| November 28, 2021
A new research paper raises disturbing questions about the corporate governance of special purpose acquisition companies (SPACs), and just in time, too — because another, separate bit of research finds that so many SPACs are hitting Wall Street these days that they are single-handedly propping up the number of quarterly filings to the SEC.
Let’s start with the research paper, published Nov. 18 by Michael Klausner of the Stanford School of Law and Michael Ohlrogge of New York University Law School. Their thesis is that the sponsors and board of directors for a SPAC have an inherent conflict of interest with the SPAC’s shareholders. Namely, the sponsors and board always have an economic incentive to support the SPAC merging with a target acquisition company, even if that deal stinks for shareholders.
The conflict arises from the complicated SPAC lifecycle. The SPAC’s sponsors act as the management team, holding an IPO to raise cash from investors and putting together a board of directors that often includes members of said management team. The IPO proceeds are then held in a trust, while the sponsors spend their own money to find a private company to acquire in a “de-SPAC” transaction. They have 18 to 24 months to close a deal, or the SPAC liquidates and the proceeds go back to shareholders.
Prior to SPAC shareholders approving a proposed merger deal, they’re allowed to redeem their IPO shares at a cost of $10 plus interest. If enough shareholders believe the proposed merger is a stinker, they’ll redeem so many shares that the trust account won’t have enough cash to complete the deal. When that happens, the SPAC has to liquidate and its sponsors lose everything.
On the other hand, SPAC sponsors typically get 20 percent equity in the public company that results from a de-SPAC transaction; even in a merger that’s a mess for shareholders, that can still leave the SPAC sponsors sitting on millions in profit.
“In sum,” Klausner and Ohlrogge say, “there is a conflict inherent in the SPAC structure between the sponsor and public shareholders with respect to the sole decision that must be made: to merge or to liquidate.”
That conflict can be avoided, such as by appointing an entirely independent board of directors and paying them only in cash, rather than in equity similar to what sponsors get. But too many SPACs, Klausner and Ohlrogge say, pack their boards with sponsors or their henchmen.
“For SPACs that are organized in this way,” they write, “there is reason for concern that the sponsor and board will propose a merger that is value-decreasing for shareholders, and that they will fail to inform shareholders sufficiently to allow them to protect themselves through the exercise of their redemption rights.”
Meanwhile, SPACs Are Piling Up
We also have a new research note from financial data firm Calcbench. The gang there wanted to know: How many 10-Q filings are pouring into the Securities and Exchange Commission? So they decided to count the total number of 10-Qs filed with the SEC each year for the last decade. (Disclosure: I do paid editorial work for Calcbench. I did not help compile this data, although we did collaborate on the research note.)
Figure 1, below, tells the tale. The SEC received more than 21,000 10-Q filings in 2012. Then the annual total went down, down, down; to a low of 16,963 filings in 2020 — a decade-long tumble of 24.6 percent.
That decline throughout the 2010s should not be a surprise. The number of publicly traded firms on U.S. markets has dwindled for 20 years, mostly due to one publicly traded firm acquiring another or private equity groups taking a publicly traded firm out of the market entirely.
This year, however, the trend reversed course. The total number of 10-Q filings for 2021 is already at 18,679 — a 10.1 percent increase over all of 2020, with a few more weeks of the year still remaining.
Where are all those new 10-Q filings coming from? Calcbench investigated that too. They looked at the change in filers year over year by SIC code. That’s the code all publicly traded firms include to identify their industry, and it gives us a sense of which industries account for how many publicly traded firms there are in any given year.
Figure 2, below, shows the 10 SIC codes with the largest increases from 2020 to 2021.
As you can see, the number of SPACs filing 10-Qs soared this year, far ahead of any other industry type. But there’s more. If you do the math, those additional 438 SPACs translate into an additional 1,752 10-Q filings per year — which is more than the entire increase we’ve seen in 2021 filings, and then some.
In other words, the falling volume of filings to the SEC has finally reversed, and new SPACs are driving it all.
So how does this research from Calcbench relate to the SPACs corporate governance research by Klausner and Ohlrogge? Funny you should ask.
Enter the Litigation and Investor Claims
Klausner and Ohlrogge note in their paper that the Delaware Chancery Court hasn’t yet issued any significant rulings about the governance of SPACs. The first case to come before the court, In Re Multiplan Stockholders Litigation, only reached a courtroom last month when defendants made oral arguments for a motion to dismiss.
In their paper, Klausner and Ohlrogge walk through numerous arguments that SPACs might use to defend themselves against lawsuits from unhappy shareholders; and why those arguments shouldn’t hold any water. I won’t rehash all the details here. Suffice to say, SPACs will try to argue that their unique governance structure shouldn’t be subject to additional judicial review — which would leave aggrieved shareholders with essentially no recourse against SPAC sponsors who might foist a bad deal upon them.
Now put everything together. We have…
- An unclear, but likely significant, number of SPACs with inherently flawed governance structures;
- SPACs surging into the public markets like nothing we’ve seen in years;
- Precious little case law from Delaware to guide disputes between SPAC sponsors and shareholders; and
- Numerous legal theories that SPAC sponsors might try in court that would leave their conflicted governance beyond judicial review.
That sounds like a corporate governance mess to me. Moreover, this mess is separate from the other messes we’re seeing with SPACs, such as poor disclosure to investors and poor internal accounting controls leading to allegations of accounting fraud after a merger.
I have no idea how the Chancery Court might decide In Re Multiplan Stockholders Litigation or other SPAC lawsuits destined to knock on the Chancery’s door. But if the court does leave SPAC shareholders at the mercy of unethical SPAC sponsors, one can easily imagine the SEC revisiting its rules for SPACs (an idea already on the SEC’s rulemaking radar) to remedy such a sorry state of affairs.
Indeed, it’s worth noting that one person Klausner and Ohlrogge thank in the footnotes of their paper is John Coates, who served as general counsel of the SEC from Jan. 20 until October. If Coates is thinking about Klausner and Ohlrogge’s concerns about SPACs, I’d bet a mortgage payment that others in the SEC Division of Corporation Finance are thinking about those concerns, too.
Food for thought as SPAC mania continues into 2022.