The Beginning of the SPAC Enforcement Wave: SEC Makes Example of SPAC for Spacing Out on Diligence

In certain respects, the planned merger between Stable Road and Momentus shares features of many SPAC transactions. Stable Road, which completed its initial public offering in November 2019, is a Delaware corporation formed for the sole purpose of merging with a privately held company. Momentus is a privately held space infrastructure and transportation startup company, which seeks to provide satellite positioning services. Although Stable Road was initially focused on targets in the cannabis industry, it pivoted toward alternative opportunities when its window to consummate a transaction was nearing an end. Stable Road retained a space technology consulting firm to conduct diligence on Momentus in late August or early September 2020 and announced the planned merger on October 7, 2020.

According to the SEC, respondents falsely represented to investors that Momentus had successfully tested its technology, when in fact the only in-space test was unsuccessful. Additionally, Stable Road’s registration statement omitted that the Committee on Foreign Investment in the United States (CFIUS) had expressed concerns regarding Momentus’s CEO in June 2018, and a December 2020 amendment to the registration statement omitted that the Commerce Department had denied the CEO’s application for an export license in November 2020. The SEC’s charging documents allege that Stable Road conducted inadequate due diligence with respect to the basis for CFIUS’s order and its potential impact on Momentus.

As a result of this misconduct, both Momentus and Stable Road were charged with fraud (negligence-based charges only with respect to Stable Road), and Stable Road was also charged with reporting violations under Section 13(a) of the Securities Exchange Act of 1934 and soliciting a proxy containing a materially false statement under Section 14(a). The sponsor and the CEO of Momentus were also charged with making negligent misrepresentations under Section 17(a) and with proxy-related violations under Section 14(a).

This enforcement action is noteworthy for several reasons. First, many commentators (including the authors of this alert) have predicted that the SEC will increasingly focus on policing misconduct in the SPAC markets. This prediction was based, in part, on recent exponential growth in SPAC-related transactions. Indeed, the year 2019 saw a then-record $13.6 billion raised across 59 SPAC IPOs, 2020 saw over $83.3 billion raised across 248 IPOs, and 2021 has already seen over $113.3 billion raised across 369 IPOs. In light of these developments, it was not surprising that just days after his confirmation, Chair Gary Gensler indicated that his enforcement agenda would include SPAC-related misconduct. Notably, in those same remarks, the Chair also expressed concerns regarding the adequacy of disclosures to SPAC investors and the structure of the SPAC vehicle generally.  

In support of the notion that the SEC’s SPAC focus is likely being driven from the top, the agency’s press release announcing the enforcement action featured a quote from the Chair—which is unusual for SEC enforcement actions—in which he emphasized the risk of the SPAC vehicle. According to Chair Gensler, “[t]his 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.” The Chair elaborated that, “[t]he fact that Momentus lied to Stable Road does not absolve Stable Road of its failure to undertake adequate due diligence to protect shareholders.” Particularly when coupled with recent guidance from then-Acting Director of Corporation Finance (and now SEC General Counsel) John Coates questioning the application of the Private Securities Litigation Reform Act’s safe harbor for forward-looking statements to de-SPAC mergers and asserting that some warrants issued by SPACs should be classified as liabilities, the Chair’s comments make clear that SPAC misconduct will remain an enforcement and regulatory priority.

The enforcement action is also notable for imposing significant penalties on the settling respondents even though the SEC acknowledges that they cooperated with the staff’s investigation. In its Order Instituting Proceedings, the Commission noted that the penalties imposed on the SPAC, the target, and the CEO of the SPAC were discounted in light of “their cooperation in a Commission investigation or related enforcement action” (likely a reference to the litigation against the CEO of the target). For that reason, and because the market is now squarely on notice that SPACs are an enforcement priority following the Stable Road matter, we expect penalties in subsequent enforcement actions to be substantially higher.

Finally, there are two additional aspects of the Stable Road enforcement action that highlight the SEC’s aggressive approach to policing SPAC-related violations. First, the SEC brought this enforcement exceedingly quickly. Momentus and Stable Road announced their merger on October 7, 2020 and filed an initial registration statement with the Commission on November 2, which was amended in December 2020 and March 2021. Although it is not entirely clear when the SEC staff commenced their investigation, Acting Director of the Division of Enforcement Melissa Hodgman noted that the “enforcement team worked with incredible speed, efficiency, and creativity to file [these] actions so that investors will have the benefit of complete and accurate information when voting on the proposed merger.” Second, although the SEC’s charging documents indicate that Stable Road was deceived by Momentus, Stable Road was nonetheless penalized $1 million, its CEO was charged individually, and its sponsors forfeited the founder’s shares they would receive if the merger were approved.     

Mitigating the Risk of SPAC-Related Enforcement and Litigation

This enforcement action should remind market participants of the risks associated with SPACs. In light of the current enforcement climate and the risk of parallel civil litigation,^[1] SPAC participants—including the SPAC itself, sponsors, investors, targets, and officers—should be mindful of the following risks and mitigation measures.

Diligence and Disclosures. By targeting a SPAC that had significantly shifted its industry focus and mandating forfeiture of founder’s shares, the SEC appears to be focused on the incentive of SPAC sponsors to consummate a questionable de-SPAC transaction rather than refund investors. Accordingly, for SPACs and their sponsors, thorough and well-documented diligence supporting an acquisition is key to risk mitigation. The Stable Road action is also a reminder that both SPACs and their targets have significant transparency obligations to the public markets. Targets and their officers can minimize risk by making comprehensive disclosures about issues impacting their business (and other items that might be material to investors) in connection with a de-SPAC transaction.

Unwarranted Enthusiasm. Given the uncertainty regarding the nature of a de-SPAC transaction (Is it a merger? Is it an IPO?) and former Director Coates’ safe harbor comments, participants should carefully scrutinize the assumptions underpinning projections that serve as the foundation for a transaction. SPACs should ensure that the projections presented to their stockholders in connection with merger approval are reasonable and supportable, and do not merely represent “pie-in-the-sky” aspirations.

Structure and Conflicts. Offering documents for SPACs likely will be scrutinized for a number of structural and conflicts issues, including: (i) overall economic interest of sponsors, including incentives to complete an acquisition within a specific time period; (ii) relationships between the SPAC and potential target company (including between management of the respective companies), or between the SPAC and any private investors; (iii) key economic terms of the securities held by SPAC sponsors, officers, directors, and PIPE investors, which may be different than the terms of securities held by ordinary public shareholders; (iv) control by SPAC sponsors, directors, officers, or their affiliates over approval of a de-SPAC transaction; and (v) potential sources of dilution of shareholders’ interests in the combined company. SPACs should ensure that all parties, particularly public investors, are adequately informed of and protected from actual and potential conflicts of interest.

Internal Controls. In addition to scrutinizing disclosures concerning a SPAC target’s financial prospects and conflicts, the SEC will also focus on the business’s internal accounting controls as well as disclosure controls and procedures. Accordingly, when the target is a less mature company and lacks a robust track record of public reporting, SPACs must devise and maintain systems of internal accounting controls that are sufficient to ensure that the combined entity is ready for the demands of operating as a public company.

Insider Trading. Amidst the attention given to recent SEC SPAC-related pronouncements, it is important not to lose sight of more traditional risks associated with SPACs, such as insider trading. SPACs, of course, are publicly traded companies, bringing with them a host of insider trading risks. For example, SPAC investors may obtain material nonpublic information (whether through its relationship with the sponsor, participation in a PIPE, association with a target company, or otherwise). We fully expect the SEC and FINRA to carefully monitor trading in SPACs’ securities in the period before the announcement of the merger target. Accordingly, SPACs should evaluate risk mitigation strategies with respect to insider trading, including ensuring that policies and procedures are reasonably designed to prevent misuse of material nonpublic information.

What’s Next

Between the increasing scrutiny from the SEC against the burgeoning SPAC market and Chair Gensler’s specific remarks, we anticipate the pace of enforcement activity against SPACs to increase. While the Stable Road action was primarily targeted at the direct participants and their respective CEOs, further actions may ensnare other advisors, such as underwriters, accountants, placement agents, and investment bankers.

We remind participants to remain vigilant and diligent in connection with potential transactions. For specific questions, please consult the authors of this article or the Pillsbury attorneys with whom you regularly consult.

^{[1] On July 15, 2021, a purported shareholder class action lawsuit captioned Jensen v. Stable Road Acquisition Corp., No. 21-cv-05744, was filed in the Central District of California alleging violations of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 by Stable Road and its sponsor, CEO and CFO, and by Momentus and its CEO.}