SPAC Litigation Heats Up As Shareholders Get Out

Back in February, we highlighted that the SPAC trend, which burst onto the scene in 2020, was marching full speed ahead into 2021.  While SPACs show little sign of slowing down, we have seen their share prices go tumbling, harming investors who were enticed to jump on the bandwagon.

To recap, a SPAC is a special purpose acquisition company – a publicly traded company whose sole purpose is to find a private company, buy it, and take it public.  This process makes it easier for startups to capitalize on the cash available to them, gets it trading on a public exchange more quickly than if it had to go through a formal IPO process, and lowers the threshold the company must reach to go public.  It also provides investors access to the hottest stocks and the ability to participate in an IPO, which is typically off-limits for most retail investors. 

SPACs are also known as “blank-check companies” because investors put their money into the SPAC months before an acquisition target is identified, trusting the SPAC founders to find a solid company that will generate a profit for shareholders.  With the surge in popularity, competition is heating up for SPACs to acquire the best and the brightest, inflating deal values, which are already auspicious given that the target company does not go through the same rigor it would be subject to had it gone through the traditional IPO route.  As a result, companies are free to tout their future growth expectations and need very little proof of its ability to achieve its projected goals.  In fact, oftentimes, the target company has no revenue in the year prior to being acquired. 

SPACs are often negotiated behind closed doors, and while extremely beneficial for SPAC founders they can be detrimental to retail investors. SPAC founders typically receive 20% of the equity in the SPAC for an investment of approximately 3-4% of the IPO proceeds.  This gives the SPAC founders equity stakes worth millions while diluting the value of shares held by external investors.  The return on investment can be enormous, with SPAC founders generating an average of more than eight times their investment.  With this payday, SPAC founders are highly incentivized to take a deal even if they know the company’s shares will slump after the deal closes.  For this reason, investors must be very cautious and should not rely on the SPAC’s due diligence.

SEC Chairman Gary Gensler is concerned that retail investors do not understand the risks of trading SPAC shares, including the potential for dilution, and are bearing much of the cost associated with subpar deals.  A recent study found that although SPACs initially price at $10 per share, the median SPAC holds cash of just $6.67 per share by the time of the merger, causing SPAC investors to suffer significant dilution.  The SEC is now weighing new protections for investors in SPACs and questioning the liability shield that Congress implemented 25 years ago, which allows the target company to make rosy projections about future results with less risk of facing a lawsuit than if it would have touted those figures during a traditional IPO.

Worth The Investment?

There is much speculation around the recent decline in SPAC share prices.  According to data compiled by JPMorgan Chase & Co, it could be outflows from ETFs tied to the space and a drop in stock market and options trading activity by individual investors in March and April after such activity boomed to start 2021.  Active trading in options and warrants, which is more volatile than shares, can amplify stock moves in either direction.  Alternatively, investors may be favoring cryptocurrency or just trading in different stocks.

Regardless of the reason, the decline highlights the risks of speculative trading.  According to a study entitled "A Sober Look At SPACs," released last November, among 38 companies that went public through a SPAC between January 2019 and June 2020, the median six-month return for such companies was -23.8%.  In addition to poor returns, SPACs carry with them the risk of conflicts of interest, mismanagement and fraud.  Shareholders have allegedly suffered billions of dollars in collective losses due to this misconduct and are now seeking redress through securities fraud class actions and shareholder derivative litigation.  The below is a list of companies sued in 2021 for violating shareholders' rights:

Be Cautious

If you have concerns about SPACs or any publicly traded company you are invested, in Robbins LLP is here to answer your questions.