Do SPACs have a fiduciary duty to consider utilizing R&W insurance in their de-SPAC transactions?

Introduction

A renaissance is underway in the use of special purpose acquisition companies (a “SPAC”), the popularity of which has soared in 2020. According to Pitchbook, as of September 23, 2020, there have already been 104 SPAC registrations, compared to 46 in all of 2019. At the same time, the use of representations and warranties insurance (“RWI”) has become a nearly regular component of private M&A transactions. Yet while these two trends may seem complementary, the use of RWI is relatively uncommon in de-SPAC transactions (i.e., the acquisition of a target company by the SPAC). While certain nuances to de-SPAC transactions may complicate the use of RWI, such issues can be overcome (practically and commercially) with the resulting RWI coverage providing a significant financial protection for the shareholders of the SPAC. Additionally, the process of obtaining non-binding RWI coverage terms to evaluate the potential use of RWI is cost-free. Taking these facts into consideration, the question arises: are many SPAC boards and managers unintentionally disregarding certain of their fiduciary obligations if RWI is not considered in connection with a de-SPAC transaction? The short answer is: probably not. However considering the benefits and minimal downside, questioning whether or not RWI should be used in a de‑SPAC transaction may need to become part of a responsible director’s playbook.

Benefits of Using RWI in a De-SPAC

The strategic decisions made by directors of Delaware corporations are typically accorded the protection of the business judgment rule, which “is a presumption that in making a business decision, the directors of a corporation acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the company.” (Aronson v. Lewis, 473 A.2d 805 (Del. 1984)). Except in cases where there was a failure to act in good faith, the business judgment rule will generally excuse directors who were not “grossly negligent” in informing themselves of relevant information. Although this is a very difficult standard to meet, can a SPAC’s board of directors consider themselves properly ‘informed’ if RWI is not evaluated? Particularly with SPACs, where the purpose of the company is to consummate an acquisition, are directors really fulfilling their fiduciary duties if they have not even considered the use of RWI? In answering these questions, it is important to examine the potential benefits of using RWI in a de-SPAC transaction.  

Recourse for Loss. Most de-SPAC transactions are public-style acquisitions without seller indemnification of buyer (“NSI”). According to Deal Point Data, 70 out of 94 de-SPAC transactions in the last two years had no seller indemnity.  Therefore, in the event of a post-Closing loss incurred by buyer as a result of a breach of seller’s representations, buyer generally has no recourse to seller to recover for such a loss. RWI can, and often does, mitigate this risk when used in NSI transactions. 

Shareholder Lawsuits. Although SPACs have not been involved in much litigation as compared to traditional IPOs, since SPACs are publicly listed companies, a SPAC’s directors and officers are just as susceptible to shareholder lawsuits as their traditional public company counterparts. The accelerated timeline of de-SPAC may also increase the potential risk to directors and officers if there are losses incurred at the target. RWI can help mitigate this risk by providing coverage for any losses that arise out of a breach of a representation or warranty, which in turn demonstrates directors’ attention to equity value for shareholders post-Closing.  While historically there has not been much litigation by SPAC shareholders, the SEC recently announced that it will be taking a closer look at SPACs and the incentives of SPAC founders,[1] and with the increasing popularity of SPACs, litigation is all but inevitable.    

Competition & Timing.  In the current environment, there is a huge amount of SPAC capital being raised and a limited number of attractive deployment opportunities. Different SPACs are often competing for the same set of acquisition targets, and many SPAC founders are very familiar with the use of RWI insurance. In addition, a target may be simultaneously considering an IPO, which would not require sellers to provide any post-closing indemnity. SPACs that are unwilling to offer sellers a clean exit may be viewed as less competitive in these contexts. This concern is heightened when taking into account the fact that a SPAC is typically required to complete an acquisition within 18-24 months after it goes public. If this timeline is not met, the SPAC is dissolved and all funds are returned to its investors. The use of RWI polices provides a way to potentially increase the competitiveness and therefore success rate of a de-SPAC, simultaneously reducing the risk of potential bad faith claims by SPAC shareholders relating to failed bids. 

Relationships with Management. One of the key benefits of using RWI in the traditional M&A context is that it avoids situations in which buyers must sue a target’s management team after closing due to a breach of a representation or warranty. In a SPAC transaction, the management structure at the target company will usually remain in place following the de-SPAC.  By utilizing M&A insurance, the buyer can bring a claim directly against an insurer rather than needing to initiate a potentially adversarial and distracting process with management or other rollover sellers.

Reputation. The use of RWI policies provides a way to streamline and make more appealing many aspects of SPAC transactions. Given that SPAC management teams typically go through several IPO and acquisition phases, the reputation of the team for future SPAC transactions is paramount.  RWI policies help to burnish the credentials of the SPAC management team and highlights the management team’s ability to guide such transactions across the finish line. 

Key Considerations

As demonstrated above, the use of RWI can have numerous benefits in a de-SPAC transaction. Despite these benefits, the use of RWI by SPACs is still not commonplace and certainly not as widely used as in general private M&A transactions. Part of this may be attributable to the fact that many of the advisors involved in de-SPAC transactions are public M&A practitioners that are not as familiar with RWI and how it can facilitate transactions. While there is no single explanation to the reluctance of SPACs embracing RWI, there are a number of considerations/hurdles that SPACs may face that have traditionally served as a deterrent. 

Buyer Due Diligence. Fulsome buyer diligence is key to the successful placement of RWI policies universally, and de-SPAC transactions are no exception, as insurers will still need to engage in their typical underwriting process. Underwriters require thorough buyer diligence to validate the reps they are being asked to cover in addition to thoughtfully populated seller disclosure schedules. Cost-wary SPAC managers may be reluctant to commissioning (and incurring the expense of) full scale diligence work product, however RWI insurers need that diligence work product for their files in order to underwrite the risk.

Post-Closing Equity. Another key consideration when using RWI in the de-SPAC context is the percentage of post-closing equity that will be owned by the SPAC. If seller parties will own a substantial equity stake in the target after the de-SPAC, RWI insurers face the moral hazard issue of insuring a seller for a large portion of losses that occurred under seller’s ownership. As a result, in such scenarios the RWI insurer may pro-rate losses and associated policy payments by the percentage of this ownership interest, which in turn makes the use of RWI much less attractive. In addition, many SPACs are structured such that (i) the SPAC will buy a minority stake in the target, (ii) there is a private investment in public equity (a “PIPE”) component in which investment firms, mutual funds and other large accredited investors obtain a stake, and (iii) then the rest of the stock is owned by public shareholders. When structured this way, the RWI policy will also have this co-insurance component whereby losses and policy payments are pro-rated based on the SPAC’s ownership interest. While the exact breakdown of post-Closing equity may not be known in the early stages of the de-SPAC, having a general understanding of who the major post-Closing shareholders are intended to be can be a critical factor in deciding whether or not the use of RWI is commercially palatable.

Policy Costs. Budget considerations prohibit a SPAC from incurring unnecessary and irrecoverable costs before the closing of the de-SPAC transaction. As there is no cost to obtaining initial non-binding RWI terms from insurers, a SPAC can begin to navigate possible RWI options without incurring any out of pocket expenses.  In order to begin underwriting, however, a SPAC would need to commit to a nominal $25,000 to $40,000 underwriting fee, which is the cost of the insurer engaging outside counsel to help them underwrite the transaction (larger RWI policies (>$50M in limit) that include excess insurers would also require an additional $5,000 for each excess insurer participating in the coverage). When the de-SPAC transaction signs and the RWI policy is bound, the SPAC is typically required to pay a 10% deposit on the insurance premium to secure the coverage. Although a SPAC may be hesitant to incur this pre-closing cost, it is not unlike advisor fees and other non-refundable expenses that a SPAC unavoidably incurs pre-close. Oftentimes this 10% deposit payment is a cost beyond the payment capacity of the SPAC pre-Closing, however this can always be discussed with the prospective RWI carrier(s) in considering innovative ways to address this concern. While traditionally it is best practice to bind RWI coverage at signing, it is not unusual to put the RWI coverage in place at Closing, with the RWI underwriting process completed in advance. With this approach the only direct cost incurred up until Closing would be the underwriting fee. 

Timeline. The process for putting a RWI policy into place can move quickly, in sync with deal timelines. The first step is to obtain initial non-binding RWI terms from insurers, which typically takes two to three business days. In order to obtain terms, buyer would need to provide the RWI broker with (i) the draft purchase agreement, (ii) target financials and (iii) a deal book or target overview. The RWI broker would then prepare a summary of all quotes obtained from markets and review the terms with buyer and buyer’s counsel in order to select an insurer. The next step is to begin the underwriting process, which generally takes place within the one to two week period before the anticipated transaction signing date. Buyer would provide the insurer with all diligence reports and the latest drafts of the transaction agreement and disclosure schedules, insurer would schedule an underwriting call with buyer and buyer’s advisors at least one business day after receiving these materials. Following the underwriting call, the insurer would provide a list of any follow-up underwriting questions and a draft RWI policy. The timing for finalizing underwriting is tied to due diligence and deal negotiations being finalized and can take one to three business days, though insurers can move more quickly if necessary. RWI policy negotiations would also take place during this time.      

Conclusion

There are clearly a number of attractive features to the use of RWI in de-SPAC transactions. For one, they provide an improved indemnity structure and mechanism for recourse in situations where none previously existed, allowing SPAC directors and officers to mitigate the risk of post-Closing losses for investors. Given the significant increase in volume of SPAC transactions, the corresponding increase in shareholder litigation is inevitable, and the use of RWI would only strengthen directors’ position of having acted for the benefit of the shareholders. There are also challenges with using RWI policies in the context of SPAC transactions, but many of the hurdles are not unlike those that have been encountered in traditional M&A transactions. Fulsome buyer diligence will continue to be important to obtaining optimal coverage under the policy. Understanding post-closing equity will be important in ascertaining whether an insurer will pro-rate losses. Strategic timing and availability of funding will also play a key role. Yet despite the obstacles, the protection offered by RWI in the event of a post-Closing loss would outweigh all other considerations.  

With respect to de-SPAC transactions, given (i) the various potential benefits of using RWI, (ii) the surmountable nature of the hurdles that RWI typically poses, and (iii) the ability to obtain specific non-binding RWI coverage terms from insurers at no cost, it’s not unreasonable to ask whether a board of directors of a SPAC is acting ‘on an informed basis’ if they are not at least considering the use of RWI in their de-SPAC transaction. Practically speaking any such argument brought against a SPAC’s board would likely be rejected at the outset (and we certainly don’t want this article to provide additional angles for some unscrupulous plaintiff’s attorneys), however, given the minimal effort needed for evaluation of RWI and all the other benefits and considerations discussed, it may be time to add ‘consider the use of RWI’ to every de-SPAC acquisition checklist.

[1] See https://www.cnbc.com/video/2020/09/24/sec-chairman-jay-clayton-on-disclosure-concerns-surround-going-public-through-a-spac.html.