Assessing The SPAC Risk Landscape
SPACs have had an eventful and tumultuous year. The undeniable momentum that has recently quelled will likely stabilize with time but the SPAC roller coaster has definitely entered its next apex with the obsession seemingly shifting from investors to regulators, plaintiff firms, and short sellers. As the overwhelming majority of SPACs appear to be underperforming, trading below their IPO price of $10, there has been considerable speculation over an impending wave of shareholder litigation. Many experts also believe SPACs, operating within ambiguous regulations, filing potentially lofty financial projections, and riddled with potential conflicts of interest, may be low hanging fruit for litigation and enforcement actions. There also seem to be some signals that activists are on the rise. In addition to short sellers increasingly targeting SPACs, plaintiff’s firms are also reportedly forming dedicated SPAC task forces. By taking aim on the directors/officers and alleging mis-management and breaches of fiduciary duties, these activist campaigns can result in hostile takeovers and shareholder litigation. While the litigation environment is as complex as the transactions themselves, much of the risks facing SPACs tend to revolve around the following:
Accounting and Misleading Projections: One of the main allures to SPACs lies in their required filings and disclosures. Since de-SPAC transactions have generally not been viewed as traditional IPOs, they have been able to expedite the IPO process with fewer disclosures and historically rely on the PSLRA’s safe harbor provision for forward looking statements when filing financial projections. However many experts are concerned that this approach may be incorrect and may ultimately result in misleading projections. The SEC has recently addressed this concern reminding SPACs that reliance on the PSLRA is “uncertain at best”, further citing “the PSLRA excludes from its safe harbor “initial public offerings,” and that phrase may include de-SPAC transactions”. Accordingly, SPACs that incorrectly rely the safe harbor provision moving forward may ultimately be welcoming regulatory actions and securities litigation. Additionally a recent SEC statement has also addressed the accounting treatment of warrants. When preparing financial statements, SPAC warrants were historically classified as equity, however per the newly released SEC guidance, warrants may need to be re-classified as a liability. In addition to creating potential delays for current transactions, this will also result in increased regulatory scrutiny and required financial restatements which may result in shareholder litigation. The recent shareholder complaint against Virgin Galactic appears to be the first of such lawsuits.
Inadequate Due Diligence and Inadequate Disclosures: A significant amount of litigation has also arisen from inadequate disclosures and inadequate due diligence when underwriting the target company’s financials, and operations/controls during the de-spac process. Failing to disclose material information such as special relationships, management issues, known product quality issues, legal risks, declining user base, internal compliance failures, and/or losses of large clients will also continue to drive shareholder litigation and regulatory actions against both the target company, SPAC sponsor, and their respective directors. The following cases are demonstrative of the risks involved with litigation alleging inadequate due diligence:
- Pittman V Immunovant: HSAC (a SPAC) entered into a purchase agreement with Immunovant Sciences, a biopharma company, with the new post-merger public company becoming Immunovant Inc. Following a stock drop instigated by the announcement of a paused clinical trial, shareholders filed a class action lawsuit against Immunovant and certain executives, alleging the securities’ purchase price was artificially inflated. Particularly the plaintiffs alleged Immunovant performed inadequate due diligence and failed to disclose certain product safety issues resulting in false and misleading statements.
- Cambridge/Ability: Following the merger of Cambridge Acquisition (the SPAC) and Ability Computer & Software, a cell technology company, investors of Cambridge Capital suffered large losses resulting from fraudulent statements made by 2 of Ability’s CEOs that misled investors regarding their “game changing technology” and nonexistent large product orders. In response, the SEC was quick to file charges against Ability and its 2 executives in question, alleging they collectively defrauded the SPAC’s shareholders. In a separate action however, the SEC also filed charges against Benjamin Gordon (the CEO of the special purpose acquisition company “Cambridge Capital”), citing Gordon “negligently failed to take reasonable steps and conduct appropriate due diligence to ensure that Cambridge shareholders voting on the merger were provided with material and accurate information concerning Ability's business prospects”
- VectoIQ/Nikola: In March of 2020, VectoIQ Acquisition Corp, a SPAC led by former GM execs, acquired electric auto manufacturer Nikola. Roughly 6 months after the acquisition, a short seller issued a report citing their belief that Nikola was a “complex fraud”. Following the report, a number of investigations and lawsuits were filed against the new “pubco”. One of the lawsuits in particular included the CEO of VectoIQ as a defendant, alleging (among other wrongdoings) that VectoIQ falsely represented the due diligence involved with selecting Nikola as their target, effectively allowing Nikola to make a series of overstatements regarding their design, manufacturing and production capabilities resulting in false/misleading public statements.
Conflicts of interest: One of the inherent risks posed by SPACs is the conflict of interest that exists between the interest of the shareholders and that of the SPAC sponsor. The financial incentive for the SPAC sponsor to consummate a deal (in a relatively short window of 12-24 months) may ultimately result in a sponsor entering into a transaction that may not be in the best financial interest of the shareholders. This was recently illustrated in the 2021 case against Acamar Parters Acquisitions Corp in which the shareholders alleged the SPAC executives/managers lacked independence and breached their fiduciary duties by; entering into an unfavorable deal at the last minute and promising a number of the SPAC managers executive appointments on the board of the new public company. Only a month later similar litigation was filed against Mutliplan Corp (a post-merger public company) and certain directors/officers, when shareholders of the SPAC alleged its sponsors ignored multiple financial “red flags” and made absent or misleading disclosures, in order to consummate a deal that solely benefited them, through their collection of fees and ownership of discounted stock. Specifically, the lawsuit alleges the SPAC failed to mention the loss of a large customer, ultimately resulting in a gross overpayment for the acquisition.
Post IPO Claims: In addition to potential merger objection litigation, the new public company is subject to all of the standard public company risks, including securities claims and stock drop litigation, increasing derivative litigation, regulatory enforcement actions and potential for bankruptcy proceedings (among others). Following the Cyan ruling however, the newly public company should also be aware of the potential for parallel litigation in both state and federal courts which can ultimately result in more costly section 11 litigation.
Given this environment, it’s understandable that D&O insurance is a costly necessity for SPACs. As we discuss here, placing D&O insurance for these transactions is also a complex exercise with seemingly endless structuring options. When assessing associated risk on a more micro level, there are certain factors that can create an increased likelihood of litigation and challenges when attempting to secure D&O coverage. For example, foreign domiciled SPACs and those targeting high risk industries such as companies involved with crypto or cannabis are more likely to encounter litigation as well as a considerably narrower insurance market (often limited to 1 or 2 carriers) with higher premiums. This is in contrast to their US domiciled counterparts and those targeting more stable industries such as the technology or energy sectors which will benefit from a wider market with lower premiums.
Due to the potential for due diligence failures to generate shareholder claims, when applying for D&O insurance, insurers will carefully underwrite the SPACs acquisition strategy. The more detailed the acquisition strategy, the better. Is the SPAC looking at US companies only or considering foreign companies? Will the target company be revenue generating or pre-revenue? What other metrics will be utilized when ultimately deciding on one target over another? How were these metrics decided upon? What is the anticipated timeline for the acquisition? A clearly defined, well established, risk managed strategy will be extremely helpful in opening the market and ultimately obtaining more favorable pricing. Insurers will also require clarity surrounding the SPAC’s due diligence process when underwriting the target company’s financials, operations, compliance, and any potential conflicts of interests. Lastly, an experienced sponsor and strong advisors can significantly ease risk concerns. Sponsors and advisors that have previous experience and proven track records in the SPAC space can be extremely valuable in easing the insurance underwriting process, resulting in lower premiums and broader policy terms & conditions.