Recent years have seen an explosion in the US in the use of SPACs, short for Special Purpose Acquisition Company, to raise equity capital for the purposes of acquiring another company. The use of SPACs has potentially significant implications for directors’ liabilities and D&O insurers. In this article we explore some of the issues that have recently arisen in the US, and consider whether we may start to see similar trends in the UK market.
What is a SPAC transaction?
A SPAC is a form of blank cheque company that allows a privately owned company to become a listed company in a process that is faster and often cheaper than a traditional IPO and offers more certainty in the process. Traditional IPOs can take two to three years, whereas a SPAC merger through which a private company becomes public can be completed in a matter of months.
It works as follows. A SPAC is formed by a sponsor or directors with venture capital or similar skills. The SPAC raises capital through an initial public offering (IPO), but because the company has no operations or historical financial statements the process for obtaining regulatory approval can be completed relatively quickly. The organizational documents for the SPAC usually allow the SPAC a defined period of several years to identify a target and complete an acquisition. Investors in the IPO (or in open market stock purchases after the IPO) therefore will not usually know the target for an acquisition, which will form the business of the company after the acquisition, when they invest. In the US, the business combination transaction by the SPAC will be subject to stockholder approval. Stockholders also have the right to redeem their shares if they do not agree with the proposed business combination or if no transaction is proposed before the initial period expires. The target for SPAC acquisitions is commonly a privately held company, and there is a reverse merger so that the acquired company becomes a publicly traded one (known as the de-SPAC process).
In the US there has been a huge increase in the number of SPAC transactions in the past few years. 248 SPACs were listed in the US in 2020 raising GBP63.5 billion. Some of these have been high-profile. In the first three months of 2021, SPACs have already exceeded last year’s figure.
However, SPAC transactions have begun to attract the attention of the SEC, and we have seen a number of lawsuits arising from the SPAC process, in some instances after negative short seller reports.
Proposed business combination transactions by SPACs have become a regular target of stockholder lawsuits under Section 14(a) of the Securities Exchange Act alleging inadequate merger disclosures in seeking stockholder approval. In this respect SPAC litigation experience is fairly typical, because nearly all public company mergers are now the subject of such lawsuits. More specific to SPACs, however, there are a number of securities fraud class actions underway asserting claims under Sections 10(b) and 20(a) of the Exchange Act based on stock price declines of the merged company after a de‑SPAC merger has been completed. The allegations in these cases have concerned issues at the acquired companies such as problems with their financials, relationships with third parties, supply chain issues and the existence of investigations by outside agencies. A recent class action filed in Delaware also raises potentially significant challenges to the structure of SPACs under Delaware law and asserts breaches of the directors’ fiduciary duties in connection with a large SPAC business combination transactions.
The defendants in these lawsuits depend on the context. The recent Delaware case, for example, names the directors and officers of the SPAC before the de-SPAC merger as defendants. On the other hand, securities fraud actions might name directors or officers of the on-going company. In some cases the sponsor is also named, for example, where there are allegations that the transaction has been set up so as to favour the sponsor or certain individuals, or that it was necessary to enter into a merger transaction come what may, as otherwise the interests that the sponsor and individual directors have been granted in the SPAC will be worthless.
In the UK, SPAC transactions have not, so far, taken off in the same way as in the US. It is reported that only four SPACs1 were listed in the UK in 2020. However, at DLA Piper we have seen increasing interest in UK (and European) SPACs, and it is possible that we may see them gain more traction, particularly if there is regulatory reform.
The regulatory environment in the UK is currently less favourable towards these types of transactions than in the US. Some of the main issues are:
- the fact that it is a more expensive and time consuming process than in the US, as the SPAC listing will be cancelled during the reverse take-over and there is a need to produce a new prospectus once the SPAC secures an acquisition so that the holding company may be readmitted;
- investors in the UK do not have the same exit or voting rights as in the US. In the UK, shareholders do not vote to approve the deal.
- further, shares in the SPAC would be suspended from trading once an acquisition target has been identified until a deal prospectus is published, meaning that an investor that is unhappy with the proposed target cannot simply sell up.
There is a possibility that, going forward, we will see some change in the regulatory regime relevant to SPACs. Lord Hill published his Listing Review on 3 March 2021. The aim of the review was to look at the Listing Rules with a view to strengthening the UK’s capital markets and ensuring that London remains an attractive place to invest in light of Brexit. Lord Hill noted the danger that the UK is not perceived as a viable location to list a SPAC transaction and has recommended removal of the FCA rule outlined above requiring a presumption of suspension of trading. The Government has indicated that it will consider the recommendations in the report. The FCA has stated in response that it will be consulting on changes to the Listing Rules applying to SPACs shortly, aiming to make any changes to rules and guidance by early summer.
It is therefore possible that, if these changes go ahead, we will see the SPAC transaction gain popularity in the UK. Other European countries such as the Netherlands are also seeing increased interest in SPACs. Amsterdam has already seen an increase in share-trading since Brexit, and its flexible listing rules may be attractive for future SPACs.
The UK is generally speaking a less litigious environment than the US. However, having said that, we are starting to see a mobilisation of claimants in class-action type claims in the UK, often with the backing of litigation funders and driven by claimant law firms. There have been several examples of high profile multiple shareholder actions in recent years. In addition, as already set out, it is harder for a UK investor (at present) to remove itself from the transaction, and this has the potential to lead to more disgruntled claimants.
Directors in the UK may face similar types of claims as in the US. There may be liability in connection with the prospectus issued in relation to the original SPAC IPO, or in relation to the re-admission documents. Claims can be brought under section 90 Financial Services and Markets Act 2000 (FSMA) by shareholders who suffer loss as a result of any untrue or misleading statement or omission of any matter in a prospectus or listing particulars. It is not necessary for a shareholder bringing such a claim to establish any reliance on the statement or omission2. Section 90A allows shareholders to bring a claim where they have suffered loss as a result of untrue or misleading statements made knowingly or recklessly, or dishonest omissions from, company announcements and other publications. It is also of course possible that directors could face claims for breach of fiduciary duty, for example for failure to identify an appropriate target, or in connection with the due diligence carried out, or a failure to fulfil the promises contained in a SPAC fundraising document.
The rise of SPACs in the US has led to a significant increase in demand for specialised D&O insurance. Market commentators have reported that insurers are seeking to limit their exposure in this relatively unknown market and that premiums are increasing exponentially. In some circumstances, premiums are reported to have risen fivefold over the past year. An increase in class action lawsuits, and related insurance claims, alongside an increase in demand -as SPACs become more popular - will likely increase pressure on premiums further.
SPACs and their management will wish to ensure they have adequate cover throughout the SPAC lifecycle, from the initial IPO, through to the acquisition of the target company and including the post-merger operations. Careful navigation may be required of the policy wordings and design of a programme to obtain adequate coverage for the different stakeholders throughout the SPAC journey, with consideration perhaps being warranted to separate policies and/or sub-limits that are ring-fenced for the protection of particular parties.
In underwriting such risks, as with the assessment of any D&O or POSI (public offering or prospectus liability) risks, key issues for Insurers to consider and scrutinise will be the quality and experience of the SPAC’s management team, as well as the professional advisers assisting in each step of the process, the record of the SPAC sponsor, the litigation environment of the jurisdiction of the SPAC, and the sector/industry in which they intend to select their target and the due diligence and vetting process that is applied, as well as, or course, the offering size. Concentration risk may also become an increasingly relevant factor where insurers already have a material exposure to SPACs in a particular sector or industry.
Where separate policies are implemented to build up a continuity of coverage, careful consideration will need to be given to the triggers for coverage under each policy, the possibility of double insurance and the "tie-in" of any applicable retention or limits of indemnity if the policies are intended to be interactive with one another in this way. Those with experience of providing POSI insurance alongside D&O insurance will be well aware of the challenges of aligning several products with potentially overlapping coverage seamlessly.
1 In Lord Hill’s report on the Listing Rules
2 Note that reliance is not an express requirement of s90 FSMA, however, the issue has not been tested in court.