Jekyll2021-09-07T09:50:23-04:00https://blog.watchdogresearch.com/feed.xmlWatchdog Transparency BlogWatchdog Transparency is a publication based on reports created by Watchdog Research, Inc.September Gray Swan Portfolio2021-09-07T09:36:00-04:002021-09-07T09:36:00-04:00https://blog.watchdogresearch.com/posts/september-gray-swan-portfolio<p>At Watchdog Research we evaluate a company’s past to get an idea of its future. As part of our research, we assign every company a Gray Swan Event Factor. We have developed a statistical model that looks at the size, industry, and historical flags for each company to evaluate the probability that a company will suffer a Gray Swan Event, and the likely impact of such an event on its stock price. These calculations are rolled into our Gray Swan Event Factor.</p>
<p>We grouped together all the companies with the highest Gray Swan Event Factors and put them into a mock portfolio. Here is the performance of our mock Gray Swan Portfolio benchmarked to the S&P 500.</p>
<p><img src="/uploads/September%20Portfolio.png" alt="September Portfolio.png" /></p>
<p><strong>Portfolio Disclaimer and Details</strong></p>
<p><em>Disclaimer</em></p>
<p>The risk of a Gray Swan Event is only one factor to consider when investing. Some companies in this portfolio have had fantastic returns; other low-risk companies have had disastrous returns. Our model can help evaluate risk, but you as an investor must make your own informed decisions. This mock portfolio should not be considered investing advice, it is designed to foster discussion concerning a topic that we believe is underappreciated, accounting-related risks for publicly traded companies.</p>
<p><em>Portfolio Details</em></p>
<p>Our Gray Swan Portfolio is made of 171 companies of all sizes, including micro and nano cap companies. The majority of companies in the portfolio are small cap companies; the next largest group is mid cap. Large cap companies are the smallest group.</p>
<p><img src="/uploads/GS%20Portfolio%20by%20Size.png" alt="GS Portfolio by Size.png" /></p>
<p><em>Special Considerations for 2021</em></p>
<p>There are two separate new phenomenon which were not anticipated by our statistical models which have affected our expectations for this portfolio. The first is the Covid-19 pandemic, which has benefited many pharmaceutical companies. As you can see in this chart, if you separate out Pharmaceuticals with high Gray Swan Event Factors, their performance so far this year has generally outperformed the S&P 500.</p>
<p><img src="/uploads/GS%20Portfolio%20by%20Industry.png" alt="GS Portfolio by Industry.png" /></p>
<p>To hammer home the point, here is a look at the comparative performance of the Large Cap segment of the Gray Swan Portfolio with and without BioNTech (BNTX) a co-manufacturer of the Covid-19 vaccine with Pfizer.</p>
<p><img src="/uploads/GS%20Portfolio%20LG%20CAp.png" alt="GS Portfolio LG CAp.png" /></p>
<p>The other novel issue is the emergence of SPACs and the recent guidance by the SEC that forced many SPACs to <a href="https://blog.watchdogresearch.com/posts/concern-is-warranted-warrants-as-liabilities-vs-equities/">restate</a> their financials, dramatically increasing the number of restatements filed this year. Of the 27 restatements filed by companies in this portfolio, 21 were filed by former SPACs.</p>
<p><strong>Gray Swan Portfolio September Spotlight</strong></p>
<p>BioNTech SE (BNTX)</p>
<p>Market Cap: $90.3 Billion</p>
<p>GSEF on 1/1/2021: 6.1%</p>
<p>Current GSEF: 3.46%</p>
<p>Returns YTD: 338.6%</p>
<p><strong><em>Notable Flags from 2020:</em></strong></p>
<p>BioNTech is a foreign company listed on the Nasdaq in the Pharmaceutical industry. In 2020 they disclosed a material weakness in their internal controls for insufficient management review of their control procedures. Additionally, a suit was filed against them in connection with their merger with Neon Therapeutics (settled a month later). Both flags increased BNTX’s risk for a Securities Class Action suit in 2021, an event that could have damaged their performance.</p>
<p><strong><em>Notable Events from 2021:</em></strong></p>
<p>Despite a cybersecurity breach of Covid-19 vaccine information stolen from a government agency, 2021 has brought BioNTech unprecedented success for the company. They successfully partnered with Pfizer to create a Covid-19 vaccine that has been approved by the FDA, the only vaccine to get full regulatory approval so far this year. Additionally, to provide the vaccine at no cost to their citizens, many governments have purchased large quantities of the vaccine, driving sales.</p>
<p><strong><em>Analysis</em></strong>:</p>
<p>Investing in a relatively small pharmaceutical company is always a risky proposition, but BNTX is a great example of why some investors think it is worth the risk. Even investing in companies with promising technology to combat Covid-19 has been risky, as the SEC has brought <a href="https://www.sec.gov/news/press-release/2020-111">enforcement actions</a> against some companies for making false and misleading claims. BNTX’s ability to manufacture a commercially successful vaccine has clearly outweighed any negative impact that their internal control issues might have generated.</p>
<p><strong><em>Final Note</em></strong></p>
<p>We are highlighting BNTX this month to make a few points about our statistical risk analysis. The fact that a company has a high accounting/governance/legal risk profile does not mean that the company is necessarily a bad investment. Investors need to make a multi-factored analysis when deciding where to put their money.</p>
<p>Additionally, our statistical analysis looks at the past performance of similar companies to estimate what will happen to a particular company in the future. However, past performance is not necessarily indicative of future performance, especially in individual cases.</p>
<p>Finally, despite enormous gains from BNTX and the relative success of firms in the pharmaceutical industry, the Gray Swan Portfolio has underperformed the S&P 500 up to this point. This indicates that accounting, legal, and governance issues captured by our Gray Swan Event Factor are not properly accounted for by the market.</p>
<p><strong>Contact Us</strong></p>
<p>If you would like to learn more about our research, you can start a conversation by reaching out to us at jcheffers@watchdogresearch.com.</p>john_cheffersAt Watchdog Research we evaluate a company’s past to get an idea of its future. As part of our research, we assign every company a Gray Swan Event Factor. We have developed a statistical model that looks at the size, industry, and historical flags for each company to evaluate the probability that a company will suffer a Gray Swan Event, and the likely impact of such an event on its stock price. These calculations are rolled into our Gray Swan Event Factor.Executives Dumping Stock is a Bad Leading Indicator2021-08-25T15:24:00-04:002021-08-25T15:24:00-04:00https://blog.watchdogresearch.com/posts/executives-dumping-stock-is-a-bad-leading-indicator<p><em>Red-Flag insider sales by executives nearly double the likelihood of a securities class action lawsuit.</em></p>
<p>Most publicly traded companies assign executives some stock in the company as a part of their compensation. This theoretically keeps their interests aligned with the interests of the company, since a well-run company’s stock should rise, and a mismanaged company’s stock should fall. Of course, it is not that simple since a company’s stock prices are only correlated with the actual health of a company.</p>
<p>It is common for executives to regularly sell some amount of stock to support their lifestyle. But it raises a big red flag when an executive sells off a large percentage of their holdings. This could indicate that the executive has some information, yet unknown to the public, that something bad is going to happen that will harm the stock price.</p>
<p>Our research indicates that large insider sales are associated with an increased incidence of securities class actions in the <em>following year</em>.</p>
<p><img src="/uploads/Table%20Insider%20Sales%20Leading%20Indicator%20SCA.png" alt="Table Insider Sales Leading Indicator SCA.png" /></p>
<p>We assigned a red flag anytime an executive sold over 50% of their holdings, or the CEO or CFO sold over $500,000 in shares. There have not been any significant changes in how often we issued red flags over the last five years, but there is a significant difference between small, mid, and large cap companies.</p>
<p><img src="/uploads/Inisder%20Sales%20By%20Size.png" alt="Inisder Sales By Size.png" /></p>
<p>In our analysis we found that red-flag insider sales <strong>nearly doubled</strong> the probability that a company would be subject to a securities class action lawsuit in the following year.</p>
<p>Interestingly, this correlation between insider sales and securities class actions is significantly weaker if you look at events in the same calendar year. A red-flag insider sale only increases the probability of having a Securities Class Action during the same calendar year by a factor of 1.35.</p>
<p>This disparity in risk between the year the trade is made, and the year <em>following</em> the trade means that the correlation is not simply due to the fact that both red flag insider sales and securities litigation disproportionately affects large companies.</p>
<p>The fact that the association between insider sales and securities litigation grows stronger over time has troubling implications. It indicates that executives may be trading on material information concerning potential adverse events as much as a year before that information reaches the public.</p>
<p>If you want to learn more about our research, start a conversation by emailing jcheffers@watchdogresearch.com.</p>john_cheffersRed-Flag insider sales by executives nearly double the likelihood of a securities class action lawsuit.Restating the (Financial) Facts: A Review of the Academic Literature on Restatements2021-08-19T14:38:00-04:002021-08-19T14:38:00-04:00https://blog.watchdogresearch.com/posts/restating-the-financial-facts-a-review-of-the-academic-literature-on-restatements<p><em>Restatements have become less common, but other methods of correcting prior periods have increased.</em></p>
<p><em>The Roots and Consequences of Corporate Financial Restatements</em></p>
<p>Financial restatements, i.e., restatements for violations of U.S. Generally Accepted Accounting Principles (GAAP), fall into <a href="https://www.bdo.com/insights/assurance/financial-reporting/accounting-changes-error-corrections">several categories</a>. The most serious “Big-R” or <em>reissuance</em> restatements address material errors that call for the reissuance of a past financial statement. The “little-r” <em>revision restatements</em> are intended to deal with immaterial misstatements, or adjustments made in the normal course of business. A third, even milder form of correction is the <a href="https://www.bdo.com/insights/assurance/financial-reporting/accounting-changes-error-corrections">out-of-period adjustment</a> (OOPA), used when an error is corrected within the current period but the change is deemed immaterial to both the current and prior period(s).</p>
<p>Financial restatements usually signify that a company isn’t doing well; although sometimes, as in the recent <a href="https://www.wsj.com/articles/a-wave-of-earnings-restatements-slams-a-hot-market-11625218380">spate</a> of <a href="https://www.accountingtoday.com/news/sec-warnings-on-spacs-dampen-deals-and-accounting-services">restatements</a> by SPACs, they represent a response to a regulatory change, in this case the SEC’s requirement to reclassify warrants. Even when there is no evidence of fraud, Big-R restatements, little-r revisions, or even OOPAs may be <a href="https://blog.auditanalytics.com/the-rise-of-out-of-period-adjustments/">indicators</a> of systemic management problems. Here we examine some of the scholarly literature from the past two decades or so to find the roots and indeed the consequences of corporate restatements.</p>
<p><em>Rise and Fall</em></p>
<p>Writing in 2008, Susan Scholz described the enormous <a href="https://d.docs.live.net/5e0cd83b3f050a02/Documents/WDR/Scholz,%20Susan.%20The%20changing%20nature%20and%20consequences%20of%20public%20company%20financial%20https:/www.yumpu.com/en/document/view/11456779/the-changing-nature-and-consequences-of-public-company-">increase</a> in restatements starting 20 years ago, from 90 in 1997 to 1,577 in 2006. Restatement frequencies begin to accelerate in 2001, before the passage of the Sarbanes-Oxley Act of 2002 (SOX).</p>
<p>However, the number peaked in 2006, and has been <a href="https://onlinelibrary.wiley.com/doi/abs/10.1111/jbfa.12445">falling</a> ever since, to a 19-year low of 484 in 2019, according to <a href="https://blog.auditanalytics.com/2019-financial-restatements-review/">Audit Analytics</a>. That number includes little-r revision restatements, which comprised over 80% of all restatements in 2019; that year there were just 63 Big-R restatements. Of the 2019 restatements, 57% had no impact on income statements. The number fell further in 2020, with only 42 Big-R restatements, representing 0.8% of companies:</p>
<p><img src="/uploads/Restatements%202011-2020.png" alt="Restatements 2011-2020.png" /></p>
<p>Source: Watchdog Research’s <em>“2020: Frequency and Impact of Restatements” by Burke and Yarbrough. (available on request)</em></p>
<p>The <a href="https://blog.auditanalytics.com/the-rise-of-out-of-period-adjustments/">number of OOPAs</a> also <a href="https://digitalcommons.kennesaw.edu/dba_etd/29">rose</a> while <a href="https://blog.watchdogresearch.com/posts/trends-in-financial-restatements-and-error-corrections/">restatements fell</a>, with the most referenced adjustment issue in OOPAs being taxes.</p>
<p><em>Not Just Sloppy</em></p>
<p>Restating companies are typically <a href="https://www.yumpu.com/en/document/view/11456779/the-changing-nature-and-consequences-of-public-company-">unprofitable</a> even before the restatement. Even when there is no apparent fraud, restatements often show <a href="https://onlinelibrary.wiley.com/doi/abs/10.1111/j.1468-5957.2010.02199.x">evidence</a> of preceding underlying meaningful earnings management. <a href="https://journals.vgtu.lt/index.php/JBEM/article/view/10489">Future fraud</a> occurrences are positively correlated with restatements due to negligence, and with the severity of restatements.</p>
<p><em>Bad News for Those at the Top</em></p>
<p>Among the least surprising findings is that <a href="https://journals.aom.org/doi/abs/10.5465/amj.2006.23478165">CEOs</a>’, <a href="https://journals.sagepub.com/doi/abs/10.1177/0148558X0902400103">CFOs</a>’, <a href="https://www.sciencedirect.com/science/article/abs/pii/S0737460718300569">directors</a>’, and <a href="https://onlinelibrary.wiley.com/doi/abs/10.1111/j.1475-679x.2005.00172.x">audit committee members</a>’ <a href="https://meridian.allenpress.com/ajpt/article-abstract/28/1/205/54431/Financial-Restatements-Audit-Fees-and-the">careers</a> <a href="https://journals.aom.org/doi/abs/10.5465/amj.2006.23478165">all decline</a> after restatement, with some exiting voluntarily and others being shown the door. Conversely, firms whose CEOs and CFOs have more experience make <a href="https://experts.syr.edu/en/publications/the-financial-expertise-of-cfos-and-accounting-restatements">fewer restatements</a>.</p>
<p>Auditors are also likely to <a href="https://meridian.allenpress.com/accounting-horizons/article-abstract/26/3/439/165825/Evidence-on-the-Association-between-Financial">resign</a> or be <a href="https://meridian.allenpress.com/ajpt/article-abstract/32/2/119/167289/Do-Financial-Restatements-Lead-to-Auditor-Changes">replaced</a> after <a href="https://meridian.allenpress.com/ajpt/article-abstract/28/1/225/54441/Financial-Restatements-and-Shareholder">restatements</a>, though this is less common for <a href="https://meridian.allenpress.com/accounting-review/article-abstract/89/3/1051/127359/Determinants-and-Market-Consequences-of-Auditor">Big Four</a> accounting firms. Again, firms employing <a href="https://www.sciencedirect.com/science/article/abs/pii/S0278425407000038">auditors</a> with more experience, or even having <a href="https://meridian.allenpress.com/ajpt/article-abstract/23/1/69/54343/Audit-Committee-Characteristics-and-Restatements">audit committees</a> with greater financial experience, undergo fewer restatements.</p>
<p><em>Clawbacks Create Perverse Incentives</em></p>
<p>Clawback provisions allow companies to reclaim some portion of executive compensation after restatements that show worse performance. Clawbacks are meant to deter misreporting. However, there is a higher likelihood of <a href="https://d.docs.live.net/5e0cd83b3f050a02/Documents/WDR/www-2.rotman.utoronto.ca">auditor dismissals</a> after Big-R reissuance restatements when firms have clawback provisions in place, a “shoot the messenger” type of reaction. But if the firm with clawbacks only issues a little-r revision, the auditors are less likely to be dismissed, giving the appearance of quid-pro-quo cooperation.</p>
<p>Thus, clawback policies may create perverse incentives for managers to replace uncooperative and independent auditors who insist on a restatement with more compliant ones, who might try to skirt the issue with a mere revision. The effect of clawback provisions is stronger when the CEO earns higher incentive compensation, suggesting that auditor dismissals are more about the effects on managers’ careers than about concern for the firm.</p>
<p>Firms with clawback provisions are also more likely to have <a href="https://digitalcommons.kennesaw.edu/dba_etd/29">more OOPAs</a>, including firms with previous restatements and future restatements. This also indicates management may be opportunistically using lesser corrections such as OOPAs to avoid pay deductions that would occur if there were a restatement.</p>
<p><em>First, the Bad News About Little-r Revisions</em></p>
<p>Many times, little-r revisions are used when* *Big-R reissuance restatements should have been used. Rachel Thompson found that almost 40% of <a href="https://www.proquest.com/openview/16bbe51c0b4adb4a20f7b635a8b63b00/1?pq-origsite=gscholar&cbl=18750">revisions</a> meet at least one materiality criterion, and therefore should have been restatements. She reports that firms <a href="https://clsbluesky.law.columbia.edu/2019/10/15/do-firms-conceal-material-misstatements-by-reporting-revisions-rather-than-restatements/amp/">conceal</a> material misstatements by reporting revisions rather than restatements, especially when it affects compensation. However, the market is not fooled in the long run and punishes revising firms with material misstatements, but with a lag time.</p>
<p>Managers behave opportunistically by manipulating <a href="https://www.scielo.br/j/rbgn/a/phz8kXqY7bxkfZN9RN6rtyC/abstract/?lang=en">earnings</a> to stay within the revision limits. But when auditors require auditees to make financial restatements, management opportunism may potentially decrease.</p>
<p><em>Now, the Good News About Little-r Revisions</em></p>
<p>As <a href="https://meridian.allenpress.com/accounting-horizons/article-abstract/29/3/667/99244/An-Analysis-of-Little-r-Restatements">compared</a> to Big-R restating firms, little-r revising firms are generally more profitable, less complex, and show some evidence of stronger corporate governance and higher audit quality. Little-r <a href="https://meridian.allenpress.com/accounting-horizons/article-abstract/29/3/667/99244/An-Analysis-of-Little-r-Restatements">firms</a> have lower free cash flows, higher board expertise, higher CFO tenure, are less likely to use a specialist auditor, and are less likely to have material weaknesses in their internal controls than either restating or even non-revising firms.</p>
<p>Greater purchases of <a href="https://digitalcommons.kennesaw.edu/dba_etd/29">non-audit services</a> (NAS) shortens the length of the adjustment period, decreases the number of OOPAs, and lessens the likelihood of a revision restatement.</p>
<p><a href="javascript:;">Badertscher</a> & <a href="javascript:;">Burks</a> <a href="https://meridian.allenpress.com/accounting-horizons/article-abstract/25/4/609/52564/Accounting-Restatements-and-the-Timeliness-of">note</a> that the SEC recommends more use of catch-up revision adjustments rather than restatements to correct accounting errors. They found that lengthy lags, which were considered a possible detrimental outcome of this policy, are uncommon, and appear to be largely unavoidable consequences of fraud investigation. The proposed reforms would have a negligible effect on disclosure timeliness.</p>
<p><em>The Market Speaks</em></p>
<p>The average market reaction to restatement announcements is negative, with a more pronounced <a href="https://etd.ohiolink.edu/apexprod/rws_olink/r/1501/10?clear=10&p10_accession_num=kent1529433790993659">negative market reaction</a> to more transparent negative effect restatements than the positive reaction to more transparent positive effect restatements. In other words, bad news causes more of a market downturn than good news causes a market upturn.</p>
<p>Although small-cap companies are five times <a href="https://blog.watchdogresearch.com/posts/the-impact-of-restatements-the-bigger-they-are-dot-dot-dot/">more likely</a> to issue a restatement than large-cap companies, the drop in share price is worse for the latter.</p>
<p><img src="/uploads/Restatements%20abnormal%20returns.png" alt="Restatements abnormal returns.png" /></p>
<p>Source: Watchdog Research’s <em>“2020: Frequency and Impact of Restatements” by Burke and Yarbrough. (available on request)</em></p>
<p>However, beginning in 2001, the <a href="https://d.docs.live.net/5e0cd83b3f050a02/Documents/WDR/Scholz,%20Susan.%20The%20changing%20nature%20and%20consequences%20of%20public%20company%20financial%20restatements.%20Us%20Treasury%20Department,%20April%202008.">magnitude</a> of market reactions declined notably, coinciding with the increase in restatements between 2001 and 2006. <a href="https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1652982">Hirschey et al.</a> attributed this more subdued market response to restatement announcements to effects of SOX. Firms also <a href="https://www.sciencedirect.com/science/article/abs/pii/S0278425413001038">responded</a> to the legislation; those incurring a negative market reaction in the year following restatement announcements reported their financial statements more conservatively post-SOX.</p>
<p>Restatements attributed to <a href="https://www.yumpu.com/en/document/view/11456779/the-changing-nature-and-consequences-of-public-company-">fraud</a> and those affecting revenues tend to have more negative market reactions. However, the percentages of restatements due to fraud declined from 29% of 1997 restatements, to <a href="https://kb.osu.edu/handle/1811/76651">under 1%</a> in 2014. The proportion of restatements explained by clerical errors also fell from over 14% in 2008 to about 1% in 2014, with the remaining 98% explained by accounting errors. These reductions in fraud and clerical error have been attributed to increased regulation, technology, and education.</p>
<p><em>How can Firms Avoid Restatements?</em></p>
<p>What reduces the need for restatements? As noted above, having more experienced <a href="https://experts.syr.edu/en/publications/the-financial-expertise-of-cfos-and-accounting-restatements">officers</a> and <a href="https://www.sciencedirect.com/science/article/abs/pii/S0278425407000038">auditors</a> coincides with lower rates of restatement. <a href="https://d.docs.live.net/5e0cd83b3f050a02/Documents/WDR/American%20Accounting%20Association%20DOI:%2010.2308/accr-50440">Audit effort</a> is also negatively correlated with restatement. Better <a href="https://meridian.allenpress.com/accounting-review/article-abstract/91/4/1167/99385/The-Effect-of-Employee-Treatment-Policies-on">employment practices</a> reduce both internal control ineffectiveness and the need for financial restatements. <a href="https://meridian.allenpress.com/ajpt/article-abstract/33/2/27/54691/The-Relationship-between-Audit-Report-Lags-and">Time pressure</a> appears to be a factor increasing the probability of financial restatements, so perhaps allowing more time for the initial statements could reduce the incidence of restatements.</p>
<p><em>Conclusion</em></p>
<p>Restatements of every kind, but particularly the more serious Big-R reissuance restatements, have declined dramatically in the last fifteen years, as have restatements due to fraud or clerical error. It is not entirely clear why. One explanation is that financial reporting has improved, another plausible explanation is that firms are reclassifying restatements as revisions and out-of-period adjustments to lessen the impact of the correction on the company, its auditors, and its executives.</p>
<p>It is clear that the careers of executives and auditors involved with restatements suffer. Although recommended by the SEC because of its timeliness, a little-r revision or an OOPA may be used to cover up material misstatements, especially when executive compensation depends on an absence of Big-R restatements. The market still falls after a negative restatement, but not as strongly as in the pre-SOX years.</p>
<p>If you are interested in our report on Restatements, or are just interested in learning more about our team, please contact <a href="mailto:jcheffers@watchdogresearch.com">jcheffers@watchdogresearch.com</a><em>.</em></p>elise_roseRestatements have become less common, but other methods of correcting prior periods have increased.Cyber Incidents Continue to Rise2021-08-10T09:17:00-04:002021-08-10T09:17:00-04:00https://blog.watchdogresearch.com/posts/cyber-incidents-continue-to-rise<p><em>Cybersecurity incidents experienced a lull in 2020, but are coming back with a vengeance in 2021.</em></p>
<p>Cybersecurity has gone from a niche concern to a hot topic in the D&O insurance world. A cybersecurity breach can be extremely disruptive to any business, but (adding injury to injury) these breaches can also be the source of damaging class action litigation.</p>
<p>At Watchdog Research we analyze information disclosed by public companies, including information on cybersecurity incidents, Securities Class Action lawsuits, and disclosure controls.</p>
<p>The research presented here relates to Nasdaq and NYSE listed public companies and is derived from our report “<em>Cybersecurity Incidents and Litigation: 2021</em>,” by Joseph Burke, PhD, Joseph Yarborough, PhD, and John Cheffers and primarily based on data from Audit Analytics.</p>
<p><em>Overview</em></p>
<p>We began by looking at incidents that occurred at companies listed on the NYSE and Nasdaq over the past ten years, and the growth rate of cybersecurity incidents is alarming:</p>
<p><img src="/uploads/CyberImage_1.png" alt="CyberImage_1.png" /></p>
<p>Despite concerns that cybersecurity incidents would increase during the pandemic as businesses moved more of their operations online, total reported cybersecurity incidents fell during 2020. However, through July 2021, there have already been 106 reported cybersecurity incidents, putting 2021 on pace for a record breaking year.</p>
<p>If you segregate the companies by size, you can see that risk is most concentrated for large companies. Large companies, those with a market capitalization of $10 billion or more, are the population most at risk for a cyberattack.</p>
<p><img src="/uploads/CyberImage_2.png" alt="CyberImage_2.png" /></p>
<p>Another interesting development this year is that Ransomware attacks and Unauthorized Access attacks have become much more common in the last few years.</p>
<p><img src="/uploads/CyberImage_3.png" alt="CyberImage_3.png" /></p>
<p><em>Cybersecurity Securities Class Actions</em></p>
<p>A cyberbreach at a company creates all sorts of problems, including litigation. Even though the number of cyber security incidents have increased dramatically, the number of cyber-related lawsuits has not followed suit. As we can see here, the probability that a public company is named as a defendant in a cybersecurity related suit has remained very low.</p>
<p><img src="/uploads/CyberImage_4.png" alt="CyberImage_4.png" /></p>
<p>Our review of these cases indicates that it is often difficult for the plaintiffs in these cases to allege specific damages based on a mere breach of information.</p>
<p>Additionally, the fact that a company suffered a cybersecurity breach, even a serious one, will not necessarily prove that the company failed to take reasonable cybersecurity measures (see the dismissal of the suit against <a href="https://www.dandodiary.com/2021/06/articles/securities-litigation/marriott-data-breach-related-securities-and-derivative-suits-both-dismissed/">Marriott</a>).</p>
<p><em>Disclosure Controls Concerning IT Issues</em></p>
<p>Under Section 302 of the Sarbanes Oxley Act of 2002 (SOX), public companies must assess and report on their disclosure controls on their quarterly and annual reports. As part of their SOX 302 assessments, companies have increasingly included discussions of information technology (IT) and cybersecurity issues.</p>
<h2><img src="/uploads/CyberImage_5.png" alt="CyberImage_5.png" /></h2>
<p>According to Audit Analytics, which gathers and categorizes this information, an IT issue is defined as:</p>
<p>[D]eficient program controls, software programs/implementation, segregation of duties associated with personnel having access to computer accounting or financial reporting records and related problems with oversight/access to electronic data/programs</p>
<p>A disclosure control relating to IT can also be an early warning signal for cybersecurity issues. For example, PayPal has only issued one disclosure control in the last five years, and it was on October 24, 2017 and related to IT issues. On December, 1st, 2017, PayPal <a href="https://www.foxbusiness.com/markets/paypal-says-personal-data-may-be-compromised-for-1-6-million-tio-users">revealed</a> that it had suffered a major cybersecurity breach related to their acquisition of TIO. This led to a securities class action suit that was eventually dismissed.</p>
<p><em>Conclusion</em></p>
<p>The chance of being involved in a cybersecurity securities class action lawsuit is still relatively low, but it is increasing rapidly. Additionally, the risk profile is far higher for large companies, which are more likely to be a victim of a cybersecurity incident.</p>
<p>Companies are also apparently increasing their scrutiny of their own systems, as the number of companies that have identified IT issues in their disclosure controls has increased significantly over the last decade.</p>
<p>Thankfully, cybersecurity litigation remains relatively rare, despite the increases in attacks. If company boards wish to mitigate their risk of being victimized twice (by hackers and by lawyers), then they need to learn from their successful peers and make wise and strategic decisions.</p>
<p>If you want to learn more about our research or the report this blog is derived from, then please contact <a href="mailto:jcheffers@watchdogresearch.com">jcheffers@watchdogresearch.com</a>. The underlying report is currently available for $499. You can pair this report with a snapshot of the Cybersecurity Incident data ($1500) for $1749.</p>john_cheffersCybersecurity incidents experienced a lull in 2020, but are coming back with a vengeance in 2021.Concern is Warranted: Warrants as Liabilities vs. Equities2021-08-05T12:42:00-04:002021-08-05T12:42:00-04:00https://blog.watchdogresearch.com/posts/concern-is-warranted-warrants-as-liabilities-vs-equities<p><em>The SEC issued accounting guidelines that pumped the breaks on the white-hot SPAC market and caused many SPACs restate their financials.</em></p>
<p>A SPAC, also known as blank-check company, is a stock created by sponsors that raises money in an initial public offering with no underlying business. Investors entrust their money to one of these sponsors, instead of to an operating company.</p>
<p><a href="https://www.jdsupra.com/legalnews/five-key-takeaways-from-the-sec-s-3931115/">Typically</a>, the SPAC must use its cash within two years to buy a private company (in a de-SPAC transaction), or refund the money to investors. Generally, investors don’t know what the acquisition target will be until the announcement.</p>
<p><strong>Reserve now, buy later</strong></p>
<p>A SPAC IPO is usually structured to offer investors a unit of securities consisting of (1) shares of common stock and (2) <a href="https://www.investor.gov/introduction-investing/general-resources/news-alerts/alerts-bulletins/investor-bulletins/what-you">warrants</a>. A warrant is a contract that gives the holder the right to purchase in the future a certain number of additional shares of common stock at a certain price.</p>
<p>The <strong><a href="https://lawcast.com/2021/06/25/a-resolution-for-spac-warrant-accounting/">terms of warrants</a></strong> vary greatly across different SPACs. In general, sponsors receive the more advantageous private placement warrants and outside shareholders receive less-desirable public warrants. A SPAC itself can redeem warrants pursuant to their terms. Warrants are often exercised when the merger target is announced.</p>
<p><strong>A liability, not an asset</strong></p>
<p>Recently, the SEC issued <a href="https://www.sec.gov/news/public-statement/accounting-reporting-warrants-issued-spacs?utm_medium=email&utm_source=govdelivery#_ftnref6">accounting guidelines</a> stating that SPACS must consider warrants, often previously classified as equities of the entity, to be liabilities. This is because an outside third party could make a cash tender offer, and the SPAC would be obliged to give all warrant holders cash for their warrants. The classification of warrants also depends on their <a href="https://www.pkfod.com/insights/spac-warrant-valuation-insights-and-considerations/">value</a> on redemption; the value can vary greatly according to the terms of the SPAC’s IPO.</p>
<p>Many people consider this an unnecessary burden. “In reality, the company will never pay cash because the warrant holder will exercise [the warrant] and get the equity. That’s more valuable to them.” said Harris <a href="https://www.cfodive.com/news/spac-warrants-liability-change-SEC-CFO-accounting-antoniades/598655/">Antoniades</a>, managing director of global investment bank and advisory firm Stout.</p>
<p><strong>Workarounds</strong></p>
<p>In June, <a href="https://www.cfodive.com/news/whats-behind-the-secs-spac-warrant-concerns/601658/">Smith and Tomov</a> delineated many of the convoluted provisions necessary to classify warrants as derivatives, a form of equity. “In many of the deals, the warrants don’t meet an exception in FASB’s accounting standards for derivatives. As a result, they’re misclassified as equity”.</p>
<p>Recently, legal (<a href="https://lawcast.com/2021/06/25/a-resolution-for-spac-warrant-accounting/">Laura Anthony</a>, Esq. and <a href="https://www.whitecase.com/publications/alert/clarity-emerges-aftermath-sec-statement-spac-warrant-accounting-roadmap-changes">Joel Rubenstein et al</a>. of White and Case, LLC.), and <a href="https://www.pkfod.com/insights/spac-warrant-valuation-insights-and-considerations/">financial</a> (Noam Hirschberger, CFA and Eric Gelb, CPA of PKF O’Connor Davies) groups also addressed the fine points of the SEC statement. They came up with several suggestions on how current SPAC agreements might be amended, or how future SPAC contracts might be worded, so that warrants could indeed be classified as equities of the entity rather than liabilities.</p>
<p>One solution would require the sponsors to give up some of the considerable financial advantages they enjoy in holding private placement warrants. It remains to be seen if the sponsors would be willing to do so.</p>
<p>Another approach is to simply <a href="https://www.reuters.com/business/wall-street-grapples-with-new-spac-equity-contracts-after-regulator-crackdown-2021-06-08/">not include warrants</a> in the SPAC’s IPO. That’s how flamboyant SPAC proponent Chamath Palihapitiya handled his latest series of biotech SPAC IPOs in June. Alternatively, new contracts might include rights agreements, commonly used in Europe, rather than warrants, but rights agreements are considered riskier for the investor.</p>
<p><strong>Demanding a recount</strong></p>
<p>Meanwhile, the SEC ruling has caused a flurry of <a href="https://www.accountingtoday.com/news/sec-warnings-on-spacs-dampen-deals-and-accounting-services">new filings</a>, as almost three-quarters of existing SPACs scrambled to <a href="https://www.wsj.com/articles/a-wave-of-earnings-restatements-slams-a-hot-market-11625218380">amend their statements</a> to conform to the new guidelines. The <a href="https://www.jdsupra.com/legalnews/five-key-takeaways-from-the-sec-s-3931115/">new standards</a> are forcing companies to redo the initial IPO valuation and analyze the value of the warrants each quarter, rather than just at the start of the SPAC. They will also have to use more complex valuation models, said Antoniades.</p>
<p>At the same time, the ruling has caused a huge <a href="https://www.institutionalinvestor.com/article/b1s46zt9m0tj4c/IPO-Market-Cools-as-SPACs-Face-Downturn">drop</a> in the <a href="https://www.wsj.com/articles/a-wave-of-earnings-restatements-slams-a-hot-market-11625218380">number</a> of SPACs <a href="https://www.reuters.com/business/wall-street-grapples-with-new-spac-equity-contracts-after-regulator-crackdown-2021-06-08/">created</a> (from 298 January-March 2021 to just 32 in April and May 2021), and fueled <a href="https://www.cfodive.com/news/spac-warrants-liability-change-SEC-CFO-accounting-antoniades/598655/">speculation</a> both that such was the SEC’s intent, and that the IPO market may shift away from SPACs and back to traditional IPOs. However, after an initial <a href="https://www.wsj.com/articles/a-wave-of-earnings-restatements-slams-a-hot-market-11625218380">tumble</a>, the market appears to have <a href="https://www.whitecase.com/publications/alert/clarity-emerges-aftermath-sec-statement-spac-warrant-accounting-roadmap-changes">shrugged off</a> the reclassification, and value of existing SPACs has not plunged.</p>
<p><strong>Conclusion</strong></p>
<p>The SEC has issued new guidelines requiring SPACs to classify or reclassify warrants as liabilities. This means they have to appear on balance sheets quarterly rather than only once, and to undergo a more complex valuation process. This and other recent <a href="https://blog.watchdogresearch.com/posts/unsafe-to-mislead/">guidance</a> from the SEC has put the brakes on a previously red-hot SPAC market.</p>elise_roseThe SEC issued accounting guidelines that pumped the breaks on the white-hot SPAC market and caused many SPACs restate their financials.Why Are Companies Using 10-K/As to Disclose Bad News in 2021?2021-08-03T15:06:00-04:002021-08-03T15:06:00-04:00https://blog.watchdogresearch.com/posts/why-are-companies-using-10-k-slash-as-to-disclose-bad-news-in-2021<p><em>SPACs have been utilizing amended annual reports, 10-K/As, to break bad news in 2021.</em></p>
<p>If you have ever had to tell someone bad news, you know that you can lessen the impact by picking your moment carefully. It is a way of abdicating responsibility, and it is extremely common in corporate America. For example, negative corporate disclosures tend to be released on a Friday evening, preferably before a long weekend.</p>
<p>For public companies, it is not just about <em>when</em> the disclosure is made, but <em>how</em> it is made. We are seeing a concerning trend in 2021 where companies are waiting to make their initial disclosures of bad news such as going concern opinions, ineffective internal control disclosures, and financial restatements in an <em>amended</em> annual 10-K filings (10-K/As), instead of 8-Ks and other traditional methods and long after the original “clean” 10-K was filed with the SEC.</p>
<p>Lordstown Motors is an electric car company that went public via SPAC. On June 8th, Lordstown Motors filed a 10-K/A, more than two months after it released its annual report on March 25th. As reported by Francine McKenna in <em><a href="https://thedig.substack.com/p/a-rollercoaster-ride-for-lordstown">The Dig</a></em>, Lordstown disclosed a going concern opinion, an ineffective internal control assessment by management, and two subpoenas from the SEC (indicating that the SEC was conducting a formal investigation, not an informal inquiry). Lordstown also disclosed that their restatement announced in <a href="https://www.sec.gov/ix?doc=/Archives/edgar/data/1759546/000110465921064530/tm2110489d2_8k.htm">May</a> would include an additional charge of $23.5 million, perhaps what tipped it into the “going concern” warning range.</p>
<p><strong>10 Years of Data on 10-K/As</strong></p>
<p>Until 2021, it was very unusual to see these sorts of disclosures originate in the 10-K/A. Generally, this sort of negative information that could move the stock price would be released in an 8-K, or in a press release. This graph represents initial disclosures by filing over the last ten years: (All our analysis is for publicly traded companies on the NYSE and Nasdaq.)</p>
<p><img src="/uploads/Initial%20Disclosure%20Methods.png" alt="Initial Disclosure Methods.png" /></p>
<p>As you can see, 10-K/As are not even represented on this graph. That’s because they account for less than 1% of initial disclosures and are lumped in with some other filings in the “all other methods” category.</p>
<p>Another point that adds context is that 10-K/As themselves are not rare. They are filed by about 10% of companies a year.</p>
<p><img src="/uploads/10-KAs%20per%20year.png" alt="10-KAs per year.png" /></p>
<p>Even though they are used to amend 10-Ks, 10-K/As are not typically used to communicate serious issues at a company for the first time, like an internal control issue, going concern issue, or a restatement. Over the last ten years only <strong>3.6%</strong> of 10-K/As were used to reveal ineffective internal controls. Going concern opinions were even more uncommon, with only <strong>.06%</strong> of 10-K/As being used to reveal a going concern opinion. Finally, there were nearly 6,000 10-K/As filed from 2011-2020, but only 3 of them were used to initially disclose a non-reliance restatement.</p>
<p><strong>2021 Brings a Big Change</strong></p>
<p>Lordstown’s use of a 10-K/A to disclose its going concern and internal control issues was, therefore, highly unusual. But Lordstown was just the biggest, most closely-watched company of many in 2021 that used this stealth maneuver. In 2021, companies have used 10-K/As to first disclose internal control issues, going concern warnings, and restatements at levels far in excess of the normal incidence.</p>
<p>According to our analysis, this change is due almost entirely to companies that went public via a SPAC.</p>
<p><img src="/uploads/Initial%20Disclosures%20Table%20final.png" alt="Initial Disclosures Table final.png" /></p>
<p><strong>Conclusion</strong></p>
<p>SPACs and companies went public via SPACs have started using the 10-K/A to disclose bad news in a way that is novel and a bit sneaky. This may be due to incompetence, or it may be part of an effort to soften the impact on share price. What the market doesn’t read, the market doesn’t see and react to. (Fortunately, our Watchdog Reports capture all this information regardless of where it is filed!)</p>
<p>This is just another example of how SPACs, and the companies that go public via SPACs, <a href="https://blog.watchdogresearch.com/posts/matchmaker-matchmaker-sponsor-advantage/">differ</a> from companies that go public via a traditional IPO. This may raise questions about the competence of the accounting, finance and legal advisors to these companies and their auditors, who are also supposed to be act as a control on bad financial information.</p>
<p>We’ve written previously about how SPACs are in a hurry to make deals and are incentivized to <a href="https://blog.watchdogresearch.com/posts/money-to-burn/">overpay</a> for acquisitions. That’s bad for investors. The penchant for hiding bad news in a 10-K/A is a sign that many SPACs are not prepared to become a successful public company, and that their sponsors may have pushed them through a SPAC merger because the payout was too good to turn down.</p>
<p>If you are interested in more learning more about our research, contact jcheffers@watchdogresearch.com.</p>
<p><em>This article was amended on 8/9/2021 to correct the final table. We made an error that inflated the number of going concern opinions and have revised the numbers accordingly.</em></p>john_cheffersSPACs have been utilizing amended annual reports, 10-K/As, to break bad news in 2021.Unsafe to Mislead2021-07-27T08:43:00-04:002021-07-27T08:43:00-04:00https://blog.watchdogresearch.com/posts/unsafe-to-mislead<p>Legal liability for those involved in SPACs <em>may be higher</em> than in conventional IPOs because of potential conflicts of interest.</p>
<p>A SPAC, also known as blank-check company, is a stock created by sponsors that raises money in an initial public offering with no underlying business. Investors entrust their money to one of these sponsors, instead of to an operating company.</p>
<p><a href="https://www.jdsupra.com/legalnews/five-key-takeaways-from-the-sec-s-3931115/">Typically</a>, the SPAC must use its cash within two years to buy a private company (in a de-SPAC transaction), or refund the money to investors. Generally, investors don’t know what the acquisition target will be until the announcement.</p>
<p><strong>No more free passes</strong></p>
<p>On April 8, 2021, John Coates, Acting Director, Division of Corporation Finance of the US Securities and Exchange Commission, wrote an <em><a href="https://www.sec.gov/news/public-statement/spacs-ipos-liability-risk-under-securities-laws">article</a></em> primarily addressing the legal liability attached to disclosures in the de-SPAC transaction. He stressed that in some cases the risk of liability for those involved in SPACs may be higher, not lower, than in conventional IPOs because of potential conflicts of interest in the SPAC structure.</p>
<p><strong>Unsafe to mislead</strong></p>
<p>Coates stressed that both federal and state law prohibit any material misstatement in, or omission from, SPAC registration statements either in the IPO or as part of a de-SPAC merger. In conflict-of-interest settings, Delaware corporate law in particular has stricter requirements on both fiduciary duties and on a duty of candor.</p>
<p>Some SPAC advocates have argued that “safe harbor” provisions of the Private Securities Litigation Reform Act (PSLRA) of 1995 provide SPACs protections when making projections. The PSLRA was passed to curb frivolous securities lawsuits and its <a href="https://www.law.cornell.edu/uscode/text/15/78u-5">safe harbor provision</a> protects stock issuers from legal liability for projections, also known as “<a href="https://www.law.cornell.edu/definitions/uscode.php?width=840&height=800&iframe=true&def_id=15-USC-1658834582-1964343826&term_occur=999&term_src=title:15:chapter:2B:section:78u%E2%80%935">forward-looking statements</a>.” However, the safe harbor does not apply to any situation where the issuer knows the statement is untrue, misleading, or omits material facts.</p>
<p>Even more relevant, <a href="https://www.law.cornell.edu/uscode/text/15/78u-5">15 US Code 78u-5b1B</a> <em>specifically excludes</em> blank check companies from any safe harbor protections. Initial Public Offerings are also excluded from using the safe harbor provisions by <a href="https://www.law.cornell.edu/uscode/text/15/78u-5">15 US Code 78u-5b1D</a> because of a danger for abuse. Coates argues that a de-SPAC transaction essentially functions as an IPO because even though the public entity has existed as a legal entity for some time, the actual operations from de-SPAC entity will come from the projections of a private company:</p>
<blockquote>
<p>“…the public knows nothing about this private company. Appropriate liability should attach to whatever claims it is making, or others are making on its behalf.”</p>
</blockquote>
<p><a href="https://www.sec.gov/news/public-statement/spacs-ipos-liability-risk-under-securities-laws">Coates</a> rightly insists that PSLRA does not protect against false or misleading statements when made with actual knowledge that the statement was false or misleading.</p>
<p>He also warns against only disclosing favorable projections while omitting mention of equally reliable but unfavorable projections. Statements about current valuation or operations are also outside the safe harbor.</p>
<p><strong>The party’s over</strong></p>
<p>This heightened scrutiny caused alarm in some quarters. <a href="https://www.spglobal.com/marketintelligence/en/news-insights/latest-news-headlines/tech-and-spacs-sec-regulation-could-result-in-fewer-but-better-spacs-64000801">Michael Fitzgerald</a>, a managing director at MorganFranklin Consulting LLC, a Vaco company, said,</p>
<blockquote>
<p>“One of the biggest advantages of SPACs over traditional IPOs is the availability of target projections and information on valuation that are not common in a traditional IPO prospectus. Changes in securities laws or elimination of safe harbor protections could reduce the benefit of SPACs in the future.”</p>
</blockquote>
<p>However, Withers partner M. Ridgway <a href="https://www.cfodive.com/news/new-spac-scrutiny-CFO-forward-looking-guidance-withers-barker/598728/">Barker</a> and <a href="https://www.jdsupra.com/legalnews/five-key-takeaways-from-the-sec-s-3931115/">others</a> didn’t see the SEC as prohibiting forward-looking disclosures in SPAC deals. They feel the new guidelines are a signal that the Commission would examine what sponsors and target companies say about their merger, looking for the kinds of statements that are banned in traditional IPOs.</p>
<p><strong>See you in court</strong></p>
<p>In March the SEC opened an <a href="https://www.reuters.com/business/exclusive-us-regulator-opens-inquiry-into-wall-streets-blank-check-ipo-frenzy-2021-03-25/">inquiry</a> into Wall Street banks seeking information on how underwriters are managing the risks involved on their SPACs. Stanford University reported that investors have sued eight target companies acquired by SPACs this year. Some of the lawsuits allege that the SPACs and their sponsors hid weaknesses ahead of the de-SPAC transactions, allowing them to make huge profits when the SPAC combined with its target.</p>
<p>Lawsuits could go the other way as well. <a href="https://us02web.zoom.us/rec/play/Znwtw0auC_8E3VhUqKMubB36yIYb_68ZmR2uVzdrfnb_s4IPHGdQZljJDaySg3IyrgMLsVa9ZXFqeM0_.2lQLCsjtBGGv6mSr?startTime=1620154753000&_x_zm_rtaid=0JMEqKCfTtalGZBaGkyrXg.1620655622652.f15c27c1bd68e43e3819ebadb837735a&_x_zm_rhtaid=600">Paul Atkins</a>, CEO of Patomak Global Partners and former SEC commissioner predicted that if the SEC attempted to limit SPACs, companies and investors would take legal action against the regulatory agency. “At some point there will be people who will push back and this may well be tested in court if the SEC is overly aggressive on this.”</p>
<p><strong>Conclusion:</strong></p>
<p>Recent SEC publications indicate that those involved in <em>SPACs</em> may not have safe harbor protection from legal liability under the PSLRA. In fact, the risk of liability for those involved with SPACs <em>may be</em> higher than in risk of launching a conventional IPO because of structural conflicts of interest in SPACs.</p>elise_roseLegal liability for those involved in SPACs may be higher than in conventional IPOs because of potential conflicts of interest.Slouching in SPAC-land: Poor Returns2021-07-14T09:27:00-04:002021-07-14T09:27:00-04:00https://blog.watchdogresearch.com/posts/slouching-in-spac-land-poor-returns<p>The investment returns for most SPACs are not as good as those for traditional IPOs.</p>
<p>A SPAC, also known as blank-check company, is a stock created by sponsors that raises money in an initial public offering with no underlying business. Investors entrust their money to one of these sponsors, instead of to an operating company.</p>
<p><a href="https://www.jdsupra.com/legalnews/five-key-takeaways-from-the-sec-s-3931115/">Typically</a>, the SPAC must use its cash within two years to buy a private company (in a de-SPAC transaction), or refund the money to investors. Generally, investors don’t know what the acquisition target will be until the announcement.</p>
<p><strong>New but not necessarily improved</strong></p>
<p>Investors always intend to make money. Unfortunately, the track record for profitability among SPACs is not stellar. Most of the larger SPACs formed since 2020 that were still trading as of April 30, 2021, have <a href="https://www.spglobal.com/marketintelligence/en/news-insights/latest-news-headlines/tech-and-spacs-sec-regulation-could-result-in-fewer-but-better-spacs-64000801">declined in value</a>. Nearly 200 of these stocks dropped between 0% and 2% compared to their IPO prices; over half of those did worse. Overall, the <a href="https://www.renaissancecapital.com/IPO-Center/News/71816/Updated-SPAC-returns-fall-short-of-traditional-IPO-returns-on-average#:\~:text=Of%20the%20313%20SPACs%20IPOs,for%20traditional%20IPOs%20since%202015.">mean return</a> of SPACs since 2015 was -9.6%; the median return was -29.1%. Only 31.1% had positive returns. Traditional IPOs had returns of <strong>47%</strong> over the same period.</p>
<p><strong>Riding the roller coaster</strong></p>
<p>Investors may be fooled by short-term performance of SPACs. In the first phase of their <a href="https://www.indexologyblog.com/2021/04/15/special-purpose-acquisition-companies-spacs-part-iv/">life cycle</a>, post-IPO, i.e., the initiation of the SPAC, SPACs somewhat underperformed the S&P SmallCap 600 Index. However, on announcement of a target for acquisition, the stocks temporarily soar, and some of the stocks continue to do well for a little while.</p>
<p>But only 30 days later, most are back to underperforming the S&P SmallCap 600. After the de-SPAC deal is completed, the stocks tend to decline, and investment returns get worse over time after the merger deal, with mean down 17.6% and median down 28.8% a year later.</p>
<p><strong>Down when the market is up</strong></p>
<p>The <a href="https://www.cnbc.com/quotes/.SPACCNBC">CNBC SPAC 50 Index</a>, which tracks the 50 largest U.S.-based pre-merger blank-check deals by market cap, has <a href="https://www.cnbc.com/2021/06/02/a-spac-frenzy-this-year-could-lead-to-riskier-deals-heres-why.html">slumped</a> nearly 4% year to date, erasing all 2021 gains, at a time when the Nasdaq has gained 6%. The <a href="https://www.cnbc.com/quotes/.SPACDEAL">CNBC SPAC Post Deal Index</a>, which includes the largest SPACs that have come to market and have announced a target, is down about 15% year to date.</p>
<p>Tech SPACs that have closed a deal have <a href="https://www.spglobal.com/marketintelligence/en/news-insights/latest-news-headlines/tech-and-spacs-too-much-of-two-good-things-63177042">underperformed</a>. Financial firms and industrials have done better. Automotive companies have done particularly well, though that is possibly due to speculative investment in driverless or “green” technology.</p>
<p><strong>Conclusion:</strong></p>
<p>SPACs may seem to be a good alternative to traditional IPOs for small-time retail investors, because of the relatively low cost to own shares. However, over the last 18 months, the average investment returns for SPACs have been far inferior to those for traditional IPOs.</p>elise_roseThe investment returns for most SPACs are not as good as those for traditional IPOs.Matchmaker, Matchmaker–Sponsor Advantage2021-07-07T15:38:00-04:002021-07-07T15:38:00-04:00https://blog.watchdogresearch.com/posts/matchmaker-matchmaker-sponsor-advantage<p><em>The structure of SPACs leads to an inherent advantage for sponsors.</em></p>
<p>A SPAC, also known as blank-check company, is a stock created by sponsors that raises money in an initial public offering with no underlying business. Investors entrust their money to one of these sponsors, instead of to an operating company.</p>
<p><a href="https://www.jdsupra.com/legalnews/five-key-takeaways-from-the-sec-s-3931115/">Typically</a>, the SPAC must use its cash within two years to buy a private company (in a de-SPAC transaction), or refund the money to investors. Generally, investors don’t know what the acquisition target will be until the announcement.</p>
<p><strong>Beware the unknown “spouse”</strong></p>
<p>One could think of the sponsors of a SPAC as matchmakers. The retail investor puts money in based on the reputation of the matchmaker, who may have brought about brilliant financial “marriages” in the past.</p>
<p>However, the investor has little to go on but trust in the promises of the matchmaker. The matchmaker is obliged to find a “spouse” (merger target), but it could be an indifferent or even a poor match for the investor.</p>
<p>The matchmaker is guaranteed to make money, and in some cases has undisclosed or even blatant conflicts of interests in the proposed match. The retail investor may end up with no money, no dowry, and an unhappy marriage.</p>
<p><strong>Nothing down</strong></p>
<p>SPAC sponsors usually buy into a SPAC at more favorable terms than retail investors in the IPO or subsequent investors on the open market. Often a sponsor obtains 20% of the shares in a SPAC for either nothing or a nominal <a href="https://www.investor.gov/introduction-investing/general-resources/news-alerts/alerts-bulletins/investor-bulletins/what-you">investment</a>.</p>
<p>Chamath Palihapitiya, the “King of SPACs”, in a <a href="https://www.bloomberg.com/opinion/articles/2021-05-27/spacs-can-take-away-the-insiders-advantage-in-ipos-and-markets">plea</a> for regulation of the trendy vehicles, recommends that the government require sponsors to commit personal capital to the SPAC. Palihapitiya notes that only 48 of the 127 SPACs that have announced, but not yet closed on, a deal had some form of sponsor investment, with only 10 making long-term commitments to the companies.</p>
<p>Celebrities or <a href="ttps://www.bloomberg.com/news/features/2021-05-13/spac-king-chamath-palihapitiya-hopes-his-hype-will-keep-mesmerizing-you">big-name investors</a> receive far more value than they pay for. Often the retail investor has little information other than the reputation of the <a href="https://thinkadvisor.tradepub.com/free/w_johc18/">sponsor</a>. “You might think of investing in a new SPAC as being more interested in the jockey than the horse.” <a href="https://www.bloomberg.com/opinion/authors/AOq-oPqQBBI/chamath-palihapitiya">Palihapitiya</a> advises examining the amount the sponsor is investing to assess the legitimacy of a SPAC. Although most of the SPAC’s capital has been provided by IPO investors, the sponsors will <a href="https://www.sec.gov/corpfin/disclosure-special-purpose-acquisition-companies">benefit</a> more than other investors from the SPAC’s completion of an initial business combination.</p>
<p>But Chamath <a href="https://www.bloomberg.com/opinion/authors/AOq-oPqQBBI/chamath-palihapitiya">Palihapitiya</a> himself exemplifies sponsor advantage. He received 20,500,000 “founders shares” of the SPAC IPOC, worth $205 million in stock, for an <a href="https://www.socialcapitalhedosophiaholdings.com/">investment</a> of $25,000 from his firm Social Capital Hedosophia, and for promoting the SPAC and its target Clover. He also bought $100 million worth of shares at the regular price, so he obtained 30.5 million shares for the price of slightly over 10 million.</p>
<p><strong>Dilution is not the solution</strong></p>
<p>Another problem is <a href="https://thinkadvisor.tradepub.com/free/w_johc18/">dilution</a>. Many investors sell their shares when the merger is announced, which is usually the highest point of value in the SPAC life cycle. This drains the cash that could help the soon-to-be-acquired company. The sponsors, who initially put down almost nothing, are still in the deal. Retail SPAC investors who stay with the deal hold shares backed by substantially less cash than at their initial investment.</p>
<p>U.S. Senator John Kennedy (R-La.), <a href="https://www.kennedy.senate.gov/public/2021/4/kennedy-introduces-spac-act-to-increase-transparency-surrounding-blank-check-companies">introduced a bill</a> to ensure investors have adequate transparency into SPAC deals, particularly when it comes to what are called “founder’s shares,” a special class of shares that go to the SPAC sponsors after the merger is completed.</p>
<p><a href="https://www.cfodive.com/news/as-sec-ramps-up-spac-rules-lawsuits-could-follow/599906/">Kennedy said</a> when introducing the bill, “When SPAC sponsors convert the shares that they receive in the merged company, the public’s shares of that company are diluted and lose value. The valuation of SPAC shares may fall even further if a SPAC sponsor chooses a weak company with which to merge.”</p>
<p><strong>Under pressure, overvalued</strong></p>
<p>As the deadline for a merger approaches, sponsors may have an incentive to complete a transaction on terms where they make money but the retail investor does not. <a href="https://www.finra.org/rules-guidance/notices/08-54#:\~:text=A%20SPAC%20typically%20must%20complete,of%20the%20assets%20in%20escrow.">FINRA</a> warned investors of this as far back as 2008:</p>
<p>SPAC managers have a strong incentive to buy a company, even at inflated values, since they will get 20 percent of the company at a nominal price.</p>
<p>If a deal doesn’t go through, the firms that create SPACs must return the money initial investors paid in. The sponsors definitely want to avoid this scenario. So there’s a lot of <a href="https://www.spglobal.com/en/research-insights/articles/special-purpose-acquisition-companies-spacs-part-ii">pressure</a> for SPAC sponsors to find a target company for merger.</p>
<p>The company targeted for acquisition must comprise over 80% of the trust account assets. This creates an <a href="https://www.spglobal.com/en/research-insights/articles/special-purpose-acquisition-companies-spacs-part-ii">incentive</a> for the SPAC’s sponsors to overvalue a target company to get the deal done. If sponsors have relatively little “skin in the game”, they are not harmed, but retail investors don’t get their money’s worth.</p>
<p><strong>Conclusion: Beware the matchmaker</strong></p>
<p>Retail investors who provide the bulk of the funds for SPACs have to weather the ups and downs of the market. Sponsors are not usually required to put very much, if any, of their own money into their SPACs. Therefore, they are guaranteed to make a profit when the merger happens, regardless of how the SPAC performs. Sponsors also have perverse incentives to target weaker companies for acquisition to avoid refunding money if the de-SPAC transaction doesn’t go through. Investors are cautioned to examine the matchmaker with care, because in most cases, they won’t find a matchless match.</p>elise_roseThe structure of SPACs leads to an inherent advantage for sponsors.Sizzle and PIPE Dreams in SPAC-land2021-06-28T10:00:00-04:002021-06-28T10:00:00-04:00https://blog.watchdogresearch.com/posts/sizzle-and-pipe-dreams-in-spac-land<p><em>SPACs are allowed to make dazzling projections without supporting data and retail investors may not be aware of some conflicts of interest that influence sponsors’ investment behavior.</em></p>
<p>Special purpose acquisition companies (SPACs) have <a href="https://www.cnbc.com/2021/05/27/sec-considers-new-investor-protections-for-spacs.html">exploded</a> in popularity in the last 18 months, with 90% created in 2020 or 2021. A SPAC, also known as blank-check company, is a stock created by sponsors that raises money in an initial public offering with no underlying business. <a href="https://www.jdsupra.com/legalnews/five-key-takeaways-from-the-sec-s-3931115/">Typically</a>, the SPAC must use its cash within two years to buy a private company (in a de-SPAC transaction), or refund the money to investors. Generally, investors don’t know what the acquisition target will be until the announcement.</p>
<p>The SPAC usually uses additional funds from a <a href="https://www.fool.com/investing/2021/03/26/spac-investing-101-what-is-a-pipe-and-what-should/">PIPE</a> (private investment in public equity) to accomplish the de-SPAC. By starting the company this way, a SPAC purports to <a href="https://thinkadvisor.tradepub.com/free/w_johc18/">avoid</a> the regulatory requirements of a traditional IPO.</p>
<p>Proponents of SPACs <a href="https://www.jdsupra.com/legalnews/spacs-an-attractive-alternative-to-a-8460350/">tout</a> them as good for small-time retail investors, because of the relatively low cost to own shares (usually only $10) and the ability to divest of shares before the merger. However, there are a number of notable risks for investors.</p>
<p><strong>The Sizzle</strong></p>
<p>SPACs have a looser regulatory environment than traditional IPOs. They can make projections that traditionally are “<a href="https://www.sec.gov/news/public-statement/spacs-ipos-liability-risk-under-securities-laws">not commonly found in conventional IPO prospectuses</a>.” This allows the sponsors, those who start the SPAC, to “sell the sizzle, not the steak”, because until the merger is announced, there is, in fact, no steak to sell.</p>
<p>Investors have little information to go on in assessing the SPAC. In particular, retail investors may not be aware of conflicts of interest that influence sponsors’ investment behavior. The SEC admitted as much when it provided <a href="https://www.sec.gov/corpfin/disclosure-special-purpose-acquisition-companies">guidance</a> for SPAC disclosure:</p>
<p><em>The economic interests of the entity or management team</em> … <em>often differ from the economic interests of public shareholders which may lead to conflicts of interests</em> as they evaluate and decide whether to recommend business combination transactions to shareholders.</p>
<p>Despite this guidance, SPAC sponsors have <a href="https://techcrunch.com/2021/06/04/um-where-is-the-sec-when-it-comes-to-spacs-and-conflicts-of-interest/">continued</a> to target companies where they have apparently have a personal vested interest. SPAC are not prohibited from these self-interested transactions. They only have to tell investors, usually in a lengthy disclosure, that the SPAC capital might be used to buy one of their own companies.</p>
<p>A recent story <a href="https://techcrunch.com/2021/06/04/um-where-is-the-sec-when-it-comes-to-spacs-and-conflicts-of-interest/">featured</a> in TechCrunch looked at the example of Reid Hoffman, a SPAC sponsor who is close to finalizing a merger deal with autonomous vehicle startup Aurora. But Hoffman’s venture firm, Greylock, began investing in Aurora in 2018, and he is on its board of directors. He could set the price for acquisition of Aurora by his SPAC at a level that would greatly enhance its value and therefore his bottom line.</p>
<p>SPAC proponent Chamath Palihapitiya, the “King of SPACs”, invested in insurance company Clover through his firm Social Capital <a href="https://www.bloomberg.com/news/features/2021-05-13/spac-king-chamath-palihapitiya-hopes-his-hype-will-keep-mesmerizing-you">before</a> one of his SPACs merged with Clover <a href="https://www.reuters.com/article/us-clover-health-m-a-social-capital/clover-health-to-go-public-via-3-7-billion-deal-with-social-capital-idUSKBN26R1XB">last year</a>. <a href="https://www.forbes.com/sites/jonathanponciano/2021/06/07/spac-king-regains-billionaire-status-as-trading-frenzy-boosts-clover-health/?sh=3990179f3828">Since the merger</a>, Clover has been the subject of an SEC investigation, an undisclosed Justice Department inquiry, and an accusation by short-seller Hindenburg Research of fraud, including kickbacks, misrepresentation and undisclosed third-party deals.</p>
<p>Nothing stops these ethically questionable investments because the SEC’s guidelines are suggestions, not law.</p>
<p>Investment banks that sponsor SPACs also have a <a href="https://www.spglobal.com/marketintelligence/en/news-insights/latest-news-headlines/tech-and-spacs-sec-regulation-could-result-in-fewer-but-better-spacs-64000801">potential</a> conflict of interest. Some banking sponsors invest minimal amounts into a SPAC, but then also underwrite the launch of the IPO and serve as advisors for the deal to acquire an operating company. Often those fees are much larger than the bank’s investment as a sponsor, so the bank might have a much greater financial interest in completion of the merger deal than in the success of the SPAC itself. In March the SEC opened an <a href="https://www.reuters.com/business/exclusive-us-regulator-opens-inquiry-into-wall-streets-blank-check-ipo-frenzy-2021-03-25/">inquiry</a> into Wall Street banks, seeking information on how underwriters are managing the risks involved in their SPACs.</p>
<p>The SEC may be looking into the depth of due diligence SPACs perform before acquiring assets in the de-SPAC transaction, and whether huge payouts are fully disclosed to investors. The regulators may also be <a href="https://www.reuters.com/business/exclusive-us-regulator-opens-inquiry-into-wall-streets-blank-check-ipo-frenzy-2021-03-25/">concerned</a> about the heightened risk of insider trading between the initiation of the SPAC and when it announces its acquisition target.</p>
<p>Retail investors should be aware that SPAC sponsors who have a vested interest in the target company may be using the merger to shore up a failing venture, a risky investment strategy.</p>
<p><strong>PIPE Dreams</strong></p>
<p>Retail investors also fare <a href="https://www.fool.com/investing/2021/03/26/spac-investing-101-what-is-a-pipe-and-what-should/">worse</a> than the PIPE investors, who come in just before or after the merger is announced. The PIPE investors come in after they know the target, but still get to buy shares for $10, though they are often worth $15 or $20 right away. Ordinary investors can’t buy at the lower price this late in the game.</p>
<p><strong>Waking From the Dream</strong></p>
<p>Allison Herren Lee, the SEC’s current acting chair, <a href="https://www.cfodive.com/news/ipo-deregulation-Allison-Herren-Lee-Jay-Clayton/586858/">said</a> last October at the Practicing Law Institute’s SEC Speaks, “In the short term, a SPAC investment acts largely as a blank check, so it is critical that [there’s an understanding of] the material risks involved.” As Paul <a href="https://www.sec.gov/news/public-statement/munter-spac-20200331">Munter</a>, <em>Acting Chief Accountant of the SEC,</em> noted,</p>
<p>Whether a company enters the public markets through a merger with a SPAC, traditional IPO, or other process, the quality and reliability of financial reporting and the quality of audits on the financial statements provided to investors is vital to our efforts to protect investors and to the confidence of investors in our markets.</p>
<p>Over the past six months the SEC has <a href="https://www.jdsupra.com/legalnews/five-key-takeaways-from-the-sec-s-3931115/">signaled</a> that SPACs will be subject to increased levels of scrutiny. One key area of focus has been on the disclosure of germane conflicts of interest from each SPAC participant: insiders like the sponsors and management team; the IPO’s public shareholders; and third parties like underwriters. These parties will need to avoid conflicts or scrupulously disclose them if they wish to avoid enforcement actions and liability.</p>
<p>Rajiv Shukla, chairman and CEO of SPAC Alpha Healthcare Acquisition Corp., <a href="https://www.spglobal.com/marketintelligence/en/news-insights/latest-news-headlines/tech-and-spacs-sec-regulation-could-result-in-fewer-but-better-spacs-64000801">believes</a> the SEC will also likely require enhanced disclosures on other financial interests of sponsors over the lifecycle of the SPAC deal.</p>
<p><strong>Conclusion</strong></p>
<p>Retail investors who are interested in investing in a SPAC should do as much due diligence on the sponsors of the SPAC as they reasonably can. After all, since there is no underlying company, you really are just investing in the sponsors. If in the past, the sponsors have used SPAC funds to invest in target companies with financial ties to those sponsors, you may want to reconsider giving them your money.</p>
<p>Up next: SPAC Risks Part 2: Matchmaker, Matchmaker–Sponsor Advantage</p>elise_roseSPACs are allowed to make dazzling projections without supporting data and retail investors may not be aware of some conflicts of interest that influence sponsors’ investment behavior.