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Targeting SPACs

Increased SEC focus on special purpose acquisition companies has implications for D&O insurers

December 07, 2021 Photo

Special purpose acquisition companies (SPACs) are surging. Between 2011 and 2019, there were between nine and 59 SPAC initial public offerings (IPOs) each year. Fast forward to 2020, where there were 248 SPAC IPOs. Through the first nine months of 2021, there were 439 SPAC IPOs—63% of all U.S. IPOs—that collectively raised $126 billion.

So what is a SPAC and why are they suddenly so popular? A SPAC is a company that is formed through an IPO for the purpose of acquiring an existing company within a certain time period. If a target company is not identified within the time period, then the money is returned to investors. SPACs are often referred to as “blank check” companies because the IPO does not identify a particular target company (though it may identify a particular segment of the economy). SPACs offer a mechanism for a private company to go public at a negotiated M&A valuation while avoiding the expensive underwriting costs and fees of traditional IPOs.

As SPAC offerings have surged in the past two years, so has the Securities and Exchange Commission’s (SEC) scrutiny of SPACs. This article discusses the increased focus by the SEC on SPACs and addresses the potential implications for D&O insurers.

Increased SEC Scrutiny

The SPAC process is not risk-free for investors, and there has been increased private litigation in addition to the attention from the SEC. This focus has been highlighted by the following:

•    On April 8, 2021, the SEC’s director of the division of corporate finance announced that the staff at the SEC was “continuing to look carefully at filings and disclosures by SPACs and their private targets,” and that “[t]hey will continue to be vigilant about SPACs and private target disclosures.” The announcement discussed the SPAC process in detail in order to “focus on legal liability that attaches to disclosures” in these transactions. It specifically discussed various ways that aspects of the SPAC process may trigger liability under the securities laws.

•    On April 12, 2021, the SEC’s director of the division of corporate finance and its chief accountant issued a statement addressing the accounting implications of certain types of warrants in connection with transactions. SPACs frequently issue warrants to their founders as well as to initial investors in the SPAC IPOs. The SEC statement explained that, while such warrants have generally been classified as equity instruments, in many cases the warrants are more appropriately classified as liabilities. This may require restatements for existing SPACs as well as different accounting treatment of warrants in the future.

•    On July 13, 2021, the SEC announced its first enforcement action involving a SPAC when it reported that it was bringing charges against Stable Road Acquisition Company, its sponsor, and its CEO—as well as the merger target Momentus Inc. and its CEO—for misleading statements about the transaction. The SEC announced that it had settled with most of the parties for $8 million in penalties as well as forfeiture of the founder’s shares, and that it had filed a complaint against the target company’s CEO. In announcing the action, SEC Chair Gary Gensler stated, “This case illustrates risks inherent to SPAC transactions, as those who stand to earn significant profits from a SPAC merger may conduct inadequate due diligence and mislead investors.”

•    On Sept. 9, 2021, Gensler delivered remarks to the investor advisory committee that acknowledged the commission could do more to strengthen SEC disclosures. Significantly, Gensler stated that he was directing SEC staff to evaluate investor protection at all stages of the SPAC process and to make rulemaking regulations “to elicit enhanced disclosures and conduct economic analysis to better understand how investors are advantaged or disadvantaged by SPAC transactions.” This statement was similar to testimony that Gensler delivered on May 26, 2021, to a congressional subcommittee of the House Committee on Financial Services regarding potential risks associated with SPAC transactions.

Implications of SEC Scrutiny

The SEC’s attention to SPACs has a number of implications for the insurance market, particularly for D&O insurers. First, the SEC has indicated that it intends to bring more enforcement actions involving SPACs. While it brought the first such action in July 2021, the surge of SPACs has only taken place in the past two years, which likely creates a time delay in such actions. When the SEC brings an enforcement action, the action will likely be expensive to defend. The enforcement action can also provide a road map for private litigants to bring litigation, as well. Thus, erosion of D&O towers for these parties—potentially the towers for the SPAC, the target company, and the go-forward company—is likely to be substantial.

Second, the SEC is expressly signaling an interest in further rulemaking about SPACs, as they have become a significant part of the IPO market. While the agency has not announced any proposed rules, it will likely impose additional reporting and accounting requirements on SPACs. The costs incurred to comply with these rules are not covered under D&O policies. However, legal fees incurred for investigations, enforcement actions, and litigation over the failure to comply with the requirements will create risks for which insureds may seek coverage.

Finally, we note that this focus may simply be mirroring actions already coming from the plaintiffs’ securities bar. In the first six months of 2021, there were 15 securities class-action suits brought against SPACs, compared with five in all of 2020 and two in 2019. On April 1, 2021, Robbins Geller Rudman & Dowd, one of the leading plaintiffs’ class-action firms, announced that it had formed a SPAC taskforce that “includes an experienced group of litigators and in-house investigators, forensic accountants, and economists dedicated to rooting out and prosecuting fraud on behalf of injured blank check company investors.”

The SEC is moving quickly in response to the SPAC surge over the past two years. Its statements and focus suggest a wave of rules and enforcement scrutiny is on the horizon, which will almost certainly impact the D&O insurance industry.

About The Authors
Multiple Contributors
Steven Carabases

Steven Carabases is global head of financial line claims at Hartford Global Specialty. steven.carabases@thehartford.com

Patrick Maloney

Patrick Maloney is a senior claims consultant at Hartford Global Specialty. patrick.maloney@thehartford.com

David Topol

David Topol is a partner at Wiley LLP.  dtopol@wiley.law

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