Special Purpose Acquisition Corporations: Specs to Consider When Structuring Your SPAC - Part II

Friday, September 1, 2006 - 01:00

A special purpose acquisition corporation, commonly known as a "SPAC," and formally a "development stage company," is a corporation formed for the purpose of raising capital through an initial public offering ("IPO") of its securities, in order to fund an acquisition of an existing operating company or companies. Though the SPAC itself has no business operations, investors entrust an experienced founding management team to seek out and consummate a value-building acquisition of an operating business, often in a particular industry, sector or geographical area. The IPO's proceeds provide the target company with immediate capital, an advantage over other more traditional structures.

Several notable patterns in the structuring of SPAC deals have emerged from the recent spate of SPAC offerings. This article will briefly describe and analyze these structural elements and trends and suggest considerations for potential issuers and their counsel when planning for, structuring and executing a SPAC offering. Part I of this two-part article provided an overview of the evolution and structure of SPACs. Part II will address several current salient issues confronted by SPACs, including officer compensation, the decision whether to list on an exchange and the benefits and challenges of overseas offerings.

Officer Compensation And Alignment Of Incentives - Norms And Trends

Typically, the Founding Stockholders and other directors and officers of the SPAC do not receive salaries or management or finders' fees prior to or in connection with the consummation of the initial business combination. They do receive reimbursement of expenses. Several very recently filed SPACs have been structured to include compensation for their officers and others have disclosed planned officers' compensation and finders' and consulting fees, suggesting that the practice of SPACs not to compensate their insiders prior to the initial business combination may be changing. This change may reflect a trend in the nature of the sponsors initiating SPACs, toward more robust teams of experienced managers and operators. In effect, of course, these payments are largely funded by the capital contributions of the insiders themselves.

Monthly costs for space and secretarial and other administrative services are paid only from the money not held in trust. Having paid nominal consideration for up to 20% of the SPAC's stock, the SPAC management team hopes for delayed, but substantial, capital appreciation upon successful consummation of the first business combination. The Founding Stockholders often rent out their own space to the SPAC for its operational activities, thereby collecting part of the monthly overhead costs. This amount ranges from $3,500 per month to as much as $10,000 per month, which the SEC views as a form of "hidden compensation." Information about any payments to an entity affiliated with any Founding Stockholder must be fully disclosed in the registration statement.

Some SPACs allow or expect Founding Stockholders to acquire units in the IPO. Others even require Founding Stockholders to buy units in the IPO or warrants as part of a separate private placement or in the aftermarket. Nevertheless, most SPACs place limits on total Founding Stockholders' purchases of shares in order to preserve the 20% limit on insider ownership of the company's stock after the IPO. One consideration to bear in mind is the effect of exercise of the over-allotment option, which dilutes the 20%. If possible, it may be preferable to increase the size of the IPO (and concurrently adjust insider ownership to maintain the 20%) so as to minimize the likelihood of such an exercise.

Most SPACs also employ other structural features to align the management team's monetary interests with those of the investors. In most SPACs, Founding Stockholders enter into an escrow agreement for their pre-IPO shares. In such an arrangement, the consummation of a business combination triggers a graduated release schedule for such shares. The shares may also be released if the SPAC is liquidated, though the shares are limited in their liquidation rights compared with shares held by public stockholders.

Selecting An Exchange

SPAC securities may be traded in a variety of ways once an offering is complete. The decision as to where the shares will be listed is a fundamental one for any SPAC, as many consequences relating to distribution and resale flow from that initial choice. While most SPACs are listed on the National Association of Securities Dealers (NASD) Over-the-Counter Bulletin Board ("OTCBB"), several SPACs are now listed on AMEX.1

Under the Securities Act, securities that are listed on a national securities exchange, such as AMEX or the NASDAQ Global Market,2 are considered "covered securities" and are exempt from state registration requirements. Securities quoted on the OTCBB are not considered covered securities and are therefore subject to blue sky regulation. SPACs wishing to avoid state securities registrations may sell to institutional investors in reliance on applicable exemptions or to retail investors after complying with applicable registration requirements. States that require a qualitative evaluation of the securities being offered typically refuse to allow SPAC securities to be registered in such states. Many states (including New Jersey, Texas, Arizona and Washington) prohibit the offer or sale of securities issued by SPACs to retail investors. Jurisdictions that accept SPAC offerings currently include Colorado, Delaware, Washington, D.C., Florida, Illinois, Indiana, Hawaii, New York, Rhode Island and Wyoming.

AMEX Listing Requirements

The AMEX has four3 sets of listing standards, two of which may be applicable to SPACs. An issuer desiring to be listed on AMEX may choose one set and must also comply with one of three additional choices for meeting the public float requirement. The standards that may be applicable to a SPAC are Standards 3 and 4. Standard No. 3 has four requirements: a minimum market capitalization of $50 million, a minimum market value of public float of $15 million, a minimum share price of $2 and minimum shareholders' equity of $4 million. Standard No. 4 has only three requirements: a minimum market capitalization of $75 million, a minimum market value of public float of $20 million and a minimum share price of $3. Most SPACs will be eligible for Standard No. 3 or 4 upon consummation of the IPO. The structuring of a SPAC offering to avoid the penny stock rules ensures that the minimum share price will exceed $3, and most SPACs raise in excess of $50 million from the public offering.

Even if a SPAC meets one of the listing standards, it must also satisfy one of three options regarding number of public shareholders and shares held by the public. These standards are likely to present difficulties for the typical SPAC. For purposes of this calculation and for determining the market value of public float, directors, officers, controlling shareholders and other affiliates are excluded. Option No. 1 requires 800 public shareholders and 500,000 publicly-held shares. Option No. 2 requires 400 public shareholders and 1,000,000 publicly-held shares. Option No. 3 requires 400 public shareholders and 500,000 publicly held shares and an average daily trading volume of 2,000 shares. Options Nos. 1 and 2 may be attainable for a SPAC. For example, a typical SPAC offering for $90 million at $6 per share would involve the offering of 15,000,000 shares, easily meeting the minimum public float requirement. Since SPAC securities are marketed primarily to institutional investors, however, particular attention should be given to the required number of public shareholders. While an advantage to listing on AMEX is that the blue sky registration requirements applicable to sales to retail investors are not applicable, state securities registrations may be required in order to sell to sufficient public investors prior to listing to satisfy the public shareholder listing requirement (especially where the applicable states require registration prior to any offering of the securities, despite the AMEX listing pending final completion of the IPO).

Both qualitative and quantitative considerations enter the analysis of whether a SPAC may be listed. While AMEX has not adopted special criteria for IPOs, it has indicated that added emphasis is placed on qualitative factors, in particular (i) the quality of the SPAC's management team and (ii) the nature of the underwriter with regard in particular to its management team, internal policies and suitability, and its experience in these types of offerings.4 Companies listed on AMEX must also comply with its corporate governance requirements, including creation of an audit committee comprised entirely of independent directors and a board of directors comprised of a majority of independent directors. As the board of directors of most SPACs usually consists primarily of the Founding Stockholders, compliance with these independence requirements can be difficult as the most likely candidates for board membership, such as officers, employees of the underwriters and outside counsel to the SPAC, are all likely to have relationships with the SPAC that prevent them from serving as independent directors, particularly for purposes of serving on the audit committee, which has stricter independence standards, but also for purposes of general board service.

In addition, the minimum gross offering must be at least $60 million, with at least $50 million of cash to be held in the trust account.

The listing application process is fairly straightforward. The issuer must submit a signed listing agreement through which it agrees to AMEX's standard terms and conditions, a one-page listing application that details the securities being listed, a filing fee that ranges from $45,000 (for up to 5 million shares) to $70,000 (for over 75 million shares), a letter from the lead underwriter representing that the offering will be sold to a minimum of 400 investors, basic information about the identity of the issuer's officers, directors and 10% or greater shareholders and a form certifying the number of public shares and public shareholders outstanding.

Although AMEX does not specify the timing for reviewing and approving an initial listing application, based on a recent discussions with representatives from AMEX, the process for a SPAC application typically takes about six weeks.

Overseas Offerings: Listing Requirements For The London Stock Exchange's AIM

Many SPACs conduct offerings outside the United States. Such offerings must comply with local securities regulation and, to the extent sold in the United States, federal and state securities laws. For purposes of federal securities laws, compliance may usually be accomplished by following the procedures applicable to public offerings or by tailoring the U.S. portion of the offering to meet the requirements of Regulation S.

Many SPACs have recently begun accessing the European securities markets, primarily through sales to institutional investors. The London Stock Exchange's AIM market has been particularly welcoming for SPACs. To register on AIM, a company must first receive approval from its nominated advisor ("Nomad"), who is responsible for determining whether the company is appropriate for listing on AIM. The Nomad must be approved by the London Stock Exchange.5 Further steps include appointing a broker, preparing an AIM admission document and ensuring that the company's shares are freely transferable in the United Kingdom. The SPAC must also be registered as a public limited company or the legal equivalent in its home country - for the United States, this would be a corporation.

In determining whether a company is appropriate for listing on AIM, the Nomad will consider the experience of the management team, the viability of the company's business model, and, if the AIM admission involves a fund raising, the likelihood that the broker will raise sufficient funds. The Nomad's responsibility, above all else, is to judge the quality of the management team by considering, among other things, its structure, skill set, strength and depth, its experience in business, both generally and in the sector in which the company intends to operate, its ability to operate as a team, and the presence of strong, non-executive directors in the corporate governance structure.6

Listing on AIM could be a viable option for SPACs. AIM is self-described as combining "the benefits of a public quotation with a flexible regulatory approach."7 To list on AIM, a company need not have a trading record or any percentage of its shares in public hands. In addition, listing on AIM does not require a minimum market capitalization.

Thinking Through a SPAC's Possible Dissolution: DGCL 275

A SPAC initially avoids the application of Rule 419 by structuring its offering so that it results in over $5 million in tangible assets. If no business combination is ultimately consummated, however, the SPAC will no longer avoid the penny stock rules if its net assets decrease during liquidation of the trust fund. The SPAC may then constitute a blank check company for Rule 419 purposes. If this were to occur, the company would have to follow special procedures for the dissolution of a blank check company. The SEC requires that a SPAC either disclose the risk of re-classification as a blank check company or that it change the way it is structured. The SEC has recently focused increased attention on this issue in its review of SPAC registration statements.

In order to avoid these restrictions, the terms of a SPAC should provide that, if no business combination occurs within the allotted time, the board will take action to dissolve the company in accordance with the prospectus. The SPAC's charter should provide that, at that point, the SPAC's sole purpose will consist of winding up, and as such, the SPAC will no longer have as its purpose the purchase of an unidentified target company. Therefore, the company would not be considered a blank check company under Rule 419.

Conclusion

Forming a SPAC and taking it public can be an arduous process. Nevertheless, the SPAC structure provides the enterprise's founders with significant flexibility during the offering phase and beyond into the business combination phase, while also providing investors with a unique opportunity to participate in a new venture from its very beginning through a rather conservative investment that promises a return of the vast majority of the investment if the investor is not satisfied with the direction in which the SPAC intends to go. Entrepreneurs considering a SPAC offering should be aware of the myriad of choices and decisions with which they will be confronted as they select their investor audience and address other challenges. As demonstrated by the recent success of several SPACs that have begun business combinations, pursuing these challenges may be very rewarding.1 PACs may not be listed on the NYSE or NASDAQ until after the completion of a business combination. However, once such combination is completed, SPACs may be listed upon the satisfaction of certain criteria.
2 On July 1, 2006, the NASDAQ National Market was renamed the NASDAQ Global Market.
2 Standard No. 1 requires minimum pre-tax income in the latest fiscal year or in two of the last three fiscal years of $750,000 and, therefore, is not a viable option for companies that lack an operating history. Standard No. 2 requires a minimum operating history of two years and is, likewise, not a viable option.
3 According to Mitchell C. Littman in his presentation entitled "Starting a Blank Check Company: Legal and Regulatory Issues Involved with Forming a SPAC," before AMEX accepted the application of Cold Spring Capital, Inc., it conducted enhanced due diligence review of the SPAC and its offering, inquiring into the suitability of the investment, the details of the firm's sales practice, and the regulatory history of the underwriter and the selling syndicate or any affiliates.
4 A list of approved Nomads can be found at www.londonstockexchange.com/en-gb/products/companyservices/ourmarkets/aim/nomad/.
5 A Professional Handbook: Joining AIM, p. 22-25.
6 London Stock Exchange website at http://www.londonstockexchange.com/en-gb/products/companyservices/ourmarkets/aim.

M. Ridgway Barker is Chairman of the Corporate Finance & Securities Practice Group of Kelley Drye & Warren LLP. Randi-Jean G. Hedin is a Partner in the Corporate Securities & Finance Practice Group. Acknowledgement is given to Jeffrey A. Letalien , an Associate in the Corporate Finance & Securities Practice Group and Julia Sitarz , a Summer Associate in the Stamford office .

Please email the authors at mrbarker@kelleydrye.com or rhedin@kelleydrye.com with questions about this article.