There’s risk at every stage of a special purpose acquisition company’s (SPAC’s) lifecycle, and a recent surge in activity around investments in these “blank check companies” is creating a heightened level of attention for underwriters dealing with directors and officers insurance.
“It’s interesting because these are risks we’ve seen before - basically, investors suing a company and its directors and officers due to the company’s actions or lack of action - but the vehicle that’s the subject of it, the SPAC, is something that up until recently was pretty rare,” said Todd Greeley, COO for financial lines, at QBE North America.
SPACs offer an increasingly popular alternative to the traditional IPO process for bringing a private company public. For financial lines insurers, SPACs create a new dimension of concern because the risks start the day the SPAC is formed and go all the way to the end when the SPAC either finds and acquires its target company and undergoes the de-SPAC process or, so far relatively rarely, an SPAC doesn’t find a suitable investment within its timetable, typically two years, and returns the money to investors.
SPACs have exploded globally to a record $170 billion this year, outstripping last year’s total of $157 billion, according to data from Refinitiv. Greeley compares the explosion to the game of musical chairs - all of these SPACs are hunting for a limited number of private companies to acquire, and, at some point when the music stops, someone’s not going to have a chair. It becomes even more complicated when the same sponsor has created multiple SPACs that are pursuing the same or similar targets, and the potential conflict of interest from that situation is “high on the list of things we’re really sensitive to,” noted Greeley.
“The severe claim often arises when nobody realized there was a conflict until it was too late,” said Tom Kocaj, SVP, management liability, at QBE North America. “It’s hard for us, as underwriters, to sniff that out, but any time we see a chance there could be a conflict of interest - a single sponsor creating multiple SPACs that are competing for the same asset, or competing for an asset in which the sponsor or a member of the board of the SPAC has an interest - we ask a lot of questions to make sure the SPAC team is thinking about potential conflicts and eliminating them, or at least being transparent to investors to protect themselves.”
“We’re going to be focused on the potential for a plausible case that the directors breached some duty by virtue of pursuing a company where there was some interest in the company by the sponsor or a member of the board of the SPAC,” Greeley said.
Conflicts of interest are going to be a major focus for the US Securities and Exchange Commission (SEC), and likely also the plaintiffs’ bar, as those types of lawsuits are most likely to get past the motion to dismiss.
Recently, the SEC has also been showing interest in the controls investment banks have in place related to services provided for SPACs, and “it wouldn’t be a surprise to see them take a closer look over time as the SPAC industry continues to grow. Regulatory attention could potentially bring regulatory investigations, and the litigation that typically follows,” said Kocaj.
Other emerging risks on the radar include the variety of issues that can arise from the targets and how viable they are. A well-established business with a predictable 50-year operating history that makes an annual profit and lines up with the experience of the SPAC sponsor seems lower risk, versus a three-year-old electric vehicle company that has a great idea and interesting technology but hasn’t made any money yet. For various reasons, other targets may not be ready to go public, and that creates a riskier situation when it comes to yielding the results represented by the sponsor and the SPAC making the purchase.
Considering all the emerging risks, D&O insurance rates for SPACs have been rising even faster than for the D&O market overall. Kocaj also attributes the rising price to simple supply and demand - record numbers of SPACs coming to market with no sign of stopping, and each requiring a D&O policy.
SPACs can, however, mitigate these increases by presenting a low risk profile. Kocaj notes a variety of things the SPAC can do. First, show that the sponsor has been successful with past investments and not attracted litigation. Second, present a clear idea of the type of company the SPAC will pursue and choose a management team whose experience aligns closely with that target. Third, pick a team of high quality, experienced advisors when it comes to outside counsel, investment bankers, accountants, etc. Finally, demonstrate strong due diligence in discovery of potential conflicts of interest and following the SEC’s recently released guidelines for the SPAC process.
“To sum it up, the more focused, experienced, aligned and transparent the sponsor, management team, and outside providers are, the less risk we see for potential litigation,” Kocaj said.
Underwriters are also keeping an eye on the way premiums are charged for an SPAC. Premium for the initial policy is collected upfront, and then there’s a charge for the run-off premium when the target is acquired, and the de-SPAC process commences. The combination of those two premiums is what underwriters expect to collect for covering the risk, and the possible loss of the run-off premium is another potential issue, Kocaj noted.
More risk factors will likely emerge and come into sharper focus as people become more aware of SPACs, more claims roll in, and more action from regulatory authorities occurs.
Though there has been a spattering of SPAC-related claims in the industry, QBE hasn’t seen much action on that side of the equation because they’ve been selective - “we haven’t jumped into the deep end of the SPAC pool,” Greeley said - and because the SPACs they have written are relatively recent vintage. Greeley predicts more claims on the horizon, mainly where the target company was purchased near the end of the SPAC’s lifecycle and its performance post-acquisition falls below projections.
While there’s not a lot of precedent around SPACs as of yet, it’s currently being created, and Greeley expects “we’ll get some clarity as the SEC and the plaintiffs’ bar focus on this space a little more.”