Presentation at The SPAC Conference, June 12, 2024

Asim Grabowski-Shaikh, Partner, BakerHostetler

Good afternoon, everyone, and thanks for having me here. I’m happy to be here with you. My name is  Asim Grabowski-Shaikh. I’m a partner in the Capital Markets Group with BakerHostetler out of their New York office. BakerHostetler, for those of you who don’t know, is one of the largest firms in the United States. We’re the largest firm in the US without an international presence. Over the last 17 years, I’ve been involved in many SPAC and de-SPAC transactions. On the IPO side, it’s SPAC representation and underwriter representation. And on the de-SPAC side, it’s representing the target, representing the SPAC, representing the sponsor, and representing special committees. It’s been a long morning. I’m the last thing standing between you and lunch, so I promise to try and keep this on time and on point. So here’s what we’re going to talk about today. I’m going to spend a little bit of time talking about PIPES, and in particular, we’re going to focus on how SEC guidelines might impact de-SPAC related PIPEs.

We’ll talk a little bit about changes in PIPE practice over time, and we’ll explore how PIPE practice, how liability concerns, have crept up into the market. So quick show of hands, how many people here are familiar with PIPEs? Okay, that’s a good majority. So why are we talking about PIPEs when available? PIPEs play a special role and a critical role in de-SPACs because they often help solve two very important problems. One is the minimum cash condition and the other is excessive redemptions. At the end of the day, the amount of money that the SPAC raises in its IPO has little to do with the amount of capital available to the combined company at the end of the day, post de-SPAC, right? This is a function of the SPAC product. All but $5 million is subject to redemption.

So PIPEs are really important because it’s one way to make sure that capital is committed, it’s good for the sponsors, it’s good for the target, and depending on the size of the pipe relative to redemptions, it also has the potential to have a dramatic and dilutive impact on public shareholders. I think you’ve heard a lot of this data throughout the course of this conference. 2021 was a peak year for SPACs, about 95% of de-SPACs had some sort of pipe with an average size of about $316 million. You go to 2022, now you see the contraction in the market. The average size of the pipe falls 80% to roughly $65 million. PIPEs become difficult to access. These dollars start to dry up. So what happened in 2022? Well, the SEC put out proposed rules that helped to chill the market at the same time as deals and PIPEs.

These things are taking longer to close. And when you look at the post de-SPAC companies, the performance isn’t there, right? It’s not the story they were telling before the deal happened. So as a result, you see traditional pipe investors start to walk away from a de-SPAC and the de-SPAC market, and that’s a trend. Unfortunately, that’s still continuing. So before the SEC put out these proposed rules in 2022, there were a number of ways that PIPE financing was arranged, with the most common being the SPAC’s IPO underwriter, right? If the SPAC had a different financial advisor than the IPO underwriter, they could also bring money to the table. The target may have some strategies that it wants to bring to the table, and the target could also have financial advisors. So how do you get the PIPE investor on board? Well, you give it the target’s projections, right?

And then the PIPE investor comes in, they perform enhanced due diligence. Anytime you can secure a PIPE investment into the de-SPAC transaction, it’s a win, right? And it’s a win for a couple of reasons. First, it validates the valuation of the deal. Remember, this is a SPAC valuation that is privately negotiated between the SPAC and the target. It validates the management team. There’s nothing else out there at this point in time doing that. And then, of course, it helps solve for the cash crunch. That’s the minimum cash condition and offsetting the impact of redemptions. But historically, no one in this process ever thought that they were underwriting a  de-SPAC offering as a public offering because they were arranging for a PIPE financing. So what changes now that we have these new rules that are coming into effect soon? The answer: not much. The market impact was largely felt two years ago when people preemptively shifted to comply with these proposed regulations.

And so then we have the PIPE market and that chilled in the face of rocky performance in the face of these proposed rules. So, what did we see? Some banks, including some of the bulge bracket banks, they jumped out of the pool, right? They were afraid of becoming statutory underwriters, and the use of projections was generally considered to be a very risky proposition, especially if the safe harbor rules would no longer protect them. So before we get too deep into some of the new rules, it’s worth a moment to consider why the SEC proposed and adopted new rules. So when it comes to rationale, they’ve laid it out pretty clearly, and that’s supported by enforcement actions. What are their concerns? Lofty unsupportable projections, a lack of diligence, and sometimes the failure to uncover material misrepresentations, right? They want to protect investors. They want to hold people accountable.

So, let’s quickly look at two enforcement actions. Spruce Power makes hybrid electric vehicles. The SEC claimed they made materially misleading statements about their sales pipeline. They said it’s $220 million largely from existing sales or orders that supported growth projections from $21 million in 2020 to $75 million in 2021. They said by 2024, their projected revenue of $1.4 billion with a “B” would be based on a conversion rate of one-third. Well, it turns out that $220 million sales pipeline, realistically, it was more like $20 million, right? The projected revenue, they had never in their history used a conversion rate to predict revenue, let alone a conversion rate of one-third. In fact, their sales force estimated their conversion rate was 5% to 25% of the $20 million. So obviously, this company wildly underperformed. A lot of people got really mad. They paid an $11 million fine to settle that claim.

Hyzon Motors, a hydrogen fuel cell vehicle company, faced SEC enforcement action against the company and two of its top executives for statements made before and after the de-SPAC claims. Again, material misrepresentations about the status of their business dealings with potential customers and suppliers. The company had suggested sales were imminent, and they misrepresented having delivered their first vehicle. They didn’t do it. They also had a misleading video showing their vehicle running on hydrogen power. Guess what? It wasn’t  equipped to do that, right? So the company even said it sold 87 vehicles in 2021. Guess how many that they actually sold? Zero, right? They paid $25 million in fines to settle those claims with the SEC and the executives. Those two executives, they paid $200,000 each. So this is a little bit of insight into why the SEC is focused on things like forward looking statements, projections, and liability.

The question is:  is everyone that helps arrange a de-SPAC PIPE, an underwriter? Well, when the new rules were proposed, that’s exactly the question everyone was asking, right? In the SEC’s proposal, we see that they’re thinking about how to increase the accuracy of disclosure. So what does the SEC know? They know that PIPEs are important. Sometimes they’re critical. In fact, there were points in time where the amount that was raised in the PIPE financing exceeded what the SPAC raised in its IPO. The SEC knew that the IPO underwriter was typically involved in the de-SPAC and in the PIPE. And some companies were painting, call it an overly rosy hyperaggressive picture of what their business looked like and would look like in order to push a deal through. The SEC’s thesis was that if it made the IPO underwriter an underwriter of the de-SPAC, it would lead to better and more accurate disclosure because the underwriter would be presumptively liable for false or misleading statements in that de-SPAC registration statement.

That’s going to force the underwriter to dig deeper, perform additional due diligence, or be liable to the target shareholders and the former SPAC shareholders. So how do you make the IPO underwriter and underwriter of the de-SPAC get there? The SEC first has to take the position that every de-SPAC is a distribution of securities. Once you have a distribution, you just need someone to participate in it, right? Then the SEC starts to describe what participation looks like. And they did that by focusing on specific action. Effectively they said, if an IPO underwriter acts as a financial advisor to a SPAC, identifies a potential target, helps to negotiate the deal with the target or arranges a de-SPAC PIPE, that’s it. That’s participation in a distribution. It’s pretty easy to find. And that means the IPO underwriter is a de-SPAC underwriter.

It’s very controversial. It’s not what market practice is. So, there was significant pushback against this proposal. This scared IPO underwriters from participating in the IPOs and in the de-SPAC. It even scared some financial advisors and placement agents who had nothing to do with the IPO because they just didn’t want to get caught up in this hornet’s nest. So as a result, you had players move away from the de-SPAC market. Now, ultimately two years later, this proposal wasn’t adopted, right? But the market shifted and PIPEs cooled off, and the SEC now concedes in its adopting release that an underwriter is not an unlimited concept. So instead of adopting the rule, what does the SEC do? It provides guidance on the underwriting issue. Generally, it continues to think of underwriting and distribution, and broadly and in a flexible manner. So first, the SEC tackles the question of what is a distribution?

It’s not defined in the securities laws, and it’s not limited to traditional capital raise activity. Here’s what the SEC says: It refers to the entire process in a public offering through which a block of securities is dispersed and ultimately comes to rest in the hands of the investing public. It’s looking at purpose and effect. And they go on to say that a de-SPAC is therefore a distribution of securities, full stop. And that’s because the SPAC investors and the public receive an interest in the combined company. The structure of the transaction is very clever. We can create structures, no longer matters. That’s now codified in a rule. So the guidance is now an underwriter is present if someone sells for the issuer or participates in the distribution of de-SPAC securities to SPAC investors and the general public.

So as far as distribution is concerned, that’s broad. It’s not the traditional construct where the underwriter purchases shares from an issuer with the intent to distribute. And it’s also not just the IPO underwriter, right? That was what they were talking about in the proposal. It’s anyone who offers or sells for an issuer in connection with the distribution directly or indirectly. So not every de-SPAC will have an underwriter. It’s now a facts and circumstances analysis. But be aware, even if you don’t have some party identified as an underwriter in connection with the de-SPAC, you still might be one if you participate in a distribution. So that leads us to the next big question. What does it mean to participate? Well, it’s not obvious, and there’s limited case law on this. Now, the SEC has flagged for us that they found participation when someone is engaged in activity necessary to the distribution or distribution related activity, that’s really nebulous, right?

You can’t put a finger on that. So practically, the SEC decided we’re not going to adopt the proposed rule, but we’re also not going to provide the bright lines in this guidance that we provided in the proposed rules. It’s up to us to figure this out. And so I expect that we’re going to see this evolve over time. And ultimately the way that it evolves and the regulators deal with it is going to have an impact on whether or not PIPE investors return to the market. So what’s the net effect of these rules on PIPEs? Practically, I think it’s more of the same. Some market participants will continue to keep their distance from SPACs and de-SPACs as a regulatory response unfolds onto others who are in it or likely to protect themselves against underwriter liability for PIPE activity, right? They’re going to do this the way that an underwriter does it in a normal, regular-way IPO, they’re going to build a due diligence defense to counter presumptive liability.

I expect to see more enhanced due diligence, negative assurance letters, legal opinions, comfort letters. All of that means that it’ll add complexity, time and cost to these deals. And it’s going to put pressure on a PIPE market that’s already facing strong headwinds. Private Securities Litigation Reform Act (PSLRA) rules changes, as well. I mention this for awareness because I think impact is going to be felt by the PIPE market. The effect of the PSLRA is to provide safe harbors and registration statements for forward-looking statements. Projections are forward-looking statements. So with the prior practice, and you still see this to some degree, target shares projections with the SPAC. They need to entice PIPE investors. PIPE investors need to see a compelling investment thesis. So those projections are shared with the PIPE investor. Ultimately, they’re disclosed in the de-SPAC registration statement. And in prior practice, all these market participants were protected from forward-looking statements through the PSLRA, right?

It’s a liability shield. And that included projections, even if they were let’s just say a little bit in the clouds as part of the new rules, there’s an effort to normalize de-SPACs in IPOs. And the SEC says, well, guess what? There is no PSLRA protection in an IPO, so there’s no safe harbor. And now there will be no safe harbor covering forward looking statements in de-SPAC registration statements. So there’s a real risk that liability will attach to these projections. The market impact, again, we’ve seen it play out over the last two years. Parties are less willing to share aggressive projections, if anything at all. Maybe that’s a good thing. But the SPAC board may not want to rely on any projections or consider them to be material. Ultimately, this could lead to less information to share with a PIPE investor, and that’ll help control disclosure of projections in de-SPAC registration statements too, in an effort to limit liability.

It may not encourage PIPE investors to the table, but the impact of all this could be opposite to the effect that the SEC had intended. It’s not more and better information, it’s less information, and it’s going to have a chilling impact on finding willing participants in the PIPE market. It can also fuel redemptions, right? Less information for shareholders to make an investment decision on. So this could usher, in my view, a new category of target, less of a growth story, someone who’s not dependent on an immediate capital infusion. I’m just going to spend 30 seconds here drawing attention to additional disclosures associated with PIPEs. Tabular disclosure regarding dilution material terms, board considerations on fairness, benefits to pipe investors.

So, we will wrap it up here with key takeaways. Again, potential underwriter liability. It remains a big issue. Parties arranging PIPE financings to build a due diligence defense. So increased due diligence, negative assurance letters, legal opinions, comfort letters, PIPE negotiations could become more complex. There’s going to be additional concern over market perception and dilutive impact. You’ll see impact to projections and valuations, right? Valuations are likely to be more conservative projections. There may be a move to avoid projections if at all possible. And targets without immediate cash needs may be favored overgrowth companies. Appreciate you guys bearing with us as we close out this morning session. I’ll be around if anyone has any questions or would like to talk. Thank you for your time.