On April 12, 2021, when John Coates, the acting director of the SEC Division of Corporate Finance, and Paul Munter, the SEC’s acting chief accountant, issued a statement noting their concerns about the way that SPACs were accounting for warrants issued in connection with SPAC IPOs, they also noted that some entities may need to reclassify the warrants from equity to liabilities, and that the change in accounting treatment might require some entities to restate prior financial statements. As it has turned out, many SPACs have in fact reclassified their warrants and many have in fact restated their financials, as discussed below. In at least one case, discussed in earlier post on this site (here), a SPAC-acquired company that restated its financial based on the warrant accounting issue has been hit with a securities class action lawsuit – which raises the question whether other restatements by other SPACs and de-SPACs will trigger further securities class action litigation.
That is the question asked in a June 22, 2021 Law360 article by Elaine Harwood, Steven McBridge and Laura Simmons of Cornerstone Research entitled “Will SPAC Restatement Wave Trigger Shareholder Litigation?” (here). As discussed below, the authors’ article addresses several interesting and important questions about the warrant accounting issue and the possibility for further litigation.
The most important point the authors make in their article is that since the April staff statement about warrant accounting issues, almost 500 SPACs have restated their accounting for warrants – and, they note, “additional restatements may be forthcoming.” The authors note further that of the 497 SPACs that (as of June 22, 2021) have reclassified warrants as liabilities, the majority “corrected previously issued financial restatements to reflect a restatement, while some implemented a revision, whereby the correction was applied only to the current and future financial statements.”
The authors note that while the restatement of the accounting of warrants has no effect on cash flows, the liabilities that the warrants represent have to be recognized at “fair value” – meaning that changes in fair value will affect earnings, which could potentially create income statement volatility.
The authors note further that nearly all SPACs that have restated their financial statements have also “determined that weaknesses existed in their internal controls.” Thus, out of the 497 firms that restated their financials due to the warrant accounting issue, more than 90% identified a material weakness in the SEC filings in which the restatement was reported.
The recognition of weaknesses in internal controls in connection with the restatement is significant with respect to the question whether the restatements will result in further securities class action litigation. In the Virgin Galactic case (discussed here), in which the company defendant was sued following the firm’s restatement of its financials due to the warrant accounting issue, the plaintiffs specifically alleged that the company had “deficient disclosure controls and procedures and internal controls over financial reporting” and that as a result the company improperly accounted for the warrants outstanding when the company merged with the SPAC.
The authors note that plaintiffs’ allegations in securities class action lawsuits related to weaknesses in internal controls are not new and “have frequently been observed in securities class actions.” The authors report that their research shows that almost 60% of securities class action cases involving accounting allegations filed in 2020 included claims related to weaknesses in internal controls.
The authors note further that the firms the warrant accounting issue is not the only complex accounting issue firms may face in connection with the SPAC process; other issues that may arise include “accounting for compensation in earn-outs, the adoption of new accounting standards on the timeline for public rather than private entities, and the application of generally accepted accounting principles in areas not previously faced by private companies.”
Given that many firms are restating their financials and also reporting internal control weaknesses – the kinds of things that in the past have attracted securities litigation – and the fact that there has already been one securities suit filed against a de-SPAC company that restated its financial statements because of the warrant accounting issue raises the question whether other lawsuits against companies that restate their financials due to the warrant accounting issue will follow.
The author note that while the answer to this question remains to be seen, they note further that “whether other class actions will follow depends, at least in part, on the magnitude of the stock price reactions in response to the financial restatement and/or disclosures of material weaknesses in internal controls.”
However, the authors further note that given the developments they describe in their article, and other recent events such as the Robbins Geller law firm’s formation of a SPAC litigation task force, “it seems likely that accounting issues involving SPACs will be a continuing area of interest for plaintiffs counsel involved in securities class actions.”
The authors are of course asking interesting questions. Their important contribution to the dialog is their research showing just how many companies have restated their financials based on the warrant accounting issue, and showing further that many companies noted internal control weaknesses in connection with their restatements. As the authors note, it remains to be seen whether or to what extent further litigation will result from all of this. But they authors are correct that given all of the circumstances, the possibility of further litigation cannot be overlooked, and these issues should be closely watched.