Special Purpose Acquisition Companies: too Alternative to be an Alternative Investment Fund?

A post by guest blogger Victor Denil

While Special Purpose Acquisition Companies (SPACs) made a comeback to the American stock markets in 2020, Euronext Amsterdam became the SPAC champion on the old continent, with 16 SPAC listings (FT, 17 February 2021). As we appear to be past the hype, burning legal questions to understand the legal landscape for alternative investment funds, and in particular European SPACs come to the fore. One of these questions is whether European SPACs are subject to the Alternative Investment Fund Managers Directive (AIFMD)? There is no clear answer to this question. In this article, I will try to summarize the pros and cons and I will bring on three arguments why AIFMD could apply in my opinion.

The European Securities and Markets Authorities (ESMA) defined SPACs in a public statement as “shell companies that are admitted to trading on a trading venue with the intention to acquire a business and are often referred to as blank check companies”. SPACs typically work as follows. Firstly, SPAC insiders – umbrella term for the sponsors, founders and management of the SPAC – will establish the SPAC with a very limited upfront investment, usually $25.000, for 20% of total shares. Secondly, in the SPAC-IPO, SPACs will issue “units”, generally consisting of a share and one or more warrants, in exchange for $10 of cash.[1] Thirdly, following the deposit of the IPO proceeds in a trust account, the SPAC will begin looking for a target company. Once a SPAC has found a particular target company, the negotiations between the SPAC and the private operating company essentially have the form of a M&A process. Finally, when the SPAC and the target company agree on the merger, both companies combine into one new, publicly-traded company in the so-called de-SPAC transaction.

The structure of SPACs has a number of agency problems that were also present in previous generations of SPACs. MORLEY appropriately frames this issue when he says that “by repeating many of the failures and successes of other innovations that came before, SPACs are taking this old cycle and making it old again”. On top of the general legal uncertainty of a “new” phenomenon like SPACs, the interests of SPAC insiders and retail investors are severely misaligned. This misalignment is the result of both the dilution of retail investors and the “unit” structure (e.g. investors can sell their shares in the de-SPAC transaction and keep their warrants). Furthermore, there are information asymmetries between the SPAC insiders and public investors. SPACs do not perform any economic activity and have not yet decided on a target-company. As a consequence, prospectuses tend to be largely boiler-plate language and historical financial information is not required, since there is none (Prospectus Dutch Star Companies One, p. 44).

Scholars therefore claim that the disclosure requirements of SPACs are not as stringent as during a traditional IPO. Recent litigation and regulatory proceedings have already surged in the United States, with shareholders claiming that SPAC sponsors provided inadequate disclosure (HLS Forum on Corporate Governance). To leave agency problems unrestrained makes the legal framework governing SPACs potentially inefficient. There are reasons to believe that public shareholders, mainly retail investors, are insufficiently protected against the misalignment of interests, the complexity of SPACs and possible misrepresentation of information in SPAC-prospectuses.

At the heart of the appropriate policy response lies the question whether the AIFMD applies to the SPAC management team.[2] SPACs have notoriously tried to position themselves outside the scope of the AIMFD. Article 4(1)(a) AIFMD defines an Alternative Investment Fund (AIF) as a (i) collective investment undertaking (CIU) that invests (ii) raised capital in accordance with a (iii) defined investment policy for the (iv) benefit of investors and that is (v) not subject to the UCITS-Directive. It is the SPAC’s management team that will be subject to the AIFMD, if a SPAC meets the definition of an Alternative Investment Fund (“AIF”) (Art. 4(1)(b) AIFMD). It is important to note that the AIFMD applicability would end after the de-SPAC transaction because of the holding company exemption (Art. 2(3)(a) AIFMD).

The European supervisor ESMA published guidelines about the AIFMD in 2013 and has recently updated its Q&A to include a question on whether “managers of SPACs are subject to the AIFMD”. ESMA states that SPACs “might not meet all the elements” to qualify and that this should be assessed on a “case-by-case basis”, which does not give a conclusive answer (Q&A, p. 46-47). The majority of scholars oppose the idea that SPACs should be subject to the AIFMD.[3] Even the UK supervisor FCA indicated in a policy statement that “it is not [its] intention that the package of changes we consulted on should bring a SPAC within the scope of the UK AIFM regime”. Other scholars are unsure whether SPACs are subject to the AIFMD or advocate a case-by-case approach.[4] There is, however, a compelling case for an AIFMD applicability on European SPACs, and such applicability could be efficient. A case-by-case analysis for each SPAC nevertheless remains wise.

There is discussion whether SPACs are a CIU and/or have a defined investment policy. The other three conditions of an AIF do not seem to pose particular problems. ESMA’s guidelines determine that a CIU does not have a general and commercial purpose, that it must raise capital with the aim of a pooled return and that it cannot grant day-to-day discretion or control to unitholders. I believe that the initial investment in a SPAC, which takes place before the de-SPAC transaction, is made as a pooled investment out of blind faith in the SPAC insiders. Even though it may eventually be undertaken with the objective of making a long-term investment in a particular company, this should not be viewed as a general and commercial purpose. This can only be a valid argument after the de-SPAC transaction, when the holding company exemption applies. I therefore believe that SPACs could initially qualify as a CIU. In relation to the second condition, I am of the opinion that SPACs typically have an investment purpose, i.e. to consummate a business combination and thereby generate a pooled return for investors, that should be regarded as a defined investment policy (Prospectus Dutch Star Companies One, p. 59-60). This is the first argument that I would like to bring on.

A second teleological argument is based on the considerations of AIFMD. Recital 2 of the AIFMD shows that the Directive was drafted to ensure a coherent approach to the risks related to alternative assets, and recital 3 states that it must form a “framework that is capable of addressing those risks taking into account the diverse range of investment strategies and techniques employed by AIFMs”. If theAIFMD functions as a ‘basket’[5] for all types of collective investment funds that do not fall within the purview of other directives then concluding a SPAC is an AIF seems straightforward. ESMA acknowledges this broad scope in its FAQ: “the overarching objective of the AIFMD is to create, for the first time, a comprehensive and secure framework for the supervision and prudential oversight of AIFM in the EU”. Other objectives of the AIFMD, according to ESMA, are: “the increase of transparency towards investors and the increase of the accountability of AIFM holding controlling stakes as other objectives of the AIFMD” (FAQ). Simply put, the objective of the AIFMD was to have a very broad scope and to include all alternative investment funds.

A third argument in favour of AIFMD applicability is that there is resemblance of SPACs to the family of alternative investment funds, namely private equity funds, of which the management is subject to the AIFMD.[6] Recital 8 of the AIFMD specifically mentions that “managers of private equity funds or AIFMs managing AIFs whose shares are admitted to trading on a regulated market should not be excluded from its scope”. Private equity funds are all non-listed entities and one may wonder how an “operating, publicly listed company” (SPAC) and a “typical AIF” could relate to each other. But the family resemblance is more compelling than what meets the eye. Unsurprisingly, SPACs are oftentimes nicknamed a “single-shot private equity fund” or “poor man’s private equity fund”.

SPACs resemble private equity funds first and foremost, structurally. They both typically have multiple shareholders, are headed by external managers, have few full-time employees and only have liquid assets before making any acquisition. Secondly, they invest in companies based on the management experience of the SPAC/PE-fund executives, who are compensated similarly, in an effort to maximize shareholder value. Finally, the same type of large investors (e.g. pension funds, family offices, HNWI…) appear to be the essential investors as so-called Limited Investors in a PE, and in providing additional financing for SPACs in a Private Investment in Public Equity (PIPE) to add liquidities for the proposed merger if many shareholders redeem their shares in the de-SPAC transaction.

Unlike SPACs, private equity funds normally do not dilute their “Limited Partners”. Private equity funds moreover have a longer time horizon than SPACs, which normally only have 18-24 months to find a suitable target company. Conversely, if SPACs perform a de-SPAC transaction, it suddenly does not have a predetermined time horizon anymore. DAVIDOFF comments on the similarities between them: “despite crucial distinctions, SPACs nonetheless attempt to replicate the returns of private equity by using similar structures and procedures”. Of course SPACs are not identical to private equity funds. But it is exactly the point of the broad range of the AIFMD that SPACs shouldn’t be the Siamese twin of existing alternative investments. Meeting the AIF’s definition suffices, which should be construed as broadly as possible pursuant to the objectives of the Directive. Having some resemblance to the family of alternative investments only makes the case for its applicability more compelling.

Moving beyond an analysis of the legal lingo of the AIF definition, the protection of retail investors generally warrants closer examination in investigating the applicability of the AIFMD to SPACs. SPACs have a number of legal flaws, most of which are harmful to individual investors.

AIFMD applicability means that SPAC insiders would require an AIFM authorisation. As a result, the relevant financial supervisor is given more capabilities to influence the SPACs’ policies by its supervision of SPACs. The applicability of the AIFMD would introduce “new” obligations for SPACs:

  • The AIFM should have sufficient initial capital and must cover potential professional liability risks (Art. 8(1)(b) juncto 9 AIFMD). The former obligation might increase the skin in the game of SPAC insiders, whilst the latter may increase moral hazard if the SPAC insiders buy Directors & Officers insurance to protect themselves against professional liability. Therefore, it is difficult to predict the precise effect of the obligations.
  • The information obligations and transparency requirements of the AIFMD would apply to SPACs. This information is mostly already included in the SPAC-prospectus. According to the AIFMD, SPAC insiders would be obliged to include some additional information in the prospectus or disclose this information separately (Art. 23(3) AIFMD). However, it is doubtful that this would lead to a real improvement in investor protection.
  • SPAC executives would have to pass fit and proper tests. This is a key component since SPAC-investors essentially buy shares simply because they believe in the SPAC insiders. This would also avoid situations like in the United States where famous sportspeople launched SPACs (The economist, 16 February 2021).
  • The AIFMD would require SPACs to have both a conflict of interest and a remuneration policy. The COI policy may reduce agency conflicts between SPAC insiders’ and public investors’ interests, while the remuneration policy may shield public investors from the significant dilution they currently suffer.

The AIFMD might not be able to solve all of the deficiencies in SPACs’ structure, but it definitely would be a step forward in my opinion.

The question is whether the protection of applicability of AIFDM is preferable to a total restriction of SPACs to the professional segment of financial markets as is the case on Euronext Paris (Euronext Paris Rule Book II, rule P.1.0.2.) and was also proposed by the Belgian supervisor FMSA in its consultation on SPACs. AIFMD applicability would have the advantage of investor autonomy. Colaert also argues that “product governance measures threaten to impair non-professional investors’ access to investment products”. Even though Colaert discusses “plain vanilla products” that are significantly less complex, I find that SPACs should remain available to retail investors. A complete ban is always effective, but there might exist more proportional measures. AIFMD applicability could be an appropriate solution to immediately protect the interests of retail investors without having to intervene in the market and prevent the paternalistic edge of the product governance regime.

AIFMD applicability would require intervention of the European legislator, however. At the moment, AIFMD’s goal of being a comprehensive framework is not met in practice. This notion is supported by the fact that it is still debatable whether SPACs match the definition of an AIF before a de-SPAC transaction. Hence, the scope of the Directive remains unclear notwithstanding the recently amended ESMA Q&A on the application of the AIFMD. The AIFMD’s current scope is, at the very least, less extensive than what the Directive’s purpose suggests. SPACs therefore continue to be a relevant case study for the implications of financial regulation.

This post is based on a master thesis written for the Economics, Business & Law degree (“ERB”) at KU Leuven.

Victor Denil

[1] See for a more in-depth review of the SPAC-structure: R. LAYNE and B. LENAHAN, “Special Purpose Acquisition Companies: An Introduction”, Harvard Law School Forum on Corporate Governance 2018; A.R. BROWNSTEIN, A.J. NUSSBAUM and I. KIRMAN, “The Resurgence of SPACs: Observations and Considerations”, Harvard Law School Forum on Corporate Governance 2020.

[2] See for the definition of an AIF: C. MARTOUGIN, “The Alternative Investment Fund Managers Directive (AIFMD)”, Euredia: revue européenne de droit bancaire et financier 2011, 345-365; S. LANDUYT, “Toepassingsgebied van het wetgevende kader voor de fondsensector in België na de AIFMD”, RDC-TBH 2015, 666-682.

[3] See for example: A. COIBION, A. DE SELYS LONGCHAMPS and V. BURKI, “Are we ready for the SPAC? Testing the Belgian legal framework”, TRV-RPS 2021, 431-448; M. DE MUYNCK and B. VAN DEN HOVE, “Special Purpose Acquisition Companies (SPACs): Inleidende beschouwingen naar Belgisch en Europees kapitaalmarktenrecht”, TBH 2021, 155-167; AFME and LATHAM & WATKINS, European SPACs: Guide to Regulatory Obligations, 2022, 1-47, https://www.afme.eu/publications/reports/details/European-SPACs-Guide-to-Regulatory-Obligations.

[4] See for example: S.N. HOOGHIEMSTRA, “Wat is een beleggingsinstelling onder de AIFM-richtlijn?”, Ondernemingsrecht 2014, nr. 3.3.1.; H.M. VAN KESSEL and D.J.R. LEMSTRA, “De SPAC (special purpose acquisition company)”, Ondernemingsrecht 2020/143, 794-805; T. CRUYSMANS, “Special Purpose Acquisition Company (SPAC) – Caractéristiques et cadre réglementaire de la nouvelle attraction boursière du moment”, BFR 2021, 227-253; AFM MARKET WATCH, The Dutch SPAC market: an overview, 2022, 1-8.

[5] D. ZETZSCHE, “The AIFMD and the joint principles of European asset management law” in D. ZETZSCHE (ed.), The Alternative Investment Fund Managers Directive, Wolters Kluwer, Alphen aan den Rijn, 2012, 748.

[6] D. ZETZSCHE, “Introduction: overview, regulatory history and technique, transition” in D. ZETZSCHE (ed.), The Alternative Investment Fund Managers Directive, Wolters Kluwer, Alphen aan den Rijn, 2012, 10-13.

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