As merger and acquisition activity heats up, SPACs can use insurance to safeguard their investments against target liabilities that emerge following a de-SPAC transaction.
Protecting SPAC Investment
SPACs are completing IPOs at a record pace. With the addition of over 140 so far this year, there are now more than 330 SPACs actively searching for a target to acquire. As SPAC sponsors identify and pursue candidates for acquisition, they should bear in mind recent SPAC litigation, including Modern Media Acquisition Corp’s (Modern Media) troubled transaction with Akazoo S.A. (Akazoo), and consider whether representations and warranties (R&W) insurance should play a role in protecting investors against a similar fate.
The Akazoo Transaction
In September 2019, Akazoo, a music streaming company, completed its business combination with Modern Media in a transaction that valued Akazoo at $469 million. In April 2020, Quintessential Capital Management issued a report that claimed it had uncovered fraud and offered the opinion that “Akazoo looks like an accounting scheme.” As a result, Akazoo’s board of directors launched an internal investigation into its revenue sources and contractual arrangements. The board formed a special committee, which determined that “former members of Akazoo’s management team and associates defrauded Akazoo’s investors, including Modern Media, by materially misrepresenting Akazoo’s business, operations, and financial results.” The board announced that prior financial statements should not be relied upon because they are materially false and misleading.
The special committee stated that Akazoo had “only negligible actual revenue and subscribers for years and that former members of Akazoo management and associates participated in a sophisticated scheme to falsify Akazoo’s books and records, including due diligence materials provided to [Modern Media] and its legal, financial, and other advisors in connection with the Akazoo business combination in 2019.”
Following this report, on June 19, 2020, a class action lawsuit was filed that claimed that 1) Akazoo overstated its revenue, profits and cash holdings; 2) Akazoo holds significantly lesser music distribution rights than it stated and implied; 3) Akazoo does not operate in 25 countries, contrary to its continued statements; 4) Akazoo has a significantly smaller user base than it stated; 5) Akazoo closed its headquarters and other offices around the world; and 6) as a result, Akazoo’s public statements were materially false and/or misleading at all relevant times.
The Role of R&W insurance
Had Modern Media obtained an R&W insurance policy in connection with the transaction, losses resulting from these alleged misrepresentations would likely have been covered by the policy. While the scope of policy coverage is ultimately determined by the actual representations and warranties negotiated in the underlying acquisition agreement, these representations regularly include broad statements about the target’s material contracts and the accuracy of the target’s financial statements, which appear to be at issue in the Akazoo deal. Further, a properly drafted buyer R&W insurance policy would have covered losses resulting from a breach regardless of whether fraud by the sellers was alleged. In that event, the insurer would retain the right to subrogation and to seek to recover damage against the sellers.
R&W insurance is now a well-established tool that is used in the majority of private company acquisitions. It replaces or supplements typical seller indemnities for pre-closing taxes and breaches of representations in an acquisition agreement, protecting the buyer broadly against unidentified liabilities related to the acquired business for pre-closing periods. With a few narrow exceptions, it can be obtained regardless of the target company’s industry, including highly regulated ones like healthcare and financial services. Further, the standard term of coverage on R&W insurance policies is six years for so-called fundamental representations and tax representations, and three years for all other representations in the acquisition agreement, a vastly longer period than a customary escrow or holdback period supporting a seller indemnity for these types of exposures. There are a number of other advantages that insurance has over a traditional seller escrow and indemnity approach, as well.
Since Akazoo, a series of recent class action litigations that potentially implicate breaches of representations have been filed with respect to the de-SPAC transactions for targets Churchill Capital, Nikola and QuantumScape. This trend seems to have refocused the SPAC community on the importance of negotiating a meaningful source of recourse, whether it is seller indemnity or insurance, for breaches of representations in the acquisition agreement. This is clear from the significant increase in de-SPAC transaction inquiries that have been fielded by R&W insurance brokers, including NFP, over the past six months.
This recent spike in interest in R&W insurance likely also stems from favorable changes to policy coverage on two matters that are of particular importance in de-SPAC transactions. Historically, binding R&W insurance coverage at the signing of a delayed-closing transaction required the payment of significant upfront costs prior to closing. Insurers also had limited appetite to provide full coverage for transactions where new investors were acquiring a minority interest in the target. Given the limited liquidity available to SPACs prior to closing and the prevalence of minority investments in de-SPAC transactions, SPAC sponsors’ skepticism about the utility of R&W insurance in their deals was, until recently, well-founded.
In the current R&W insurance market, policies can be obtained at signing without any upfront payments. Premium payment deposits and underwriting fees may be fully deferred until the closing or abandonment of the transaction. Further, some insurers have been willing to provide non-prorated policy coverage, even where the buyer is acquiring substantially less than 50% of the target’s equity. In that event, a seller or management statement regarding the accuracy of the representations is required. With these two key developments, R&W insurance has become a much more effective solution for de-SPAC transactions.
Any SPAC considering the use of R&W insurance should engage outside legal counsel and insurance advisors with experience negotiating coverage specifically for de-SPAC transactions. The use of R&W insurance in these deals is certain to raise unique legal and insurance issues. For example, the insurance policy, while arranged by the SPAC prior to the signing, should become a direct asset of the combined company in connection with the closing. The use of R&W insurance will also impact the SPAC’s approach to due diligence, which will need to be broad and well documented to support the R&W insurer’s underwriting process. It will also influence the approach to negotiating and drafting key provisions of the acquisition agreement, including the scope of the representations.
As this new wave of SPAC M&A heats up, sponsors should seriously consider structuring robust protection against unidentified pre-closing target exposures to avoid an outcome similar to the Akazoo case. When the process is managed by experienced advisors, R&W insurance is an effective way to manage risk in the context of de-SPAC transactions.