Locke Lord QuickStudy: SPACs and the Implications for D&O ‎Insurance

Special Purpose Acquisition Companies or “SPACs” have emerged as a significant part of the ‎financial and transactional markets. A SPAC is a company with no commercial operations, formed ‎strictly for the purpose of publicly raising capital to acquire an unidentified private company (called ‎the target company), through a process that has similarities to an IPO and results in a publicly-held ‎operating company. The SEC defines a SPAC as a “blank check company” that “is created ‎specifically to pool funds in order to finance a merger or acquisition opportunity within a set ‎timeframe” [Blank Check Company | Investor.gov]. The merger or acquisition opportunity is called a de-SPAC transaction (or in the recent ‎words of SEC Chair Gary Gensler, a “SPAC target IPO”), and it typically must take place within two ‎years after the initial public offering or the SPAC is required to liquidate. The growth in popularity of ‎SPACs suggests that this is an important alternate way to go public. SPACs, though, present unique ‎risks with potential increased exposure to liability at each stage of the SPAC/de-SPAC process. This ‎in turn has implications for directors and officers (“D&O”) insurance, including the prospect of ‎increased demand, tightening markets and rising costs for this insurance. This article examines the ‎effect of the rise in SPAC popularity on the D&O insurance market.‎

The 2020 SPAC boom

The year 2020 was dubbed “the year of the SPAC,” with exponential growth in the number of SPAC ‎IPOs from previous years. From July through December 2020, there was more than one new SPAC ‎IPO per day [2020 Has Been the Year of SPAC IPOs: Here Are the Prominent 4 | Nasdaq]. In total, there were 238 SPAC IPOs that raised a total of $86 billion, accounting for 46% ‎of total IPO proceeds and 55% of all IPOs in 2020.^[1]

SPAC popularity continued into 2021 with 954 SPAC IPOs in the U.S., surpassing the number of ‎SPACs in 2020 [SPAC Analytics]. The growth of SPAC IPOs was somewhat suppressed by new SEC scrutiny and the ‎Acting Director of the Division of Corporation Finance’s April 8, 2021 statement regarding the liability ‎that can attach to the disclosures required for a de-SPAC transaction, but SPAC IPOs have ‎continued and there are numerous SPACs out there in search of de-SPAC transactions.‎

Risks associated with SPACs

As the SEC highlighted in recent enforcement actions, there are several events associated with the ‎formation of a SPAC and with a subsequent de-SPAC transaction that can lead to unwanted ‎litigation and potential liability for SPACs, their sponsors, target companies, and the directors and ‎officers of each. This has been underscored by the number of private securities antifraud and ‎corporate breach of fiduciary duty cases that have been filed against the parties involved in SPAC ‎and de-SPAC transactions. SPAC litigation also could involve aiding and abetting claims against a ‎number of the parties involved in the challenged transaction.‎

The risks of liability associated with SPACs can arise from the adequacy of disclosure in the original ‎SPAC offering, breakdowns in negotiations between the SPAC and its target company, shareholder ‎attempts to prevent or undermine the transaction, failure to comply with the SEC disclosure ‎requirements in seeking approval of the de-SPAC transaction, and subsequent disclosure failures of ‎the newly created public company. SPACs, by their nature, can be replete with conflicts of interest ‎and the SEC requires all conflicts to be adequately disclosed to potential investors and current ‎shareholders [SPAC IPOs plunged 87% during Q2 amid tougher SEC scrutiny | CFO Dive]. In addition, these conflicts of interest and judgments made during the transaction ‎process can lead to breach of fiduciary duty claims.‎

Recent Enforcement Actions and Litigation

There have been a number of enforcement actions and private securities and derivative actions ‎involving SPACS and de-SPAC transactions. The following are some recent examples, with an ‎emphasis on the potential liability associated with de-SPAC transactions.‎

On July 13, 2021, the SEC brought regulatory charges against the SPAC Stable Road Acquisition ‎Company, its sponsor, its CEO, the proposed merger target Momentus, Inc., and the target’s founder ‎and former CEO for misleading claims about Momentus’ water-based propulsion technology and for ‎the failure of the SPAC to conduct adequate diligence [SEC Charges SPAC, Sponsor, Merger, Target and CEOs for Misleading Disclosures Ahead of Proposed Business Combination | SEC.gov]. In its disclosures, Momentus claimed that it ‎had successfully tested its technology in space when, in actuality, the space test failed its primary ‎objectives‎ [SPAC Action Met With Litigation and Regulatory Reaction | Law.com].

On July 29, 2021, the DOJ brought criminal charges against Trevor Milton, the founder and former ‎CEO of Nikola, a SPAC target, for allegedly defrauding investors by making false statements about ‎the early success of Nikola’s semi-truck prototype, primarily through traditional and social media ‎platforms [SPAC Action Met With Litigation and Regulatory Reaction | Law.com]. On December 21, 2021, Nikola settled the fraud charges brought against it by the SEC for ‎‎$125 million [Nikola Corporation to Pay $125 Million to Resolve Fraud Charges | SEC.gov].

In addition to regulatory actions, SPAC-related litigation has increased since 2020. The Stanford ‎Law School Securities Class Action Clearinghouse keeps an updated record of all SPAC-related ‎securities claims.^[2] For example, Hyzon Motors and two of its former officers were the subject of a ‎securities class action lawsuit filed on September 30, 2021, arising out of Hyzon’s July 2021 de-‎SPAC transaction.^[3] The complaint alleges that Hyzon issued materially false and misleading ‎statements in connection with its de-SPAC transaction by misrepresenting its customer contracts, ‎deals and partnerships, and falsely claiming it could deliver certain vehicles to the market in 2021. ‎The Hyzon litigation is just one of forty-two ongoing class actions arising out of SPAC transactions. [Securities Class Action Clearinghouse | Stanford Law School].

Other SPAC-related lawsuits have sought high-stakes, precedential rulings that “could alter the legal ‎landscape in which SPACs operate” [SPAC Action Met With Litigation and Regulatory Reaction | Law.com]. In March 2021, after the publicly traded corporation Multiplan ‎Corp. was attacked by a short seller, shareholders of the SPAC Churchill Capital Corp III that ‎acquired MultiPlan brought a lawsuit in the Delaware Court of Chancery alleging breach of fiduciary ‎duty against the board and sponsor, arguing that the de-SPAC transaction was both rife with ‎conflicts of interest and “grossly mispriced.^[4] Plaintiffs and commentators alike are currently awaiting ‎a highly-anticipated ruling on the defendants’ motion to dismiss, in which they argue that the ‎plaintiffs’ claims are derivative and should be dismissed for failure to properly make a demand, and ‎that the entire fairness standard should not apply [SPAC Action Met With Litigation and Regulatory Reaction | Law.com]. A ruling in this case could have a substantial ‎effect on de-SPAC transactions and related litigation.‎

Most recently, on December 10, 2021, shareholders of Paysafe Limited, a digital payments company, ‎filed a securities class action lawsuit on behalf of investors who purchased shares of Paysafe or the ‎SPAC Foley Trasimene Acquisition Corp II that merged with Paysafe. They allege that Paysafe and ‎the SPAC failed to make numerous disclosures surrounding their de-SPAC transaction. More ‎specifically, the complaint alleges that, in violation of the antifraud provisions of the federal securities ‎law, there were significant adverse developments in Paysafe’s business that were not disclosed to ‎shareholders and investors as required by the antifraud provisions of the federal securities laws [Post-SPAC-Merger Fintech Company Hit with Securities Suit | The D&O Diary]. This ‎recent lawsuit demonstrates that de-SPAC related litigation is alive and thriving, and can be ‎anticipated to increase in 2022.‎

Implications for D&O insurance

The explosion of SPAC IPOs and de-SPAC transactions and resulting litigation has increased the ‎demand for D&O insurance. The exponential increase in the number of SPACs in 2020 and beyond ‎created a backlog of SPACs ‎waiting in line for insurance from insurers who faced pressure to meet ‎the demand. This left some SPACs exposed to being uninsured or underinsured until a policy was ‎obtained‎ [Top D&O Insurance Considerations for SPACs and SPAC Targets | JD Supra].

Increased litigation involving SPACs has also played a role in the coverage and cost of D&O ‎insurance. ‎Because the litigation risks associated with SPACs have proven to be higher than ‎previously expected, D&O insurers may no longer be willing to insure the same risks at the same ‎price as before. ‎Also, there are not that many insurers currently in the market who are willing to write ‎‎D&O coverage for SPACs. Because of this, the price of D&O ‎insurance has nearly doubled since ‎‎2020. D&O insurers have typically reduced their maximum exposure ‎limits from $10 million to $5 ‎million, while continuing to charge similar premiums. In the first ‎quarter of 2021, SPACs found the ‎premium for a $5 million primary D&O policy to be at ‎least $1 million. This reduced coverage and ‎increased cost, as noted above, leads to the problem of uninsured or underinsured SPACs, which ‎ultimately leaves ‎management of the SPAC and post-transaction entity at risk of being inadequately ‎protected from exposure to liability. ‎

The complexity of SPAC transactions also has created a need to better understand the intricacies of ‎D&O insurance coverage. These include adequate insurance for the SPAC itself, particularly in ‎connection with its capital-raising and acquisition activities, for the target company in de-SPAC ‎transaction, and for the ongoing public entity. Also important is a need for a heightened ‎understanding of tail coverage and limitations on typical exclusions. As a result, advice from ‎competent experts, including experienced counsel and insurance professionals, is more important ‎than ever.‎

For more information on the matters discussed in this Locke Lord QuickStudy, please contact the ‎authors or your regular Locke Lord contact.‎

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^{[1] https://blog.auditanalytics.com/spac-popularity-continues-to-grow; https://caia.org/blog/2021/06/02/will-the-2020-spac-ipos-boom-‎continue. ‎
[2] See https://securities.stanford.edu/current-trends.html. ‎
[3] See https://www.dandodiary.com/2021/10/articles/securities-litigation/fuel-cell-vehicle-company-hit-with-spac-related-securities-suit-‎following-short-seller-report/. ‎
[4] See In re MultiPlan S’holders Litigation Consol., C.A. No. 2021-0300-LWW (Del. Ch. 2021).‎}