The following conversation between Lisa J. Stark and Priya Cherian Huskins took place in advance of the American Bar Association Business Law Section’s Virtual Section Annual Meeting in September 2020.
LISA: Welcome to Business Law Today’s Spotlight Series. This is Lisa Stark, incoming Chair of Business Law Today. I am fortunate to be joined by Priya Cherian Huskins. Priya serves on the board of Woodruff Sawyer & Company, a 100-year-old commercial insurance brokerage. She chairs Woodruff Sawyer’s D&O claims group, and is an expert on the topic of D&O insurance.
Priya recently authored “Why More SPACs Could Lead to More Litigation (and How to Prepare),” an article published in Business Law Today which discusses the dramatic increase in IPOs this year lead by SPACs (special purpose acquisition companies). In her article, Priya anticipates an increase in SPAC-related litigation and gives some practical tips for avoiding SPAC-related litigation. Priya, what is a SPAC?
PRIYA: In simplest terms, the idea is that a group of individuals, the SPAC sponsors, will raise money in an IPO and then go forth and find a good company to acquire. The SPAC is the special purpose vehicle used to accomplish the task. The IPO money is put into a trust, and the sponsors have 18-24 months to find a suitable target. Shareholders can then either accept the transaction or redeem their money.
LISA: Perfect. So why are we seeing more IPOs by SPACs right now?
PRIYA: I don’t really know the answer. But I can observe that some of the rules regulating these vehicles have loosened up a bit. Also, we are in a low interest environment where investors are clamoring for returns. I’d also observe that success begets interest. So that explains perhaps the explosion in SPAC popularity right now. There is no doubt that a wave is now barreling towards us, but like most waves, it’s actually not that sudden. Momentum for SPACs has been building for a while now. And I think the last element is that SPACs create a way for companies, private companies to go public. And that is very compelling in the environment where market volatility makes a traditional IPO a little bit more risky for operating companies.
LISA: And it’s that risk element that we’re going to focus on today. What are the different types of SPAC-related litigation that might follow all of this increase in SPAC activity?
PRIYA: SPAC-related litigation can be usefully placed into five categories. And these categories track the SPAC lifecycle. So, first one, SPAC IPO suits. Now, this is actually a theoretical category. To date, we have seen no securities class action lawsuit filed against a SPAC IPO registration statement. But, for completeness, that’s where we should start. The second category, merger objection suits challenging the proposed merger. Now, these are actually quite common, and in many ways look, smell, and feel exactly like all of the other merger objection suits we are used to seeing in the public company environment. The third category is merger failure suits. And this category is the one that arises when a SPAC completes the merger, and only later the true condition of the target comes to light. And of course the true condition, if there’s litigation, is not good. The fourth category, is securities class actions against the operating company. Remember that the point of the SPAC transaction included having a private company become a publicly-traded company. And like any publicly-traded company, that company is subject to stock drop litigation. The last category, the fifth one, is bankruptcy. I mention this in particular because if, after the merger closes, the target company ends up going bankrupt quickly, sponsors should expect that they may also, or at least the SPAC, may also be brought into bankruptcy-related litigation.
LISA: Sounds a bit messy.
PRIYA: It could be.
LISA: It could be. So, you mentioned sponsors. SPAC acquisitions are often related party transactions with a SPAC its sponsor and/or the target often having some overlap in terms of directors, stockholders, and management. Are there any litigation-related issues that we should be concerned about given the conflicts that are inherent in these types of IPOs?
PRIYA: Absolutely yes. SPACs are exciting, and there is nothing about them that erases all the normal fiduciary duty issues that are always implicated by M&A deals that may have related parties involved. The few cases that have gone to litigation for SPACs all feature a lot of conversation about the sponsor’s incentives. People involved in SPAC transactions are well advised to brush up on the law when it comes to independence in the context of M&A transactions. And remember, it’s not just financial relationships that can be problematic. Social relationships can also cause independence problems as well.
LISA: Friends, family, and golf buddies, right?
PRIYA: That’s right.
LISA: Are there any recent SPAC-related lawsuits that our audience should know about?
PRIYA: I am very interested in the fact that there have been some pretty messy pieces of SPAC-related litigation. Again, it’s the M&A context that tends to be the most interesting. The classic case is the Heckmann Corporation case. This is sometimes known as the China Water case. This is a slightly older case, but it is very instructive. Because it has all of the elements that I am talking about where there is a target, there is a proxy, the deal closes, and after the deal closes it looks like it wasn’t a terrific deal. And remember too that sponsors of the SPAC see a tremendous upside if they can successfully close the deal. And what looks like an economic win can later be recharacterized in litigation as an improper incentive.
LISA: It’s that incentive that creates the conflict that causes public shareholders to sue. So finally, I think this is maybe the most helpful part of the conversation. How can SPACs, their sponsors, and target companies reduce risks related to litigation and ultimately reduce litigation?
PRIYA: Sure. First, I actually want to mention that we tend to think about civil litigation, plaintiff litigation, when we think about SPACs and this kind, these kinds of transactions. But just as a quick reminder, the SEC may also be interested in what’s going on. I haven’t seen much hand wringing and the kind of warnings that we’ve seen for other innovations, think initial coin offerings from the SEC. But they haven’t failed notice what’s going on. Might be useful to consider the June 2019 enforcement action against Benjamin Gordon. He was the CEO of Cambridge Capital Acquisition Corp. He agreed to a cease and desist, a personal fine of $100,000, and a 12-month bar from working with anything really associated with the SEC. And the SEC is also pursuing the principles of the target of the SPAC transaction ability computer. So, a lot went wrong in that deal, possibly some outright fraud. And, when you read through the SEC’s press releases and related documents, it’s very clear that the SEC was focused on the proxy statement’s disclosure that Cambridge Acquisition Corp. had conducted thorough due diligence. They’re focused on that because they kind of don’t think that’s true. So that’s a starting point, as much as we all care very much about plaintiff-style litigation, there is nothing scarier than when the government is coming after you. Anybody affiliated with a SPAC may want to just remember that this is a regulated situation, and the SEC and ultimately the DOJ has jurisdiction.
Now let me talk about what is, because I started with the SEC, the more friendly part of litigation. So, when we think about how can SPAC sponsors protect themselves from litigation, a couple tips. First and foremost, and we talked about this a little bit already, treat the M&A process with the same level of diligent effort that you would if you’re on the board of a public company doing the deal. It’s not going to be okay to be fooled by the target since you are the one asking investors to read the proxy materials and vote for the transaction. The diligent effort and the documentation of the diligent effort is exactly the same as it would be in any other situation. Another tip is to be timely in your efforts to find a target. It’s notable how many of the SPACs that end up in litigation were at the very end of their timeline, and basically were in the position of heroically throwing an acquisition target across the finish line. Given the upside that sponsors experience from closing a deal, this is a recipe for extreme skepticism by the court if the deal has any problems.
Finally, buy good D&O insurance from a broker who actually understands the entire SPAC lifecycle and its attendant risks. There is a lot of insurance out there being slung by insurance brokers who are very junior, know very little about the current D&O litigation environment, and are slamming together expensive D&O insurance policies without really knowing what the policies are supposed to cover. Remember, your broker isn’t just taking orders for insurance policy limits. The policies are negotiated, they’re bespoke, very customized. If you have a claim, you will hope that the individual who placed the policy can actually advocate for you with the carriers. Not all brokerage houses are set up this way, so you’re going to want to ask about your broker’s experience, not just with placing the SPAC IPO insurance, but about getting claims paid for IPO companies, about M&A transactions and claims payment, perhaps in warranties policies and claims payment. And of course, working with operating public companies of the type that you’re going to have on your hands after the SPAC transaction. I have to tell you, some of the best deals my insurance brokerage has ever worked on are deals our clients walked away from due to what we uncovered in the insurance diligent process of all things. So, working with an insurance broker who can take a holistic integrated approach to the entire SPAC lifecycle is much, much better than relying on a junior broker who will need to hand you off to another silo at the very next stage of the SPAC lifecycle, or if there is a claim against the insurance.
In summary, be diligent, be timely, and don’t forget to put some early attention on the D&O insurance.
LISA: Thank you so much, Priya. This has been a fascinating conversation. Again, Priya’s article is called “Why More SPACs Could Lead to More Litigation (and How to Prepare).” Thank you so much for joining our Business Law Today spotlight series. And Priya, thank you so much.
PRIYA: Thank you very much.