SEC’s Latest Move to Curb SPACs May Slow but Won’t Stop Market

Last week, the Securities and Exchange Commission issued a letter indicating the agency plans to put forth new accounting guidelines. The guidance noted that warrants, as currently structured in most SPACs, will likely need to be classified as liabilities (as opposed to equity instruments) for accounting purposes. Warrants are essentially long-term options giving the holder of the warrant the right to buy more stock at a specified price. While many, including corporate finance attorney Doug Ellenoff (Partner, Ellenoff, Grossman & Schole), view the prospective change as little more than an accounting headache, one well-respected industry stakeholder (who asked to remain anonymous) suggested that the SEC would gain tighter influence over the SPAC market over time, saying they thought this move on warrants could well be a first salvo. By instituting this change, the SEC has essentially slowed down the formation of SPACs, and it has increased the scrutiny on the warrant element of most SPACs. Once the sponsors of SPACs make the necessary adjustments, the influence of warrants would be more visible under the new accounting treatment.

Our Take: To be clear, this is not the first initiative the SEC has undertaken in an attempt to cool the once red-hot SPAC market. As Ellenoff noted, back in November “[former SEC chairman] Jay Clayton made some comments, and there have been at least five different announcements in 2021 alone [intended] to have the same effect. The warrant liability accounting treatment that came in last Monday is further indication the SEC wants to influence the market and impede the speed at which deals are being processed.”

It’s not clear why the SEC chose to home in on warrants. But the accounting changes seem to have gummed up the registration process and may well result in a more educated retail investor. As it stands, many retail investors, buying stock a week after a company IPOs, are likely aware of public warrants and how they work (because they are stapled to the stock and benefiting from them). However, they are not paying attention to—or may not fully understand—the dilutive effects of sponsor warrants.

Our unnamed industry stakeholder suggested that by making it more difficult for a new SPAC to gain approval with warrants, the SEC could both trim the number of sponsors looking to capitalize on the craze (as it becomes harder to get an IPO done) and reduce the sheer number of new SPACs formed (eliminating or reducing warrants would reduce sponsor upside). The thinking is high-quality operators with strong deal flow may be more efficient and more likely to find transactions that are suitable, while making a SPAC less attractive to athlete/celebrity sponsors or those who might jump in simply in hopes of making a quick buck. SPAC sponsors who wish to gain SEC approval quickly may also opt not to have sponsor warrants (which could help to protect the retail investor).

While the SEC’s efforts may affect the formation of new SPACs, for existing SPACs the changes in accounting methodology are likely to amount to little more than a nuisance. Sponsors will have to restate all of their historical financial statements and have their audit on 2020 financials redone. Warrants will need to be marked to market each quarter on the balance sheet, and because there is no market when warrants are issued, the issuer will have to get them appraised (historical appraisals will also be needed). But all of that is expected to wash through existing SPACs pretty quickly once the rules come in.

Ellenoff agreed that the SEC released the warrant liability statement last week in part because they are concerned the SPAC market may have moved too quickly and without, in their judgment, the proper corporate governance to protect the investing public. “The week before, they put out a statement about projections,” he said. “A week or two before that, they put out a statement about celebrity involvement in SPACs. So, it’s clearly a coordinated publicity campaign to send a message to the market that they want participants in the SPAC market to take their roles and responsibilities very seriously.”

But the corporate attorney does not foresee accounting changes having a material impact on the formation of new SPACs. “It is going to result in a substantial waste of time by many hundreds of SPACs to revise and restate their historic accounting statements for a non-cash charge that I don’t believe a single prudent investor cares about,” Ellenoff said. “Furthermore, it will not dissuade any future sponsors who want to form a SPAC. It will harm existing public investors who have backed a SPAC, who have identified a proposed business combination, by delaying or causing that deal from proceeding in a timely manner or possibly from being consummated at all. There are those that like to believe this is an attack on smaller deal guys. It’s not. It’s a warning to the broader SPAC community to process all deals as if it were an IPO and to undertake the requisite diligence and valuation work.”

For the record, Ellenoff does not believe there are a lot of “promoters,” who are sponsors of SPACs. He believes that most SPACs are formed by legitimate PE, VC and business executives. “Should the brokerage community properly vet sponsors? Of course. Will there be some less than ideal candidates? Yes. But those that don’t respect proper process and procedure should be taken out to the woodshed for any non-compliance. Have I observed a pervasive level of abuse or concern? No. Moreover, there is nothing about warrants that would stop that,” he said.

Moreover, Ellenoff does not think the SEC efforts will have any meaningful impact on the SPAC industry. “There are always solutions to accounting issues,” he said. “It’s not going to affect the ability to create private warrants. As an industry, we will have to revise some of the terms to make them non-transferable or swap private warrants with identical public warrants. But there will be warrants issued to sponsors, both large institutional investors and smaller institutions.” He reasoned there are too few public companies relative to the capital available for market investment, which the SPAC mechanism is effectively solving for. Thus, it is unlikely the accounting measure will do anything other than slow the market for a spell.

Ellenoff suggested the bigger concern for SPACs right now is how to fix public warrants so that they can retain the equity accounting treatment of the warrants rather than have them deemed liabilities for accounting purposes. “Various professionals (including all of the major law firms) have been working collaboratively to respond to the SEC’s concerns about public warrants and believe that there are a variety of different solutions.” At the time of publication, the suggested language has not yet been approved by the SEC.

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