On March 31, 2021, the Securities and Exchange Commission (SEC) provided public statements from Acting Chief Accountant Paul Munter and from the Division of Corporation Finance addressing Special Purpose Acquisition Companies (SPACs). Although each of the statements were distinct and addressed different issues, the primary focus of both was to raise awareness of critical accounting, financial reporting and governance considerations that a private operating company should carefully consider and address prior to consummating a business combination with a SPAC.
SPACs are shell companies that raise capital through an initial public offering (IPO) for the sole purpose of acquiring a privately held operating company. The SPAC’s business combination with the target is commonly referred to as the “de-SPAC” transaction. As a result of the de-SPAC and related transactions, the target company becomes a publicly listed company with additional capital to pursue its corporate strategy and the SPAC shareholders, who do not choose to redeem their shares, will own shares of a publicly traded operating company. As Mr. Munter’s statement notes, SPACs have been used for decades as a way for private companies to enter the public markets, but they have increased dramatically in popularity in recent months. In fact, as of April 8, 2021, there have already been over 300 SPAC IPOs during 2021, as compared to around 60 and 250 SPAC IPOs during all of 2019 and 2020, respectively.
Statement from Paul Munter
Given the recent explosion in SPAC IPOs and the resulting dramatic increase in de-SPAC transactions, it is worth carefully reviewing the risks and challenges associated with de-SPAC transactions. Mr. Munter’s statement identifies five categories of key considerations related to a private company entering the public market by merging with a SPAC:
- Market and timing considerations
- Financial reporting considerations
- Internal control considerations
- Corporate governance and audit committee considerations
- Auditor considerations.
Market and Timing Considerations
SPACs can bring private companies into the public markets more quickly than a traditional IPO, but there can be risks associated with speeding up the process. Mr. Munter notes that many SPAC acquisition targets may be at an earlier stage in their development compared to companies that pursue a traditional underwritten IPO. For that reason, these businesses may not be as prepared to handle the scope and intensity associated with the substantial increase in regulatory requirements, attention from the press and analysts, fluctuations in market value and increased liability risk.
Given the speed at which a target company becomes a publicly listed issuer, it is essential that target companies have a detailed plan in place to address these demands that aligns with the accelerated timeline of a de-SPAC transaction. Prior to consummating a de-SPAC transaction, target companies should thoroughly evaluate the functions they have in place to meet SEC filing, audit, tax, governance and investor needs following the de-SPAC transaction. The combined company will need a capable, experienced management team that understands public company reporting and internal control requirements and expectations.
Financial Reporting Considerations
Target companies often encounter complex issues when accounting for and reporting a merger with a SPAC. Given these accounting complexities, the combined public company will need finance and accounting professionals with substantial public company experience, sufficient knowledge of the relevant reporting requirements and adequate staffing to meet deadlines to file the current and periodic reports required of public entities. Particular issues that may require significant experience and good judgment include:
- Whether financial statements should be prepared in accordance with U.S. Generally Accepted Accounting Principles (GAAP) or in accordance with International Financial Reporting Standards.
- Public company disclosure requirements.
- Identifying the entity in the merger that should be treated as the acquirer for accounting purposes.
- Accounting for earn-out or compensation arrangements and complex financial instruments.
- Applying GAAP standards to accounting and reversing previously-elected Private Company Council accounting alternatives available to private companies.
- Determining effective dates to adopt recent accounting standards that may allow a slower adoption timeline for private companies.
Internal Control Considerations
Public companies are generally required to maintain internal control over financial reporting (ICFR) and disclosure controls and procedures (DCP). Target companies must understand the ICFR and DCP requirements and have a plan in place to comply with those requirements on a timely basis after becoming public companies. Management generally needs to conduct an annual evaluation of its ICFR and is required to evaluate the effectiveness of a public company’s DCP at the end of each fiscal quarter (or, in the case of foreign private issuers, each fiscal year).
Corporate Governance and Audit Committee Considerations
It is crucial that boards have a clear understanding of their members’ roles, responsibilities and fiduciary duties, and that management understands its responsibilities for communicating and interacting with the board. Composition of the board is always crucial, but particularly so in the post-merger publicly traded company. Generally, board members should possess the right level of experience and they should be prepared for key committee assignments, including to the audit committee. Additionally, a portion of the board members must be independent from the organization.
In his public statement, Mr. Munter noted that “[s]trong, effective, active, knowledgeable, and independent audit committees significantly further the collective goal of providing high quality, reliable financial information to investors and our markets.” Clear and effective communication between the audit committee, auditor and management is crucial to setting expectations and proactively reacting as reporting, control or audit issues arise during and after the de-SPAC transaction process. An audit committee made up of members with well-rounded and relevant skills and backgrounds can only enhance such communication.
While historical audits of the target company may have been performed under another standard, the target company’s annual financial statements should be audited by a Public Company Accounting Oversight Board (PCAOB) registered public accounting firm in accordance with PCAOB standards and compliant with both PCAOB and SEC independence requirements. With respect to independence, the general standard applies to all periods included in the registration statement. Under the general standard, an auditor is not independent if he or she would be in a position of auditing his or her own work or if he or she acts as management, among other things.
Additionally, an auditor should consider whether the appropriate acceptance and continuance procedures have taken place when a formerly private target company intends to go public through a de-SPAC transaction. The compressed timing and complexity of a de-SPAC transaction may require the audit firm to adjust its engagement team relative to a traditional IPO in order to ensure the team has the appropriate level of expertise and experience with SEC and PCAOB requirements.
Statement from the Division of Corporation Finance
Addressing similar topics to those discussed by Mr. Munter and detailed above, the statement from the Division of Corporation Finance focused on issues that stakeholders should carefully consider in connection with the de-SPAC transaction, including:
- Shell company restrictions
- Books and records and internal controls requirements
- Initial listing standards of national securities exchanges.
Shell Company Restrictions
As shell companies, SPACs are subject to certain restrictions under securities laws. Some restrictions that the Division of Corporation Finance highlighted included the following:
- Within four business days of the consummation of the business combination, financial statements for the acquired business must be filed pursuant to Item 9.01(c) of Form 8-K. The 71-day extension that is typically available under Item 9.01 is not available to SPACs.
- The combined company cannot use Form S-8 to register compensatory securities offerings until at least 60 days after filing current Form 10 information, usually through a so-called “Super 8-K.”
- Until three years after completing the business combination, the combined company cannot, among other things:
- Incorporate reports required by the Securities Exchange Act of 1934 (the “Exchange Act”) or proxy or information statements filed pursuant to Section 14 of the Exchange Act, by reference on Form S-1.
- Qualify as a well-known seasoned issuer.
- Use a free writing prospectus.
- Use a term sheet free writing prospectus.
- Conduct a roadshow that constitutes a free writing prospectus, including electronic roadshows.
- Rely on the safe harbor of Rule 163A from Securities Act Section 5(c) for pre-filing communications.
Books and Records and Internal Controls Requirements
In addition to the ICFR and DCP requirements that Mr. Munter discussed in his public statement, the combined company will also have to comply with the “books and records” provision of the Exchange Act, which requires issuers to maintain books, records and accounts in reasonable detail that accurately and fairly reflect the issuer’s transactions and dispositions of its assets.
The internal controls and books and records provisions apply to SPACs before the de-SPAC transaction and also generally to the combined company after the de-SPAC transaction. When planning a de-SPAC transaction, the SPAC and the target private company should consider these requirements because the target private company may not have prior experience dealing with them and may not have the appropriate resources allocated to doing so moving forward. Once the de-SPAC transaction is consummated, the combined company will need the necessary expertise, books and records and internal controls to provide reasonable assurance that it will timely and reliably file its financial reports.
Initial Listing Standards of National Securities Exchanges
To remain listed on a national securities exchange after the de-SPAC transaction, the combined company must satisfy quantitative and qualitative initial listing standards upon consummation of the de-SPAC transaction. Any material risks associated with delisting could trigger disclosure requirements for the combined company.
Quantitative standards require that the combined company meet minimum standards regarding the number of round lot holders, the number of publicly held shares, market value of publicly held shares and share price.
Qualitative standards include requirements regarding having a board of directors made up of a majority of independent directors, an independent audit committee consisting of directors with specialized experience, independent director oversight of executive compensation and the director nomination process, and a code of conduct applicable to all directors, officers and employees. A target private company that has not prepared for an IPO and that is quickly acquired by a SPAC may run the risk of not meeting these standards. Advance planning may be required to assemble all of the necessary elements.
As SPACs continue to increase in popularity and billions of dollars flow into these vehicles each month, the SEC has increased its focus on protecting investors in connection with SPAC IPOs and de-SPAC transactions and has continued to take action to educate investors with respect to critical SPAC investment considerations. The statements discussed above follow the release in December 2020 of disclosure guidance from the Division of Corporation Finance discussing disclosure considerations for SPACs in connection with their IPOs and subsequent de-SPAC transactions and an investor alert from the SEC’s Office of Investor Education and Advocacy (OIEA) seeking to educate investors about investing in SPACs. In March, as celebrities increasingly engaged with SPACs, the OIEA issued an additional investor alert cautioning investors against making investment decisions related to SPACs based solely on celebrity involvement. We can expect more to come from the SEC as the SPAC market continues to evolve.