Many special purpose acquisition companies, also known as SPACs, may be in for a reckoning in the near future. In this segment of Backstage Pass, recorded on Nov. 15, Motley Fool contributors Danny Vena, Jason Hall, and Rachel Warren discuss a recent change by the Securities and Exchange Commission (SEC) that could impact how many SPACs report their financial results.
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Danny Vena: One of the things that we talk about is just some of the recent news in the IPO and SPAC sector. I'm going to share a new story that I saw here that really was surprising to me considering this is something that happened not too long ago. I will share my screen here.
The Securities and Exchange Commission is going to require special purpose acquisition companies, or SPACs, to restate their financial results if they didn't follow accounting standards regarding shares that they offer to certain investors.
Up until now, essentially auditors have just pooled the companies that they can fix these type of errors with a revision. For those non-accountants among us, a restatement is basically getting a pretty bad report card from the SEC. The SEC is saying, no, I don't like those financials, you need to do them over again and restate them.
Whereas a revision, there's a footnote in your next set of financial statements that says, yeah, we changed something, but it wasn't a big deal. For the SEC to come out and say, no, we're going to require a restatement of financials, this is the second time that the SEC has done this. This ruling could affect hundreds of SPACs.
You may recall that just several months ago there was a big pause in the SPAC market because the SEC said, we don't like the way you've been treating warrants, and so we want you to change that. I'm going to pause here for just a minute. Give me your thoughts on that. Jason, what do you think about the SEC essentially coming in and just smacking down the way these SPACs have been handling these?
Jason Hall: I think, to a large extent, it's overdue. But there's also a part of me that I think, at the end of the day, government regulatory always happens after the facts, and you want that. To have a healthy free market, and for capitalism to succeed, and for innovation to succeed, regulation has to come after we move fast and break things, so to speak. Obviously, there are exceptions like autonomous vehicles. You don't want 5,000-pound robot-powered cars not being regulated on the front side. But, in general, it makes sense.
You want things to take time to play out, but I do think it's a little bit overdue in coming here because it's been the wild west. You just look it across. I don't have the data right in front of me, but SPACs are just wreaking havoc and destroying capital as a category, as a class, and at a higher rate than IPOs. I think that's the key thing versus traditional IPOs where you get more regulatory scrutiny. It's great, and it's overdue.
Danny Vena: It's about time.
Jason Hall: Here's the last thing I want to say. Danny, this is the sort of thing why your typical rule about not buying right after a company goes public, even IPOs, the ones that have higher threshold to begin with, makes sense because more time to find out what they've already done poorly is allowed to play out.
Danny Vena: We're going to let Rachel talk now.
Rachel Warren: [LAUGHTER]
Jason Hall: Wait, one more thing. No, I'm kidding.
Rachel Warren: [LAUGHTER] Fine. No, I know how this goes, Jason. I agree with everything you said. I think investors get a little nervous when we hear new regulations are coming out. But I think at the end of the day, it's important to remember these also exist to protect the investors.
I know one of the things that is most likely they'll be looking into besides stock dilution is also founder incentives. Some of these safe harbors for mergers which allow the use of financial projections, there was a great article on JD Supra about this talking about the legal aspects of these changes. I think one of the issues that regulators are most concerned about is some of the disclosures surrounding stock dilution.
I think this is a good thing. I think there might be some bumps in the road with these regulations rolling out, but it was interesting because there was this academic study that was done by Stanford Law School and the New York University School of Law. It essentially concluded that SPACs often performed poorly for investors of the post-merger company. I think, again, it speaks to that concern.
News like this, I think it can make investors a little nervous, but actually, I think at the end of the day, it's better for everyone all around. So I think this is definitely something to watch. Obviously investing in some of these IPO via SPACs is always a little bit of a speculative venture. But I think the more regulations in an area like this is not necessarily a bad thing.
Danny Vena: I absolutely agree with what you both said. One of the things that Jason talking about SPACs being the wild west, I can't tell you how many times I've read that in the financial articles where they've talked about SPACs just be in the wild west. What's interesting to me is we talked about it being the wild west and yet, a SPAC, even more so than an IPO, you have to absolutely trust the person that is making the decision about the company that they're going to buy.
If you don't have that trust, then there's no incentive to buy these SPACs in the first place. I'm going to switch right back here and go to my second screen share. This is a little bit more detailed. What we're talking about here is SPACs typically issue two types of shares. They'll issue Class A shares and Class B shares. The Class B shares are the ones that are historically controlled by early insiders or people that invested in the company, some of these big hedge funds.
The Class A shares are usually redeemable. What that means is investors can turn them in and essentially get their money back. If they say, "We're going to acquire Don Cheatham's Bar and Grill," and you go, "I've had their food. I hate it. I don't want to be part of this investment anymore."
There's a period of time before the merger where you can turn your shares, and you get your $10 back if you don't like the acquisition target. That's been part of the allure of SPACs.
What has happened is, from an accounting standpoint, they have been treating these Class A shares as permanent equity. Essentially, these are the shares that are there and are going to be there forever. They haven't been treated that way.
They should, in fact, have been treated as temporary equity because of that redemption feature. This is just the latest controversy surrounding the SPAC craze. Expect to see more of that going forward.