On January 24, 2024, the SEC introduced a set of new rules designed to enhance the transparency and accountability of SPAC (Special Purpose Acquisition Company) IPOs and de-SPAC transactions. These new regulations aim to bring the disclosure requirements for SPACs in line with those of traditional IPOs and clarify the legal liabilities that may arise during a de-SPAC transaction. The rules apply not only to SPACs but also to shell companies and blank check companies in general, and the compliance deadline is set for July 1, 2025.

While the new rules primarily focus on disclosures and liability, they also touch on a critical issue that has long plagued SPACs: concerns over their classification as unregistered investment companies under the Investment Company Act of 1940 (the “'40 Act”).

The Investment Company Act and SPACs: Key Considerations

One of the persistent issues SPACs face is whether they qualify as unregistered investment companies. Allegations have surfaced claiming that SPACs, which hold IPO proceeds in escrow accounts invested in short-term government securities or money market funds, are actually investment companies. Such accusations have led to several lawsuits, including one against Bill Ackman’s $4 billion SPAC, Pershing Square Tontine Holdings, Ltd., the largest SPAC in history.

To determine whether a SPAC qualifies as an “investment company,” the SEC applies a multi-factor test known as the Tonopah factors. These factors assess a SPAC’s assets, the sources of its income, its development, public representations, and the activities of its management. A SPAC that fails this test may be in violation of the '40 Act, exposing its sponsors and management to legal risks.

Tonopah Factors: How the SEC Evaluates SPACs

1. Nature of SPAC Assets and Income:
   A SPAC holding government securities and cash in an escrow account, pending a de-SPAC transaction, is generally not considered an investment company. However, a SPAC that invests in corporate bonds or other investment assets, or one that fails to complete a de-SPAC transaction and instead seeks to be a passive investor, could fall under the definition of an investment company.
2. Management Activities:
   The SEC will look closely at the activities of SPAC officers and directors. If they fail to actively seek a business combination or spend excessive time managing the SPAC’s investment portfolio, the SEC could find that they are acting as investment advisers, requiring compliance with the Investment Advisers Act of 1940.
3. Duration:
   The longer a SPAC operates without completing a de-SPAC transaction, the more likely it is to be seen as an investment company. Typically, SPACs have 12-18 months to complete a transaction, and delays beyond this time frame raise concerns that the SPAC’s purpose is drifting from business acquisition to investment management.
4. Holding Out:
   If a SPAC markets itself as offering investors exposure to its investment portfolio before completing a business combination, it risks being classified as an investment company under Section 3(a)(1)(A) of the '40 Act.
5. Merging with an Investment Company:
   A SPAC that merges with a target that qualifies as an investment company, such as a closed-end fund or business development company, may itself be deemed an investment company.

Addressing the Risks: SEC’s Guidance

In its final rule release, the SEC decided against adopting a proposed limited safe harbor from the '40 Act for SPACs. Instead, the SEC issued guidance on how SPACs can ensure compliance with the '40 Act by applying the Tonopah factors. The SEC advises that SPACs continue to avoid engaging primarily in investment activities, such as managing a portfolio of investment securities, and focus on completing de-SPAC transactions in a timely manner.

Implications for SPAC Sponsors and Legal Counsel

For SPAC sponsors and their legal counsel, the new SEC rules and accompanying guidance represent a shift toward heightened scrutiny. SPACs must carefully navigate the legal and regulatory landscape to avoid being classified as unregistered investment companies. Here are some key steps sponsors should take:

1. Focus on Timely Completion of de-SPAC Transactions:
   Ensuring that a SPAC enters into a business combination agreement within the standard 12-18 month window is critical. Delays raise concerns about the SPAC’s status as a potential investment company.
2. Limit Investment Activities:
   SPACs should refrain from investing in securities beyond short-term government securities and cash-equivalents. Engaging in investment activities could lead to classification as an investment company.
3. Monitor Management Activities:
   SPAC officers and directors must prioritize seeking a business combination over managing investment assets. Legal counsel should advise on the potential risks of being classified as an investment adviser under the Investment Advisers Act of 1940.

Conclusion

The SEC’s new rules for SPACs emphasize the importance of timely and transparent disclosures while also addressing lingering concerns over the Investment Company Act. With the compliance deadline set for July 1, 2025, SPAC sponsors and their legal counsel should take proactive steps to ensure that their SPACs are not classified as unregistered investment companies. By focusing on business combinations and limiting investment activities, SPACs can mitigate the legal risks associated with the '40 Act and continue operating within the boundaries of the law.