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Attack of the SPACs

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Special Purpose Acquisition Vehicles (SPACs) have surged in popularity due to their ability to raise capital through the public equity markets.

Somewhat surprisingly, through July 2005, SPACs have accounted for 20 percent of the total IPO registrations with 38 SPACs having been filed and 13 having gone public as reported in Corporate Financing Week.

The facts on SPACs

SPACs are formed with the sole objective of effecting a merger, capital stock exchange or asset acquisition (also called a "business combination") with an unidentified target. In other words, a SPAC's purpose is to become a publicly traded corporate-buyout fund.

SPACs typically are formed by a small group of investors who initially hold 100 percent of the common equity. These "initial stockholders" also serve as the management team during the period where the SPAC is searching for the prospective business combination.

Generally, a SPAC's directors and officers receive no compensation from the SPAC for any services they perform other than reimbursement for out-of-pocket expenses.

A SPAC's registration statement sets forth a description of the target sector, the criteria that management will use to screen prospective targets, biographies of management and directors as well as a description of the securities to be offered in the IPO. Typically, SPACs will target a specific industry such as technology, shipping, advertising, mining, banking, health care or energy.

SPACs trade on the OTC Bulletin Board; however, the American Stock Exchange recently stated that it will consider listing SPAC securities if certain prerequisites are met. A SPAC also may be listed on Nasdaq or the NYSE after the business combination is completed and the SPAC otherwise satisfies their listing criteria.

Hedge funds are the most common investors in SPACs and their interest in this product has been a significant factor in the surge of SPAC IPOs.

Some of the reasons for hedge fund interest are: SPACs provide immediate liquidity assuming a vibrant secondary market; SPACs allow hedge funds to show their investors that they are not maintaining excess cash and SPACs give hedge funds flexibility to continue owning the shares after the initial business combination or protection if they vote against a business combination.

The unique structure of SPACs

SPACs are part of a broader category designated under Delaware law as "blank check" companies. Although not technically a "blank check" company under Rule 419 of the Securities Act of 1933, the structure of a SPAC generally follows most of Rule 419's requirements. Rule 419 of the Securities Act imposes restrictions upon issuers that are deemed to be "blank check" companies. "Blank check" companies generally lack assets, operating history or revenues, and all of their securities must be placed in escrow until after the completion of a business combination.

These self-imposed restrictions are included in the SPAC's registration statement and are intended to provide a level of investor protection. With few exceptions, SPACs share the following characteristics:

Proceeds are protected in trust: A fixed percentage (usually around 90 percent) of the SPAC's IPO proceeds are deposited in trust and will not be released until either (1) the business combination occurs, or (2) the SPAC is liquidated.

Time limit on effecting the business combination: In the event a SPAC fails to effect a business combination within a pre-set time limit (typically 12 to 18 months), the SPAC is required to liquidate and distribute a pro rata share of the escrowed funds to the stockholders.

Minimum size of business combination: The SPAC's business combination, which can include one or more operating businesses, must have a fair market value in excess of 80 percent of the SPAC's net assets at the time of the acquisition.

Shareholder protection: SPACs must obtain majority approval from its investors before any business combination can be effected. If a shareholder votes against a business combination that is subsequently approved, that shareholder has the right to convert their common stock into a pro rata share of the trust account.

In the event that more than 20 percent of the disapproving shareholders seek to convert their shares, a SPAC would be prevented from completing the proposed business combination.

Lock-ups for management: Typically, the pre-IPO shareholders who are management are required to enter into lock-up arrangements until some period of time (usually six months) after a business combination has been effected.

D&O issues for SPACs

If the IPO is successful, a SPAC must comply with SEC reporting and corporate governance requirements as a result of its public company status. A SPAC must also comply with all of the corporate governance requirements imposed by the Sarbanes-Oxley Act of 2002.

Of course, this includes all of the legal risks entailed in being a director or officer of a public company. As such, most SPACs include a budgeted amount for directors and officers (D&O) insurance in their registration statements.

In general, the structure of D&O coverage available to SPACs is the same as for any other IPO company. However, many carriers still are not comfortable with underwriting SPACs primarily because of the uncertainty of what the actual "business combination" will look like and/or historical experiences with "blank check" companies.

There are also some unique SPAC-specific coverage issues worth noting. Specifically, there are significant differences in how carriers will respond when the business combination actually takes place.

Special attention should be paid to the change-of-control provisions and the auto-subsidiary thresholds that exist in every D&O contract. Under the change-of-control provision, the D&O policy converts to run-off coverage either upon the acquisition by another entity or after a merger/business combination such that the insured is not the survivor.

With the auto-subsidiary threshold, any acquisition over a certain percentage (typically around 25 percent of assets) automatically will be covered for a period of 90 days and is then subject to additional underwriting. After underwriting the new subsidiary, the insurer may choose to make a coverage or premium adjustment.

Given that the purpose of a SPAC is to make such a large acquisition, the above provisions should receive very close analysis. The D&O broker should amend these provisions to ensure that the SPAC's directors and officers have coverage for pre- and post-acquisition activities - when the risk of litigation will most likely increase.

Town is a broker with Carpenter Moore Insurance Services Inc. Niedernhofer is a senior account executive in Barney & Barney's Executive Risk Practice. For more information, call (858) 587-7144 or e-mail JohnN@barneyandbarney.com>

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