This post is authored by Priyanshi Jain and Simran Lunagariya, fifth-year students of B.Com. LL.B. (Hons.), at Institute of Law, Nirma University.
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The market dynamics for Special Purpose Acquisition Companies (SPACs) have drastically changed, ranging from 638 in 2021 to 57 in 2022 so far. Amidst the plunging SPACs, the Securities Commission Exchange (SEC) has come up with new rules. These rules were called for in the backdrop of recent trends such as the drastic wave of SPAC Litigation as seen in Momentus Suit.
More often than not, there are inconsistent disclosures at the time of SPAC and de – SPAC. Private investment in public equity (PIPE) investors get to know the information which the investing public is not able to access. Pursuant to this, the PIPE investors sway the information for their own good. The celebrity endorsement in the SPAC Initial Public Offering (IPO) has significantly contributed to upending the votes of the investors before the proper disclosures are filed. Additionally, there is no alignment between gatekeepers’ obligations and investors’ incentives. Hence, in the whole SPAC process, the investors are not offered the same rights which they get while going for a traditional IPO.
Therefore, in order to protect the investors, the SEC follows a three-pronged approach, i.e., firstly, hints toward information asymmetries. Secondly, catch hold of fraudulent practices, and lastly, pacify the conflicts. That said, the proposed rules are an extension of such approaches, Section 140a of the Securities Act provides the much-needed investor protection but at the cost of extending the liability of the underwriters.
Through this blog, the authors juxtapose the declining investors’ interest and increasing gatekeepers’ obligation. To begin with, the authors will analyze Section 140a and then subsequently state a few recommendations which could be adopted.
2. A PRIMIERE ON SECTION 140a
The SPACs bloom is getting deflated as the regulator is increasing the scrutiny. Recently, SEC has sent letters to many issuers requesting them to disclose information related to their SPAC dealings and how the underwriters are managing the deal. These letters may be an antecedent to the formal investigation, which had been seen in the case of Lordstown Motors. There have been various instances wherein the SEC has cited its fears on account of celebrity endorsements in SPACs, lack of proper disclosures in dealings, and insider trading. Therefore, the proposed rule Section 140a gives power to the regulator to scrutinize the deals but on account of the increased liability of the underwriters. Hence, the authors will analyze whether the proposed rule has failed to walk the talk or not.
The Proposed Rule, Section 140a, imposes the liability on underwriters, which is not only limited to SPAC IPO but extends to de – SPAC as well. The pushback for this move was to motivate the underwriters to act judiciously in the whole SPAC process, but to the contrary, the underwriters have withdrawn, citing the fear of such an overtly dictating regime. The issues which are associated with the proposed rules are as follows;
Firstly, Section 2(a)(11) of the Securities Act, 1933 coins the term “underwriters”. It refers to ‘any person who offers to sell the securities on behalf of the issuer or undertakes any such similar activities’, the definition though widely worded, does not aim to extend to de – SPAC activities wherein traditional underwriters have no role to play. SPAC IPO, as well as de – SPAC, cannot be collated with each other as the stages of transactions involved are way too different. For instance, the target company in de – SPAC process is not identified at the initial phase of SPAC IPO. Therefore, the proposed rules are overriding the statutory contextual meaning.
Secondly, Section 11 of the Act gives the right to an investor to impose liability on the underwriters. It states that if in any registration statement, a material statement is omitted or untruly depicted, then the underwriter will be exposed to civil liability. The provision is overarching to ensure all the compliances in the best possible manner. Having stated that, if as per the proposed rules, the underwriters in a SPAC IPO would be certified as an underwriter in the de – SPAC process, then the liability surmounted in Section 11 may be extended to de – SPAC underwriters. Strict liability will be imposed on all such underwriters if they qualify to be an underwriter in the de – SPAC process, wherein the role of underwriters may or may not come into the picture.
Thirdly, the de-SPAC transactions, in particular, raise the issue of who will be held liable for the total amount of securities supplied if the SEC's new criteria are enacted. The broad interpretation of some parties as underwriters, even if they do not engage in actual underwriting activity while disregarding certain other parties whose actions seem to be more closely related to actual underwriting is concerning. This is since these regulations do not explain the scope of an underwriter's obligation, broker-dealers, investment banks, and asset managers’ risk.
Hence, in a nutshell, the proposed rules go beyond what is stated in the Act. Aristotle’s principle of like should be treated alike does not hold true in this scenario since the protection of investors may be ensured but not even the minutest regard, if any, is given to the underwriters. As a result, the fate of the underwriters in the whole SPAC process is riddled with ambiguity.
To address the debacle created by the new rule under section 140a, the following approach can serve as the rescuer:
1. Investment banks are susceptible to increased legal risks as a consequence of this proposed accountability rule. The regulatory threat has led to the cancellation of a $1.7 billion SPAC acquisition by Sports Ventures Acquisition Corp. and Sports Ventures Acquisition Corp. Furthermore, Goldman Sachs Group Inc. decided to restrict its involvement in SPACs. There are now 590 US-listed SPACs looking for a buyer. Investment banks would be unable to advice on de-SPAC transactions, perhaps effectively closing the market. Over and above that, depending on the specifics of the situation, the proposal might extend responsibility to financial advisors or third-party investors that participated in SPAC acquisitions. Precisely, the latest rule is unclear about the demarcation of the liabilities of underwriters and other intermediaries. As a result, investing in SPAC transactions becomes riskier than investing in standard IPOs.
An unprecedented havoc is created by the definition of an “underwriter” because the person who does not perform traditional underwriting activity is included in the definition of an underwriter, but those who do take part in such activity are excluded. Underwriter performs various tasks, including capital markets advisor, private placement agent, and M&A financial advisor. This means that when it comes to the responsibility of underwriters such as investment banks, the liability should be restricted to those who can carry out the requisite due diligence/underwriting in reality. Rather than other activities, they do throughout the SPAC and de-SPAC transactions. Also, for a SPAC IPO underwriter to be regarded as an underwriter in the de-SPAC transaction, the regulation should specify the kind and degree of engagement required. Lastly, other intermediaries like asset managers and brokers shall be assured of no subsequent penalties concerning de-SPAC by limiting the liability to an entity that traditionally performs the role of an underwriter.
2. Disclosures and liabilities related to underwriter responsibilities should align with those in a traditional IPO, such as excluding from the Merger Registration Statement and merger-related disclosures like the background of the merger and projections. Also, there should be some way to clarify what distribution means in the context of an underwriter's role.
3. It is possible that the guidelines might have unforeseen repercussions in future merger deals involving public operating companies, such as SPACs. The proposed guidelines ignore the fundamental distinctions between a SPAC and de-SPAC. Furthermore, as per the definition of securities in Section 5, the securities are limited to only a particular kind of transaction and cannot be extended to other types of transactions. Therefore, the liability of an underwriter in the SPAC shall not be extended to de-SPAC activities. The role of an underwriter in de-SPAC activities is entirely different from that of SPAC. In the de-SPAC, underwriters will also have to do due diligence for the target company with whom the current company will get merged. While the mindset of the SEC has been to treat them like transactions alike, they should not merge SPAC and de-SPAC because they form to be two different transactions. It's unknown when the underwriters' obligations will kick in. At the very least, a trigger limit should be established to mark the beginning of the underwriter’s liability.
4. In order to catch hold of the information asymmetry concerning to SPAC transactions and subsequent de-SPAC activities. The securities regulator shall work on creating external mechanisms like special corporate rating requirements for SPAC and de-SPAC deals. Corporate rating for these transactions would increase credibility and provide authentic information to investors. This would help in avoiding strict liability on the underwriters and increase the confidence of investors too.
5. In Singapore, Rule 625 of SGX rules mandates that SPACs disclose information on the issuer's organization and underlying risk concerns, as well as its business plan, takeover terms, and any possible conflicts of interest. By taking a hard position on SPACs, Hong Kong is hoping to safeguard investors and prevent lower-quality firms from becoming listed through the back door. These countries have also considered a strong stance for investor protection in SPAC regulations however, they have not imposed any personal liability on the underwriters. Hence, SEC’s stance on the underwriter’s liability should be diluted.
Although safeguarding underwriters is a national priority, protecting investors is a worldwide imperative. Investors' economic rights are often jeopardized when security concerns are ignored totally. Even though many Asian and Chinese investors are eager to get their hands on SPACs, the rising dangers connected with so many companies operating on a blank check in the USA have prevented some of them from doing so. Having said that, the SEC's nascent SPAC regulations are placing an excessive burden on underwriters, which will have a detrimental impact on the market performance.
It is incumbent on the regulator to find a balance in enforcing regulations on SPAC and de-SPAC operations while also holding underwriters accountable. The SPAC ecosystem in the United States serves as an exemplar for other countries. Essentially, in order to safeguard investors, underwriters should not be overburdened.