Lessons on SPACs From the Enforcement World
By Matt Kelly
Special purpose acquisition companies are all the rage these days as a faster, simpler path for privately held operating companies to go public. There’s just one problem with the SPAC model: neither party involved in a SPAC transaction has much incentive to dwell on effective financial reporting and disclosure controls.
Regulators began demonstrating that point over the summer. First, the Securities and Exchange Commission settled a case against a SPAC for misleading disclosures about an acquisition it was trying to make. Second, the Justice Department opened an investigation into an electric vehicle startup that a SPAC had already taken public for accounting fraud.
Each case demonstrates the perils of SPACs in different ways — and considering the flood of money and deals pouring into the SPAC sector, nobody believes they’ll be the last enforcement actions we’ll see against SPACs, either.
Let’s first review what a SPAC transaction is. The SPAC itself is a publicly traded holding company. It raises money through an IPO first, and then holds those proceeds in trust while the SPAC’s sponsors (that is, the management team) searches for a private operating company to acquire. When the SPAC finds such a target, the two firms “deSPAC” into a single, merged entity that goes forward as a publicly traded operating company.
The catch: a SPAC typically has only 18 to 24 months after its IPO to find an acquisition target. If the SPAC doesn’t close a deal within that window, investors get their money back. So the more time passes without a deal, the more pressure the SPAC feels to close any deal. That’s when corners get cut, and the seeds of future enforcement actions get sown.
So internal control professionals should think long and hard about what the risks in these transactions truly are, and how to anticipate today the compliance and enforcement risks you might encounter tomorrow if a SPAC comes knocking on your door.
Example 1: Disclosure Controls
In July of this year the SEC sanctioned SPAC firm Stable Road Acquisition Corp. and a space technology firm it sought to acquire, Momentus Inc. Why? Because the two firms didn’t properly disclose that Momentus’ proposed satellite technology failed a crucial in-orbit test; nor that Momentus’ chief executive, a Russian national, had been flagged as a U.S. national security risk.
Disclosures for SEC filings typically run through the legal team. Still, the disclosures that SPACs and their targets need to make are voluminous and painstaking — so you’ll need a disciplined approach to cataloging all the potential disclosures, chasing down the details, and storing the information for necessary SEC reporting.
In fact, the SEC warned SPACs and acquisition targets last year about the need for appropriate disclosures to investors, especially about potential conflicts of interest. So whether you are a SPAC or a potential acquisition target, you’ll need to think about the disclosure processes and controls you have in place.
The SPAC and its acquisition target also need to disclose all material risks to the resulting operating company — and this is important because if you don’t disclose those risks properly, the SEC could disrupt your proposed merger. That’s what happened with Stable Road and Momentus: as part of the SEC settlement, private investors that had previously committed to the merger (scheduled for August 2021) had the chance to rescind their interests. Several did, pulling out half the cash they had promised in the original merger agreement.
Example 2: Financial Reporting Controls
We also have the case of electric pickup truck manufacturer Lordstown Motors, which disclosed in July that it is under investigation by the Justice Department for possible misconduct related to its merger with SPAC firm DiamondPeak Holdings Corp. in October 2020. The SEC is also investigating Lordstown for other potential accounting improprieties.
Neither agency has brought any charges against Lordstown or its executives yet. But shareholder lawsuits say the company inflated the figures for pre-sale orders and executives dumped their shares before the market caught wind of trouble. The former CEO and CFO of Lordstown were forced out in June.
The cautionary tale here is about the pressure to close SPAC deals quickly—generally four to six months from the SPAC and its target signing a letter of intent to a completed deSPAC transaction. In contrast, a traditional IPO with investment bankers, audit firms, a roadshow, and all the other trappings might take a year or longer.
If you’re a potential acquisition target, that means you’ll need either to have strong financial reporting controls in place already, or the ability to ramp up a system of ICFR quickly.
For example, you should perform a readiness assessment as soon as your firm announces that a SPAC deal is forthcoming. You’d need systems to identify, test, remediate, and document ICFR. You might need new processes for procurement or payroll, or control environment changes such as better training or more experienced accounting staff.
Consider what that hurry-up treatment of ICFR might look like, and the resources you’d need. The more you lay the groundwork today for a smooth buildup of ICFR, the easier your pre-acquisition due diligence and preparation will be.
None of This Needs to Happen
All too often, the missteps that arise from SPAC deals are rooted in management teams moving too quickly and not building the financial reporting capabilities that a public company should have.
A better course is to develop technology and business processes that will let your firm ramp up its ICFR and disclosure systems quickly. Your high-speed road to life as a public company will be a lot less bumpy.