May 3, 2022
By M. Machua Millett
As of late April, 562 special purpose acquisition companies (SPACs) are actively searching for private company reverse-merger targets to take public on the Nasdaq stock exchange and New York Stock Exchange. Another 104 SPACs are under definitive agreement with private companies to take them public through a de-SPAC (also known as a reverse merger or business combination). A smaller, but not insignificant, number of SPACs filed on foreign exchanges in Europe and Asia (with the Middle East and Brazil trailing close behind) are also looking for private company targets.
At the same time, the steady drumbeat of de-SPAC–related litigation filings continues along with the occasional US Securities and Exchange Commission (SEC) investigation or enforcement action. On March 30, the SEC released a new set of proposed rules potentially expanding the disclosures required for, the public filing obligations of, and the liability imposed upon private companies going through de-SPACs and their directors and officers. The SEC has made clear its intention to require diligence and disclosures comparable to those needed in a traditional initial public offering (IPO).
Any projections included in de-SPAC filings will be highly scrutinized. Short sellers will attack any perceived weaknesses in post–de-SPAC companies, and plaintiffs’ attorneys will be more than happy to file litigation against SPACs, target companies, and their respective directors and officers in the wake of any stock drop caused by short sellers’ reports. The public (and perhaps the SEC and courts) will also likely presume the cause of post–de-SPAC stock price drops to be public corrections of previous misrepresentations or failures to disclose.
So, what is a private company director to do if presented with the proposed reverse merger of their company with a SPAC?
First, private company directors should accept that the relatively quiet private company on whose board they have served until now is about to enter into a very public affair. The transaction will receive a fair amount of scrutiny if all goes well and a tremendous amount of negative scrutiny (including potential litigation and SEC action) if the post–de-SPAC stock price of the new operating company decreases significantly.
Recent de-SPAC–related litigation and SEC regulatory announcements and enforcement actions show the potential exposures for private company directors, and those exposures need to be managed and ameliorated through a comprehensive diligence and public preparedness process, paired with a thorough review of indemnification and insurance:
1. Comprehensive Diligence and Public Preparedness Process: It’s no coincidence that many of the SEC’s proposed rules focus on two pillars historically used to differentiate de-SPACs from IPOs. For some time, the SEC has been signaling its conclusion that one cause of the sheer number of SPACs and de-SPACs in the last few years has been the perceived unlevel playing field between de-SPACs and IPOs. The proposed elimination of the “safe harbor” for financial projections contained in de-SPAC filings, coupled with potentially heightening the diligence and disclosure requirements for all involved in the de-SPAC process (SPACs and target companies, their directors and officers, SPAC sponsors and advisors, de-SPAC advisors, investment banks, and so on) all purportedly aim to level that playing field. (Note that this leaves aside whether the field was ever unbalanced in the first place.)
Therefore, private company directors involved in a de-SPAC transaction must ensure their company extensively vets any projections for reasonableness (or eliminates projections entirely from de-SPAC–related public filings), as well as fully discloses any risk factors that could pose a hurdle to achieving such projections. Having projections further analyzed by high-quality, independent external advisors will likewise become an expected best practice, if not a requirement.
Public preparedness will also be scrutinized particularly harshly in hindsight should anything go wrong post–de-SPAC closing. The board must implement robust processes to ensure the newly operating public company will be ready not only to comply with public filing, accounting, and auditing requirements but also to deal with regulations and less clearly established expectations in areas such as environmental, social, and governance principles; board and executive diversity; bribery and anti-money laundering rules; board governance; and information security. Again, close oversight by the board (and documentation of such involvement and oversight) for these policies, procedures, and processes is essential, along with independent advice from highly qualified outside advisors.
2. Thorough Review of Indemnification and Insurance: Even well-intentioned, diligent boards rely on indemnification and insurance as backstops for litigation and enforcement activity (directors and officers [D&O] insurance, as well as cyber, crime, property, and casualty insurance). These well-worn backstops should certainly be revisited in the lead-up to a de-SPAC transaction. Every board member should fully understand their rights to indemnification and advancement—and any exceptions or limitations—before proceeding with a de-SPAC process. Likewise, any director should be able to request an explanation of the existence, extent, protections, and limitations of any existing private company D&O insurance.
Finally, as a new operating public company, the de-SPAC target will need to place a public company D&O policy at the time of the de-SPAC close. The board must make sure that appropriate coverage is in place to protect itself and the company’s balance sheet in areas such as the total coverage limit, deductibles, policy language, and cost. This process should include a comprehensive discussion of peer benchmarking, securities-litigation data analytics, claims scenarios, the litigation and enforcement environment, and dedicated personal asset protection (Side A coverage).
None of the de-SPAC–related litigation or SEC regulatory or enforcement action has (to date) changed the fundamental economic reasons why a de-SPAC makes sense for some private companies. However, it has certainly focused attention on potential risk exposure for private companies and their boards that pursue such a reverse merger. In turn, board members would be wise to take the above basic (if sometimes somewhat complex) steps to minimize their potential exposure.
M. Machua Millett is the SPAC and de-SPAC practice leader at global insurance brokerage Marsh USA, a former securities litigation defense and insurance coverage lawyer, and a graduate of Harvard Law School and Tufts University.