Home Finance Three Areas of Focus for Compliance Teams as New SPAC Regulations Loom

Three Areas of Focus for Compliance Teams as New SPAC Regulations Loom

by internationalbanker
By Steve Brown, Managing Director & Head of Business Development, StarCompliance





Investor interest in special purpose acquisition companies (SPACs) exploded in 2020 as private companies in various sectors sought to bypass the traditional IPO process. The number of SPAC IPOs in 2020 and 2021 outpaced previous years by about 500%. While the volume continues to rise, the pace slowed in the second quarter of 2021 after the SEC announced its consideration for new guidance on SPAC IPOs.

A merger with a publicly traded shell, or “blank check” company, might offer some unique advantages to a private firm looking to go public, but the transaction could raise many accounting and reporting concerns. That was the impetus behind the SEC actions last spring, and new Chairman Gary Gensler recently hinted that more aggressive SPAC regulations could be on the horizon.

Indeed, some SPACs have already faced regulator ire. The SEC announced its first enforcement action on July 13, 2021, against all parties involved in one proposed SPAC transaction: the SPAC and its sponsors and CEO, as well as the proposed merger target and its founder and CEO. The action addressed misleading claims about the target’s technology and national security risks associated with the target’s founder and CEO, highlighting the SEC’s focus on investor protection.

Regulators in the EU and Asia have already issued rules and guidelines to allow the issuance of SPACs in those jurisdictions, and it’s unlikely that deal activity will come to a complete halt in the United States. As such, compliance teams must understand the risks that these entities can pose to their firms.

How regulators view SPACs

Global regulators’ recent statements and actions underscore some of the specific areas that compliance teams should focus on when it comes to SPACs.

First is the potential misalignment of interests and incentives between SPAC sponsors and shareholders. SPACs form when a sponsor provides seed capital to pay for the shell company’s expenses as it seeks a target — in the form of an already operating private company — for merger or acquisition (the de-SPACing transaction). To raise more capital, SPACs sell units of securities to the public that typically include one share and one warrant for a portion of a share. Shares are redeemable upon completing a de-SPACing transaction or the expiration of the SPAC’s lifecycle if the SPAC and target company don’t make a deal.

Warrants, the complex financial instruments at the center of the SEC’s concerns, can be bought and sold on the public market or redeemed for stock following a transaction. Investors are betting that sponsors will be able to find and execute a deal before the SPAC lifecycle ends, at which point their warrants would become worthless. If a deal is made, sponsors, whose shares typically constitute a 20% equity stake in the SPAC, stand to profit immensely — even if the deal is bad for investors, which points to the second area of concern.

The SEC expects sponsors to conduct the appropriate due diligence on potential acquisition targets and provide adequate disclosures to shareholders. This is important for M&A advisors to keep in mind. They should always investigate potential red flags identified during legal reviews, financial assessments, accounting, and the due diligence process to ensure the accuracy of public statements about the target.

Finally, the SEC is adamant that any potential risks related to the target company are clearly articulated, and that retail investors have access to the suitability analysis conducted by the sponsors.

Old risks from a new source

In many ways, the compliance risks posed by SPACs are similar to those posed by traditional IPO and M&A transactions. However, those markets are better defined, and expectations among issuers and advisors are generally better understood. Though SPACs have been around since the 1990s, their resurgence means that compliance and legal teams should work closely with their bankers and sales personnel to develop and implement appropriate policies and procedures. Firms cannot overlook potential internal conflicts at the employee or firm level.

The SEC has sent letters to a number of investment banks seeking information on SPAC deal fees and trading volumes, controls over regulatory compliance and insider trading, due diligence processes, and disclosure of compensation of SPAC sponsors. Given the likelihood that tougher SPAC regulations are coming, firms should focus on the following three areas in particular:

  1. Insider trading and employee monitoring

There has yet to be a landmark SPAC insider trading case, which means firms must rely on existing case law and practices to determine the best course of action for preventing one. Firms should proactively assess their investment banking, capital markets, and asset-management business units to uncover any possible loopholes in their compliance programs. Now is also the time for compliance teams to thoroughly review their control room technology capabilities and capacity to capture market data for comparison with watch and restricted lists as well as firm, customer, and employee trades.

  1. Due diligence and public disclosure

Firms must continually monitor the SPAC landscape to identify companies that pose unacceptable risks. They should evaluate SPAC sponsors and perform comprehensive background checks on company personnel (and executives at target companies) and ensure that these entities have adequate personal account dealing and insider trading monitoring procedures.

That evaluation should include a review of personal account dealing with preapproval questions to identify any potential conflicts of interest. Likewise, compliance teams should review training procedures to ensure that sponsors and target company personnel understand insider trading rules.

In reviewing disclosure statements, firms must strive to confirm that SPAC management teams’ assumptions are reasonably based and that all compensation and incentives for advisors and management team personnel are clearly communicated to investors. Firms that don’t already have standards for due diligence, risk assessment, and valuation in connection with both the de-SPAC transaction process and any related private investment in public equity (PIPE) must establish them quickly.

  1. Conflicts of interest

There are many potential SPAC-related sources of conflicts of interests, including situations in which a bank or firm:

  • Underwrites and also advises the SPAC
  • Provides M&A advisory to assist the SPAC with finding a potential target or advises the target from a sale-side perspective
  • Assists the SPAC with a PIPE offering
  • Writes research on the SPAC or the sector on which the SPAC is focused
  • Trades or makes a market in the SPAC
  • Has employees that invest in the SPAC or the sector on which the SPAC is focused
  • Has affiliates that provide lending, trust, cash, or wealth and asset management services to the SPAC or its officers
  • Has board interlocks between the firm and the SPAC
  • Employs personnel with outside business interests, private investments, or other relationships with the SPAC or sector on which the SPAC is focused

If a simple analysis of deals, transaction parties, and mitigating factors reveals a potential conflict, firms should determine whether they need to update their policies to address it. Compliance teams will also need to work with the relevant counterparties, such as business and legal, to identify the best way forward: disclosure, consent, abstaining from the opportunity, etc. As with any other scenario, conflicts of interest are not inherently bad, provided that firms properly identify, manage, and disclose the situation.

The recent explosion of interest in SPACs doesn’t create novel compliance risks for firms, but that’s no reason to rest on your laurels. As Gensler suggested, new SPAC-related rules and regulations are bound to surface soon, and staying on top of compliance as they do will require having adequate processes and procedures in place well ahead of time.


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