SPAC Sponsors, PSLRA Lead Plaintiffs, and Sunk Costs

So the SEC dropped a couple of hundred pages of proposed new rules governing SPAC transactions. 

I’d say the rules fall into three categories: 

First, there are the ones meant to harmonize the regulatory framework for SPACs and for more traditional IPOs, both in terms of requiring disclosures akin to those in the IPO context, and in terms of imposing similar liability regimes, so that SPAC target companies will be vulnerable to Section 11 liability, financial advisors that shepherd the de-SPAC process will be treated as underwriters, and the PSLRA safe harbor will be unavailable for de-SPAC related projections.

(That last point is tricky: As the SEC acknowledged in its release, and as Professor Amanda Rose points out in a paper, because the de-SPAC is a merger, companies may essentially be required to include projections, like the ones that underlie financial advisors’ opinions, in their proxy statements.  Which would mean, unlike in a traditional IPO, there would be no minimizing liability exposure simply by failing to include projections in the SEC filings.  Couple that with Section 11 liability and it could be pretty intense.  That said, the SEC is proposing to require issuers to include climate-related forward-looking information in registration statements, where no safe harbor would apply, so there is that to even the scales.).

Second, there are the ones meant to address the particular pathologies of SPACs, namely, their conflicts of interest, which encourage sponsors to pursue even bad deals over liquidation, and the dilution that public shareholders suffer as a result of the promote, the redemptions, and the warrants.  And the SEC deals with these the way it deals with most things: extensive new disclosure requirements, including ones regarding conflicts, dilution, and SPAC-specific requirements for the basis of any projections.  Many of these, drawn from the take-private rules, are disclosures meant more to force governance improvements than to actually reveal information, like disclosure of the fairness of the transaction, whether a majority-of-the-minority vote is required, and whether the independent directors had their own counsel to negotiate the deal on behalf of public stockholders.

Third, there’s the investment company thing.  Professors Robert Jackson and John Morley have filed lawsuits against a couple of SPACs arguing that their variation from the SPAC structure – or just their delay in finding a merger partner– rendered them investment companies.  The SEC proposes to formalize when a SPAC will avoid becoming an investment company, namely, if they keep the current form (no variations, like Bill Ackman proposed), sign a deal in 18 months, and close in 24.

Now, we all know that the SPAC market has cooled significantly; it operated like a speculative bubble for a while, along with meme stocks and joke cryptocurrencies, but a lot of that sheen has worn off, which means we may see less … umm… hasty work in the future and fewer outlandish projections, even without the new rules.

That said, the SPAC form still suffers from inherent incentives for SPAC sponsors to merge even with poor-quality firms.  Sure, yes, the sponsor will prefer a high-quality target to a poor-quality one, but sometimes a high-quality target is hard to find, and in those instances, the sponsor would prefer the chance of a payout with the poor-quality firm to liquidation.

Professors Michael Klausner and Michael Ohlrogge have a paper where they discuss at length how sponsor earnouts – which are supposed to mitigate these conflicts by only allowing sponsors to receive additional shares if the post-merger trading price hits certain targets – are almost comically weak.   They offer some suggestions for reform, for example, by encouraging more cash investment by the sponsor and shortening the earnout time periods, though they admit their proposals would only remove incentives for extremely bad deals, and not incentives for just, you know, mildly bad ones.  I was fortunate enough to see Michael Ohlrogge present this paper (and Amanda Rose present hers) at Vanderbilt’s Law & Business Conference in March, and one of the things he mentioned was that it’s easy to incentivize people to work hard to find a good deal, but it’s more difficult to incentivize people to admit failure.

Which made me think that this problem is not unlike the lead plaintiff/counsel problem in securities cases.  I previously talked about this here, and the issue is that plaintiffs’ attorneys in securities class actions are incentivized to seek lead counsel status, with an institutional client as a proposed lead plaintiff, relatively early in the case, before expending the time and funds on a full investigation.  Once they’ve secured the lead spot, that’s when the real investigatory work begins, but at that point, even if the investigation turns up nothing, it’s very hard to admit that, drop the case, and confess error to the client.  So, they’re incentivized to pursue cases that, by then, even they know are pretty weak.

I don’t have a solution for this problem in the securities class action context but I can offer one for SPACs, though even I’m not sure I like it: If we want to incentivize a behavior, we have to actually incentivize it.  In this case, if the behavior we want to encourage is getting sponsors to seek liquidation when there are no good mergers to be had, then maybe there needs to be a payout for that.  Smaller than what they’d get for a good merger, obviously, and we’d need layers of independent-review protections to ensure that sponsors made serious efforts to identify a likely target, and the money would have to come out of the liquidation payments to investors (which would make the SPAC form less attractive for that reason alone, but also might encourage greater diligence from the initial investors), but at the end of the day, maybe the way to get people to admit failure is to pay them to do it.