Editor’s Note: This article is part of Joanna Makris’s Behind the Wall series, where she provides retail investors with the insider scoop on the hottest technologies and trends from today’s business leaders, industry experts and money managers.

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My latest Fireside Chat continues a status check on the health of special-purpose acquisition companies (SPACs).

First, before we dive in, let’s acknowledge that SPACs have served as an effective IPO alternative while allowing investors to obtain shares of privately held companies a lot earlier than would otherwise be possible.

In fact, I still think there are plenty of fast-money trades and even longer-term investment opportunities among pre- and post-merger SPACs. However, I’ve become much pickier about what I’m buying right now. (For more detail on what to buy and sell in SPACs today, check out our recent Fireside Chat with SPAC expert Kris Tuttle). 

As any savvy growth investor knows, there has always been a dark side to SPAC investing … that’s part of their “charm.” Some companies tell tall tales, raise money from overzealous retail investors and ultimately underperform consensus expectations as public companies. The insiders — and good stock pickers — reap the spoils.

But now there’s another reason to be cautious on SPACs: they’re facing some serious legal trouble. SPAC valuations have come down to earth as investors see that the reality of post-merger businesses is often less rosy than the forward projections from the S-1 filings. As a result, lawsuits are rising and regulators are stepping up their scrutiny of the market. That could mean changes to the way SPACs operate going forward. 

Let me offer a bit of perspective before we get into the nitty-gritty of the future of SPAC investing.

PSTH Stock and the Failed Bid for UMG: Mo’ Better Blues 

Last month, SPACs and the law came to a head. The world’s largest SPAC, Pershing Square Tontine Holdings (NYSE:PSTH), was named a defendant in a shareholder lawsuit filed by former Commissioner of the Securities and Exchange Commission, Robert Jackson, and Yale Law Professor John Morley. The lawsuit requests that the special status attributed to PSTH as a SPAC be revoked. The complaint alleges that PSTH is an unregistered investment company and that sponsor and director warrants represent unlawful compensation under the Investment Company Act of 1940.

PSTH has drawn a lot of attention — for two reasons. First, its sheer size. It’s the largest SPAC ever ($4 billion in IPO proceeds). Second, there’s the allure of its high-profile billionaire CEO, Bill Ackman.

The promise of PSTH was that Ackman would find an attractive investment opportunity in a private company and — through the magic of “SPAC-ing” — shares in PSTH would become shares in that other company. No one knew what that “unicorn” would look like. But “Tontards,” as PSTH’s faithful were once called, were willing to make a blind bet of “hopium” on Ackman: That he’d find a great deal and get the merger done.

Unfortunately, like many things in the SPAC world, things didn’t turn out as planned. PSTH failed in its attempt to acquire a 10% stake in record label Universal Music Group (OTCMKTS:UMGP) from Vivendi SA — the first attempt by a SPAC to acquire a minority interest in a company. 

While PSTH pulled out of the deal, that hasn’t stopped Ackman from moving forward in his deal-making quest. As the billionaire investor shared on Twitter, “If you find yourself in a leaky boat, often times you are better off switching boats than patching leaks to complete the mission.”

Ackman says he’ll return the $4 billion he collected from PSTH investors if regulators approve his new “boat.” This new investment vehicle, called a SPARC (Special Purpose Acquisition Rights Company), if approved, would allow Ackman to search for deals without a strict deadline for a transaction.

Whether you still believe in Ackman and his unicorn-hunting prowess is certainly a conversation worth having another time. But, the bigger question investors should be asking is whether the legal brouhaha results in some simple wrist slapping for PSTH or a broader crackdown of the SPAC industry. 

Making sense of the lawsuit and its implications isn’t easy. So, we got a better understanding from William Birdthistle, who’s on the cutting edge of securities law at Chicago-Kent College of Law. Read on to understand exactly why Ackman is in hot water with the law, and whether his new SPARC idea can pass regulatory snuff to become a sea-worthy investment vessel.

And for SPACs concerned about avoiding legal scrutiny, Birdthistle has some timely advice on what they should do with their cash right now. Finally, he shares his opinion on whether regulatory tightening is ahead and whether SPACs go the way of the dodo bird, much like the recent scams behind unregulated, high-risk cryptocurrency Initial Coin Offerings (ICOs). 

With all of that in mind, let’s dive into the chat.

Let’s start from the top. From a legal perspective, very simply, what do you think is the problem with SPACs?

Why do you think PSTH was targeted for this lawsuit?

It appears that Ackman has navigated around some of these concerns with a new structure called a SPARC. Can you explain really what that is and whether or not that does navigate around some of these concerns?

Are there any other potential structures that are being talked about that may be more amenable to regulation?

You know, as a securities lawyer looking at this issue, and looking at the definition of investment company, the first thing that comes to my mind, and I’m sure to many others, though I haven’t seen it discussed much publicly, is that the trigger for becoming an investment company is actually engaging in the business of investment. 

So if you raise that $4 billion, and you wait 24 or 30 months for the merger, typically what [SPAC] companies tend to do is [to] put that money, while they’re waiting, into investments — like ETFs, money, market funds, treasuries, things like that, all of which are securities. And that’s the problem. That’s what triggers the definition of an investment company.

So one way to avoid that problem would simply not to be not to invest in those securities. You could hold it in cash instead. Now normally, most people in the investment world would say, “that’s crazy, you can’t raise such a large amount of money and then keep it in cash. You’re foregoing all those potential gains.” But in this environment, where the interest rates and the yields on those kinds of securities are really, really low. I’m not sure a whole lot is being foregone if you kept it in cash.

So if I were starting a SPAC tomorrow, and I had to try to avoid the reach of the 40 Act — just keeping the investments, keeping the assets raised in cash seems to be the easiest, most obvious way to avoid it.

The problem, as I mentioned earlier, is that if you’ve been running a SPAC differently for the last 18 months, it’s a little too late. If a court determines that this is a violation of the 40 Act, then you’ve already violated it. But if you’re looking for a new model going forward, keeping it entirely in cash is certainly one way to evade the reach of the 40 Act.

So if this lawsuit prevails, and the court rules that SPACs should be considered investment companies, what are the implications operationally for SPACs and for the equities that we’re looking at as investors?

Yeah, it’s a great question, because I think many people would simply say, what’s the big deal, if it’s a 40 Act company, fine, then just register … just do it.

The problem is that unlike the 33, and the 34 Acts, where registration, it’s not easy … but if you want to file an S-1 into the 33 Act, you can kind of do it. And it requires primarily disclosure — just tell us what you’re doing. That’s what a typical IPO registration statement says … “here’s how we run our business.”

The 40 Act is different. The 40 Act does require registration, usually under a form N-1 … that’s sort of a, you know, a parallel document to an S-1. So you do have to discuss and divulge all that information about what you’re doing. The difference is that the 40 Act also requires you to change the way you do business — in a lot of material ways. So one way is just that, you know, 60% of your board has to be independent … you’re required to have a certain amount of diversification in the assets you hold, you’re not allowed … and this is the big one that’s alleged in the lawsuit … you’re not allowed to engage in affiliated transactions with yourself. So remember, the compensation for sponsors in a SPAC — the promote — is a scenario in which they get a certain amount of the proceeds that have been raised … sometimes a pretty high number. That would be prohibited under the 40 Act, even if you register.

So the problem for SPACs is that registration is a headache and expensive. But that’s not the real dilemma. The dilemma is you also have to conduct your affairs in a certain way that’s basically antithetical to the ways in which SPACs want to do business.

It sounds like this could really potentially halt merger transactions among SPACs … if this [lawsuit] prevails.

Yeah, I mean, it’s certainly a threat. There’s no doubt about it. And we know it’s a threat for a couple of reasons. First, you can just look at the lawsuit and come to that conclusion.

But more importantly, Ackman said as much.

You know, in his letter — again — within 48 hours, he said, basically, we’re going to redeem the fund. I mean, that’s a pretty large concession. He said in the letter, [that] the case is without merit. But if you’re offering to redeem $4 billion — that’s a pretty strong backhanded compliment that you think that the case has some legs.

The other item was [that] something on the order of 50 plus law firms, within 10 days of the complaint, wrote a joint letter — which is unheard of for law firms, saying “we don’t think SPACs are investment companies.” You know, that’s awfully quick for a legal analysis. The letter didn’t contain any legal analysis.

I think what this speaks [of] is a strong concern — with the possibility that all the M&A activity from SPACs may go away.

So I think you’re certainly right that a reasonable observer would think that the lawsuit and the attention the lawsuit is generating with regulators perhaps poses a threat to ongoing SPAC M&A activity. But from a more narrow legal analysis, you know, that’s not necessarily true if the plaintiffs have in fact picked a SPAC that’s particularly problematic.

So if we think that Pershing Square or a court thinks that Pershing Square is particularly troublesome, it’s because of that issue that we discussed earlier, where they chose to invest in a minority or they propose to invest in a minority stake of UMG as opposed to a full merger. You know, a court could say “this SPAC is problematic … this SPAC is a 40 Act company without actually affecting the other 1,500 SPACs.

Now, I think there’s a chance that they may do that and that would be a reasonable judicial approach. Many courts like to do the minimum, they don’t like to pass sweeping rules that they don’t have to. They just want to rule on the issue before them. 

So that would be a scenario where Pershing Square has trouble, but the other SPACs don’t. The problem, of course, is, you know, most prudent conservative, reasonable observers would fear that this is gonna cause a large chilling effect more broadly across the industry. And if you’re a potential merger target, you have to be pretty brave to look at this lawsuit and contemplate a future merger with even a different SPAC and think …” it’ll be fine … it’ll be no problem.”

I think most people would say, “well, let’s take a look and see what happens. What is the court going to say here? What are the regulators going to say here?”

So yeah, I think your concern, I think the concern you suggested in your question is not unreasonable. I think prudent cautious people would wait to learn a little bit more about how this unfolds.

This space has already come under fire for loose financial disclosures, creative accounting … guidance that’s multiple years out into the future. And now, given there are more eyes on this space and potentially the SEC is moving in …what are your views on potential regulatory tightening of SPACs?

Yeah. You know, there certainly have been moves in that direction, and it’s kind of impossible to ignore them.

So many months ago, a director at the SEC, gave a speech in which he raised some of the issues that you just did … where he said, you know, the compensation here is kind of unorthodox. And it’s very high. And it’s hard to be certain that the shareholders are getting a great deal out of it.

You know, that’s SEC-speak for “we’re concerned.” It’s a little bit modest … it’s a little demure … it’s not bomb throwing, but to people who work in this area, you know, that’s a real signal.

The other thing was that [there] was a signal much more recently, just a few days ago … where the investment advisory committee of the SEC adopted a plan to solicit specific information about the operations and finances of SPACs.

Now, one thing that the industry and the law firm letter we mentioned a second ago said, is that tons and tons of  SPACs have received approval from the SEC over the last 18 months. So hasn’t the SEC, given their blessing?

Now, again, I think most securities lawyers would know that simply getting your paperwork processed by the SEC does not constitute an endorsement or a blessing by the SEC. In fact, it’s very commonly the case that when there’s fraud or allegations of mis-dealings, you know, plaintiffs will sue on documents that have been processed by the SEC. Nobody in those situations says “the SEC blessed it” — just like you turn in the form and the government accepted it.

So similarly, here, you know, I think, you know, it’s very difficult, I think, for a reasonable observer to say that the FCC has been blessing this process for 18 months. And now when they’ve actually taken affirmative steps to say, well, we’re going to solicit information and really learn a lot more about this area. You know, that is not uncommonly a first step towards a regulatory approach. First, let’s gather the data.

So yeah, putting those two things together plus the prominence of the lawsuit … I think it’s a reasonable guess, to assume that the SEC may clear its throat and make some concrete guidance in this area in the coming months. And again, if I were a participant in this field, I might want to be cautious and wait to see what that guidance is.

If you barrel ahead full steam with an M&A project, you know, it’s expensive, you need a lot of investment banking time, you need a lot of lawyers’ time, some accountants … those deals are expensive. And if those deals end up being, you know, undercut, then you’ll have spent that money, you know, futilely.

So yeah, I think a reasonable observer would want to know more about what the regulator is going to do. And I think they might also suspect that something’s coming.

Is there a possibility that [SPACs] could be outlawed altogether? … [meaning] that SPACs were ultimately a transient vehicle for the public markets, and [now] it’s ‘game over’ and we go back to purely traditional IPOs?

I’d be surprised if that happened. Frankly, that’s rare. That almost never happens. So if you look in the past, when very popular fundraising mechanisms have been looked at by the SEC, almost, at least in my knowledge, rarely, if ever, does the SEC say “you can’t do that at all anymore.”

So 50 years ago, people used to do corporate spin-offs as a way to skirt the IPO process. A private company would merge with a public company, the public company would then distribute the shares of the private company to its public shareholder base, and voila! — you have an IPO without having gone through the IPO process.

The SEC said, “you know, we think you need to declare a lot more information about that information that’s commensurate with an S-1.” That is to say, we’re not we’re not banning spin-offs. We’re simply saying that you need to treat them the same way you would treat an IPO. And that that immediately shut down that business. Companies still do spin-offs all the time, but they’re now primarily led by business motives … they’re not led by an effort to skirt the IPO process.

Similarly, [cryptocurrency] ICOs — Initial Coin Offerings that we heard so much about three or four or five years ago … they were all the rage, big buzz. The premise of those was that they’re not securities and, therefore, they didn’t need to be registered. And again, after 18 months, a year, so the SEC, bestirred itself and took a closer look, looked at one of those deals and said, “that might be a security.”

Again, it’s not saying “you can’t do it.” It’s saying “it might be a security, therefore, it might need to be registered.”  And that also cut down a ton of activity. You don’t hear much about ICOs anymore.

So if I were to guess about SPACs, if there were to be some regulatory intervention, I’d be very surprised to be shocked, frankly, if they said you can’t do a SPAC. I think simply they’d say, if you want to, you just have to register and abide by the 40 Act. Or you could take the approach we mentioned earlier … which is just keep all the proceeds in cash, and then you haven’t triggered the 40 Act.

So again, neither of those would constitute an outright ban. The first, though, would be so prohibitive to the business model that I think people wouldn’t want to do it. The second, you know, in a-low interest rate environment … I’m not sure what the big problem with the second approach is.

Again, it’s a problem for the people who haven’t been doing it. But for a new SPAC created today, I presume they could continue that way. So no, I don’t think it’ll lead to an outright ban.

But it does sound like the bottom line is you think changes are on the way?

Oh, yeah, I think almost certainly. I think right now, there seems to be a large holding pattern. I mean, not entirely. Occasionally, you still hear of more business going on in SPACs. But I think most people looking at this litigation, that we’re discussing the Morley-Jackson litigation against Pershing Square, I think there’s very much a holding pattern.

You know, litigation is often quite lengthy, but there are some inertia and early initial steps that give you a signal. So there’s a “motion to dismiss” stage pretty early on. If the court does something dramatic there, we might know a lot more. And also, as we just said, in a couple of weeks or months, it’s not inconceivable that another SEC piece of guidance or signal might come out that would tell us more.

But yeah, I think I think it’s more of a holding pattern than a shutdown. And I think people will be watching very, very closely to see what’s coming. Because yes, as you said, I think it’s highly likely changes are coming.

If I’m a pre-merger SPAC right now, what’s your advice to me? And what, should these companies do operationally, if anything, right now?

You know, if I were to advise a SPAC, I’d be certainly tempted to move my proceeds into cash. And then I could make a claim that under the definition of an investment company, I’m not engaged in the business of investing in securities … to be quite clear.

I might try to consummate my merger immediately, to have it done. That’s hard. That’s bold, that’s dangerous, given everything that we’ve just discussed, but it would certainly get you out of the space quickly.

But, you know, I think “what’s done is done” for most of the existing SPACs. I think, if I were looking to do something, you know, preventative, I would be looking to create new SPACs that just didn’t invest the proceeds in securities.

On the other hand, you know … who knows, maybe we’ve reached a SPAC peak. You know, by the time that celebrities are running these things, and it’s gotten this much attention, and that attract this much litigation … maybe the bubble has burst, maybe it’s time to move on to other things. You know, there’s a lot of other ways to raise money.

And yeah, like I said, when I see a long list of celebrities leading these, it starts to lose a little bit of credibility as a vehicle for promoting the greatest and most insightful investments going forward. So maybe they’ve had their run. I don’t know.

Your comments and feedback are always welcome. Let’s continue the discussion. Email me at jmakris@investorplace.com.

On the date of publication, Joanna Makris did not have (either directly or indirectly) any positions in the securities mentioned in this article.

Joanna Makris is a Market Analyst at InvestorPlace.com. A strategic thinker and fundamental public equity investor, Joanna leverages over 20 years of experience on Wall Street covering various segments of the Technology, Media, and Telecom sectors at several global investment banks, including Mizuho Securities and Canaccord Genuity.

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