the money game

The Big SPAC Crackdown

Chamath Palihapitiya and Richard Branson’s SPACing of Virgin Galactic in 2019 helped launch a two-year frenzy on Wall Street. Photo: Justin Lane/EPA-EFE/Shutterstock

In the wild world of SPACs, the Stable Road Acquisition Corp. stands out for more than just its now-ironic name. The company, which last October inked an agreement to merge with a space transportation start-up called Momentus, might go down in financial history as a case study in how America’s multiyear SPAC boom finally came to an end.

At a basic level, a SPAC is a specially created shell company designed to do a bare-bones initial public offering and then merge with a real-world company looking to go public, without the arduous process that an IPO generally entails. In this instance, Stable Road was the publicly traded shell company and its arranged marriage with Momentus, a private start-up boasting a technology it claimed could move satellites into orbit after launch, planned to set a valuation of $1.2 billion for the combined entity. But the road for Momentus after the announcement of the merger has been anything but stable: When the deal was finally consummated last month after a settlement with the Securities and Exchange Commission, the company was only worth $700 million.

So-called space deals like Momentus became popular in SPAC land after Silicon Valley entrepreneur Chamath Palihapitiya’s initial SPAC (he now has launched several) teamed up with Richard Branson’s Virgin Galactic in late 2019, opening the floodgates on what has become one of the most remarkable financial frenzies in recent memory. In the last 20 months, investors handed over more than $200 billion to publicly traded SPAC shell companies, which simply raise money to go out and find companies to buy. Though high-risk space start-ups have gotten a lot of the headlines, the hundreds of SPAC deals done over the past two years have covered sectors from insurance to electric vehicles to cryptocurrencies.

The fate of Stable Road’s Momentus deal provides a hint into why we might be seeing fewer SPACs next year and beyond: It was an early victim of what is shaping up to be a crackdown by both regulators and lawmakers. Under the Biden administration and a Democratic Congress, authorities seem keen to close the loopholes that have allowed these complicated financial deals — which often provide huge windfalls to their sponsors and early hedge-fund investors while burning individual investors who get in late to the game — to flourish.

In announcing the settlement with Stable Road, Gary Gensler, the SEC’s new chairman, wasn’t shy about stating his perspective: “This case illustrates risks inherent to SPAC transactions,” he said, adding that the SEC’s actions “will prevent the wrongdoers from benefitting at the expense of investors.” As part of the deal, Stable Road CEO Brian Kabot and Momentus paid more than $8 million to settle charges with the agency, regarding “misleading claims about Momentus’s technology” and the failure to disclose foreign ownership and national security risks connected to its founder and former CEO, Mikhail Kokorich, a Russian citizen living in Switzerland whom the SEC is pursuing separately.

One of President Biden’s earliest appointments, Gensler earned a reputation for aggressiveness during the Obama administration, when he led a regulatory effort to rein in the swaps market that almost took down the entire financial system in 2008. During that era, the SEC was derided for being asleep at the wheel ahead of the market crash. By all accounts, Gensler is determined not to let it happen again under his watch and has made stemming the abuses of SPACs a high priority, both on the enforcement and policy side.

“The SEC’s paying close attention, and there’s going to be a lot of scrutiny,” says David Peinsipp, a partner at the law firm Cooley, in San Francisco, which has advised several SPAC clients.

It’s a big change from Trump’s SEC, whose enforcement efforts critics viewed as lax. “The SEC has been moving quickly to investigate suspected issues with these companies,” says short seller Nate Anderson, founder of Hindenburg Research, which has made allegations of fraud against six SPACs since 2020. “It’s a very impressive feat to pull off from a regulatory perspective.”

The SEC and the Justice Department are already investigating five of the SPAC companies that Anderson is shorting, including such well-known names as DraftKings, Clover Health — a venture-backed insurance provider taken public by Palihapitiya — and electric truck maker Nikola, whose founder, Trevor Milton, became the public face of alleged SPAC malfeasance after luring investors with a video showing a truck rolling down a hill and claiming it was operating on Nikola’s electric and hydrogen technology. Both the DOJ and the SEC have already charged Milton with securities fraud.

In the Stable Road–Momentus case, the SEC took action before shareholders even had a chance to vote on the merger of the two entities, which Anderson memorably calls “prophylactic pre-merger enforcement. It is protecting retail investors before they have the opportunity to get harmed.” After more than halving Momentus’s price tag, the merger went through, but 20 percent of its original investors redeemed, and the stock traded below its offering price.

Regardless of a deal’s outcome, SPACs largely are a no-lose proposition for their sponsors, who typically receive 20 percent of the company’s shares for a nominal cost. During the nearly two-year SPAC boom, sponsors have seen average returns of 958 percent, according to JP Morgan Asset Management. Investors in the SPAC’s IPO — typically hedge funds that often redeem their shares at cost while holding onto warrants after a merger is struck — also have an edge. JP Morgan found they gained an average 40 percent.

Meanwhile, a number of studies have shown that SPACs have created double-digit losses for most investors over time. After peaking in February earlier this year, SPAC stocks are down more than 20 percent in 2021, according to multiple indices and ETFs tracking them.

This year’s precipitous decline is a function of a glut of money chasing deals (meaning lower-quality companies are coming public), the inability of these newly public firms to meet their lofty promises, and the chill on the market due to the realization that more regulation and enforcement actions are coming.

Key to this dynamic is SEC chair Gensler, who started his career at Goldman Sachs before going to work in Washington, first in the Treasury Department and later as an adviser on the 2002 Sarbanes–Oxley legislation. He is the rare regulator who both understands financial markets and how to operate in Washington.

“There is no doubt he wants to make it very clear that the sheriff is back in town,” says Andrew Park, senior policy analyst at Americans for Financial Reform, an investor advocacy group that earlier this year co-authored a letter to the House Financial Services Committee suggesting several SPAC reforms. At least one of them, which it claimed would “tamp down pre-merger hype,” has made it into draft legislation.

One of the advisers on that letter, Boston College Law School professor Renee Jones, was recently named by Gensler to head the SEC’s Division of Corporation Finance. She joined in June and is viewed as someone who can be “creative” in maximizing the SEC’s powers.

While the recent SPAC boom is something of an anomaly, SPACs have been around since the early 1990s, when they were invented to get around a new rule promulgated by the SEC to avoid the conflicts of interest and fraud that had been endemic among blank-check companies, which were then penny stocks.

SPACs have long had a dodgy reputation, and until recently were viewed as vehicles used by those who had no other route to going public. One reason is that, by qualifying as mergers, they can get around the rules for IPOs, which are prohibited from making forward-looking financial projections in the prospectus and during the quiet period, which lasts 40 days after shares start trading.

Manhattan U.S. Attorney Audrey Strauss highlighted that distinction during the announcement of the indictment against Nikola founder Trevor Milton, saying he “took advantage of the fact that Nikola went public by merging with a Special Purpose Acquisition Company or ‘SPAC,’ rather than through a traditional IPO, by making many of his false and misleading claims during a period where he would have not been allowed to make public statements under rules that govern IPOs.”

It’s hardly surprising that these days the most speculative companies choose SPACs for their entry into the public markets. For example, nine electric-vehicle companies became public through a SPAC in 2020, with combined annual revenues of $139 million — but told investors they would generate $26 billion by 2024, according to the Financial Times.

Once the deals are signed, many companies have quickly dialed back their revenue projections. Others have disappointed investors with poor earnings reports.

“We have seen a large number of SPACs that issue incredibly rosy near-term projections, and then almost immediately fall well short of them,” says short seller Anderson. “And it comes to the point where the question is raised of how much of this is just optimism versus selling retail investors a bill of goods.”

Unlike IPOs — and those subject to the SEC’s rule on blank-check companies — SPAC sponsors, target companies, and their advisers may also be able to take advantage of what’s called the “safe harbor” provision of the Private Securities Litigation Reform Act of 1995, which may limit the ability of investors to sue them over their financial projections.

The House Financial Services Committee’s draft legislation would amend securities laws to get rid of the safe harbor protection for SPACs. The bill, which received bipartisan support, is still in limbo, however, and there’s no assurance it can pass the Senate.

In the meantime, the SEC appears to be ready to go it alone, if it has to.
In April, SEC General Counsel John Coates (who was then the acting director of corporation finance) roiled the SPAC world with a lengthy public statement addressing the safe harbor issue. He called the claim about reduced liability exposure for SPAC participants “overstated at best and potentially seriously misleading at worst.”

For one thing, he noted that the safe harbor provision only applies to private litigation and would not affect the SEC’s ability to bring charges. Moreover, he suggested that the SEC could simply decide to consider the merger between a company and a SPAC an IPO, with all the consequences that would entail.

If Coates’s comments were designed to slow down SPAC activity, they appear to have succeeded: In the first three months of 2021, 298 SPACs raised $83 billion; since then, 120 more have gone public, raising $39 billion.

Meanwhile, more than 400 SPACs that have already gone public — including some from last year — are still looking for partners, according to industry tracker SPAC Analytics. Even many of those who’ve announced deals may not be able to complete them. Currently 80 percent of these special acquisition companies are trading below their offering price as redemptions mount and new investors stay away.

“The SEC is saying, ‘A SPAC acquisition is not really an acquisition, it’s an IPO,’” says Douglas Ellenoff, whose law firm Ellenoff, Grossman & Schole has been advising SPACs for more than a decade. He fears SPACs are being “stigmatized.”

There’s little doubt in SPAC land that the environment has shifted from the freewheeling days when a social-media maven like Palihapitiya would go on Twitter to promote his deals, bragging that his ability to do so was one of a SPAC’s advantages. Now, at least one of the deals he promoted heavily on CNBC — Clover Health — is under investigation, and Palihapitiya has become more circumspect in his commentary.

 “Coates’s statements have had an impact on how people view the level of protection they’re going to have for a long period of time,” says Cooley partner Peinsipp, whose firm has represented Palihapitiya. “A lot of people are feeling nervous about what the regulatory environment requires of them.”

SPACs have two years to find a merger partner before they have to return investors’ money, which means liquidations are no doubt in the offing. Hedge-fund manager Bill Ackman, who launched the world’s largest SPAC, Pershing Square Tontine Holdings, last year with $4 billion, recently told shareholders he might dissolve it. Ackman wants to give investors their money back and grant them warrants on a newly designed security that he argues will be better for investors than a traditional SPAC — if the SEC approves his newfangled instrument.

The latest twist in Ackman’s Tontine drama came just weeks after the SEC flexed its muscles by thwarting his initial plans for the SPAC to take a 10 percent stake in Universal Music through its upcoming IPO, instead of going the traditional route of merging with a private company. Ackman claimed the New York Stock Exchange had approved the plan months earlier, but the SEC insisted that it did not meet SPAC guidelines.

Even SPAC proponents admit the slowdown may be a good thing. “The frenzy led to, frankly, a number of transactions that probably shouldn’t have come to pass anyway,” says Alex Vogel, a Washington lobbyist who is one of the people behind a new SPAC lobbying group that is just getting off the ground in an attempt to defend the industry in D.C.

And while the loss of the safe harbor protection for SPACs is seen as inevitable, SPAC advisers, big-name investors, and sponsors worry about how far legislation — or the SEC — will go.

The letter to Congress that the SEC’s Jones signed off on also called for bringing SPACs under the SEC’s rule for blank-check companies and extending liability not just to SPAC sponsors but also their underwriters and financial advisers, who have raked in millions of dollars in fees during the boom.

“There’s no doubt to me that there is additional legislation, additional oversight, and it is all coming,” says Vogel. “I do not at all see this issue going away.”

The Big SPAC Crackdown