Council of Institutional Investors cites major investor protection concerns as amicus in SPAC case

By Lene Powell, J.D.

The Council of Institutional Investors (CII) has filed an amicus brief in one of three high-profile lawsuits on behalf of a SPAC investor brought by former SEC Commissioner Robert Jackson, Jr. In the association’s view, special purpose acquisition companies (SPACs) raise significant investor protection concerns due to a “fundamental” misalignment of interests between SPAC sponsors and public investors. The brief cites specific concerns with SPACs, including share value dilution and disproportionately high compensation paid to SPAC sponsors relative to risk (Assad v. E.Merge Technology, November 12, 2021).

Jackson-Morley SPAC lawsuits. In August 2021, a shareholder sued three SPACs in lawsuits brought by former SEC Commissioner Robert Jackson Jr. and Yale Law professor John Morley. In the lawsuit against Pershing Square Tontine Holdings and the other two SPACs, the shareholder asserted that the SPACs are functioning as unregistered investment companies in violation of the Investment Company Act. According to the complaints, structuring the companies as SPACs rather than as investment companies has allowed the defendants to extract compensation in forms and amounts that violate federal law.

In an unusual joint public statement, 49 top law firms criticized the Jackson-Morley lawsuits, later growing to a total of more than 60. The firms asserted that a SPAC’s typical practice of temporarily holding investor funds in short-term treasuries and qualifying money market funds while engaging in its primary business of seeking a business combination with one or more operating companies does not make it an investment company under the 1940 Act.

The firms added that more than 1,000 SPAC IPOs have been reviewed by the staff of the SEC over two decades and have not been deemed to be subject to the 1940 Act.

CII investor protection concerns. In its amicus brief filed in the E.Merge Technology suit, CII said it neither embraces nor rejects the SPAC model as a vehicle for companies seeking to access public capital markets. However, CII believes that the current SPAC model presents significant concerns for investors.

CII said its concerns arise from what it views as the core problem, namely, the misalignment of interests between a SPAC’s sponsor and public investors in a SPAC IPO.

“This misalignment is fundamental and exists regardless of the quality of the target company, the price that the SPAC sponsor negotiates to pay for the target company, and the target company’s ultimate success as a public company,” wrote CII.

According to the association, these concerns are particularly significant given the growing prominence of SPACs in the IPO market. According to a research report by a CII affiliate, during the first quarter of 2021, SPACs accounted for 70 percent of all IPOs and 67 over of overall IPO market value. In contrast, in 2017, SPACs represented just 7 percent of IPOs and 2 percent of overall market value. (See previous Securities Regulation Daily coverage for more details on the SPAC boom.).

Share value dilution. CII’s concerns fall into main areas: share value dilution and compensation. CII points to four sources of dilution:

• The “promote”, which dilutes the cash raised in the SPAC IPO;
• “Warrants” to purchase shares at a future point in time;
• A sponsor’s ability to demand and receive additional shares at no cost to maintain a fixed percentage of share ownership; and
• the underwriting fees associated with the IPO taking the SPAC public.

CII noted that from an investor’s standpoint, it is not possible to calculate the actual degree of dilution until after the de-SPAC has occurred. In the E.Merge Technology case, the SPAC has not yet identified a target. But academic research suggests the costs can be significant. According to a study cited by CII, costs embedded in the SPAC structure are “much higher” than those for a traditional IPO to bring a company to market, even accounting for underwriters’ underpricing shares in an IPO. And, SPAC investors tend to disproportionately bear these costs.

“SPAC shareholders that hold shares at the time of a merger, as opposed to the shareholders of target companies, tend to bear SPAC costs and as a result experience steep post-merger losses. This explains the current attraction of SPACs to their targets, but it is not a sustainable situation,” the study authors stated.

Compensation. CII noted that the completion of a merger transaction could make the E.Merge sponsor’s $25,000 investment worth more than $100 million for what may be little more than two years’ work.

Although SPAC sponsors do take financial risks and incur costs, the defendants make too much of these points, said CII. A 2020 survey on SPAC liquidations found that since 2009, 92 percent of all SPACs managed to complete a merger deal; only 8 percent of all SPACs had to liquidate for failing to close such a deal.

“[D]efendants’ emphasis on the ‘all or nothing’ nature of SPAC compensation requires some context. A 92% success rate is nothing to sneeze at,” wrote CII.

Of course, said CII, not every SPAC merger will yield a 6000 percent return on an investment of $25,000 (not counting expenses), but the disconnect is still there. Moreover, the misalignment of interests is of even more of a concern in a market where there may be too many SPACs chasing too few quality targets, yet the two-year clock is always ticking. In this environment, a SPAC may strike a merger deal that the SPAC might pass up in a less heated market.

Inadequate disclosure. In conclusion, the current disclosure regime may provide inadequate information to investors considering a SPAC investment, said CII.

This is Docket No. 1: 21-CV-7072 (JPO).