A special purpose acquisition companies’ sole purpose is to raise funds in an IPO and then use those funds to acquire a private company. Last year, I predicted that more SPACs would lead to more litigation against SPAC directors and officers, and we are now seeing this prediction come true. This is also why SPACs have D&O insurance with pre-negotiated tail policies.
So, no worries for the SPAC directors and officers, correct? Not so fast. There are some traps for the unwary when it comes to tail policies, which I will explain in this article.
A Quick Background on Tail Policies for SPACs
As a reminder, SPAC D&O policies are a little different from operating company D&O policies in a couple of critical ways. One difference is that they are usually two-year policies, tracking to the life of the SPAC.
Another way they are different is that at the time a SPAC’s broker is placing the D&O insurance program for the SPAC IPO, the broker should also be negotiating the terms of the SPAC’s D&O tail policy.
As a reminder, the tail policy is the six-year extension of the SPAC’s insurance policy. It is designed to respond to claims that arise after the business combination closes if the claims are related to pre-closing activity.
Tail Risk Is Going Up
The risk associated with SPAC business combinations is not trivial. A lot of experts and regulators are analyzing these risks–not the least of which is the Securities and Exchange Commission. In April 2021, the acting director of the division of corporate finance at the SEC, John Coates, made a speech outlining the liability risk under securities laws for SPAC IPOs.
In his speech, Mr. Coates stated liability is higher for SPACs than traditional IPOs:
”It is not clear that claims about the application of securities law liability provisions to de-SPACs provide targets or anyone else with a reason to prefer SPACs over traditional IPOs. Any simple claim about reduced liability exposure for SPAC participants is overstated at best, and potentially seriously misleading at worst. Indeed, in some ways, liability risks for those involved are higher, not lower, than in conventional IPOs, due in particular to the potential conflicts of interest in the SPAC structure.”
That speech referenced an article I wrote on how more SPACS could lead to more litigation (that article is linked to in the introduction of this one). I suggest reading that to get a better overview of what could go wrong for directors and officers in these transactions.
This type of complex litigation is exactly why law firms like Robbins Geller are launching a “SPAC task force” in preparation for these claims.
Indeed, we are already seeing an uptick in de-SPAC litigation. According to the D&O Databox, Woodruff Sawyer’s proprietary database of D&O litigation, there were seven securities class action cases filed against de-SPAC companies in 2020.
That same number of securities class actions was filed in just the first quarter of 2021. Not all of these suits name the directors and officer of the SPAC. However, it is already obvious that the plaintiffs have realized that this is a fruitful path to pursue.
Tail Policies Are Valuable to the Target Company, Too
In light of the factors mentioned thus far, it is not surprising that tail policies for SPACs in the current market are expensive. While the SPAC itself pays for its own two-year D&O insurance policy at the time of the SPAC IPO, the target company typically pays for the SPAC’s tail policy.
The target company should want to do this in part because the target company will also agree to indemnify the directors and officers of the SPAC for future claims that arise against them related to the de-SPAC transaction.
The target company should be motivated to pay this premium given that the target company’s own go-forward D&O insurance policy will exclude anything having to do with the SPAC. The SPAC’s tail policy is the only way for the go-forward company to protect its balance sheet against future SPAC-related claims.
Ensure the Broker You Trust Is the Broker Who Handles Claims
The trap for the unwary arises when a target company attempts to insist that its broker, and not the SPAC’s own broker, should place the SPAC’s tail policy. The SPAC directors and officers will not benefit from this arrangement.
If they agree to this change in brokers, the SPAC directors and officers are essentially putting their trust in a D&O insurance broker that they did not choose, essentially a stranger with no relationship with the SPAC directors and officers.
There is no reason this needs to happen–other than the desire for an easy commission for the seller’s insurance broker. However, what can seem like an inconsequential decision to have the seller’s broker take over the tail policy can have serious ramifications.
Mainly, does that broker have your best interest in mind when it comes time to handle claims? And, how do they handle claims?
Keep in mind that the broker’s commission associated with the placement of a tail policy is intended to support six years of claims activity. That commission exists because there can be very difficult claims that arise after the deal closes.
Any knowledgeable broker will tell you that claims in this arena are difficult, require a sophisticated approach to advocacy, and all too often can take the full six years (or more) to resolve. If you are a SPAC director or officer named as a defendant in litigation, you want the broker you chose to represent you to be up at bat on your behalf.
To be sure, post-close litigation will also likely involve the target company directors and officers, as well as their insurance program. And, of course, their broker will handle those parts of the claims.
Professional brokers coordinate with each other all the time, so appropriate cooperation is easy to achieve. What the SPAC directors and officers avoid by using their own broker, however, is not having anyone at the table specifically looking out for their interests.
During litigation, you will coordinate with your broker to maximize any available recovery from your D&O insurance policies. This is where choosing a broker that has a robust claims advocacy practice is important.
If you had a good diligence process when your SPAC chose its D&O broker, the sophistication of the claims practice was likely one of your concerns.
When placing D&O insurance, SPACs need to ask themselves: Do they want the broker that they chose at the time of their IPO to advocate for those claims? Or do they want a broker with whom they have no relationship to be in charge of making sure that their personal liability is covered?
Of course, there are real reasons why you’d want to switch brokers—for example, if you found the original broker to be incompetent—but simply allowing the target’s broker to grab the commission associated with a tail policy is not one of those reasons.
For more information on the topic of D&O insurance for SPACs, see our Guide to D&O Insurance for SPAC IPOs.
Visit our SPACs industries page for more insights and resources related to Special Purpose Acquisition Companies.
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