SPACs are running into choppy water these days. The Delaware Court of Chancery’s January 2022 opinion denying motions to dismiss in the MultiPlan Corp. litigation may be a significant source of concern for SPACs. Certainly, the case and Vice Chancellor Will’s 61-page opinion are of great interest to all in the SPAC community.
First and foremost, MultiPlan is the first time Delaware courts have applied fiduciary duty principles in the SPAC context. The courts’ decisions in this case could foretell its treatment of increasing numbers of SPACs that find themselves faced with lawsuits in Delaware court, a state where many SPACs are registered.
Second, the opinion touches on multiple topics, including conflicts of interest, disclosure, and the legal standard to be used for SPAC-related cases. Many law firms have put out excellent summaries and analyses of the case, including Skadden, DLA Piper, Mayer Brown, and Cooley.
Most articles analyzing this decision, however, do not discuss its directors and officers (D&O) insurance-related implications. From the insurance perspective, there are several interesting points to note.
Which SPAC D&O Insurance Policy Would Respond?
The first point of interest is which D&O insurance policy will be tapped to cover defense costs for the defendants. The defendants here, like in many other SPAC-related suits, are the SPAC (Churchill Capital Corp. III), the SPAC’s sponsor (managed by an entity wholly owned by Michael Klein, a serial SPACer), and the SPAC’s directors and officers, Klein among them.
The shareholder plaintiffs allege that defendants breached their fiduciary duty when they issued a false and misleading proxy statement. The plaintiffs allege that there should have been disclosure about the fact that MultiPlan’s largest customer was building an in-house platform to compete with MultiPlan. This lack of disclosure, according to the plaintiffs, impaired Class A stockholders’ informed exercise of their redemption and voting rights.
Even though the MultiPlan lawsuit was brought four months after the close of the business combination, the allegations relate to misstatements in the proxy statement that was filed prior to the business combination. Therefore, the policy that would respond on behalf of the SPAC and its directors and officers would be the D&O policy placed at the time of the SPAC IPO or to be more precise, its tail.
The tail is very important here. Remember that D&O insurance policies are “claims made” policies, meaning that the policy cannot have expired and must be active for it to respond to a claim. A “tail” is a reference to paying additional premium so that the policy stays open for claims past its natural expiration. In the case of SPACs, the initial IPO policy is typically an 18- or 24-month policy. These policies typically include pre-negotiated terms for a six-year tail. When the SPAC closes its business combination, it must ensure that the tail premium is paid as part of the closing of the business combination.
The concern is what happens if—as was exactly the case in MultiPlan—shareholders decide to sue the SPAC and its directors and officers after the deal closes. Here, the lawsuit was brought four months after the close of the business combination and the related “change of control” as that term is typically defined in D&O policies. Presumably in this case, as is typical, the SPAC purchased the SPAC IPO’s tail policy at the time business combination closed. As a result, one would expect the SPAC’s original D&O insurance policy to respond to the pending litigation on behalf of the SPAC and the SPAC’s directors and officers.
It’s worth noting that while the go-forward public company may have agreed to indemnify the SPAC and the SPAC’s directors and officers against future claims brought after the deal closed, the go-forward public company’s D&O insurance will almost always exclude coverage for these types of claims. This, in addition to the fact that the target’s purchasing of the tail is market practice, is a big reason why the go-forward public company is typically willing to provide the funds for the SPAC’s tail policy.
Unscrupulous Behavior by Certain Brokers
It is also worth noting that some unscrupulous D&O insurance brokers have started suggesting to SPACs that they should purchase their tail from new carriers instead of adhering to the pre-negotiated tail terms they agreed to at the time of the SPAC IPO. Unlike in a traditional M&A context, this practice is heavily frowned upon in the SPAC context. Recall that carriers who wrote the SPAC IPO policy did it with the expectation of their ultimate receipt of the full premium. The first portion of the SPAC D&O policy premium is paid at the time of the initial IPO, with the second portion paid when the business combination closes.
Indeed, to offset high upfront costs for working capital–poor SPACs, most carriers have historically agreed to under-charge at the time of the IPO because they understand that the tail will be purchased from them. SPAC directors and officers who choose to ignore this understanding may find it difficult, if not impossible, to get good terms for their next SPAC. Unsurprisingly, insurance carriers keep close track of which SPAC teams are “shopping” the tail.
D&O Insurance Carriers Are Concerned about Conflicts of Interest
Another MultiPlan case theme that insurance carriers are monitoring closely is the issue of conflicts of interest. Vice Chancellor Will discusses at length the conflicts of interest existing in this case among the SPAC, its CEO and Chairman Michael Klein, and his affiliate, The Klein Group LLC. The SPAC’s board selected The Klein Group LLC as its financial advisor and paid it $30.5 million in connection with the merger and its financing. These interrelations led Vice Chancellor Will to conclude that the less defendant-friendly “entire fairness standard” rather thanthe more common “business judgement rule” standard should be applied in this case. This determination essentially made winning a motion to dismiss impossible for the defendants.
Judge Will’s conclusions intersect with insurance carrier concerns in two different ways. One is that D&O insurance underwriters have become highly sensitive to potential conflicts of interest between SPAC teams, their sponsors, and directors on one hand; and public shareholders on the other. It is standard now for an insurance underwriter to ask multiple follow-up questions and request to see extensive disclosure around all potential conflicts of interest. If these questions and requests are not satisfied, and in some cases even if they are, many insurers are unwilling to offer coverage for claims arising out of transactions with affiliated entities of the SPAC or will only do so at elevated pricing.
Insurance carriers are also interested in the issue of whether claims in MultiPlan are direct or derivative. Direct cases are easier to bring because, unlike the derivative ones, they do not need to go through an extra step of satisfying demand futility requirements. In MultiPlan, Vice Chancellor Will decided that the claims are direct because “the plaintiffs are not suing because Churchill did not combine with MultiPlan on more favorable terms. They are suing because the defendants, purportedly for self-serving purposes, induced Class A stockholders to forgo the opportunity to convert their Churchill shares into a guaranteed $10.04 per share in favor of investing in” the combined entity.
From a D&O insurance perspective, there is a real consequence to the direct versus derivative distinction because of the way the insurance agreements work. The “Side A” part of the ABC D&O insurance program responds on a first-dollar basis, but only to non-indemnifiable claims. Settlements of derivative suits are usually not indemnifiable under Delaware corporate law, while direct suits are indemnifiable. While many SPAC D&O insurance programs are structured as traditional “ABC” programs, some SPAC teams, as a cost-saving alternative, are choosing to structure their programs as “Side A” only.
To the extent that a SPAC purchased a Side A–only policy, and the lawsuit is determined, like in MultiPlan, to be a direct one, there may be no D&O insurance response for a settlement (outside of a corporate bankruptcy).
For more about the various insurance agreements for a D&O insurance policy, you can refer to this article: Side A Insurance Overview for Directors & Officers. As a reminder, as long as a company is solvent, defense costs are always indemnifiable, which is to say not covered by a Side A–only D&O insurance program.
The Potential Effects of the Multiplan Case on the D&O Insurance Market
D&O insurance carriers, along with the rest of the SPAC market, are worried that cases like MultiPlan are easier to bring because they are direct and not derivative cases. If plaintiffs decide that this is a lucrative venue for them, litigation frequency will, of course, go up. If litigation frequency increases, SPACs will be more difficult to insure, and rates for D&O insurance for SPACs, which are already quite high, will surely rise.
Some have suggested that the MultiPlan litigation has prompted many SPAC teams to consider incorporating their SPACs outside of the United States, with the Cayman Islands being the preferred jurisdiction. The theory is that plaintiffs will be less successful in attempting lawsuits against Cayman-organized SPACs. This solution may create more problems than it may solve. Setting aside complex tax structuring and other difficulties, SPACs organized in the Cayman Islands will have a harder time securing D&O insurance because many US insurance carriers will not be able to offer D&O coverage for non-US entities.
An earlier version of this article appeared in the Woodruff Sawyer SPAC and D&O Notebooks on March 8, 2022.