Congress Targets SPAC Founder Shares

Under new draft legislation, brokers would not be able to recommend deals to retail investors when sponsors get more than 5 percent of the SPAC.

Michael Nagle/Bloomberg

Michael Nagle/Bloomberg

The House Financial Services Committee is working on legislation that would prohibit investment advisors, brokers, and registered representatives of brokers from recommending special purpose acquisition companies whose sponsors receive more than 5 percent ownership “or similar economic compensation,” according to draft legislation.

The ban, as proposed, would only apply to recommendations to unaccredited investors — not the institutions and hedge funds that typically invest at the IPO stage and can get their money back if they don’t like the deal the SPAC strikes with its merger partner.

Retail investors come in after the IPO at a higher price, and many have been burnt over the past year as the SPAC boom turned into a bust.

The draft legislation takes aim at one of the biggest criticisms of SPAC sponsors, which is the 20 percent of the SPAC’s ownership, or promote, that they receive for a nominal consideration.

The 20 percent promote was also raised as a major concern in a letter written to SPAC executives two weeks ago by Senator Elizabeth Warren and three other Democratic senators: Sherrod Brown, Tina Smith, and Chris Van Hollen.

“We are concerned about the misaligned incentives between SPACs’ creators and early investors on the one hand, and retail investors on the other,” they wrote. The 20 percent promote, they said, “reduces the cash per share for investors,” among other issues.

The letter was sent to Howard Lutnick, chairman and CEO of Cantor Fitzgerald; Michael Klein, founder of M. Klein and Co.; Tilman Fertitta, chairman and CEO of Fertitta Entertainment; Chamath Palihapitiya, co-Founder and CEO of the Social+Capital Partnership; David Hamamoto, CEO and chairman of DiamondHead Holdings Corp.; and Stephen Girsky, managing partner at VectoIQ.

“Industry insiders may be able to take advantage of retail investors throughout the SPAC process to the benefit of large institutional investors such as hedge funds, venture capital insiders, and investment banks: SPAC creators, or ‘sponsors,’ have incentives to quickly strike merger deals, regardless of the quality of the deal or of the company to be acquired; early investors (often investment banks and hedge funds) are essentially guaranteed risk-free investments; both sponsors and early investors profit from hyperbolic, pre-merger claims about the company to be acquired; and retail investors who purchase shares based on those hyperbolic claims are often left with devalued shares,” Warren said in a statement.

The letter was the latest in a string of attempts to close the regulatory loopholes associated with SPACs, which have been under the scrutiny of both Congress and the Securities and Exchange Commission this year.

An earlier draft of a SPAC reform bill would also amend the securities laws to get rid of what’s known as the “safe harbor” provision of the Private Securities Litigation Reform Act of 1995, which may limit the ability of investors to sue SPACs over their financial projections. That loophole was also mentioned in the senators’ letter.

It’s unclear if language nixing the safe harbor will also be included in the new legislation, or indeed, if any of it will become law.

Still, even some SPAC participants aren’t too worried about the latest draft’s inclusion of a ban on retail recommendations for deals involving a promote above 5 percent.

“I’m ok with it,” said Douglas Ellenoff, whose law firm Ellenoff Grossman & Schole is a long-time advisor to SPACs. “If there is an audience that wants to buy this stuff… and proactively doing it on their own that isn’t going through a broker for a recommendation, it still can be done.”

If regulators really want to protect retail investors, he suggested, they should take enforcement action against brokers who allow retail investors to buy excessive amounts of SPAC stock. He said this could be in violation of the brokers’ duty to make sure transactions are suitable investments for their clients.