SPAC Transactions: Enforcement and Litigation Risks

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In the first three months of 2021, there have been approximately 300 initial public offerings (IPOs) of special purpose acquisition companies (SPACs) that have raised $100 billion, which are significant increases over the record number of transactions and amounts raised in all of 2020. Inevitably, the growth in SPAC deal activity has attracted scrutiny from market regulators, including the US Securities and Exchange Commission (SEC) and Financial Industry Regulatory Authority (FINRA), as well as private plaintiffs. We expect this will continue and perhaps increase, particularly if retail investors get involved in SPAC IPOs. SPAC market participants—including sponsors, target companies, directors and officers on both sides of the transactions, and investment banks—should be aware of the enforcement and litigation risks involved. This advisory surveys the lay of the land regarding these risks and identifies practical suggestions about ways to anticipate and mitigate them.

A Brief Overview of SPACs

SPAC deals have existed in various forms for more than 25 years. A SPAC is a publicly traded, non-operating company that is used solely as a vehicle to acquire an operating target company in the future. In the SPAC IPO, the cash proceeds from the offering of common stock and warrants to purchase common stock are placed into a trust account for use to acquire an operating company (the target). In general, the SPAC is required to use the trust funds within two years to make an acquisition, or it must return the funds to its investors. A sponsor team, which is often composed of sophisticated business managers and investors, raises these funds for the SPAC and guides it through the IPO and, upon identifying a target, through one or more acquisitions (the so-called de-SPAC transaction).

SPACs have grown in popularity for many reasons, including because there is a perception that they involve an easier process than traditional IPOs in that they provide private companies with a quicker way to go public with more price transparency. In addition, the capital raises effected by private investments in public equity (PIPEs), which often accompany de-SPAC transactions, provide these companies with an additional influx of capital. In the current market environment, SPAC IPOs and PIPEs have been attracting enormous amounts of capital from investors.

Regulatory Guidance Emphasizes Disclosure and Warns of Potential Risks

As highlighted in a recent speech by then-Commissioner and now Acting Chair of the SEC Allison Herren Lee, the SEC has recognized the innovative potential of SPACs to "enliven public markets and expand investor opportunities." Lee, however, also emphasized the need for enhanced scrutiny of disclosures relating to "relevant risks and sponsor compensation," and for exploring whether additional protections are necessary to prevent sponsors from pursuing less-than-ideal acquisitions.

On December 22, 2020, the SEC's Division of Corporation Finance issued guidance cautioning about the need to consider "disclosure obligations under the federal securities laws as they relate to conflicts of interest, potentially differing economic interests of the SPAC sponsors, directors, officers and affiliates and the interests of other shareholders and other compensation-related matters." The guidance raises a series of disclosure questions in checklist form that address considerations relating to possible ways that conflicts of interest may manifest as well as other potential disclosure issues. For example, the guidance raises questions regarding (i) whether sponsors may have incentives to complete an acquisition within the redemption deadline or face losses if the transaction is not completed in that timeframe, (ii) the control that sponsors and management have over the identification, timing, and approval of target acquisitions, (iii) how the economic terms of the securities that sponsors own may be different than those of their common stock investors, and (iv) how investment banks are compensated, including whether they perform additional services (such as identifying potential targets and providing financial advisory services), how they are paid fees, the conditions to such payment, and whether any conflicts of interest exist given the possible deferral of a portion of fees until completion of target acquisitions.

The SEC also published investor bulletins in December 2020 and March 2021, which focused on the unique features, potential conflicts, and distinct risks of SPACs. The latter bulletin addressed the wide-spread phenomenon of celebrity-endorsed SPACs and warned the public to "[n]ever invest in a SPAC based solely on a celebrity's involvement or based solely on other information you receive through social media, investment newsletters, online advertisements, email, investment research websites, internet chat rooms, direct mail, newspapers, magazines, television, or radio."

Additionally, on March 31, 2021, the SEC's Division of Corporation Finance and Acting Chief Accountant issued two separate public statements about certain accounting, financial reporting, and governance issues that should be considered in connection with SPACs. The Division of Corporation Finance described certain limitations that SPACs are subject to both pre- and post-combination, such as books and records and internal control requirements as well as initial listing standards for national exchanges. The Acting Chief Accountant highlighted complex financial reporting and governance issues involving SPACs, including considerations regarding timing, financial reporting, internal controls, and corporate governance. The Acting Chief Accountant also stressed the importance of ensuring that auditors of a target company have both the necessary experience in audits of SEC registrants under the PCAOB standards and the required independence under the SEC rules, adding that "[a]uditor independence, auditor registration with the PCAOB, and other audit-related requirements should be assessed early in the transaction, particularly since these considerations may result in a need to retain a new auditor or to perform additional audit procedures on prior period financial statements."

FINRA also recently warned investors about what it perceives as risks of investing in SPACs. In a March 2021 newsletter, FINRA discussed the basics of SPACs and identified the possible risks as including (i) less due diligence than in a traditional IPO, (ii) exposure to potential speculative investments and reliance on financial projections of the target company, (iii) the existence of various fees and sponsor incentives, (iv) the fact that sponsors may possess material nonpublic information and trade on that knowledge as well as other issues that could create conflicts of interest, and (v) the potential for a fall in price from the typical $10 SPAC IPO price once the SPAC starts trading, including before a target is identified or the de-SPAC transaction takes place.

Taken together, these statements demonstrate that securities regulators are viewing SPAC transactions with caution. This presages enhanced scrutiny by the SEC and other regulators, particularly once Gary Gensler is confirmed as the next Chair of the SEC. Gensler reportedly has said that his enforcement agenda will include heightened scrutiny of SPACs, among other issues affecting capital markets.

SEC Enforcement Related to SPAC Transactions

In the recent past, there have only been a handful of enforcement proceedings involving SPACs, including the following actions:

• In June 2019, the SEC brought a federal court enforcement action and separate administrative proceeding relating to the merger between a SPAC called Cambridge Capital Acquisition Corporation (Cambridge) and its target, an Israeli-based communications company called Ability Computer & Software Industries, Ltd. (Ability). These actions concerned alleged misstatements made to investors during roadshow meetings and in proxy materials relating to Ability's supposed ownership of a "game-changing" cellular interception product, as well as its existing backlog and potential pipeline of purchase orders, which resulted in a net loss of approximately $60 million. The SEC filed a complaint against Ability and its officers and later settled with Ability on a no-admit-no-deny basis pursuant to which Ability paid disgorgement and a civil penalty. The case against the individual defendants remains ongoing. The SEC also brought an administrative proceeding against Cambridge's CEO based on his alleged negligence in conducting due diligence and ensuring the accuracy of disclosures to investors, which was settled pursuant to a cease-and-desist order that required him to pay a $100,000 civil penalty and imposed a 12-month industry bar.
• In September 2020, the SEC filed an action against Akazoo S.A., a Luxemburg-based music streaming company that was taken public as a result of a merger with a SPAC called Modern Media Acquisition Corp. (MMAC). The merger closed days before MMAC's deadline to either make an acquisition or redeem the funds held in trust. The SEC's complaint followed the company's Form 6-K, which disclosed that an internal investigation found that the company's former management had made fraudulent misrepresentations regarding its subscriber base, operations, and revenue over a multi-year period. The SEC did not charge the sponsors or the executives individually.

In addition to filed actions, there have been recent enforcement developments with respect to investigations involving SPACs. Most significantly, on March 24, 2021, the SEC's Division of Enforcement (Enforcement Division) reportedly opened an inquiry relating to "how underwriters are managing the risks involved," and sent letters to a number of Wall Street banks requesting the voluntary disclosure of information relating to SPAC deals, including information about fees, volumes, compliance, and internal controls. This inquiry may relate to the due diligence performed by SPACs, the disclosures relating to payouts, and potential insider trading, and it could be a signal of further enforcement activity to come.

We expect the Enforcement Division will consider issues involving disclosures, conflicts of interest, and insider trading, among other things, and ultimately focus on investor harm when making determinations regarding which matters to investigate. In the past, the Enforcement Division has been skeptical of transactions involving public shell entities, particularly given that they historically were used as vehicles for pump and dump schemes by shady promoters. Now, however, SPACs have come out of the shadows and are being used as a legitimate alternative to bring a company public. The Enforcement Division is likely to be sensitive to interfering in legitimate transactions and avoid using its enforcement powers to stifle legitimate innovation. However, as SPACs gain mainstream acceptance and retail investors want to get involved, it is possible that fringe players will once again emerge to exploit the popularity of the investment opportunity. If this happens and misconduct results in actual investor harm, the Enforcement Division will likely move quickly and deliberately to shut down any fly-by-night operators and use its enforcement powers to send the message that fraud in connection with SPACs will be investigated and charged. This, in turn, will make it more difficult for legitimate sponsors because they will be saddled with the consequences and sins of those who sought to exploit the opportunity at the expense of investors. Until then, we expect the Enforcement Division will wade carefully into the SPAC waters to gather information from mainstream financial institutions about how they operate, continue to make pronouncements cautioning retail investors, and otherwise engage in monitoring and surveillance in an effort to detect misconduct in connection with SPACs.

Private Litigation Related to SPAC Transactions

SPAC transactions will continue to attract shareholder and other private litigation at each step of the SPAC lifecycle. This will especially be true in the event that regulatory activity increases, as private litigation often follows the disclosure of enforcement proceedings. The following are examples of claims that plaintiffs may pursue at each phase of the life of a SPAC:

Litigation involving the IPO. In connection with its IPO, a SPAC files a registration statement with the SEC on Form S-1, which contains disclosures that could conceivably give rise to liability under Sections 11 and 15 of the Securities Act of 1933 (Securities Act). Section 11(a) allows plaintiffs to assert claims for any material misstatements or omissions in a registration statement against, among others, each person who signed the registration statement, each director of the SPAC, and underwriters. There is no requirement that any of those parties knew about the falsity of any statements or omissions—such parties have so-called strict liability for these material misstatements or omissions for which they have no due diligence defense. Section 15(a) provides for joint and several liability for any person who directly or indirectly controlled a primary violator.

A SPAC IPO registration statement is generally much less detailed then a registration statement for a traditional IPO. This is because the SPAC is not an operating company and frequently has simple and straightforward financial statements. As a result, there is less material to give rise to a shareholder lawsuit—and, indeed, there are few if any examples of such lawsuits at the SPAC IPO stage. Nevertheless, SPACs and their sponsors, directors and officers, and others involved in preparing an IPO registration statement should be aware that there are several other areas of potential claims, including regarding potential inadequate disclosure regarding conflicts of interest.

Litigation involving the de-SPAC transaction. The majority of SPAC-related litigation has focused on allegations arising from the de-SPAC transaction, which requires the SPAC to file a proxy statement with the SEC in relation to the vote on the transaction by the SPAC's stockholders. The proxy statement for a de-SPAC transaction contains disclosures that could give rise to liability under Sections 10(b), 14(a), and 20(a) of the Securities Exchange Act of 1934 (Exchange Act). In some situations, such as if the de-SPAC transaction utilizes a so-called "double dummy" structure where a holding company acquires both the SPAC and the target company, a registration statement also needs to be filed with the SEC—and plaintiffs could additionally assert claims under Section 11 of the Securities Act for misstatements and omissions in this registration statement.

Actions targeting de-SPAC transactions may resemble the traditional merger-related disclosure actions. For instance, in 2019, a plaintiff filed a lawsuit against the SPAC Black Ridge in connection with its merger with Allied Esports, and the complaint asserted the usual allegations of omissions, such as inputs and assumptions underlying financial analyses and whether any of the underlying NDAs contained "don't ask, don't waive" provisions. Rosenblatt v. Black Ridge Acquisition Corp., No. 19-CV-01117 (D. Del. June 17, 2019). An action alleging similar omissions was filed in relation to the Boxwood/Atlas merger. Wolf v. Boxwood Merger Corp., No. 19-CV-02184 (D. Del. Nov. 22, 2019).

However, some potential allegations involving de-SPAC transactions, while also raised in traditional disclosure actions, dovetail with concerns expressed by the SEC in its recent SPAC-related guidance. For instance, the Black Ridge complaint alleged that the proxy statement failed to disclose the fact that the advisors' compensation was contingent upon the consummation of the merger and whether the advisors had provided services for the companies in the past. In addition, complaints filed in connection with a number of other de-SPAC transactions made further allegations about potential conflicts of interests, scrutinizing the selection process for the target company and the relationship between sponsors and PIPE investors. Hutchings v. Churchill Capital Corp III, No. 20-CV-06318 (S.D.N.Y. Aug. 11, 2020); Rosenblatt v. Chardan Healthcare Acquisition Corp., No. 19-CV-01801 (D. Del. Sept. 25, 2019); Wheby v. Greenland Acquisition Corp., No. 19-CV-01758 (D. Del. Sept. 19, 2019).

As a general matter, SPACs have been successful in fending off these complaints. All of the above actions were dismissed after the merger was closed, and others were resolved by voluntary amendments to the proxy statement and the payment of a mootness fee. Chardan Healthcare Acquisition Corp., No. 19-CV-01801 (D. Del. Oct. 16, 2019); Wheby v. Greenland Acquisition Corp., No. 19-CV-01758 (D. Del. Oct. 15, 2019). Plaintiffs continue to file similar cases without significant variation in allegations or approach, and plaintiffs' counsel appear to view SPACs as a good source of litigation, with the recent guidance from the SEC serving as somewhat of a playbook. It remains to be seen how successful those cases will be. Although litigation regarding these matters may be viewed by some market participants as the cost of doing business, for others the lawsuit itself may represent a large cost and intrusive distraction from their day-to-day business.

Litigation post-de-SPAC transaction closing. While cases challenging de-SPAC transaction proxy statement disclosures usually terminate at the deal closing, actions filed after the merger can be protracted. Following the closing of the transaction, the target company could attract stock-drop litigation under Section 10(b) of the Exchange Act in the event the company's share price suffers a statistically significant decrease below the market's expectation. In such cases, the target company could face liability based on the disclosures in the de-SPAC transaction proxy statement, as well as disclosures in the "Super 8-K" that the target company is required to file within four days after closing. As noted above, unlike in a traditional IPO, a de-SPAC transaction proxy statement often contains financial projections about the target company, rather than merely historical financial information, for marketing reasons. Although such projections are often considered to be essentially protected as forward-looking statements under the Private Securities Litigation Reform Act's safe harbor, we expect that private plaintiffs will test that safe harbor, in part, by claiming that the projections were knowingly false or misleading when made.

For example, the online delivery company Waitr went public in 2018 by merging with the SPAC Landcadia, but the share price dropped in 2019. It is now facing claims under Sections 10(b), 14(a), and 20(a) of the Exchange Act for allegedly misstating Waitr's financial projections and intrinsic value. Welch v. Meaux, No. 2:19-cv-01260 (W.D. La. Oct. 16, 2020). The oral argument for a motion to dismiss in that case is scheduled to take place on April 20, 2021. Given the number of post-de-SPAC transaction complaints that have been filed recently, courts will likely take cues from this decision. How the court scrutinizes Waitr's financial projections also could affect plaintiffs' strategies as well as companies' disclosure of forward-looking statements.

In addition, given that SPACs have deadlines by which they must complete a business combination or be liquidated by returning funds to investors, litigation against SPACs often include allegations regarding the timing of de-SPAC transactions. For example, the complaint in the Waitr litigation alleges that the "acquisition was ultimately completed with less than 30 days remaining before even the extended deadline expired." In the past, courts have closely scrutinized deals that closed shortly before the deadline. For instance, a New York state court found that sponsors' interests deviated from those of shareholders due to the sponsors' ability to receive a material benefit from completing a merger and avoiding liquidating the trust, thereby rebutting the business judgment rule. AP Services, LLP v. Lobell, 2015 WL 3858818, at *6 (N.Y. Sup. Ct. June 19, 2015). Similarly, the Southern District of New York has observed that the "desire to avoid impending liquidation was also a motivating factor for" the SPAC officers at issue. In re Stillwater Cap. Partners Inc. Litig., 858 F. Supp. 2d 277, 288 (S.D.N.Y. 2012).¹

These actions put the target company and the SPAC sponsors at risk. In a case in the District of Delaware, plaintiffs sued both the post-merger company, the directors, and the SPAC sponsors, alleging that the SPAC sponsors failed to conduct due diligence and ignored red flags before the merger. After the court sustained plaintiffs' claims on a motion to dismiss, the case eventually settled for $27 million to be paid half in cash and half in stock. In re Heckmann Corp. Sec. Litig., No. 1:10-cv-00378 (D. Del May 22, 2014).

Some Practical Considerations

Sponsors, target companies, their respective directors and officers, and their investment banks would be well-advised to anticipate the likelihood of increasing and enhanced scrutiny by regulators and the plaintiffs' bar. While every situation is different, there are some practical considerations to bear in mind based on the statements of regulators and lessons learned from prior cases:

• Prepare in Advance. Just like a traditional IPO, prepare in advance of the SPAC IPO and target acquisition to make sure that the SPAC and de-SPAC'ed company are ready for the rigors of going public. Focus on the internal accounting function and internal controls, outside auditors, financial reporting, corporate governance, due diligence function, legal counsel, and investor relations, among other things, including having the right personnel and effective procedures and processes in place. Be mindful of the potential perception of rushing this process, even if the reality is that the company is well-prepared.
• Anticipate Disclosure Needs. Anticipate and prepare accurate disclosures with particular attention to the types of issues identified by the SEC and FINRA, such as those contained in the SEC's checklist of questions from its December 22, 2020 guidance covering potential disclosure issues regarding conflicts of interest and other matters. Pay special attention to disclosures regarding financial projections of the target company by diligencing them and their key assumptions as well as by disclosing such assumptions and risks related to them.
• Process Is Key. Ensure an appropriate and well-planned process is run by the boards of directors of both the SPAC and the target company for the de-SPAC transaction, just as in any M&A context, including adequate due diligence into the target company to avoid unpleasant surprises or the appearance of a deficient process.
• Be Mindful of Timing Perceptions. If possible, enter into the de-SPAC transaction well in advance of the deadline so as to avoid the appearance of rushing into a deal to stave off the need to redeem investors' common stock.
• Pay Attention to Fiduciary Duties. Consider the relevant factors in the exercise of fiduciary duties, which apply to both sets of boards of directors in the de-SPAC transaction. Be aware of the ways in which the SEC has identified potential conflicts of interest among the parties when running the M&A process and what that means for board deliberations and decision-making, including how the record will reflect these things.
• Protect Your D&Os. Protect your directors and officers by having robust indemnification provisions in the charter, by providing them a separate indemnification agreement, and by obtaining adequate directors and officers liability insurance.
• Watch Your MNPI. The SEC's Enforcement Division is focused on insider trading, including through monitoring, among other things, unusual trading patterns. In light of the access to material non-public information by different parties at different stages of a SPAC's life, be cognizant of the risks of trading, including the possible perception of access to such information.
• Beware of the Gatekeeping Function of Investment Banks. The SEC and FINRA are likely to focus on the important role that investment banks play as intermediaries or so-called gatekeepers in the capital raising process, whether in connection with the SPAC IPO, PIPE, or otherwise. The gatekeeping function touches on how bankers diligence and participate in the disclosure and offering processes, including in roadshow meetings. As a result, investment banks are considering the issues raised more generally for SPACs (summarized above) and, in particular, the checklist of issues set forth in the SEC's December 22, 2020 guidance. In addition, in some instances, investment banks are developing policies and practices that are tailored to the SPAC capital raising product.

Arnold & Porter will continue to monitor and report on enforcement and litigation developments related to SPACs as well as develop best practices for our clients. If you are seeking advice on how to mitigate risks in connection with SPAC transactions, please reach out to any author of this Advisory or your regular Arnold & Porter contact.

© Arnold & Porter Kaye Scholer LLP 2021 All Rights Reserved. This Advisory is intended to be a general summary of the law and does not constitute legal advice. You should consult with counsel to determine applicable legal requirements in a specific fact situation.