May 28, 2021
What SPACS Mean for D&O Exposure
by Jason Remsen
Although many of the risk exposures remain the same as those in traditional M&A deals, lack of historical data has fueled uncertainty.
The rapid rise to fame of special purpose acquisition companies (SPACs) brings with it a host of uncertainty and risks along with the promise of fortune. In the U.S., 274 SPACs were launched in 2020, and so far in 2021 about $100 billion has been raised, according to the Wall Street Journal. Such is the growing appeal of SPACs that the Securities and Exchange Commission took the unusual step in March of warning that it is “never a good idea to invest in a SPAC just because someone famous sponsors or invests in it or says it is a good investment.”
In addition to warning against basing investments solely on celebrity endorsements, the SEC recently issued further guidance on the booming SPAC market, and many believe that increased scrutiny will continue, with further regulation coming. From an insurance perspective, much of the focus has been on the risk exposures of executives and directors involved in the deals, resulting in an explosion of D&O insurance demand. Although many of the risk exposures remain the same as those in traditional M&A deals, lack of historical data has fueled uncertainty over future litigation possibilities. Perhaps the biggest difference in SPAC risk exposure is the speed with which deals must be completed. As with other areas of the mergers and acquisitions market, the use of representations and warranties (R&W) insurance can offer real benefits to both buyers and sellers to help manage these risks.
Managing the risks
The use of R&W insurance has become a standard feature and a valued tool to facilitate deals in the private equity (PE) space over the last several years, with myriad benefits for both sides of the transaction. Participants in SPAC transactions should also consider R&W insurance once a target has been identified and work is underway to complete the de-SPAC merger.
The risks to be insured on a SPAC transaction are not radically different from a PE deal – for the buyers, the exposures are largely the same. However, there is one significant difference in SPAC transactions that may drive risky behaviors: deals are being done against the clock.
One of the key attributes of SPACs is that deals must be completed within a two-year time frame, which imposes considerable pressure on the founders to find the target and close the merger. In a typical PE deal, despite months – sometimes years – of due diligence and the seemingly good intentions of both parties, it’s not uncommon for M&A issues to arise under sales contracts—often after the ink has dried. The aggressive timeline of a SPAC transaction only heightens these risks. Some parties may be tempted to cut corners in the due diligence process and SPAC sponsors are well aware that discovering bad news might derail the deal.
This time pressure can also mean that SPAC sponsors may make concessions during the negotiation of the purchase agreement, because they have an incentive to close the business combination and don’t have a fiduciary duty to the investors. In most cases, sponsors are able to sell their shares soon after the deal is done, so they are less interested than other investors in the target’s long-term performance. This last issue can, and in some cases has, been resolved by making sponsors hold shares in the SPAC longer so that their interests are more aligned with other investors. The more interest the sponsor has post-deal, the deeper they may dig to understand the target, and the more invested they may be in the due diligence process.
How R&W can make it happen
In simple terms, R&W insurance hedges risk for both buyer and seller. When evaluating coverage options, working with a team of underwriters experienced in executing deals under tight time constraints can give SPAC acquirers certainty that they will have insurance in place when they sign a deal.
Equally important is choosing an insurer that has a deep bench of underwriters with depth and breadth of experience across sectors, as they will be able to highlight any soft spots in the diligence that need to be addressed to ensure meaningful coverage.
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There is also competitive pressure for targets. Having R&W insurance can be an advantage to the targets in an auction process, making them attractive to investors. Should there be any misrepresentations or breaches post-closing, the seller is liable for losses for the period of time set out in the agreement. To cover any legacy liabilities, a portion of the proceeds from the sale are typically held up in escrow, handcuffing sellers from using those funds. When a target has R&W insurance, it removes the requirement to have an escrow and the sellers can realize the entire proceeds of the deal on closing. For a purchase in the hundreds of millions of dollars, the ability to liberate a 10% escrow with an insurance policy is very attractive.
While the risk profile for a SPAC target is not critically different from that of any other business requiring R&W insurance, the abbreviated timelines involved on SPAC deals and their shorter track record makes it harder to predict outcomes. Just as a celebrity relies on their reputation to secure endorsements, so too must an SPAC sponsor seeking investor and target company trust. R&W insurance serves as an important tool to facilitate these fast acquisitions, transferring risk to the insurance company and keeping reputations intact.