Make SPACe: Changes and Challenges with the introduction of SPACs

Background

Special Purpose Acquisition Companies (SPACs) have seen a massive upsurge in the last two to three years after years of fairly limited use since their inception in the 1990s. SPACs are found to be reliable in a turbulent market and have thus found a new impetus in the covid outbreak. It is also propelled by the fact that several celebrities including Shaquille O’ Neal and Serena Williams have invested in SPACs.  While SPAC deals in India are still at a nascent stage, the number of equity investors considering SPAC as an option is on a steady rise. Sponsored by private equity veteran Rohan Ajila and Gautam Pai, a SPAC named Global Consumer Acquisition Corp has raised $170 million from listing in the US, while two other India-related SPACs have said that they intend to raise capital in the US. In view of these developments, in March 2021, the Securities and Exchange Board of India (SEBI) tasked an expert group formed under its Primary Market Advisory Committee (PMAC) to deliberate upon and come out with a framework to introduce SPAC structures in India. Also, International Financial Services Centre Authority (IFSCA) came out with a consultation paper (hereinafter referred as ‘IFSCA paper’) that laid down a framework of regulations to keep a check on the functioning of prospective SPACs in India.

SPAC is an entity that is established for the sole purpose of making an acquisition or buyout. It does not have any business operation and is run by a management team, usually possessing expertise in the particular sector and is often backed by a sponsor. They raise capital through an Initial Public Offering (IPO), which is held in a trust account and aims to acquire a company within a particular time limit, which usually is around the two-year mark. Upon the approval of the SPAC shareholders of the acquisition of the target company, the SPAC, and the target company combine into a publicly traded operating company. From the perspective of any business, SPACs have a one-up over IPO as they involve a less cumbersome regulatory process to go public because it just has to merge into the SPAC, thus abstracting the entire IPO process. Also, SPACs provide a better incentive structure with the sponsors as compared to investment banks who often want to maintain their sell-side relationship.

REGULATORY ISSUES

Corporate Veil

The capital that SPACs raise through IPOs is on the basis of an unspecified business. As per the SEC regulations, the prospectus of the SPAC must state that there is no specific business to be targeted for acquisition under consideration. As it is, SPACs will not be involved in any business operations. All of this puts the investors in a precarious situation, as they would have no way of knowing about the prospects of their investments based on the performance or even the objectives and future of the SPAC entity. To curb this difficulty to an extent, the ‘IFSCA paper’ envisages a list of disclosures to be made in the offer document during the public offer, which includes inter alia risk factors, capital structure, and key information about the issuer like previous acquisition experience and details of sponsors and their experience in acquisition. These disclosures would serve as one of the essential principles of corporate law, that is the funds provided by the shareholders and also the creditors are dedicated towards the fulfilment of a defined object. Although the exact target entity will be unknown to the shareholders at the time of the IPO issue, a detailed offer would go a long way in helping the public to assess the prospects of that particular acquisition and the subsequent operating company that will be formed.

The advent of the SPAC regime would manifestly be as an exception to Section 248 and other such provisions which are unfavourable to the operations of ‘shell companies’ thus barring the concerned authorities to exercise their power. These circumstances might prove to be conducive for corporate frauds like the ‘pump and dump’ schemes. To remedy this, the principle of piercing the corporate veil is invoked. This basically means the dilution of the corporate identity of the entity and identifying it with the personalities behind it and examining their behaviours and actions. In the case of State of Kerala v Selva J. Jayalalitha, it was stated that although a company is a separate entity from the personnel running it, the corporate veil cannot be used as a mere cloak to misdirect the investors. In the current jurisprudence, the Courts ought to exercise this power with caution and reluctance. But the emergence of SPACs should expand the scope of the principle’s application in a guarded way as the features of SPACs demand more protection for the investors and lenders. This expansion of the scope of piercing the corporate veil is justified in the case of SPAC as it is a policy and economic issue that might pertain to corporate actors’ behaviour.

Investors’ Funds

As is the case with any entity, there is no guarantee of success which, for SPACs, means not being able to close the acquisition deal with any target company within the given time frame. In such a case the company goes into liquidation and the investments are returned to the investors. To simplify this process, SPACs are stipulated to keep a large part of the proceeds from the IPO in an interest-bearing escrow account controlled by an independent escrow agent, until the consummation of the SPACs business acquisition. The portion provided in the ‘IFSCA paper’ is 90% of the total proceeds. This will imbibe a sense of confidence in the minds of the investors and will thus attract more investments in the IPOs. The SPAC shall also have a pre-determined liquidation distribution process in accordance with which the escrow account shall be liquidated.

However, there is a mechanism in practice that seeks to save an acquisition negotiation failing due to a shortage of funds with the SPACs. Many a time in advance of signing an acquisition agreement, the SPAC will arrange for Private Investment in Public Equity (PIPE), a form of equity financing which can be used to cover the balance amount required to complete the transaction. The PIPE is allocated shares usually at the same price as the SPAC IPO. This method is usually more efficient due to reduced regulatory scrutiny. PIPE increases the chances of the SPAC to realise the objective it was set out for and thus inspires trust from the investors. This is especially handy when the deadline to acquire the target is very close.

Flexibility in Shareholding

The acquisition of a company by the SPAC is approved if a majority of its shareholders give assent to it. The dissenter of the De-SPAC transaction may opt out of it by converting its securities into a pro rata portion of the aggregate amount deposited in the escrow account. This right to redeem their share is major protection that is provided as it provides an easy ‘exit option’ to the minority shareholder and immunes them from possible domination of the majority shareholders. Even the retail investors could benefit out of it as unlike exchange trade, they will be immune to the substantial fall or rise of the secondary market.

In order to attract more investment in SPACs while imbibing a sense of security in the investors, there is a need to allow the issue of share warrants which were abolished by the Companies Act, 2013. Share warrants are instruments that entitle their bearer who are fully paid-up shareholders to the shares therein specified, and may provide, by coupons or otherwise, for the payment of the future dividends on the shares specified in the warrant. If an investor is dissatisfied with the prospects of the SPAC, he may sell the shares but can retain the warrants and could later accrue the benefits if the SPAC is successful and turns out to be better than expected. This could be explained by the fact that there are no business performance reports available to the investors to keep a track of and assess its future. The success of a SPAC during IPO solely hinges on its ability to find a suitable target company within a timeframe.

The Road Ahead

The current gamut of corporate laws including Company Law, SEBI Regulations, FEMA, and the Income Tax Act, 1961 (ITA) is unfavourable to exclude SPAC-like entities or companies with no operational prospects but is fundamentally antithetical to it. For example, Section 248 of the Companies act enables the Registrar to eliminate a Company’s name for registration, if it fails to commence its business within 12 months from the date of its incorporation, and this provision is in fact aggressively used in practice by shutting down numerous shell companies.  Also, Schedule V of SEBI Listing and Disclosure Regulations (LODR) requires the company to report their ‘Discussion on financial performance with respect to operational performance’. Due to these roadblocks, the start-ups are being shut out from the global SPAC hunt.

The introduction of SPACs would also attract a host of regulatory challenges. It might be particularly endangering to the minority shareholders and retail investors as there will be no business operations that could portray the performance, prospects, and life of the company for them to assess. 

Conclusion

SPACs provide a more efficient and reliable mechanism for a private company to go public. To tap this development, SEBI has planned to roll out a framework for the introduction of SPACs in India.

The Indian laws of corporate governance are antithetical to the concept of non-operational companies concerning both existence and listing. Thus, drastic amendments have to be undertaken to accommodate SPACs in the scheme of things. This will carry with it a host of regulatory issues as well. These steps include expanding the scope for piercing the corporate veil and ensuring a continuous mode of disclosure. Also, an efficient mechanism for the inflow and outflow of cash from the SPACs has to be established. The minority shareholders and the retail shareholder also have to be protected by way of a simplistic opt-out option and other flexibilities like issuing share warrants. The objective of the changes should be to protect the investors so that more and more investment could be stimulated by avoiding any scope for committing fraud.

(This post has been authored by Kishalaya Pal, a Third-Year law student at Dr. Ram Manohar Lohiya National Law University, Lucknow.)

CITE AS: Kishalaya Pal, ‘Make SPACe: Changes and Challenges with the Introduction of SPACs’ (The Contemporary Law Forum, 29 July 2021) <https://tclf.in/2021/07/29/make-space-changes-and-challenges-with-the-introduction-of-spacs/> date of access.

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