SEC’s Recent Enforcement Actions a Sign of Increased Scrutiny of SPACs

In one of the most high-profile actions recently undertaken by the Securities and Exchange Commission’s Fort Worth Office, the SEC in late October settled securities fraud charges for nearly $40 million against Akazoo, S.A., a special purpose acquisition company (SPAC) that had merged into a private music streaming company. The action is noteworthy because it puts the spotlight on SPACs, an increasingly popular alternative for capital raising to the traditional initial public offering process and because it highlights the heightened risk to investors in SPACs.

SPAC transactions are increasingly in the SEC’s enforcement and regulatory crosshairs. In public statements and testimony, SEC Chairman Gary Gensler has repeatedly emphasized the need for close regulation of SPACs, citing risks inherent to SPAC transactions in which sponsors who stand to earn significant profits may conduct inadequate due diligence and mislead investors. And as recently as a couple of weeks ago, Senator Elizabeth Warren sent a letter to the SEC asking the agency to investigate a proposed SPAC transaction involving former President Donald Trump’s Trump Media and Technology Group for failure to disclose key facts in the SPAC’s offering documents.    

In the Fort Worth action, the fraud extended to multiple groups of investors – the initial SPAC investors, later private equity investors who invested in conjunction with the merger, and the investing public, once shares of the combined company were traded publicly over the NASDAQ. The SEC Division of Enforcement’s focus on SPACs is likely to intensify as the transactions become increasingly popular among companies looking for a fast, less expensive way to go public and amongst private investors looking for an accessible way to invest in a company that is ready to go public.

A Brief Primer on SPACs

A SPAC is a company with no commercial operations formed solely to raise capital for the purpose of acquiring or merging with an existing company. SPACs are formed by sponsors who receive what is known as a “promote” of 20% of the company’s equity in exchange for a “nominal investment.” Just about anyone can sponsor a SPAC – and recently celebrities such as Colin Kaepernick, Shaquille O’Neal, Larry Kudlow and pop star Ciara have promoted their own SPACs. A SPAC is often formed with a focus on a particular industry or business sector but does not generally know which company it will acquire in advance. For this reason, SPACs are often referred to as “blank check companies.”  

The funds raised by a SPAC, typically through an IPO, are placed in a trust account and cannot be dispersed except to complete a merger or acquisition – this is known as a de-SPAC transaction – or to return the money to investors if the SPAC is liquidated. A SPAC usually has two years to complete a deal to acquire a company, obtain shareholder consent for an extension of the two-year deadline or it must liquidate. This last point is critical, as sponsors receive their 20% promote only if they close a deal in that two-year widow.   

SPACs have become enormously popular in recent years, with nearly 250 SPAC IPOs raising approximately $83 billion in 2020 and more than 300 SPAC IPOs raising more than $95 billion in the first three months of 2021. SPACs are popular in part because they allow target companies to go public more quickly and cheaply than through traditional IPOs. Among other advantages, the target company negotiates directly with the SPAC as to valuation. One common, though not always present feature, of a SPAC transaction is the SPAC’s need to raise additional capital for the acquisition of the target company. This is commonly done through a so-called private investment in public equity (PIPE), transaction, in which the SPAC issues shares in a private arrangement with a select group of investors in conjunction with the SPAC/target business combination. PIPEs are often needed because many initial SPAC investors cash out before the de-SPAC transaction.     

As is apparent from this model, SPAC sponsors have a strong incentive to quickly close a deal with a target – and potentially cut corners on due diligence and disclosures – because the sponsor stands to gain enormously if a deal is closed in the two-year window while earning nothing if a deal fails to close within two years.

SEC v. Akazoo, S.A.

In Akazoo, a SPAC named Modern Media Acquisition Corp., which was formed in 2017 and traded publicly on the NASDAQ, was formed for the purpose of affecting a merger or acquisition of a company in the “media, entertainment, and marketing service sector.” Modern Media had a deadline to complete such a deal by February 2019 or dissolve, liquidate, or request an extension from its shareholders. The SPAC failed to meet the deadline and sought and obtained extensions from its shareholders. Modern Media eventually identified a private company operated under the name Akazoo Ltd., which purported to have a free, ad-supported streaming radio service and a portfolio of patented artificial intelligence-based technologies. Modern Media’s failure to consummate a merger by the initial February 2019 deadline caused many of its shareholders to divest before the merger (the de-SPAC transaction), leaving the SPAC with insufficient funds to finalize the transaction, requiring it to raise capital through a PIPE.

As it turns out, Akazoo’s CEO and CFO allegedly gave false information to Modern Media to induce the SPAC to enter into the merger/de-SPAC transaction – false statements including misrepresentations about the number of registered users Akazoo had, as well as Akazoo’s revenues, profitability and business relationships. Modern Media incorporated these false statements in its Proxy statement regarding the merger, encouraging Modern Media shareholders to support the transaction based on wildly false information. On top of this, the SPAC and Akazoo management made the same false statements to investors in the PIPE offering – a cash raise necessitated by the many investors who had earlier cashed out when Modern Media failed to meet its initial de-SPAC deadline. The misstatements continued following the de-SPAC, as Akazoo’s shares traded publicly on the NASDAQ, with the company continuing to make the same false statements as all along.

Less than a year later, a short selling hedge fund publicly released a detailed report concluding that Akazoo was essentially a scam, with few subscribers and revenue. Shortly thereafter, Akazoo’s share price dropped substantially and an internal investigation soon revealed that, indeed, Akazoo had only negligible actual revenue and subscribers for years and that the fraud had been perpetrated by former members of Akazoo’s management team. Akazoo settled the case late last month, agreeing to pay nearly $40 million in disgorgement to be returned to the investors, including those in a pending securities class-action lawsuit in the Eastern District of New York.  

In the Matter of Momentus, Inc., et al.

The Akazoo enforcement action comes on the heels of another high-profile SPAC enforcement action, this one in July 2021 against a SPAC named Stable Road Acquisition Corp., which was formed for the purpose of merging with a privately held company (no sector specified) and taking it public. Stable Road entered into a negotiation with Momentus, a company which held itself out as a space infrastructure concern providing, among other things, satellite positioning services. The Momentus fraud closely tracks the facts of Akazoo. As alleged in a complaint filed against Momentus’ CEO, the CEO made multiple misrepresentations first to Stable Road – regarding the efficacy and commercial value of Momentus’ technology and governmental concerns about the CEO’s background likely to prevent the company from obtaining government permissions necessary to operate and then repeated the false statements to PIPE investors and in registration statements. The SEC charged the SPAC, Momentus and their respective CEOs. All settled with the SEC (for about $8 million) except the Momentus CEO whose case is proceeding in the District of Columbia.

In announcing the Momentus fraud, Chairman Gensler noted that the case “illustrates risks inherent to SPAC transactions, as those who stand to earn significant profits from a SPAC merger may conduct inadequate due diligence and mislead investors.” Critically, Gensler emphasized the SPAC’s failure to conduct adequate due diligence even as it was lied to by Momentus’ CEO: “The fact that Momentus lied to Stable Road does not absolve Stable Road of its failure to undertake adequate due diligence to protect shareholders. Today’s actions will prevent the wrongdoers from benefiting at the expense of investors and help to better align the incentives of parties to a SPAC transaction with those of investors relying on truthful information to make investment decisions.”

The Takeaway

Senator Warren’s recent letter to the SEC asking it to investigate the former president’s SPAC transaction is only the most recent public call for SEC scrutiny. In August 2021, the SEC Advisory Panel released recommendations for SEC regulation of SPACs, including that the agency “regulate SPACs more intensively by exercising enhanced focus and stricter enforcement of existing disclosure rules under the Securities Exchange Act of 1934.” And as the Akazoo and Momentus actions demonstrate, the agency has also stepped up regulatory actions, a warning to the sponsors and investors in SPACs that the agency will use all the tools at its disposal to address risks to investors and the markets from SPACs.

Republished with permission. This article, "SEC’s Recent Enforcement Actions a Sign of Increased Scrutiny of SPACs," was published by The Texas Lawbook on December 6, 2021.