The recent surge in SPACs
SPACs have exploded in popularity because forming a new, publicly traded company with a SPAC can be accomplished more quickly than through a traditional IPO. In 2019, $13.9 billion was raised across 59 SPACs. In 2020, the figures grew exponentially to over $83 billion raised across 248 SPACs. As of August 27, 2021, SPAC sponsors have raised over $122 billion across 416 SPACs.
With more SPACs comes more litigation
SPACs were a more popular target for federal class action lawsuits in the first half of 2021 than “other hot-button litigation areas, such as Covid-19 or cryptocurrencies.” (SPACs Are Having Their Day–In Court, Wall Street Journal, August 25, 2021). Prior to the surge in SPACs in 2019, there were only two class action lawsuits concerning SPACs in federal court. Eight months into 2021, 19 SPAC-related class action lawsuits have been filed.
SPACs are also exposed to heightened regulatory scrutiny
Sixty law firms, including Reed Smith, “have united in opposition to recent lawsuits” filed by shareholders that argue SPACs should be regulated as investment companies under the Investment Company Act of 1940. Should these plaintiffs prevail, SPACs would be subject to a new regulatory regime, including certain disclosure requirements that generally do not apply to typical IPOs or mergers (49 Law Firms Push Back Against Litigation Targeting SPACs, Law360, August 27, 2021).
The Securities and Exchange Commission (SEC) has also tightened regulatory and enforcement efforts regarding SPACs. On April 12, 2021, the SEC issued guidance advising that SPAC warrants (instruments that allow investors to buy additional shares at a fixed price) may need to be classified as liabilities rather than equity for many SPAC transactions.
In Lavin v. Virgin Galactic Holdings Inc. ‒ a putative class action complaint filed in federal court in Brooklyn ‒ the plaintiff alleges that the defendants violated the Securities Exchange Act by failing to treat its SPAC warrants as liabilities rather than equity, in accordance with the SEC’s April 12 guidance.
One can expect to see growth in this area as the SEC strengthens its oversight against the heated SPAC market.
So, how can SPAC exposure be mitigated?
When it comes to forming a SPAC, you should be mindful of:
- The sponsors’ ability to raise capital in the SPAC’s IPO through an underwritten offering
- Finding a suitable target company that is “public company ready” in short order following the IPO
- Orchestrating the financing around the de-SPAC transaction.
As for insurance implications:
- There are separate directors and officers (D&O) insurance programs involved in SPAC and de-SPAC transactions.
- The SPAC
- A SPAC D&O policy should be put in place once the SPAC is formed.
- When the de-SPAC transaction closes, this policy will go into run-off, usually for six years.
- The target company
- The existing operating business will likely have its own private company D&O insurance, which should cover the private company and its directors and officers in connection with the merger negotiations and the transaction.
- The private company typically will have a smaller risk profile, and thus will also have lower private company D&O limits.
- The newly formed public company
- At the closing of the de-SPAC transaction, a go-forward D&O insurance program will need to be in place for the go-forward exposures of the newly formed public company in addition to the run-off of the SPAC D&O policy.
Effective risk management in the insurance context can entail:
- A two-year policy term for the SPAC D&O policy
- The sponsors have up to two years to combine with a target company.
- A six-year policy term for the run-off (tail policy) of the SPAC D&O policy
- Six-year policy term commensurate with the statute of limitations.
- Broad definitions and narrow exclusions:
- Broad definition of claim, interview, and investigation demands
- Broad definition of Loss
- Broad definition of Wrongful Act, including dual capacity claims
- Narrow fraud exclusion subject to “final adjudication”
Possible options policyholders have tried to reduce premiums include:
- Opting for “Side A-only” coverage for non-indemnifiable claims against directors and officers, instead of “full-side” or “ABC” coverage
- Reducing limits for the SPAC, then increasing the limits for the newly formed public company
- Shorter policy periods
There is no “magic” formula. You should compare alternatives, negotiate terms and conditions, and work with trusted advisors.
Client Alert 2021-242
