This Essay is part of Bulletin’s symposium on special purpose acquisition companies (SPACs). Please click here for an introduction by Professor John Morley putting the 2020 SPAC boom and the regulatory reform agenda into context.

Introduction

A remarkable fact about modern U.S. securities markets is that most public securities can be safely bought and held by investors who understand nothing about the security’s terms or underlying business. The mechanisms that enable this are what one of us has called “indirect investor protection”—that is, protection that does not rely on the investors themselves or on their agents to be effective.¹1.See generally Holger Spamann, Indirect Investor Protection: The Investment Ecosystem and Its Legal Underpinnings, 14 J. LEG. ANALYSIS (forthcoming 2022). The most important of these mechanisms is the market price.

The market price is generated by competition for mispriced securities between traders who do understand the underlying terms and business.²2.This special case of indirect investor protection has long been recognized in the literature. See, e.g., Burton G. Malkiel, A Random Walk Down Wall Street (1973); see also Burton G. Malkiel, The Efficient Market Hypothesis and Its Critics, 17 J. Econ. Persp. 59, 59 (2003). Traces can be found even in Berle and Means’ 1932 treatise. See Adolf A. Berle & Gardiner C. Means, The Modern Corporation & Private Property 265 (1932) (“buy in the open market on the faith of the market appraisal”). These traders will snatch up any security that is priced too low and happily (short) sell any security that is priced too high. Competition between traders keeps securities’ prices close to their fundamental value; that is, their expected discounted long-term payoffs. At the right price, no investment is a bad investment.³3.Ideally, prices would equal fundamental value—an idea known as market efficiency. But attaining this ideal is not necessary for the mechanism to be useful to less knowledgeable investors. The closer prices are to fundamental value, the less investors can lose by investing at the market price. Even critics of market efficiency acknowledge that “the efficient markets model a useful approximation of reality for individual firms.” Robert J. Shiller, Speculative Asset Prices, 104 Am. Econ. Rev. 1486, 1501 (2014). See also Andrew Lo, Adaptive Markets and the New World Order, 68 Fin. Analysts J. 18, 18 (2012) (“the (Efficient Market Hypothesis) is not wrong; it is merely incomplete.”). And once investors have bought a standard security, they do not need to do anything to preserve the value of their investment.⁴4.Collectively, equity investors need to vote on things like mergers. However, an individual shareholder’s abstention has no effect on the overall outcome. Moreover, whatever the outcome chosen by a majority of investors applies to all investors, meaning that sophisticated shareholders cannot gang up on the unsophisticated.

Special Purpose Acquisition Companies (“SPACs”), however, are different than traditional publicly traded securities. By their nature, SPACs undermine indirect investor protections and threaten to lure unwary investors into poor investments. SPACs do this by offering two alternative payoffs for the same security: the post-merger share, or a cash redemption. Unlike traditional stocks, the structure of the SPAC does force investors to do something: decide whether to redeem.

Empirically, in the vast majority of recent SPACs, the right choice—the one that sophisticated investors typically make and that has historically generated far higher payoffs—is to redeem.⁵5.See infra Part III. By contrast, most unsophisticated investors appear not to redeem.⁶6.That redemption is the better choice in the vast majority of SPACs is probably not coincidental. As explained in this Essay, promoters have incentives to set up SPACs even though they do not expect the SPAC to find a valuable merger opportunity that would make SPAC shares worth more than their redemption value. We should thus expect many such SPACs to be formed. Effectively, SPACs have decoupled the payoffs received by sophisticated and unsophisticated investors. SPACs thus disable the indirect protection provided by the market price. Put bluntly, the market price for a SPAC security reflects the higher payoff received by sophisticated investors that redeem their shares. Unsophisticated investors that do not redeem receive on average a much lower payoff, but this is not and cannot be reflected in the pre-de-SPAC market price. As a result, unsophisticated investors systematically overpay for SPAC shares. Their overpayment is captured, directly or indirectly, by sophisticated players: SPAC sponsors and SPAC IPO investors. This allows the latter to make money from SPACs, even if SPACs create no or even negative social value.

In a nutshell, this “SPAC trap” plays out as follows. Under the terms of a SPAC, shareholders can elect to redeem shares for the IPO price of $10 (plus interest) if and when the SPAC merges with a target (the “acquisition” for which the SPAC is set up). The redemption value sets a floor for the pre-merger SPAC share price. Sophisticated traders know that a share includes a right to receive $10, so the share trades at $10 or more. But that $10 floor is too high for those who will never exercise the right to redeem. These non-redeeming investors will instead retain a share of the post-merger company, the average value of which has historically been far below $10. Thus, investors who buy at the market price of $10 or higher without intending to redeem systematically lose money.⁷7.In principle, the problem is symmetric. If the sophisticated investors anticipated the merger to be beneficial for SPAC shareholders in the sense of generating more than $10 value per share, they would not redeem, and the market price would reflect that higher payoff. Unsophisticated investors who bought at that higher price and then redeemed would lose money. However, this does not seem to be a practical problem because it is hard to see why an unsophisticated investor would buy a share for more than $10 with the intention of redeeming for $10. By contrast, it is not hard to see why an unsophisticated investor might buy for $10 and not redeem in the mistaken belief that the post-merger share will be worth more than $10. Of course, the losing investors’ money does not evaporate: it is directly or indirectly captured by the SPAC’s sponsor and IPO investors, in ways we explain below.

The Essay proceeds as follows. Part I explains the mechanics of modern SPACs, with particular focus on redemption. Part II provides a numerical example demonstrating how even an efficient market fails to price the expected payoff to unsophisticated SPAC investors. This allows SPAC sponsors and sophisticated investors to enrich themselves by transferring value from unsophisticated investors without creating any social value. Part III briefly reviews other authors’ empirical findings of the returns to SPAC investors, which are consistent with our theoretical analysis. Part IV then explains why the SEC’s recent proposal to change SPAC regulation does not address the fundamental problem we identify.

I. SPAC Mechanics

A SPAC is a blank-check company created with the purpose of engaging in a merger with an unidentified target (the “de-SPAC”). A sponsor first creates the SPAC and organizes its IPO. Before the IPO, the sponsor obtains shares of the SPAC for a negligible price as the “promote.” The promote is customarily one quarter as many shares as will be issued in the IPO, or about 20% of the post-IPO total. The sponsor also obtains additional warrants or shares in exchange for the cash required to cover the SPAC’s operating and IPO costs.⁸8.Michael Klausner, Michael Ohlrogge & Emily Ruan, A Sober Look at SPACs, 39 Yale J. on Regul. 228, 232-36 (2022). In the subsequent IPO, the SPAC sells bundles of shares and warrants to public investors, customarily at a price of $10 per bundle of one share and some number of warrants. SPACs deposit 100% of the IPO proceeds in a trust account invested in treasury securities.⁹9.Ramey Layne & Brenda Lenahan, Special Purpose Acquisition Companies: An Introduction, Harv. L. Sch. F. on Corp. Governance n. 1 (July 6, 2018), https://corpgov.law.harvard.edu/2018/07/06/special-purpose-acquisition-companies-an-introduction/#1 (https://perma.cc/VK6Q-D52Q); Clifford Chance LLP, Guide to Special Purpose Acquisition Companies, Clifford Chance Thought Leadership, 2 (Sept. 2021), https://www.cliffordchance.com/content/dam/‌cliffordchance/‌briefings/‌2021/09/‌guide-to-special-purpose-acquisition-companies.pdf (https://perma.cc/GJ7Q-KN2U); Klausner et al., supra note 8, at 237. Customarily, the SPAC has two years from the IPO to merge with a target. If the SPAC does not merge with a target, it must return the IPO proceeds to the SPAC shareholders.¹⁰10. Recent SPACs have reduced this time period to 15 months with the possibility of extension. If and when the sponsor identifies a target, the SPAC shareholders vote on the de-SPAC.

Regardless of their vote, modern SPAC shareholders have the right to redeem their shares for their pro rata value in the trust account holding the IPO proceeds plus accrued interest. This makes the investment effectively riskless.¹¹11. “Riskless” subject to the slight discount rate adjustment explained in note 26 and the counterparty risk of the trustee absconding with the money. Non-redeeming SPAC shareholders remain shareholders of the combined entity together with the sponsor (whose ownership share is determined by the number of shares granted to the sponsor), the target shareholders (in proportions set by the de-SPAC agreement), and any additional investors brought on to facilitate the transaction (usually, the SPAC raises extra equity capital through a separate private placement known as a PIPE before the transaction). The payoff for non-redeeming shareholders thus depends on the quality of the target and, more to the point, the terms of the de-SPAC. These must be sufficiently favorable to the SPAC to overcome the dilutive effect of the sponsor’s shares and any exercise of warrants.¹²12. The median post-dilution SPAC cash per SPAC share is $5.70. See Klausner et al., supra note 8, at 246. With hundreds of SPACs competing for targets in recent years, it was highly unlikely that de-SPAC terms would be so skewed in favor of SPACs, a conjecture borne out by the returns data in Part .

Shareholders who “approve and redeem” vote for the deal and take their money back at the same time. In earlier SPACs in the 1990s and early 2000s, this was not possible because as a matter of market practice, these SPACs required investors to vote against the de-SPAC if they wanted to redeem.¹³13. Cf., e.g., Millstream Acquisition Co., Amendment No. 5 to Form S-1 Registration Statement (Form S-1), at 21 (Aug. 1, 2003) (“we will offer each public stockholder the right to have her shares of common stock converted to cash if she votes against the business combination and the business combination is approved and completed.”). The earlier SPACs also conditioned the de-SPAC on redemptions not exceeding 20%.¹⁴14. See Vijay Jog & Chengye Sun, Blank Check IPOs: A Home Run for Management 6 (Aug. 2007) (unpublished manuscript), https://ssrn.com/abstract_id=1018242 (https://perma.cc/KL8B-NEMA); Milan Lakicevic & Milos Vulanovic, A Story on SPACs, 39 Managerial Fin. 384, 388 (2013). Earlier SPACs thus had a second line of indirect investor protection defense beyond the market price: sophisticated SPAC shareholders’ votes and redemption decisions.¹⁵15. That said, even earlier SPACs had terrible returns for investors (but great returns for sponsors). See, e.g., Jog & Sun, supra note 14; Johannes Kolb & Tereza Tykvová, Going Public via Special Purpose Acquisition companies: Frogs Do Not Turn Into Princes, 40 J. Corp. Fin. 80 (2016). If sophisticated investors held at least that blocking percentage, the acquisition would not go through if it was a bad deal for non-redeeming SPAC shareholders. At a minimum, sophisticated investors in earlier SPACs could not push for the acquisition while running for the exits themselves. They had to “put their redemption decision where their vote is.”

Later SPACs, however, tore down this line of defense by detaching redemption from voting and by eliminating the redemption cap. In a broad sample of SPACs from 2010 to 2018, “every SPAC . . . gives shareholders the right to redeem their shares” regardless of their vote.¹⁶16. Usha Rodrigues & Mike Stegemoller, Redeeming SPACs 28 (Univ. of Georgia Sch. of L. Legal Stud. Research Working Paper, Paper No. 09, 2021), https://ssrn.com/abstract_id=3906196 (https://perma.cc/9YVM-5N5Y). The redemption cap first rose to an average of 84.23% from 2009 to 2012 and was later eliminated altogether.¹⁷17. Milan Lakicevic, Yochanan Shachmurove & Milos Vulanovic, Institutional Changes of Specified Purpose Acquisition Companies (SPACs), 28 N. Am. J. Econ. & Fin. 149, 177 (2014); see also Rodrigues & Stegemoller, supra note 16, at 25. In modern SPACs, sophisticated shareholders can redeem in unlimited numbers, all while voting for the acquisition. In doing so, sophisticated shareholders leave unsophisticated, non-redeeming shareholders holding the bag.¹⁸18. Cf. Mira Ganor, The Case for Non-Binary, Contingent, Shareholder Action, 23 U. Pa. J. Bus. L. 390, 414-16 (2021) (suggesting that SPAC shareholders should be allowed to make their redemption decision contingent on the redemption decisions of other SPAC shareholders to allow them to “mimick” the behavior of putatively more sophisticated players); Rodrigues & Stegemoller, supra note 16 (pointing out that voting while redeeming is a form of empty voting).

SPACs incentivize this “approve and redeem” strategy through the warrants bundled with their IPO shares. The warrants will expire as worthless if the SPAC does not complete an acquisition, whereas they retain option value if the SPAC does merge.¹⁹19. To wit, the post-merger shares could become worth more than the exercise price (generally $11.50) before the warrants’ expiration date even if that is unlikely and the expected value is far below both the exercise price and, more to the point, below $10. For the warrants to create incentives to “approve and redeem,” they must be owned by the approving shareholders at the time of the vote. Data on warrant ownership is not available. However, warrants are distributed in the IPO, and most SPAC IPO investors appear to hold their shares until just before the merger. Klausner et al., supra note 8, at 241. Unless the IPO investors sell their warrants before they submit their vote, they thus have the incentive to “approve and redeem.” Selling after the vote but before the merger closes is inconsequential. To the extent warrants trade before the vote, a SPAC shareholder might also have acquired warrants post-IPO. Some redeeming SPAC shareholders, particularly IPO investors, may also have continuing relationships with the SPAC sponsor (e.g., the expectation of participating in future SPAC IPOs).²⁰20. Yet another motivation to “approve and redeem” is simply to get the money out: without a merger, the cash remains locked in the SPAC’s trust account until the SPAC expires. Paradoxically, this motivation to approve the deal is strongest when confidence in the SPAC’s management to find a good target is lowest. Unlike the warrants, however, this liquidity motivation and the continuing relationship mentioned in the main text only create incentives to “approve and redeem” ex post, not incentives to participate in the SPAC IPO in the first place. The SPAC sponsor always has a strong incentive to complete an acquisition even if the post-acquisition share value is far below $10. Without the acquisition, the sponsor’s “promote” is worthless; with the acquisition, the sponsor’s promote will be worth something (on average over $100 million in recent years).²¹21. See infra Part II.

Redemption rates have been significant in the last decade. In a sample from 2010 to 2018, the median redemption rate was 54.2%, with a mean redemption rate of 59.9%.²²22. See Rodrigues & Stegemoller, supra note 16, at 55. In successful de-SPACs from the first quarter of 2019 to the second quarter of 2020, the median redemption rate was 73%, with a mean redemption rate of 58%. Of those SPACs, approximately one quarter exhibited a redemption rate of over 95%.²³23. See Klausner et al., supra note 8, at 240-43. While the identity of non-redeeming SPAC shareholders is generally unknown, we do know that SPAC IPOs are almost exclusively subscribed by institutional investors who redeem or sell virtually all their shares before the merger.²⁴24. See id. at 241-42. It thus stands to reason that the non-redeeming SPAC shareholders are less sophisticated retail investors and institutions.

Notice one crucial upshot from this sketch of SPAC mechanics: the SPAC sponsor and IPO investors can expect to make money from setting up the SPAC, even if they do not expect the SPAC to find an acquisition target on terms that would be an attractive investment at $10 per share. That is, the sponsor and IPO investors can profit even if they expect that non-redeeming SPAC shareholders will get a bad deal. All that is required is that the expected acquisition is not so bad that the shares and warrants received in the sponsor’s promote will be worth less than the sponsor’s out-of-pocket costs paid to investment bankers and other service providers. Savvy SPAC IPO investors get the market rate on a safe investment of $10 per share plus the warrant, meaning that they earn above-market returns.²⁵25. Cf. Douglas Cumming, Lars Helge Hab & Denis Schweizer, The Fast Track IPO – Success Factors for Taking Firms Public with SPACs, 47 J. of Banking & Fin. 198, 200 (2014) (describing the SPAC IPO bundles of shares and warrants as a “‘riskless’ zero-coupon bond with an option on a future acquisition”). Savvy investors who buy SPAC shares after the IPO get at least the market risk-free return if they buy for $10,²⁶26. As previously noted, we ignore details of interest rates and discounting for simplicity. Since these details are critical for safe returns, however, we spell them out here. Assuming that the post-merger share will be worth less than $10, the break-even price of the post-IPO, pre-merger SPAC share for a savvy investor planning to redeem is $10 plus expected interest discounted at the then-current safe yield for the expected duration of the SPAC. As a first approximation, interest and discount rate exactly offset each other because the trust fund repeatedly invests in short-term treasuries at then-current market rates. The one complication is that the SPAC’s horizon (e.g., 15 months) will generally be longer than the short-term duration of the respective treasury securities (e.g., one month). There are two ways to appreciate this complication. One is from the redemption perspective: since redemption generally occurs further into the future than the short-term treasury maturity, it should be discounted at a different (and generally higher) rate than the short-term treasury interest rate. The other is from the perspective of liquidity (and entails an illiquidity discount): short-term discount rates are appropriate for riskless liquid investments, but there is no guarantee that the SPAC shareholder will be able to sell the share before merger for exactly the (short-term discounted) redemption value before the merger. Either way, however, the appropriate discount to the $10 redemption value is very small, and our argument would go through by substituting that slightly smaller (and time-varying) value for $10 in the text. and more if they buy for less.

The losers are the non-redeeming SPAC shareholders. Indeed, the non-redeeming shareholders’ losses are the source of the sponsor’s and warrant holders’ gains. The latter gain by obtaining a claim on the cash in the SPAC for free or at least for less than $10. Non-redeeming shareholders lose through the concomitant dilution. It is the transfer of value from non-redeeming SPAC shareholders to SPAC sponsors and IPO investors that makes the SPAC attractive for sponsors and IPO investors, even if they do not expect to find a good acquisition target.

We do not know if all SPAC sponsors and savvy SPAC investors are consciously aware of this feature, and we are not suggesting that modern SPACs were intentionally designed as a trap for unsophisticated investors. But it is easy to see why sponsors and sophisticated investors are attracted to the modern SPAC structure, given the advantages it confers on them.

II. Numerical Example of the Failure of Price Protection

We will now illustrate how prices fail to protect SPAC investors using a stylized version of a typical SPAC. While we omit some complexities, the rules that we do mention are typical of recent SPACs, and the numbers are roughly representative unless otherwise noted.

Let us assume that our hypothetical SPAC issues 25 million shares: 5 million to the sponsor for zero consideration, and 20 million to investors in its IPO for $10 each.²⁷27. This roughly corresponds to the size of the median SPAC. See Klausner et al., supra note 8, at 232. The IPO investors’ cash consideration is invested in treasury securities in a trust account. For simplicity, we assume that the treasury rate is exactly zero rather than just very low. Thus, after the IPO and until the de-SPAC, our SPAC has 20×10⁶×$10=$200 million in its trust account.

Within the two-year deadline, our SPAC then proposes a de-SPAC. Assume a majority of SPAC shareholders other than the sponsor vote in favor, but 75% of them elect to redeem and obtain their $10 cash per share. This leaves 10 million SPAC shares outstanding, half of them held by the sponsor, and 5×10⁶×$10=$50 million in the trust account. Let us further assume that the SPAC and the target reach a deal in which each non-redeemed share of the SPAC (including those held by the sponsor) will be worth exactly as much as its pro-rata share of the remaining cash, or $5. After the de-SPAC, assume the shares trade for $5 dollars per share. Thus, this SPAC turns out to be a terrible deal for non-redeeming shareholders who bought their shares at a price of $10 in the IPO or later. These non-redeeming investors lose half of their investment.

One might wonder whether efficient market prices would protect naïve investors from this fate if they bought in the post-IPO market, before the merger, at the prevailing market price. But market prices would offer no such protection. As an illustration, imagine the extreme case in which all sophisticated players foresee the full trajectory of our SPAC from its founding. Will this prediction lead to a market price of $5 for the SPAC shares before the de-SPAC, on the theory that efficient market prices reflect the expected value of the future cash flows? The answer is no. A share includes a right to receive $10, so it trades at $10 (or more). If a SPAC share did trade at $5, sophisticated traders would immediately snap it up because they would earn a certain profit of $5 by buying for $5 and redeeming for $10.

Analogous arguments show why no price below $10 can persist in the market for pre-de-SPAC shares, irrespective of the expected value of the post-de-SPAC shares.²⁸28. Empirically, market prices of SPAC shares tend to be $10 or more. See Klausner et al., supra note 8. The market is efficient, but its price reflects the cash flows that will accrue to sophisticated investors who know they can and should redeem. Put differently, the problem is that non-redeeming investors do not use what they paid for: the right to redeem. With standard equity securities, this simply cannot happen because there is nothing that investors need to do to receive the full value of the security; even completely naïve investors can safely “buy in the open market on the faith of the market appraisal.”²⁹29. Berle & Means, supra note 3. By contrast, the availability of SPACs’ “approve and redeem” strategy renders that appraisal worthless and thus sets a trap for unwary investors.

Alternatively, if the SPAC shares were inefficiently priced above $10 in the post-IPO market, naïve non-redeeming investors purchasing at that price would fare even worse. Unlike prices below $10, prices above $10 do not necessarily offer a free lunch to sophisticated traders. To profit from the overpricing, traders must short sell the stock, which in turn requires borrowing the stock (and hoping that prices correct before the stock loan is recalled). SPAC shares are often hard to borrow, in part because of the redemption feature: institutional investors who plan to redeem cannot lend out their shares.³⁰30. Cf. Matthew Fox, A Handful of Heavily Shorted Stocks Are Being Squeezed Higher as Investors Redeem Shares Ahead of Merger, Bus. Insider (Aug. 26, 2021). https://markets.businessinsider.com/news/stocks/spac-short-squeeze-investors-redeem-shares-mergers-complete-2021-8 (https://perma.cc/4EJ6-5ATG).

To reassure readers that our example is logically consistent and practically relevant, let us briefly review other participants’ returns and decisions. The sponsor makes money, assuming—realistically—that the cost of setting up the SPAC is less than $25 million: the post-de-SPAC value of the sponsor’s promote is 5×10⁶×$5=$25 million.³¹31. Moreover, the sponsor generally obtains additional shares or warrants to offset these costs. In our example, we could imagine that the sponsor obtained warrants, which are worthless if the merged entity has a certain value of $5 per share; then the analysis in the main text stands unaffected. Alternatively, we could imagine that the sponsor obtained additional shares or that the warrants have value; in that case, the sponsor does better and the non-redeeming shareholders concomitantly worse. Redeeming shareholders break even assuming they purchased SPAC shares for $10 in the IPO or later in the open market and do not have warrants. If they do have warrants, they can do better than break even by voting in favor of the de-SPAC and hoping for a fortuitous development in the target’s business. (Non-redeeming shareholders without warrants will do concomitantly worse.) Target shareholders may have gained or lost in the de-SPAC: it depends on whether the target as a standalone company was worth less or more, respectively, than the $200 million value of their 40 million post-de-SPAC shares.

We would expect targets to agree to a de-SPAC only if target shareholders at least break even, and we take no position on the hotly debated question of whether SPACs actually create value by taking companies public that otherwise would have stayed private. Rather, our point is that the sponsor and SPAC IPO investors stand to make money by taking from non-redeeming SPAC shareholders—even if the de-SPAC creates no social value. And as demonstrated above, this is possible even if non-redeeming SPAC shareholders purchase their shares in a completely efficient market.

III. SPAC Participants’ Returns

Actual returns for various SPAC participants are in line with our example. Non-redeeming SPAC shareholders have done terribly, while sponsors and redeeming shareholders have done well.

SPACs have long underperformed for non-redeeming SPAC investors.³²32. See Klausner et al., supra note 8, at 256-58. As of April 4, 2022, only 18% of the 345 SPACs that successfully completed a de-SPAC since 2018 were trading above their IPO offer price. The average cumulative return on these 345 SPACs is ‍‑32.8%.³³33. Renaissance Capital, SPAC Merger Returns Crumble, Upending the 2022 SPAC Market, IPO Pro (April 19, 2022), https://ipopro.renaissancecapital.com/reviews/2022SPACReportPro.pdf (https://perma.cc/RQ7Z-M8Q5). The more SPAC shareholders redeemed, the worse the remaining ones fared.³⁴34. Rodrigues & Stegemoller, supra note 16.

Returns for redeeming SPAC shareholders and sponsors are a different matter. Redemption values have been as high as $10.30, which is considerable in the extremely low interest rate environment of that period.³⁵35. Renaissance Capital, supra note 33. We are not aware of a single redemption below $10 (or more generally below the IPO share price, in past cases where the IPO share price was different from $10). On top of this, “approve and redeem” IPO investors get the value of the warrants, as discussed above. That value is positive, even though it has dropped from $2.20 ($1.10) per average post (pre) de-SPAC warrant in July 2021 to $0.55 ($0.21) on May 27, 2022.³⁶36. Boardroom Alpha, Average Warrant Price, (May 2022), https://app.boardroomalpha.com/spac_tracking/warrants. Sponsors have also done well. Mean sponsor returns in the period 2019-2020 are over $100 million, for a 549% return rate.³⁷37. Klausner et al., supra note 8, at 263. Another type of participant, the PIPE investors (who often invest at much less than $10 per share), also did well, averaging a positive 72% return.³⁸38. Id. at 259.

As we indicated before, we cannot pinpoint precisely who redeemed and who did not. Nor do we know precisely who bought when. Thus, we cannot say for sure that retail and other less sophisticated investors were the ones earning the poor non-redeeming returns. It is highly plausible, however, that this was the case.

IV. The SEC’s Proposed Rule

On March 20, 2022, the SEC proposed new rules for SPACs.³⁹39. Special Purpose Acquisition Companies, Shell Companies, and Projections, 87 Fed. Reg. 29,458 (proposed May 13, 2022). In typical SEC fashion, the proposal focuses on disclosure and liability for misleading or incomplete disclosure.⁴⁰40. See Gibson Dunn, SEC Proposes Rules to Align SPACs More Closely with IPOs (April 6, 2022), https://www.gibsondunn.com/wp-content/uploads/2022/04/sec-proposes-rules-to-align-spacs-more-closely-with-ipos.pdf (https://perma.cc/Q4VS-ACWA). The redemption mechanism—and particularly the “affirm and redeem” strategy––is unaffected. Even under the new rules, SPACs would therefore remain a trap for unsophisticated investors.

The SEC’s proposal is grounded in the SEC’s longstanding official framework that assumes investors can and will protect themselves as long as they have sufficient information. The proposal states: “We are of the view that greater transparency and more robust investor protections could assist investors in evaluating and making investment, voting, and redemption decisions with respect to these transactions.”⁴¹41. Special Purpose Acquisition Companies, Shell Companies, and Projections, 87 Fed. Reg. at 29,463. Tell investors everything, and they will understand and act optimally. Or so the theory goes.

Theoretically, it is possible that more explicit information about fees, expected dilution, and SPAC sponsor conflicts will deter unsophisticated investors from SPAC investments, even though the availability of this information in another form did not. ⁴²42.  The conflict between sponsor and non-redeeming shareholders with respect to the merger and the underlying dilution of the shareholders’ stake is inherent in the SPAC structure. Thus, the conflict is apparent even from the SPAC’s governing documents, which are filed at the IPO. In addition, even under existing rules, the IPO filings and the merger proxy must explicitly disclose the conflict, which they do. If SPAC investors were the type that read SEC disclosures, however, it would hardly have been necessary for the SEC to remind them, a year earlier, that “[i]t is never a good idea to invest in a SPAC just because someone famous sponsors or invests in it or says it is a good investment.”⁴³43. Sec. & Exch. Comm’n, Celebrity Involvement with SPACs – Investor Alert (Mar. 10, 2021), https://www.sec.gov/oiea/investor-alerts-and-bulletins/celebrity-involvement-spacs-investor-alert (https://perma.cc/V3WN-NP8N). In general, the information presented in SEC filings is much too complex and plentiful for unsophisticated investors, particularly retail investors, to absorb.⁴⁴44. See, e.g., William O. Douglas & George E. Bates, The Federal Securities Act of 1933, 43 Yale L.J. 171, 172 (1933); William O. Douglas, Protecting the Investor, 23 (n.s.) Yale Rev. 522, 523-524 (1934); see also Sec. & Exch. Comm’n, Disclosures to Investors – A Reappraisal of Federal Administrative Policies under the ‘33 and ‘34 Acts 51–52 (1969) (sometimes referred to as “The Wheat Report”). The remarkable fact highlighted in this Essay’s introduction is that this neglect is usually without consequence, thanks to indirect investor protection.⁴⁵45. Spamann, supra note 1. The problem is that SPACs disable indirect investor protection by decoupling the payoffs to sophisticated redeeming SPAC shareholders from those of unsophisticated non-redeeming SPAC shareholders. The SEC’s proposal does nothing to re-couple these payoffs.

To be sure, the SEC’s proposal might yet kill SPACs. New rules on underwriters and liability suits might make SPACs too expensive, too cumbersome, or both. Additional disclosures on conflicts and dilution might be picked up by the press and other commentators and eventually break the hype around SPACs, even if unsophisticated investors themselves never read the disclosures. But the SEC’s proposed rules do not tackle directly what we see as the main problem.

Conclusion

We have argued that modern SPACs’ redemption feature sets a trap that allows sophisticated SPAC sponsors and investors to earn above-market returns by exploiting naïve investors. Crucially, this redemption feature drives a wedge between the value received by different investors from the same SPAC share. Savvy players who know to redeem their shares get at least $10 per share. This puts a floor on the market price of SPAC shares before the merger: professional arbitrageurs know that each share must be worth at least $10 to anyone who exercises the redemption right. Retail investors, however, tend not to exercise the redemption right even when doing so has the highest expected return. Because of this wedge, retail investors are not protected by the market price against paying too much, as they would be for normal securities. SPACs may not have been designed to trap unsophisticated investors while enriching sophisticated sponsors and investors. But such a trap has regrettably become a feature of modern SPACs.

The SEC’s recent proposal on SPACs does not directly address this nefarious dynamic, and the SEC may lack statutory authority to do so. However, stock exchanges could easily take steps to address it. One simple reform would be to require SPACs to tie redemption to a vote against the deal, as SPACs did into the early 2000s. This would not eliminate all conflicts of interest, but it would go a long way towards disarming the SPAC trap.

†Lawrence R. Grove Professor of Law, Harvard Law School; hspamann@law.harvard.edu.

††LL.M. 2022, Harvard Law School; hguo@llm22.law.harvard.edu.

We thank Michael Klausner and Michael Ohlrogge for their generous and very helpful comments.