SPAC of Everything: Challenging Financial Regulation in Times of Crisis

By the end of 2020, more than 240 special-purpose acquisition companies (SPACs) listed in the U.S. (on NASDAQ or the NYSE), raising a record $83 billion, according to SPAC Research. SPACs have already surged past last year’s record in the first quarter of 2021, raising $98.1 billion. These numbers are eye-catching. In 2007, the average size of a SPAC initial public offering (IPO) in the U.S. was $183 million. By 2019 the average size has increased to $228 million and between 2020–2021 the average is $394 million. Why are SPACs suddenly so popular?

SPACs Defined

SPACs are cash-shell companies set up, as the name indicates, with a special purpose: to conduct an acquisition. SPACs seek funds on the primary market through an initial public offering (IPO). They issue units composed of common share and warrants. SPAC managers or sponsors usually acquire 25% of the capital raised for a nominal value (often $25,000). Usually, all warrants in a SPAC are tradable and detachable until the moment of business combination.

IPO funds are held on trust or deposited in an escrow account. Subsequently, once the SPAC completes the envisaged business combination, funds are released. This phase is also defined in the specific SPAC jargon as “De-SPAC,” and ends in a liquidation of the vehicle. Generally, the release of funds must occur within 24 to 36 months, depending on the exchange and the jurisdiction in which the SPAC is listed. A possible extension of the liquidation date can happen, although a proxy solicitation to consent to the life-extension can be expensive for the promoters (i.e., investors in the SPAC). In case of a failure of the acquisition or business combination, the SPAC winds up and the funds are returned to investors.

SPACs as Risk-Free Investments

SPACs are risk-free for their initial investors. In fact, investors are guaranteed full redemption of funds from the trust or escrow account until the acquisition or combination materialises.[1] Furthermore, SPACs rely on market practices and self-regulation, rather than statute. Indeed, nowadays no statutory definition of SPACs has been provided by American exchanges through their listing requirements and any applicable securities regulation.

The SPAC: An American Financial Innovation  

In the 1980s, SPACs were named “blank check companies,” and they were listed on the Penny Stock Market (PSM) where they performed “pump-and-dump” schemes. Consequently, the Securities and Exchange Commission (SEC) issued Rule 419 and, in 1990, the U.S. Congress enacted the Securities Enforcement and Penny Stock Reform Act (PSRA). The Act imposed minimum regulation standards as well as the requirement that the IPO funds had to be held in trust until completion of the business combination. PSRA set the acquisition period at 18 months and entitled dissenting shareholders to a redemption right. As a result, the blank check companies disappeared from the PSM. They re-appeared in 2003 first on unregulated venues such as the OTC, then AMEX, and then in regulated markets such as the NYSE and NASDAQ. In those markets, SPACs did not issue penny stocks, but were voluntary complying with Rule 419 such as the trust account rule, the release of at least 80% of funds held in trust, the requirement of minimum capitalisation, etc. This evolution is referred to as SPAC 2.0, and it was reflected in markets’ regulation both at the NYSE and NASDAQ.[2]

Subsequently, in 2015, they evolved further and de-coupled the right to vote from the right to redeem shares. Indeed, in connection with the De-SPAC phase, SPACs are required to offer shareholders the right to redeem their public shares for a pro-rata portion of the proceeds held in trust. This possibility was originally reserved only to shareholders who voted against a proposed business combination. Since 2015, SPACs offer the ability to redeem their public shares to every shareholder by virtue of a mandatory redemption offer. This does not apply to warrants. This means that investors now can vote in favour or against the business combination and still have the possibility to redeem their shares, and keep only the warrant. This shift in practice can be referred to as SPAC 3.0.

Furthermore, between 2019 and 2020, the fractional warrant practice became more regular even though it was first introduced in 2007 through the SPAC of Liberty Media Acquisition Corp. This means that each warrant entitles the holder to purchase one common share and each unit is comprised by one share and a fraction of one warrant. In other words, it introduces an incentive to buy more shares to be entitled to have one full warrant. This can be seen as SPAC 3.5.

The table below summarizes the evolutionary transactional trends in the SPAC spectrum:

Evolutionary Transactional Trends in SPACs
SPAC 2.0Abide by SEC’s Rule 419 (80% funds held on trust, redemption rights for shareholders, etc.) despite its non-applicability
SPAC 3.0Decoupling of the right to vote from the right to redeem shares
SPAC 3.5Fractional warrant structure

Conclusion

The boom that made 2020 the “Year of the SPAC” started to cool in April 2021, following warnings from the SEC. As I have argued, those warnings are based on possible misconceptions about SPACs. I argue that SPACs are the second coming of the IPO or IPO 2.0. Tight financial regulation is not always the appropriate solution to mitigate risks posed by financial innovations. Think of the 2007–2010 crisis when a lack of proper regulation of the over-the-counter (OTC) derivatives market and subprime mortgages prompted the enactment of legislation focused on financial stability effects rather than on underlying triggers. As a result, the risks posed by derivatives markets today are still high despite an important increase in regulatory practices.

Overregulation can be and is generally considered a “game-killer” of financial innovations (for instance, cryptocurrencies and crowdfunding practices). SPACs are dominated by the mantra of self-regulation and in doing so, act against common wisdom in investing. According to common thinking, stricter rules should equal better investor protection. This is not applicable in financial innovation and within the complexity of contemporary financial markets. SPACs are the primary example that shows how innovation has become a market segment on which investors can bet as much as they do in commodities, stocks, and bonds or private debt. Furthermore, SPACs have paved the way for the inclusion of retail investors in what originally was accessible only to institutional investors in late-stage venture capital financing (think of a SPAC that is investing in a promising company or zero-revenue company such as Arrival in the UK).

SPACs 3.0 and 3.5 show the dynamicity of these investment vehicles, and how they can increase markets’ liquidity despite the austerity and price volatility characterizing the post-COVID-19 era. SPACs’ numbers demonstrate that there is an actual market for SPACs with liquidity and proper volumes, and that they represent money creation vehicles.

Indeed, the COVID-19 pandemic has imposed a dramatic re-formulation of the rule of law, giving way to a more flexible and dynamic form of regulation where traditional instances of statutory law are unable to provide answers to new legal issues. Since their origin, SPACs have never been regulated by a statute, but rather by market practices. The subsequent evolution of these market standards has been recognised by exchanges and most importantly, investors. However, SPACs 3.0 and 3.5 have not yet been prescribed either by an exchange or a regulator. Indeed, the NYSE and NASDAQ rules have only codified the emergence of SPACs 2.0.

It is possible that SPACs can become a plausible substitute for traditional IPOs in the future because promoters bear sustainable costs in terms of compliance and underwriters’ fees, units are sold as low as $10 in US or €10 in Europe, and market liquidity is endorsed towards a renascence of equity instruments. As opposed to a SPAC in 2007, the 2020–2021 SPACs are remarkable for their new reputation. For the first time, important underwriters are acting as bookrunners and co-managers (including Citigroup, UBS Investment Bank, JP Morgan, etc.) Furthermore, there has been a shift in the quality of the teams that are sponsoring SPACs (e.g., Bill Ackman, Goldman Sachs, Michael Klein, Douglas Braunstein, Chamath Palihapitiya, etc.) and there is a higher quality of investors in terms of important hedge funds. This is only part of the secret success story. SPACs are one of the most remarkable forms of capitalism: they are a form of financing, and so far they represent a unique alternative acquisition model as well as an alternative path to traditional IPOs.

Daniele D’Alvia is the CEO and Founder of SPACs Consultancy Ltd. and a Teaching Fellow in Banking and Finance Law at Centre for Commercial Law Studies (CCLS) at Queen Mary University of London

[1] Daniele D’Alvia, Milos Vulanovic, The Promise and Limits of a SPAC Revolution (September 2020), Bloomberg Law Professional Perspective. 

[2] Daniele D’Alvia, The International Financial Regulation of SPACs between legal standardised regulation and standardisation of market practices (2020) 21 (2) Journal of Banking Regulation, 107–204. 

One thought on “SPAC of Everything: Challenging Financial Regulation in Times of Crisis

  • Some of the regulation that resulted from the great recession did, in my view, improve safety – – by improving transparency of OTC derivatives markets for example. Part of the credit freeze in late 2008/early 2009 was due to a lack of information – – no one, not even regulators, knew “who was exposed to who and for how much”.

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