A special purpose acquisition corporation, commonly known as a 'SPAC,' is a corporation formed for the purpose of raising capital through an initial public offering ('IPO') of its securities in order to fund an acquisition of an existing operating company or companies, often in a particular industry, sector or geographical area.1After an approximately 10-year drought, SPACs reemerged on the IPO market in 2003 and their prevalence among IPOs has increased dramatically since 2005.2In preparing for the IPO, one critical prerequisite is to obtain directors and officers ('D&O') liability insurance, to become effective on the closing of the offering. Given the unique structure of a SPAC, however, several coverage issues need to be thoughtfully considered prior to the purchase of a D&O insurance policy. This article will briefly describe these coverage issues and suggest considerations for potential issuers when obtaining D&O insurance.
D&O Insurance - Background
D&O insurance is purchased primarily to cover claims brought against the directors, officers and/or the corporation alleging violations of the Securities Act of 1933, as amended (the '1933 Act') and/or the Securities Exchange Act of 1934, as amended (the '1934 Act').3 Such claims typically seek damages in the form of a rescission of the sale of the security (i.e., the investor recoups his purchase price plus interest) or monetary damages measured as the difference between the 'inflated' value of the stock (resulting from the issuers' fraud or material misstatement) and the 'true' value of the stock (i.e., what the value would have been absent such fraud or material misstatement).
D&O insurance typically covers:
• Claims against the directors and officers alleging a wrongful act, such as breach of duty, neglect, error, omission, misstatement or misleading statement (known as insuring agreement Side A);
• Losses incurred by the entity as a result of the entity's responsibility to indemnify a director or officer for a wrongful act, as defined above (known as insuring agreement Side B); and
• Securities claims against the entity (known as insuring agreement Side C).
Accordingly, D&O insurance is designed to protect the personal assets of the directors and officers (through Side A), the entity for its obligations to indemnify the directors and officers (as is typically required by the company's by-laws and state corporation laws) (through Side B) and the corporation's assets from securities claims (through Side C).
SPAC Structure And Possible Liability Events
Virtually all SPACs provide in their charters that the company must consummate a business combination no later than 18 months after completion of the IPO (or within 24 months after such closing, if a letter of intent, agreement in principle or definitive agreement (collectively, an 'LOI') has been executed within such 18-month period and the business combination relating thereto has not been consummated within such 18-month period). The period between completing the IPO and consummating the initial business combination (the 'IBC') includes several distinct processes and events from which possible claims can arise, including:
• The registration statement and offering process;
• Post-offering and pre-acquisition communications (e.g., periodic reports, press releases);
• The acquisition and investment process and decision; and
• The proxy solicitation process (through which shareholders are asked to approve the IBC).
Prior to initiating discussions with a broker regarding the scope and limits of a D&O insurance policy, the SPAC's management team and board of directors should consider the risks inherent in each process and event and implement processes, procedures and controls to mitigate such risks.4Residual risk, after management of potential risks through diligent processes and procedures, should be managed through an appropriate level of D&O insurance.
D&O Insurance ConsiderationsFor SPACs
The unique structure of a SPAC raises several coverage issues different from an existing operating company that is pursuing an IPO. The structural elements of a SPAC that impact D&O insurance include (i) a corporate existence of 18 to 24 months within which the corporation must consummate an IBC, failing which it is required to dissolve and liquidate; (ii) a corporate purpose initially solely focused on an IBC which may result in a 'change in control' of the corporation; (iii) the placement of virtually all of the offering proceeds into a trust account to be released only in connection with the IBC5 ; and (iv) a public company with no operating business or financial results.
A standard D&O policy is for a 12 month period. However, given the 18 to 24 month 'life' of a SPAC, a 12 month policy is, most likely, insufficient to meet the needs of the SPAC.6To address this issue, the D&O insurance market has begun to offer an 18 month policy. However, it should be noted that a potential coverage gap still exists, even with an 18 month policy. This coverage gap could occur if the SPAC executes an LOI with a target company within 18 months after the offering but has not consummated the transaction. In this situation, the SPAC structure provides an additional 6 months within which to complete the acquisition. However, a renewal or extension of the original D&O insurance would have to be negotiated at that time to provide the necessary coverage for this 6 month period.7
Scope of Coverage
Similar to the term of the policy, the scope of the coverage provided by the D&O insurance, which will be effective upon the closing of the IPO, should be broad enough to cover the full 'life' of the SPAC, including a 'look back' provision to provide coverage for the offering road show as well as any private placements which may be scheduled as part of the management team's investment in the SPAC and which occur prior to the offering.
Looking forward, the D&O policy should provide coverage for the IBC consummated by the SPAC.A common provision of a D&O policy provides that if the company acquires any assets or any entity by merger, consolidation or otherwise or assumes any liability of another entity, and such assets, entity or liabilities exceed a certain percentage8of the total assets or liabilities of the company, then the policy will continue only for a limited period of time (for example, 90 days), unless the insurer agrees to continue to provide coverage upon such terms, conditions, limitations and additional premium that the insurer, in its sole discretion, deems appropriate. As the corporate purpose of a SPAC, as defined in its charter, is to acquire one or more operating businesses through a merger, capital stock exchange, asset acquisition, stock purchase or other similar business combination, and such acquisition must have a fair market value equal to at least 80% of the SPAC's net assets, then such limiting provision of the standard D&O policy is inappropriate for a SPAC. Accordingly, the company should seek an endorsement waiving the merger and acquisition limitation with respect to the IBC consummated by the SPAC.9
Similarly, the standard D&O policy also contains a provision that if a transaction results in a 'change of control' in the company, then coverage will cease for any claim arising after the change in control transaction.10As the IBC may result in a 'change in control' of the SPAC, a waiver of this limitation should be negotiated with regard to the IBC.
Finally, should the SPAC fail to consummate an IBC within the 18 to 24 month period following the offering, its charter will require it to begin the process of dissolution and liquidation. With the D&O policy set to expire after 18 months, the SPAC board of directors should consider extending or renewing the policy, for the applicable statute of limitations period, to cover potential claims that may arise from the dissolution and liquidation process.
A related coverage issue is the decision whether to purchase the coverage provided by each of the insuring agreements. Most relevant for a SPAC to consider is whether the coverage provided by Side A is necessary given the funds held by the SPAC in its trust account. Side A insurance typically covers claims against directors and officers alleging wrongful acts, such as breach of duty, neglect, error, omission, misstatement, or misleading statement, if the entity cannot provide indemnification due to its financial situation (e.g., illiquidity or bankruptcy).11A SPAC typically operates, prior to its IBC, with very limited assets, as the substantial majority of its assets are held in a trust account to be used to fund its IBC. In the event that an indemnifiable claim is filed against the directors and officers, the issue is whether a SPAC can access the funds in the trust account, if necessary, to pay the retention and any portion of the claim not covered by the D&O insurance. If the trust account cannot be accessed, then Side A coverage may be advisable, given the limited assets of the SPAC outside of the trust, to protect the personal assets of the directors and officers.Conversely, if the trust assets may be used to pay the retention and the portion of the claim that exceeds the coverage limits, if any, then the SPAC should consider whether the purchase of Side A insurance is necessary.12
The coverage limits of D&O insurance are typically looked at in terms of the SPAC's market capitalization subsequent to the IPO. For SPACs, the coverage limits have been, in general, as follows:
• Offerings << $100 million - $5 million of coverage;
• Offerings between $100 million to $250 million - up to $10 million of coverage; and
• Offerings above $250 million - $15 million+ of coverage.
The pricing for such coverage should be assessed in terms of the cost per million per month of coverage. In determining pricing, the carriers have little information upon which to assess the potential insurable risks, as the SPAC has no operating business and limited financial history. To this end, the structure of the SPAC and its corporate governance processes can be positive factors to highlight to potential carriers.13
One critical prerequisite for a SPAC is to obtain D&O insurance prior to its IPO, to become effective on the closing of the offering. Given the unique structure of a SPAC, however, several coverage issues need to be thoughtfully considered prior to the purchase of a D&O insurance policy.
1See 'Special Purpose Acquisition Corporations: Specs To Consider When Structuring Your SPAC - Part I and Part II,' The Metropolitan Corporate Counsel, Volume 14, No. 8 and No. 9, August and September 2006.
2 In 2005, more than 60 SPACs filed registration statements for IPOs, compared with just 14 filings in 2004. From January 1, 2006 through June 30, 2006, 20 SPACs filed registration statements and 24 SPACs successfully went public. See 'Special Purpose Acquisition Corporations: Specs To Consider When Structuring Your SPAC - Part I,' The Metropolitan Corporate Counsel, Volume 14, No. 8, August 2006. As of November 1, 2006, there were 72 publicly-traded SPACs (or former SPACs that have done deals). Of these SPACs, 10 had consummated business combinations, 28 had announced, but not yet consummated, business combinations and 2 had abandoned attempted business combinations (rejected by shareholders) and started seeking approval for dissolution. The remaining 32 SPACs are still in the process of seeking a target business to acquire. There were another 48 SPACs in registration.
3 Claims are typically filed pursuant to Sections 11 and 12 of the 1933 Act (alleging that the registration statement or offers or sales of a security, respectively, contained an untrue statement of material fact or omitted to state a material fact necessary in order to make the statements not misleading) and Section 10b-5 of the 1934 Act (alleging fraud in connection with the purchase or sale of securities).
4 For example, during the post-offering and pre-acquisition period, the corporation will be required to file periodic reports pursuant to Section 13 of the 1934 Act. Implementation of disclosure controls can mitigate the risk of possible misstatements in such reports.
5 Funds placed into the trust account may also be used to pay stockholders who vote against the IBC and also elect to convert their shares into cash at a conversion price equal to a pro rata share of the amount held in the trust account.
6 Of the 72 publicly-traded SPACs, 10 had consummated business combinations. Of these 10, the time period in which the IBC was consummated averaged 18 months.
7 If it is likely that the acquisition will be successful, then the renewal of the D&O policy is not inefficient as it will be needed for the ongoing operating company.However, renewal or extension could be costly if there is a risk that the acquisition will not be consummated before the end of the 24 month period (either for lack of shareholder approval or failure to meet closing conditions).
8 The percentage is typically 10 - 15% of the total assets or liabilities of the acquiring company. However, certain policies also have set the acquisition threshold at 25% or 35%.
9 Similarly, the policy language should be reviewed to ensure that a secondary equity and/or a debt securities' offering is covered by the policy in the event that such financing transactions are utilized to finance the SPAC's IBC.
10 A 'change in control' is typically defined as: (i) the merger or acquisition of the company, or of all or substantially all of its assets by another entity such that the company is not the surviving entity; (ii) the acquisition by any person, entity or affiliated group of persons or entities of the right to vote; select or appoint more than fifty percent of the directors to the company; or (iii) the appointment of a receiver, conservator, liquidator, trustee, rehabilitator, or any comparable authority, with respect to the company.
11 Side A insurance also provides insurance if the claim is not indemnifiable by the company, for example, in a shareholder derivative action.
12 In determining whether the trust account may be accessed by the SPAC to pay such claims, the company's charter, by-laws, the IPO terms as set forth in the prospectus and the applicable law of the state of incorporation should all be reviewed. In the event that Side A insurance is purchased, the SPAC should ensure that such coverage is non-rescindable in the event the primary coverage provided by Side B is rescinded, as, for example, in the case of a misstatement or fraud in the application process.
13For example, the sophistication and experience of the management team, particularly in the management of public companies, can be an important factor in determining the pricing for a D&O policy. In addition, carriers will look to the experience and quality of the IPO underwriters, the attorneys and the company's accounting firm as additional factors. The carriers will also look to the corporate governance processes and procedures that the company has adopted as well as its compliance with the applicable listing exchange's independence and other governance requirements.
Randi-Jean G. Hedin is a Partner in the Corporate Finance & Securities Practice Group of Kelley Drye & Warren LLP. Karen G. Narwold is a Special Counsel in the Corporate Finance & Securities Practice Group of Kelley Drye & Warren LLP.