Investor Jeremy Grantham says special purpose acquisition companies, which raise money in an initial public offering and then find a promising company with which to merge, are a “license to rip investors off.” On an investing podcast in February, the co-founder of Boston’s GMO complained: “It’s a testimonial to the sloppiness and slow-moving nature of the SEC that they haven’t banned these things long ago.”
Such criticisms will have stung the U.S. Securities and Exchange Commission, whose core mission — besides aiding capital formation — is to protect the investing public and the integrity of financial markets.
I’ve written plenty about why SPAC financial disclosures, incentives and due diligence are problematic and how inexperienced retail investors risk being left holding the bag. Blank-check companies have raised an astonishing $170 billion in North America in the past 12 months, so it’s potentially a very large bag.
With the nomination of Gary Gensler to lead the SEC, America’s financial policeman has become much more assertive. The SEC isn’t banning SPACs, but what began as gentle reminder to investors not to gamble on a blank-check company solely because a celebrity is involved, has morphed into a more comprehensive examination of the SPAC structure.
A succession of verbal interventions on various aspects of SPAC behavior could have a chilling effect on new issuance. The SEC is throwing sand in the wheels of the capital-formation process, perhaps deliberately. Such caution isn’t without downsides — it wasn’t long ago that we were complaining that not enough technology companies were going public — but it’s appropriate given the magnitude of the SPAC boom and potential harm to shareholders.
The latest broadside came on Monday when the SEC issued new advice on the accounting for share warrants, which SPACs issue to persuade investors, often hedge funds, to seed them with capital.
I won’t dwell here on the arcane matter of whether warrants should be treated as equity instruments, as they have been until now, or rather as a liability, as an SEC official suggested is appropriate in some instances. It’s surprising these accounting questions are only emerging now given that SPACs have been around for years.
Stumbling Blocks
The important bit is that after the SEC’s comments, SPACs will have to consider whether they’ve erred when they published previous financial statements, and if so whether they need to restate them. This will make SPAC accountants, financial advisers and lawyers pretty queasy and it’s not the only regulatory stumbling block they’re now facing.
Last week a senior SEC official warned SPACs not to assume they have blanket freedom to publish potentially misleading statements about their future financial performance. He was referring to a legal stipulation that all but prevents companies going public via the traditional IPO route from making similar rosy forecasts. Until now SPACs have interpreted those rules as not applying to them. My view is such projections are often far too optimistic and are being used to justify wildly inflated valuations.
The SEC’s increased assertiveness comes at a particularly sensitive moment for the SPAC market. New IPOs have already slowed to a trickle because of rising bond yields and an oversupply of SPACs seeking deals.
Critics will carp that the SEC is closing the gate too late, while SPAC fans will say any hiatus caused by tougher regulation will deprive companies of the equity capital they hoped to raise to fund jobs and investments in clean technology (many SPAC-backed firms are in the electric-vehicle industry). If too heavy-handed, regulators risk further inflating the cost of the director and officer insurance that SPAC sponsors must purchase. They may also provide succor to class-action lawsuits that allege SPAC investors have often been misled.
There’s a balance to be struck, but after such an epic boom it makes sense to try to slow things down a little. The heavy involvement of inexperienced retail investors in trading SPACS adds to that urgency. International financial centers such as London, which are mulling adapting their regulatory regimes to attract more SPAC issuance, will be watching the U.S. approach closely.
There are hundreds of SPACs looking for merger targets. Bankers, lawyers and the SEC are already swamped with filings to submit and review. A pause will help the market mature and may prevent some very green investors from losing their shirts.