Perspectives: Special purpose acquisition companies — A closer look at recent lawsuits

In the early days of the COVID-19 pandemic, investors were drawn to special purpose acquisition companies. As these vehicles seemed to offer a faster, more certain valuation for private companies to go public — the “targets” in the deals — the SPAC initial public offering trend increased significantly in 2020 and 2021.

SPACs are companies with a limited life span established solely to effect a merger. Also known as “blank check” companies, they attracted investors looking to more easily tap capital markets to invest in potentially high-growth ventures. In 2021, though, the values of several companies that went public via SPACs declined after they failed to meet their growth projections, among other things, and the market cooled. 

But just as the traditional IPO process raises the prospect of a new risk to the newly public company and associated federal securities litigation brought by its investors, the same is true for SPAC-related IPOs. As each suit is likely to be accompanied by a claim submitted to the SPAC’s directors and officers 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 litigation 

At 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, equating to a litigation rate of 16%. An annual breakdown of the litigation frequency reveals a sharp upward trajectory: 8% for 2019-2020, 17% in 2021, and 24% in 2022. 

The litigation rate will continue to rise as there is an average nine-month lag between the de-SPAC transaction and the litigation filing date. Accordingly, additional litigation relating to these 393 SPAC mergers is expected to continue this year and possibly beyond. 

Allegations in recent suits

The allegations in the 64 federal SPAC lawsuits include the following:

• Violations of Sections 10b, 11 and 14 of securities regulations: Allegations relating to a) fraud; b) holding officers accountable for untrue statements of fact or material omissions within registration statements relating to the initial SPAC formation or the de-SPAC; and c) allegations that investors were not fully informed when asked to vote their shares. 
• Breach of fiduciary duty: Allegations the SPAC structure creates an inherent conflict of interest between the SPAC sponsor and its board with the SPAC’s investors. 
• Allegations that the offering documents contained untrue statements of fact and that the SPAC sponsors made false or misleading statements with inadequate disclosures relating to the risks faced by the target.
• Shareholder derivative lawsuits: Allegations relating to harm to the SPAC from false statements made by its directors and officers and serious breaches of fiduciary duties.

There was a notable development relating to SPAC lawsuits in January when the Delaware Chancery Court denied a motion to dismiss filed by the defendants in a class action alleging the directors and sponsors of a SPAC breached their fiduciary duties to the SPAC shareholders. This is an indication that lawsuits of this nature will move forward.

Struggle to find merger targets

Additional litigation may stem 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 investors. When liquidation occurs, the SPAC sponsors potentially lose their initial investments. Thus, the demand for a SPAC merger partner may be furious as that 24-month deadline approaches, as the absence of a target can lead to material financial consequences for the SPAC sponsors. 

Accordingly, some SPACs may feel pressure to do whatever they have to do to complete a merger transaction. Mergers completed primarily to avoid the potential financial consequences of 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. Quoting industry analysts, the article noted that “many SPACs will likely liquidate.” The poor performance of many de-SPACs post-merger has made it difficult for SPAC sponsors and merger target executives “to convince companies to merge with SPACs,” the article said.

Further, in 2022 at least two lawsuits were brought against SPAC sponsors relating to their liquidation plans. In one case, SPAC investors filed a lawsuit disputing the manner in which the SPAC’s directors and officers intended to deal with a financial asset of the SPAC in connection with the liquidation. 

Legal and regulatory scrutiny

The U.S. Securities and Exchange Commission, the Financial Industry Regulatory Authority, and the U.S. Department of Justice are likely to continue to focus on the SPAC market. In 2021, they brought several enforcement and investigative actions against SPACs, SPAC sponsors and targets’ 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 charges that it had defrauded investors by misleading them about its products, technical advancements and commercial 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 increasing the number of federal lawsuits against SPAC sponsors. 

The path ahead

The surge of SPAC-related lawsuits and enhanced regulation materially detract from 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 of the premerger target for alleged wrongful acts, the courts have interpreted D&O insurance coverage well beyond what was intended when the policies were priced. 

Accordingly, as SPACs lose favor with investors, filing and resolution of SPAC-related claims and associated D&O liability coverage 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