Understanding & writing D&O policies for SPACs

As the number of special purpose acquisition companies (SPACs) has rapidly grown, so have SPAC-related litigation and investigations. On top of this, executives in this space face challenges finding sufficient coverage for the financial risks they face due to narrower coverages for SPACs than what is typically seen in director & officers (D&O) liability policies.

First, some background on SPACs, which are publicly listed shell companies that raise investor capital to acquire or merge with a privately-held company within two years and take that business public. A SPAC that does not acquire a target within that time period must liquidate and return the shareholders’ investment. Additional investment may flow into the company at the time of the merger. The corporate transaction allows the target company to quickly gain access to the public shell company’s cash and stock market listing and might be a more attractive option than a traditional initial public offering. SPAC growth has been phenomenal — 59 SPAC IPOs raised $13.9 billion in 2019, and the value of SPAC investments rose to $83.3 billion in 2020. While data for 2021 is still being collected, SPAC IPOs are estimated to have raised $100 billion by the end of May.

SPACs are often sponsored by private equity and hedge funds with established reputations in capital markets, but celebrity sponsors like basketball legend Shaquille O’Neal and pop star Jennifer Lopez, and politicians like former House Speaker Paul Ryan, have also helped attract investors by serving on SPAC management teams. The heavy reliance shareholders place on these sponsors to choose and evaluate target companies increases the risk that the SPAC sponsors and management team will be named as defendants in litigation if the SPAC fails to complete a transaction within the two-year window.

Likewise, as SPACs have gained in popularity, regulators like the U.S. Securities and Exchange Commission have increased their scrutiny of the vehicle, posing additional risks to individuals involved in a SPAC initial public offering. D&O liability insurance is the typical vehicle that executives use to mitigate the risks of costs or liabilities stemming from litigation or enforcement actions.

Higher insurance costs, narrower coverage

Second, some background on the current D&O insurance market. This market has been difficult over the past 24 months because of an increase in D&O claim frequency and severity. Premiums rose by 20% in 2019 and 40% in 2020. Even mature public companies have had difficulty finding policies with sufficient capacity and broad coverage terms. While a hard insurance market generally leads to new entrants that will compete on coverage pricing and terms, thereby increasing capacity and giving policyholders more leverage in negotiations with underwriters during policy placements and renewals, that correction has not happened in the current market as quickly as it has in the past.

Although SPACs have been in use for over a decade, the exponential growth in SPAC-related activity is a newer phenomenon, and insurance underwriters in the D&O market have been cautious about over-exposure to these risks. That caution has led to a smaller market willing to insure SPAC risks, higher premiums, lower policy limits and broadly worded exclusions. The policy placement process for SPACs is, therefore, more complicated than it would be for a mature public company, and negotiations to broaden the coverage by securing more favorable terms and conditions may be extended.

SPAC litigation is on the rise

Emerging litigation risk remains the driving force behind high premiums for SPAC D&O insurance coverage. In particular, New York and Delaware saw a growth of SPAC-related state court litigation. Between September 2020 and March 2021, at least 35 SPACs faced one or more shareholder lawsuits filed in New York state court, for example.

Claims raised against SPACs can arise at various points during the SPAC and de-SPAC life cycle. SPACs may face litigation based on SPAC IPO registration statements, de-SPAC proxy statements, potential de-SPAC registration statements, financial projections, the redemption of SPAC shares, de-SPAC deadlines, and post-SPAC public status, to name a few. Most lawsuits filed against SPAC directors allege that the directors breached their fiduciary duties by providing inadequate disclosures concerning proposed de-SPAC mergers.

Using D&O liability insurance to mitigate risks

The key to negotiating D&O liability insurance for a SPAC is to analyze policy options with a deep understanding of the risks facing the SPAC at each stage of its existence — during initial formation, the de-SPAC process, and the post-SPAC period for the going-forward company. The SPAC entity has different needs at each stage, and coverage should be structured to adequately protect the shell corporation, the private company, and the going-forward public company — and each of their associated executives — throughout the process.

D&O liability insurance is traditionally written for one-year policy periods — although SPACs can find policies that provide coverage for the full two-year acquisition period — and so the SPAC entity may be looking at multiple insurance policies before the going-forward public company secures its own coverage. Likewise, the private company that the SPAC entity plans to acquire will have its own private company D&O liability insurance coverage during the De-SPAC period. And the going-forward public company must secure its own D&O coverage. This means there will be multiple D&O policies in play for SPACs, and the coverage terms and coverage periods must be coordinated to avoid gaps that could threaten the stability of the entities and the pocketbooks of the individual sponsors and management teams.

While there is a myriad of policy terms and conditions that must be analyzed and negotiated, often focus is placed on how to allocate coverage between the various D&O liability insurance policies that may be triggered by a lawsuit, how to protect against regulatory risk, how to structure the new public company’s D&O coverage to potentially cover the risk of “prior acts,” how to protect individuals in situations where corporate indemnification may be unavailable, and how to secure adequate defense costs coverage even in situations where liability risk may be excluded.

And finally, because many of the litigation risks may not manifest into lawsuits until after the acquisition concludes, the SPAC policies and the private company D&O insurance generally need “tails” so that those policies respond to litigation concerning pre-merger conduct filed after the policy periods of that coverage ends. The standard tail period is six years. The practice is to negotiate the tail coverage at the time as the initial D&O policy. While tails can be expensive, the litigation and regulatory risks justify securing the additional protection.

If SPACs continue to remain popular and litigation trends persist, SPAC management should be prepared to invest in coverage. The costs are significant — but the peace of mind a good D&O insurance policy can offer to the SPAC sponsors and management is invaluable.

Reed Smith partner Courtney Horrigan is a member of the insurance recovery group and represents public and private corporations and nonprofits in insurance coverage litigation and domestic and foreign arbitrations. She also counsels policyholders during renewals and placements of management liability insurance. She can be reached at chorrigan@reedsmith.com.

Stephanie Gee is an associate in the firm’s insurance recovery group. She represents policyholders in insurance coverage disputes on a wide array of policies. She can be reached at sgee@reedsmith.com.

Kya Coletta is also an associate in the firm’s insurance recovery group. She represents and advises corporate policyholders at various stages, including risk management counseling, claims handling and insurance coverage litigation. She can be reached at kcoletta@reedsmith.com.

Opinions expressed here are the authors’ own. 

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