The Securities and Exchange Commission (“SEC”) appears to be playing catch-up with the boom in special purpose acquisition companies (“SPACs”) by issuing guidance over the last weeks cautioning companies on the accounting treatment of warrants and the liability risk of forward-looking disclosures.
In an April 8 statement, John Coates, the SEC’s Acting Director of Corporate Finance indicated: “The staff at the Securities and Exchange Commission are continuing to look carefully at filings and disclosures by SPACs and their private target disclosures so that the public can make informed investment and voting decisions about these transactions.”
On April 12, the Division of Corporation Finance (“Corp Fin”) of the SEC issued a Staff Statement from Acting Director Coates, and Acting Chief Accountant, Paul Munter, relating to the accounting treatment of warrants issued by SPACs.
“We encourage stakeholders to consider the risks, complexities, and challenges related to SPAC mergers,” Acting Chief Accountant Munter noted in on earlier statement dated March 31.
Already more than 550 SPACs have filed to go public this year – twice as many as in 2020 – itself a record year for the IPO alternative. The boom is driven by companies leveraging the SPAC merger process as a quicker and cheaper way to go public than a traditional IPO.
Are the Warrants being Categorized Properly?
The accounting issue or concern centers on whether the warrants, which SPAC sponsors issue to encourage investment in their shell company, are being categorized properly.
Because SPACs have no means of making money until it identifies and then merges with a promising target, it uses the warrants as an enticement of gains over and above anything the shares generate.
The warrants are issued in fractions and entitle holders to buy additional shares post-merger. They typically come packaged with the shares as a unit. Many SPAC sponsors utilize public warrants for public shareholders and other warrants for private placement, founders or working capital. These warrants often have different terms and conditions.
SPACs have been around for decades and have typically treated these warrants as equity instruments, but the SEC, now that SPACs are booming, are starting to look closely at the accounting practices connected with them and are seeing potentially problematic patterns.
In the April 12 statement, The SEC staff indicated warrants, depending on their terms, should NOT be treated as equity investments but are more appropriately treated as liabilities.
“The warrants should be classified as a liability measured at fair value, with changes in fair value each period reported in earnings,” the statement indicated. “While the specific terms of such warrants can vary, we understand that certain features of warrants issued in SPAC transactions may be common across many entities.”
Further, the SEC staff has already begun an outreach to discuss their concerns and reportedly are putting new SPAC approvals on hold until the issue is resolved.
The Bottom Line
The pipeline of hundreds of filings for new SPACs could be affected as the SEC stated they will not declare any registration statements effective unless the warrant issue is addressed.
The immediate challenge is that already existing SPACs could be affected too. That being said, companies that have already completed their merger and are operating publicly could be forced to revise their treatment of the warrants.
Disclosure Liability Issue
With respect to forward-looking disclosures, another key issue is the safe-harbor provision in the Private Securities Litigation Reform Act (“PSLRA”), a 1995 law intended to curb frivolous securities lawsuits.
The safe harbor gives some protection to companies discussing performance expectations during a merger. The statements are typically intended to assure investors and analysts the merger makes sense from a growth perspective.
SPACs, which are built around mergers, have been relying on that protection as they make forward-looking statements about their deal. But the SEC isn’t sure the protection applies the way companies might think it does; since SPACs are IPOs, the restriction around forward-looking statements pre-IPO should be seen as remaining in force.
“Any simple claim about reduced liability exposure for SPAC participants is overstated at best, and potentially seriously misleading at worst,” Acting Director Coates said in his April 8 statement. “Indeed, in some ways, liability risks for those involved are higher, not lower, than in conventional IPOs.”
Acting Director Coates further indicated the safe harbor in the PSLRA only applies in private litigation and doesn’t prevent the SEC from taking action to enforce federal securities laws.
“Even if the safe harbor clearly applies, its procedural and substantive provisions do not protect against false or misleading statements made with actual knowledge that the statement was false or misleading,” Mr. Coates stated. “A company in possession of multiple sets of projections that are based on reasonable assumptions, reflecting different scenarios of how the company’s future may unfold, would be on shaky ground if it only disclosed favorable projections and omitted disclosure of equally reliable but unfavorable projections, regardless of the liability framework later used by courts to assess the disclosures.”
The safe harbor is also not available, Acting Director Coates indicated, if the statements in question are not forward-looking.
“Statements about current valuation or operations have been viewed as outside the safe harbor by some courts, even if they are derived from or linked to forward-looking projections or statements.”
The flurry of recent cautionary notes about the treatment of SPACs could likely see increases now that the Senate has confirmed Gary Gensler, the former Commodity Futures Trading Commission head, as SEC chair.
Both Gensler and acting chair Allison Herren Lee are cautious about deregulatory efforts to spur more IPOs. That doesn’t necessarily mean the SPAC boom is about to deflate, but it suggests the IPO alternative will be subject to more regulatory scrutiny going forward.
Next Steps
SPACs that have already completed their IPO will need to confirm whether their outstanding warrants contain the provisions that have been called into question by the Staff Statement, and if they do, consider along with their auditors, the impact on their financial statements for prior periods, including whether any accounting errors in prior period are “material” and need to be restated to account for outstanding warrants as liabilities rather than as equity.
The Staff Statement provides that SPACs may correct material errors relating to the warrant accounting treatment by amending their most recent Form 10-K and any subsequently filed Form 10-Qs. In addition, going forward, these companies will need to determine whether quarterly valuations of the warrants and mark-to-market accounting treatment will be required.
SPACs that have not yet completed their IPO have additional options. This may include accounting for their warrants as liabilities on a go-forward basis or structuring the warrants to exclude the features that would give rise to a need to classify the warrants as a liability and maintain the ability to classify the warrants as equity.
Conclusion
Ultimately, the impact that the Staff Statements will have on the market for existing and future SPACs, and whether additional SEC guidance on SPAC accounting matters will be issued, is yet to be seen.
It is important to highlight that the Staff Statements represent staff views of Corp Fin and the Office of the Chief Accountant. It is not a rule, regulation, or statement of the SEC. However, issuers should anticipate the need to address the matters set forth in the Staff Statement in a satisfactory manner in connection with the SEC comment and review process with respect to IPOs and their ongoing periodic reports made under the Securities Exchange Act of 1934.
Cherry Bekaert has the SPAC technical knowledge and background in serving numerous SPACs and their interactions with outside Audit Firms. Cherry Bekaert will help SPACs needing an independent Technical Memorandum in determining the warrant accounting and, if determined a liability, a dedicated Valuation Group to complete the valuation.
For assistance or questions, contact a member of Cherry Bekaert’s team associated with SPAC Warrant Evaluations.
