(Bloomberg Businessweek) -- A pattern of prescient and potentially very lucrative trading has taken shape on a once-obscure corner of Wall Street—and U.S. investigators are suspicious.
The setting is the world of special-purpose acquisition companies, or SPACs, the shell corporations that have flooded onto markets in recent years to raise money from investors and then hunt for companies to buy. The instrument is a stock warrant, which gives holders the right to buy shares at a specified price in the future. SPACs happen to issue a lot of warrants.
The curious trading pattern starts when someone buys piles of a SPAC's warrants, sending the daily volume of trading 10, 20, or even 60 times above normal levels. Within a few weeks, word emerges that the SPAC has found a business to buy, often sending the warrant prices soaring.
Such spikes in warrant trading appear before about one out of every four SPAC deals, a Bloomberg review of almost 300 mergers announced since late 2018 shows. The potential profits can be dramatic: In more than a dozen cases, warrant buyers would have at least doubled their money if they held on to the instruments for mere days or a few weeks. In one case, the warrants soared 888%.
The U.S. Securities and Exchange Commission is now examining warrant trades that took place before deals to discern whether they were illegally based on inside information, according to people with knowledge of the matter. The SEC may open more inquiries as it sifts through additional reports of well-timed bets flagged by market surveillance systems, such as one run by the Financial Industry Regulatory Authority.
The potential for making big money in warrants burst into public consciousness last year, when a surge in warrant trades preceded the October announcement that former President Donald Trump would merge his media platform with a SPAC called Digital World Acquisition Corp. In December, Digital World disclosed that Finra sought information on trades that occurred before the deal was announced. The SPAC also said the SEC requested descriptions of the company's trading policies and procedures. Authorities haven't accused anyone of wrongdoing.
Bloomberg's analysis shows there have been even larger spikes in warrant trading before numerous other SPAC deals.
Warrant trades before SPAC merger announcements can be benign. Investors may act in response to a SPAC issuing an update on the prospects of finding a target company, a press report that talks have opened, or market moves affecting the price of underlying shares. Yet Bloomberg was unable to find public information that would explain about two-thirds of the bursts of warrant trading, including several of the most profitable. “The increase in volume before an announcement is a telltale sign of someone with information,” says John Griffin, a University of Texas finance professor who has studied options trading ahead of takeovers.
Spokespeople for the SEC and Finra declined to comment. It isn't clear which warrants they are examining. The opening of an inquiry doesn't necessarily mean authorities will bring an enforcement case.
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SPACs, also known as blank-check companies, rapidly evolved from a financial world backwater into a fad, before coming under more scrutiny. Hundreds of the shell companies have raised money in initial public offerings in recent years, setting out to find private companies that they can merge with and bring onto public markets. The newly combined company inherits the SPAC's stock market listing, but generally adopts the name of the acquisition target. For the private company, it's a way to go public quickly; for some SPAC investors, the hope is to get in early on a hot new stock.
Initial investors in a blank-check company usually end up with both common shares worth $10 each and warrants that they can trade or eventually exchange for shares. The contracts typically give holders the right to acquire stock at $11.50 once a merger is completed. That makes the value of the contracts sensitive to an announcement that a deal is pending.
Bloomberg focused on trading in the 30 days prior to a merger announcement, a period in which someone might learn that a deal is in the works. Any day in that window when the volume was at least 10 times higher than the typical amount of trading was tagged as a spike. Bloomberg then calculated how much warrants purchased that day would have gained if the buyer kept them through the merger announcement.
VectoIQ Acquisition Corp.'s purchase of electric vehicle maker Nikola Corp. two years ago shows how quickly investors can profit. More than 1.6 million VectoIQ warrants traded hands over two days in February 2020, reaching a price of 91¢ each at the end of the second session. Almost two weeks later, the SPAC's disclosure of a deal with Nikola sent the price soaring to $2.62. The contracts later climbed significantly higher. A spokesperson for Nikola declined to comment. Nikola separately agreed to pay $125 million last year to settle an SEC lawsuit accusing it of defrauding investors by misleading them about its technology and products. The company didn't admit or deny wrongdoing in that case.
Other spikes may have generated even larger payouts. Take Opes Acquisition Corp. About 2.25 million of the SPAC's warrants traded hands on a Friday in June 2020, more than 60 times the normal amount, closing at around 42¢ each. The following Monday morning, June 8, the company announced that it had signed a letter of intent to combine with BurgerFi International, a fast-casual restaurant chain.
Buyers of the warrants on June 5 would have been sitting on a pile of securities worth about $930,000 at the end of that day. If they held them through June 30, when the merger agreement was announced, the contracts would have gained 888%, or about $8 million in additional value. A spokesperson for BurgerFi declined to comment.
To be sure, the market for some SPAC warrants is thin, leading to situations where relatively small trades could result in a spike in volume. A modest purchase could also snowball if other traders or algorithms take notice and pile on, betting that someone else in the market knows something. In other words, some of the trading during a spike may not be based on any special information.
There's nothing illegal about many kinds of informed trading, even involving mergers. Accidentally overhearing of a pending deal on the subway, then trading on that information, is permissible. That's because to prove insider trading prosecutors generally need to show that someone purposely breached a duty to keep information confidential. If authorities do suspect impropriety, it can be tough to unravel who leaked the information. The list of insiders is often vast, including company executives, bankers, lawyers, and public-relations specialists.
Notably, the cast of Wall Street players involved in SPACs differs somewhat from the crowd dominating more traditional mergers and acquisitions. That's because historically SPACs were the domain of smaller underwriters and specialized law firms. There weren't enough deals for big banks to justify building out franchises. As the market took off, the likes of Citigroup, Goldman Sachs, and Morgan Stanley quickly ramped up.
At smaller underwriters and law firms, compliance practices may not be as robust in preventing the misuse of material nonpublic information, says Michael Ohlrogge, a professor at New York University School of Law, who's written extensively about SPACs. “Not all the law firms that are working on SPACs are top tier—or even close to it,” he says.
The growing market also has attracted more hedge funds, some of which try to arbitrage price differences between the common shares and warrants. Traders might, for example, speculate on whether a SPAC has enough time to complete a deal before reaching its deadline to do so. The question for investigators is whether some knew more than they should.
“When you have a market that has evolved this rapidly,” says Chris Wallace, a portfolio manager at Levin Capital Strategies, who has invested in blank-check companies and their warrants, “odd things may occur.” —With Dan Reichl and Crystal Tse
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