Inside Chicken: Remarks before Fordham Journal of Corporate and Financial Law Conference: “Here to Stay: Wrestling with the Future of the Quickly Maturing SPAC Market”

Thank you, AJ [Harris]. It is a pleasure to be part of the Fordham Journal of Corporate and Financial Law conference. I have to start with the standard disclaimer. My views are my own and not necessarily those of the Securities and Exchange Commission or my fellow Commissioners.

A family I know recently acquired a flock of mail-order chickens to produce free-range eggs. A baker’s dozen—thirteen little chicks—have now grown up into twelve egg-producing hens. The thirteenth is still holding out for an egg-stra egg-laying incentive, I guess. Each of these hens has her own look and personality. My favorite is the chicken who desperately wants to move out of the hen house, which is actually quite a functional dwelling, and into her featherless family’s house. This would-be inside chicken, in an effort to ingratiate herself with her “peeps,” runs up to greet any family member who comes out of the house. She also has a habit of walking up onto the deck and looking longingly through the sliding glass doors when the family is sitting inside at the dining room table. If I were part of the family, I certainly would have caved by now to the hopeful bird pleading with me from the outside, but the family has not been moved by her fowl pleas.

Also on the lookout for a better perch is Journey, thus renamed because the family found her trying to cross the road in front of the house. With a bit of effort, they managed to catch her and return her to the coop before she made the trek. Why did this chicken try to cross the road? Maybe she thought that the chicken coops are more luxurious on the other side or maybe there is a handsome rooster waiting there for her. Along with the would-be inside chicken, Journey is not content to remain in the hen house. The eleven other chickens, however, seem quite content with their coop. The food is good and plentiful; the sleeping accommodations are cozy; and the structure keeps predators out. Accordingly, as the sun goes down in the evening, these eleven hens happily take refuge in their coop.

The chickens, of course, got me thinking about companies and specifically about companies’ decisions around going public or staying private. Why is it that some companies want to go public and others are perfectly content to remain private? For those that decide to go public, how do they select a time and method for going public? Is there anything we at the SEC can do to make it more likely that private companies will choose earlier in their lives to become publicly listed companies so that retail investors can share in their growth? Is there anything we can do to assist them as they think about whether public markets or private are best for them? To that end, I will put in a shameless plug for a new interactive tool created by our Office of the Advocate for Small Business Capital Formation, which helps companies explore their options for raising funds in the private and public markets.[1]

Average retail investors have very limited access to the private markets. The standards that keep retail investors low in the investor pecking order and thus confined to the public markets are protective—in my view overly so. Even retail investors’ indirect exposure is limited because retail funds typically have not placed many private companies in their portfolios. Our regulations prohibit more than 15 percent of open-end fund assets being held in private investments,[2] and our staff’s admonitions have prevented even closed-end funds, which do not have the same liquidity demands, from holding more than that amount in private investments.[3] Incidentally, our Asset Management Advisory Committee recommended we reconsider that staff limitation on closed-end funds.[4] To give you a sense of how small the retail exposure to private investments is, one study indicated that private company investments accounted for only 0.15% of U.S. large-cap equity funds’ $5.1 trillion in assets as of December 2017.[5] Private companies may be too small for a large retail fund to gain adequate exposure to justify an investment, but as larger companies are staying private longer, some funds are defying this trend by crossing over into the private markets.[6] Still, generally only companies that go public have broad access to both institutional and retail money. And retail investors are able to invest in only a small subset of companies.

As with the chicken ratio I described earlier, the ratio of companies that even contemplate going public versus those content to remain private is low. No one formula works for every company in determining whether and when to go public. Even if Journey does not decide to cross the road, being free-range and having the option to do so, has some value to her. Companies likewise benefit from having the option of remaining private or becoming public.

Most companies stay private for their entire lives. Compare, for example, the estimated 31.7 million small businesses in the United States last year to the approximately 4,000 public companies.[7] The private market is the right place for many companies focused on serving their local communities or filling a small niche demand.[8] Moreover, for a company whose founders do not want to give up control, the private markets are generally a better fit.[9] Companies that stay private may find that their funding needs are well-satisfied through founders’ personal funds, reinvested income, bank loans, or funds available in the private markets.[10]

For other companies, however, going public is a natural and even necessary phase of their corporate journey. They may want to go public to maximize their capital-raising options, provide liquidity to their owners, benefit from robust secondary markets, or enjoy the reputational benefits associated with being publicly listed and traded. A company that needs to raise large amounts frequently will have an easier time doing so as a public company. A company may view being public, with all of the attendant transparency and listing requirements, as a way to signal its quality.

Going, and being, public, of course, come with costs, which have to be weighed against the benefits. Public companies face greater scrutiny from the general public, short sellers, and regulators than their private counterparts. A whole set of rules governs public company financial reporting and other disclosures. Public companies in the United States often face costly shareholder litigation. And, increasingly, public companies are subject to disclosure demands related to any manner of topics of interest in social and political conversation. Moreover, sometimes the benefits of being public are elusive as liquidity for small public companies and research coverage may not meet expectations. Living inside the human house would bring greater comfort and better food, but would come with a whole array of uncomfortable rules that might be ill-suited for the average chicken.

Many companies doing the cost-benefit analysis are concluding that the benefits of going public do not justify the costs. Consequently, a lot of growth is happening outside of the public markets and thus outside of the nest eggs of most retail investors. Over the years, the number of public companies in the United States has declined, rather than increased as one might expect with a growing and increasingly prosperous population. After the dot-com boom’s peak of more than 7,000 public companies in the United States in the 1990s, the number quickly dropped to more than 5,000 in the 2000s, and has been below 4,000 since 2010.[11] Companies that go public tend to be larger than they used to be because they are waiting longer to go public. For example, the median age and sales of a technology company initial public offering (“IPO”) in 2001 was 9 years and $24.6 million; in 2020, those figures were 12 years and $201.7 million.[12]

An initial public offering is the most common method for a company to go from being private to being listed on an exchange. Last year, 218 IPOs raised $78.2 billion, compared to 160 IPOs raising $46.3 billion in 2019, and 192 IPOs raising $46.9 billion in 2018.[13] Companies generally ponder and plan for an IPO over a period of years. Once a company has decided to go public, it hires a raft of professionals—including investment banks, auditors, lawyers, and consultants—to shepherd it through the process and ensure the company can meet the demands of being public. Internal controls over financial reporting, risk and compliance management procedures, corporate governance structures, tax planning, and internal structures to handle ongoing reporting obligations all demand attention. Only after the company has all its chickens on the roost is it time to file a registration statement with the SEC and go through the iterative process of responding to comments raised by accountants and lawyers in the SEC’s Division of Corporation Finance. A company traditionally sells its stock through a firm commitment offering. The issuer and underwriters agree on the terms of the deal, including, importantly, the price based on the underwriters’ due diligence. The underwriters purchase the securities at an agreed-upon discount to the price at which they subsequently resell the securities to dealers and institutional investors. From there, secondary trading on an exchange begins at market prices based on orders to buy and sell the securities. The IPO process is a good one because it helps to ensure that companies are ready for the attention, scrutiny, and regulatory obligations that public markets inevitably bring.

The expense and time involved in the IPO process, concerns over underpricing, and the varying needs of companies going public have led some companies to explore alternatives to the traditional IPO. Specifically, the standard IPO is facing competition from direct listings and SPACs. A direct listing offers a company a way to list its shares on an exchange without an underwritten offering. Given the absence of underwriters, a designated market maker, in consultation with the company’s financial advisor, sets the opening price. Thereafter, the shares trade on an exchange at market prices based on orders to buy and sell the securities. The direct listing model allows existing shareholders, including employees, to benefit from public market liquidity. Companies have not yet used direct listings to raise capital, but new exchange rules allow them to do so.[14]

Despite their limited use—only twelve companies have availed themselves of this option[15]—direct listings are a promising innovation for mature, financially strong companies that want to provide liquidity to their shareholders. Direct listings may be attractive to issuers seeking to avoid paying underwriter commissions or experiencing an “IPO pop” in their share price, which might signal that money has been left on the table. Direct listings also may be attractive to the investors who in a traditional IPO would only be able to buy shares in aftermarket trading; in a direct listing, they can purchase shares in the initial public offering. On the downside, the absence of underwriters may mean less due diligence and one fewer deep pocket to sue. Some critics are concerned that primary direct offerings, in which registered and unregistered shares trade simultaneously, could eliminate Section 11 liability given the difficulty of tracing shares purchased to the relevant registration statement, but others point to a decision by the Ninth Circuit last month that shares purchased in a direct listing can be traced back to the registration statement.[16]

Rather than engaging in an IPO or conducting a direct listing, a company wanting to be part of the public markets may simply be acquired by a public operating company. By doing so, the company sidesteps the process of going public through an initial public offering, but nevertheless gains exposure to the benefits and burdens of being public. Of course, those benefits and burdens are borne with the assistance of the acquiring company and its established network of advisors.

Alternatively, a private company can engage in a merger transaction with a Special Purpose Acquisition Company (“SPAC”). A SPAC sponsor takes a shell company public without any operations and then sets out to find an operating company with which to merge. The SPAC model is no spring chicken, but it is newly popular. Through three quarters of 2021, 489 SPAC IPOs have raised $137 billion; in 2020, 248 SPAC IPOs raised $83.4 billion, and in 2019, 59 SPAC IPOs raised $13.6 billion.^[17] In stark contrast, in 2009 SPACs were rare as hen’s teeth with only one SPAC IPO that raised $36 million.^[18] SPACs have been around since 1993^[19] and were developed as the SEC was overhauling its rules relating to blank check companies as mandated by the Penny Stock Reform Act of 1990.^[20] Those legislative and regulatory efforts were reactions to widespread abuses in blank check offerings in the 1980s. At the time, such offerings were prime vehicles for pump and dump schemes, complete with unscrupulous brokers in boiler rooms cold-calling retail investors. SPACs have since risen and fallen in popularity depending on market conditions, but it is only recently that SPACs became the subject of dinner-table conversation.

Dinner-table chatter about SPACs may have to be accompanied by, in addition to the obligatory butter chicken, a white board because the SPAC structure is not simple. As I mentioned, a SPAC is a company with no operations, but with plans to find and merge with an operating company within a preset time frame. It raises money through an IPO. It offers shares and warrants to investors and holds the offering proceeds in a trust account for use in a later acquisition. After the IPO, the SPAC’s securities are freely tradeable on an exchange at market price. Investors rely on the SPAC’s sponsors to identify, value, and propose an acquisition of a promising private operating company. In exchange for these services, the SPAC sponsor receives a significant stake in the SPAC and has a number of economic incentives to complete an acquisition, incentives that at times may conflict with the interests of the SPAC shareholders. While SPAC investors rely heavily on the SPAC sponsors, the shareholders typically have the right to vote on the proposed acquisition and to redeem their shares for the original SPAC IPO share price. This second stage, often referred to as the de-SPAC transaction, involves the completion of the business combination. Investors in the SPAC receive disclosures about the target company upon which to make their decision of whether they want to stay in or want out. Institutional or wealthy investors may supply additional cash in a concurrent private investment in public equity (“PIPE”) transaction. In spite of the complexity inherent in the structure, SPACS are so popular that celebrities have gotten into the game. Or maybe they are so popular because celebrities have gotten into the game.^[21] A chicken and egg question.

SPACs are celebrities in their own right. They have enthusiastic fans and passionate detractors. The fans argue that SPACs offer private companies a quicker and in some ways easier avenue to the public markets, a path that makes going public possible for companies that might otherwise not have had a viable way of doing so and that gives retail investors a chance to participate in the growth of promising companies. Professor Steven Davidoff Solomon notes that “SPACs[] have single-handedly revived the market for initial public offerings, taking small companies public by the dozens.”[22] While not exactly a neutral observer, a sponsor of SPACs puts it this way: “SPACs . . . can give a large swath of investors access to the kind of high-growth companies the well-connected have been making billions of dollars off of for years.”[23]

SPAC critics argue that SPACS are not what they are cracked up to be. While SPACs are a way of getting more companies into the public markets earlier in their lives, SPACs likely are not appropriate for retail investors not inclined to monitor their investment closely to determine whether to redeem.[24] More specifically, critics contend that the complexity, opacity, and mechanics of the process and the slimmed down protections work to the detriment of retail investors and the benefit of the sophisticated parties involved in these transactions. In what has become a seminal research paper on this recent flurry of SPAC activity, the authors identified substantial dilution of the post-merger shares that stems from the sponsor’s promote fee, underwriting fees, and warrants and rights and observed that these costs are primarily borne by the SPAC shareholders.[25] The authors conclude that the median SPAC costs as a percentage of post-merger equity are 14.1%, which means that the transaction must generate significant surplus value for the SPAC and target shareholders to merely break even.[26] Moreover, the authors find that the median cost of a SPAC is 50.4% of the amount raised in the offering, which is far higher than the total IPO costs of approximately 27% of cash raised.[27] Others, such as the CFA Institute, also have pointed with concern to the competing incentives embedded in the SPAC structure: the economic incentives for an IPO investor may differ from those of an investor who purchased later in the secondary markets, and PIPE investors who receive discounted shares may have different incentives than the SPAC shareholders.[28] An article by two professors who spoke earlier today identifies problems arising from so-called empty voting when investors both redeem and vote for the merger.[29] In other words, they egg the merger on even though they are not committing their own capital to it. Moreover, what is good for the SPAC sponsor may not be good for the SPAC investors. Heightening these dynamics is the fact that, given how many SPACs are looking to merge with targets within the next couple years, finding a suitable target at a good price may be hard. While a rushed deal may be beneficial for the sponsor running up against the SPAC’s pre-set termination date, the investors who do not redeem may be left holding the bag. In other words, the arrangement may set up an unhealthy dynamic—a sort of game of chicken as the sponsor races to find a target before the preset clock runs out and runs the SPAC off the cliff.

On balance, however having more than one way for companies to get into the public markets is good. As Jennifer Schulp of Cato observed, “Direct listings and SPACs may encourage companies to go public that otherwise have spent their high growth years private, out of reach of most retail investors.”[30] Having multiple roads to the public markets may not mean a chicken in every retail investor’s pot, but could make it more likely that retail investors will get to invest in a broader swath of growing companies.

Accepting that different companies will prefer different routes to the public markets, the Commission should focus its efforts on (1) prior to engaging in rulemaking, understanding who the investors are and what incentives they have at each stage of the SPAC process, (2) against that backdrop, ensuring that disclosures are clear and accurate, (3) maintaining a sensible substantive regulatory framework for SPACs, and (4) paring back unnecessary requirements on going and being public. The goal of this exercise would be to ensure that companies have workable options for getting into the public markets and investors, including retail investors, have the ability to invest in a wide variety of companies during their growth stages.

The first order of business should be to understand investor incentives and behavior at each stage: the IPO, pre-acquisition secondary trading, PIPE, and post-merger. If retail investors are being fleeced, as some critics assert, then I agree we need to evaluate how to level the playing field and ensure appropriate protections. However, the limited evidence thus far suggests that retail investors may play a limited role in SPACs. Building upon the research conducted by Professor Klausner and others, the Committee on Capital Markets Regulation (“CCMR”) finds that institutional investors contribute the vast majority of investment dollars at the IPO stage.[31] Moreover, institutional investors typically redeem their shares, which means the shares are removed from trading and not available for purchase by retail investors.[32] Finally, the CCMR finds that public secondary market trading is extremely limited, which suggests little retail activity. Specifically, it concludes that the 30-day average trading volume for all SPACs was approximately 0.08% of outstanding shares.[33] More studies by academics and the Commission staff would be helpful in informing us about retail investor participation in SPACs.

Second, we should continue to ensure that disclosures are providing investors with material information. The large number of SPACs has given the staff of the Division of Corporation Finance, under the leadership of Renee Jones, an unrelenting flow of work and many opportunities to think about disclosures during the SPAC and de-SPAC processes. The lessons our staff is drawing from these reviews will inform any future SPAC rulemaking. Indeed, early lessons were already reflected in staff guidance issued in December 2020.[34] In addition, both the Investor Advisory Committee (“IAC”) and the Small Business Capital Formation Advisory Committee have held helpful discussions of SPACs.[35] The IAC produced a recommendation that included a number of potential disclosure enhancements.[36]

Drawing from both the staff guidance and the work of the advisory committees, we can identify some areas where clear disclosure is important. As an initial matter, SPACs are not all identical, so disclosure needs to enable investors to understand each SPAC on its own terms. Disclosure also needs to lay out the economics of the transactions. The IAC recommends tabular disclosure of cash per share contingent on specified levels of redemption to aid investors in understanding the impact of de-SPAC dilution. The IAC similarly suggests requiring disclosure of the sponsor’s total investment in the transaction, the value of that investment if a merger closes, and the break-even post-merger price for the sponsor. Standardized tabular disclosures could help to address one criticism of existing disclosures, which is that investors need to comb through disclosures from disparate places to put together a picture of what is really going on in a transaction.

Not surprisingly, the wave of SPACs has led to certain structural modifications in SPACs. For example, it is becoming more common for these transactions not to include warrants, which some observers have criticized as harmful to retail investors.[37] In addition, PIPE investors are increasingly pressuring sponsors to retain skin in the game post de-SPAC and to modify the size and nature of the sponsor promote fees.[38] If incentives are properly aligned, sponsors would not be able to count their chickens before the de-SPAC hatches. In any case, disclosures should be designed to convey the specific mechanics of the SPAC and de-SPAC clearly. If disclosure rulemaking is necessary, we should avoid prescriptive requirements regarding features that may be obsolete by the end of the notice and comment period. We also should make sure to retain disclosures that are working.[39]

Third, the SEC should maintain a sensible substantive regulatory framework for SPACs. Most importantly, the SEC has a role in reminding companies considering going public through a SPAC that no matter the route you take to go public, being a public company is a serious commitment. Firms need to make sure they are ready for public company obligations. To help, staff in the Division of Corporation Finance issued a statement on certain accounting, financial reporting, and governance issues that a private operating company should carefully consider before a it enters into a business combination with a SPAC.[40]

Guidance of that sort is very important, but as with any other area, we should be mindful of the effect our pronouncements can have in the market. If the staff believes fundamental changes are necessary, they should bring recommendations for proposed rules to the Commission that we can consider and issue for public comment. Over the past year, the staff took a couple of steps outside the rulemaking process that concern me precisely because they represented sweeping changes for the industry without notice and comment rulemaking or even a meaningful opportunity to provide input. The former Acting Director of the Division of Corporation Finance, for example, issued a statement questioning conventional thought on the availability of the PSLRA[41] safe harbor for projections used in de-SPAC transactions.[42] A subsequent staff statement on accounting for warrants in SPACs[43] seemingly caught the industry by surprise and led to a notable slowdown in the SPAC IPO market and ultimately resulted in approximately 571 restatements, representing over 85% of all SPACs.[44]

A recent well-publicized legal challenge seems to be inviting us to jump into the fray yet again by departing from more than two decades of practice and treating SPACs as investment companies. In August of this year, lawsuits were filed against three separate SPACs.[45] The gist of the complaints is that SPACs are investment companies under Section 3(a)(1) of the Investment Company Act of 1940 because their primary business is investing in securities.[46] Although the facts and circumstances of the SPAC at issue in at least one of those suits were unusual, some SPAC critics have latched on to this argument to attempt to apply it to all SPACs. Many in the industry and in the securities bar disagree.[47] SPACs are not investment companies, they argue, because, unlike actual investment companies as defined by the Investment Company Act, SPACs are not “primarily engaged … in the business of investing, reinvesting or trading in securities,” [48] nor do they propose to be. In fact, SPACs state quite clearly in their prospectuses that their sole purpose is to bring about a merger, in one fashion or another, with an existing business, and to do so within a set period of time. Essentially, then, a SPAC, unlike an investment company, is typically designed to put all its eggs into one basket, albeit a basket to be identified at a later date. If the SPAC fails to bring about such a merger within the period of time described (usually 18 to 24 months), it will liquidate and cash investors out. While it may make some sense to put some parameters around SPACs to make sure they do not morph into something that does look like an investment company, applying the Investment Company Act regime to SPACs as currently structured would not serve investors. It would catch them by surprise. SPAC disclosures are clear about what the purpose of the SPAC is and that purpose is not to be an investment company.

Fourth, the SPAC wave is an opportunity for us to think about a bigger question: Why are so few companies going public? At last month’s Small Business Capital Formation Advisory Committee meeting, Sara Hanks keenly observed: “it seems to me like the very existence of SPACs . . . is an indictment on the complexity of going and being a public company, and shouldn’t we . . . address the issue of why SPACs exist in the first place, which is it’s really difficult to become a public company.”[49] Similarly, J.W. Verret noted that we should stop treating the traditional IPO as if it is the gold standard.[50] The Commission should consider whether the rules governing IPOs, direct listings, and SPACs are appropriately calibrated. For example, the interplay of GAAP and certain exchange listing rules may be limiting the ability of SPACs to merge with small companies with a value of less than $300 million.[51] We should consider whether there are ways to make SPACs, with appropriate investor protections, a viable vehicle for smaller companies to go public. We also could explore ways to enhance potential stepping stones to the public markets, such as Regulation A. Additionally, the extent to which SPACs rely on the PSLRA safe harbor for forward-looking statements when disclosing projections has garnered significant attention. Should SPACs be able to rely on this safe harbor when a company conducting a traditional IPO would not have the same ability? If projections are so important to companies going public through the SPAC process and if the safe harbor is a motivating factor of using the SPAC vehicle, then perhaps we should re-visit the policy considerations that have led to the prohibition on a new public company conducting a traditional IPO from relying on the safe harbor. Such a question, of course, would be a matter for Congress because the IPO prohibition is written into the statute.

The problems and solutions lie not just in the process of going public, but in the rules companies face once they are public. We have to make sure not to burden public companies unnecessarily. Allowing for scaled compliance with regulations by small and emerging companies, for example, can make being public less daunting. In addition, we should stick to the standard practice of tying the obligations imposed on public companies to the objective of providing material information to investors. Requiring companies to disclose information that is not material to an investment decision increases the costs associated with being a public company. If we expand beyond that into required disclosures on social and political matters, the chickens will come home to roost; fewer companies will be public.

While I do not want to sound like Chicken Little, the falling number of public companies over the last twenty-plus years does cause me some concern. As I mentioned earlier, the fewer the companies in the public markets, the more limited is retail investors’ ability to diversify across a broad range of companies since they have only limited access to private company investments. Society benefits from active and attractive public capital markets, but the Commission must remain neutral as to whether and how any particular company decides to go public. We can build sensible routes to, and rules for, public markets and do our best to keep costs down for public companies. Having a diverse array of options for companies to go public therefore helps; it enables companies to find the route to going public that works for their unique circumstances.

Thank you for listening today. I look forward to your comments and questions. Only I am too chicken to answer questions about particular SPACs.