HFSC SPACs Hearing

House Financial Services Subcommittee on Investor Protection, Entrepreneurship, and Capital Markets

Going Public: SPACs, Direct Listings, Public Offerings, and the Need for Investor Protections

Monday, May 24, 2021

Witnesses 

• Stephen Deane, Senior Director of Legislative and Regulatory Outreach, CFA Institute
• Andrew Park, Senior Policy Analyst, Americans for Financial Reform
• Usha Rodrigues, Professor & M.E. Kilpatrick Chair of Corporate Finance and Securities Law, University of Georgia School of Law
• Scott Kupor, Investing Partner, Andreessen Horowitz

Opening Statements
Chairman Brad Sherman (D-Calif.)
In his opening statement, Sherman emphasized the importance of the $132 billion in securities transactions that go towards initial public offerings (IPOs), stating that this investment in companies helps provide for a prosperous future. He then outlined the three elements of focus for this hearing: 1) how treatment of companies varies across the avenues for going public; 2) the need for Congress to determine the necessary level of investor protection; and 3) the allocation of opportunity to invest in a new IPO. Sherman expressed concerns about underpricing for traditional IPOs and the difference in liability levels for traditional IPOs versus special purpose acquisition companies (SPACs). Sherman also argued that if there is a need to hold underwriters accountable, then such requirements should be applied for both traditional IPOs and SPACs. He concluded by questioning whether retail investors are missing out on these investment opportunities and the need to investigate these issues in detail.

Ranking Member Bill Huizenga (R-Mich.)
In his opening statement, Huizenga emphasized that the strength of our financial markets is vital during this challenging economic environment, but strict regulation has hindered progress. He stated that small businesses have relied heavily on financing during the pandemic and added that 80 percent of business debt financing comes from investors in our markets, not banks. He continued that the decline of IPOs is a result of the going public process being lengthy and costly due to regulatory and compliance burdens. Huizenga said this results in more companies opting for private venues to raise capital, and that when companies remain privately funded instead of going public, it ultimately hurts American investors. He also touched upon the fact that this has implications for our global competitiveness, noting that the U.S. IPO market has declined while foreign markets are growing, particularly China’s IPO market having produced one-third of the world’s IPOs in 2020. He concluded that with the decline in IPOs, Congress need to be focused on crafting a legislative and regulatory framework that makes our markets more attractive and provides various paths for companies to go public.

Testimony
Stephen Deane, Senior Director of Legislative and Regulatory Outreach, CFA Institute
In his testimony, Deane said SPACs present two different sets of investors and investment outcomes – one that is excellent for the big investors who exit at the time of the merger and one that results in poor returns or losses for the ordinary investors who stay on. Deane said the “winners” are the big investors – the SPAC sponsor, the hedge funds, as well as investors in the private investment in public equity (PIPE). However, Deane explained that retail investors tend to be the “losers” when they can only buy their shares after the merger. He said there are three particular features of SPACs that contribute to this divergent record of returns: dilution, misaligned incentives, and an uneven regulatory playing field that permits forward-looking statements at the time of the merger. He said the sponsor has a strong financial interest to complete the merger even if it is a bad deal for ordinary shareholders. Deane said the CFA Institute has raised questions about the investor protection issues and plans to make recommendations regarding the surge in SPACs and the implications for investor protection, corporate governance, and market integrity. Moving forward, he said investor education is necessary but that it is not sufficient on its own and urged Congress and the securities regulators to remain vigilant in protecting investors as well as enhancing the transparency and integrity of the securities markets.

Andrew Park, Senior Policy Analyst, Americans for Financial Reform
In his testimony, Park focused on the rise of SPACs, stating that this trend is likely driven in part by private companies’ desire to exploit the perceived speed, streamlined disclosures, limited liability, reduced shareholder rights offered by the SPAC process, and the greater negotiating power offered that allows them get a higher price than in the private market. He noted that given these features, it is not surprising that highly speculative companies are looking to access the public markets via SPAC mergers. Park said this exponential growth is particularly concerning because retail investors are buying into this kind of hype, and in some instances pouring their life savings into certain SPACs when data continues to show that they perform poorly over the medium and long run. He added that a large part of the underperformance comes from the upfront compensation to the sponsor regardless of the quality of the acquisition. He concluded by urging the Committee to take action to address the dramatically misaligned incentives that characterize these deals and their extremely poor performance for retail investors. Park’s suggestions included amending the Exchange Act to align the rules governing forward looking projections in SPACs with those of IPOs and broadening the definitions of blank check companies to better protect main street investors.

Usha Rodrigues, Professor & M.E. Kilpatrick Chair of Corporate Finance and Securities Law, University of Georgia School of Law
In her testimony, Rodrigues stated that SPACs bill themselves as cheaper, faster, more certain alternatives to IPOs. She emphasized that while she has written extensively about SPACs, she does not believe there is anything fundamentally wrong with the current IPO process and it does not need fixing. She said the nature of a traditional IPO is a slow and painful process but is important for protecting the public capital markets. She continued that public markets represent a vast new source of capital for companies and allow ordinary citizens to invest. Rodrigues outlined her support for the proposal to exclude SPACs from the Private Securities Litigation Reform Act’s (PSLRA) Forward-Looking-Statements Safe Harbor. She also said since the de-SPAC is the functional equivalent of an IPO, she supports the proposal to extend Section 11 liability to SPAC sponsors and underwriters, noting that banks currently face no Section 11 liability in the de-SPAC transaction. Rodrigues said she is more hesitant about the proposals to apply the definition of a “Blank Check Company” to include SPACs and for enhanced disclosures at the SPAC offering and merger stages, arguing that disclosures alone are not enough.

Scott Kupor, Investing Partner, Andreessen Horowitz
In his testimony, Kupor highlighted a number of trends concerning IPOs and capital formation. First, Kupor outlined that roughly up until 2016, the raw number of IPOs was declining significantly, but with the benefit of increasing IPOs in the last few years, we are starting to see better growth and noted in 2020 there were close to 500 IPOs in the U.S., double the rate of the prior year, and 103 of those were venture-backed companies. Second, he stated that the characteristics of IPO candidates have changed as fewer small companies are making it to the public markets or are just staying private for longer. Third, Kupor said the effect of these changes is a “hollowing out” of the U.S. capital markets and a decline in corporate competition. He noted that in the last two decades, the number of publicly listed companies in the U.S. declined by 50 percent while other developed countries have experienced a 50 percent increase. Kupor emphasized that these declining trends have a negative effect on job growth and access to economic opportunities in addition to creating a two-tiered capital markets structure in the U.S. Kupor then discussed a variety of recommendations to Congress and the relevant regulators including: 1) expand the Emerging Growth Company (EGC) status; 2) require enhanced short positions disclosures; 3) clarify the tracing rules with respect to direct listings; 4) ensure liability regimes around SPACs; 5) amend the Accredited Investor definition to expand its ranks; and 6) amend the registered investment advisers (RIAs) restrictions on incentive-based compensation.

Question & Answer
SPACs
Huizenga asked which of the three avenues is the most attractive path to bring a company public. Kupor said they all differ, and that SPACs are typically faster for companies and there is more certainty around the initial pricing. He said companies opt for direct listings when they do not need to raise primary capital because they likely have already made a name for themselves and can successfully go public with less marketing burden. Kupor said traditional IPOs are for companies who need access to primary capital. Rep. French Hill (R-Ark.) echoed Huizenga and emphasized the importance of bringing down the cost of going public and staying public. Kupor asserted that the framework governing EGCs is the right framework to give public investors more opportunity to invest in a private market. Rep. Bryan Steil (R-Wis.) focused on EGC status and how the structure assists companies in accessing capital.

Rep. Maxine Waters (D-Calif.) cited a letter from the CFA Institute to the House Financial Services Committee outlining that initial SPAC sponsors and hedge funds that have access to the early investor pool receive “attractive investment returns on an essentially risk free investment while avoiding the disclosure obligations and risk associated with a typical IPO.” In response, Park stated that investors do not have sufficient insight into the financials and that the compensation structure of SPACs should be examined further.

Rep. Warren Davidson (R-Ohio) stated that the Securities and Exchange Commission (SEC) has failed to provide regulatory clarity in this space, resulting in volatility. Kupor noted that this has led to significant disparity between institutional investors and retail investors.

Rep. Sean Casten (D-Ill.) asked if there is a difference between SPACs and putting trust in a sponsor not a company versus investing in a private equity fund. Park said the major difference is the private equity fund has a debt investment and some set of security while the business model for SPACs requires a lot of marketing and hype to attract investors. He added that this is why the SEC has warned to not buy into a SPAC just because they hire a celebrity to promote them.

Casten then pointed to Deane’s testimony in which he said there is pressure to deploy capital on a SPAC before a window closes and asked if it is similar to a private equity fund nearing the end of its lock up period. Deane said it is similar, but a private equity firm might have five or seven years to do it while a SPAC has 18 months or two years. He also said a private equity firm has a diverse portfolio whereas the SPAC is one firm or target.

Underwriter Concerns
Sherman asked if is legal for an underwriter to only make investments available to their “best customers” or the trustee of a large trust. Rodrigues said this notion of “IPO spinning” is not legal, and that the allocation of IPO shares from the syndicate to investors is relatively opaque and an ethically questionable practice. Sherman added that he wants to make sure it is illegal to bring a fiduciary the chance to make $100,000 in profit that is not available to the other customers of the brokerage.

Liability Concerns
Rep. Juan Vargas (D-Calif.) said the whole Committee appears to agree on the issue of liability and having either the same or no system for all options. Kupor said he is not taking a position on what the appropriate liability level should be, just that it should be a level playing field. Rodrigues mentioned the importance of forward-looking statements to investors, noting that IPOs have strict liability standards but SPACs as an “empty shell” get to say whatever they want about their future prospects. Park agreed that ensuring the strength and accuracy of forward-looking statements is very important.

Barriers to Going Public
Huizenga asked if there are concerns about Congress or the SEC making it more difficult for companies to go public. Kupor said companies are staying private longer because it is very difficult to be a small cap company in the public markets. He stated that Congress needs to think about how to increase liquidity and volume of activity for small cap companies and that before introducing more regulation, the relevant policymakers and regulators should question if such regulation will help or hinder access for retail investors to these opportunities.

Rep. Ann Wagner (R-Mo.) asked which regulatory requirements, like additional disclosure and filing requirements, make going public less attractive for companies. Kupor said the EGC status of being able to defer some of the Sarbanes-Oxley requirements is helpful, especially for small cap companies. He said there are other issues related to pay and disclosure that pose challenges, but added that when these companies get larger, those requirements become more manageable.

Wagner mentioned her Modernizing Disclosures for Investors Act, which would allow issuers of securities traded on a national exchange to disclose quarterly financial information in a simpler manner and reduce the costs that deter companies from going public. She then asked if it is beneficial for businesses to continue to have multiple pathways for going public. Kupor said yes, and that the markets are demonstrating that trend right now. He added that there are many issues related to SPACs, but that having three options will help from a market perspective. Kupor continued that the different avenues create competition, help improve IPO pricing, and result in better price discovery. He concluded that it is crucial to preserve competition, choice, and investor protections.

Disclosure Concerns
Rep. Anthony Gonzalez (R-Ohio) mentioned the syndication of risk capital at the pre-IPO stage and asked if, when buying the sponsor, it is possible for someone to know who owns the sponsor or if the sponsor can syndicate the risk capital and not disclose it. Kupor responded that he believes the answer is yes.

Rep. Michael San Nicholas (D-Guam) asked if there is a difference between a SPAC and a closed-end equity fund in their function of pulling together investors. Deane said closed-end mutual funds invest in different things and have diversified portfolios, in addition to offering the ability for one to see what their assets are. As it relates to a SPAC, Deane said pre-IPO, there are no assets and the merger target is just one private company.

San Nicholas questioned why an investor would invest in a SPAC prior to its IPO. He continued that if they know the target being invested in, it might imply insider trading. The other option he outlined is if they are investing simply because of the management team, then the management should be under the regulation of the Investment Company Act of 1940. He suggested regulating SPACs as management companies rather than IPOs.

IPO Pricing
Rep. Jim Himes (D-Conn.) asked about IPO pricing behavior, who benefits when IPOs are underpriced, and if there is any long-term fundamental value in having a big IPO “pop.” Deane said IPOs offer tremendous strengths in investor protection but problems remain as issuers are leaving money on the table through the “pop.” Rodrigues said the initial investors in the IPO get a huge bump in value on day-one, and that banks then benefit from that. She concluded that the “losers” are those that have to buy at the market price, who she characterized as mostly retail investors.

Direct Listings
Gonzalez asked who benefits from direct listings and how projections are made in that process. Kupor said direct listings are for companies that do not need primary capital, and the benefit is utilizing an auction mechanism to derive the opening price for the stock. He outlined that it works for those concerned about underpricing because there is probably a closer market price with direct listings. Kupor argued that direct listings should remain a viable option because they will help address many challenges being discussed around traditional IPOs.

Venture Exchanges
Rep. Tom Emmer (R-Minn.) mentioned the reintroduction of his bill, the Main Street Growth Act, which allows the SEC to provide for the creation of venture exchanges, offering streamlined regulation and strong investor protections which will help emerging companies gain access to capital. Emmer asked if the creation of venture exchanges would help incentivize more emerging growth companies to go public. Kupor said the concept of a venture exchange is positive and could help address after-market issues like liquidity and volume of trading that impact small cap stocks. He said it is important to make sure it does not create adverse selection of risk and that there is an opportunity to graduate from it over time.  

For more information on this hearing, please click here.