Pershing Square Tontine Holdings' failed attempt to invest in Universal Music Group continues to be a problem for the Pershing Square Holdings hedge fund. A lawsuit filed Tuesday (Aug. 17) alleges that PSTH is not a proper special purpose acquisition company (SPAC), but rather an investment firm, a legal distinction that determines how SPACs can use its funding and compensate its founders.

The complaint, filed in the U.S. District Court for the Southern District of New York, seeks a declaratory judgment that PSTH is an investment company and requests damages reflecting PSTH's "breach of fiduciary obligations" under the Investment Company Act of 1940, a law that primarily regulates mutual funds that’s stiffer than the rules that govern SPACs. Plaintiffs allege that PSTH dedicated most of its time to purchase the common stock of Universal Music Group. The lawsuit cites a PSTH document released on July 8 that describes how the company began its due diligence of UMG in October of 2020 – three months after its IPO – and constantly engaged with the label group until the share purchase agreement was signed on June 20.

The Securities and Exchange Commission defines a SPAC as "a shell company with no operations" that raises funds through a conventional IPO and then places the proceeds in a trust "for a future acquisition of a private operating company." The process is known as a reverse merger, in which the private company merges with a publicly traded SPAC. A SPAC's original investors – often hedge funds – buy warrants that allow them to acquire additional stock at a fixed price (they make a profit if the share price is above a warrants' strike price). In contrast, an investment company such as a mutual fund makes money by charging investors a pre-established fee.

Pershing Square, led by Bill Ackman, called the lawsuit "totally without merit" in a statement on Tuesday. "The complaint bases its allegations, among other things, on the fact that PSTH owns or has owned U.S. Treasurys and money market funds that own U.S. Treasurys, as do all other SPACs while they are in the process of seeking an initial business combination.  PSTH has never held investment securities that would require it to be registered under the Act, and does not intend to do so in the future."

By identifying itself as a SPAC rather than an investment company, PSTH has paid itself in "complex securities of the Company that were never offered for purchase by the Company's public investors," not the "reasonable" and "transparent" fees as required by the ICA and the Investment Advisor Act of 1940, the complaint claims. An investment company would normally collect fees from the funds raised from investors. But according to the complaint, PSCM paid the defendants for their work by selling them two types of securities "either for free or for prices far below the securities' actual value," resulting in an "unreasonable level" of compensation in violation of the ICA and IAA.

The lawsuit was brought by George Assad, a PSTH shareholder. The complaint does not name Ackman, but lists as defendants PSTH's four directors: Lisa Gersh, Michael Ovitz, Jacqueline Reses and Joseph Steinberg.

The lawsuit also claims that investors never warmed to PSTH's plans to invest in UMG after speculation about a high-profile acquisition sent the share price to $34.10 on Feb. 16. PSTH traded at $20.08 on Tuesday morning, just barely above their $20 redemption value. (SPAC investors have the right to redeem their shares before a reverse merger.)

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Of course, the deal that precipitated the lawsuit didn't happen: PSTH, a SPAC that raised $4 billion through an IPO on July 22, 2020, announced on June 4 that it planned to acquire a 10% stake in UMG before Vivendi lists the music company on the Euronext Amsterdam stock exchange on Sept. 21. But PSTH scrapped those plans on July 19, in part because the SEC questioned “whether the structure of our [initial business combination] qualified under the NYSE rules,” Pershing Square explained in a letter to its shareholders. Ackman and PSH -- the hedge fund, not the SPAC — then regrouped and bought a 7.1% stake in UMG on Aug. 10.

Vivendi plans to spin off UMG, which it acquired in 2000, and take advantage of strong investor interest in music companies. It will retain a 10% stake in UMG and distribute 60% of common shares to Vivendi shareholders. A consortium of investors led by Chinese tech company Tencent owns the remaining 20% of UMG.