The Big Problem With All of These SPACs

SPACs have rapidly gained popularity over the last few years, but should we really be so trusting of these “blank-check” companies?

Dec. 8, 2021

The past two years have seen the unprecedented rise of the SPAC. A SPAC, or special-purpose acquisition company, is a method companies can use in order to go public instead of following the traditional IPO route.

The rate of SPACs has multiplied immensely in recent years. 2019 saw 59 total SPACs created, which contrasts massively with the 295 created in the first quarter of this year alone! What was once a fringe aspect of the financial world has now become in vogue.

The process has unfortunate roots in the infamous “blank-check corporations” of the 80s that saw an abundance of scams, eventually forcing a federal crackdown. Finally though, SPACs seem to have shed this infamy and are now a legitimate route for investors to get involved in new companies. 

But is all as above board as we have been led to believe?

How does a SPAC actually work?

First, let’s briefly examine how a SPAC works. Typically when a company wants to go public it files for an IPO. This sees it disclose intricate details about the operations and finances of the company, following which people can choose to invest and purchase shares.

In a SPAC, this process gets reversed. A shell company goes public and investors pool their money with no idea about the actual end investment. The shell company will then actively seek a company to merge with and take public. This company will reap the benefits of money already having been raised, and investors will now own stock in a real company.

For a more comprehensive look into SPACs, you can read our in-depth article here.

So what’s the problem?

Unfortunately, SPACs raise a couple of problems that could prove very costly for the average investor.

First, the entire process enables companies to circumvent the thorough review process attached to filing for an IPO. This extensive vetting is important and allows investors to see a totally clear view of a company from top to bottom. A good company should be more than happy to showcase its value to potential shareholders, so blatant avoidance of this could be cause for concern.

Another potential issue is the disproportionate value offered to those who invest in the shell company before any merger is made with a genuine company. These sponsors, often hedge funds of venture capitalists, gain key advantages over average investors. 

This also raises issues of potential insider information being used. If the shell company engages in talks with the company it’s looking to purchase before it goes public itself, this is a rule violation. This is an allegation currently being weighed against Digital World Acquisition Corp., the company looking to take Donald Trump’s social media startup public.

And that’s not the only pending litigation facing recent SPACs. Electric vehicle (EV) maker Lucid this week announced the receipt of an SEC subpoena. This likely comes on the back of another EV maker, Nikola, having to pay penalties arising from fraud allegations surrounding its own troubled SPAC.

What happens next?

It’s hard to say right now. The floodgates could potentially open in a slew of shareholder class action lawsuits for SPACs following the recent uptick in investigations into the mergers. One thing we do know, however, is that tougher rules for SPACs are very likely to be announced sooner rather than later.

SEC Chair Gary Gensler stated that “I think we hopefully will propose something, subject to my fellow commissioners’ views, in the early part of next year” when asked about tighter regulations for SPACs. These rules will likely attempt to bring SPAC disclosure filings closer to current requirements for IPOs in an attempt to protect investors.

SPACs are by no means inherently bad, and many companies will undoubtedly continue to use the method to debut on the public markets. However, as things stand the landscape is ripe for an unscrupulous few to take advantage of a lack of regulation. Companies debuting by this method can see phenomenal initial growth but attention certainly needs to be given to the underlying financials.

Waiting for a couple of earnings reports before investing is always a wise idea, particularly in the case of a SPAC where information is already difficult to come by. 

Ready to start investing in stocks with huge potential? Check out our list of market-beating companies so you can get on the path to financial freedom. Get free access now.