SPACs and pension funds maybe a marriage made in hell: A risky investment vehicle for funds requiring a safe and stable rate of return

What follows is a high-level presentation I prepared for the California Lawyers Association 2022 Annual Meeting that was held in San Diego, California between 15-17 September 2022. At the meeting, I was a panelist at a seminar-type panel discussion entitled, Everything You Never Knew You Needed to Know About SPACs. For my part of the presentation, I was asked to prepare materials and discuss the “dark side” of SPACs and chose to focus on the implications of pension funds, such as the California Retirement System (“CalPERS”) or the Teacher Retirement System of Texas (“TRS”) using SPACs as an investment vehicle.
 
Just to level set, a Special Purpose Acquisition Company or SPAC “is a publicly traded corporation with a two-year life span formed with the sole purpose of effecting a merger, or “combination,” with a privately held business to enable it to go public. SPACs raise money largely from public-equity investors and have the potential to de-risk and shorten the IPO process for their target companies, often offering them better terms than atraditional IPO would.”[1] However, if for any reason the combination does not occur within the allotted time frame, the funds raised must be returned to the investors through a process known as “redemption.”
 
And why we all need to know about SPACs is because a few years ago the financial investment community fell madly in love with SPACs as a more cost and time efficient means to bring new ventures to the public marketplace than via a traditional IPO. However, this year SPAC-to-de-SPACs transitions, or completed mergers, are in decline; with few, if any, finding likely and amenable "marriage" partners. And those that have or can identify one or more likely targets are either unable to consummate the marriage or have sustained substantial losses since the deals have closed and the new companies “birthed.” As such, redemptions by investors are on the rise, which may or may not result in adverse tax consequences for the investors in the unrequited SPACs.
 
What are the investment norms for pension funds?
 
Because a pension fund is an employee retirement tool that contractually pools the initial and on-going contributions of employees and their employers and then invests those funds into financial instruments with the dual goal of achieving the financial growth needed to meet the on-going defined benefit obligations to each employee upon their retirement or to their beneficiaries upon their death as promised according to the provisions outlined in the specific employer pension plan. As such, the pension funds must be so prudently managed by a fiduciary such that it, the plan, can achieve these dual goals over time and on an on-going basis.
 
The IRS defines a fiduciary as a person being in a position of trust with respect to the participants and beneficiaries in the plan. A fiduciary’s responsibilities include:

• acting solely in the interest of the participants and their beneficiaries;
• acting for the exclusive purpose of providing benefits to workers participating in the plan and their beneficiaries, and defraying reasonable expenses of the plan;
• carrying out duties with the care, skill, prudence and diligence of a prudent person familiar with the matters;
• following the plan documents; and
• diversifying plan investments.[2]

 
What are the investment norms for SPACs?
 
Using state of Delaware as an example, pursuant to Section 141(a) of the Delaware General Corporation Law, directors of the entities that control the SPAC, as well as its acquisition target(s); the subject directors are vested with the exceptional authority to manage or direct the affairs of a corporation. As such, in Delaware a board of directors of any type of corporation owes fiduciary duties to that corporation and its shareholders.[3] Delaware courts sometimes describe the purpose of fiduciary duties as “maximising the long-term value of the corporation” for the benefit of a corporation’s shareholders.[4]
 
“The notion that fiduciary duties serve to protect a corporation’s long-term value is based on the assumption that every corporation has a “perpetual life in which the residual claimants have locked in their investment.” Frederick Hsu Living Tr. v. ODN Holding Corp., No. CV 12108-VCL, at *18 (Del. Ch. Apr. 14, 2017), as corrected (Apr. 24, 2017).
 
“But this assumption is not fully applicable to a SPAC, [whose fiduciary-like promoters, known as sponsors] and whose [corporate-like] existence is limited to the discrete timeframe in which investors typically retain the right to exit at their investment price plus interest. Few courts have had occasion to address whether or how traditional rules concerning fiduciary duties under Delaware law apply to SPACs. The courts that have done so, however, have not applied a different or modified set of fiduciary duty rules to SPACs. Nevertheless, courts recognise that “fiduciary duties of directors have context-specific manifestations.”[5]^,[6]
 
What are the investment risks associated with SPACs?
 
SPACs provide less information to potential investors.In a traditional IPO, the company seeking to go public typically has to provide a wealth of disclosures and go through due diligence processes prior to launch. In contrast, with a SPAC, there is less required documentation, and early investors typically invest solely based on the reputation of the sponsors. These investments represent a fractional ownership of a deposit in a trust account.
 
SPACS by their very nature are speculative investments. Through SPACs, investors may become exposed to domestic or foreign companies and businesses of varying risk profiles – and may encounter a "hype-based" business model that focuses on investors' hopes for outsized gains without sufficient attention paid to potential long-term risks. There is a possibility that the speed of the SPAC process may attract "hot" sectors or business models that may be only short-term fads instead of viable long-term businesses. Companies that merge with SPACs and become public avoid more stringent scrutiny than the companies would have been subject to if they went through the traditional IPO process. For example, the acquisition company's financial statements are not reviewed by the SEC until after the acquisition occurs, meanwhile the SPAC is allowed to present their own financial projections of the target company to investors (something not allowed when marketing a traditional IPO).
 
Fees and sponsor incentives. SPAC sponsors take on reputational risk to take a SPAC public and find a suitable target company. As a result, the SPAC sponsors are generally compensated for this risk in the form of a bigger discount to the price that a target company may obtain if it opted for traditional IPO. When a SPAC raises money from public investors, the public investors typically pay at least a 5.5% investment banking fee and generally give the sponsors a 20% interest in the SPAC in the form of equity, potentially in addition to other indirect fees.
 
SPACs are magnets for conflicts of interest and fraud. As noted above, the SPAC process relies heavily on underwriters and sponsors who are incentivized to identify an acquisition target due to ownership stakes both parties take in the SPACs. Investors should be aware of the potential for conflicts of interest between SPAC sponsors and SPAC shareholders since sponsors (given their heavily discounted 20% interest in the SPAC's common stock) may profit when an acquisition is completed even if the acquisition proves unsuccessful for the investors. This also raises the risk of potential misuse of funds and potential fraud through misrepresentation or omissions regarding the prospects of the target company. In addition, underwriters and SPAC sponsors may possess material, non-public information regarding potential SPAC acquisition targets and trade around that knowledge.
 
Trading price. SPACs are typically priced at $10 per unit during the IPO, but when these units begin trading their market prices may fluctuate – sometimes significantly – even before a merger target is identified. Given the fees mentioned above, buying at an elevated price can make it more difficult for investors to see a positive return on their investment when an acquisition is complete”[7]
 
Since pension funds and SPACs investment norms are misaligned, why are some pension funds looking at SPACs as potential investment vehicles?
 
Because “[p]ublic pension plans lost a median 7.9% in the year ended 30 June 2022, according to Wilshire Trust Universe Comparison Service data (released 9 August 2022) their worst annual performance since 2009 and a fresh sign of the chronic financial stress facing governments and retirement savers.” 
 
Much of the damage occurred in April, May and June, when global markets came under intense pressure driven by concerns about inflation, high stock valuations and a broad retreat from speculative investments including cryptocurrencies. Funds that manage the retirement savings of teachers, firefighters and police officers returned a median minus 8.9% for that three-month period, their worst quarterly performance since the early months of the global pandemic.
 
The results underscore the pain felt by many investors in a year characterised by a rare combination: simultaneous sharp declines in both stocks, which are understood to be risky, and bonds, which aren’t and accordingly are often purchased by investment managers as hedges.”[8]
As such, pension plans are looking to replace their losses, like the rest of the investment community. And pension funds have made substantial investments in SPACs. For example, on 7 December 2021, the Teacher Retirement System of Texas’ (“TRS”) Special Opportunities announced that it had invested just over $200M in seven SPAC opportunities and was exploring additional opportunities and carefully monitoring market and regulatory developments.[9]
 
Additionally, scholarly analysis of SPACs have lain bare some of their shortcomings
 
“Special Purpose Acquisition Company (SPAC) IPO investors have earned annualised returns of 23.9%, while investors in the merged companies have earned -11.3% in the first year on common shares but 72.2% on warrants. The authors rationalise why certain companies go public via a SPAC merger despite their high costs. The Scholars also identify the economic roles of SPAC sponsors and investors and analyse the agency problems that certain SPAC features address. To complete mergers, sponsors sometimes forfeit a portion of their shares and warrants, often transferring them to investors. Even so, sponsors have earned average annualized returns of at least 112%.”[10]
 
SPACs are uniquely structured to yield high returns for sponsors and directors, and sometimes private investors, even if public investors' returns dip post-merger. This is due to a number of features, including:

• Sponsors receive "promotes" or 10-20% of shares for a nominal contribution for forming the SPAC, which means they are able to receive high returns even with bad performance post-merger;
• Sponsors may receive warrants that are more favorable than public warrants, which allow them to buy shares post-merger at a set price;
• SPACs often times need additional investments through PIPE investment, which such private investment may be on more favorable terms than the public investors received; and,
• Sponsors are often experienced industry professionals and may have obligations to other business entities.

 
Thus, SPACs are structured to incentivize sponsors and members of the SPAC to complete a merger, even on terms that may not be in the best interest of the public shareholders. If the sponsors do not complete a deal within the standard 12-to-24-month time frame, the SPAC gets liquidated and the investors get their money back while the sponsors are left with nothing.[11]
 
The core challenge for SPAC governance is to address the inherently conflicting interest of a sponsor and public shareholders. SPACs respond to this conflict by holding proceeds of their IPOs in trust and by granting public shareholders a right to redeem their shares for a pro-rata portion of that trust. For the redemption right to be effective, however, a SPAC's board must provide shareholders with accurate and complete information regarding the merger. Doing so may conflict with the interests of the SPAC’s sponsor, which will profit substantially even in a deal that is bad for SPAC investors. The independence of a SPAC's board is thus necessary for a SPAC to be managed in the interest of shareholders.
Unfortunately, SPAC directors often have financial ties to a sponsor and are compensated in ways that align their interests with those of the sponsor. Where this is true, and where SPAC shareholders file suits alleging a breach of the duties of loyalty and candor, a court should affirm that the board has a duty to provide shareholders with the information they need to exercise their redemption right, and review the conduct of the sponsor and the board under an entire fairness standard.[12]
 
As a result of the foregoing, the SEC has begun to focus Its attention on SPACs
 
The Securities and Exchange Commission (“Commission”) is proposing rules intended to enhance investor protections in initial public offerings by special purpose acquisition companies (“SPACs”) and in subsequent business combination transactions between SPACs and private operating companies. Specifically, “[the Commission is] proposing specialised disclosure requirements with respect to, among other things, compensation paid to sponsors, conflicts of interest, dilution, and the fairness of these business combination transactions.
 
The proposed new rules and amendments to certain rules and forms under the Securities Act of 1933 and the Securities Exchange Act of 1934 would address the application of disclosure, underwriter liability, and other provisions in the context of, and specifically address concerns associated with, business combination transactions involving SPACs as well as the scope of the Private Securities Litigation Reform Act of 1995. Further, [the Commission is] proposing a rule that would deem any business combination transaction involving a reporting shell company, including a SPAC, to involve a sale of securities to the reporting shell company’s shareholders and are proposing to amend a number of financial statement requirements applicable to transactions involving shell companies.
 
In addition, [the Commission is] proposing to update [its] guidance regarding the use of projections in Commission filings as well as to require additional disclosure regarding projections when used in connection with business combination transactions involving SPACs. Finally, [the Commission is] proposing a new safe harbor under the Investment Company Act of 1940 that would provide that a SPAC that satisfies the conditions of the proposed rule would not be an investment company and therefore would not be subject to regulation under the Act.”[13]
 
And FYI, CalPERS, the State of California’s “State Employees’ Retirement System” (SERS)[14] has voiced its support for the SEC Rule Making provisions.[15]