FINRA Provides Update on Sweep: Special Purpose Acquisition Companies (SPACs)

October 2023

Background

In October 2021, FINRA launched a targeted exam (sweep) to review firms’ offering of, and services provided to, Special Purpose Acquisition Companies (SPACs) and their affiliates (e.g., sponsors, principal stockholders, board members and related parties). FINRA’s review focuses on a cross-section of firms that participated in SPAC offerings and included, among other things, reasonable investigation, best interest, disclosure of outside activities or potential conflicts, net capital and supervision.

Below FINRA poses several questions for firms to consider as they evaluate whether their supervisory systems are reasonably designed to address risks of their SPAC-related activities. These questions are based on FINRA’s observations to this point in our review. In addition, the Appendix notes additional guidance FINRA has provided regarding member firms’ relevant obligations.

Member firms and associated persons that offer the purchase and sale of securities of SPACs, that sponsor or are under common control with the sponsor of a SPAC, or that engage in underwriting SPACs, should be aware of their regulatory obligations, including but not limited to FINRA Rules 2090 (Know Your Customer), 2241 (Research Analysts and Research Reports, Identifying and Managing Conflicts of Interest), 2262 (Disclosure of Control Relationship with Issuer), 3110 (Supervision), 3270 (Outside Business Activities of Registered Persons), 3280 (Private Securities Transactions of an Associated Person), 4110 (Capital Compliance), 4512 (Customer Account Information), 5110 (Corporate Financing Rule – Underwriting Terms and Arrangements) and 5121 (Public Offerings of Securities with Conflicts of Interest). In addition, members or associated persons that recommend SPACs to retail customers must comply with the SEC’s Regulation Best Interest (Reg BI).

This update, including the Questions for Consideration, does not create new legal or regulatory requirements or new interpretations of existing requirements, nor does it relieve firms of any existing obligations under federal securities laws and regulations. Member firms may consider the information in this update in developing new, or modifying existing, practices that are reasonably designed to achieve compliance with relevant regulatory obligations based on the member firm’s size and business model. Moreover, some questions may not be relevant due to certain firms’ business models, sizes or practices.

In future publications, FINRA may provide additional information on this and other sweeps, including but not limited to findings and effective practices.

Questions for Consideration

Reasonable Investigation

As discussed in Regulatory Notice 10-22 (Obligations of Broker-Dealers to Conduct Reasonable Investigations in Regulation D Offerings) and Regulatory Notice 23-08 (FINRA Reminds Members of Their Obligations When Selling Private Placements), members are required to conduct reasonable investigations of the issuers and the securities they recommend, including SPACs.¹ When recommending a SPAC, firms may consider the following questions:

• Does your firm perform an independent review of due diligence materials prepared by or received from third parties? How does your firm document its independent review, assessment of and follow-up on potential red flags, and final conclusions?
• Does your firm participate in due diligence meetings, calls or presentations conducted by the third party or other participating members? How does your firm document its participation and the information it has received and reviewed?

Underwriting: Terms & Arrangements, Disclosures & Capital Compliance

When engaging in underwriting activities, firms must comply with FINRA Rules 5110 (Corporate Financing Rule – Underwriting Terms and Arrangements), 5121 (Public Offerings of Securities with Conflicts of Interest), 2262 (Disclosure of Control Relationship with Issuer), and 4110 (Capital Compliance), among others. The following questions, where applicable, may help firms assess their compliance in these areas.

• When reviewing a draft or final prospectus (or similar document), does your firm coordinate with the issuer to ensure that the prospectus (or similar document) meets the disclosure requirements in Rule 5110(b)?
  • Does the prospectus (or similar document) include a description of each item of underwriting compensation received or to be received by a participating member?
  • Does the prospectus (or similar document) include a disclosure on the cover page of the underwriter’s commission or its discount to the public offering price?
  • If the underwriting compensation includes items of compensation in addition to the commission or discount disclosed on the cover page, is there a footnote to the offering proceeds table on the cover page that includes a cross-reference to the section on distribution arrangements?
  • How does your firm document its review?
• Does your firm consider whether the prospectus (or similar document) describes or discusses each item of underwriting compensation received or to be received, such as: (1) any securities (e.g., share, warrant, right) to be acquired by your firm or an affiliated SPAC sponsor; (2) whether your firm or a firm affiliate is, or is under common control with, the issuer of the securities (as defined in Rule 5121); and (3) any services, or payments received for providing additional services, to the SPAC (e.g., advisory or other services in connection with the SPAC’s business combination or merger efforts)?
• Does your firm monitor the compensation it receives to ensure it conforms with the proposed compensation submitted to and reviewed by FINRA’s Corporate Financing department? If so:
  • Does your firm’s review consider any services provided (or to be provided) to the SPAC or a SPAC affiliate in connection with its post-IPO business combination or merger?
  • Does your firm assess the impact of any changes to its proposed compensation (e.g., conversion of cash to shares)?
  • How does your firm document its actions and decisions?
• Does your firm review its calculation of the open contractual commitment charge in connection with firm commitment underwritings?
  • Does your firm’s review coincide with the effective date of the offering?
  • Does your firm’s review consider updates or amendments to the terms of the offering or your firm’s commitment (as reflected in the final prospectus (or similar document))?
  • How does your firm document its calculations and any subsequent review?

Conflicts of Interest: Underwriting & Research

When identifying and addressing potential or actual conflicts of interest, firms must comply with FINRA Rules 5110 (Corporate Financing Rule – Underwriting Terms and Arrangements), 5121 (Public Offerings of Securities with Conflicts of Interest), and 2241(b) (Research Analysts and Research Reports, Identifying and Managing Conflicts of Interest), among others. The following questions, where applicable, may help firms assess how they identify, address and disclose potential or actual conflicts of interest when underwriting or recommending transactions in SPACs.

• Does your firm review for pre-existing relationships between the SPAC, SPAC sponsor, or members of its management and board of directors, and companies operating in the SPAC’s expressed business or target area (pre-merger)?
  • Does your firm take steps to determine whether the SPAC, SPAC sponsor, or members of its management team or board of directors has an existing or prior connection with any of the potential merger or acquisition targets? Does your firm consider the type or length of relationship?
  • Does your firm ask whether the SPAC sponsor or any member of its management team or board of director received any information from or participated in exploratory discussions with the potential target? Does your firm consider when the prior exchange of information or discussions occurred?
  • How does your firm document its review and assessment?
  • Does the prospectus (or similar document) disclose such relationships or interactions?
• Does your firm permit its representatives to purchase, otherwise acquire, or sell shares of SPACs for which your firm acts as underwriter or a distributor? Does your firm assign or transfer shares or warrants it receives (or may receive) to affiliates or other designees? Is your firm made aware when an affiliate purchases or acquires shares or warrants issued by SPACs for which your firm acts as an underwriter or distributor? If so:
  • Does your firm impose any requirements or restrictions on the representatives, affiliates or designees, such as a purchase or sale window or lock up period, pursuant to Rule 5110(e)?
  • Does your firm consider the status of the initial public offering or merger, trading markets or type of security (e.g., share, warrant, right) when assessing whether and what requirements or restrictions to impose or when they should expire?
  • How does your firm document, communicate and monitor compliance with any requirements or restrictions imposed?
• Does your firm prepare and distribute research reports? If so, do the research reports comply with the relevant conflict management, content and disclosure requirements contained in Rule 2241?
• Does your firm or any affiliate provide services to SPACs following the initial public offering? If so, where your firm also acted as underwriter, does the prospectus (or similar document) disclose your firm’s retention, the services to be provided and your firm’s anticipated compensation?
• Does your firm participate in proxy solicitation activities (e.g., vote to approve proposed merger or acquisition) in connection with offerings where your firm acted as underwriter? If so, does your firm require its representatives to make conflict disclosures to investors when discussing or making a recommendation? How does your firm document the disclosure(s)?

Supervision

Firms’ supervisory systems, procedures, processes, and controls for underwriting and recommending transactions in SPACs should consider their respective overall risk profile, customer characteristics, and business activities, and firms must comply with FINRA Rule 3110 (Supervision), among others. The following questions may help firms assess their supervision:

• Does your firm have SPAC-specific written procedures as it relates to reasonable investigation, conflicts of interest, communications with and disclosures to potential investors, and employee trading?
• When recommending that retail customers transact in SPACs, does your firm ensure that such recommendations comply with Reg BI?
• Does your firm have enhanced requirements applicable to the reasonable investigations and best interest assessments to be conducted, or the minimum risk disclosures to be provided, prior to recommending the purchase or sale of a SPAC? If so, do these requirements differ when assessing a purchase or sale in a pre-merger or post-merger context?
• Does your firm require representatives to take training regarding the unique characteristics and risks associated with SPACs prior to recommending the purchase or sale of a SPAC to any customer? If so, how frequently is the training offered?
• Does your firm conduct periodic or ongoing reviews of customers’ trading activity to assess whether their risk tolerance or investment objectives have changed or whether the sale of or additional investments in SPACs would be in the customers’ best interest?
• Does your firm conduct a regular review of watchlist securities? If so, does your firm’s review include or consider the trading and outside business activities conducted by the firm’s registered representatives, or your firm’s publication of research reports?
• Do your firm’s written supervisory procedures (WSPs) address associated persons engaging in SPAC-related activities outside of the firm, including how associated persons would notify your firm of such activities and how your firm would assess it in accordance with FINRA Rules 3270 (Outside Business Activities of Registered Persons) and 3280 (Private Securities Transactions of an Associated Person)?
• Does your firm conduct a regular review of its representatives’ Form U4 disclosures to ensure that reported outside activities, e.g., SPAC sponsors, service on a board of directors or management position (whether undertaken away from your firm or on behalf of firm affiliates), are current and accurate?

Conclusion

This update notes key requirements for members that participate in SPAC offerings. The information presented in this update is intended to remind member firms of the relevant rules and provide them with ideas and questions that they can use to enhance their supervisory programs. Additional resources can be found in the Appendix.

Appendix

Regulatory Guidance

• Regulatory Notice 23-08 (FINRA Reminds Members of Their Obligations When Selling Private Placements)
• Regulatory Notice 22-05 (FINRA Adopts Amendments to Rule 2165)
• Regulatory Notice 20-34 (Proposed Amendments to FINRA Rule 2165 and Retrospective Rule Review Report)
• Regulatory Notice 10-22 (Obligations of Broker-Dealers to Conduct Reasonable Investigations in Regulation D Offerings)

Publications and Other Resources

• 2023 Exam and Risk Monitoring Report – Reg BI and Form CRS
• 2023 Exam and Risk Monitoring Report – Outside Business Activities and Private Securities Transactions
• 2023 Exam and Risk Monitoring Report – Trusted Contact Persons
• 2023 Exam and Risk Monitoring Report – Private Placements
• Private Placements Topic Page
• Public Offerings Topic Page
• SEC Regulation Best Interest Topic Page
• Supervision Topic Page