SPACs in the UK – the new listing rules and their potential impact on deal activity and claims trends

Last Tuesday the Financial Conduct Authority (FCA) published its changes to the listing rules designed to increase investor protection whilst making the UK a more attractive jurisdiction to list SPACs. They will come into force on 10 August 2021. SPACs that meet the criteria under the FCA’s new rules will be able to benefit from the disapplication of the existing general presumption that trading will be suspended when a SPAC announces its potential acquisition target. The rationale for this change is to provide protection to investors at a stage when there is still limited public information available. Additional investor safeguards will also be included in the UK’s new regime, such as ring-fencing initial capital raised, the need for prior shareholder/investor approval to any combination and redemption rights.

What is a SPAC and why is everyone talking about them?

There has been a resurgence in the popularity of “SPACs”, aka Special Purpose Acquisition Companies, over the last couple of years, in particular in the US, with billions of dollars of capital being raised to fund SPAC IPOs.

As our colleagues discussed in their earlier piece, {SPACS in the City, increasing exposure to D&O} SPACS in the City, increasing exposure to D&O , a SPAC  is itself an investment vehicle structured as a shell company (also called a “blank check” company), which has no actual operations.  It is created by a sponsor for the sole purpose of raising capital through an IPO, following which (usually within 18 months to 2 years) it will acquire and merge with a (typically private) company.  The result is a single public entity consisting of the business of the target company and the capital of the SPAC. Unlike a traditional IPO where the “go public” process and capital raising function occur simultaneously, in a SPAC transaction the capital raising occurs before the target company to be taken public has even been identified.

This alternative means of taking a company public has proven particularly popular amongst start-ups who see it as an easier way to access public funds than a traditional IPO.

To date, the popularity of SPAC transactions has not yet been mirrored in the UK; in no small part due to differences in listing rules which made the floating of SPACs impractical and more risky to investors. However, in November 2020 the UK Listings Review, chaired by Lord Hill, was launched as part of a plan to strengthen the UK’s position as a leading global financial centre.  Following its March 2021 report recommending changes to the UK’s listing rules be considered, on 30 April 2021, the FCA opened a consultation in relation to those proposed changes, and now, after considering feedback from the market and evidence from the US, has published its final changes to the Listing Rules for SPACs which closely mirror those of the US.

Changes to listing rules

Whilst SPACs have existed for decades, they continue to have risks and can be a complex investment structure, as a result of which investors should ensure they understand the key risks and features of a SPAC before deciding whether to invest.  That said, the FCA appears hopeful that its changes to the listing rules for the both the Main Market and AIM will attract more activity in the UK in future. 

The key change is that, for SPACs that meet certain criteria, the presumption of suspension in trading in the SPAC shares after announcement of a proposed business combination will be removed.  This presumption had been criticised as far too restrictive and sponsors therefore historically considered the UK to be a less palatable market for SPAC deals. 

The changes provide an alternative to having to provide detailed information about a proposed target to the market in order to avoid suspension (something that can be very difficult to do at this stage in the SPAC lifecycle, when typically no target has been identified).  If a SPAC is unable to meet the criteria set (for example the capital size requirement), the SPAC can still list on the exchange, however it will not benefit from the removal of the suspension of trading.

The other related changes, which are aimed at safeguarding investors’ interests, include the following:

• A SPAC will need to raise £100m in its initial capital raising.  This was lowered from £200m in response to market feedback; however, the FCA feels the £100m threshold is still sufficiently high to attract institutional investors, which should bring with it more experience and a higher degree of scrutiny of the company;
• Requiring public shareholder approval of any proposed acquisition/combination.  SPAC founders, sponsors and directors are prevented from voting;
• The inclusion of a “redemption” option, which allows investors (i.e. public shareholders) to redeem their shares and exit the SPAC prior to the acquisition/combination being completed, whether or not that investor/shareholder approves the transaction;
• Ensuring that the money raised from public shareholders during the initial capital raising is ring-fenced and cannot be used for anything other than to fund the SPAC transaction (apart from any specifically agreed costs of running the SPAC);
• Introducing a limit on the time following a SPAC’s IPO within which it must complete an acquisition.  This will be two years, with an option to extend to three years with shareholder approval; however, there will be an ability to extend the two year period by 6 additional months in limited circumstances (where a transaction is well advanced) without shareholder approval.  In the current M&A environment, there is already a lot of dry powder, so pressure to find an attractive target at a good price, in a small window, can be high.  If no suitable target is found in the required timeframe, the SPAC is liquidated and investors’ funds are returned; and
• Requiring investors to be given sufficient disclosures on key terms and risks throughout the lifecycle, from the SPAC IPO through to the announcement and conclusion of any acquisition/combination.  Given the nature of the SPAC process, this will typically become more detailed once the target has been identified as the SPAC itself has no operating or financial history.

The UK’s reverse takeover rules will continue to apply to SPACs, meaning that the SPAC’s shares will be cancelled on completion of the combination and a new prospectus for the newly combined entity will be required to be published. 

Whilst sponsors will provide investors with some initial investment information in the IPO prospectus (for example, regarding the likely industry or geographic location of focus for the potential target), investors typically decide to invest on the basis of very limited information as to what the target is ultimately likely to be.  Often considerable importance is placed on the perceived experience and connections of the sponsor.  Requiring prior shareholder approval of any combination and allowing investors the option to redeem their SPAC shares before the acquisition completes, are both changes that are intended to offer investors greater control and flexibility over their investments.  As to whether requiring prior shareholder approval will in reality prove to be important remains to be seen, as typically in the US investors are incentivised to proceed with a deal whether or not they are entirely supportive of it, given that they will typically retain the right to redeem their shares, often without needing to surrender their warrants.  

Ring-fencing the capital raised from investors is intended to help protect against high redemption rates.  If too many investors redeem their shares and there is no cap, it can create uncertainty and gives rise to a need to find more (often PIPE) funding.

In order to align the incentives longer term, tweaked structures are being considered by the market.  In addition to ring-fencing the capital raised from investors, these include structures that start with a lower “promote” (i.e. the percentage equity the SPAC sponsor receives for a token capital contribution), which can grow over time if the post-combination entity’s shares perform well, as well as including a percentage cap on the ability of investors to redeem their shares and requiring any redeeming investors to surrender their warrants.  Some recent SPACs have attempted to address some of these issues by entering into forward purchase agreements which require SPAC sponsors to purchase additional (non-redeemable) shares in the SPAC (usually at a discounted price) in the event that additional capital is needed to complete the transaction. 

Criticism in the US

As the UK regime moves closer to the US model, it is worth bearing in mind that the SEC has been vocal about its concerns that the US rules may be too lax in certain respects.  Although SPACs are intended to be a quicker and more streamlined process for taking a company public, the structure has faced some criticism for being geared towards favouring the sponsor’s and pre-merger (redeeming) shareholders’ interests, at the expense of post-merger shareholders and the longer term performance and viability of the newly public company. 

It remains to be seen whether the rules in the US and UK will be revised in order to counteract these potential tensions/issues, or if the market may itself react proactively to seek to address the imbalances and align interests longer term. 

We have recently seen the SEC bring its first securities fraud enforcement action relating to the SPAC process last month. On 13 July 2021, the SEC brought charges against the SPAC, ‘Stable Road Acquisition Company’, its sponsor, its CEO as well as the SPAC’s target company (Momentus), and Momentus’s former CEO.  The charges relate to misleading statements/disclosures that were allegedly made about Momentus’s technology ahead of the SPAC’s proposed business combination with Momentus.  Litigation remains on foot against Momentus and is former CEO; however, certain of the other parties have settled with the SEC, agreeing to penalties totalling over US$8m, tailored investor protection undertakings and the forfeiture by the SPAC sponsor of the founder shares it stood to receive if the combination, scheduled for later this year, is approved.  In this case, the SEC alleged that the SPAC itself had repeated Momentus’ (and its CEO’s) misrepresentations, as well as completely failing in its due diligence obligations to investors. These proceedings serve as an example of the types of claims and D&O exposures that we could begin to see in the UK following the amendments to the UK listing rules if they result in an uptick in UK SPAC activity.  

The SEC is clearly keeping an increasingly watchful eye on how parties to a SPAC transaction fulfil their due diligence and disclosure obligations to public shareholders.  Just like with any M&A activity, there will be a spotlight on the due diligence carried out and the disclosures made in the lead up to any combination, and a failure to carry out those processes to a high standard could result in claims, potentially against a number of different parties.

SPAC founders clearly need to be alive to the risk that their own diligence is likely to be reviewed under a close lens, even in the event that the target business turns out not to be as initially represented.  In the broader sense, SPACs will likely want to consider the adequacy of the indemnities they are provided under the acquisition agreement and whether W&I insurance may be necessary to protect against potential losses resulting from the inaccuracy of a target’s representations and warranties.

As mentioned in our colleagues’ earlier article, it comes as no surprise that a key stage of the SPAC lifecycle which carries with it substantial litigation risk and, as a result, potential exposure for D&O insurers, is the process of identifying and merging with the target company.  In addition to potential D&O liability for material misrepresentations or omissions in the pre-combination documentation, or due diligence failings, there is the usual risk of securities class actions from plaintiffs against the newly public company after the combination, if they are not happy with the combination that has occurred or for other reasons.  Potential claims could also come from creditors in circumstances where a SPAC combines with a target that subsequently becomes bankrupt. 

US claims experience tells us that the potential defendants to SPAC-related litigation  are one or more of the SPAC, the SPAC’s former D&Os, the target, the target’s former D&Os, the newly combined entity and/or the current directors of the newly combined entity.  For D&O insurers, depending on who is sued, this could potentially involve three different sets of insurance for:

1. the SPAC and its D&Os, which will provide runoff coverage for a certain period to cover claims for wrongful acts that occurred pre-combination;
2. the target and its D&Os, which will also provide runoff coverage on the same basis; and/or
3. the combined company and its D&Os, which will require new insurance for wrongful acts taking place moving forwards.

It is of course possible that some individuals named in a suit could be sued in more than one capacity, as it is not uncommon, for example, for a D&O of the SPAC to also serve as a D&O of the newly combined entity.  This could give rise to issues as to which insurance should respond, or potentially to disputes about the proportion of defence costs to be allocated between two policies where a D&O is sued in more than one capacity.

It is also worth remembering that, whilst taking a private company public through a SPAC process can bypass the lengthy and a complex traditional processes of going public, there are increased regulatory and compliance burdens for a public company, which private company managers may not necessarily have the experience to deal with straight away.  It is therefore essential that thought is given to the public company management team and that robust reporting processes are in place, to ensure that the newly combined entity is ready to operate as a public company from day one.

What comes next for the UK SPAC market?

We will have to wait and see whether SPACs accept the invitation to list in the UK markets and, if they do, whether we may begin to experience some of the claims trends we have seen in the US already.  D&O insurers will need to ensure that they understand the nature of the particular risk they are underwriting to in each case, including giving consideration to the experience and quality of the sponsor and how the SPAC transaction is structured.   M&A activity is, of course, by its very nature an area that attracts substantial litigation, whether it is a SPAC or other structure of deal, and this can – even when meritless – cause substantial defence costs in the tens of millions to be incurred.

While the FCA have stated that they wish to avoid a regulatory ‘race to the bottom’ on standards, there are some gaps in how the new rules will, in practice, address some of the fundamental issues that have been identified in the SPAC process and which the SEC appears to be closely considering at this juncture. In light of this, should SPACs take off meaningfully in the UK, we should be prepared to potentially see similar litigation exposure in the UK to what the US has experienced over the past few years, and potentially some regulatory intervention, if the FCA was to follow in the footsteps of the SEC’s recent approach.