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March 18, 2024

Economic Perspectives on the Role of Information Disclosure in SPACs

Author(s): Marc Martos-Vila

Originally Published by Business Law Today (August 10, 2022)

A ruling in In re Multiplan Corp. Stockholder Litigation accepting the relevance of misstatements in a Special Purpose Acquisition Company (“SPAC”) transaction continues to highlight the role of information disclosure in corporate financing. SPACs are public shell companies whose purpose is to acquire a privately held company within a given time period. This business combination transaction (known as the “de-SPAC” transaction) effectively allows the private company to become publicly traded.1 In denying motions to dismiss, the Court considered the allegation that SPAC’s fiduciaries (including the SPAC sponsor and board of directors) misstated certain information about the business combination. The SPAC investors, the Court argued, would have been “substantially likely to find this information important when deciding whether to redeem [their shares ahead of a proposed acquisition].”2 As I will explain further below, the redemption right alluded by the Court is a typical feature of SPACs.

The Chancery Court’s decision is also related to commentary and research on the role of information disclosure in SPACs. Some have argued that an advantage of SPACs over IPOs stems from the view that the Private Securities Litigation Reform Act (“PSLRA”) safe harbor for forward-looking statements applies to SPACs as opposed to initial public offerings (“IPOs”).3 The logic is that under this safe harbor protection, SPACs are able to provide forward-looking statements to investors that make the subsequent business combination transactions more attractive, compared to IPOs.4

However, even if this perceived advantage did contribute to the rise in SPACs in 2020–21, others are skeptical about such advantage. Among them is the Securities and Exchange Commission’s former Acting Director of the Division of Corporation Finance John Coates, who, in a statement delivered while in office, argued that “liability risks for those involved [in SPACs] are higher, not lower, than in conventional IPOs.”5 Mr. Coates went on to contend that this is particularly true due to “the potential conflicts of interest in the SPAC structure.”6 A March 2022 SEC proposal along the same lines would require companies to increase disclosure related to conflicts of interest, compensation, and dilution costs related to SPAC transactions.7

This article provides economic and financial insight to help frame the role of information in SPAC transactions.

Information Asymmetries in Corporate Finance

Information disclosure serves a clear economic purpose, which is to help alleviate the asymmetry of information between investors and company insiders. Nobel prize recipient George Akerlof used the term “market for lemons” in the used car sales market to illustrate the harm that information asymmetries cause.8 Akerlof argued that sellers of used cars have more knowledge about their quality than potential buyers. Because buyers cannot tell cars’ quality apart, the price at which these cars sell must be the same irrespective of true quality. But then the seller of a good quality car would receive less than the true value of the car. He concludes that “bad cars drive out the good because they sell at the same price as good cars.”9 If left unattended, the market breakdown caused by asymmetric information results in less commerce.

The same issue arises in corporate finance. Investors typically know less about the quality of a given asset compared to those who manage it. To solve information asymmetries and alleviate their cost, a host of contractual solutions, economic institutions, and regulations exist. For example, the IPO underwriting process provides a certification role that entices investors to participate in the IPO even when they have less information than the company insiders.10 Similarly, in the context of mergers and acquisitions, the acquiring company conducts exhaustive due diligence before completing the acquisition of its target. Finally, regulation and government agencies establish disclosure requirements, registration statements, and monitoring aimed at alleviating the cost of information asymmetries.11

Information asymmetries are relevant because the two sides of the trade have different objectives. Going back to Akerlof’s example of a used car, its seller wants to obtain the highest price whereas a prospective buyer wants to pay the lowest price possible. Investors and company insiders might have misaligned incentives as well. For example, CEOs might undertake extravagant investments or engage in self-dealing behavior.12 This is why a CEO’s compensation package often includes stock options. A CEO only benefits from public stock options when the company’s stock reaches a certain level. To the extent that shareholders prefer a higher stock price, stock options can contribute to aligning CEO and shareholder incentives.13 I next explain how misalignments between investors and company insiders might apply in the context of SPACs, specifically between SPAC sponsors and its investors.

The Role of Information Disclosure in SPACs

SPACs are not immune to the asymmetry of information and diverging interests that exist in financial markets. First, SPAC investors likely have less information about acquisition prospects in general, and the ultimate target investment company specifically, compared to SPAC sponsors.14 This is so because the SPAC target is a privately held operating company often in a nascent industry. And this is more likely to be true if investors are relatively “unsophisticated” (i.e. retail investors compared to institutional investors). Partly because of this, investors can redeem their shares (at the price paid, plus interest) before the completion of the acquisition. This redemption right provides a hedge against pre-acquisition risk as it allows the SPAC investor to cash the shares and recover the full investment irrespective of the market price of the SPAC share at the time. Furthermore, a recent feature of the last wave of SPACs decouples the acquisition vote from the redemption decision. That is, the SPAC investor can redeem her shares and vote “yes” to the acquisition, if she wishes to do so. Klausner et al. report an average redemption rate of 58% for their 2019–20 merger cohort, indicating that a majority of SPAC shares are redeemed before the acquisition is completed.15

Second, existing literature posits that conflicts of interest between SPAC sponsors and SPAC investors are also likely to exist.16 Initially, SPAC sponsors typically hold 20% to 30% of the SPAC’s equity (the “promote”) in the form of common shares. However, they pay less than SPAC investors for these common shares.17 While having skin in the game typically helps alleviate differing interests between investors and SPAC insiders (as I have argued above with the use of stock options in publicly traded companies), the fact that SPAC sponsors acquire their equity stake at a significantly lower price than SPAC investors can create conflicts. Two observations are worth mentioning here. First, if the SPAC finds no acquisition target companies, the SPAC is liquidated and the funds raised in the SPAC’s IPO, which sit in a trust, are returned to investors (with interest). Because the promote has no redemption rights, SPAC sponsors can only make a profit if the business combination is completed. Second, because SPAC sponsors pay less (per share) than SPAC investors, there is a range of acquisition prices for which SPAC investors earn negative returns whereas SPAC sponsors’ returns are positive. The evidence provided below indicates that this scenario might not be uncommon.

Thus, in the presence of information asymmetries and diverging interests, the role of (credible) information disclosure can play an important role. The safe harbor debate introduced at the beginning of this article can be analyzed in this context. Any credible information about the acquisition proposed by SPAC sponsors is likely to help investors decide to vote in favor of or against the business combination, and whether to redeem the SPAC shares. Forward-looking projections provided in the acquisition prospectus are part of this information set. The evidence summarized below indicates that indeed this information is relied upon by those investors more likely to suffer a bigger information gap vis-à-vis SPAC sponsors.

What Do Current Studies Tell Us About SPACs and the Role of Information Disclosure?

Several studies have calculated annualized returns, a common measure of performance, for SPACs. For purposes of this article, I focused on studies that include the latest wave of SPAC transactions.18 Table 1 below provides average returns reported in three studies. These returns correspond to common shares and do not include returns stemming from any warrants or rights.19 Moreover they are adjusted by the returns on a comparable basket of securities, that is, they are calculated as the SPAC’s excess return over a comparable index.

As shown in Table 1, all studies show that pre-de-SPAC returns are on average positive. In contrast, these studies show average negative de-SPAC returns. In other words, a SPAC investor who redeemed their shares before the acquisition would have more than recovered their investment (consistent with SPAC’s redemption rights), whereas an investor holding onto their common shares past the completion of the acquisition would have, on average, lost money during the first year.

Table 1. Summary of SPAC Performance, by SPAC Period and Study20

SPAC Performance by SPAC Period and Study

The averages above paint only part of the picture as variation across transactions exists. For example, Gahng et al. found that:

    • More reputable lead underwriters are associated with higher SPAC and de-SPAC returns;
    • deals with more potential dilution (based on warrants and rights present in each unit) perform relatively worse in terms of de-SPAC returns; and
    • high redemption rates and longer timelines to close the business combination are both associated with lower subsequent de-SPAC returns.

Turning now towards the issue of information disclosure, studies on SPAC’s disclosure of forward-looking statements report that a majority of de-SPACs provide at least one financial projection. Dambra et al. found that 85% of their sample of SPACs provided revenue forecasts in their investor presentations.21 Blankespoor et al. found that 80% of the transactions in their sample provided at least one financial projection, with revenue and EBITDA being the most common forms.22

Furthermore, Dambra et al. draw several conclusions from their study. First, they found evidence that revenue forecasts are biased overall. Second, they found that “SPAC investors respond favorably to merger announcements as a function of the revenue CAGR disclosed in the investor presentations.”23 Indeed, returns around the time of the investor presentations are larger the higher the revenue growth disclosed in that presentation.24 Third, they found that retail investors engage in more trading when revenue growth forecasts are higher, but they did not find the same pattern when institutional investor trading was analyzed.25 They interpret this result to suggest that such disclosures get the attention of relatively less sophisticated investors.

In summary, economic research performed so far indicates that the average poor performance of de-SPAC transactions highlights the importance of information disclosure to investors, particularly retail investors. Thus, changes in regulation in that regard will most likely dictate the course and popularity of SPACs going forward. The debate generated around the recent SEC proposal is testimony of that.26 Stay tuned.

 

1. For a summary of SPAC features, see Gahng, M., Ritter, J., and Zhang, D., “SPACs”, SSRN Working Paper, January 29, 2021; and Klausner, M., Ohlrogge, M., and Ruan, E., “A Sober Look at SPACs”, Yale Journal of Regulation, forthcoming, 2021.
2. In re Multiplan Stockholders Litigation, consolidated case number 2021-0300 (Delaware Court of Chancery, January 3, 2022) at p. 56. See also, Jacques, F., “The Evolving Landscape of SPACs,” Business Law Today, February 7, 2022.
3. Blankespoor, E., Hendricks, B., Miller, G., and Stockbridge, DJ, “A Hard Look at SPAC Projections,” Management Science, forthcoming, February 2022.
4. Ryan, V., “SPACs – They’re back,” CFO, December 3, 2020.
5. Statement of John Coates, “SPACs, IPOs and Liability Risk Under the Securities Law,” April 8, 2021.
6. Id.
7. Securities and Exchange Commission, File No. S7-13-22.
8. Akerlof, G., “The Market for ‘Lemons’: Quality Uncertainty and the Market Mechanism,” Quarterly Journal of Economics, vol. 84, no. 3, Oxford University Press, 1970, pp. 488–500.
9. Id. at p. 490.
10. For a general discussion, see Tirole, J., The Theory of Corporate Finance, Princeton University Press, 2006, at p. 246.
11. Tirole at p. 246.
12. Tirole at pp. 16-17. Some also argue that CEOs might be overconfident. See Kaplan S., Sørensen, M., and Zakolyukina, A., “What is CEO overconfidence? Evidence from executive assessments”, Journal of Financial Economics, 2021. Whatever a CEO’s objective might be, the implication is that they may undertake actions that are not in the best interest of shareholders unless there are proper incentives in place.
13. Id. at pp. 20-25, where problems with the design of stock options are also discussed.
14. In turn, as in most acquisitions, SPAC sponsors might also have less information about the target private operating company than the target management in place at the time of the acquisition.
15. See Klausner et al. at p. 19. Gahng et al. report a 37% average redemption ratio (p. 57).
16. See Klausner et al. at p. 23. Additionally, the SEC argues that there can be conflicts between non-redeeming shareholders and redeeming shareholders holding onto warrants. See SEC File No. S7-13-22, p. 172.
17. As explained in Gahng et al., “[t]ypically, the units purchased by investors include Class A shares that can vote on a merger and are redeemable. The sponsors purchase Class B shares that do not have voting privileges and are not redeemable but will convert into Class A shares, which will be subject to lockup restrictions, when a merger is completed. The sponsors typically pay a total of $25,000 for 5,000,000 or more Class B shares, a price of about 0.5 cents per share.” (p. 1). On the other hand, SPAC investors typically pay $10 a unit.
18. For earlier studies, see Kolb, J., and Tykvová, T., “Going public via special purpose acquisition companies: Frogs do not turn into princes,” Journal of Corporate Finance, volume 40, 2016, pp. 80-96. See also, Dimitrova, Lora, “Perverse incentives of special purpose acquisition companies, the “poor man’s private equity funds”, Journal of Accounting and Economics, volume 63, issue 1, 2017, pp. 99-120. These studies found de-SPAC underperformance, as explained further below.
19. See Gahng et al. for returns on warrants.
20. Gahng et al.; Klausner et al.; Dambra, M., Even-Tov, O. and George, K., “Should SPAC Forecasts be Sacked?” SSRN Working Paper, January 24, 2022.
21. Dambra et al., p. 3.
22. Blankespoor et al., p. 2.
23. Dambra et al., pp. 18-19.
24. Id. pp. 19-20.
25. Id. pp. 20-22.
26. Zanki, T., “SEC’s proposed SPAC crackdown meets industry resistance”, Law360, June 22, 2022.

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