Comments from the SEC(nut) Gallery: SEC Comment Letters Focus on SPAC Conflicts of Interest

November 08, 2021

Ever since the SPAC market exploded in late 2020 and early 2021, the SEC has sounded alarm bells through investor alerts, staff statements and public comments.  In March of 2021, it warned investors not to invest in SPACs just because of celebrity endorsements. In April, an SEC staff announcement said SPACs needed to account for warrants as liabilities, not equity, which led to many SPACs slamming on the IPO brakes and to post-combination companies restating their financials.  And when Gary Gensler took over as SEC Chairman in April, he promised further scrutiny of SPACs.

Greater scrutiny has arrived in the form of the SEC review process as reflected in comment letters over the last few months relating to SPACs.  The SEC selectively reviews filings made under the Securities Act of 1933 and the Securities Exchange Act of 1934 to monitor compliance with applicable disclosure and accounting requirements. After reviewing a filing, the SEC will send a comment letter to the issuer with detailed comments regarding critical disclosures that appear to conflict with SEC rules or accounting standards, as well as disclosure that appears to be deficient in explanation or clarity. The SEC doesn’t evaluate a transaction’s merits from an investment perspective.

Companies generally respond to each comment in a response letter back to the SEC and, where appropriate, in amendments to its filings.  Comment and response letters are kept confidential until the SEC has completed its review, at which point they become publicly accessible on the SEC’s EDGAR system.

The SEC could issue comment letters at two different junctures in a SPAC life cycle.  First, in connection with the S-1 filed to cover the shares to be issued in the IPO, and then, assuming the SPAC identifies a target, in connection with the S-4 registration statement relating to the business combination or “de-SPAC” transaction.  Because the SPAC is by definition a shell company at the time of its IPO, the far more interesting comment letters are the ones relating to the business combination S-4.

Recent comment letters sent to SPAC sponsors relating to proposed business combinations reveal the SEC’s enhanced focus on conflicts of interest inherent in most de-SPAC transactions.  For examples, see here, here and here.  The following are three conflict of interest comments that have appeared in several SPAC comment letters, followed by the ways in which sponsors have been responding.

Please revise to quantify to the extent known the interest of the SPAC officers and directors in the business combination. For instance, we note the reimbursement of out of pocket expenses, working capital loans, and the continuation of [SPAC director] as a director of the post-combination company.

In response to this comment, sponsors have added more detail into the right of SPAC board members to be reimbursed for out of pocket expenses in connection with identifying, investigating and consummating a business combination; conversion of working capital loans made by the sponsor and SPAC officers and directors to the SPAC; and the expected dollar amount of board compensation that will be paid to SPAC directors who continue as directors of the post-combination company.

We note your risk factor that the sponsor, certain members of the Board, and officers of [the SPAC] will benefit from the completion of a business combination. Please revise to highlight that these parties may be incentivized to complete an acquisition of a less favorable target company or on terms less favorable to shareholders rather than liquidate.

In response to this comment, sponsors are disclosing in tabular format the public shareholders’ and the SPAC’s initial shareholders’ (including the sponsor’s) investment per share and how these compare to the implied value of a share of post-combination company common stock upon completion of the business combination.  Often, the implied value of the post-combination company common stock represents a decrease from the initial public offering price of $10.00 per public share, but a significant increase in value for the sponsor and other insiders relative to the price they paid for their founder shares.

Sponsors are also adding language to the valuation information above to the effect that in light of the foregoing per share value analysis, the sponsor and insiders holding holding founder shares may be economically incentivized to complete an initial business combination with a riskier, weaker-performing or less-established target business, or on terms less favorable to the public shareholders, rather than liquidating the SPAC.

We note that your charter waived the corporate opportunities doctrine. Please address this potential conflict of interest and whether it impacted your search for an acquisition target.

Every SPAC following its IPO engages in the business of identifying and combining with one or more targets.  But the SPAC’s sponsor and officers and directors are typically affiliated with other entities (operating companies or investment vehicles) engaged in a similar business, including other SPACs.  Those officers and directors may become aware of business opportunities that may be appropriate for presentation to both the SPAC and the other entities to which they owe fiduciary or contractual duties.  It’s fairly common for a SPAC’s certificate of incorporation to renounce the SPAC’s interest in any corporate opportunity offered to any director or officer unless the opportunity is expressly offered to the individual solely in his or her capacity as a director or officer of the SPAC and the opportunity is one the SPAC is legally and contractually allowed to pursue and it would otherwise be reasonable for it to pursue, assuming the director or officer is permitted to refer that opportunity to the SPAC without violating any legal obligation.

The common rationale for the “corporate opportunity” waiver is that in the absence of the waiver, certain candidates would not be able to serve as an officer or director, and the inclusion of the waiver provides greater flexibility to attract and retain the best officers and directors.

In response to the comment, however, sponsors have been adding to the foregoing disclosure that the personal and financial interests of the directors and officers may influence their motivation in timely identifying and selecting a target business and completing a business combination. Further, the different timelines of competing business combinations could cause directors and officers to prioritize a different business combination over finding a suitable acquisition target for the SPAC. Consequently, directors’ and officers’ discretion in identifying and selecting a suitable target business may result in a conflict of interest when determining whether the terms, conditions and timing of a particular business combination are appropriate and in the public shareholders’ best interest, which could negatively impact the timing for a business combination. Sponsors then state whether they believe any such conflicts of interest impacted the SPAC’s search for an acquisition target.