Special Purpose Acquisition Companies (SPACs) have been making headlines for two years straight. While enthusiasm for blank-check companies has notably cooled off, regulators have zoomed in on SPACs which are benefitting from a regulatory loophole. When SPACs take a start-up public, securities law treats these deals as mergers rather than initial public offerings (IPO). As a result, SPACs are taking advantage of lax rules that allow them to overstate their profitability. The loophole might be closing soon, though.
Currently, SPACs benefit from what is known as a “safe harbor” regulation. The Private Securities Litigation Reform Act (PSLRA) introduced a protection from liability for forward-looking projections made by publicly listed companies for certain events of interest to the public markets. These include, among others, business combinations such as mergers. The safe harbor for forward-looking projections was introduced to encourage established publicly-traded companies to communicate business developments to the public markets without fearing unwarranted lawsuits. Disclosure has traditionally been a pillar of securities regulation, and encouraging disclosure and communication is usually deemed good regulatory practice. IPOs, however, are explicitly excluded from the safe harbor under the PSLRA. Lawmakers deemed initial public offerings too risky to exempt companies making forward-looking statements from liability.
The safe harbor does not exempt SPACs from liability altogether. Companies are still liable for false or misleading statements. The safe harbor rule only protects companies from liability for forward-looking projections (as opposed to statements on current facts) that are made in good faith and that are not false or misleading. For example, if a company announces a new business combination, it can publish its projections on why it thinks this will increase profits. If these projections later turn out to be too optimistic, the company cannot be held liable—unless the numbers were falsified to begin with.
In contrast, companies and underwriters going public via an IPO need to be diligent about their communications. If a company communicates profit expectations too optimistically during an IPO process, it might find itself becoming a target of securities class action suits.
Going public via a SPAC provides a clear advantage. For a SPAC, the actual IPO is the listing of the blank-check company. When a SPAC takes a start-up public, the start-up will subsequently be listed as a public company. The process of getting there, though, is technically a merger. Companies and underwriters do not need to fear lawsuits as much as in an IPO. They have more leeway to make optimistic predictions about the future. This is especially beneficial for start-ups that go public before they reach profitability. In the absence of a profitable business model, optimistic projections might be the only information that investors can base their decisions on.
However, companies going public via an IPO and companies going public via a SPAC get treated differently based on a technicality. There is no reason to assume that lawmakers who explicitly excluded IPOs from the safe harbor knowingly left the safe harbor open for SPACs. Apart from a short boom phase around 2008, SPACs are a relatively new phenomenon that simply was not on any regulator’s mind.
This is changing, though. John Coates, Acting Director of the Division of Corporate Finance at the SEC, issued a statement earlier this year, addressing whether SPAC mergers and IPOs should be treated differently. Subsequently, the U.S. House Committee on Financial Services introduced draft legislation that would change the PSLRA to exclude SPACs from the safe harbor.
Meanwhile, many SPACs discovered that the safe harbor did not protect them from lawsuits altogether the hard way. Securities class actions against SPACs are on the rise. Since the safe harbor still requires forward-looking projections to be made in good faith, there is ample room for judges to protect investors that rely on such information.
Even with the safe harbor still open, the climate is changing. Companies going public via a SPAC will need to be a lot more cautious in the future. The time for overly optimistic projections might be over for good.