Understanding the new rules necessitates a working understanding of SPACs themselves. SPACs are a form of “blank-check” company, in which capital is raised by investors through an Initial Public Offering (IPO). [2] SPAC IPOs differ greatly from traditional IPOs, however, in that at the time of a SPAC IPO, the SPAC has no physical operations of its own. [2] Instead, post-IPO, a SPAC is granted a two year term during which it must acquire or merge with an existing company, thereby taking that company public without ever going through the traditional, and often costly, IPO process. [2]

New SPAC IPOs have been on a meteoric rise since 2020. In 2019, just 59 SPAC IPOs occurred, while 2020 saw 247 and 2021 saw a record 613 SPAC IPOs. [2] These 613 SPAC IPOs in 2021 represented over $160 billion of capital raised. [2]

Yet even with the number of SPAC IPOs growing rapidly, the actual financial of SPACs is currently lagging behind index funds, which track to the S&P 500. [3] In fact, the ETF which tracks the prices of companies which stem from SPAC IPOs is down 33% year over year, while the S&P 500 is up 17% over the same time period. [3]

This performance disparity perfectly highlights the SEC’s core rationale for introducing SPAC disclosure rules. At present, SPACs raise money through IPOs with minimal disclosure requirements. More striking, the companies they eventually acquire or merge with are not subject to typical disclosure requirements either – leaving investors uniquely vulnerable to fraudulent misrepresentations.

The SEC’s newly proposed rules present an opportunity to clarify some aspects of the SPAC IPO process for prospective investors.

First, the rules, if enacted, would require new disclosures from and about SPAC sponsors, conflicts of interest, and dilution sources. [4] First, the rule proposes the adoption of a broad definition of SPAC sponsors as “the entity and/or person(s) primarily responsible for organizing, directing, or managing the business and affairs of a SPAC. . .” [4]

The rule further requires disclosures regarding conflicts of interest between SPAC sponsors and their public investors. [4] Such a conflict of interest could potentially arise if one SPAC sponsor is in the process of sponsoring multiple SPACs, or if a SPAC acquires a private company in which the SPAC’s sponsor already holds some financial interest. [4]

Additionally, the new rules look to better tackle issues relating to forward-looking projections made both by SPACs and by their potential target companies, further demystifying SPAC processes for their investors. [1]

In announcing the proposed rule, SEC Chair Gary Gensler harkened back to Congress’s initial attempt at addressing information asymmetries, misleading information, and conflicts of interest over 90 years ago when it first created the SEC in the wake of the 1929 market crash. [1] Gensler then noted that because, functionally, SPAC IPOs present firms with an alternative to traditional IPOs, investors “deserve the protections they receive from traditional IPOs, with respect to information asymmetries, fraud, and conflicts, and when it comes to disclosure, marketing practices, gatekeepers, and issuers.” [1]

The SEC’s proposed rule will be subject to a 60-day public comment period before ultimately being adopted by the regulator. If enacted in much the same format as the rules currently stand, investors stand to gain critical information about the true viability of SPACs in which they choose to invest.

As news around this proposed rule develops, Savage Villoch attorneys are ready to handle your questions or concerns. Reach out for consult today!

Sources:

[1] https://www.sec.gov/news/press-release/2022-56

[2] https://www.investopedia.com/terms/s/spac.asp

[3] https://www.forbes.com/sites/jonathanponciano/2022/03/30/sec-unveils-new-spac-rules-targeting-unreasonable-financial-projections-and-requiring-more-disclosures/?sh=6395435c74dd

[4] https://www.sec.gov/rules/proposed/2022/33-11048.pdf

By way of a brief overview, in January 2021 a group of about 100 stocks experienced monumental price and trading volume fluctuations. These stocks, many of which were consumer-centered companies with high brand awareness, gained rapid attention over social media platforms like Reddit and YouTube.

While the SEC’s report addresses the events and impacts of the meme stock phenomenon broadly, it focuses the bulk of its analysis around GameStop Corp (“GME”), arguably the most famous of the meme stocks.

The report notes that five factors – large price moves, large volume changes, large short interest, frequent Reddit mentions, and significant mainstream media coverage – all converged around GME in late January 2021.

In 2020, GME’s stock price swung substantially, starting the year at around $6 per share before falling to $3 in April and then rebounding to reach about $20 per share by the end of the year. [1]

Then, when Ryan Cohen, the co-founder of the popular pet-focused e-commerce company, Chewy, Inc., announced he would be joining GameStop’s board of directors on January 11, 2021, the stock took off. While GME traded at $20.65 per share that day, its rose to a high of $347.51 per share by January 27^th. Along with these price increases came similar increases in volume. Trading volume from January 23-29 averaged 100 million shares trader per day, more than 1,400% higher than average daily trade volume during 2020. [1]

As this market volatility unfolded, perspectives on its driving force into two main camps – those who touted GME as a prudent, even undervalued, investment because of its potential to break into the e-commerce market, and those who felt short interest was fueling the moves. [1] As social media users focused their attention on short interest from large institutional investors like hedge funds, a “short squeeze” on GME was triggered. The Reddit retail investors viewed themselves as fueling GME’s price increases, forcing hedge funds to close out their short positions at significant losses.

However, as GME and other meme stocks skyrocketed, some app-based trading platforms popular among retail investors placed temporary restrictions on trading in these stocks. The platforms cited various reasons for these restrictions, including margin calls from clearing agencies to cover increased risk. Conversely, retail investors believed that the restrictions were put in place in response to pressure from hedge funds with short positions at risk of losing money – claims that made their way to a Congressional hearing in February.

The SEC’s report ultimately provides a few important takeaways for the investing public. First, the report notes that it was “positive sentiment” about GME – whether a legitimate belief in GME’s fundamentals or a desire to profit from a rise in price – that fueled the sustained appreciation of GME’s stock price, not short-sellers who were “buying-to-cover.” [1] In fact, the report quite succinctly noted that “[s]taff believes that hedge funds broadly were not significantly affected” by the run on GME. [1]

Furthermore, the report also briefly touched on the rationale behind trading restrictions enacted by broker-dealers like Robinhood, noting that it had found evidence that clearing agencies had indeed demanded to be paid billions in additional margin by their member firms to account for volatility risks. [2]

The report concluded with four areas targeted for further study and consideration, noted as the following:

1. Forces that may cause a brokerage to restrict trading
2. Digital engagement practices and payment for order flow
3. Trading in dark pools and through wholesalers
4. Short selling and market dynamics. [1]

Each of these areas falls squarely within the ambit of SEC Chairman Gary Gensler’s already stated policy goals, inherent in his aim of promoting a more “fair, orderly, and efficient” market in the United States. [3] While the report did not outline specific improvements to be made, it serves as an important starting point for potential policy changes for protecting retail investor interests moving forward.

Sources:

[1] https://www.sec.gov/files/staff-report-equity-options-market-struction-conditions-early-2021.pdf

[2] https://www.latimes.com/business/technology/story/2021-10-18/sec-gamestop-report-debunks-conspiracies-backs-commission-chiefs-plan

[3] https://www.barrons.com/articles/sec-report-changes-what-we-know-about-januarys-gamestop-frenzy-51634590024

Robert Jackson, a professor at NYU School of Law and former SEC Commissioner, and John Morley, a Yale Law School professor, recently filed three suits against high-profiles SPACs in New York federal court. The suits argue that each SPAC is operating as an unregistered investment company, and under the Investment Company Act of 1940 (the “Act”), compensation paid to the SPAC’s sponsors and directors was illegal and void under the Act. However, in the decades-long history of SPACs, these entities have never been classified as investment companies under the Act, nor has the SEC purported that they should.

At the center of this debate lie two secondary, though potentially even more important, questions: what is a SPAC, and what is a SPAC’s primary purpose? The answer to these questions determines whether SPACs should indeed be classified as investment companies under the Act, as Jackson and Morley contend, or whether SPACs may continue to operate independently of the Act, as the SPAC industry and a wide coalition of law firms believe.

A SPAC is a type of blank check company which operates with the aim of finding an existing company to merge with, thus taking that company public. Typically, a SPAC is founded by an institutional investor, or group of institutional investors, who raise capital to go public via a SPAC IPO. The SPAC’s sponsors typically must then find a company with which to merge within 18 to 24 months. While SPAC sponsors search for a merger target, investors’ dollars are typically placed in trust accounts which hold various securities. [1]

Because SPACs have no sales or operations of their own, investors face a considerable degree of risk when they choose to invest in a SPAC before a merger occurs. At the same time, the merging company reaps the benefit of bypassing rigorous and time-consuming financial disclosures which the traditional IPO process entails. Once a merger occurs, the company has automatically gone public.

Under the Investment Company Act of 1940, “an investment company that is or holds itself out as being engaged primarily, or proposes to engage primarily, in the business of investing, reinvesting, o trading in securities.” [2] Jackson and Morley argue that because SPACs invest the proceeds from their IPOs in trust accounts while they search for a target to merge with, most SPACs are just this – entities who engage primarily in investing in securities.

SPAC industry players, including the group of over 60 large law firms in the United States, contest this view. The law firms quickly signed onto a statement which refutes the factual and legal basis of the lawsuits, arguing that the primary business of a SPAC is that of identifying and acquiring a company within a specific period of time. [2]

Their argument centers on a plain text analysis of the Act’s language, and states that so long as a SPAC engages in its primary business of acquiring a company, their short-term investments in their trust accounts do not make them an investment company under the Act. [2]

While this public refutation from some of the country’s leading law firms is noteworthy, its impact on the three lawsuits filed is attenuated. It is also important to note that some of these firms represent and receive earnings from SPAC dealings themselves. [1]

The outcome of each of these anti-SPAC cases will be interesting to track, particularly considering their potential impacts on the SPAC industry. One expert maintains that if a court were to determine that SPACs are investment companies subject to the Act, the decision would “wreak havoc in the industry, forcing sponsors to restructure their compensation and find new ways to safeguard investors’ capital.” [3] As these cases progress, please reach out to our attorneys with any questions you might have.

[1] https://www.reuters.com/legal/litigation/49-firms-72-hours-how-spac-bar-united-against-law-profs-splashy-lawsuits-2021-08-30/\

[2] https://www.jdsupra.com/legalnews/over-55-of-the-nation-s-leading-law-4944524/

[3] https://www.reuters.com/legal/litigation/49-firms-72-hours-how-spac-bar-united-against-law-profs-splashy-lawsuits-2021-08-30/

At the heart of the civil and criminal complaints against Nikola are allegations that as its CEO, Trevor Milton, regularly spread false and misleading information about the progress of Nikola’s EV products and technologies. Nikola’s focus is on manufacturing low- and zero-emissions trucks, and the complaints allege in part that under Milton, Nikola published a promotional video of a prototype truck which did not actually work, but appeared to only because the truck was set in neutral and rolled down a hill. [1]

Promotional videos like that one, along with Milton’s enthusiastic social media posts and numerous podcast and television appearances, all painted a picture of exciting and impressive forward progress at Nikola, which Federal prosecutors and SEC regulators allege was nothing more than an illusion. [2]

This illusion allegedly created by Milton came at a steep cost – and was seemingly targeted retail investors in particular. Nikola went public via a Special Purpose Acquisition Company (“SPAC”) in June 2020, and once it began trading publicly, the value of its shares increased by $7 billion. However, Nikola’s value dropped steeply once the public learned of ongoing federal investigations into the company and its operations, leading to huge losses borne by retail investors who had been misled. [1]

Of course, EV companies and their executives are in a unique position given the bounding public interest in, and relative infancy of, the EV market. When attempting to evaluate a new or existing EV company, projections into the future must be made, and no fool-proof roadmap for this technology currently exists.

However, these uncertainties pose a particularly risky situation for prospective retail investors who can be easily misled by companies making false claims about their highly complex products or technologies – especially when, as here, these claims are being shared rapidly over social media.

Here, Nikola’s non-traditional IPO process put unsuspecting retail investors at even greater risk. When a company goes public via a SPAC, the traditional “quiet period” after a company is publicly listed is not required. This allowed Milton to continue amplifying false claims about Nikola on social media just after going public, thereby attracting additional retail investors, and driving the stock price up further. [3]

In pursuing these securities fraud charges against Nikola, the SEC continues to signal its sharp focus on SPAC regulation in the interest of protecting investors. As we all navigate the rapid influx of SPACs along with the continued push for broad adoption of EVs, retail investors should continue to carefully research prospective investments by identifying concrete achievements such as milestones hit and actual sales or delivery figures to date, while steering clear of “bandwagon effect” investing. These careful considerations, along with continued scrutiny by regulators, are some of the best ways to protect your assets in the market.

Sources:

[1] https://www.marketwatch.com/story/nikola-electric-truck-prototypes-were-powered-by-hidden-wall-sockets-towed-into-position-and-rolled-down-hills-prosecutors-say-11627572394

[2] https://www.sec.gov/news/press-release/2021-141

[3] https://www.nytimes.com/2021/07/29/business/nikola-trevor-milton-fraud.html

Let’s consider an example of margin investing with Robinhood. An investor deposits $5,000 cash into a margin account, and Robinhood lends another $5,000 to allow the investor $10,000 worth of securities. The “margin” is the difference between the value of the securities and the loan from Robinhood. This type of investing increases both purchasing power and financial leverage. [1]

If the securities in the margin account increase in value, the investor has the opportunity for a higher profit than they would have had they invested $10,000 of their own.

On the other hand, if the securities decrease in value, the margin investor is at risk of losing more than they would have had they invested $10,000 of their own.

One of the most significant risks of margin investing stems from margin calls. Because securities purchased on margin are used as collateral against the loan Robinhood extends, Robinhood sets “margin maintenance requirements” on each margin account. These requirements are minimum portfolio values that must be maintained by the investor, and they help Robinhood protect the money they’ve loaned. [2]

So, if the market is volatile, as it has been recently, and the value of securities in a margin account falls too far, Robinhood will issue a margin call. The investor must then either deposit additional cash into their account to meet the margin maintenance requirement or close out their position(s).

However, per Robinhood’s Margin Account Agreement and Margin Disclosure Statement, when Robinhood issues a margin call, they also have the right to sell the account holder’s securities without notice nor consultation. [3],[4]

The language of the agreement specifically states that Robinhood is authorized to liquidate or sell the securities in a margin account to cover any margin deficiency, and that they are not required to notify the account holder before making such a sale. The agreement also stipulates that Robinhood has the sole authority to choose which securities are sold in order to satisfy a margin call, and that Robinhood’s margin maintenance requirements are subject to increase at any time, with no advanced written notice required. [3],[4]

Based on this agreement, which all Robinhood margin investors are required to sign, Robinhood has quite a bit of power over margin accounts. Understood in context, however, these stipulations are designed not to put the investor at risk, but instead to allow Robinhood to protect the money they’ve loaned to investors via immediate liquidation and/or covering losses by requiring additional cash deposits. [3],[4]

Margin investors should also be aware that Robinhood’s margin account agreement explicitly states that any disputes must be resolved via arbitration, so neither party to the agreement may sue one another in court. If a dispute arises, an arbitration case would be filed with the Financial Industry Regulatory Authority (FINRA) in order to reach a resolution or settlement. [3],[4] FINRA arbitration is designed to create a fair and expedited alternative to a traditional court case, but it’s important to understand the arbitration process before deciding to make the leap into margin investing.

So, depending on your risk tolerance, margin trading may or may not be an investment tool you want to use in your accounts.

In our next post, we’ll be sharing a start-to-finish overview of what you can expect from the FINRA arbitration process, particularly as it pertains to margin investing.

Sources: [1] https://www.investopedia.com/ask/answers/041315/why-purchasing-stocks-margin-considered-more-risky-traditional-investing.asp [2] https://robinhood.com/us/en/support/articles/margin-overview/ [3]https://cdn.robinhood.com/assets/robinhood/legal/RHS%20Customer%20Margin%20and%20Short%20Account%20Agreement.pdf [4]https://cdn.robinhood.com/assets/robinhood/legal/RHS%20Margin%20Disclosure%20Statement.pdf