SPAC Liquidations and Extensions Create D&O Insurance Riddles: Part 2
September 29, 2022
For a special purpose acquisition company (SPAC) that has not completed a business combination but is approaching its deadline for finding a suitable target, two questions loom large: do we extend or liquidate?
In part 1 of this blog series, I focused on director and officer (D&O) insurance issues that a SPAC needs to address ahead of an extension. For part 2, I am tackling D&O insurance issues that arise in a liquidation context.
Similar to Bill Ackman’s SPAC that liquidated in July, several other big-name SPAC sponsors have shut down and liquidated their SPACs lately. SPACResearch is reporting 19 liquidated SPACs as of September 22, 2022. The word on SPAC street is that many more will hit the market before the end of the year, now that there’s a specter of the new potential excise tax that could hit SPACs in 2023. All those SPACs that are thinking of liquidating need to add the question of what happens to their D&O insurance coverage post-liquidation to their “to-do” list.
SPAC D&O Tail
While SPAC sponsors are understandably distraught at the thought of failing to find a suitable merger target and having to liquidate the SPAC, most know to consult their business and legal advisors to achieve an orderly distribution of SPAC funds and to wind down the SPAC’s operations. Most legal, financial, and logistical questions are, therefore, taken care of in due course.
The question of insurance coverage, however, often falls by the wayside. Many SPAC teams don’t stop to think about the possibility of risk to the SPAC’s directors and officers after liquidation is completed. And they also don’t necessarily think about the fact that the D&O policy they purchased for their SPAC at the time of its IPO will terminate once they liquidate.
How Does the SPAC D&O Insurance Work?
Almost all SPACs that have gone through an IPO and are out looking for merger targets are covered by what I’ll refer to as a “SPAC IPO D&O policy.” This policy covers the SPAC and its directors and officers for things like securities class action settlements as well as defense costs related to investigations and enforcement actions by the Securities and Exchange Commission (SEC). This policy typically starts running at the IPO and tracks the SPAC’s initial investment period, which means that if the SPAC’s investment period was set at 24 months, the policy would expire at 24 month or if the SPAC liquidates earlier, at the liquidation date. The policy does not typically automatically extend to a longer period if the SPAC needs to liquidate.
The Merger Scenario
When SPAC teams were purchasing this policy, they most likely walked through the scenario where the SPAC would merge with a target company and their D&O coverage would extend (via tail) to cover their directors and officers after the merger. They also assumed their directors and officers would get an indemnity from the combined entity at the time of the merger, which is market standard. With the indemnity and the tail coverage being paid out of the merger transaction costs, SPAC teams got comfortable that they would be covered in case they got sued after the merger.
The Liquidation Scenario
But in a liquidation scenario, there is no merger. There is no combined entity to offer an indemnity. There are no transaction funds to cover the cost of the SPAC’s tail. The original SPAC D&O policy expires unless the SPAC team elects tail coverage. And that tail coverage, which was typically pre-negotiated to cost between 200% and 400% of the original SPAC IPO policy premium, now needs to come out of the directors’ and officers’ pockets.
The pre-negotiated costs of that tail coverage are not insignificant. Depending on how a SPAC’s IPO policy was structured and when it was purchased, tail costs could run into millions of dollars. After losing their shirt on a failed SPAC, not many of the SPAC team members are eager to go find another shirt to pay for that tail premium.
Is There Risk Post-Liquidation?
A knee-jerk reaction from most teams I’ve spoken with is to not even bother with the tail. And I can certainly understand where they’re coming from. The usual refrain is, “if we give back all of the money to the investors plus interest and close up shop, what could we possibly get sued for?” That’s a great question.
The answer is not immediately clear, but most of us who’ve been watching the SPAC space would likely agree that the risk of a lawsuit, even after an orderly liquidation, is far from zero. Take, for example, the situation with FAST Acquisition Corp., which was well summarized by Kevin LaCroix in The D&O Diary.
In that case, a pre-liquidation lawsuit emerged between the SPAC and its shareholders, who are accusing the SPAC’s team of a breach of fiduciary duties in keeping the termination fee after a failed merger. The shareholders petitioned the court to stop liquidation until their claim is resolved. The circumstances in this case are a bit unusual, but it is an example of an unforeseen outcome and a dispute that could arise in a liquidation scenario.
Over the last couple of years, we’ve seen all sorts of novel dispute theories being tried in court against SPACs and their directors and officers. Now that the tide of liquidations is coming in, we can’t assume that all shareholders will walk away quietly from every liquidation. Furthermore, the threat of an investigation from a regulator into the way a liquidation is conducted is not off the table either.
The risk is certainly much lower than in a post-merger scenario, but it does exist. What this means is that without tail coverage in place, a SPAC’s directors and officers may need to cover the attorney fees related to that investigation or defense costs of that litigation (even if it is frivolous) out of pocket.
Can Tail Costs be Managed?
For those SPAC teams that are unwilling to take that risk, there are ways they can work with their SPAC insurance broker to minimize the cost of the tail coverage.
First, a good insurance broker will be able to negotiate the cost of that pre-negotiated tail down from 200% to 400% of the initial policy premium to 100% to 150%—or even lower. Remember that it would be a one-time cost of extending that policy’s coverage for six years after the liquidation. Many carriers are willing to discuss this reduction in the current market because they also agree that the risk of a lawsuit or government action is lower.
Second, considering that the risk is potentially lower in a liquidation scenario than in a merger scenario, you might consider opting for a tail that might be a fraction of your original policy limit. So, for example, if your original IPO D&O policy had a total limit of $10 million, you might consider lowering that to $5 million, thereby saving a portion of the costs of that tail.
All of this is possible, and a knowledgeable insurance broker will be able to offer you guidance on taking these steps. But whichever way you decide to proceed, do not wait until the last minute. If your team is considering liquidating, get in touch with your insurance broker right away to make sure you understand what options, risks, and solutions exist for your team.
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