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The Big SPAC Crackdown

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The Big SPAC Crackdown

Chamath Palihapitiya and Richard Branson’s SPACing of Virgin Galactic in 2019 helped launch a two-year frenzy on Wall Street.
Photo: Justin Lane/EPA-EFE/Shutterstock

The Stable Road Acquisition Corp. is a standout in the wild world SPACs. It’s more than its ironic name. The company, which last October inked an agreement to merge with a space transportation start-up called Momentus, might go down in financial history as a case study in how America’s multiyear SPAC boom finally came to an end.

A SPAC is a shell company that has been created to offer a bare-bones initial public sale and then merge with a real company seeking to go public. It does not require the lengthy process of an IPO. Stable Road, the publicly traded shell company, was married to Momentus, a private start up that boasted a technology that could lift satellites into orbit. Momentus had a valuation of $1.2billion for the combined entity. Momentus has had a turbulent ride since the announcement of the merger. The company was valued at $700 million last month, after a settlement was reached with the Securities and Exchange Commission.

So-called space deals like Momentus became popular in SPAC land after Silicon Valley entrepreneur Chamath Palihapitiya’s initial SPAC (he now has launched several) teamed up with Richard Branson’s Virgin Galactic in late 2019, opening the floodgates on what has become one of the most remarkable financial frenzies in recent memory. Investors have given over $200 billion to publicly traded SPAC shell corporations, which raise money to find companies to purchase. While high-risk startups in the space are often the most prominent, the hundreds upon hundreds of SPAC transactions that have taken place over the past two decades have involved everything from insurance and electric vehicles to cryptocurrency.

The fate of Stable Road’s Momentus deal provides a hint into why we might be seeing fewer SPACs next year and beyond: It was an early victim of what is shaping up to be a crackdown by both regulators and lawmakers. Under the Biden administration and a Democratic Congress, authorities seem keen to close the loopholes that have allowed these complicated financial deals — which often provide huge windfalls to their sponsors and early hedge-fund investors while burning individual investors who get in late to the game — to flourish.

In announcing the settlement with Stable Road, Gary Gensler, the SEC’s new chairman, wasn’t shy about stating his perspective: “This case illustrates risks inherent to SPAC transactions,” he said, adding that the SEC’s actions “will prevent the wrongdoers from benefitting at the expense of investors.”Momentus and Stable Road CEO Brian Kabot paid more than $8M to settle charges against the agency as part of the agreement. “misleading claims about Momentus’s technology”Mikhail Kokorich, a Russian citizen currently living in Switzerland, was not made public about foreign ownership.

One of President Biden’s earliest appointments, Gensler earned a reputation for aggressiveness during the Obama administration, when he led a regulatory effort to rein in the swaps market that almost took down the entire financial system in 2008. The SEC was ridiculed for its inability to prevent the crash of the swaps market during that time. Gensler has stated that he is determined to prevent it from happening again. He has made it a priority to stop the abuses of SPACs, on both the policy side and enforcement.

“The SEC’s paying close attention, and there’s going to be a lot of scrutiny,”David Peinsipp (a partner at Cooley) in San Francisco has advised numerous SPAC clients.

It’s a big change from Trump’s SEC, whose enforcement efforts critics viewed as lax. “The SEC has been moving quickly to investigate suspected issues with these companies,”Nate Anderson, a short seller, is the founder of Hindenburg Research. Since 2020, Hindenburg Research has made fraud allegations against six SPACs. “It’s a very impressive feat to pull off from a regulatory perspective.”

The SEC and the Justice Department are already investigating five of the SPAC companies that Anderson is shorting, including such well-known names as DraftKings, Clover Health — a venture-backed insurance provider taken public by Palihapitiya — and electric truck maker Nikola, whose founder, Trevor Milton, became the public face of alleged SPAC malfeasance after luring investors with a video showing a truck rolling down a hill and claiming it was operating on Nikola’s electric and hydrogen technology. Milton was already indicted by the DOJ, and the SEC for securities fraud.

In the Stable Road–Momentus case, the SEC took action before shareholders even had a chance to vote on the merger of the two entities, which Anderson memorably calls “prophylactic pre-merger enforcement. It is protecting retail investors before they have the opportunity to get harmed.” After more than halving Momentus’s price tag, the merger went through, but 20 percent of its original investors redeemed, and the stock traded below its offering price.

Regardless of a deal’s outcome, SPACs largely are a no-lose proposition for their sponsors, who typically receive 20 percent of the company’s shares for a nominal cost. According to JP Morgan Asset Management, the average return for sponsors during the SPAC boom of nearly two years was 958 percent. Investors in the SPAC’s IPO — typically hedge funds that often redeem their shares at cost while holding onto warrants after a merger is struck — also have an edge. JP Morgan reported that they had an average of 40 percent gain.

A number of studies show that SPACs have caused double-digit losses over the years for most investors. Multiple indices and ETFs that track SPAC stocks show that they have fallen more than 20% since their February peak.

This year’s precipitous decline is a function of a glut of money chasing deals (meaning lower-quality companies are coming public), the inability of these newly public firms to meet their lofty promises, and the chill on the market due to the realization that more regulation and enforcement actions are coming.

Key to this dynamic is SEC chair Gensler, who started his career at Goldman Sachs before going to work in Washington, first in the Treasury Department and later as an adviser on the 2002 Sarbanes–Oxley legislation. Gensler is a rare regulator who understands both Washington’s financial markets as well as how they operate.

“There is no doubt he wants to make it very clear that the sheriff is back in town,”Andrew Park, senior analyst at Americans for Financial Reform (an investor advocacy group) says that he co-authored a letter to Congress earlier this year proposing several SPAC reforms. It claimed that at least one of them would. “tamp down pre-merger hype,”It has been included in draft legislation.

One of the advisers on that letter, Boston College Law School professor Renee Jones, was recently named by Gensler to head the SEC’s Division of Corporation Finance. She joined the SEC in June, and is considered someone who can be trusted. “creative” in maximizing the SEC’s powers.

Although the SPAC boom of recent years is a rare phenomenon, SPACs were created to circumvent a new rule by the SEC. This was to avoid fraud and conflicts of interest that were common among blank-check stocks, which at the time were penny stocks.

SPACs have had a bad reputation for a long time and were used as vehicles by people who didn’t have any other options to go public. They can qualify as mergers to get around the rules regarding IPOs. These rules prohibit forward-looking financial projections in prospectus or during the quiet period (which lasts for 40 days) after shares begin trading.

Audrey Strauss, Manhattan U.S. attorney, highlighted this distinction during the announcement about the indictment against Nikola founder Trevor Milton. She stated that he “took advantage of the fact that Nikola went public by merging with a Special Purpose Acquisition Company or ‘SPAC,’ rather than through a traditional IPO, by making many of his false and misleading claims during a period where he would have not been allowed to make public statements under rules that govern IPOs.”

It’s hardly surprising that these days the most speculative companies choose SPACs for their entry into the public markets. For example, nine electric-vehicle companies became public through a SPAC in 2020, with combined annual revenues of $139 million — but told investors they would generate $26 billion by 2024, according to the Financial Times.

Many companies reduce their revenue projections quickly after the deals have been signed. Some companies have disappointed investors by releasing poor earnings reports.

“We have seen a large number of SPACs that issue incredibly rosy near-term projections, and then almost immediately fall well short of them,”Anderson is a short seller. “And it comes to the point where the question is raised of how much of this is just optimism versus selling retail investors a bill of goods.”

Unlike IPOs — and those subject to the SEC’s rule on blank-check companies — SPAC sponsors, target companies, and their advisers may also be able to take advantage of what’s called the “safe harbor”Provision of the Private Securities Litigation Reform Act of 1996, which could limit investors’ ability to sue them for financial projections.

The House Financial Services Committee’s draft legislation would amend securities laws to get rid of the safe harbor protection for SPACs. The bill, which received bipartisan support, is still in limbo, however, and there’s no assurance it can pass the Senate.

In the meantime, it appears that the SEC is ready to do it all alone, if needed.
John Coates, then acting director of corporate finance and SEC general counsel, made a long public statement in April about the safe harbor issue. He called the claim about reducing liability exposure for SPAC participants “safe harbor”. “overstated at best and potentially seriously misleading at worst.”

For one thing, he noted that the safe harbor provision only applies to private litigation and would not affect the SEC’s ability to bring charges. He also suggested that the SEC could consider a merger between a SPAC and a company an IPO with all of the consequences that this would entail.

If Coates’s comments were designed to slow down SPAC activity, they appear to have succeeded: In the first three months of 2021, 298 SPACs raised $83 billion; since then, 120 more have gone public, raising $39 billion.

Meanwhile, more than 400 SPACs that have already gone public — including some from last year — are still looking for partners, according to industry tracker SPAC Analytics. Even many of those who’ve announced deals may not be able to complete them. As redemptions increase and investors stay away, 80 percent of these companies that are special acquisitions are currently trading below their asking price.

“The SEC is saying, ‘A SPAC acquisition is not really an acquisition, it’s an IPO,’”Douglas Ellenoff of Ellenoff Grossman & Schole, whose law firm Ellenoff Grossman & Schole has been advising SPACs more than a decade. He is concerned that SPACs may be being misused. “stigmatized.”

There’s little doubt in SPAC land that the environment has shifted from the freewheeling days when a social-media maven like Palihapitiya would go on Twitter to promote his deals, bragging that his ability to do so was one of a SPAC’s advantages. Now, at least one of the deals he promoted heavily on CNBC — Clover Health — is under investigation, and Palihapitiya has become more circumspect in his commentary.

 “Coates’s statements have had an impact on how people view the level of protection they’re going to have for a long period of time,”Cooley partner Peinsipp said that the firm has represented Palihapitiya. “A lot of people are feeling nervous about what the regulatory environment requires of them.”

SPACs have two years to find a merger partner before they have to return investors’ money, which means liquidations are no doubt in the offing. Hedge-fund manager Bill Ackman, who launched the world’s largest SPAC, Pershing Square Tontine Holdings, last year with $4 billion, recently told shareholders he might dissolve it. Ackman wants to give investors their money back and grant them warrants on a newly designed security that he argues will be better for investors than a traditional SPAC — if the SEC approves his newfangled instrument.

The latest twist in Ackman’s Tontine drama came just weeks after the SEC flexed its muscles by thwarting his initial plans for the SPAC to take a 10 percent stake in Universal Music through its upcoming IPO, instead of going the traditional route of merging with a private company. Ackman claimed that the New York Stock Exchange approved the plan several months prior, but the SEC said it didn’t meet SPAC guidelines.

Even SPAC supporters admit that slowing down may be a positive thing. “The frenzy led to, frankly, a number of transactions that probably shouldn’t have come to pass anyway,”Alex Vogel is a Washington lobbyist and one of the founders of a new SPAC lobbying organization that is trying to defend the industry in D.C.

And while the loss of the safe harbor protection for SPACs is seen as inevitable, SPAC advisers, big-name investors, and sponsors worry about how far legislation — or the SEC — will go.

The letter to Congress that the SEC’s Jones signed off on also called for bringing SPACs under the SEC’s rule for blank-check companies and extending liability not just to SPAC sponsors but also their underwriters and financial advisers, who have raked in millions of dollars in fees during the boom.

“There’s no doubt to me that there is additional legislation, additional oversight, and it is all coming,” says Vogel. “I do not at all see this issue going away.”

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