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Article | Executive Pay Memo North America

SPAC sponsors: Why D&O Coverage is critical

ABCs of SPACs, Part III

Executive Compensation|Mergers and Acquisitions
Mergers and Acquisitions

By Nirali V. Shah , John M. Orr , Josephine Gartrell , Heather Marshall , Robert Hermenze and Shannon Williams | April 21, 2021

D&O insurance is often a secondary consideration for SPAC sponsors but more focus is warranted.

The main purpose of a special purpose acquisition company (SPAC) is to identify a target company it can acquire or merge with, resulting in the target becoming a public company. At closing of the transaction, SPAC shareholders have the ability to “cash out” their investments or retain their shares and utilize warrants to obtain ownership in the newly formed company. SPAC sponsors and founders generally receive a pre-negotiated ownership stake in the newly formed public company. In addition, with the rise in popularity of private investment in public equity (PIPE) financing, new equity owners may be brought into the mix at the time of transaction.

The first article in this ABCs of SPACs series explained what a SPAC is as well as some of the common terminology associated with SPACs. The second article identified a few of the considerations that are particular to companies merging with a SPAC, the de-SPACing process and how SPAC transactions differ from traditional IPOs. This article switches to an often overlooked gating item to SPAC formation — namely, how critical it is that public companies carry directors’ and officers’ liability insurance (D&O insurance).

Public company D&O insurance protects executives from liabilities arising out of violations of securities laws, shareholder class actions and derivative cases. D&O insurance will help pay for defense costs, settlements and other liabilities as prescribed within the policy terms. In addition, D&O insurance may provide coverage when insured persons are not indemnified by the organization, thus providing a last line of defense in the protection of individuals’ personal assets.

The public lifecycle of a SPAC starts with the filing of a Form S-1. The entity then prices its public equity offering and lists on a public exchange. Like all other publicly traded companies, the SPAC entity and its directors and officers are subject to securities laws, such as the Securities and Exchange Acts of 1933 and 1934. Unlike private entities going through a traditional IPO, and because a SPAC does not have an operating entity, no D&O coverage typically exists at the time a SPAC files an S-1. As such, it is important that SPAC founders consider D&O coverage during the formation process in order to cover potential liabilities arising out of potential violations of securities laws. While D&O coverage is not generally incepted until the SPAC is pricing its offering, coverage should encompass all prior activities undertaken in formation.

SPAC sponsors are often surprised to find out that the cost of D&O insurance can be quite high and the market is subject to significant volatility. Many factors contribute to D&O underwriters’ risk perception, but there may be several factors which can help give underwriters more assurance about a particular SPAC offering. These factors include (but are not limited to):

  • The SPAC sponsor and management team: Underwriters consider whether the team that makes up the SPAC has the depth and breadth of expertise to identify a target, enact a transaction (“de-SPAC”), and expertise specific to the industries being targeted. Because D&O underwriters have little to base their risk perception of a SPAC upon, highlighting the experience and quality of a SPAC management team is critically important.
  • The warrant structure: A SPAC unit usually consists of one share of common stock and some portion of a warrant, which can be utilized to purchase additional shares of the SPAC at a certain exercise price. Warrants not exercised will typically convert into a portion of equity of the post de-SPAC company, though this conversion may not always be automatic. Depending on the structure of the warrants, the fraction may differ, or, in certain cases, no warrant may be offered at all. They are also typically out of the money, meaning that the exercise price of the warrant (e.g. $11.50) is higher than the typical offering price of a SPAC common stock share (e.g. $10). The Securities Exchange Commission (SEC) has recently issued statements regarding the proper accounting of warrants. D&O underwriters may scrutinize not only the structure and terms of warrants, but also adherence to the SEC’s guidelines and requirements for proper disclosure and accounting.
  • Target Industry: Another important risk factor is the target industry or industries potentially identified by the SPAC. D&O underwriters may consider certain industries higher risk than others. While there may be limitations on reducing risk in this category, SPAC sponsors and management teams should be aware of the impact industry may have on perceived D&O risk.

Proper planning regarding D&O insurance can save SPACs time, money, exposure to liability and general hassle. Partnering with a trusted D&O broker will maximize efficiency and minimize cost for a SPAC’s D&O purchase. Expert D&O brokers should also scrutinize proposed policy forms and negotiate appropriate coverage enhancements to ensure the policy is as responsive as possible should a claim be asserted.

Make sure your SPAC is protected — don’t forget the D&O!

Authors

U.S. IPO Leader
FINEX North America

D&O Liability Product Leader
FINEX North America

Director, Executive Compensation (San Francisco)

Senior Director, Executive Compensation (New York)

Analyst, Rewards (New York)

Analyst, Executive Compensation (New York)

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