity or management team that forms the SPAC (known as the sponsor(s)), as well as the SPAC’s officers, directors and affiliates and the shareholders who invest in the SPAC. Corp Fin asks SPACs to carefully consider their disclosure obligations under the federal securities laws. For example, the sponsor has a limited period of time to identify an acquisition target and complete a business combination. Corp Fin notes that, “[a]s a SPAC nears the end of that timeframe, its options may narrow, giving acquisition targets significant leverage in negotiating the terms of a business combination transaction.”[iv] This may cause a significant divide between the economic interests of the sponsor, which are to close the deal quickly, and the economic interests of the shareholders, which may be better served by waiting to close the right deal at the right price. Corp Fin asks SPACs to consider whether they have clearly described the financial incentives of the SPAC sponsors, directors and officers to complete a business combination transaction and how these incentives may differ from the interests of the shareholders. Further, Corp Fin suggests that SPACs consider disclosing whether it is possible to extend the time to complete the business combination. Relatedly, Corp Fin asks SPACs to consider whether they clearly disclose the financial impact on the sponsor, directors, officers and affiliates if the SPAC ultimately fails to complete any business combination transaction.
Another example of potential conflicts highlighted by Corp Fin are those associated with any additional financing that may become necessary to complete the business combination transaction. Corp Fin suggests potential disclosures about how the terms of the additional financing may impact the public shareholders and, if the additional financing involves issuing securities, how the price and terms of those securities compare to and differ from the terms of the securities sold in the IPO.
Further, Corp Fin emphasizes potential conflicts associated with evaluating other acquisition candidates. Corp Fin suggests that SPACs provide, among other things, detailed information about how and why a targeted company was selected over alternative candidates, how the nature and amount of consideration the SPAC will pay to acquire the operating company was determined and what material factors the board of directors considered in its determination to approve the transaction.
An Active Plaintiffs’ Bar
The potential issues that Corp Fin raises in its guidance are echoed in the allegations investors have raised in shareholder class action complaints. For example, Immunovant, Inc. is a clinical-stage biopharmaceutical company that develops monoclonal antibodies for the treatment of autoimmune diseases. In December 2019, it became a publicly traded company through a reverse merger with Health Sciences Acquisitions Corporation (Health Sciences), a SPAC. Immunovant is developing a novel fully human antibody, IMVT-1401, which is in Phase IIa clinical trials. Investors filed a securities class action in the Eastern District of New York on February 19, 2021, alleging violations of sections 10(b) and 20(a) of the Exchange Act and rule 10b-5 promulgated thereunder.[v] According to the complaint, when the company announced the pending merger, it touted the commercial prospects of IMVT-1401. The complaint further alleges that after the merger, the company continued to tout IMVT-1401 in its public filings, announcing the initial results from the treatment phase of its ongoing trial and making positive statements about IMVT-1401’s safety record. However, on February 2, 2021, Immunovant issued a press release announcing a voluntary pause of dosing in IMVT-1401’s ongoing clinical trials because the company had become aware of possible safety concerns. On this news, the complaint alleges that Immunovant’s stock price fell $18.22 per share, or 42.08%, to close at $25.08 per share. The complaint further alleges that defendants made materially false and/or misleading statements and failed to disclose to investors that: (1) Health Sciences performed inadequate due diligence into the target before the merger and/or ignored or failed to disclose safety issues associated with IMVT-1401; (2) IMVT-1401 was less safe than investors were led to believe; (3) these facts foreseeably diminished IMVT-1401’s prospects for regulatory approval, commercial viability and profitability and (4) as a result, Immunovant’s public statements were materially false and misleading.
SPAC-related lawsuits are not limited to allegations of violations of the federal securities laws. Investors have also filed claims in state court alleging breaches of fiduciary duty. For example, on March 25, 2021, investors in a SPAC that acquired MultiPlan Corp. filed a class action in Delaware’s Chancery Court asserting breach of fiduciary against Churchill Capital Corp. III (the SPAC) and its directors, officers and affiliates.[vi] The complaint alleges that the structure of the SPAC “gave the Company’s board of directors incentives to get a deal done – any deal – without regard to whether it is truly in the best interest of the SPAC’s outside investors (i.e., whether the target private company is actually a good investment).”[vii] The complaint further alleges that the defendants failed to disclose serious weaknesses in MultiPlan’s business, including that its largest customer was in the process of leaving MultiPlan because it was creating a competing business unit. According to the complaint, after the merger closed, a market research report publicly disclosed the loss of the customer’s business and the effect of MultiPlan’s financial position, causing the company’s stock price drop to $6.27 per share, or 37.3% below the IPO price of $10 per share.
Notably, the complaint appears to be criticizing all SPACs – not just Churchill Capital Corp. III. The complaint describes the typical structure of a SPACs as “conflict-laden and practically invit[ing] fiduciary misconduct.”[viii] The complaint further alleges that “[t]he currently common SPAC structure creates problematic incentives for their founders, whose interests are not directly aligned with those of the public investors.”[ix] Indeed, the complaint explicitly asks the court to make clear that “the boards of SPACs like the one at issue here are subject to the same level of fiduciary duty review applicable to any other Delaware corporation,” alleging that this will cause sponsors of future SPACs to adapt and “easily choose to mitigate avoidable conflicts by structuring entities that better protect public stockholders.”[x]
An Active SEC
The SEC’s Division of Enforcement has also shown an interest in SPACs and appears to have opened several inquiries/investigations. For example, Nikola Corporation is an electric truck maker that was acquired in June 2020 by a SPAC called VectoIQ Acquisition. In September, Nikola’s stock price dropped more than 30% after a short seller issued a report accusing the company of fraud. Nikola disclosed that on September 14, 2020, the company and five of its officers and employees received subpoenas from the SEC relating to, among other things, certain matters described in the short seller’s report and issued additional subpoenas to Nikola’s officers, employees and directors later that same month.[xi] Further, the company disclosed that it had received grand jury subpoenas from the US Attorney’s Office for the Southern District of New York and the NY County District Attorney’s Office.
On March 24, 2021, Reuters reported that the Division of Enforcement had sent letters asking Wall Street banks to voluntarily provide information on their SPAC dealings, including information on SPAC deal fees and volumes and asking questions about compliance, reporting and internal controls.[xii] According to Reuters, the SEC may be concerned about the depth of due diligence that SPACs perform before acquisitions and whether SPACs are fully disclosing large payouts to sponsors and affiliates.
Other divisions at the SEC have been monitoring SPACs as well. In addition to the investor alerts and Corp Fin’s guidance, SEC staff issued a pair of public statements on March 31, 2021, that focus on, among other things, the accounting, financial reporting and corporate governance challenges associated with mergers between SPACs and private operating companies.[xiii] Specifically, the acting chief accountant highlights the importance of ensuring that the newly merged company is prepared to meet its obligations under the federal securities laws and provide investors with high quality financial reporting. This includes having finance and accounting professionals with sufficient knowledge of the reporting requirements in place and enough resources to meet required current and periodic report deadlines. Further, both Corp Fin and the acting chief accountant warns that target companies need to understand and abide by books and records and internal controls requirements. Further, the acting chief accountant emphasizes the importance of corporate board oversight, including the vital role of the audit committee, as well as the importance of issuing annual financial statements audited in accordance with the standards set forth by the Public Company Accounting Oversight Board (PCAOB). Overall, the staff’s statements emphasize the challenges newly merged companies face as they transition from a private operating company to a public company on an accelerated schedule and the steps SPAC sponsors and target companies can take to make sure they are prepared when the merger closes.
This is likely only the beginning of the SEC’s increased scrutiny of SPACs. In addition to disclosure-related issues, the nature of SPAC transactions presents heightened risk of insider trading and potential Regulation Fair Disclosure (Reg FD) issues. Given the explosion of SPACs over the last 15 months and the risks they present to investors, the Division of Enforcement is likely focused on investigating potential wrongdoing associated with the risks and challenges highlighted by Corp Fin and the acting chief accountant and will move quickly to recommend enforcement actions if necessary.
Insights for SPAC Sponsors and Target Companies
SPAC sponsors and target companies should carefully review Corp Fin’s December 22, 2020, guidance, as well as the more recent public statements from Corp Fin and the acting chief accountant. Further, SPAC sponsors should seek to mitigate inherent conflicts of interest wherever possible. This may include obtaining a fairness opinion from an independent third-party financial advisor or delaying financial incentives for the sponsor until after the acquired company meets certain benchmarks. SPAC sponsors should also perform thorough due diligence in evaluating proposed business combinations and disclose all material information in proxy statements, including any potential risks associated with a target company’s ongoing operations or future prospects. Moreover, SPAC sponsors should be mindful of the deadline for completing a business combination because acquisitions completed on the eve of the deadline will face increased scrutiny if shareholders suffer significant losses after the acquisition is complete. Finally, SPAC sponsors and target companies should ensure that they have a comprehensive plan in place to address the reporting and internal control requirements and expectations of a public operating company after the merger is complete.
Caitlyn M. Campbell recently joined McDermott Will & Emeryfrom the SEC Enforcement Division, where she served as senior counsel to the Co-Directors of Enforcement.
[v]See Complaint, Pitman v. Immunivant, Inc. et al., 1:21-cv-00918-KAM (E.D.N.Y. Feb.19, 2021).
[vi]See Complaint, Amo v. MultiPlan Corp., et al., C.A. No. 2021-0258 (Del. Ch. Mar. 25, 2021). Note that investors had previously filed securities class actions in federal court in connection with this same merger. In March 2021, two investors filed Notices of Voluntary Dismissal. See Notice of Voluntary Dismissal, Srock v.MultiPlan Corporation, et al., 1:21-cv-01640-LAK (S.D.N.Y. Mar. 15, 2021); Notice of Voluntary Dismissal, Verger v. MultiPlan Corporation, et al., 1:21-cv-01965-LAK (S.D.N.Y. Mar. 24, 2021).
[xi]See Nikola Corporation, Quarterly Report for period ended September 30, 2020 (Form 10-Q) (Nov. 9, 2020). Notably, also in September 2020, investors filed a federal securities class action alleging violations of Sections 10(b) and 20(a) of the Exchange Act, and Rule 10b-5 promulgated thereunder. See Complaint, Borteanu v. Nikola Corporation et al., 2:20-cv-01797-SPL (D. Ariz., Sept. 15, 2020).