John C. Marchisi, National Director –
SPAC Segment and Area Senior Vice President of Gallagher’s Financial Institutions Practice
By John C. Marchisi
The recent SPAC boom created many challenges, one of which being the volatility of D&O insurance premiums as SPAC operators face a heightened and evolving litigation environment.
The explosion in SPAC transaction volume brought with it an explosion in novel D&O insurance products—products that are, unfortunately, often much riskier than stakeholders suspect. It requires extremely specialized expertise, and both a historical and forward-looking perspective to navigate these situations safely.
How did this situation come about? As is often the case with any emerging market or boom, solutions are commonly rushed to market by advisors and businesses seeking to capitalize on the trend, with the market for D&O insurance for SPACs being one such example.
Specifically, several new SPAC D&O coverage structures and products have been marketed over the recent past as ways to significantly reduce premiums and retentions, while also claiming to better align coverage for the nuanced requirements and dynamics of SPAC transactions. However, we have found that many of these structures are not only strategically, but technically deficient in a material and catastrophic, ultimately representing the potential to harm not only the SPAC, but its combination target, and its investors.
We seek to provide an examination of one of these structures as a cautionary tale, a D&O policy structure which converts the D&O policy insuring agreements at the time of the business combination closing, through the “tail” endorsement, in order to accomplish savings in upfront premium.
In order to adequately contextualize the example, it can be helpful to review the technical insuring agreements of a public company D&O policy. D&O policies are written with three insuring “sides”, which are referred to as Side A, Side B, and Side C. Side A is for “non-indemnifiable” loss, which responds to insurable losses of insured persons under the policy which are deemed to non-indemnifiable by the corporation. Side A is also referred to as “personal asset protection” for this reason, as it responds to indemnify an individual, as opposed to an insured entity. Side B, which is for “indemnifiable” loss, provides indemnification to the insured entity balance sheet for losses arising from the obligation to indemnify an individual. Side C also provides corporate balance sheet protection for securities claims.
When a SPAC team is tasked with securing D&O insurance for their SPAC at the time of the SPAC IPO, they need to consider the various potential liabilities which could be associated with the transaction, while combining a future-based perspective in how they would potentially exposed to the need for indemnification after the combination is completed. There are several elements to consider, one of which being the opportunity to strategically bring insurance limits into the transaction for the benefit of the combined-entity balance sheet post-transaction. In an environment of increasing litigation and regulatory vigor and scrutiny, targets are becoming increasingly wary of pursuing a SPAC combination. A SPAC team which chooses to secure insurance at the time of the IPO which will provide protection against these unknown circumstances and potential threats will be much better positioned to negotiate a transaction, while simultaneously protecting their personal assets and interest in the combined-entity’s future financial performance.
When it comes to reporting claims under a D&O policy in an M&A situation, as D&O policies are “claims-made” policies, they require a “tail” policy be purchased in order to allow the policy holder to report claims under the policy after closing of the business combination or SPAC expiration and liquidation . Typically, with D&O insurance, the tail policy simply serves as a reporting period allowing latent or long-tail claims to be reported after the policy is no longer active, the tail policy does not represent a change in the expiring coverage terms and conditions, especially in an M&A situation.
However, the structures that came to market for SPACs do exactly that—they reduce premiums through a conversion of coverage, meaning the tail policy represents a material change in coverage terms from those which were in effect prior to the transaction closing. This change in coverage would then apply to any claims which are filed post-closing, even if the alleged wrongful act(s) occurred during the original policy period.
For example, this kind of structure provides “fully-sided” A/B/C coverage during the SPAC search period, from pre-IPO to combination closing. At closing, however, it converts to higher-limit Side A-only coverage. This means that coverage would only be available for non-indemnifiable individual loss (not corporate loss) for any claims related to wrongful acts alleged to have occurred prior to closing. The SPAC policy effectively fails to provide any balance sheet protection to the combined entity for liabilities arising out of activity that occurred pre-closing.
It is not difficult to imagine the strategic disadvantage this would create for a SPAC team as they look to negotiate and position themselves as a suitor to a target company in a hyper-competitive market, but let’s not move on to the technical side of things.
How, then, can situations be avoided in an M&A transaction where a change in insurance terms and conditions at closing could potentially lead to an unknown condition and potential for unexpected loss for the acquiring company? The answer, is through the merger agreements which the parties to the transaction agree to, which commonly make considerations for such situations within the Insurance and Indemnification sections of the agreement.
There are many variations on these agreements and the language therein. The majority, however, state that tail periods are to be obtained for a period of 6 years, “on terms not less favorable than terms of current insurance coverage,” or, “on terms not materially less favorable than current coverage”, meaning, that the terms and conditions of the coverage which a claim reported under the tail policy would be seeking not be narrowed in any way. Unfortunately, this is expressly what the aforementioned solution does in order to achieve the premium savings which make it attractive to the purchaser.
Further to this issue, is that the coverage conversion is accomplished within the language contained in the “tail” policy, which is an endorsement which is unavailable until the business combination has closed and has caused the D&O policy to “run off”. For this reason, mention of this condition is made here as the pending policy conversion has the potential to elude due diligence review.
This is just one such example of the hidden dangers concerning D&O insurance for SPACs. As such, the highly nuanced nature of this market makes it imperative that you are working with an insurance broker who specializes in your particular industry or line of coverage. Gallagher has a vast network of specialists that understand your industry and business, along with the best solutions in the marketplace for your specific challenges.
About John C. Marchisi
John C. Marchisi, National Director – SPAC Segment and Area Senior Vice President of Gallagher’s Financial Institutions Practice. John focuses on insurance and risk management for Directors & Officers Liability, Cyber Liability, and Transactional risk. John has over 15 years of experience with SPAC transactions, which began on the American Stock Exchange and New York Stock Exchange, where he led businesses and SPAC IPO listings and trading as a Managing Director and Exchange Official. John has developed proprietary analytics and resources to assist insurance carrier partners with the underwriting of SPAC insurance programs, and is responsible for numerous national publications including The Life Cycle of a SPAC – A Strategic Risk Management Perspective.