Writing on the Wall for SPAC Underwriters? New SEC Rule Increases Exposure and Risks
Last week, Holland & Knight's experienced Corporate, M&A and Securities Team dove into the details of the SEC's recent rule proposal covering enhanced disclosures for SPACs and de-SPAC transactions.1 As detailed in the post, if the proposed rule is ultimately approved, it will impact the SPAC market in several, significant respects. In today's post, we tackle some of the litigation and enforcement risks associated with a particular aspect of the proposal: the expanded definition of "distribution" for the SPAC IPO underwriter.
Then-Acting Director of the SEC's Division of Corporation Finance John Coates released a statement on April 8, 2021, covering the "unprecedented surge in the use and popularity" of Special Purpose Acquisition Companies (SPAC). In that statement, Coates foreshadowed a key aspect of the SEC's recent SPAC rule, namely the enhanced focused on underwriters:
Are current liability protections for investors voting on or buying shares at the time of a de-SPAC sufficient if some SPAC sponsors or advisors are touting SPACs with vague assurances of lessened liability for disclosures? Do current liability provisions give those involved – such as sponsors, private investors, and target managers – sufficient incentives to do appropriate due diligence on the target and its disclosures to public investors, especially since SPACs are designed not to include a conventional underwriter at the de-SPAC stage?
Coates openly questioned whether "the SEC should reconsider the concept of 'underwriter' in these new transactional paths[.]" The SEC apparently didn't wait for the proposed rule to start targeting the SPAC underwriter industry. Around the same time as Coates released his statement, news outlets reported that the SEC's Division of Enforcement had opened an inquiry into certain underwriters' practices in the SPAC space. Later in 2021, SEC Chair Gary Gensler presaged certain aspects of the proposed rule involving "gatekeeper obligations" – such as auditors, brokers and underwriters. According to Gensler, these gatekeepers "should have to stand behind and be responsible for basic aspects of their work."
As SPACs, target companies, their respective officers and directors and other market participants digest the Commission's 327-page proposed rule covering enhanced disclosures and rules for SPAC and de-SPAC transactions, this SECond Opinions Blog explores the collateral implications for SPAC IPO underwriters, including increased liability exposure and possible defense limitations.
Proposed New Rule and Key Implications
The term "underwriter" is defined under Section 2(a)(11) of the Securities Act of 1933 (Securities Act) as "any person who has purchased from an issuer with a view to, or offers or sells for an issuer in connection with, the distribution of any security, or participates or has a direct or indirect participation in any such undertaking . . . ."2 Although broadly defined, the definition does not appear to capture activities by any party in connection with the de-SPAC portion of a business combination, where there are no traditional underwriters.
While Gensler alluded to Aristotle in his statement on the proposed rule release to "[t]reat like cases alike," the Commission's proposed rule was explicit about the aim: "Although the timing of a SPAC initial public offering and a de-SPAC transaction is bifurcated because a private operating company is not identified at the SPAC initial public offering stage, the result of a de-SPAC transaction, however structured, is consistent with that of a traditional initial public offering."3
In addition to the standard definition under Section 2(a)(11), proposed Rule 140a of the Securities Act would classify the SPAC IPO underwriter as an underwriter in the de-SPAC transaction if the underwriter "takes steps to facilitate the de-SPAC transaction, or any related financing transaction, or otherwise participates (directly or indirectly) in the de-SPAC transaction . . . "4
Although proposed Rule 140a takes less than a half-page of the 50-plus pages of proposed regulations, the potential impact cannot be ignored.
Expanded Section 11 Liability Exposure: Anytime an underwriter participates in an issuer's offering, there is possible exposure to liability under the Securities Act. Specifically, Section 11 of the Securities Act imposes civil liability on any underwriter for any part of the registration statement that contains an untrue statement of material fact or omits a material fact required to be stated therein to make the statement not misleading.5
The overarching purpose of Section 11 is "to assure compliance with the disclosure provisions of the [Securities] Act by imposing a stringent standard of liability on the parties who play a direct role in a registered offering."6 For underwriters, the statute effectively imposes a negligence standard, although claims rooted in fraud may be subject to heightened pleading under Federal Rule of Civil Procedure 9(b).7 To successfully plead a Section 11 claim under the negligence standard, plaintiffs must allege that 1) the defendant was an underwriter under the Securities Act, 2) plaintiffs purchased registered securities, and 3) there was a material misrepresentation or omission in the registration statement.8
Under the proposed rule, de-SPAC transactions would need to be registered on Form S-4 (or F-4 for foreign issuer transactions) – regardless of the transaction structure – with the target company being deemed a co-registrant.9 If a SPAC IPO underwriter would qualify under proposed Rule 140a as an underwriter in the de-SPAC transaction, this means the underwriter – along with the target company and its signing executives – would have potential Section 11 liability for not only the SPAC IPO, but also for the de-SPAC transaction. This would then increase the scope of purported victims in any litigation whereby the SPAC IPO underwriter may be liable not only to IPO investors but also to investors in the de-SPAC.
Fee Arrangements Equals de-SPAC Underwriter?: Typically, SPAC underwriters will defer a percentage of their SPAC IPO underwriting fees until completion of the de-SPAC transactions. In the proposing release, the Commission suggests that the "receipt of compensation in connection with the de-SPAC transaction could constitute direct or indirect participation in the de-SPAC transaction."10 Although the Commission is correct that many SPAC underwriters do participate in the de-SPAC transaction as financial advisors and placement agents, this is not uniform. Could this result in a situation where a SPAC underwriter whose only connection to the de-SPAC transaction is deferred compensation is deemed to be engaged in the distribution of securities for the de-SPAC transaction? We hope that the comment process and final assessment of the rule will bring greater clarity on this point.
Due Diligence Defense Limitations?: Proper due diligence can shield an underwriter from Section 11 liability if the underwriter can establish that, after reasonable investigation, it had reasonable ground to believe – and did believe at the time the registration statement became effective – that the statements therein were true and there was no omission of material fact required to be stated to make the statements therein not misleading.11 To establish the due diligence defense, an underwriter must establish that it exercised reasonable care in verifying the representations in the registration statement.12
The Commission argues that the prospect of Section 11 liability for SPAC underwriters in the de-SPAC transaction will encourage greater due diligence and result in more accurate disclosures. However, the Commission seems to recognize a possible fly in the ointment with the proposed approach. In its Request for Comment No. 84, the Commission specifically seeks comment on whether the "SPAC IPO underwriter [has] the means and access necessary (via contract or otherwise) to perform due diligence at the de-SPAC transaction stage, particularly where the SPAC IPO underwriter is not retained as an advisor in the de-SPAC transaction or the target is the registrant for the de-SPAC transaction?"13 Given the enhanced definition of a distribution and the possibility that SPAC IPO underwriters are only "indirectly participating" in the de-SPAC transaction, it is possible that certain parties that would be deemed underwriters under the proposed rule may not have sufficient access to the materials necessary to formulate a due diligence defense.
Other SPAC Participants May Be Statutory Underwriters: The Commission takes the view that any person who satisfies one of the prongs of Section 2(a)(11) meets the statutory definition of an underwriter, commonly referred to as a "statutory underwriter." The Commission and federal courts have taken a broad view of statutory underwriters, typically seizing on the "participates" and "participation" language, meaning this can include parties beyond those engaged in a traditional underwriter capacity.
Although proposed Rule 140a applies only to SPAC underwriters, the proposed rule makes clear that other parties in the SPAC transaction could be deemed underwriters. The Commission noted that its discussion about SPAC underwriters "is not intended to provide an exhaustive assessment of underwriter status in the SPAC context, and neither is it intended to limit the definition of underwriter for purposes of Section 2(a)(11) of the Securities Act."14 The Commission specifically identified "financial advisors, PIPE investors, or other advisors" as parties who could be deemed statutory underwriters.15
This necessarily increases the risk of liability for multiple parties involved in the SPAC process. The implication, therefore, is that other parties who participate in the de-SPAC portion of the process – such as financial advisors and PIPE investors – would need to carefully assess their exposure for possible securities law violations.
As SPAC market participants across the board consider the implications from the proposed rule, one thing is clear: the Commission has taken the next step to bring SPAC transactions in line with traditional IPOs. The collateral consequences – from more subtle changes to changes in fee arrangements to the broader fallout of underwriters staying away from the SPAC market all together – will likely be significant.
1 See generally Special Purpose Acquisition Companies, Shell Companies, and Projections, [Releases Nos. 33-11048, 34-94546, IC-34549; File No. S7-13-22] at 95 [hereinafter "Proposed Rule"].
2 Securities and Exchange Act of 1933 §2(a)(11), 15 U.S.C. § 77b(a)(3).
3 Proposed Rule, at 95.
4 Proposed Rule 140a of the Securities Act of 1933.
5 See Securities and Exchange Act of 1933 § 11(a)(5), 15 U.S.C. §77k(a)(5).
6 Herman & MacLean v. Huddleston, 459 U.S. 375, 381–82 (1982).
7 Monroe v. Hughes, 31 F.3d 772, 774 (9th Cir.1994). Section 11 claims may be subject to heightened pleading standards when they "sound in fraud." Rombach v. Chang, 355 F.3d 164, 171 (2d Cir. 2004).
8 In re Citigroup Inc. Bond Litig., 723 F. Supp. 2d 568, 587 (S.D.N.Y. 2010).
9 The Commission is proposing to amend Forms S-4 (General Instruction L.4) and F-4 (General Instruction I.4) and mandate that the SPAC and target company be treated as co-registrants. See Proposed Rule, at 75.
10 Proposed Rule at 97.
11 See Securities and Exchange Act of 1933 § 11(b)(3), 15 U.S.C. §77k(b)(3).
12 See Securities and Exchange Act of 1933 § 11(c), 15 U.S.C. §77k(c).
13 Proposed Rule at 99.
14 Id. at 98.