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A street sign is seen in front of the New York Stock Exchange on Wall Street in New York, February 10, 2009. REUTERS/Eric Thayer/File Photo
October 21, 2021 - Hindsight is 20/20, and directors and officers of publicly traded companies are beginning to reflect as end-of-year reports near. The craze surrounding special purpose acquisition companies, or SPACs, crested over the past year, but with such popularity has come increased regulatory focus and greater considerations for director and officer (D&O) insurance coverage.
The sole operational goal of these "blank check" shell companies is to acquire a private company using money raised by sponsors through an IPO, thereby enabling the latter to quickly go public. Under the terms of a SPAC's organizational documents, if the SPAC is unable to complete a merger with a target business through the De-SPAC process, typically within 24 months from closing the IPO, it must return all money in the trust account to the SPAC's public stockholders. Although many agreed-upon mergers are still being completed, approximately 445 SPACs must soon obtain merger partners or risk being liquidated.
There are three separate D&O insurance programs involved in these SPAC and De-SPAC transactions. First, once formed, the SPAC should obtain a two-year D&O policy, typically with a six-year run-off, or "tail," policy for after the De-SPAC transaction closes. Second, the private target company will likely already have its own D&O insurance, which should cover the private company and its directors and officers in connection with merger negotiations and the transaction. Finally, the going-forward company will need a D&O insurance program put in place at the closing of the De-SPAC transaction to mitigate exposures from the newly formed public company.
Amid the global stock market volatility, 248 SPAC IPO pricings raised $83.3 billion in 2020 and were quickly surpassed by the 434 SPAC IPO pricings that raise $235.6 billion in 2021. While these numbers once reflected share-price increases and new entrants, increased regulatory and shareholder focus has decreased enthusiasm, and increased the litigation and investigation risk that liability insurance addresses. Shareholder advocates and legal and banking practitioners are calling the end of 2021 an inevitable return to earth for SPACs.
Given where SPAC shares are now trading, however, buying them in the current market could be considered more of a conservative investment than it had been in the past. Now more than ever, it is critical for SPAC management to get a firm grasp on the nuances of D&O coverage because it is an almost riskless bet that SPAC fervor will return.
The SPAC management team, or sponsors, typically own 20 percent of the SPAC's outstanding common stock upon completion of the IPO, comprised of the founder shares they acquired for nominal consideration when they formed the SPAC. Despite these generous returns, SPAC sponsors should be aware of the liability risk in connection with their role so that they can assess whether their insurance adequately addresses their needs.
Once a sponsor finds a target, the SPAC typically prepares and circulates to its shareholders a proxy statement containing information concerning the transaction and the target company, including audited historical financial statements and pro forma financial information. This document is also filed with the U.S. Securities and Exchange Commission (SEC) and is subject to SEC review.
There is an increasing amount of securities litigation by shareholders against SPAC sponsors for alleged material misstatements or omissions in the De-SPAC documents about the level of diligence undertaken. After the De-SPAC process ends, directors and officers may be faced with allegations involving breaches of fiduciary duties and securities claims. While these types of claims are familiar to public companies, for SPACs, plaintiffs are focusing on the fact that a company went public through a privately negotiated SPAC to support allegations of supposed conflicts of interest, misaligned incentives or ineffective due diligence.
Directors and officers of the SPAC should perform a careful review of the target company's D&O policy terms and conditions. Special attention should be given to exclusions, including professional services exclusions, contractual exclusions, and bodily injury/property damage exclusions. Where exclusions are overly broad, SPACs should attempt to limit them as much as possible, through narrowing the preamble language, the exclusions to save coverage for defense costs, the non-indemnified ("Side A") claims, or claims brought by security holders.
When providing policy terms for the going-forward company, insurers may agree to provide full prior acts coverage or apply a strict prior acts exclusion, which in part will dictate the options when structuring the previously mentioned run-off coverage. From a market and pricing standpoint, this D&O policy placement is very similar to any other IPO. Best practices dictate that directors and officers begin this placement process well in advance.
SPACs can expect increased focus by regulatory and private litigants on the incentives and motivations of SPAC management. Because many of these litigation risks may not become evident until after the De-SPAC process, the SPAC will need to coordinate run-off coverage for both the SPAC and the target company in order to secure "going forward" coverage for any alleged prior wrongful act.
With the unprecedented surge in SPACs has come unprecedented scrutiny. SEC staff and members of Congress are carefully looking at filings and disclosures by SPACs and their private targets. An assessment of insurance coverage for potential regulatory risk is a growing consideration for investors.
The Investor Advisory Committee seeks to address "[q]uestions about whether the targets are of sufficient size for the economics of the sponsor to be reasonable" and the "[p]otential lack of sufficient SPAC targets, which may incentivize sponsors to take substandard targets to market that are generally unprepared to satisfy legal, regulatory, and overall market expectations."
With April 2022 as the target date for the issuance of a proposal, the SEC recommends intensifying its regulations of SPACs through stricter enforcement of existing disclosure rules and analysis of the players in the various SPAC stages by the SEC. The closer the SPAC bubble gets to bursting, the closer SPACs may get to mirroring traditional IPO regulations.
Just last month several Democratic U.S. senators raised concerns about SPAC sponsors' incentives to quickly strike merger deals. In a letter sent to six serial SPAC creators, the senators sought information about SPAC use no later than Oct. 8, 2021, "in order to understand what sort of Congressional or regulatory action may be necessary to better protect investors and market integrity." The senators have yet to receive a response.
The scope of regulatory coverage can differ greatly between D&O policy forms. Given the increased regulatory scrutiny and exposure to regulatory investigations and proceedings, SPACs should carefully assess the degree to which the D&O policy is extending coverage, favor policy forms that extend a greater degree of coverage, and attempt to negotiate broader coverage where warranted.
Potential policyholders must understand how the D&O insurance market is responding to SPACs and fast-paced SEC regulations at each stage of the process — during initial formation, the De-SPAC process, and the post-SPAC period for the going-forward company.
Unique considerations for SPAC policyholders may be: determining if claims against sponsors are insured; when a run-off policy becomes implicated; how to allocate between policies when D&O coverage is shared; whether a prior acts exclusion applies to the wrongful conduct of the target company's directors and officers pre-merger; and the interplay between the private company's tail policy and the go-forward public company's coverage where a claim alleges pre- and post-coverage acts.
SPAC D&O coverage is not one-size-fits-all. Coverage requires looking at where the liabilities are flowing, where indemnity is being granted, and the types of securities afforded coverage. SPAC management should work closely with brokers and insurance partners by looking at corporate bylaws and exculpatory clauses to ensure coverage terms and periods are coordinated to avoid gaps that could threaten SPAC stability. As time-consuming as it may be, a case-by-case analysis of each SPAC is essential.
If SPAC litigation trends persist, SPAC management must be prepared to invest in coverage. With clearer hindsight about SPAC inundation and personal risks to sponsors and targets, SPAC management is better equipped to plan for appropriate D&O insurance policies.
Opinions expressed are those of the author. They do not reflect the views of Reuters News, which, under the Trust Principles, is committed to integrity, independence, and freedom from bias. Westlaw Today is owned by Thomson Reuters and operates independently of Reuters News.
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