Specialty Podcast: The SPAC and D&O Insurance Market

Sandy Crystal (00:08):
Welcome everyone. And thank you for joining us today. My name is Sandy Crystal, Executive Vice President at Alliance. Happy to have joining me, Tom Shashaty, Assistant Vice President for our financial institutions group. Tim Crowley, Senior Vice President in our management professional risk group and our SPAC practice leader, as well as John Gilbert, managing director and co-head of our mergers and acquisitions practice. Our topic for today is to discuss the emerging risks and exposures facing SPACs. We're going to talk about the directors' and officers liability insurance needs for SPAC structures, as well as other things to take into account for SPAC both with respect to the sponsor. And then what happens when there's ultimately a deal combination? The SPAC world has exploded in the last year, for comparison in 2019, there were roughly 50 SPACs that went public.

In 2020, there were 248, 2019 SPACs raised roughly 14 billion in equity in 2020, they raised over 80 billion in equity. In fact, in 2020 more equity was raised in SPACs than in the entire proceeding decade for SPACs. So, certainly, this is a trend that is not going away, and we're already seeing in the early parts of 2021, quite a number SPACs being filed, and already being launched only a few days into the new year. So with that, I want to kick it over to Tim. Who's been dealing with SPACs since 2008, to talk about how the key exposures for SPACs and how they're different from other public companies.

Tim Crowley (01:37):
Thanks, Sandy, in connection with the explosion of the number of SPACs that we've been working on over the last two years, we've really started to develop a more intricate understanding of some of the exposures and risks facing the SPACs, but also the directors and officers themselves. So, I think a key point to start at is if you really look at when the SPAC is launched, the proceeds from the IPO are put into a trust. And as a result of that trust, there are very limited uses for that money, which are designed for either the business combination or ultimately returning the money to the shareholders of a combination is not executed. So the implications of that development for the individual directors and officers is that those individuals may not have the normal sources of indemnification that they're accustomed to. We're sitting on the boards of other corporations.

If you look in, S-1 or similar documents, there is generally even now a risk factor that states that while the SPAC has an obligation to indemnify the individual directors and officers, the SPAC may not be able to do so. So first and foremost, before you look to risk transfer solutions like directors and officers liability insurance, I think it's imperative that the individual directors and officers understand that potential challenge or hurdle to available indemnification for claims arising against them, for their responsibilities with the SPAC. There are additional insurance implications of that. Generally, directors and officers liability policies function as a result of the availability or lack thereof of indemnification to those individuals. It is critical that the directors and officers of SPACs accommodate that challenge of the availability of indemnification by reviewing robust and comprehensive side, a do know sharing solutions, which provide coverage to individual directors and officers when identification is unavailable from the SPAC. When researching and evaluating insurance proposals for the SPAC, the unique operating budget of the SPAC takes its own life when evaluating those insurance proposals.

And by that, when you think about the proceeds from the IPO being put into the trust, there's a very limited operating budget that is available for operating expenses, such as insurance commonly in the S-1 documents, you'll see that there is a line item in there for an earmarked amount of expense for the D&O insurance. Through the last 18 to 24 months as the number of SPACs has exploded that insurance premium has continued to rise in the present insurance market conditions. So, when evaluating and putting together the S-1 documents, it's important to look to your key insurance advisors to make sure that those expenses are properly earmarked with today's insurance premium values. The life of the SPAC in the hunting period is generally 24 months. So, is our recommendation in preference to seek insurance policy periods of 24 months to align with the life of the SPAC.

There are two benefits to that development. First, you would illuminate some cost uncertainty in the event that you put together a 12-month policy and then needed to renew that policy in 12 months. If you went with that approach, you'd be susceptible to insurance market premium trends and developments, which may not be accommodated for in the confined operating expense budget of the SPAC. So, we believe it is the best approach to try and secure a 24-month policy term for your D&O insurance policy. For the SPAC, another item of consideration is incorporation. Commonly SPACs are incorporated in either the Cayman Islands or Delaware. For the insurance companies, some carriers do not have the capabilities or proper licenses to underwrite a company that is domiciled or incorporated in the Cayman Islands. So in that event, you might have a shallower pool of D&O insurance companies available to compete on your risks.

If the incorporation is Delaware, you should have the availability of a few additional insurance carriers that have the abilities and capabilities to underwrite this back D&O insurance policy. Another item for consideration is the actual structure and organization's chart of the SPAC itself. It is important to delineate and determine where and which entities are covered under the SPAC D&O insurance program and where other insurance products may be available or should be considered. In looking at the exposures of SPACs many of the underwriters carefully review the experience of the management team, the warrant structures, the promotion and other financial instruments that may potentially develop into claims situations. Underwriters carefully review the experience of the management team, warrant structures, the promotion and other potential financing that may be needed to execute the business combination. Common in 2020 pipe financing, was a frequent vehicle that was used to consummate the business combination. The insurance companies will look at the experience of the sponsor, whether it be a private equity sponsor, a hedge sponsor, a group of entrepreneurs, entrepreneurs, or other groups that help to sponsor the SPAC and their experience. Ultimately whether the insurance companies are looking to evaluate is the due diligence process and the ultimate method for selecting and identifying a private company that may or may not be ready to go public via the SPAC structure.

Sandy Crystal (06:49):
Tim, you, Tom, and the rest of the team worked on over 40 SPACs in 2020, given some of the considerations you just laid out for us. What are, some of the highlights on Dino insurance that people need to be thinking about when placing a policy?

Tim Crowley (07:02):
Sure. There's a wide variety of topics to consider when designing the D&O insurance program. Generally, our SPAC clients elect to incept the D&O insurance at the time of pricing of the IPO. At the point that the shares are registered, that is when the exposure is generally created against the directors and officers, which will then be transferred to an insurance company. There are a few times we've placed a D&P insurance policy prior to the IPO for the SPAC, but there are a few unique challenges that need to be considered when putting together that insurance program. For example, given that the SPAC is generally not born until the IPO, the individuals that are named in the S-1 are largely prospective directors or officers of the SPAC. So that is something that would need to be manuscript into the policy. Further, since that SPAC is not a living breathing entity yet, the insurance policy would need to be tailored to allow for where that indemnification would come from in the period of time, leading up to the IPO. When negotiating D&O insurance policies for SPACs, a highly negotiated item is generally to preset or preestablish the tail or runoff coverage for the SPAC for down the road when the business combination is consummated. Ultimately the tail coverage will provide insurance for future claims arising out of alleged of wrong occurring prior to the finalization of the business combination. So that is something that we strongly recommend is negotiated and preset even at the time of the IPO so that there are no surprises down the road, whether it be through market conditions, claims, activity, new claims trends, or other insurance carrier appetite movement. To lock in that pricing and have a preset expense for when the business combination is consummated. When looking to put together a Dino program for SPACs, it is important that the management team consider a mix of various D&O insurance products, public company D&O insurance, generally affords coverage in, three ways. Side A insurance provides coverage to the individual directors and officers and circumstances where indemnification is unavailable from the spa.

So that's the kind of true last line of defense insurance for those executives. Secondly, the side B coverage, which is corporate reimbursement for the SPAC. So, in the event that there's a claim against a director or officer and the SPAC indemnifies that individual, this coverage would pay back the SPAC for that indemnification obligation. And then side C is for securities claims against the SPAC. So when you're trying to pick a limit of liability, most facts generally provide a mix that affords some combination of ABC. So, all three of those affirmations and sharing agreements, but also a top layer of side, a D&O insurance that affords coverage only to those individuals in circumstances where indemnification is unavailable from the SPAC. For side A insurance, no retention shall apply, but under Side B or see, there will be a self-insured retention that applies towards that mix of sharing agreements.

What we've seen most recently in Q4 and now in Q1, those retention levels have escalated quite considerably in the current marketplace. If we were talking 12 to 24 months ago, you might have seen retentions in the 250,000 or $500,000 level, but in today's marketplace, we're seeing those levels rise to two and a half, 5 million, or even more, depending on the size scope, nature and industry focus of the SPAC. When identifying the total limit of liability for a SPAC, it's often more of an art than a science, some things to consider when trying to identify the total limit for the SPAC would include the size of the offering, the experience of the management team and their success in the de-SPAC process of prior transactions, the risk appetite of the management liability team and the board of directors, the industry focus and the overall due diligence process of the SPAC.

Sandy Crystal (10:56):
You know, given the changes talked about in the marketplace whether it be retentions and what's driving that, what are some of the new exposures and risks facing SPAC and what implications do these developments have in terms of how we think about structuring a D&O insurance program?

Tim Crowley (11:12):
Yeah. So if we were sitting here last year, I think it would be relatively a commonly accepted principle that the activity of this fact during the hunting phase was relatively mild as far as the attraction of potential claims from the plaintiff's bar. Towards the second half of 2020 that's changed quite a bit. One, we've seen a few SPACs received securities class action filings from the plaintiff's bar. Most notably the two high-level ones we've seen recently are Nikola and Triterras, Nikola being the more high-profile of the two. But the result of those two cases is quite similar in that both of those cases were brought by the investors of the surviving publicly traded company being filed against that public company, but also against the directors of the SPAC arising out of their performance of due diligence during the hunting phase.

So, by expanding that class period to look back at the SPAC after the de-SPAC transaction, I think that's given first and foremost, the individual directors and officers additional consideration for how they view their exposure to those types of claims. But it's certainly also given the insurance carriers kind of pause for how they were underwriting the facts with respect to both cost capacity and even also retention levels. That's kind of the first thing is that once you finish the business combination, your exposure as a director officer may not end. We've also seen a few cases even during the hunting phase, after the eight K or the LOI has been announced. But before the business combination has been consummated, we have seen a few claims that alleged that maybe there weren't the proper disclosures in that eight K regarding all of the business parameters and financial reporting issues and financial revenue generation items that could potentially lead to the folks who were voting on it from the shareholder base of the SPAC to have all the proper information to make that vote.

Another key development in late September. The SEC Chairman, Jay Clayton did release some comments, and I'm paraphrasing here, but ultimately he said that while he believes that competition to the traditional IPO process is a healthy development as far as kind of a free market economy perspective. However, he views that kind of the quicker process and the shorter due diligence and analysis from prospective investors may create a need for additional disclosures, in the offering documents of the SPAC. So, I think one of the things that they've really started to focus on is potential conflict of interest between the management and the board directors of the SPAC and the potential investor base. I think it's notable to think that Jay Clayton, the SEC chairman actually recently stepped down. But I think one of the last thing he did on December 22nd was release new guidance for SPACs and how they have to structure the verbiage and their disclosures, in S-1’s around things like potential conflicts of interest.

Sandy Crystal (14:26):
Can you and Tom elaborate more on some of these changes we're seeing given the huge uptick in the volume of SPACs and what can sponsors expect to see in 20 and forward?

Tim Crowley (14:38):
Yeah, so at the end of 2020, we did see a bit of a supply and demand issue from the insurance community. You talked about the number of SPAC from 2019 to 2020. Due to that explosion in the number of SPACs, even the optimistic underwriter heading into 2020 probably thought that maybe, they would underwrite 50 to maybe even 75 SPACs in the 2020 calendar year. With more than 200 SPACs in 2020, those insurance companies deployed a significant amount of capital that did not necessarily anticipate. And once the claims activity started being created for these structures, several of the insurance companies started to pull back on that capacity. So, while in 2019 and early 2020 D&O insurance companies commonly provided 10 million of capacity to SPACs, we saw that number drawn down to 5 million of capacity towards the end of 2020. London's capacity available to these publicly traded SPACs in the U.S. has pretty much evaporated.

Tim Crowley (15:42):
And while we're starting to access and see the Bermuda insurance marketplace provide more capacity to SPACs, is generally only in the form of Saudi insurance. Again, affords coverage for non-identifiable loss. Only another item that we're seeing is that the carriers are starting to scrutinize, their overall exposure to a given risk. They're trying to analyze, if you think of the three different pools of insurance products that come together for a SPAC, you've got the D&O insurance for the, you've got the D&O insurance for the target. You've also got, the D&O insurance potentially for the sponsor. Some of the insurance companies are starting to try and carefully look at their accumulation of capacity provided to kind of these three pools of risk where claims could come from.

John Gilbert (16:29):
I think what's important to note there is how the underwriter has been taking a look at SPACs a little bit differently and a little bit more hard in 2020, and going into 2021. It's not an overly complicated process to procure D&O for the SPAC what's important. And what helps prepare the SPAC to get the best terms possible is providing information to the underwriters to give them the full picture of the risk. The most important document is the S1 filing. So if there is a draft or if there is an actual file S-1, it's important to get that out to the insurance underwriting community, to have them start reviewing the S-1 from there, they'll build some additional questions, particularly around the management team and look at sort of the structuring of the SPAC from a sponsorship perspective, underwriters will have additional questions, and it would make sense, and it would ultimately help the SPAC to have either an underwriting conference call or to just consult their insurance broker on how to best navigate and present themselves to the insurance marketplace.

Sandy Crystal (17:25):
Let's switch gears for a minute. Tom, what are some of the trends we're seeing from financial institutions' perspective, both as a sponsor to SPAC and as an investor into SPACs?

John Gilbert (17:35):
We have the more straightforward approach in which a financial institution may sponsor a SPAC in the traditional sense, as Tim described for us. Bringing us back to the public market, finding a target and ultimately consummating a merger. Another trend we're seeing is what's being dubbed as this SPAC arbitrage investment strategy where sophisticated investors may find ways to invest in SPACs and earn profits while not necessarily participating all the way through the de-SPAC process and ultimately owning the newly combined company. Given the large number of spa IPOs, some investors can get a nice-sized allocation of IPO SPAC shares at that common $10 share price and at the same time are awarded a number of warrants. These sophisticated investors have had some opportunities to exercise these warrants and capitalize on their intrinsic value on the precipice of merger news or other metrics that move share prices.

We're not seeing a whole lot of this in the market given the low volatility of public shares, but these sophisticated buy-side investors are opportunistic and pros at protecting the downside. One of the more common trends we're seeing from a financial institution's perspective is the investment in SPACs via the sponsor's founder shares. Again, with the large number of SPACs coming into market there are times a sponsor needs a differentiate itself and gain credibility in the market by offering attractive terms to well-known financial institutions, particularly asset managers to join in and be a member of the sponsor while not necessarily absorbing the responsibilities of the sponsor and bringing us back to IPO. These terms can include locking in that $10 share price, those warrant awards, and first look at a pipe opportunity, should the merger require more capital and also the opportunity to pull out and redeem their investments. Should they not want to participate in that de-SPAC process? Again, these are just a number of trends we're seeing, obviously as more SPACs come to market, the financial institutions group at Alliant will continue to monitor the differentiation between these SPACs. And we expect to see some more developments in the near future.

Sandy Crystal (19:27):
How have you and the rest of the financial institutions group and advising clients as exposures?

John Gilbert (19:31):
Sure. One of the things we do is we prepare our asset manager clients for underwriting questions and other inquiries pertaining to SPAC investments. Whether it be true sponsorship, whether it be investments and founder shares, in some cases from a financial institution's perspective. Investment banks that may have the sales distribution for the SPACs. If there's conflicts of interest, as Tim alluded to earlier, the SEC guidelines, make that more of a highlight and something that we advise our SPAC clients to certainly pay attention to another item that we advise our clients to is do is to look at their current management and professional liability insurance policies, the E&O and D&O and policies particularly set up for asset managers could potentially have some coverage for sponsors built into the policies, depending on where the sponsor sits as a subsidiary, as an affiliate of an investment manager or as a portfolio company of a private investment fund.

There could be potential for what we call outside directorship liability coverage included in that fund policy that could potentially cover the sponsor. It's certainly important to look at your current policies and consult with your insurance broker to see if there's any potential coverage already in place. Another area of interest that we speak to our clients about are any potential assume liabilities, being a member of the sponsor via the founder, shares. Some asset managers or other financial institutions have the opportunity to invest via the founder shares. They may not necessarily be deemed quote on quote, the true sponsor. However, there could be some assume liabilities just in the nature of being a member of the sponsor. So we ask our lines to speak with their council, to explore the areas in which they may have some assume liability. If there are, we advise our clients to consider some indemnity agreements or other hold-harmless provisions that can be built into those private placement offerings in which our clients are investing into the sponsors.

And then for our financial institution clients who sponsor SPACs as of the IPO date, when the D&O insurance typically goes into place, we don't necessarily sit on the sidelines. We advise our clients to keep us in the loop when considering a target company. There's a lot to consider from a liability perspective when looking at a target. And that's where we introduce our mergers and acquisitions group and have them get ahead of the process by looking at the potential target and seeing ways in which the board of directors is protected by doing diligence and ensuring that the potential target is a good viable option for investment

Sandy Crystal (21:57):
Tom thinking from the mergers and acquisitions group perspective, when should the SPAC engage Alliance to assist in the due diligence?

Tom Shashaty (22:04):
So far, we've talked a lot about risks and insurance considerations at the SPAC, or sponsor level equally as important or more important is addressing risks associated with any transaction that may happen, including the initial business combination. Alliant M&A serves a variety of fires, whether it's strategic corporate acquirers, private equity firms, or otherwise and SPACs are no exceptions to the risks that are faced by any buyer doing an acquisition. The buyer also has an obligation. SPACs not an exception, as an obligation to take prudent steps, to conduct adequate levels of due diligence. And no exception there either is also insurance and employee benefits due diligence. Alliant M&A handles over 200 transactions annually and conducts insurance and employee benefits due diligence prior to an acquisition ever being made. And the key there is that for any SPAC going through an acquisition is to really cover a couple of things.

One is to validate the current expense associated with the insurance and employee benefit cost, because that has a direct impact on the enterprise value that's being paid. So are the insurance costs adequate as reflected on the current financial statements? Are they understated? Is the insurance inadequate and it's going to cost more going forward, are the balance sheet reserves understated, and there's going to be a large uptick for a particular balance sheet item that again, could be a purchase price type adjustment. It also could have to do with liquidity type situation. So is there a letter of credit that exists today that may increase or balloon going forward? Is there no letter credit, but given the new financial structure, I being owned by a SPAC, could that change and have an impact on that general financial picture? And again, the concern is magnified here, given the pool of public shareholders, owning the business.

In addition, what we want to look to do is to avoid really costly pitfalls associated with the transaction. So in addition to looking at financial components, our team does a deep dive review into the adequacy of the insurance policies. Is the coverage and scope adequate for the target that the SPAC is looking at that particular time? Did it meet the contractual requirements that this the target has entered into with customers or otherwise? Are they in compliance from a regulatory standpoint both from an employee benefit standpoint, whether it's ACA or otherwise, or for retirement requirements or general state requirements from an insurance standpoint. All those things are very important to look at for any buyer and again, SPACs included, as they're going through a target acquisition or business accommodation. The other thing that is also important to understand is can insurance policies and benefit plans survive the closing?

Do they continue with the transaction as if they were never affected or do they have change of control provisions and how do we address those provisions? So, that is meant to be really just a snapshot of what we look at from an insurance and employee benefits due diligence standpoint. There’s a whole lot more look at and having been through a few thousand deals myself and the team of the 50 people that we have thousands upon thousands of deals. There's not many things that we haven't seen and know what to look for. The other thing that's been certainly prevalent in M&A transactions going on in a major way, going on five years and growing is transactional risk insurance. And the most common form of transactional risk insurance is representations and warranties insurance. So rep warranty insurance has been a growing trend in the market for north of five years.

And there are many benefits to use in rep warranty insurance as with any, you assume liability to deal. You know, the buyer is going to rely on certain statements that are made by the seller in an agreement and the sellers may or not have an indemnity that says if the representations that I am making in the agreement are not correct. You the buyer have the obligation to make a claim against me for whatever misstatement I would've made. The customers I have are true and correct. The financial statements are done correctly, were in compliance with applicable law, whatever it may be. The buyer is certainly relying on a number of statements that are outlined in a 80, 90 page document for any given deal and, and rely on those statements, to con through the deal, and pay a hefty price for the transaction. Oftentimes the agreement will allow for the seller to indemnify the buyer in the event that there's a breach of that rep, that's discovered post close. An alternative to that is to use rep warranty insurance, representations and warranty insurance, to alleviate the need for the seller to be on the hook for the indemnity claims for a period of time, usually 12, 18, or 24 months, and allow an insurance carrier to assume the risk that the seller would've taken.

And there's a lot of benefits to using representations and warranty insurance for both buyers and sellers. But one of the big advantages is that it really cuts down on the time of the transaction in terms of negotiation. The seller's less inclined to fight over, minute issues, relative representations, fight over the amount or the scope of the indemnity, when it's ultimately transferred for premium to a third party insurer rep warranty. Insurance is also going to be a useful tool and has been first backs in the coming year and years and years to come as well. So, those are a couple areas to think about from a M&A transaction standpoint, as SPACs are going through their first business accommodation, as well as subsequent acquisitions that they may make over time.

Sandy Crystal (27:44):
Thank you, John. So obviously there's a lot to think about in the SPAC world, both from the, the initial offering of the SPAC and how to structure their own insurance. How to think about the sponsor and our investors in the SPACs, as well as what to think about when you get to the business combination. I'd like to thank our speakers here today, Tim Crowley, Tom Shashaty and John Gilbert. Hope everyone found it informative and enjoyed it. And we look forward to speaking with you again soon. And for more information, please visit us at our website, www.alliant.com.