SPACs – Hedging Risks in Light of SEC’s Urge for Market Slowdown

Special purpose acquisition companies (SPACs), or “blank check” companies, have been one of the most popular investments and investment vehicles over the past year – an alarming 308 SPACs have gone public since the start of 2021. In particular, SPACs have played a major role in supporting the marijuana funding boom since the cannabis industry faced a drought in late 2019. In just the first three months of this year, three SPAC initial public offerings have totaled over $570 million.

However, signals glaring from the U.S. Securities Exchange Commission (SEC) have attempted to slow down the momentum of the SPAC market. A few of these public statements so far this year include:

  • A public statement in March 2021, by Paul Munter, Chief Accountant of the SEC, highlighting the complexities encompassed by the trustworthiness of the SPAC financial reporting, governance and quality of audits.
  • A public statement on April 8, 2021, by John Coates, Director of the SEC’s Division of Corporation Finance, indicating that SPAC’s compliance with disclosure and filing requirements are in the close purview of the staff, and underscores legal liability corresponding to SPAC disclosures once a target is acquired.
  • A public statement made on April 12, 2021, by both Coates and Munter, questioning the financial and accounting disclosure for SPAC warrants.

In light of the SEC’s call to question proper compliance that can survive regulatory examination, both investors and SPACs must be mindful of financial disclosures and vigilant due diligence review. Some prudent actions include, without limitation:

  1. Careful Consideration of Accounting Standards Contemplated by Warrants Issued by SPACs. It is important for a SPAC that has issued warrants to have a solid accounting team, sensitive to the complex application of various provisions in the Accounting Standards Codification with respect to distinguishing liabilities from equity and evaluation of whether such warrants are liabilities. Generally, a warrant that is not properly indexed to the underlying shares of stock of the SPAC, among other circumstances, would disqualify the warrant from equity classification and cause potential risks for material misstatements in contravention with securities regulations and disclosure requirements.
  2. Conduct Your Own Initial Diligence. Investors interested in a potential investment with a SPAC should conduct their own due diligence review of the blank check company at the outset. It is important to understand the purpose and strategy of the SPAC, the terms with other investors, and the financial structure of the investment.
  3. Follow-Up Diligence Upon the Acquisition of a Target. Following the initial investment, investors should determine whether it meets their investment objectives to stay with the SPAC once the business combination target is announced. Key to this diligence process is review of the target business, its management team, and its reputation within its industry. Particularly in the cannabis space, risks in the market and how the target company’s financials would measure against public scrutiny are key concerns.
  4. Understand Risks Involved in the SPAC’s De-Listing From a U.S. Based Trade Exchange. Cannabis investors should also be aware that following the announcement of a target company, many cannabis SPACs will plan to migrate and list upon a foreign national trade exchange where marijuana is legal at a national level due to the federal illegality in the U.S.
  5. Prepare Against Stormy Weather. Whether you stand on the company side or on the grounds of the investor group, it’s crucial to guard against potential SEC enforcement actions, which often render large costs and high risks, as well as private litigations from poorly executed disclosures, SPAC IPO suits, securities class actions, mergers and acquisitions suits and/or bankruptcy proceedings (only available to non-cannabis SPACs).

For more information on SPACs, see “Navigating the SPAC Trend in the Cannabis and Hemp/CBD Market.”