It seems everyone has been getting into the SPAC madness lately. The latest numbers from SPACInsider show that 138 SPACs went public in 2020 in the first week of October 2020, reaching a record $ 53.7 billion. SPACs are so hot that even Oakland A’s Billy Beane and former economic adviser Gary Cohn ride the SPAC train.
As a reminder, Special Purpose Acquisition Companies or SPACs raise capital on an IPO with the intention of acquiring or merging with a private operating company that will become a public company as a result of the merger. SPACs themselves are not operational companies. While the concept is not new, its recent popularity has been explosive.
With the recent popularity of these SPACs, it is worth investigating the litigation risks for directors and officers of SPACs. I’ve written in the past about how more SPACs mean more private litigation from shareholders.
Now the Securities and Exchange Commission is sharpening its focus on SPACs.
The SEC and SPAC disclosure
In September 2020, SEC chairman Jay Clayton commented on the agency’s focus on SPACs. For the sake of clarity, there has been no manipulation of SPACs as a financial instrument per se. Chairman Clayton was positive about SPACs as a concept, noting that the concept “actually creates competition over the way we distribute shares to the public market” and “competition for the IPO process is probably a good thing” .
However, he continued, “To have good competition and good decision-making, you need good information.” It is therefore not surprising that his main concern is that the incentives and compensation of the SPAC sponsors are clear and that the information provided is both correct and easy to understand for SPAC shareholders.
You can hear the SEC chairman speak about it in the following interview. In that interview, Chairman Clayton stated that “at the time of the deal, when [shareholders] Vote: “The SEC wants to make sure they get the same rigorous disclosure that you get in connection with an IPO.”
Chairman Clayton’s remarks send a clear message that the SEC is closely monitoring the SPAC trend.
SEC enforcement action against a SPAC
However, Chairman Clayton’s current remarks should not be taken to mean that the SEC has so far ignored SPACs.
In 2019, the SEC accused Benjamin Gordon, the CEO of Florida-based SPAC Cambridge Capital Acquisition Corp., of failing to “take appropriate steps and perform adequate due diligence to ensure that Cambridge shareholders voting on the merger were with Material was supplied “and accurate information about” the prospects of the target company.
Mr. Gordon was involved in filing a power of attorney to represent the shareholders of Cambridge Capital Acquisition Corp. To call for the proposed merger with Ability Computer & Software Industries, Ltd. to vote. Unfortunately, the letter of attorney found to be extremely flawed in describing Ability’s assets and business prospects.
A summary of the case by the SEC:
The command finds that Gordon [the CEO of Cambridge] negligently failed to take reasonable steps and due diligence to ensure that the Cambridge shareholders who voted on the combination received material and accurate information about Ability’s business prospects, including Ability’s alleged ownership of a new one , breakthrough cellular wiretapping product, ULIN, Ability’s so-called backlog of the largest customer, a police agency in Latin America, the lack of actual orders from Ability backing the backlog, and Ability’s pipeline of possible future orders from customers.
It is of course illegal to solicit shareholders by means of a proxy statement that contains materially false or misleading statements.
The SEC ruling blatantly describes the SEC’s view of Mr. Gordon’s lack of care. In its decision against Mr. Gordon, the SEC notes that the proxy statement contains representations of Cambridge’s “thorough diligence” with respect to various aspects of the capability, although many of the “facts” in the proxy statement are misleading, if not misleading were completely wrong.
The SEC advises that there is no third party due diligence with respect to the intellectual property of any particular Ability asset or the alleged arrears and sales figures. Ultimately, the SEC finds that “the allegation that Cambridge conducted” thorough due diligence “was false and misleading”.
A few months after Cambridge shareholders voted to acquire Ability and completed the merger, Ability’s filing of Annual Report brought shareholders the ugly truth. The news caused the company’s share price to drop 33%. The SEC ordered an injunction for violating Section 17 (a) (2) of the Securities Act of 1933 and Section 14 (a) of the Securities Exchange Act of 1934 and Rule 14a-9.
Mr. Gordon agreed to pay a fine of $ 100,000. He also agreed to a one year suspension of working with a broker, dealer and investment advisor or participation in the Penny Stocks offering.
The principles of the target company were also followed by the SEC. The SEC accused this Israel-based company, its wholly owned subsidiary and two top executives of defrauding shareholders.
The SEC summarizes this case here:
In order to convince shareholders to vote in favor of the merger proposal, the defendants allegedly lied to SPAC shareholders about Ability’s business prospects, including Ability’s alleged ownership of a new “breakthrough” cellular wiretap product, ULIN, called Ability’s backlog from The Largest Client, a police agency in Latin America, the lack of actual orders from Ability to support the backlog, and Ability’s pipeline of possible future orders from customers.
While shareholders lost $ 60 million in the deal, the two executives benefited from a total of $ 30 million. The SEC accused executives of violating the anti-fraud and power of attorney provisions of the federal securities act.
The timeline is also important. It is noteworthy that SPACs in trouble often do so when attempting to complete a transaction at the end of their pre-arranged life. In this case, Cambridge sponsors launched the company in October 2013 with a public offering of $ 81 million. You had until December 2015 to acquire a company or to return the IPO proceeds. The power of attorney in question was made available to shareholders in early December 2015, and the transaction closed later that month.
All in all, the SEC doesn’t make it a practice to prosecute directors and officers just because business isn’t working. After all, that is the business risk. However, the SEC is keen on good disclosure because, in the words of above Chairman Clayton, “good competition and decision-making requires good information.”
The Cambridge debacle, as well as Chairman Clayton’s recent remarks, provide some clear guidelines for SPAC directors and officers:
- Care must not be taken lightly or carelessly. The SEC will not agree to sponsors of a SPAC that they were deceived by the management of a target. Instead, the SEC expects the sponsors actually did so if the proxy states that the sponsors conducted a thorough review.
- At a minimum, a thorough review includes using a third party to validate things like intellectual property ownership and other assets, and the veracity of things like backlog and pipeline.
- Take extra care and cut corners when an acquisition comes at the end of a SPAC’s life.
- Ensure that the compensation and incentives of the SPAC sponsors are clearly communicated to shareholders at both the time of SPAC’s IPO and at the time of the merger transaction.
- Make sure you get good D&O insurance.
This last point is critical. One of the reasons SPACs buy D&O insurance is to make sure there is money for a good defense attorney in the event the SEC or shareholders decide to sue the directors and officers of a SPAC.
As noted in Woodruff Sawyer’s Guide to Insuring SPACs, insurance issues for SPACs can be complex and nuanced and should be addressed before problems arise.