Authors: Dr. Phil Norton Miranda DesPain John C. Marchisi Jennifer Sharkey David Ritchie
DeSPAC transactions or "reverse initial public offerings (IPOs)"— in which a special purpose acquisition company (SPAC) takes a private company public through a reverse merger — have become increasingly popular as a pathway to the public markets during the past 12 to 24 months. As these transactions have grown in number, increased regulatory, insurer and shareholder focus have followed.
Unlike an operating company that goes public through a traditional IPO, a SPAC is a shell company when it becomes public. It lacks an underlying operating business and assets other than cash and limited investments.1
The mission of the SPAC is to find a target private company and complete the DeSPAC process within two years or less. Unlike in a traditional IPO, the DeSPAC IPO process does not require the formal due diligence that a traditional IPO demands. Theoretically, this lack of diligence can lead to critical risks such as potential restatements, incorrectly valued businesses or lawsuits.2
With the surge of DeSPAC activity and two-year deal timeline, the demand for private companies to acquire is extremely high. Approximately 718 SPACs are either actively looking for a private company to merge with or waiting to close on an announced agreement and thus complete their mission.3
The urgency to get these deals done, along with intense competition and the COVID-19 environment, may lead to shortcomings in the performance of due diligence. Sensibly, underwriters are concerned about the potential for paying Directors and Officers (D&O) claims from either insufficient due diligence or simply a lack of attractive candidates left in the DeSPAC candidate pool for SPACs with, by nature, very specific goals. Thus, how the broker advises the leadership for the SPAC and private company merger with respect to presenting the risk to the underwriters has become increasingly critical.
DeSPAC trends we saw in 2021
The main trends we saw in 2021 were related to increased scrutiny from regulators and increasing class actions suits. Here we will break down the three major trends we saw.
Constrained capacity, high premiums, increasing scrutiny from regulators
Insurers were cautious with the deployment of limits through most of 2020 and throughout 2021. Retentions/deductibles rose as early as late 2020 and have been stable through 2021, leveling out but remaining substantial. Self-insured retentions typically were in the range of $5 million to $10 million, and at times were higher than retention levels for traditional IPOs of the same size.
D&O premiums for DeSPAC transactions remained significant throughout 2021 as underwriters perceived the risk to be elevated due to uncertainty. This perceived risk was further reflected in the quality of the available terms and conditions being more beneficial to underwriters compared to typical D&O renewals. Underwriters also supported their need for higher premiums by noting a lack of historical data to frame their risk analysis and expectations of higher volatility across this business segment.
In 2022, we are seeing insurers offering DeSPACs lower retentions moving from $10 million to $7.5 million or $5 million, especially if they can maintain their capacity to lower limits. In addition, we are also experiencing a few insurers that are offering two-year limit deals, which can be attractive to some of the higher valuated transactions.
Many companies managed the rate environment through the use of alternative program structures and products, such as Side-A no indemnifiable loss policies. These "non-indemnifiable" loss policies are dedicated to coverage for the individual directors and officers, and are applicable in the event the company goes insolvent or otherwise cannot provide indemnification to the individual directors and officers.
Growing DeSPAC scrutiny from regulators
The U.S. Securities and Exchange Commission's (SEC) involvement ratcheted up attention to these deals in 2021, issuing new guidance regarding the treatment of warrants and their accounting for the first time in 20 years. In addition, there was heightened shareholder scrutiny regarding their structure, management, compensation and other issues. The new SEC guidance has added uncertainty around how claims are expected to develop. Potential liability drivers include public company readiness, the company's ability to meet compliance and reporting obligations, and the realism of its revenue projections.
Increased securities class actions for DeSPACs
According to the "Securities Class Action Filings 2021 Midyear Assessment" from Cornerstone Research, there were twice the number of federal SPAC class action filings in the first half of 2021 as there were in all of 2020, a number of which focused on the DeSPAC transaction.4 Such trends have continued as the large volume of new SPACs and DeSPACs does translate into many new D&O claims for us to consider.
Specifically, as to securities class actions related to DeSPACs, we reviewed 42 such claims made from September 2019 to February 2022; in 30 of the cases the litigation is ongoing and it is too early to learn much. In the remaining 12 cases, the results are mixed: five cases have motions to dismiss (MTD) pending, three have MTD denied and one MTD was granted, while two cases were voluntarily dismissed and one was settled.
Our reading of a sample of these early cases suggest that some cases do indeed have dubious merit and many may have been avoided with a stronger advisor at the beginning of the process. For those cases of little merit, carriers look to the retention levels to contain the defense costs, and we project that most carriers will be protected from the increased DeSPAC claim frequency by such retentions.
With an eye on these recent class actions, underwriters are focused on three key areas related to DeSPACs:
- Board composition and senior management: Has the leadership team run a publicly traded company?
- Forecasting: Is it realistic? As a merger and acquisition, DeSPACs can forecast rather liberally without major repercussions, unlike the closely vetted forecasts of traditional IPOs. Once the company is trading, those forecasts could become the subject of a 1934 SEC Act violation.
- Business model: Is it sustainable? How much of it is a pre-revenue company going to market with an unproven and high-risk endeavor as opposed to a more mature company with realized revenue and future profitability?
Current state of the DeSPAC insurance market
Capacity has improved as more insurers are willing to write the primary layer of D&O insurance for DeSPACs and thus the new entities going forward — boosted by attractive pricing, higher retentions and limited settlements that have kept carrier costs at a manageable level. The new capacity includes some new D&O market entrants, in addition to established carriers.
Carriers are also likely to be more liberal in their deployment of limits in 2022. For some markets, with a certain amount of limit to utilize for the rest of the year on an allocation basis, insurers may be more aggressive for deals occurring earlier in the year and slow down later in the year, once they have written a critical mass of DeSPAC risks.
While the deployment of limits may continue to be cautious, 2022 should see some mild improvements with slightly smaller retentions and premiums — of course, dependent as always on unique risk factors and how the client company is presented to the marketplace.
What we are watching in the DeSPAC marketplace
With an increasing amount of claims relating to the DeSPAC, the resolution of these claims will provide key information about what to expect in the DeSPAC marketplace going forward. There is also the potential for a lot of litigation related to "straddle claims" — claims that may name the SPAC, pre-merger private company and postmerger new public company involved in the DeSPAC.
The delineation between the capacities of individual directors and officers involved on both sides of a transaction will continue to be important. For example, some directors and officers involved in the SPAC may remain involved with the DeSPAC entity post business combination, while some directors and officers of the target private company may remain involved.
Given these variables, it is important to clearly outline which policy covers which individuals and in what capacity, as well as to ensure that there are no gaps in coverage. It's vital that all parties involved have access to insurance to defend a complaint and possibly fund damages if needed.
As noted previously, the litigation of DeSPAC related claims is still very new, and many claims have not yet reached the motion-to-dismiss stage. Carriers will be watching very closely as to how these hold up in court.
Looking ahead at the near-term DeSPAC market
We expect to see continually improving capacity for the near team, as the SPAC-DeSPAC combinations obtain better advice and have a better historical outlook to rely on. We expect that market conditions will continue to improve incrementally, albeit not drastically, and clients will have more insurance options to consider in 2022.
Insurers are closely observing trends and loss drivers in the space, attempting to identify higher-risk transactions and structure D&O for these transactions to avoid exposure to future significant claims. As claims are resolved, insurers will react accordingly in their pricing. For example, if resolutions are favorable to carriers, pricing for DeSPAC IPOs will likely continue to improve, coming down from peak levels recently experienced.
Outside of the U.S., the difficulty placing reverse-flow deals for DeSPACs is more challenging due to the international scope and limited markets for that specific type of DeSPAC. That said, we expect to see it get slightly easier in 2022, with general market conditions becoming more competitive than they were in 2021, and insurers continuing to write new deals, perhaps with greater new business budgets than in the prior year.
DeSPACs remain among the most nuanced D&O placements, but capacity is improving as is broking knowledge, allowing for better preparations and ultimately more underwriting appetite. Getting ready for successful underwriting requires a lot of preparation and attention to detail. Be ready to articulate the profitability of the business model, show clear growth plans and showcase board and management experience in the public markets. In addition, brokers must keep management informed on likely costs and benefits of various D&O program structures, selection of lead insurance companies and premium and coverage considerations.
Because of the highly technical nature of this market, it is imperative to work with an insurance broker who specializes in your particular industry or line of coverage. Gallagher has a vast network of specialists that understand your industry and business, along with the best solutions in the marketplace for your specific challenges, such as IPOs, SPACs and certainly DeSPAC transactions. More than ever, DeSPACs require a proactive, informed approach to the underwriting process.
Please note: A client's risk profile is the primary variable dictating renewal outcomes. Loss experience, industry, location and individual account differences will also have a significant impact on these renewals.