In the early days of the covid-19 pandemic, investors were drawn to special purpose acquisitions. As these vehicles appeared to offer a faster, safer valuation for private companies to go public — the “targets” of the deals — the SPAC trend for IPOs increased significantly in 2020 and 2021.
SPACs are limited-life companies that are established solely to effectuate a merger. Also known as “blank check” companies, they attracted investors looking to more easily tap the capital markets to invest in potentially high-growth companies. In 2021, however, the value of several companies that went public through SPACs fell after, among other things, they failed to meet their growth forecasts and the market cooled.
But just as the traditional IPO process raises the prospect of new risk for the newly public company and associated federal securities litigation brought by its investors, so do SPAC-related IPOs. Because any lawsuit is likely to be accompanied by a claim filed with the SPAC̵
7;s directors’ liability insurer, these investment vehicles represent significant exposure for both SPAC investors and D&O insurers.Here we look at the types of allegations likely to arise and some recent examples.
SPAC-Related Disputes
As of the end of last year, 393 SPAC merger transactions, or de-SPACs, had closed since 2019. During that period, there were 64 federal SPAC lawsuits, representing a 16% litigation rate. An annual breakdown of the trial rate reveals a sharp upward trajectory: 8% for 2019-2020, 17% in 2021 and 24% in 2022.
Litigation will continue to rise because there is an average lag of nine months between the de-SPAC transaction and the filing date of litigation. Accordingly, additional litigation related to these 393 SPAC mergers is expected to continue this year and possibly beyond.
Accusations in recent trials
The allegations in the 64 federal SPAC lawsuits include the following:
- Violations of Sections 10b, 11 and 14 of the Securities Rules: Allegations relating to a) fraud; b) hold officers liable for untrue facts or material omissions in registration statements relating to the original SPAC formation or de-SPAC; and c) claims that investors were not fully informed when they were asked to vote their shares.
- Breach of Fiduciary Duty: Allegations that the SPAC structure creates an inherent conflict of interest between the SPAC sponsor and its board of directors with the SPAC’s investors.
- Allegations that the offering documents contained untrue facts and that the SPAC sponsors made false or misleading statements with insufficient disclosures about the risks facing the target.
- Lawsuits by stockholders: Allegations of injury to the SPAC from false statements made by its directors and officers and serious breaches of fiduciary duties.
There was a notable development in SPAC litigation in January when the Delaware Chancery Court denied a motion to dismiss filed by the defendants in a class action alleging that the directors and sponsors of a SPAC breached their fiduciary duties to the SPAC’s shareholders. This is an indication that lawsuits of this nature will move forward.
Struggle to find fusion targets
Additional disputes may arise from SPACs looking for merger partners.
A SPAC has 24 months to find a merger target; if it does not, the sponsors must liquidate it and return the funds to the investors. When liquidation occurs, the SPAC sponsors may lose their initial investment. Thus, the demand for a SPAC merger partner can become rampant as the 24-month deadline approaches, as the absence of a target can lead to significant financial consequences for the SPAC sponsors.
Accordingly, some SPACs may feel pressure to do whatever they need to do to complete a merger transaction. Mergers conducted primarily to avoid the potential financial consequences of a liquidation without a comprehensive due diligence process may expose the SPAC to litigation.
According to The Wall Street Journal, 280 SPACs faced deadlines in the first quarter of this year. Citing industry analysts, the article noted that “many SPACs are likely to liquidate.” The poor post-merger performance of many de-SPACs has made it difficult for SPAC sponsors and merger target managers “to convince companies to merge with SPACs,” the article said.
Additionally, in 2022, at least two lawsuits were filed against SPAC sponsors related to their liquidation plans. In one case, SPAC investors filed a lawsuit challenging the manner in which the SPAC’s directors and officers intended to handle a financial asset in the SPAC in connection with the liquidation.
Legal and regulatory review
The US Securities and Exchange Commission, the Financial Industry Regulatory Authority and the US Department of Justice will likely continue to focus on the SPAC market. In 2021, they brought several enforcement and investigative actions against the SPAC, SPAC sponsors, and the target’s directors and officers.
These are not trivial actions. In December 2021, the SEC announced that Nikola Corp., a publicly traded company created through a SPAC transaction, agreed to pay $125 million to settle allegations that it defrauded investors by misleading them about its products, technological advances and commercial future prospects.
In March 2022, the SEC issued proposed rules protecting SPAC investors, which could make it easier for investors to be awarded damages and thereby increase the number of federal lawsuits against SPAC sponsors.
The way ahead
The sharp increase in SPAC-related lawsuits and improved regulation materially diminish the appeal of a SPAC as an investment vehicle.
Further, with the recent Delaware Superior Court ruling that a SPAC’s post-merger runoff policy provides coverage for the defense fees of former directors in the premerger suit for alleged wrongdoing, courts have interpreted D&O insurance coverage far beyond what was intended when the policies were priced .
Consequently, as SPACs fall out of favor with investors, the filing and resolution of SPAC-related claims and associated D&O liability will be here for years to come.
Joy Schwartzman and Anthony Pinello are consulting actuaries with Milliman Inc. Ms. Schwartzman can be reached at joy.schwartzman@milliman.com and Mr. Pinello can be reached at anthony.pinello@milliman.com
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