2020 has been called “the year of the SPAC.” (2020 has been called a lot of other things as well, but for purposes of this blog post, I am going to focus on the SPAC-related issues.) The reason for the fanfare about Special Purpose Acquisition Companies (SPACs) is that there has been a wave of SPAC offerings this year, raising tens of billions of dollars of capital. While the rush to conduct SPAC offerings has at times started to feel like a stampede, there are in fact questions being raised about at least some SPAC transactions. As discussed below, there has been a series of recent lawsuits involving SPACs, and regulators have made it clear that they are concerned about some features of some SPAC transactions. These recent developments suggest that some trouble could be brewing in SPAC-Land.
What is a SPAC?
A SPAC is a “Special Purpose Acquisition Company,” an entity with no commercial operations formed for purposes of raising capital to be used to acquire an existing business. SPACs are formed by “sponsors,” often seasoned company managers with expertise in a specific industry or business sector. The SPAC raises the capital to make the acquisition by floating shares in the SPAC on a securities exchange through an initial public offering (IPO). Investors in the SPAC may not know, and usually don’t know, the identity of the company to be purchased, and that is why SPACs are sometimes referred to as “blank check companies.”
The funds raised in the offering are placed in an interest-bearing account. The SPAC usually has two years to make an acquisition. If the SPAC does not complete a transaction in two years, the funds are to be returned to investors.
SPACs usually acquire privately held companies as part of a reverse merger, with the idea that the existing operating company would be the surviving entity, which means that the previously private company becomes a publicly traded company through the transaction (often referred to as a “de-SPAC” transaction).
Getting acquired by a SPAC is as sometimes pitched to private companies an alternative to an IPO as a way to become a publicly traded company. In some circumstances, the dollar value of the acquisition exceeds the amount of cash that the SPAC is holding in trust, in which case the SPAC will conduct a PIPE offering (private offering in public equity) in conjunction, in order to raise sufficient funds to finance the acquisition.
According to SPACInsider (here), as of October 11, 2020, there have been a total of 138 SPAC IPOs so far in 2020, raising over $53 billion in offering proceeds. By way of comparison, during the full year of 2019, the prior year with the most SPAC offering activity, there were an annual total of 59 SPAC IPOs raising an annual total of $13 billion.
According to Renaissance Capital (here), and also as of October 11, 2020, there have been a total of 209 IPO transactions so far in 2020, meaning that the 138 SPAC offerings represent 66% of all IPOs completed so far this year. According to SPACInsider, there are already at least 23 planned SPAC transactions on the calendar for the remaining months of 2020, with more potential SPAC offerings in the wings. According to the Wall Street Journal (here), more than 80% of the funds raised in IPOs during 2020 has been in connection with SPAC offerings.
Developments Involving Nikola
Among the highest profile circumstances in which questions have been raised involving SPAC acquisitions involves the recent developments involving electric vehicle maker Nikola Corp.
In June 2020, Nikola went public through a reverse merger with the SPAC company VectoIQ Acquisition Corp. in a transaction that valued Nikola at over $3.3 billion. Nikola proved to be a high-profile company, and the value of its publicly traded shares soared after the merger transaction, and its market capitalization rose above $20 billion.
However, on September 10, 2020, short seller Hindenburg Research published a scathing report about Nikola (here), in which the stock analyst firm alleged that Nikola was conducting an “intricate fraud” built on “dozens of lies” by its founder and Chairman, Trevor Milton. Among other things, the report alleged that the company used deceptive videos to promote the capabilities of its vehicles. The report also suggested that the company had misrepresented the capabilities or even the ownership of its allegedly proprietary technologies (particularly its electric battery technologies).
The company immediately denied the Hindenburg Research report. However, days later, Milton resigned as Nikola’s chairman. Media reports circulated that the U.S. Department of Justice was investigating whether Nikola misled investors, along with the Securities and Exchange Commission.
And on September 15, 2020, a plaintiff shareholder filed a securities class action lawsuit in the District of Arizona against Nikola. A copy of the plaintiff’s complaint can be found here. (The next day, a separate but similar complaint was filed against Nikola in the Eastern District of New York, here.) The defendants named in the lawsuit include two officers of Nikola. Interestingly, and in addition, the named defendants in the lawsuit also include two former officers of VectoIQ, the SPAC that purchased Nikola. The complaint is filed on behalf of investors who purchased shares of Nikola, f/k/a VectoIQ, between March 3, 2020 (when the reverse merger transaction was announced) and September 15, 2020. The complaint alleges that the defendants violated Sections 10(b) and 20 (a) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder. The complaint seeks damages on behalf of the plaintiff class.
The complaint quotes extensively from the public statements VectoIQ made prior to the reverse merger transaction, particularly statements relating to Nikola’s proprietary technology. The complaint also extensively from statements allegedly made after the merger, including in particular a number of statements on Twitter by Milton about the company’s technology. In a section of the complaint captioned “The Truth Emerges,” the complaint quotes extensively from the Hindenburg Report. (Much of this section of the complaints consists of pages and pages of verbatim quotes from the report.) The complaint alleges that the price of Nikola’s shares fell on the release on the report, as well as on the release of a subsequent report from Hindenburg.
If Nikola were the only instance where a D&O claim was filed in connection with a SPAC acquisition transaction, that would be one thing. However, there have been a number of other securities suits and other D&O claims recently filed and arising out of or relating to SPAC acquisition transactions.
These SPAC-related claims generally fall into one of two categories; claims filed in connection with the de-SPAC acquisition itself, raising concerns about how the transaction has been structured or the price to be paid for the acquired company; and claims filed post-transaction, having to do with the post-transaction activities, operations, or statements of the acquired company.
An example of a lawsuit concerning the acquisition transaction is complaint filed on October 2, 2020 in the in New York (New York County) Supreme Court and in which a plaintiff shareholder of Kensington Capital Acquisition Corp., a publicly traded SPAC, and certain directors and officers of the Kensington Capital, in connection with a planned reverse merger transaction involving QuantumScape Corporation. The complaint alleges that individual defendants breached their fiduciary duties in agreeing to sell Kensington to QuantumScape. Among other things, the plaintiff alleges that the Kensington shareholders will retain only a small portion of the post-merger company, compared to the QuantumScape shareholders. The complaint alleges that the Kensington directors and officers agreed to the merger in order translate their illiquid holdings of Kensington stock into post-transaction publicly traded shares, in ownership percentages much greater than will be retained by the other Kensington shareholders. A copy of the Kensington complaint can be found here.
Lawsuits challenging announced SPAC acquisition transactions potentially could be the new flavor of the day. Plaintiffs’ lawyers now appear to be routinely circulating trolling press releases looking for prospective plaintiffs on whose behalf the plaintiffs’ lawyers can bring lawsuit challenging proposed SPAC acquisition transactions.
An example of a post-transaction shareholder class action lawsuit in which former executives of the SPAC are named as defendants is the lawsuit recently filed against Waitr Holdings. In September 2019, a plaintiff shareholder of Waitr filed a securities class action lawsuit in the Western District of Louisiana against certain directors and officers of Waitr, which had gone public in November 2018 through a reverse merger transaction with Lancadia Holdings. The named defendants included individuals who had served as executives of Lancadia prior to the reverse merger transaction. Among other things, the complaint alleges that Lancadia and its executives misled investors prior to the merger about the business record and prospects of Waitr. A copy of the Waitr complaint can be found here.
There are actually a wide variety of circumstances in which SPACs, their sponsors, and their directors and officers have become involved in corporate and securities litigation, as detailed in a very interesting October 1, 2020 memo from the Quinn Emanuel law firm entitled “Litigation Risk in the SPAC World” (here). For any one interested in a more detailed understanding of the litigation risk surrounding SPACs, the memo is a good starting point.
Potential litigation is not the only risk that SPAC companies and their executives may face. In addition, SPACs may be facing increased regulatory scrutiny. A September 24, 2020 Wall Street Journal article entitled “Blank-Check Firms Offering IPO Alternative Are Under Regulator Scrutiny” (here), reported that in televised remarks, SEC Chair Jay Clayton said that the SEC is, according to the article, “examining how sponsors of blank-check companies disclose their ownership and how any compensation is tied to an acquisition.”
The article quotes Clayton as saying “One of the areas in the SPAC space I’m particularly focused on, and my colleagues are focused on, is the incentives and compensation to the SPAC sponsors.” The article quotes him as saying further, “How much of the equity do they have now? How much of the equity do they have at the time of the IPO-like transaction? What are their incentives?”
SPACs and SPAC transactions clearly have caught the attention of plaintiffs’ lawyers and now even regulators, apparently. At one level, that arguably is unsurprising. Any time you get any widespread phenomenon involving as much activity and capital-raising as the current SPAC enthusiasm does, there are going to be some questions asked and even some problems that emerge. Even with that said, the recent developments are noteworthy and underscore the fact that there are risks associated with the SPAC structure and process.
One thing that is particularly important to note about the litigation discussed above is that in both of the types of D&O litigation described – that is, both the litigation raising objections in connection with the planned de-SPAC transaction and the litigation raising concerns about the post-transaction activities of the ongoing operating company – named as defendants executives from the SPAC company itself.
This is important because in my experience the individuals involved in putting together a SPAC often have a perception that they are engaged in very low risk activity involving little liability exposure. This perception is usually based on the individuals’ assessment of the risks with the SPAC’s initial capital raise transaction. Indeed, that part of the usual sequence of events is relatively lower risk, because the enterprise has no history, no operations, and little to report other than the plan to raise capital.
However, as the litigation examples above show, the events later in the SPAC organization life cycle can involve considerable risk. And as the statements from the SEC Chair show, there could be considerable regulatory risk involved with the initial SPAC offering transaction itself, depending on how the entity and transaction are structured.
These developments, and in particular the developments involving Nikola, have caught the attention of the D&O insurance underwriters. The SPAC sector has always been somewhat of a specialized D&O insurance arena, with very few insurers willing to write the primary D&O insurance for SPAC companies. The recent developments have roiled this already limited marketplace.
Over a very short time frame, the pricing for D&O insurance for SPAC companies, particularly the pricing for primary D&O insurance, has shot up significantly, even by comparison to the already elevated pricing that was available for SPAC companies as recently as at the end of the summer. The insurers willing to write primary for SPAC companies also have signaled that they intend to reduce their limits exposed to any one company; for example, insurers that might have been willing to write a $10 million primary limit are now only willing to write $5 million.
As often happens when the D&O insurance industry responds to adverse developments, the insurers are sweeping with a very broad brush. The significant price increases and reductions in capacity are even being applied to SPAC transactions with experienced, seasoned management teams and focused acquisition plans and with transparent disclosures about sponsors’ arrangements within the SPAC and in connection with any SPAC acquisition transaction.
The interesting thing is that even as some questions have begun to be asked, and even as lawsuits have been filed and regulators have raised questions, the current wave of SPAC offerings – at least for now – seems poised to continue, at least for the foreseeable future.
Because of the troubles that have begun to emerge in SPAC-Land, D&O insurance is going to be even more important for the SPAC companies as they complete their IPOs and as the move toward the ultimately acquisition transaction. Given the disruption in the D&O insurance marketplace surrounding SPACs, it is going to be even more important than ever for the SPAC companies to associate in their D&O insurance acquisition process the services of a knowledgeable insurance advisor that is experienced with SPAC transactions and deeply familiar with the D&O Insurance marketplace for SPAC companies.