A version of this article was originally published in ABA’s Business Law Today.
SPAC lawsuits are increasing in frequency. There was a big jump in the number of SPAC-related cases from 2020 to 2021. Five new securities class actions were filed against SPACs in just the first two months of 2022. Several cases have gotten past a motion to dismiss.
One of the latest securities class actions—brought against the CEO and CFO of Fortress Value Acquisition Corp. (the SPAC) and the CEO and CFO of MP Materials Corp., a rare earth mining and processing company (the Target)—was filed on February 22 in the District of Nevada.
The MP Materials Lawsuit
The MP Materials lawsuit is similar to many others that came before it. It was filed after the merger was completed, followed a short seller report, involves officers of both the post-merger company and the SPAC, and alleges, among other things, that the defendants made materially false and misleading statements, and that they lacked due diligence of the target or demonstrated willful ignorance. This last allegation is what is of interest.
Although it might be too late for the defendants in this case, cases like this one should serve as a roadmap for the 600+ SPACs looking to find their targets right now. These cases can reveal how to avoid unnecessary litigation, how to find ways to refute similar allegations, and how to minimize losses.
Representations and Warranties Insurance Solutions for SPACs
Most SPAC teams are aware that well-structured D&O insurance policies at the time of the IPO and the business combination could make a big difference for their balance sheet and the protection of their directors and officers. Many, however, are unaware that a representations and warranties insurance (RWI) policy could also go a long way towards refuting allegations of insufficient due diligence in addition to covering losses from a breach of representations in the merger agreement.
At its core, the RWI policy is designed to protect the buyer (in this case, the SPAC) against two things: (i) the seller’s (in this case the Target’s) breaches of reps in the merger agreement and (ii) the Target’s fraud. However, a valuable side benefit of these policies, especially now that the number of SPAC cases alleging insufficient diligence is growing, is the insurer’s close examination of the SPAC team’s due diligence.
This second layer of diligence by a disinterested third party over the SPAC team’s diligence is important for at least two reasons. First, it either validates the SPAC team’s diligence process or points out potential problems that could be corrected and properly disclosed between the signing of the merger agreement and the close of the deal. Second, it is conducted by an experienced underwriting team and their top-tier legal counsel, who are usually well versed in the industry of the target and very knowledgeable about the array of potential risks present in that industry.
How RWI Works in a SPAC Merger
An insurance broker who specializes in both RWI and SPACs can structure the process of obtaining an RWI policy to run along the timeline of the core transaction so that it can take approximately two weeks. The policy can be bound at the signing of the merger agreement, and coverage can run starting at signing. To ease the SPAC’s typical pre-merger cashflow problem, only 10% of the premium (along with a separate underwriting fee) would be payable at the time of signing, with the remaining 90% of the premium due at closing.
|Here are our answers to some common questions about the use of RWI for SPACs:|
|Why use RWI for a SPAC?|
Defense against claims of:
Benefits SPAC and Target
Benefits SPAC and Combined Company
|How much does it cost?||3%-5% of policy limit||Minimal limit is $5 million|
SPAC at signing
Target at close
|Have other SPACs used RWI?||Yes||Happy to discuss|
|How long does it take?||1 week for quote||1 week for diligence|
What Diligence is Required?
In a SPAC transaction, the insurance underwriters would expect a standard level of due diligence like that conducted for any private company M&A deal. Many SPAC teams already run robust diligence processes and would not find this requirement a burden. Those teams who have not up until now been engaged in thorough due diligence practices should take note and consider adjusting their protocols. Regardless of whether they choose to avail themselves of the benefits of an RWI policy, to avoid allegations like those in MP Materials, they would be well advised to conduct as robust a diligence process as possible.
RWI as Avenue for Risk Mitigation
With the ready availability of insurance carriers who are willing to offer coverage for most SPAC deals, not exploring the availability of this kind of policy ahead of the merger may raise questions of whether the SPAC team’s directors and officers explored all avenues of risk mitigation. Even if it does not, failing to obtain an RWI policy could lead the SPAC teams and their targets to the kind of elbow-biting and shin-kicking regrets that the MP Materials teams may be experiencing now and that most of us would rather avoid.
Visit our SPACs industries page for more insights and resources related to Special Purpose Acquisition Companies.
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