As their profile rises, so does regulators’ scrutiny of their investment activities. How might that change the D&O claims and coverage landscape?
September 20, 2021
By Erin McGinn
Directors & Officers Liability Claims Specialist, AXA XL
Special Purpose Acquisition Companies (SPACs) are not newcomers in the investment arena. They have been active since the 1990s, but their activities have gained a higher profile in this era of enthusiastic startups that become overnight financial sensations. As investors clamor to grab the reins of the next “unicorn” (a privately held company with a valuation of $1 billion or more), SPACs have attracted increased interest — from investors and investment regulators.
SPACs are investment entities formed to provide the market with an alternative mechanism for privately held companies to become publicly traded. The SPAC owners, known as sponsors, raise capital in an Initial Public Offering (IPO) of the SPAC for the sole purpose of using such funds to acquire a privately held company at a later date in a targeted industry. In fact, these prospective shareholders don’t even know how their money will be invested — SPACs are not permitted to have any potential targets in mind. This is why SPACs are known as “blank check companies,” because their purpose is not to have those details, but rather to identify candidates for acquisition that have the potential for future growth after the SPAC has its IPO and money is available for use.
Typically, once the SPAC has identified a target and attracted enough investment to finance the deal, the acquired company is absorbed into the SPAC, with the privately held entity as a surviving, public company. This process is known as a “DeSPAC Transaction” and the resulting public entity is known as the “DeSPAC Entity.” The advantage to the private company is that it is able to become a publicly traded entity while facing less administrative and reporting hurdles than those imposed in a traditional IPO scenario.
Increased velocity — and volatility
The streamlined process eliminates many of the steps that companies must take to go public if they follow the traditional course. Those steps include filings of a high volume of financial statements and issuance of disclosures (to the SEC and to prospective shareholders) of risks and liabilities. Conversely, since the private company is simply being purchased by the SPAC and not having its own IPO, the SPAC follows guidelines imposed in connection with mergers, which brings with it a reduced volume of required disclosures. The process is comparatively fast, simple, and painless. That, in turn, makes SPACs attractive to investors whose tolerance for risk exceeds their patience with the customary pace of bringing a company public.
However, one risk inherent to the process is that the investors in the SPAC — the potential future shareholders in the newly public company — will have a different relationship with the target company than the SPAC sponsors have. For shareholders of the DeSPAC Entity, the return on investment depends on the DeSPAC Entity’s long-term performance. For sponsors, the reward is successful conclusion of the DeSPAC Transaction, upon which they typically are given roles on the board of directors of the DeSPAC Entity and a 20% ownership interest in it. This has the potential to create a serious conflict of interest risk between sponsors and shareholders and to generate claims, many of which in recent times have emerged from shareholder contentions that the SPAC sponsors were unconcerned with the target company’s ability to hit its financial targets post-DeSPAC Transaction.
...One risk inherent to the process is that the investors in the SPAC — the potential future shareholders in the newly public company — will have a different relationship with the target company than the SPAC sponsors have.
A raised profile — and rising SEC scrutiny
To some extent, the risk of those claims is baked into the DeSPAC process because the sponsors are generally not bound to adherence to standard SEC regulations regarding forward-looking statements. As SPACs gain prominence, there is growing awareness of, and concern about, that disclosure gap and, by extension, the possibility that coverage for the SPAC and subsequent DeSPAC Entity may need to evolve with changing regulatory stances on that point.
The initial repercussions have already begun. Earlier in 2021, the SEC issued a warning to SPACs that any perceived lack of scrutiny on disclosures made in connection with the DeSPAC Transaction was misplaced. Further, the SEC also released a statement regarding accounting and reporting requirements for warrants issued by the SPAC during the DeSPAC Transaction requiring them to be treated as a liability rather than an equity. That act alone was sufficient to cause a significant stall in SPAC transactions during spring 2021 — and put the sector on notice that it might be required to overhaul its practices.
Monitoring current and future baskets of liability
For now, there are three primary points during the DeSPAC process creating exposure to D&O claims – the initial cash raise by the SPAC, the merger/DeSPAC Transaction and the operation of the newly created public company.
It appears the biggest potential risk arises once the DeSPAC Transaction is complete and the private company is officially a publicly traded company. That’s when shareholders get their first unvarnished look at whether the company has the capacity to live up to the future projections on which the investment was sold. There have already been cases in which the company is unable to live up to those expectations and possibly never had the ability to do so. Claims filed on that basis can be expensive because they not only could involve initial and secondary investors in a securities class action lawsuit but also could invite government scrutiny. While actions have not escalated to this point yet, the repercussions could extend to bankruptcy filing of the DeSPAC Entity.
The announcement by the SPAC that it has found a target company to purchase involves a common and frequently seen claims scenario. Once the SPAC identifies an acquisition target and announces it to the public, the shareholders must vote on in favor of (or against) the transaction. This opens the door to claims from both sides: those who support the deal’s approval and those who oppose it. They may contend that the SPAC paid too much — or too little — for the company, that the disclosures were inadequate, or that the sponsors were embroiled in conflicts of interest. Individually, these claims have not caused significant expenses or settlements to date. But they constitute the highest volume of claims, and just on that basis they have the potential to do cumulative damage to the insurance industry if not carefully managed.
Learning to navigate a changing landscape
From an insurance perspective, the key point to remember is that once the SPAC absorbs the acquired company, it becomes a new entity that requires its own coverage. Policies therefore must contemplate that transaction and the point at which the coverage will need to be revised to reflect the circumstances and needs of the new DeSPAC Entity and the SPAC. But there are even greater challenges in unknowns such as how courts will rule in various jurisdictions at crucial points in the litigation or how the SEC may alter its stance on regulating SPACs. This is therefore a space that requires vigilant ongoing monitoring to ensure that policies keep pace with shifts in the legal and regulatory landscape.
For now, constant communication with underwriters, brokers and our current and future insureds will be the best strategy to ensure each insured, at each point during the DeSPAC process is purchasing the coverage it needs to protect against claims by shareholders or governmental entities.
