Proposed SPAC Rule Changes

With the growing popularity of special purpose acquisition companies (SPACs), both the Nasdaq and NYSE have proposed rule changes that would make listings easier, although on June 1, 2018, the Nasdaq withdrew its proposal. SPACs raised more money last year than any year since the financial crisis. The SEC has been delaying action on the proposed rule changes, now pushing off a decision until at least August 2018.

A company that registers securities as a blank check company and whose securities are deemed a “penny stock” must comply with Rule 419 and thus are not eligible to trade. A brief discussion of Rule 419 is below. A “penny stock” is defined in Rule 3a51-1 of the Exchange Act and like many definitions in the securities laws, is inclusive of all securities other than those that satisfy certain delineated exceptions. The most common exceptions, and those that would be applicable to penny stocks for purpose of the SPAC, include: (i) have a bid price of $5 or more; or (ii) is registered, or approved for registration upon notice of issuance, on a national securities exchange that makes price and volume transaction reports available, subject to restrictions provided in the rule. For more on penny stocks, see HERE.

For purposes of this blog, the discussion of “SPACs” refers to trading SPACs and thus those that are not required to comply with the provisions of Rule 419. However, I have included information on the protections afforded through Rule 419, and thus not included in a SPAC, and a brief summary of the Rule 419 requirements.

What is a SPAC?

A special purpose acquisition company (SPAC) is a blank check company formed for the purpose of effecting a merger, share exchange, asset acquisition, or other business combination transaction with an unidentified target. Generally, SPACs are formed by sponsors who believe that their experience and reputation will facilitate a successful business combination and public company. SPACs are often sponsored by investment banks together with a leader in a particular industry (manufacturing, healthcare, consumer goods, etc.) with the specific intended purpose of effecting a transaction in that particular industry. However, a SPAC can be sponsored by an investment bank alone, or individuals without an intended industry focus.

The sponsor of a SPAC contributes 10% of the total post initial public offering (IPO) capital of the company. The sponsor’s 10% capital is used to cover the IPO and ongoing SEC reporting and administration expenses. Although a sponsor will invest 10% of the capital, they typically receive founder’s shares in the SPAC that results in approximately 20% ownership in the post IPO company. Sponsors do not make money unless a successful business combination is completed and the value of their ownership increases enough to justify the time and capital commitment of acting as a sponsor.

When a SPAC completes its IPO, usually 100%, but in no event less than 90%, of the funds raised are held in escrow to be released either upon completion of a business combination transaction, or back to shareholders in the event a transaction is not completed within a set period of time. A SPAC business combination must have a market value of at least 80% of the value of the amount held in escrow at the time of the agreement to enter into the transaction. Shareholders that object to the business combination have the right to convert their shares into a pro rata share of the funds held in escrow.

A SPAC generally has 24 months to complete a business combination; however, it can get up to one extra year with shareholder approval. If a business combination is not completed within the set period of time, all money held in escrow goes back to the shareholders and the sponsors will lose their investment.

SPAC IPOs are usually structured as unit offerings with both stock and warrants to entice investors to bet on the unknown future opportunity. The number of warrants and exercise price can vary and usually have a direct correlation to the prominence and track record of the sponsors and underwriters. That is, the more prominent the sponsor and underwriter, the fewer warrants and higher the strike price. As an alternative to warrants, some SPAC sponsors agree to over-fund the IPO trust account by some multiple to the investment amount, which over-funded amount would be distributed to the SPAC investors if a business combination is not completed.

The SPAC IPO process is the same as any other IPO process. That is, the SPAC files a registration statement on Form S-1 that is subject to a comment, review, and amend process until the SEC clears comments and declares the registration statement effective. Concurrent with the S-1 process, the SPAC will either have applied for a listing on a national exchange or, following the closing of the offering, will work with a market maker who will file a Form 211 application with FINRA to receive a trading symbol to trade on the OTCQX.

At the time of its IPO, the SPAC cannot have identified a business combination target; otherwise, it would have to provide disclosure regarding that target in its IPO registration statement. Moreover, most SPACs (or all) will qualify as an emerging growth company (EGC) and will be subject to the same limitations on communications as any other IPO for an EGC. See HERE related to an IPO process in general; HERE related to testing the waters and public communications during the IPO process; and HERE related to a Form 211 application.

When trading commences, investors can trade out of their shares, choosing to attempt to make a short-term profit while the company is looking for a business opportunity. Likewise, buyers of SPAC shares in the secondary market are generally either planning to quickly trade in and out for a short-term profit or betting on the success of the eventual merged entity. If a deal is not closed within the required time period, holders of the outstanding shares at the time of liquidation receive a distribution of the IPO proceeds that have been held in escrow.

Upon entering into an agreement for a business combination, the SPAC will file an 8-K regarding same and then proceed with the process of getting shareholder approval for the transaction. The SPAC must offer each public shareholder the right to redeem their shares and request a vote on whether to approve the transaction. Shareholder approval is solicited in accordance with Section 14 of the Exchange Act, generally using a Schedule 14A, and must include delineated disclosure about the target company, including audited financial statements.

Upon approval of the business combination transaction, the funds in escrow will be released and used to satisfy any redemption requests and to pay for the costs of the transaction. Target companies generally require that a certain amount of cash remain after redemptions, as a precondition to a closing of the transaction. As will be discussed further below, the exchanges all require that the newly combined company satisfy their particular continued listing requirements.

SPACs are, by nature, “shell companies” as defined by the federal securities laws. Accordingly, SPACs have all the same limitations as other shell companies, including, but not limited to:

• A SPAC is an ineligible issuer that is not entitled to use a free writing prospectus in its IPO or subsequent offerings within three years of completing a business combination.
• After completing the IPO and until it completes a business combination, the SPAC must identify its shell company status on the cover of its Exchange Act periodic reports.
• A SPAC cannot use a Form S-8 to register any management equity plans until 60 days after completing a business combination.
• Holders of SPAC securities may not rely on Rule 144 for resales of their securities after the SPAC completes a business combination until one year after the company has filed current “Form 10” information (i.e., the information that would be required if the company were filing a Form 10 registration statement) with the SEC reflecting its status as an entity that is no longer a shell company and so long as the SPAC remains current in its SEC reporting obligations.

OTCQX SPAC Eligibility

The OTCQX tier of OTC markets allows for the listing and trading of SPACs and is the only tier of OTC Markets that does so. OTC Markets Group will consider on a case-by-case basis the listing of a SPAC that satisfies all of the eligibility requirements for the OTCQX other than the general prohibition against shell and blank check companies (for a full list of requirements, see HERE), and in addition must satisfy the following requirements:

1. a) As of the most recent annual or quarterly period end, have $25 million in net tangible assets;
2. b) Have a minimum bid price of $5.00 per share as of the close of business on each of the 30 consecutive calendar days immediately preceding the company’s application for OTCQX; and
3. c) Be an SEC Reporting Company or a Regulation A Reporting Company.

Nasdaq Proposed Rule Changes

Nasdaq had proposed rule changes to its SPAC listing requirements reducing the number of required round lot shareholders (i.e., shareholders that own at least 100 shares) from 300 to 150 and to likewise eliminate the 300-round lot shareholder continued listing requirement. Round-lot requirements are meant to assure that public companies have a deep enough investor base to encourage stable trading and limit price volatility. However, Nasdaq asserts that price volatility is less of a concern with a SPAC as it has no operations and at least 90% of the cash that a SPAC raises in an IPO must be held in escrow until a business combination is completed.

Nasdaq also wanted to require that a SPAC listed on the Nasdaq Capital Market maintain at least $5 million in net tangible assets to ensure that the SPAC does not fall within the definition of a penny stock. The proposed rules would have imposed a 30-day deadline for SPACs listed on any of its three markets to demonstrate compliance with initial listing requirements following a merger. However, on June 1, 2018 Nasdaq withdrew its proposal without further explanation.

NYSE Proposed Rule Change

The NYSE has effectuated a series of rule changes related to SPACs throughout 2017. In particular, the NYSE now requires a majority of the SPAC’s independent directors to approve the business combination. In addition, the NYSE as changed the continued listing distribution standard from a requirement of 300 total stockholders to a requirement of 300 public stockholders. The NYSE also now specifically allows a company to follow the tender offer rules under Section 14 of the Exchange Act in lieu of the proxy rules under the same section, to solicit shareholder approval and redemptions related to business combinations.

The more recent November 2017 proposed changes are more substantial, mirroring the Nasdaq proposed rule changes. Like Nasdaq, the NYSE has proposed cutting the minimum number of required odd lot shareholders in half from 300 to 150. The NYSE has also proposed adding a $5 million minimum capital requirement to ensure that SPAC securities could not be deemed a penny stock. Upon completion of a business acquisition, the new combined company would have a 30-day grace period to prove continued listing eligibility.

Rule 419

The provisions of Rule 419 apply to every registration statement filed under the Securities Act of 1933, as amended, by a blank check company that is issuing securities which fall within the definition of a penny stock. A “penny stock” is defined in Rule 3a51-1 of the Exchange Act and like many definitions in the securities laws, is inclusive of all securities other than those that satisfy certain delineated exceptions. The most common exceptions, and those that would be applicable to penny stocks for purpose of this Rule 419 discussion, include: (i) have a bid price of $5 or more; or (ii) is registered, or approved for registration upon notice of issuance, on a national securities exchange that makes price and volume transaction reports available, subject to restrictions provided in the rule.

Rule 419 requires that a blank check company filing a registration statement deposit the securities being offered and proceeds of the offering into an escrow or trust account pending the execution of an agreement for an acquisition or merger. The securities of a blank check company which is required to comply with Rule 419 are not eligible to trade, but rather must remain in escrow.

Rule 419 of the Securities Act imposes certain obligations and restrictions upon issuers that are deemed to be “blank check” companies under applicable rules and regulations. Blank check companies generally lack any revenues, assets, operating history or plan of operations. Among other things, Rule 419 requires that nearly all of a “blank check” issuer’s offering proceeds be placed in escrow until the issuer has completed a business combination. All of a “blank check” company’s securities must also be placed in escrow until after the completion of a business combination, and no trading may occur until the issuer’s securities have been released from escrow. Notably, the definition of a “blank check” company set forth in Rule 419 excludes issuers whose outstanding shares are not deemed to be “penny stock.” In turn, the definition of “penny stock” set forth in Rule 3a51-1 of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), provides an exception for issuers with less than three years of operations who have a minimum of $5 million in net assets.

The staff of the SEC has previously determined through interpretive guidance that, to the extent an issuer files a current report on Form 8-K promptly upon consummation of an IPO indicating that net assets are in excess of $5 million, the staff will not deem the issuer to be a blank check company subject to the requirements of Rule 419. As a result, SPACs generally file such a current report on Form 8-K once the IPO is consummated, thereby avoiding the restrictions imposed by the requirements of Rule 419.

Companies subject to Rule 419 are required to file a post-effective amendment to the registration statement containing the same information as found in a Form 10 registration statement on the target company. The post-effective amendment must be filed upon the execution of an agreement for an acquisition or merger. The Rule provides procedures for the release of the offering funds held in escrow in conjunction with the post-effective acquisition or merger. The obligations to file post-effective amendments are in addition to the obligations to file Forms 8-K to report both the entry into a material non-ordinary course agreement and the completion of the transaction. Rule 419 applies to both primary and re-sale or secondary offerings.

Within five (5) days of filing a post-effective amendment setting forth the proposed terms of an acquisition, the company must notify each investor whose shares are in escrow. Each investor then has no fewer than 20 and no greater than 45 business days to notify the company in writing if they elect to remain an investor. A failure to reply indicates that the person has elected to not remain an investor. As all investors are allotted this second opportunity to determine to remain an investor, acquisition agreements should be conditioned upon having enough funds remaining in escrow to close the transaction.

For purposes of Rule 419, the term “blank check company” means a company that:

1. Is a development stage company that has no specific business plan or purpose or has indicated that its business plan is to engage in a merger or acquisition with an unidentified company or companies, or other entity or person; and
2. Is issuing “penny stock,” as defined in Rule 3a51-1 under the Securities Exchange Act of 1934...

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