Since early 2020, one of the most noteworthy developments in capital markets and global M&A activity has been the significant increase in both the number of initial public offerings of special purpose acquisition companies – aka “SPACs” – and the number of private companies combining with SPACs to become public companies (such combinations are commonly referred to as “de-SPAC transactions” or “de-SPACs”).
However, SPACs are not a recent invention; they have been a part (albeit, a small one) of the U.S. capital and M&A markets since the early 1990s. SPACs are “blank check companies” – companies that raise capital in an IPO solely for the purpose of acquiring one or more unidentified target businesses within a specified period of time, typically within 15 months to two years of IPO. When a SPAC identifies a company to acquire, the two effect the de-SPAC transaction and combine, with the resulting company becoming publicly listed. Until it effects a de-SPAC transaction, the SPAC holds the money raised in the IPO in a trust account invested in Treasurys and money market accounts.
SPACs have seen an explosion in popularity in the last 18 months – in the four-year period from 2016 through 2019, a total of 104 de-SPAC transactions involving SPACs were announced. By comparison, according to published data, nearly 400 SPACs have raised more than $115 billion since the beginning of 2020 and are currently looking for acquisition targets.
This incredible volume of investment and activity has encouraged plaintiffs’ attorneys to seek creative arguments, however remote from legal and factual reality, to challenge the SPAC structure in the hopes of cashing in themselves.
One of the arguments raised by plaintiffs’ attorneys most recently is that SPACs are investment companies under the Investment Company Act of 1940. That is the basis of three derivative lawsuits filed Aug. 17 and Aug. 20 in the United States District Court for the Southern District of New York, including one involving famed investor Bill Ackman’s Pershing Square Tontine Holdings. (Assad v. Pershing Square Tontine Holdings, Ltd.,; Assad v. E.Merge Technology Acquisition Corp.; Assad v. GO Acquisition Corp.)
The plaintiffs in those cases assert that the defendant SPACs are “investment companies” subject to the requirements of the Investment Company Act of 1940 because, immediately following their IPO, they hold short-term Treasurys and other qualifying money market funds. In the case of Pershing Square, the plaintiffs also alleged that the defendant SPAC ought to be considered an investment company because of what was described as a contemplated transaction to acquire shares in Universal Music Group, though the transaction ultimately was not consummated. The plaintiffs also allege in two of the cases that the entities affiliated with the SPAC sponsor are “investment advisors” subject to the requirements of the Investment Advisors Act of 1940 because they provide advice to the SPAC regarding “the advisability of investing in, purchasing, or selling securities.”
On Aug. 19, Mr. Ackman’s Pershing Square announced that while it believed the litigation was meritless, Pershing Square Tontine Holdings would be liquidating, thereby returning proceeds to shareholders, and instead pivot to a “SPARC” structure. The primary difference between the two structures is that the public receives warrants to acquire shares in future in a SPARC. As such, a SPARC does not require investors to put up any money until a merger target is identified.
Assertions in the Recent Complaints
The Investment Company Act establishes three different bases for an entity to be considered an “investment company,” two of which are relevant to the claims in the litigation. First, an investment company is an entity that is primarily engaged, or proposes to engage primarily, in the business of investing, reinvesting or trading in “securities.” Second, an investment company also can be an entity engaged in or that proposes to engage in the business of investing, reinvesting, owning, holding or trading in securities, and owns or proposes to acquire “investment securities” exclusive of government securities and cash items) having a value exceeding 40% of the value of such issuer’s total assets (on an unconsolidated basis).
Focusing on the first definition of “investment company,” the plaintiff alleges that, counter to the representations and disclosures made by the defendant SPACs that their purpose is to identify an operating company and combine with it, the real purpose of the SPAC is to invest in securities, at least at the outset.
The complaints then challenge various transactions between SPACs and their sponsors and directors as illegal under the various provisions of the Investment Company Act and the Investment Advisors Act, including because (1) the SPAC was not registered as an Investment Company, (2) the management company was not registered as an Investment Advisor, (3) various transactions between the SPAC and SPAC sponsor were not made available to all investors, and (4) the SPAC directors were not elected by the shareholders.
The arguments made in most of these cases are not unique to the defendant SPACs. Rather they relate primarily to structural features that are near universal among SPACs. As such, the assertions in the plaintiffs’ arguments essentially allege that every SPAC in the market is operating illegally. If these arguments are accepted, then it will be much more difficult for SPACs to operate because the SPACs will become subject to the complex regulatory scheme and obligations imposed by the Investment Company Act. And entities advising sponsors on potential transactions will be subject to the equally complex requirements of the Investment Advisors Act.
However, the plaintiffs’ arguments are counter to the law, as well as decades of accepted practice by regulators, legal practitioners and the financial markets. Indeed, in the nearly three-decades that SPACs have been in existence, there have been over 1,000 SPACs that have undergone SEC review and completed their IPOs; we are not aware of a single one that has registered as an investment company under the Investment Company Act. Nor are we aware of any enforcement action taken by the SEC to prevent a SPAC from proceeding on its IPO on the basis that the SPAC was an unregistered investment company – in fact, leading law firms advising SPACs routinely provide opinions that the SPACs are not investment companies.
SPACs are Not Investment Companies
Fundamentally, the plaintiffs’ assertions and allegations are not credible; SPACs are not investment companies that should be registered under the Investment Company Act. This is because they simply do not fit into the basic definition of an investment company.
Why?
First, SPACs are not “primarily” engaged in the business of investing, reinvesting or trading in securities. As clearly disclosed in every SPAC’s IPO prospectus, a SPAC’s primary business purpose is to seek to effect a business combination with one or more businesses within a specified period of time (typically 18 to 24 months). Contrary to traditional investment companies, SPACs do not spend the bulk of their time tending to the short-term investments into which its IPO proceeds are invested. Rather, 100% of their time is spent on sourcing and evaluating potential de-SPAC opportunities. Further, if the SPAC fails in its primary purpose, it is required to liquidate and return the proceeds to its public shareholders, another clear sign that a SPAC’s primary purpose is identifying and combining with an operating company, not investing in securities.
Second, as the plaintiffs themselves concede, nearly all of a SPAC’s assets are invested in U.S. Treasurys or other short-term securities – securities that by definition are not “investment securities” as defined by the Investment Company Act. As stated above, a SPAC holds the money it raised in its IPO in a trust account invested in Treasurys and money market accounts, with the money only allowed to be used in connection with effecting a de-SPAC transaction or funding redemptions to public shareholders in the event of a liquidation. The SEC itself has previously noted in commentary regarding regulations related to blank check companies that “the limited nature of the investments, and the limited duration of the account” mean that “such an account will neither be required to register as an investment company nor regulated as an investment company.…”
Third, the SPAC structure was purposefully designed to avoid becoming subject to the Investment Company Act. For example, SPACs typically ensure that they deploy at least 80% of their IPO proceeds in the de-SPAC transaction and do not invest those proceeds in minority positions in businesses. Where SPACs do technically acquire a minority interest in a company (such as where the de-SPAC transaction is effected via an “up-C” structure, which is common where the target’s equity holders hold their interests in the target via a tax pass-through entity, such as an LLC, and wish to preserve that structure), the de-SPAC is structured so that the SPAC nonetheless will control the de-SPAC target post transaction and thereby avoid the target’s securities being deemed “investment securities.”
BigLaw Weighs In
Plaintiffs’ assertions and arguments have been rejected by nearly all leading transactional firms in the United States.
On Aug. 27, a group of over 50 law firms – a list that includes nearly all leading transactional firms operating in Texas, including Akin Gump, Baker Botts, Gibson Dunn, Greenburg Traurig, Kirkland & Ellis, Latham & Watkins, Shearman & Sterling, Sidley Austin, Simpson Thacher, Skadden Arps, Vinson & Elkins, Weil Gotschal, White & Case, Willkie Farr and Winston & Strawn, as well as other leading firms such as Cravath, Paul Weiss, Ropes & Gray and Wachtell Lipton – issued a joint statement that they view the assertion that SPACs are investment companies is without factual or legal basis: “SPACs… are engaged primarily in identifying and consummating a business combination.…” Furthermore, under longstanding interpretations of the Investment Company Act, “any company that temporarily holds short-term treasuries and qualifying money market funds while engaging in its primary business of seeking a business combination with one or more operating companies is not an investment company.”
The full statement can be found here.
Specifically, the law firms stated that they believe a SPAC is not an Investment Company under the Investment Company Act if it (1) follows its stated business plan of seeking to identify and engage in a business combination with one or more operating companies within a specified period of time and (2) holds short-term treasuries and qualifying money market funds in its trust account pending completion of its initial business combination.
Because the plaintiffs’ arguments and assertions were so contrary to decades of plain language of the Investment Company Act, long-settled regulatory guidance and interpretations, decades market practice, the joint statement was issued because those firms believed the market and regulators needed and deserved a clear, unambiguous and reassuring statement from the transactional legal community.
SPAC Practice Going Forward
The law firm statement reflects the widely held view that SPACs are legitimate investment vehicles that have and will likely continue have – and indeed should have – a place in U.S. capital raising for the foreseeable future.
That is not to say that there cannot be improvements to the SPAC structure. In fact, market forces have already been remediating many of the perceived excesses of earlier SPACs.
Already, we have seen an evolution by SPAC boards, sponsors and PIPE investors in the manner in which potential de-SPAC targets are vetted. In addition, SPAC sponsors are increasingly sharing their economics with other stakeholders, including PIPE investors and de-SPAC target companies, thereby further eroding arguments of disparate interests among SPAC sponsors and other investors.
Finally, the SEC has indicated it is evaluating disclosure rules around SPACs, and the SEC may weigh in further with additional guidance that would further address some of the concerns of investor advocates seeking increased disclosure.
Ultimately, while they may not continue to dominate the U.S. capital and M&A markets, it is clear that SPACs will continue to be a staple of the U.S. financing world, and while there may be changes that may be sought – incremental or structural – to SPACs as a result of market forces or regulation, deeming SPACs investment companies is not – and indeed, should not – be one of those changes.
Alain Dermarkar is an M&A partner at Shearman & Sterling in Dallas. His practice focuses on national and international mergers and acquisitions, takeover preparedness and special purpose acquisition companies (SPACs).
Bobby Cardone is an M&A partner at Shearman & Sterling in Dallas. His practice focuses on mergers and acquisitions and other corporate matters for public and private companies and private equity firms.
Daniel Lewis, Bill Nelson and Ann Marie Cowdrey also contributed to this article.