ISE20/20-21

• The financial regulatory authorities in Hong Kong are exploring the feasibility of introducing listing of special purpose acquisition companies ("SPACs").^{1Legend symbol denoting The Head of Listing of HKEx told in a TV interview that HKEx is studying the feasibility of SPAC listing and evaluating opinions from the industry. See BNN Bloomberg (2021).} SPACs are shell companies formed to raise capital in an initial public offering ("IPO") with the sole purpose of using the proceeds to acquire one or more operating companies. Although not a new invention, SPAC has become a driving force of IPOs in the United States ("US") and has attracted much attention worldwide in recent years. In the fourth quarter of 2020, US$38.2 billion (HK$296.2 billion) was raised by SPACs around the globe, representing 30% of global IPO proceeds.^{2Legend symbol denoting See PwC (2020).} It is widely believed that SPACs will continue to be an important source of growth in stock markets in the coming years.
• In Hong Kong, after briefing the Financial Leaders Forum^{3Legend symbol denoting The Financial Leaders Forum, established in August 2017 and chaired by the Financial Secretary, is a high-level platform comprising top leaders from the financial community as well as key financial regulators. Members are appointed by the Financial Secretary for a term of two years.} in March 2021 about the global trend of SPACs, the Securities and Futures Commission ("SFC") and the Hong Kong Exchanges and Clearing Limited ("HKEx") were asked to explore listing regimes for SPACs to further enhance Hong Kong's competitiveness as an international financial centre while safeguarding investors' interest.^{4Legend symbol denoting See GovHK (2021a).} More recently, it has been reported that HKEx plans to launch a public consultation on the listing framework of SPACs in coming June and is looking to have the first SPAC listing within 2021.^{5Legend symbol denoting HKEx responded that it would update the market in due course, without providing further details. See 香港電台(2021年).}  
• As some Members of the Legislative Council have voiced their concerns about SPAC development in Hong Kong^{6Legend symbol denoting A Member has recently sent a letter (dated 23 March 2021) to the Panel on Financial Affairs suggesting the Panel to discuss issues relating to the development of SPACs in Hong Kong. At the Council Meeting of 21 April 2021, another Member requested the Financial Secretary to comment on the Government's stance on SPAC.}, this issue of Essentials provides Members with an overview on SPAC, including its features, risks and investor protection measures with reference to some overseas financial markets.

What is SPAC?

• Emerging first in the US, SPAC originated from "blank check company".^{7Legend symbol denoting Blank check company is defined as a development stage company that has no specific business plan or has indicated a merger or acquisition with an unidentified company or companies as its business plan. See Investor.gov. (Undated).} In the early 1990s, in response to frauds involving blank check companies, the US Securities and Exchange Commission ("SEC") enacted the Penny Stock Reform Act^{8Legend symbol denoting The Penny Stock Reform Act imposed more stringent regulations on brokers and dealers in recommending penny stocks to clients.} and the relevant rule under the Securities Exchange Act of 1933^{9Legend symbol denoting Rule 419 under the Securities Exchange Act of 1933 imposed safeguard measures on blank check companies, requiring investors' funds to be held in escrow, filing of a post effective amendment upon execution of an acquisition agreement, and the return of the escrowed funds if an acquisition has not occurred within 18 months of the effective date of the initial registration statement.} to enhance regulation on disclosure and management. Thereafter, a new generation of blank check companies with safeguarding features modeled after SEC's rule changes emerged, and evolved into modern-day SPACs.
• SPAC had existed as a market niche without exchange listing until its popularity surged between 2004 and 2007 when leading investment banks began underwriting them.^{10Legend symbol denoting See Riemer (2007).} SPACs began to list on mainstream stock markets in 2008 when SEC approved rule changes proposed by Nasdaq and NYSE that allowed for SPAC listings.^{11Legend symbol denoting The first exchange listings of SPACs took place in 2005 on the former American Stock Exchange and the London Stock Exchange's Alternative Investment Market. See Corporate Counsel Business Journal (2009).}
• SPAC is commonly used as an alternative to the traditional IPO process to turn a private company into a publicly traded company. In a typical SPAC life cycle nowadays, the management team that founds the SPAC (referred to as "sponsor" and may usually be private equity firms, experienced executives in relevant industries, or other well-known businesspeople) first raises money through an IPO and then proceeds to acquire one or more private companies within a specific timeframe, usually between 18 and 24 months. After the acquisition is completed, the combined company becomes a publicly-listed operating company (the transaction is known as "de-SPAC"). If an acquisition does not take place within the time limit, the SPAC will be liquidated and the funds will be returned to the shareholders.

Growing popularity of SPAC

• In 2020, there were 248 SPAC IPOs in the US, accounting for 55% of the total number of IPOs and 46% of total IPO proceeds. The number of SPAC IPOs further surged in 2021, exceeding 300 in the first quarter of the year.^{12Legend symbol denoting See SPAC Analytics (2021).} Although listings of SPACs remain sparse in stock markets outside of the US^{13Legend symbol denoting In the UK, for example, only four SPACs were listed in 2020, raising £30 million (HK$317 million). In Asia, South Korea and Malaysia are the only major markets where SPACs are allowed to be listed.}, some countries are looking to change their regulations in order to tap into this market. For example, Singapore Exchange launched a public consultation in March 2021 to seek market feedback on a proposed regulatory framework for the listing of SPACs on its Mainboard.^{14Legend symbol denoting See Singapore Exchange (2021).} The London Stock Exchange is proposing rule changes in order to attract more SPAC listings.
• SPAC IPO shares various similarities with traditional IPO. Both are public securities offerings in which company ownership shares are sold to the public for the first time. In the US, both types of IPOs involve underwriting, SEC registration, and disclosure processes in order to get listed on stock exchanges. However, for private companies seeking to go public, SPAC IPO may be preferable to a traditional IPO for the following reasons:
  
  

  (a)	SPAC IPO is considerably quicker than traditional IPO. Since SPAC IPOs do not yet have business operations and most of the assets are held in cash, the financial and business disclosures of SPACs are substantially shorter than traditional IPOs, thus facing less regulatory scrutiny.15Legend symbol denoting See Layne and Lenahan (2018). In contrast, the preparation work involved in a traditional IPO could be burdensome, especially for small to mid-size companies;
  (b)	Some companies prefer SPAC IPO because partnering with experienced SPAC sponsors may potentially enhance company value.16Legend symbol denoting See Congressional Research Service (2020). In the US and other overseas jurisdictions where SPACs are listed, most SPAC sponsors are subject to a one-year (or sometimes longer) lock-up period, which is the post-IPO period in which they are restricted from selling their shares, compared to a 180-day lock-up period in traditional IPO17Legend symbol denoting A 180-day lock-up period is the market norm for traditional IPOs. The duration of lock up agreement is specified in the IPO prospectus and is generally not specified by law in major international financial markets (including Hong Kong). See Lexology (2020). , making it likely for SPAC sponsors to form long-term partnership with the target companies. For example, a high-profile Southeast Asian unicorn in the transportation sector has recently announced its decision to go public through a US-listed SPAC because the company sees the sponsor's value as long-term investment partners who are committed to be co-owners of the business18Legend symbol denoting See Fortune (2021).; and
  (c)	In a SPAC transaction, the target private company may face higher certainty with respect to pricing and control over deal terms as compared to traditional IPO.19Legend symbol denoting See U.S. Securities and Exchange Commission (2020). This is because the price at which the private company sells its securities is determined through negotiation between the company and the SPAC management team, which typically takes place months before the transaction closes. On the contrary, in a traditional IPO, the price is affected by market volatility and broader investor sentiment, which can vary significantly leading up to the time of pricing. The rise in market volatility amid uncertain global economic conditions in 2020 has therefore contributed to the popularity of SPACs, which offer up-front pricing and accelerated timeline for companies seeking to go public.20Legend symbol denoting See Deloitte (2020).

• From the perspective of investors, SPAC expands their investment options. Investors may wish to invest in SPACs for the following reasons:
  
  

  (a)	SPAC provides a channel for retail investors to invest in a company that will undergo merger and acquisition, similar to the type of deals that are traditionally only accessible by institutional investors and private equity funds. For professional investors, SPACs may be preferable to private equity as a way to invest in start-ups because shares of SPACs are publicly traded and therefore offer higher liquidity21Legend symbol denoting See Nilsson (2018).;
  (b)	Investors may find it desirable that their investment is protected to some extent by SPACs' built-in safeguarding features (as discussed below); and
  (c)	Investors may be attracted to SPACs due to the sector-specific expertise and network of the management teams. For example, SPACs specializing in the oil and gas industry gained popularity in the mid-2010s as depressed commodity prices drove investors toward SPAC management teams who were able to locate profitable deals.22Legend symbol denoting See Deloitte (2020).

• Despite its attractiveness, SPAC may still be a high-risk investment for general investors, as it involves investment in a company with no past financial performance, no business plan and very little assets at the time of IPO. There are also concerns that some governance issues characterized in SPAC may not be addressed. For example, the management team of a SPAC usually does not receive a salary, but is instead rewarded with a stake, usually about 20%, in the new combined company after completing an acquisition. If an acquisition is not made, the management has to return all the assets to the investors and will not receive any further compensation. Such reward structure may provide perverse incentive for the management team to complete any acquisition possible, regardless of the financial prospect of the target company. The US SEC has recently reiterated that its staff have been carefully reviewing filings and disclosures by SPACs and their acquisition targets in a bid to ensure that investors are well-informed when casting their votes on potential acquisitions. Moreover, SEC is also considering amending regulations to clarify the fact that de-SPAC transactions are subject to similar disclosure requirements and related liabilities as conventional IPOs.^{23Legend symbol denoting See U.S. Securities and Exchange Commission (2021b).}

The situation of Hong Kong

• In Hong Kong, some businesspeople reportedly have already been involved in SPAC listings overseas^{24Legend symbol denoting For instance, the IPO of a SPAC, established by a renowned Hong Kong businessperson and the founder of Paypal, raised US$595 million (HK$4.613 billion) on Nasdaq in October 2020. Another Hong Kong businessperson has filed for listing of a SPAC in the US to raise up to US$345 million (HK$2.675 billion). See The Standard (2021).}, a sign that there is certain domestic demand for the investment vehicle. However, there are concerns from the financial industry that promoting SPAC listing may be in conflict with SFC's efforts to combat backdoor listings and shell companies^{25Legend symbol denoting As stated in a Guidance Letter, HKEx believes that shell companies will invite speculative trading activities. See Hong Kong Exchanges and Clearing Limited (2019a).}, since SPACs are essentially a type of shell companies.
• In 2019, SFC and the Stock Exchange of Hong Kong ("SEHK") amended the Main Board Listing Rules in order to curb backdoor listings through shell companies. Under the Listing Rules on equity securities, shell companies are defined as "listed companies that are maintained with a low level of business operations as vehicles for backdoor listings", where backdoor listing refers to "transactions or arrangements that are structured to achieve a listing of assets while circumventing the requirements that apply to a new listing applicant".^{26Legend symbol denoting See Securities and Futures Commission (2019).} The amendments, effective October 2019, include requiring a listed issuer "to carry out a business with sufficient level of operations" in order to warrant its continued listing^{27Legend symbol denoting See Hong Kong Exchanges and Clearing Limited (2019b).}, which works precisely against SPACs. On this basis, SPACs are at present not eligible for listing on SEHK.
• Having said that, the current regulatory framework allows some flexibility for specific investment vehicles to be subject to different sets of rules. An example of such exemptions is Chapter 21 of the Main Board Listing Rules, which provides a separate set of listing and disclosure requirements for a specifically-defined type of investment companies.^{28Legend symbol denoting The primary business of investment companies under Chapter 21 of the Listing Rules (so called Chapter 21 investment companies) is to invest in listed or unlisted securities. Over 20 Chapter 21 investment companies have listed in SEHK and they are available only to professional investors.} While it is yet clear how the regulators will propose to amend the rules to facilitate SPAC listing, the Financial Secretary has said in a recent speech that SFC and HKEx have been exploring the possibility of a "Hong Kong version" listing regime for SPACs. The Financial Secretary added that the Government is mindful of the importance to safeguard the interests of the investing public while keeping in view the need to enhance Hong Kong's competitiveness.^{29Legend symbol denoting See GovHK (2021b).} More details remain to be seen.

Forms of investor protection for SPAC investment

• While Hong Kong is assessing the introduction of SPAC, listing of SPAC is already actively taking place in both the US and the United Kingdom ("UK"). In Asia, South Korea is an early mover to tap into the SPAC market. SPACs listed in these three markets normally have safeguarding measures to protect investors. The salient features are summarized below:
  
  

  (a)	Escrow account or trust: A significant percentage (for example, 90% in the US and South Korea) of the proceeds from a SPAC IPO must be held in an escrow account and subject to strict investment criteria until acquisition or liquidation. There is no such requirement in the UK, but SPACs listed in the UK usually have their proceeds invested in liquid assets such as US Treasury bonds;
  (b)	Shareholder approval of acquisition: SPAC acquisitions require majority shareholder approval in the US and South Korea. Nasdaq further requires any acquisition to be approved by a majority of the independent directors of the company. South Korea has a higher threshold for shareholder approval - approval by (i) more than two-thirds of the voting rights of shareholders present at the meeting and (ii) more than one-third of the total outstanding shares is required. Such requirement does not exist for SPAC listings in the UK, but the Financial Conduct Authority is proposing a review of the listing rules, taking reference from requirements in the US;
  (c)	Conversion right: In the US and South Korea, a shareholder who voted against an acquisition, which was subsequently passed by majority vote, is entitled to convert their SPAC common shares into a pro rata share of the aggregate amount held in the escrow account. In other words, investors who disagree with the acquisition can refund their amount invested, adjusted by funds used as working capital and any investment gains or losses. This gives investors an opportunity to exit an undesirable deal with limited loss;
  (d)	Requirement on SPAC sponsor: South Korea requires that sponsors, or management team, of a SPAC to be an authorized dealer in order to ensure professionalism and accountability. In contrast, there is no such professional requirement in the US and the UK. In both places, the quality of SPAC management is driven by market demand, as sponsors with proven track record in mergers and acquisitions and experience in managing SPACs and public companies are generally required for successful fundraising;
  (e)	Time limit for the completion of an acquisition: To prevent management from keeping investors' funds idle for unreasonable durations, a SPAC is required to complete an acquisition within 36 months from the time of IPO in the US and South Korea. In practice, most SPAC sponsors offer an even tighter timeline typically ranging from 18 to 24 months. If the deadline is not met, the SPAC will be liquidated and the amount in the escrow account will be returned to the investors; and
  (f)	Market value of acquisition target: In the US, both NYSE and Nasdaq require that the target company (or companies) must have an aggregate fair market value equal to at least 80% of the trust account. Similar to the time limit requirement, the purpose of this rule is to ensure that the SPAC's funds are used in line with investors' intention.

• While SPACs are often structured similarly, the basics of SPACs are complex and each SPAC may have its own unique features.^{30Legend symbol denoting See U.S. Securities and Exchange Commission (2021a) and (2021b).} Investors would have to carefully scrutinize the prospectus and other disclosure materials in order to fully understand the risks that they are exposed to. In the US, SEC has offered investor education on SPACs. For example, SEC's Office of Investor Education and Advocacy, in its investor alerts and bulletins, explained the concept of SPACs and warned investors about the risks associated with SPACs. SEC is also working on reforming the accounting requirements for SPACs so that valuations in financial disclosures more accurately reflect the value of SPACs.^{31Legend symbol denoting See U.S. Securities and Exchange Commission (2021c).}

Concluding remarks

• SPAC has risen in popularity in global financial markets and has attracted attention of Hong Kong's financial industry and regulators recently. Although SPAC provides an additional channel for companies to raise funds through the stock market and expands investment options for investors, it may be a relatively risky investment, involving essentially betting on a company with no past performance nor asset.
• As Hong Kong is weighing the risks and benefits of SPAC and studying possible listing regimes for SPAC listing, overseas places such as the US, the UK and South Korea may provide Hong Kong with insights on measures that can be implemented to safeguard shareholder interest. However, such safeguarding measures do not eliminate all the underlying risks of SPACs, particularly risks relating to sponsors' incentives. To this end, the US has provided investor education to communicate the risks associated with such investment vehicle.

Prepared by Denise CHEUNG
Research Office
Information Services Division
Legislative Council Secretariat
14 May 2021