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12th May 2022

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A reckoning for Spacs: will regulators deflate the boom?

At the beginning of this year, the space transportation start-up Momentus thought it would be well on its way towards its stated mission of “revolutionising space infrastructure and the space economy”. Instead, regulators intervened.

Three months after Momentus announced a $1.2bn merger with a special purpose acquisition company, Stable Road Acquisition Corp, the Securities and Exchange Commission told the companies they were under investigation for statements made about the transaction, according to filings made public last month.

The merger, which would make Momentus one of the few publicly traded space companies, had been billed in October as a “unique and compelling opportunity” for investors. Momentus projected it would reach more than $4bn in revenues in 2027, including almost $670m in sales from a fleet of robotic vehicles designed to serve large spacecraft.

Those plans are on hold. Because of the ongoing investigation, the SEC has yet to approve filings for the merger proposal. Shareholders will vote on Thursday on whether to give the Spac a three-month extension to complete the transaction, failing which the merger will probably fall through. Momentus declined to comment and Stable Road did not respond to a request for comment.

Momentus could soon be joined in limbo. Spacs, which raise money from investors to search for a company, complete a merger and take it public, have suddenly lost their lustre — not least in the eyes of regulators.

An artist’s impression of Momentus’s Vigoride satellite. The company’s space ambitions are on hold after the Securities and Exchange Commission announced it was under investigation © Momentus

Over the past year, Spacs, once considered a flaky sideshow in the finance world, have become the driving force of capital markets and dealmaking. “Blank-cheque” companies backed by well known figures on Wall Street, as well as celebrities and sports stars, have raised eye-watering sums of money, creating a $142bn pool of capital looking for merger targets. 

However, the boom has recently begun to attract the attention of regulators just as fundraising and dealmaking start to slow from a heady pace earlier this year. People familiar with the thinking of the SEC say it is concerned about multiple facets of Spacs, including their attractiveness to retail investors who may not be well versed in how the companies work, or the lucrative rewards earned by insiders. 

In a series of escalating statements, US securities regulators have raised sharply worded concerns about the recent boom in Spacs, questioning everything from optimistic revenue projections to the involvement of celebrities such as Jennifer Lopez and Alex Rodriguez in the companies. 

The SEC has not brought any cases against Spacs over the past year. But the appointment of Gary Gensler, the former head of the Commodity Futures Trading Commission, to lead the regulator has put the market on edge, with bankers and lawyers anticipating that blank-cheque companies will be a top priority for the new administration. 

“There has not been as much activity as you would have thought in terms of investigations related to Spacs,” says Luke Cadigan, a partner at law firm Cooley and former prosecutor in the SEC’s enforcement division. “That’s going to change dramatically in the weeks and months to come.”

The involvement of celebrities such as Jennifer Lopez and optimistic revenue projections have been on a list of concerns about the boom in Spacs raised by US regulators © Gary Hershorn/Getty Images

One recent statement written by John Coates, acting director of the SEC’s division of corporation finance, suggested that the rosy financial projections associated with Spacs rested on shaky legal ground. Immature technology companies, including a bevy of electric vehicle makers, have relied on the projections to drum up interest from large institutional buyers and ordinary investors who have helped fuel the boom.

Other challenges loom as well. In New York, Spacs face a rising number of shareholder lawsuits, largely alleging that directors breached their fiduciary duty by providing inadequate disclosures at the time of the transactions. Short sellers, who bet on share prices to fall, have also taken aim, alleging fraud at multiple companies that went public through Spacs.

The threats, combined with increased regulatory scrutiny, have contributed to a slowdown in the Spac market, discomfiting a cottage industry of dealmakers, advisers and investors who have benefited from the boom.

In April, fewer than a dozen Spacs completed initial public offerings, the slowest month for Spac issuance since June 2020, according to Refinitiv. Spac mergers, known as de-Spac transactions, have also slowed, as investors pull back from the so-called “Pipe” privately arranged financings that add extra firepower to the deals. 

Those who advocate reform think the reckoning is overdue, having raised concerns to the SEC as early as last year under Trump appointee Jay Clayton, who appeared to take little action until days before his departure.

“I think what we saw with Spacs is a clear recognition that they could get away with this,” says Tyler Gellasch, executive director of the investor trade group Healthy Markets. “The SEC didn’t respond immediately, and so they kept going and pushing the boundaries ever further.”

Column chart of IPO proceeds ($bn) showing Has the Spac market peaked?

Institutional focus

Spacs began booming last year as the stock market recovered from an early pandemic downturn, offering a quick and easy route for promising companies to go public. Spac founders, known as sponsors, latched on to what appeared to be an easy moneymaking opportunity, thanks to the share rewards they received for a nominal price.

The growing market also appealed to large public investors such as BlackRock and Fidelity, which had grown hungry for a new crop of fast-growing companies. By the end of April, nearly 500 Spacs with more than $140bn in assets raised through IPOs were searching for deals, according to Refinitiv data.

However, just as quickly as Spacs raised billions of dollars from eager investors, the market cratered. Two-thirds of blank-cheque companies without an announced deal are now trading below the $10 price at which investors purchase shares during IPOs, in stark contrast to the market’s peak, when Spacs largely traded at premiums.

The Trump-appointed head of the SEC, Jay Clayton. He was notified of concerns about Spacs last year by those who advocate reform but appeared to take little action until days before his departure © Win McNamee/Getty Images

Spac sponsors and advisers say multiple factors contributed to the downturn. Retail enthusiasm for speculative ventures has largely waned, sending shares in some popular companies such as electric truckmaker Nikola and battery developer QuantumScape down by as much as 80 per cent from their previous highs.

Even large institutional investors that helped lend legitimacy to the deal frenzy are taking stock after a record breaking quarter for dealmaking. Some companies have had to settle for a significant reduction in their targeted valuations to secure private financing in recent weeks, people involved in the transactions say.

The SEC’s statements have also had a chilling effect, say market experts. One recent declaration forced Spacs to change how they account for warrants, a key feature that rewards early investors with a cheap option to purchase shares in the merged company. Instead of qualifying as equity, the SEC says warrants should be considered liabilities in certain circumstances, punching a hole into the balance sheets of some Spacs.

BlackRock’s headquarters in New York. The large public investor was attracted by Spacs because it was looking for a new crop of fast-growing companies © Jeenah Moon/Bloomberg

Investigations into conflict of interest disclosures could be coming next, according to people familiar with the SEC’s thinking. Once Spacs have identified a target company, a select group of investors are made privy to market-sensitive information about the deal. 

Regulatory gap

Though Spac founders promised to improve the market’s shady reputation, investor advocates question whether they have any incentive to clean up the bad behaviour. In the US, Spacs exploit what critics view as “regulatory arbitrage” to provide financial projections that companies launching IPOs and direct listings would normally avoid. 

Because de-Spac transactions qualify as mergers, lawyers advise companies that they can present forward-looking statements and be protected from lawsuits under an exemption contained in the Private Securities Litigation Reform Act of 1995.

The appointment of Gary Gensler, the former head of the Commodity Futures Trading Commission, to lead the SEC has put the market on edge, as blank-cheque companies will be a top priority for the new administration © Jose Luis Magana/Reuters

“That is one of the benefits of going public via a Spac, particularly for pre-revenue and pre-commercialisation companies, because it allows them to tell their story in a forward-looking way,” says Andrea Merediz Basham, partner at the law firm Freshfields. “That doesn’t mean that companies have a licence to say whatever they want.”

However, the statement by Coates, the SEC official, questioned whether lawyers had relied on a limited definition of “initial public offering” when advising Spac clients on making projections. If the distinction were erased, Spacs could be subject to lawsuits for forward-looking statements.

Paul Taubman, chief executive of the investment bank PJT Partners, said on a recent earnings call that the Spac market has benefited partly from regulatory arbitrage and he expected activity to decrease as the government intervened. “We’ve always said that we expect over time those benefits — many of them — to be taken away as the playing field becomes levelled,” he said.

When flying taxi start-up Archer announced a February deal to go public in a $3.8bn deal with a Spac backed by US investment banker Ken Moelis, it projected that its revenue would increase by more than $12bn in just six years. The company does not yet have a commercial product and expects to post its first year of revenue in 2024.

Flying taxi start-up Archer has announced a $3.8bn deal with a Spac despite not yet having a commercial product © Jeff Ludes/Archer Aviation

UK electric vehicle group Arrival, which became a public listed company this year following a merger with CIIG Merger Corp announced in November, has projected that its revenue will go from $1bn in 2022 to just over $14bn in 2024. None of the company’s vehicles have hit the market yet. 

The company’s president Avinash Rugoobur, said last year that the technology is now “mature”. “We have had prototypes on the road for two years, and we understand the challenges that are ahead of us,” he said.

Spacs have also managed to skirt regulations for blank-cheque companies, which US securities laws define as companies issuing penny stocks. A law signed by George HW Bush in 1990 expanded the SEC’s oversight of the market but exempted companies selling shares at above $5, giving Spacs a workaround. Under blank-cheque regulations, Spacs would be forced to provide information on the names and addresses of investors in the vehicles, a measure reformers say would help identify who stands to profit or lose money from the vehicles.

Nikola Motor’s CEO, Mark Russell, in front of the Nikola Tre. Shares in the truckmaker have fallen sharply from their previous highs after a dip in retail enthusiasm for speculative ventures © USA Today Network via Reuters

In February, a letter sent to the House Financial Services Committee by the progressive non-profit Americans for Financial Reform called on Congress to expand the blank-cheque company definition and amend securities law to exclude Spac mergers from liability protections. The committee did not respond to a request for comment.

“As long as there’s money to be made in every part of the Spac issuance process, I don’t expect to see changes unless you start to see some more scrutiny,” says Andrew Park, senior policy analyst at AFR. 

Activist opportunities

The Spac market has provided easy targets for short sellers, who say the vehicles allow dealmakers to more easily foist poorly run companies on the investing public.

Three companies targeted by the short seller Hindenburg Research — Nikola, electric-vehicle maker Lordstown and insurance group Clover Health — have drawn attention from regulators.

Lordstown said in March it was responding to an SEC request for information on its Spac transaction and vehicle pre-orders. The insurance company Clover Health, which is backed by Chamath Palihapitiya, also said in February it had received a letter from the SEC. Meanwhile, both the SEC and the Department of Justice have made inquiries into claims levelled against Nikola in the short seller’s report.

Lordstown has yet to issue a formal response to the claims in the report, while Clover and Nikola have both disputed some of Hindenburg’s allegations

The Lordstown Motors Endurance electric pickup truck. The company said in March it was responding to an SEC request for information on its Spac transaction and vehicle pre-orders after it was targeted by short seller Hindenburg Research © Matthew Hatcher/Bloomberg

Short sellers and other market watchers say the speed and ease of Spacs can lead to insufficient due diligence on the part of sponsors, who are incentivised to strike any deal before a two-year deadline or risk losing the cash they invested to set up the shell company.

“The activist short sellers have never had a more robust opportunity set,” says one hedge fund analyst.

Momentus, the satellite company, faces more than just an SEC investigation. The company has told shareholders that the Department of Defense views it as a risk to national security because its co-founders Mikhail Kokorich and Lev Khasis are Russian nationals.

Kokorich, who ran into national security issues with a previous space start-up, stepped down as chief executive two days after Momentus became aware of the issues with the DoD, the company says. Momentus says it voluntarily submitted a notice to the Committee on Foreign Investment in the United States, which has begun a review of the company’s ownership that is expected to conclude by mid-June.

Shareholders now have to weigh Kokorich’s importance to the company as it tries to execute a lofty vision. One Momentus investor presentation cited, as a “long-term growth opportunity”, the possibility of mining water and precious metals from asteroids.

In a statement, Kokorich said Momentus does not raise national security concerns. He said he plans to divest his shares, which have been placed in an irrevocable trust.

SEC’s move

Bankers and lawyers are watching for signals from Gensler, President Joe Biden’s choice for SEC chair. The former Goldman Sachs banker developed a reputation as being tough on Wall Street during his post-financial crisis tenure at the CTFC, taking aim at the opaque swaps market.

The SEC has not brought any enforcement actions against Spacs since 2019, when it settled charges against the former chief executive of Cambridge Capital Acquisition Corp. Officials alleged the executive failed to conduct proper due diligence on a company that manufactured cellular interception products, depriving shareholders of sufficient information about the business. The executive agreed to a cease-and-desist order and a $100,000 civil penalty, without admitting or denying the allegations.

One person familiar with the SEC’s thinking says it is concerned about the way that Spacs present financial projections, with growth targets that appear out of line with business fundamentals. At the same time, the SEC is also considering how it could allow companies going through traditional IPOs to more easily make projections, the person adds.

Some academics and market reformers have asked that the SEC consider more severe changes to the Spac market, calling for bankers to face the same liability risks as they would on underwritten IPOs for their work on Spac transactions. The SEC has sent letters to banks asking for more information on their work with Spacs, say people briefed on the correspondence.

Others think the SEC should focus on structural changes to improve the disclosures Spacs make to shareholders, rather than punishing bad actors after they have already harmed ordinary investors. 

The amount of capital sitting in Spacs has drawn worries that sponsors will not be able to find suitable targets, pushing them towards companies of questionable value.

“We need to really focus on disclosure,” says Anat Alon-Beck, assistant professor of law at Case Western Reserve University in Cleveland, Ohio. “We want to prevent bad transactions from happening in the first place.”

2021-05-04 04:00:30

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