Author: John C. Marchisi
Introduction
As Special Purpose Acquisition Company (SPAC) issuance and activity was on its way to realizing record-setting levels, several issues arose over the course of 2021 which presented challenges not only to the Directors and Officers (D&O) liability insurance marketplace, but to the entirety of the SPAC industry.
Throughout the history of the SPAC, both the acceptance of the vehicle as a viable solution and the degree to which it has been able to realize success has been largely, if not strictly, predicated upon the level of certainty that it can provide to each of the interested parties to the transaction, be it sponsors and stakeholders, capital providers, potential targets, and regulators. The ability to provide high levels of certainty is fundamental, evidenced as the motivation and goal behind every structural iteration, amendment, rule change, feature, and execution strategy employed throughout the 20+ year evolution of the vehicle. This will continue to drive further innovation and ultimately dictate future success.
The condition of the D&O insurance marketplace as it relates to SPAC transactions is commonly summarized as a supply and demand issue yet fails to identify the reasoning and influences responsible for the misalignment.
For a more in-depth discussion on SPACs, you can listen to our on-demand webinar, The Life Cycle of a Special Purpose Acquisition Company, here.
Market review
In 2018, Gallagher released "The Life Cycle of a SPAC — A Strategic Risk Management Perspective"1 as an advisory tool designed with D&O liability insurers in mind. The paper opened by voicing concerns over how SPACs were perceived amongst D&O insurers at that time, recognizing the issue as the key risk facing SPAC operators as sustainable access to insurance would be threatened if the growth we projected for the SPAC was realized.2
The efforts to modernize underwriting assumptions were successful and resulted in bringing much needed capacity to the D&O market. However, the record-setting SPAC issuance of 2020 accelerated demand for D&O insurance to levels that threatened to outstrip the available supply once again. As mentioned previously, the historical ebb and flow of uncertainty is directly correlated to each of the components required to realize a successful outcome. Beginning with signals pointing toward a potential shift in regulatory scrutiny, policymaking and/or litigation uncertainty surrounding SPAC transactions (coupled with deal fatigue and capital allocation concerns) began to influence the market again.
These aforementioned influences combined to result in a rapid upward shift in D&O liability insurance rates, which reached a top at the end of 2020. Although SPACs had historically performed and been underwritten for claim severity over frequency, the rising uncertainty signaled a potential shift in claim frequency, which insurers responded to through a material increase in policy retentions. Moving forward, as SPAC operators continue to face material increases in their total cost of risk, forming a partnership with a deeply experienced and capable broker is critical in order to manage the current insurance market conditions and the factors that influence the ability to achieve favorable results.
We are currently following several issues with the potential to impact the terms and availability of SPAC D&O liability coverage as they continue to develop, including:
- The potential for enhanced scrutiny following the Delaware Court of Chancery's application of the entire fairness standard and denial of a motion to dismiss, allowing allegations of a breach of fiduciary duties and conflicts of interest to proceed towards trial.
- A rise in enforcement activity, which we expect to continue for the next several years.
- Challenges or potential legislative reform regarding the applicability of safe harbor provisions under the Private Securities Litigation Reform Act (PSLRA) as it relates to the use of forward- looking statements in connection with a business combination,3 noting that PSLRA has been critical for many D&O defenses.
In spite of aforementioned issues, which are developing, our outlook for the year ahead is positive, as the increased uncertainty in the marketplace serves to further distinguish our proprietary underwriting and broking process and our ability to deliver superior results. The market has been stable for our clients throughout the past twelve months, seeing an average reduction of only 10%-15% off earlier highs. We continue to manage the appetites and expectations of the participating insurers and expect opportunities to achieve further premium relief through our advisory process and program structures to continue.
Regulatory developments
The most significant impact to the SPAC market was through the increased vigor of policymakers and regulators, which left SPAC teams and their advisors navigating a consistent wave of change and challenges that emerged throughout 2021 as a result.
In response to developing concerns surrounding the protection of investors, beginning in late 2020, the Securities and Exchange Commission (SEC) began to publish formal notices and guidance directed toward SPAC sponsors, advisors and investors. The SEC's approach continued to evolve over the course of 2021. Early efforts to educate investors were followed with guidance concerning disclosure and compliance responsibilities. Comments regarding SPAC structure began signaling a period of increased scrutiny, ultimately resulting in a number of formal enforcement actions being brought against SPACs and their combination targets.
A timeline of key notices and developments are listed below:
- December 22, 2020 — Disclosure Guidance:4 The SEC's Division of Corporate Finance releases guidance on disclosure considerations for both the initial IPO and proposed business combination. The release specifically addressed the disclosure concerning potential conflicts of interest between SPAC sponsors, directors, and officers, and the financial incentives associated with the completion of a business combination. Comments with regard to potential disclosures regarding the initiation of communications between the SPAC were also included and are worthy of noting.
- March 10, 2021 — Investor Alert and Bulletin:5 The SEC's Office of Investor Education and Advocacy (OIEA) cautioned investors with regard to potential risks associated with investing in SPACs which are endorsed by or affiliated with celebrities.
- March 24, 2021 — Inquiry:6 The SEC opens an inquiry into SPAC activity, requesting information pertaining to internal controls and pricing practices. The inquiry was a voluntary request for information as opposed to a formal investigative demand.
- March 31, 2021 — Statement:7 Division of Corporate Finance issues statement to address certain accounting, financial reporting, and governance issues in connection with a proposed business combination.
- April 8, 2021 — Statement:8 Statement regarding SPACs, IPOs and Liability Risk under the Securities Laws.
- April 12, 2021 — Statement:9 Statement regarding accounting and reporting considerations for warrants issued by SPACs.
- May 25, 2021 — Investor Alert and Bulletin:10 The SEC's Office of Investor Education and Advocacy (OIEA) furthers efforts toward investor protection with information regarding SPAC structure.
SEC enforcement action filings
The SEC brought 434 stand-alone enforcement actions in fiscal year 2021, a 7% increase over 2020.11 The notable decrease in 2020 is thought to have been related to COVID-19-related shutdowns, with the recent results signaling a return to an upward trajectory, which is projected to remain for the next several years.
| SEC Enforcement Action Results — Fiscal Years 2017 to 2021 | |||||
| FY 2021 | FY 2020 | FY 2019 | FY 2018 | FY 2017 | |
| Stand-alone Enforcement Actions | 434 | 405 | 526 | 490 | 446 |
| "Follow-On" Administration Proceedings | 143 | 180 | 210 | 210 | 196 |
| Delinquent Filings | 120 | 130 | 126 | 121 | 112 |
| Total Actions | 697 | 715 | 862 | 821 | 754 |
Source: https://www.sec.gov/news/press-release/2021-238
SPAC-related enforcement actions
SPAC transactions were the target of several enforcement actions in 2021. In one such example, the SEC brought an enforcement action against a SPAC, its sponsor, and certain individuals of both the SPAC and the private company target. The action alleged a failure to conduct adequate due diligence leading to material misstatements, inaccurate registrations, and proxy solicitations.12 The comments made by the SEC in connection with this action, introduced concerns over the alignment between SPAC operators and the investing public.
To that point, the settled order contained statements by SEC Chair Gary Gensler, noting that the case "illustrates the risks inherent to SPAC transactions, as those who stand to earn significant profits from a SPAC merger may conduct inadequate due diligence and mislead investors."
The parties to the action (not including the CEO of the private company target), settled by agreeing to civil penalties totaling close to $8 million and equitable remedies which included a forfeiture of 250,000 founder shares, an agreement to voluntary termination of Private Investment in Public Equity (PIPE) commitments with investors, and the implementation of qualitative governance measures.
SPAC-related litigation
Although the core allegations and influences which lead to litigation filed in connection with a SPAC transaction remains unchanged, there have been developments which will influence D&O liability insurance as the issues develop and mature including short-sided activism and cyber as discussed later in this report.
Disclosure-based lawsuits
Public merger "strike suits," a trend that had plagued public M&A transactions until a ruling by the Delaware Court of Chancery in 2016, have re-emerged in connection with proposed SPAC business combinations. These pre-closing disclosure-based claims challenge the accuracy or completeness of the documents filed in connection with the proxy solicitation and are commonly resolved with supplemental disclosures and payment of a "mootness" fee.
However, a trend has developed over the past year concerning the potential to couple these claims with a cause of action for alleged violations of Section 10(b) of The Securities Exchange Act of 1934, which is common in post-stock drop litigation. Although these lawsuits may be filed in either federal or state court, there has been a significant increase in filings in New York State Court, which is believed to be a favorable forum shopping effort given the recent stance taken by the Delaware Court of Chancery on the subject.
Over the course of the past year, there have been several D&O insurance program structures brought to market which purport to drastically reduce upfront premium commitments. It is critical for all interested parties, regarding insurance, to gain an accurate understanding of the potential impacts of these coverage designs, as they most often result from a material reduction in D&O insurance coverage quality and responsiveness.
Instances stemming from adverse performance or developments in the post-closing period resulting in a destruction of shareholder value are a common cause of scrutiny, with the potential for litigation alleging false and misleading statements and/or projections made in connection with the proxy solicitation process and filings. It is critical to understand the ways to properly mitigate these risks in order to differentiate the risk profile in the eyes of insurers, for the purposes of the D&O liability placement for both the SPAC search period, and upon readying for the combined entity program moving forward of closing.
The timing of these claims is critical to keep top of mind, as the trends continue to justify cause for concern. We always discuss with our clients available program structures, especially in relation to certain solutions, which have come to market over the past year to ensure optimal coverage understanding. As SPACs continue to make headlines, the scrutiny of proposed SPAC targets has accelerated in large part through the presence of activists, which is a contributing factor to this shift and will surely prove problematic for the unproven coverage program designs just mentioned.
Short side activism
There have been several follow-on securities class action lawsuits and regulatory investigations resulting from short side activist reports issued in connection with SPAC combinations and proposed merger targets. We discussed the topic during the IPO Edge "SPACtivism and M&A"13 webinar in July 2021.
Although obviously dependent upon the factual particulars of each case, short side activism in the SPAC context differs from that of traditional operating corporates, in that short activism campaigns have been directed at the parties of a SPAC transaction have included allegations of a direct violation of securities laws. In a typical operating company setting, letters by short activists will typically allege mismanagement of the business in a way that is more likely to result in triggering internal or external investigations as opposed to litigation.
Process-based lawsuits
As a result of having a completely unique history and level of involvement with SPAC transactions, the issues and chronology of events which give rise to scrutiny and the potential for liability come as no surprise as the litigation and regulatory environment develops and matures around the vehicle. The Life Cycle of a SPAC whitepaper1 purposefully divided the life cycle in a way that placed the greatest emphasis upon the process which SPAC operators are entrusted to undertake during their search period. Questions as to whether SPAC structure is inherently conflicted are being contemplated. Much of the current narrative on the subject contains an incomplete understanding of several key concepts; however, the accuracy and completeness of the statements represented during the proxy solicitation process are a direct result of the effectiveness of the process executed by the SPAC and the SPACs advisors, and will tie to the potential for liability to arise as a result.
Cyber-related risks
Further to this point, are the potential for cyber-related issues, which influence and threaten to infect the process. Cyber liability can arise in several forms in the SPAC context; however, it remains a critical issue that the insurance industry has failed to address.
The industry needs to come to the realization that there is an extreme latency to which situations destructive to shareholder value may arise. It remains to be seen whether allegations challenging the adequacy of the due diligence performed and alleged failures to act upon "red flags" may be enough to establish negligence under Section 14(a) and survive motion to dismiss.
As we have led the industry in an effort to bring awareness toward cyber-related risk to SPAC operators and their advisors, we have a wealth of information on the topic. Our resources include on-demand webinars,14 articles15 and publications1 that provide in-depth insight and actionable strategies.
Securities class actions
Thirty-three securities class actions were filed against SPACs in 2021, as opposed to a total of seven in 2020. While there was surely an increase of core filings, it is critical to contextualize the comparison in the proper way in order to determine whether SPACs are seeing a litigation rate that is higher than that of alternative pathways to IPO. At the mid-point of 2021, the core litigation rate involving SPAC transactions over the previous three years, was approximately 14%.16 The litigation rates involving SPACs have been subject of several articles to date; however, there have been instances that incorrectly compares the litigation rates associated with SPAC transaction against a litigation rate of 4.2%, which is the likelihood of a filing against a U.S. exchange-listed company. A comparison of this nature skews the results in a way that is negatively misleading, whereas a more appropriate statistical analysis would compare the litigation rate associated with U.S. listed (non-SPAC) IPOs, which is well-established and demonstrable. A comparison conducted in this way provides that the core litigation rate (14%) of SPAC transactions is comparable to the cumulative rate of that experienced by new public issuers within the first three years following an IPO.16
Shareholder derivative suits
Private plaintiffs have filed a number of lawsuits alleging breaches of fiduciary duty under state law. These claims are of specific interest when looking to project the condition of the D&O liability marketplace for SPACs. Further to the comments made by the SEC with regard to potential conflicts of interest, the Delaware Court of Chancery recent denial of a motion to dismiss and application of the entire fairness standard, has now set the stage for discussions across the industry on multiple topics, including transaction economics and disclosure practices.
Coverage terms and conditions
With regard to coverage terms and conditions, the quality of available coverage remains unchanged over the prior year. The core concerns on the minds of SPAC D&O underwriters remain and are reflective of the broader sentiments voiced by regulators and policymakers. The scrutiny facing SPACs which has been occupying the press and the associated headline risk exerts an influence on both carrier appetite and the D&O underwriting process. As a result, there have been several brand name carriers who have either paused or significantly altered their appetite at various points over the course of the past year. However, we have continued our advisory work with market underwriters and insurers to help hone their understanding of potential issues to better inform the underwriting process. As a result, we have been successful in bringing additional insurers and capacity to market, have negotiated several SPAC specific coverage grants, and have narrowed certain issues that were cause for concern due to the original designs being overly restrictive, sometimes in a dangerously broad and sweeping fashion.
Much of the current scrutiny centers around the potential for conflicts of interest, and the adequacy of disclosures made at both the time of the IPO and in connection with the business combination.
For the purposes of D&O underwriting, the market is addressing the presence of affiliated entities and/or related party transactions that have the potential to influence the process and be later implicated in a complaint.
Policy language addressing related party transactions and affiliated entities has a material impact on the D&O liability insurance coverage quality for SPAC transactions as it varies significantly in how it is being addressed amongst the participating insurers. Each insurer and respective coverage form aims to address the issue in a specific way, which can include warranty statements, absolute exclusions, or condition precedents, which are a specific concern.
Over the target — DeSPAC process
As mentioned, the potential liability associated with a SPAC transaction centers around the combination closing process. To be clear, when contemplating the risks, which are associated with these transactions, it is critical to be mindful not only of the activities, which will be performed, but to be mindful of where such activities occur during the life cycle of the transaction. As the litigation landscape continues to evolve and the impact of several novel complaints continuing to develop, there are several ways in which SPACs and stakeholders can best guard against these risks.
The complexity of the coverage necessary for the proper management of these transactions continues to amplify the importance of working with a broker who possesses the knowledge, niche experience, and breadth of resources necessary in order to coordinate the nuances of SPAC transactions throughout the entirety of the transaction life cycle, a requisite unlike any other insurance specialization.
Beyond the associated coverage mechanics, the 2021 SPAC Market Conditions Report17 referenced the increasing number of SPACs, which had shifted their targeting focus to earlier-stage businesses as an emerging risk, which we manage through our work in facilitating transaction and public company readiness.
There has been a clear correlation between the maturity of a proposed combination target and the litigation, short side activism, and enforcement actions, which have arisen. These claims challenge the condition and/or viability of the proposed business through asserting claims alleging false and misleading statements, which were made in connection with the proxy.
While the aforementioned scenarios have the potential to arise either prior to the closing of the combination, or during the post-closing period, the analysis we conduct and the strategy we employ produces results, which manage the risks associated with the potential adverse scenarios, which are simply unmatched.
Conclusion
Because of the highly nuanced nature of this market, it is imperative that you are working 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.
Please note: A client's risk profile is the primary variable dictating premium outcomes. Qualitative factors, loss experience, location, and individual account nuances will also have a significant impact on the results achieved for these programs.
This report addresses the current trends related to the management of the potential risks which are associated with the formation, operation, and execution of a SPAC transaction through the use of insurance products.
