What is a SPAC?

The new craze on Wall Street is SPACs, or a special purpose acquisition company. SPACs are shell companies formed with the sole purpose of raising funds so it can buy an existing business. There were over 100 SPAC IPOs in 2022. They are often referred to as blank check companies because they are formed without a specific acquisition target in mind. Investors do not know which company the SPAC intends to acquire so they must feel comfortable being in the dark. It’s like giving money to someone who will go shopping for you, and you hope you’ll like what they buy.

Other than raising funds by selling shares, the SPAC has no day-to-day operations, no inventory, no machines, and no revenue. The management of the SPAC usually has expertise in a particular industry and is searching for a company to acquire in that area. The money raised from selling shares is held in a trust account. If the SPAC hasn’t acquired a company in 24 months after forming, the money will be returned to SPAC shareholders plus interest. Typically, it takes six-to-twelve months to complete the transaction.

Going Public

When a SPAC and a private company agree to a merger, the private company receives the funds. The SPAC then goes through a short regulatory and legal process to go public. This is one of the advantages of using a SPAC to go public. Traditional IPOs take more time and cost more money to go through the IPO process with the Securities and Exchange Commission (SEC).

Once the process is completed, the original SPAC is then dissolved and delisted from trading and the private company is now a public company. SPAC shareholders can decide if they want to be a part of the deal or drop out and get their money back. This provides a level of flexibility that makes the SPAC appealing.

Some have pointed to greed in these SPAC transactions and worry whether Wall Street is headed for another collapse in money-grabs by SPACs. The SPACs declined in value in 2022 but seem to be making a comeback in 2023. There was a median slide in SPAC value of 41 percent in 2022.

Increasingly, finance professionals warn the SPAC phenomenon will end badly for the investing public. A mix of hedge funders, private-equity dealmakers, bankers, lawyers and assorted promoters see the excesses building. They worry about the inflated valuations, questionable disclosures, and a growing misalignment of interests.

Financial Reporting Issues

There are quite a few financial reporting issues for regulators to be concerned about including:

• Whether financial statements are prepared under Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS).
• Whether disclosures are adequate and protect investor interests.
• Whether internal controls over financial reporting (ICFR) are operating as intended.
• Whether the public company complies with Public Company Accounting Oversight Board (PCAOB) standards.
• Whether corporate governance mechanisms are in place.
• Whether the audit committee is involved in decisions related to the SPAC and resulting public company.

Audit Issues

There are a number of questions for auditors to meet their obligations including:

• Who will audit the resulting public company?
• Does the audit firm have adequate procedures in place to evaluate client acceptance?
• Do the auditors comply with financial reporting and regulatory standards set by the SEC?
• Is the audit engagement team experienced enough to handle the SPAC?
• Does the audit engagement team possess the necessary skills to meet their ethical and professional obligations?
• Is the audit firm independent of the SPAC and resulting public company.
• Are there conflicts of interest for the audit firm.
• Does Marcum have sufficient policies and procedures to provide reasonable assurance the engagement was conducted in accordance with standards.

Marcum LLP

Marcum LLP had a tripling of its public company clients over a small period, the majority of which are SPACs. At its peak, the firm audited more than 400 SPACs in the 2020-2021 period. The SEC charged Marcum with systematic quality control failures and violations of audit standards in connection with hundreds of SPACs in 2020. The firm settled for $13 million in fines, a seemingly small amount given the size of the SPAC market.

According to a lawsuit against Marcum, the SEC said:

“The strain of this growth, however, exposed substantial, widespread, and pre-existing deficiencies in the firm’s underlying quality control policies, procedures, and monitoring. These deficiencies permeated nearly all stages of the audit process and were exacerbated as Marcum took on more SPAC clients. Moreover, in hundreds of SPAC audits, Marcum failed to comply with audit standards related to audit documentation, engagement quality reviews, risk assessments, audit committee communications, engagement partner supervision and review, and due professional care. Depending on the audit standard at issue, violations were found in 25-50 percent of audits reviewed, with even more frequent, nearly wholesale violations found as to certain audit standards across Marcum’s SPAC practice.”

The order against Marcum finds it engaged in improper professional conduct within the meaning of Rule 102(e) of the SEC’s Rules of Practice, violated multiple audit standards across numerous engagements, and violated Rule 2-02(b)(1) of Regulation S-X.

According to investigative journalist, Francine McKenna, writing for “The Dig,”

"In my mind, as someone who's trying to deter this type of conduct, that doesn't work. That's just showing me that, you know, dear Mr. Defense Counsel, that just makes it apparent to me that the penalty is not having the desired deterrent fact, and that we need to up our penalties. So, I think you will see us really ratcheting up penalties where appropriate, so they do have that desired deterrent effect, particularly in these auditor independence cases. Because, you know, there's almost a static penalty amount and it's sometimes viewed as a cost of doing business. And that can't really be the case."

My Concerns

According to data from Audit Analytics, Marcum LLP collected $45.6 million in fees in 2020 and 2021 from SPAC audits. This continued in 2022 and now 2023, with $30.5 million more in fees for SPACs so far. From all clients in 2020 and 2021 combined, Marcum LLP collected $161.3 million in fees, a 193% increase from the 2019 fee total of $55 million.

I worry about the ability of audit professionals to meet their due diligence requirement and experience needs to meet prescribed audit standards. Accounting firms are having trouble hiring newly minted accounting graduates thereby creating a pipeline problem. Moreover, mid-level auditors are leaving firms in increasing numbers and going to work in private industry. This could explain why Marcum is relying more on partner-level oversight, which could be a recipe for disaster.

How can a firm take on hundreds of SPAC clients and still meet their ethical and professional responsibilities? The question with SPACs is are they a sustainable form of investing or is this another financial disaster waiting to happen?

Posted by Dr. Steven Mintz, aka Ethics Sage, on September 5, 2023. You can learn more about Steve’s activities by checking out his website at: https://www.stevenmintzethics.com/ and signing up for his newsletter.