According to the staff of the SEC’s Office of the Chief Accountant, in “just the first two months of 2021, both the number of new SPACs and amount of capital raised by those SPACs have been reported to already match approximately three-fourths of all such activity last year.” And there was quite a bit of SPAC activity last year. In light of the incredible volume of SPAC deals, on Wednesday, the staffs of Corp Fin and the OCA issued special guidance for SPACs. These statements address shell company, financial reporting, accounting, internal control, governance and auditor considerations in connection with a de-SPAC transaction, that is, a transaction in which a private operating company undertakes a business combination with a SPAC, ultimately becoming a public operating company. Both staffs seem to question whether the timing and other circumstances of de-SPAC transactions mean that the private operating company targets may not be fully equipped for what comes next and want stakeholders to carefully consider whether each of these private targets, in the words of OCA, has “a clear, comprehensive plan to be prepared to be a public company.” Corp Fin also wants all those who are clamoring for SPACs to be aware of all restrictions, impediments and other potential hiccups that come with the package. Could they possibly be trying to put the kibosh on SPAC fever? According to Reuters, analysts think the SEC is “worried about how much due diligence is performed by SPACs before acquiring assets, and about disclosures to investors.”
Corp Fin statement regarding shell company restrictions. SPACs are shell companies and, consequently, are subject to a number of limitations. Notably, however, they are not considered to be within the SEC’s definition of “business combination-related shell companies” and, as result, are not able to take advantage of the exceptions to the shell company limitations designed for business combination-related shell companies. Accordingly, the following shell company limitations identified by the staff will apply:
- No 71-day 8-K exception for financial statements; financial statements of the acquired business must be filed on Form 8-K within four business days of the completion of the business combination;
- Ineligible for Form S-1 incorporation by reference of Exchange Act reports and proxy statements until three years after the completion of the business combination;
- Delayed eligibility for Form S-8 until at least 60 calendar days after the combined company has filed current Form 10 information; and
- Combined company considered an “ineligible issuer” for three years following the completion of the business combination, with the result that the combined company cannot be a WKSI, use a free-writing prospectus, use a term sheet free-writing prospectus available to other ineligible issuers, conduct a roadshow that constitutes a free-writing prospectus (including an electronic roadshow), or rely on the safe harbor of Rule 163A from Securities Act Section 5(c) for pre-filing communications.
Timing issues. OCA expressly (and Corp Fin implicitly) addresses timing risks in connection with de-SPAC transactions. According to OCA, an IPO candidate engaged in a regular, less complex and slower IPO process has usually spent a long time carefully gearing up for the requirements of being a public company. One of the attributes of a SPAC transaction is the speed with which it can be completed. But that attribute comes with its own challenges. In comparison with a SPAC private merger target,
“[a] private company may spend years preparing to transition to a public company in a traditional IPO, focusing on significant changes to enterprise-wide functions and processes to mitigate risks related to regulatory requirements, increased attention from the press and analysts, fluctuations in market value, or potential shareholder action. Many SPAC acquisition targets may be at an earlier stage in the entity’s development compared to companies that pursue a traditional IPO. Additionally, because of the increased number of SPACs seeking to identify target companies, private companies that were not contemplating an IPO or were otherwise earlier in their preparations to become a public company may become SPAC acquisition targets in the current environment.”
Because SPACs can be completed so quickly after a target private company is identified, OCA advises that private target companies have a comprehensive plan in place to address the demands of public company status on an accelerated timeline, such as robust financial reporting, internal controls, audit, tax, governance and investor relations, along with “a capable, experienced management team.”
Financial reporting, books and records and internal controls requirements. The Corp Fin staff highlights the importance to reliable financial reporting of the SEC’s “books and records” and “internal controls” provisions, along with requirements to maintain adequate internal control over financial reporting and disclosure controls and procedures. These requirements apply to the SPAC before the business combination and to the combined company after the business combination. However, the Corp Fin staff cautions, the private operating company that becomes a public reporting company following the de-SPAC transaction may not have prior experience with, among other things, preparation of financial statements and other disclosures under SEC rules. “Upon consummation of the business combination,” the Corp Fin staff cautions, “the combined company will need the necessary expertise, books and records, and internal controls to provide reasonable assurance of its timely and reliable financial reporting. A private operating company may have viewed the necessity for those capacities differently prior to the business combination, and may not be able to develop those capacities without advance planning and investment in resources.”
With regard to ICFR, OCA advises that management needs to understand the timing of the first annual ICFR assessment, whether an auditor’s report on ICFR is required under SOX 404(b), and when the staff may not object to the exclusion of a company’s annual ICFR assessment, and related disclosures. (For example, Corp Fin notes that, in the event that management of the combined company is unable to assess ICFR in the fiscal year in which the transaction was consummated, in some circumstances, the staff will not object if the combined company were to exclude management’s assessment of ICFR in the Form 10-K for the year the transaction was consummated. See Reg S-K CDI 215.02.)
To illustrate the complexity of topics that the combined company may encounter, the staffs highlight some thorny issues that may involve significant judgment in accounting for and reporting the de-SPAC transaction, including:
- Determination of whether financial statements should be prepared in accordance with U.S. GAAP or IFRS;
- Public company disclosure requirements, including the form and content of financial statements, identification of the predecessor entity and the preparation of pro formas;
- Identification of which company is the “acquirer” for accounting purposes, “including variable interest entity considerations, and whether the transaction is a business combination or reverse recapitalization”;
- Accounting for earn-outs or compensation arrangements and complex financial instruments;
- Application of GAAP for public companies (e.g., EPS, segment disclosures, and expanded disclosure requirements for certain topics such as fair value measurements and post-retirement benefit arrangements) and reversal of previously elected private company accounting alternatives; and
- Determination of the effective dates of new accounting standards that were not applicable to private companies, and related required disclosure.
Initial exchange listing standards, including governance. To remain listed after the de-SPAC transaction, the combined company will need to satisfy the quantitative and qualitative initial listing standards upon consummation of the business combination. The Corp Fin staff cautions that the private company SPAC target will need to “consider how it will maintain a listing throughout and after the merger. Any material risks associated with delisting, such as the likelihood of the commencement of delisting proceedings by an exchange or the failure to maintain a listing, could trigger disclosure requirements for the combined company.” Initial quantitative standards include the number of round lot holders, publicly held shares, market value of publicly held shares and share price. In particular, the Corp Fin staff points out that, if there were too many redemptions prior to the business combination, the SPAC may not have sufficient round lot holders to meet the listing requirement upon consummation of the business combination.
In addition, the exchanges impose a number of corporate governance qualitative standards, such as requirements for a majority of independent directors and independent board committees, and a code of conduct applicable to all directors, officers and employees. Will the private SPAC target have had adequate opportunity to prepare to meet these listing standards? “Advance planning,” the Corp Fin staff observes, “may be necessary to identify, elect, and on-board a newly-constituted independent board and audit committee, and for them to adequately oversee the preparation and audit of the company’s financial statements, books and records, and internal controls.” Potential non-compliance could be a risk factor, and failure to satisfy a listing standard could require 8-K disclosure.
OCA emphasizes, in particular, the vital role of the audit committee in “auditor selection, a shared responsibility for compliance with auditor independence rules, and oversight of financial reporting, ICFR, and the external audit process.” Effective communications between the audit committee, auditor and management are important for proactive engagement, addressing audit issues and setting the appropriate “tone at the top.” An audit committee composed of directors with appropriate skills and background is “critical to the effectiveness of this dialogue.”
OCA statement regarding auditor considerations. The shift from independence determinations and an audit conducted under AICPA standards to independence determinations and an audit conducted under PCAOB standards may add additional time and complexity to the audit process. In addition, appropriate acceptance and continuance procedures “may require the audit firm to quickly make adjustments to its engagement team to ensure the team has the appropriate level of expertise and experience with SEC and PCAOB requirements.” In that context, auditor independence under the SEC’s rules. is particularly important. The OCA notes that independence questions have arisen related to partner rotation and prior involvement by the auditor in the target’s financials. The OCA advises that it is “important to understand that the general standard of independence applies to all periods included in a registration statement. Under the general standard, an auditor is not independent if, among other things, he or she would be in a position of auditing his or her own work or if he or she acts as management.” OCA advises that auditor independence and audit-related requirements “should be assessed early in the transaction, particularly since these considerations may result in a need to retain a new auditor or to perform additional audit procedures on prior period financial statements.”