The SEC's Final Rules on SPACs

Introduction

In the early 2020s, Special Purpose Acquisition Companies (SPACs) surged in popularity because they offered a faster and more flexible route to public markets than traditional initial public offerings (IPOs).¹ However, this rise also brought scrutiny. Many investors and regulators felt SPAC disclosures lacked consistency, individuals responsible for organizing SPACs (sponsors) faced conflicts of interest, and some mergers relied on overly optimistic estimates of future financial performance (projections).² As a result, the U.S. Securities and Exchange Commission (SEC) adopted Final Rules on Special Purpose Acquisition Companies, Shell Companies, and Projections in Release No. 33-11265 (Final Rules) in January of 2024.³

The Final Rules were designed to strengthen investor protections and improve transparency of SPAC initial public offerings (IPOs) and de-SPAC transactions. The new framework brings SPACs closer in line with traditional IPO standards, addressing disclosure and accountability gaps for companies entering public markets through SPACs instead of traditional IPOs.

This article provides background on SPACs and de-SPAC transactions, explains the SEC’s rationale behind the new rules, and discusses how the changes affect companies, investors, and the broader market.

Background

What is a SPAC?‍

A Special Purpose Acquisition Company (SPAC) is a type of shell company, meaning that it has no active business operations and generally no assets other than cash and cash equivalents.⁴ It raises money through an IPO with the intention to later merge with a private company, essentially providing a faster alternative route for that company to go public.

Under § 229.1601(b) of Regulation S-K, a SPAC is defined as a company that:

1. Conducts a primary offering not subject to Rule 419 of the Securities Act,⁵
2. Seeks to complete a merger or similar business combination within a set timeframe (usually 24 months), and⁶
3. Returns funds to investors if no combination is completed.⁷

What is a De-SPAC Transaction?

A de-SPAC transaction occurs when the SPAC merges with or acquires a private company, also called the “target.”⁸ After the merger, the target becomes a public company by being the wholly owned subsidiary of the publicly traded SPAC, which then typically adopts a name similar to the target’s name. The newly combined public entity also has access to the funds raised through the SPAC’s IPO.

The SPAC and De-SPAC Process

A typical SPAC lifecycle involves three main stages:

1. SPAC IPO: The SPAC raises money from public investors.
2. Target Identification: The SPAC’s management identifies and negotiates with a potential target company.
3. De-SPAC Merger: The SPAC merges with the target, making the target company public.⁹

For more general information on SPACs, please refer to this article.

Why Did the SEC Issue the Final Rules?

The SEC’s primary goal in issuing the Final Rules was to protect investors. To accomplish this, the SEC identified common dangers faced by investors in SPAC IPOs and de-SPAC transactions. Three of these issues specifically addressed by the Final Rules are dilution of shareholder interests, conflicts of interest among SPAC sponsors and managers, and unreliable projected financial results. 

Dilution

Dilution occurs when a SPAC investor’s ownership percentage decreases throughout the SPACs life cycle due to factors largely outside the investor’s control. The SEC cites several potential sources of dilution, “including: (a) shareholder redemptions, (b) SPAC sponsor compensation, (c) underwriting fees, (d) warrants, (e) convertible securities, and (f) PIPE financings.”¹⁰ The following illustrates a few of these:

• Shareholder redemptions: Investors who elect to redeem their shares and receive cash from the SPAC reduce the funds available for acquiring a target, while the sponsors generally retain the same amount of ownership, warrants, and other compensation. This can leave the remaining investors with a smaller relative share of the SPAC’s assets.
• SPAC Sponsor compensation: SPAC sponsors generally hold about 20% equity ownership in the SPAC, and their ownership may increase if they are also compensated with warrants or with “an earnout component” that gives them more shares if the stock performs well.¹¹ This type of compensation allows SPAC sponsors to receive more equity ownership, thereby reducing investors’ proportional value.
• Private Investment in Public Equity (PIPE) Financing: Institutional investors may offer additional funding to fill gaps in a SPAC’s capital needs through PIPE financing, which often involves purchasing public stock at below market price.¹² Again, this could dilute ownership across more investors and reduce value for existing shareholders.

Despite these issues, some research suggests that SPAC dilution of the cash value of a shareholder’s investment may not negatively affect the value of that investor’s shares following the de-SPAC transaction.¹³ Regardless, potential dilution in SPAC and de-SPAC transactions is clearly a material issue to the SEC and is one of the concerns that led to the Final Rules.

Conflicts of Interest

Conflicts of interest related to SPACs can arise from how SPAC sponsors and management are compensated and when “determining whether to proceed with a de-SPAC transaction.”¹⁴ 

One of the most prominent conflicts of interest results from the difference between sponsors’ and investors’ financial incentives. Investors generally contribute a set amount (usually $10) for one unit of a SPAC, which consists of a certain amount of common stock and warrants. On the other hand, SPAC sponsors are usually granted 20% ownership in the SPAC for a nominal investment because they started the SPAC. This 20% interest is called the “founder shares” or “promote” and often translates into profits for the sponsors if they complete a de-SPAC transaction, even if that transaction is not the most profitable or in the best interests of the public shareholders (who usually hold the other 80% interest).¹⁵ Financial pressure on sponsors is intensified by the time limit placed on the SPAC to complete the de-SPAC merger before it must liquidate and return funds to investors.¹⁶ 

Other conflicts of interest may occur for sponsors if:

• They are involved with other SPACs and must divide their attention,
• They have obligations to other companies that compete with the SPAC or that affect their ability to give full attention to the SPAC, or
• They are incentivized to merge the SPAC with a company they are affiliated with, even if it is not the best option available.¹⁷

The SEC also notes that for underwriters, a large portion of their fees for underwriting the SPAC IPO is often tied to the completion of a subsequent de-SPAC transaction, thus incentivizing underwriters to push for completion of a deal regardless of its quality.¹⁸

Projections

Before the Final Rules, private companies merging with SPACs often included aggressive financial projections in their filings, taking advantage of uncertainty regarding the Private Securities Litigation Reform Act (PSLRA) safe harbor for forward-looking statements.¹⁹ The PSLRA protects companies from liability for projections if those statements are identified as forward-looking and include meaningful cautionary language. 

The PSLRA deliberately excludes forward-looking statements “made in connection with an initial public offering” or “by a blank check company,” but the law does not explicitly refer to SPACs or de-SPAC transactions.²⁰ Despite a SPAC being considered a blank check company immediately following its IPO, some SPAC sponsors argued that once a SPAC identified a target and filed a proxy or registration statement for the merger, the SPAC was no longer operating as a blank check company and could thus rely on the PSLRA safe harbor. Through this rationale, SPACs routinely included optimistic financial projections in de-SPAC filings that investors relied on—projections that would not typically appear in a traditional IPO prospectus.

The SEC noted that investors in de-SPAC transactions were not receiving the same quality of financial information as investors in traditional IPOs, particularly regarding forward-looking projections. This understanding, along with concerns about dilution and conflicts of interest, helped fuel the creation of the Final Rules, as emphasized by Former SEC Chair Gary Gensler when he explained, “just because a company uses an alternative method to go public does not mean that its investors are any less deserving of time-tested investor protections.”²¹

What Do the Final Rules Require?

Overall, the Final Rules require SPACs to provide disclosures and take on liability that more closely aligns them with traditional IPO requirements. The Final Rules also directly address the SEC’s principal points of concern, including dilution, conflicts of interest, and projections. 

Dilution

The SEC now requires companies to disclose information about potentially material sources of dilution. For SPAC IPOs, the SPAC must disclose²² net tangible book value per share, as adjusted. This measure simply helps investors evaluate how their ownership value in the SPAC may change throughout the IPO process and afterward. The Final Rules further require the prospectus front cover page to indicate (1) whether sponsor compensation could materially dilute investors’ equity interests, (2) the current sources of dilution affecting net tangible book value per share, as adjusted, and (3) material potential future sources of dilution.²³

For de-SPAC transactions, similar disclosures surrounding dilution are required, including detailed tables showing dilution at potential redemption levels, relevant terms of any material financing transactions and their dilutive impact, and the amount and associated dilutive effects of compensation paid to the SPAC sponsor, management, and affiliates.

Conflicts of Interest

In an attempt to ensure investors are properly informed about conflicts of interest, the SEC now requires disclosures discussing material actual or potential conflicts of interest. This includes conflicts relating to the decision to pursue a particular de-SPAC transaction, compensation structures for SPAC sponsors and management, and compensation arrangements between the SPAC sponsor and its own management.²⁴ 

For de-SPAC transactions specifically, the SPAC must disclose whether the SPAC sponsor or management have any material interest in other entities or in the target company. Each officer's and director's fiduciary duties to other entities must also be described. Disclosures should include any material interests held by the target company’s management, including any affiliation with the SPAC sponsor or the SPAC. Finally, if the local law requires the board of directors to determine if the de-SPAC merger is advisable and in the best interest of the SPAC’s shareholders, then this determination needs to be disclosed, along with the material factors the board considered, such as valuation work and financial projections. 

Projections

The Final Rules change regulation of projections by increasing both disclosure standards and liability exposure. The most significant change is the adoption of a new definition of "blank check company" under the PSLRA, as mentioned earlier, which makes the PSLRA’s safe harbor for forward-looking statements unavailable to SPACs. This step better aligns the treatment of projections in de-SPAC transactions with that of traditional IPOs and incentivizes SPACs to avoid using overly optimistic projections.

Additionally, the rules amend Item 10(b) of Regulation S-K to strengthen protection-related disclosures across all SEC filings, not just for SPACs. This updated guidance requires that projections based on historical data be clearly separated from those that are not. When projections are based on historical results, the relevant historical data or operational history must be presented with equal or greater prominence. If non-GAAP financial measures are included, they must be clearly defined, explicitly compared to the most directly related GAAP financial measure, and explained as to why the non-GAAP measure was used (for more information on non-GAAP measures, see this article).

For de-SPAC transactions, new Item 1609 of Regulation S-K mandates specialized disclosures whenever projections are included in a filing or exhibit (such as an investor presentation in a Form 8-K report). This item requires disclosure of the purpose of the projections as well as who prepared them. Further transparency comes from required disclosure of all material underlying assumptions for the projections, such as growth rates or discount rates used, and why they were chosen. Item 1609 also addresses projection reliability and relevance by requiring a statement whether the disclosed projections still reflect the view of the SPAC's or target company’s management or board as of the most recent practicable date prior to the disclosure document's dissemination. If the projections no longer represent current management views, the filing must state the purpose of the disclosure and the reasons why management or the board continues to rely on such projections.

Summary

The following table summarizes some of the main requirements included in the Final Rules: