The impact of the SEC proposals regulating investor disclosures

When special purpose acquisition companies (SPACs) first emerged in 2010, they were promoted by banks and other investors as legitimate finance vehicles to help private companies raise capital in the stock market. For the next seven years, the number of new SPACs grew slowly but steadily, raising less than $10bn per year. It wasn’t until 2020 and even 2021 that SPACs took off, raising more capital than all previous years combined.

But today, the excitement over SPACs is waning, and criticism among academics, practitioners and the financial press is mounting. Why? As information regarding the returns to different SPAC investors becomes available, we are learning that SPAC sponsors and hedge funds who participate in the SPAC initial public offering (IPO) do very well, while retail investors who buy shares when a merger is announced and hold past the merger period do very poorly. Also, it turns out that SPACs have some serious character flaws.

These flaws are the main reason the US Securities and Exchange Commission (SEC) is proposing regulations to police SPACs and protect unsavvy investors from possible ruin. And while there’s reason to applaud the SEC’s move to defend the little guy, there has been debate about the necessity of these proposed regulations.

My take is that not all the proposed regulations may be necessary and that the SEC, in this case, may be overreacting to a trend that could be already in a phase of self-correction. But let’s look at the debate from both sides of the aisle.

Questionable value

The SEC’s proposals aim to peel back the SPAC’s smooth veneer and expose its faults: that the retail investor’s stake in the final merged entity is significantly diluted by early bird deals that benefit private investors and SPAC sponsors; and that, overall, SPAC sponsors have no commitment to a successful merger because even if the SPAC fails, they get their initial investment back. They risk nothing.

In short, the SEC is calling out SPACs for what being what many people, including regulators, believe them to be: sophisticated financial vehicles used to channel abundant cash into companies of questionable value.

The SEC argues that if the end goal of a SPAC is to take a company public, then SPACs should operate by the same rules as IPOs, which means that they should be required to disclose important information about sponsors’ compensation and the risks involved for investors.

But not everyone agrees that SPACs and IPOs are identical. I agree with warnings that the proposed SEC regulations could take us back to the time before the SPAC boom when some companies were frozen out of the market due to a lack of capital. Could the new regulations have a stagnating effect on the economy? Maybe, but the very high rate of redemption suggests most SPACS are not identifying value in the segment of private firms overlooked by more traditional investors, such as venture capitalists.

Those across the aisle, who reject the proposals, argue that SPACs should benefit from the same ‘safe harbour’ from liability as any company going through a merger. But this argument glosses over a crucial fact: a SPAC is a company in name only; it has no revenue, no property or tangible value. The jury is still out on whether SPACs sponsors give advice that can increase the target company’s value through the merger.

Self-regulation

The best argument against the SEC’s interference is that there are signs that the SPAC market, now past its wild youth, is maturing. There are signs of ‘self-regulation’ in the recent downward trend in the number of warrants offered to IPO investors. And it’s my opinion that the public debate triggered by the SEC proposals, the resulting Congressional hearings and the recent flurry of academic research papers have done more to spotlight the risks associated with SPACs than the regulations ever could. So, is there actually a need for the proposed regulations?

Throwing the IPO rulebook at SPACs is not the best way forward. They play an important role in the funding of disruptive companies, some of which could improve the global economy in ways we can’t yet imagine. In my opinion, the SEC should let SPACs continue to do what they were designed to do, but it should also develop a regulatory framework specific to SPACs, warning investors of the high risk in the transaction and forcing disclosure of the implied dilution of late investors’ stake in all scenarios. If SPAC sponsor teams are transparent about the exact amount of skin they have in the game, then everyone wins.

Enrique Schroth is professor of finance at EDHEC Business School.