Warrant officers

Amadeo Giannini founded the Bank of Italy in October 1904 to serve what he called “the little fellows”, immigrants whom other bankers thought not worth the paperwork.^{3Santa Clara University Digital HumanitiesAmadeo Peter Giannini} He took their deposits and lent on a handshake. He also, being a banker, kept books. The handshake worked because the ledger underneath it was true.

The special purpose acquisition company, or SPAC, has lately been a handshake with rather less ledger. A SPAC raises money from the public, parks it in a trust and has a limited time to buy a private firm, which thereby becomes public without the bother of a conventional listing. As John Coates, the acting director of the Securities and Exchange Commission’s (SEC) corporate-finance division, put it on 8 April, “a SPAC is a shell company with no operations.”^{2U.S. Securities and Exchange CommissionSPACs, IPOs and Liability Risk under the Securities Laws8 Apr 2021} Ordinary investors have been invited in alongside it, and they have not always been shown what the sponsors keep.

On 12 April Mr Coates and Paul Munter, the SEC’s acting chief accountant, issued a staff statement that is easy to mistake for housekeeping.^{1U.S. Securities and Exchange CommissionStaff Statement on Accounting and Reporting Considerations for Warrants Issued by Special Purpose Acquisition Companies (SPACs)12 Apr 2021} Its subject is the warrants issued in a SPAC’s formation and initial offering: the right to buy shares later at a fixed price. Many SPACs have booked these as equity, which is tidy, because equity sits on the balance sheet and never troubles the income statement. The staff now says that, depending on their terms, such warrants may have to be treated as liabilities, measured at fair value, with changes in that value reported in earnings each period.^{1U.S. Securities and Exchange CommissionStaff Statement on Accounting and Reporting Considerations for Warrants Issued by Special Purpose Acquisition Companies (SPACs)12 Apr 2021}

The reasoning is dull and sound. Equity treatment is available only when a contract is, in effect, a plain bet on the company’s own shares. In one of the staff’s examples the characteristics of the holder affected the settlement amount, yet the holder, the statement notes, “is not an input into the pricing of a fixed-for-fixed option on equity shares”, so the warrants were “classified as a liability measured at fair value.”^{1U.S. Securities and Exchange CommissionStaff Statement on Accounting and Reporting Considerations for Warrants Issued by Special Purpose Acquisition Companies (SPACs)12 Apr 2021} In another, a tender-offer clause let all warrant holders be paid in cash while only some common shareholders would be. The staff concluded that this too required liability classification.^{1U.S. Securities and Exchange CommissionStaff Statement on Accounting and Reporting Considerations for Warrants Issued by Special Purpose Acquisition Companies (SPACs)12 Apr 2021}

Why should anyone outside an accounting department care? Because a liability measured at fair value moves with the market. Rising warrant values mean losses on the income statement, and falling ones mean gains, whatever the business is doing. For firms promising investors a clean path to the public markets, that is a good deal more noise than they advertised. The statement also points to the rules on restating earlier financial statements and to the internal-controls requirements of the Sarbanes-Oxley Act, which suggests the staff expects some sponsors to be revisiting their homework.^{1U.S. Securities and Exchange CommissionStaff Statement on Accounting and Reporting Considerations for Warrants Issued by Special Purpose Acquisition Companies (SPACs)12 Apr 2021}

We think this is the right call and the right size of intervention. It bans no SPAC. It tells nobody what to price or whom to invite. It says that if an instrument behaves like a liability, it should be called one, and it leaves each warrant to be judged on its terms. That is how a market regulator ought to behave: insist on the ledger, and let investors do the sums. A boom that cools because its books were read, rather than because its promoters were banned, is a healthy one.

The strongest objection is that this is regulation by footnote. The statement is staff opinion with no legal force, sponsors followed the rules as they understood them, and a changed reading of accounting rules punishes people who played fair. There is something in that. Auditors and lawyers will bill hours for work thought finished, and nobody enjoys a surprise from a regulator in the middle of a deal.

But the objection proves less than it seems. Accounting is not a rule one can hide behind; it is a description of what a contract is. If a warrant can oblige a SPAC to pay cash in circumstances that common shareholders do not share, that was true on the day it was issued. The statement did not create the liability. It merely mentioned it. Mr Coates’s earlier warning applies here too: “any simple claim about reduced liability exposure for SPAC participants is overstated at best.”^{2U.S. Securities and Exchange CommissionSPACs, IPOs and Liability Risk under the Securities Laws8 Apr 2021} Participants who priced the vehicle on the assumption of lighter scrutiny are free to reprice it.

Nor is this a case against SPACs as such. A shell company can be a perfectly respectable way to take a young firm public, and nothing here prevents one. The point is narrower. A route to the public markets that leans on a favourable accounting treatment will be only as popular as that treatment.

Giannini’s customers did not need to read his accounts, because he did. The new SPAC investors will have to read theirs.