In the finance world, Special Purpose Acquisition Companies (SPACs) are proliferating like Dutch tulips. This year alone, they’ve exploded in popularity, with multitudes of celebrities, politicians, and influencers sponsoring SPACs of their own. The list includes the likes of Colin Kaepernick, Shaquille O’Neal, Alex Rodriguez and Tony Hawk. Even amidst new concerns from the SEC, which reportedly opened an inquiry into the investment risks of SPACs and issued a bulletin warning prospective investors to exercise caution investing in celebrity-sponsored SPACs, SPACs have raised staggering amounts of capital.
SPACs’ attractiveness to investors stems from a similar surge in capital invested in private equity, which gobbled up over half of all publicly traded companies over the past two decades. As a result, there is pent-up appetite for publicly traded investment in general and, in particular, in the kinds of early stage or smaller cap companies that are often the targets of SPACs. Yet with over 400 SPACs currently in the hunt for acquisitions or investment opportunities, market observers have commented that the target pool may increasingly comprise companies not quite ready for life as a publicly traded entity. When that reality manifests in adverse disclosures or disappointing financial returns, stock prices drop and securities suits are filed. Combine less sophisticated retail investors looking for higher returns and some SPACs pursuing lower quality companies, and it is not surprising that the SEC is scrutinizing the sector. Indeed, the currently overheated SPAC environment could instigate more failed investments and stock price drops, leading to a wave of new securities litigation.
Underwriters of D&O insurance for SPAC sponsors and targets are closely following the SPAC explosion and are now pricing the risks into premiums, compounding the price increases already seen in a tight insurance market. The cost of D&O insurance for SPACs can be eye-popping, even for policies with enormous retentions and modest limits. In the first quarter of 2021, a SPAC could expect the premium for even a $5 million primary D&O policy with a $5 million retention to be $1 million or significantly more. But even as coverage for SPACs becomes increasingly costly, and in some cases unavailable, securing effective D&O coverage remains as critical as ever for SPACs and their sponsors. This can most often be accomplished with support from experienced professionals capable of helping SPACs structure their D&O insurance to their unique coverage needs.
Overview of SPACs
A SPAC, often called a “blank check company,” is a shell company formed with the sole purpose of taking another company public without the target company undergoing a formal IPO process. A SPAC itself does not engage in any commercial operations. Instead, a team of “sponsors” forms the SPAC, the SPAC raises capital through an IPO, the capital is placed in an interest-bearing escrow account, and the sponsors then have two years to find a target company and effectuate a suitable merger or acquisition, subject to shareholder approval. If a SPAC does not find and merge with a target within the specified timeframe, the SPAC is liquidated, its sponsors lose their investment, and each shareholder’s investment is returned with interest. If a merger is closed, the resulting company is referred to as a “de-SPAC.”
SPACs have few assets beyond the capital raised in the SPAC IPO, and at the time of the SPAC IPO, the sponsors are prohibited from having a target in their sights. Investment in a SPAC, therefore, is tantamount to a bet on the investment acumen and negotiating ability of the SPAC’s management team.
Potential SPAC Legal Liabilities
As SPACs multiply, so too does the likelihood that at least some will underperform expectations, resulting in disappointed investors and ensuing securities litigation. Hedge funds are already beginning to place bets against certain SPACs in short-sale transactions as a greater number of SPACs must compete for a finite number of suitable merger targets. And, unsurprisingly, commentators are starting to forecast a surge of SPAC-related litigation on the horizon, cataloging at least eight SPAC-related class action complaints filed during the early part of 2021. Insurers continue to be concerned that such litigation could prove especially costly due to uncertainty in the post-Cyan securities landscape, in which companies could potentially face the prospect of litigating securities claims concurrently in state and federal courts.
In a recent article published by the Harvard Law School Forum on Corporate Governance, Pillsbury attorneys described the many potential exposures SPACs could face as a result of the SPAC explosion , including the following:
- SPAC IPO Registration Statement: SPACs must file SEC registration statements when they initiate an IPO to raise the capital used to fund a de-SPAC transaction. Though usually less complex than traditional IPO registration statements, there remains potential for strict liability under Section 11 of the Securities Act of 1933 for misstatements or omissions in a registration statement. For example, after a de-SPAC falters, liability could arise from an inflated statement of SPAC management team’s credentials.
- De-SPAC Proxy Statement: A de-SPAC transaction requires approval by a majority of the SPAC shareholders, who vote in accordance with SEC proxy rules. Deficient proxy statements can lead to potential liability under the Securities Act. Although it can be relatively painless to cure a proxy statement before consummation of a de-SPAC transaction, litigation challenging a proxy statement after the de-SPAC transaction closes could prove costly and more protracted.
- Post De-SPAC Liability: When a de-SPAC transaction is entered into near the two-year deadline and de-SPAC share prices are disappointing, shareholders may allege that the sponsors settled on a rushed transaction to avoid liquidation of the SPAC and loss of their own investment. Likewise, SPAC directors and officers have recently been sued by de-SPAC shareholders after completion of a de-SPAC transaction for pre-transaction conduct such as alleged misrepresentations as to the target’s business plans and prospects. Finally, some shareholder class actions have arisen immediately after completion of a de-SPAC transaction, underscoring the risks inherent in taking a company public. Other cases may involve allegations concerning conduct both before and after a de-SPAC transaction.
In recent weeks, the SEC has escalated its scrutiny of SPACs, compounding the potential for risk. Last week, the SEC issued a statement expressing marked skepticism that forward-looking de-SPAC projections are protected by the PSLRA safe harbor, and suggesting that de-SPAC transactions are part of the initial SPAC “IPO,” and thus subject to the greater scrutiny surrounding public offerings. On April 12, the SEC then issued new, potentially disruptive accounting guidance, which could prompt SPACs to have to reclassify certain warrants (previously accounted for as equity) as liabilities on their balance sheets. In sum, the potential risks for a SPAC are multitudinous.
SPAC D&O Insurance Coverage
With pressure on pricing, terms and availability, what is a prospective SPAC policyholder to do?
As an initial matter, it is imperative that SPACs structure D&O coverage so that it is seamless for the duration of the SPAC lifecycle. To that end, a two-year policy period (lining up with the timeframe to finalize a de-SPAC transaction) will usually better suit a SPAC than the traditional one-year policy period of most D&O policies.
Second, it is usually advisable for SPACs to negotiate a provision that replaces the “Change-In-Control” provision that appears in most D&O policies with a provision that automatically converts coverage to tail run-off (at a pre-agreed premium) once a de-SPAC transaction closes. The run-off coverage provides coverage for wrongful acts occurring before the de-SPAC transaction and will typically remain in effect for a six-year period. Separate coverage is placed contemporaneously for the de-SPAC that covers any wrongful acts committed after the transaction date.
Relatedly, some lawsuits may involve so-called “straddle claims” that allege wrongful acts that occurred both before and after a de-SPAC transaction. To ensure that coverage is seamless for those claims, complementary “straddle clauses” should be included in both the SPAC run-off terms and the de-SPAC policy. Taken together, those clauses will (1) allocate “that part of loss attributable to wrongful acts” that occurred before the de-SPAC transaction to the SPAC run-off coverage and (2) allocate loss attributable to wrongful acts that occurred after the de-SPAC transaction to the de-SPAC policy.
SPACs should also pay careful attention to the definition of “Loss” in their insurance policies. To the extent possible, it is advisable to eliminate or temper any language suggesting that certain kinds of Loss are “uninsurable” and thus excluded. To that end, the Loss definition should at least include the now-market-standard “pledge” not to assert that claims under Sections 11 and 12 of the ’33 Act are uninsurable. In addition, it is also advisable to clarify the so-called “bump-up exclusion” language that appears in the definition of Loss or elsewhere in the policy. Insurers often cite such language in seeking to exclude any Loss relating to allegations that the price paid in acquiring an entity was inadequate.
Finally, given the relative scarcity of D&O coverage for SPACs, serious consideration should be given to purchasing Side A Difference in Conditions (DIC) D&O coverage in addition to or in lieu of entity coverage. DIC coverage provides company directors and officers additional excess coverage above the company’s existing D&O tower, and it also provides “drop-down” (first dollar) coverage for certain claims otherwise excluded by the primary D&O coverage. Given the limited availability of coverage for SPACs, DIC coverage at least provides additional peace of mind to SPAC directors and officers.
As SPACs have proliferated, it has become challenging for SPACs to purchase cost-effective D&O coverage. To help navigate the difficult placement process, SPACs should work closely with experienced professionals to ensure that they have purchased the most effective coverage available.