Directors’ and Officers’ Liability Insurance, Independent Director Behavior, and Governance Effect

• Author: Xuesong Tang,Ning Jia
• Published date: 01 December 2018
• Date: 01 December 2018
• DOI: http://doi.org/10.1111/jori.12193

DIRECTORS’AND OFFICERS’LIABILITY INSURANCE,

INDEPENDENT DIRECTOR BEHAVIOR,AND

GOVERNANCE EFFECT

Ning Jia

Xuesong Tang

ABSTRACT

We examine the effect of directors’ and officers’ liability insurance (D&O

insurance) on the behavior of independent directors and the effectiveness of

their governance role. Using a unique data set, we find a negative relation

between D&O insurance and personal board meeting attendance by

independent directors and a positive relation between D&O insurance and

meeting attendance by authorized representatives. Content analysis of

independent director opinion reports indicates that D&O insurance encour-

ages independent directors to behave less responsibly. Insured independent

directors are also more likely to be busy. Collectively, D&O insurance

reduces the effectiveness of independent directors in corporate governance.

INTRODUCTION

Directors’ and officers’ liability insurance (D&O insurance) is a liability cover for

company directors and managersto protect them from claims that may arise from the

decisions and actions taken withinthe scope of their regular duties. D&O insurance is

now a common part of corporate risk management in North America and Europe,

and is becoming popular in emerging economies as well. Despite increasing

prevalence, there is an ongoing debate about the merits of D&O insurance, especially

Ning Jia is at the School of Economics and Management, Tsinghua University, Beijing, P.R.

China. Jia can be contacted via e-mail: jian@sem.tsinghua.edu.cn. Xuesong Tang is at the School

of Accounting, Southwestern University of Finance and Economics, Chengdu, P.R. China. Tang

can be contacted via e-mail: tangxs@swufe.edu.cn. We thank Qiang Cheng, Mei Feng, Pingyang

Gao, Zhaoyang Gu, Qingchuan Hou, Jing Liu, Feng (Harry) Wu, Xian Xu, Jianming (Jimmy) Ye,

Weining Zhang, participants of the 3rd CKGSB colloquium, and the Journal of International

Accounting Research Second International Conference for helpful comments. Ning Jia gratefully

acknowledges the financial support of the National Natural Science Foundation of China

(Project 71372049) and BNP Paribas-Tsinghua Center for Globalization of Chinese Enterprises.

Xuesong Tang gratefully acknowledges the financial support of the National Natural Science

Foundation of China (Projects 71372206 and 71672152) and support by Program for New

Century Excellent Talents in University (NCET-13-0963). We remain responsible for any

remaining errors or omissions.

© 2016 The Journal of Risk and Insurance. Vol. 85, No. 4, 1013–1054 (2018).

DOI: 10.1111/jori.12193

1013

its role in corporate governance. One view is that because D&O insurance shields

directors and officers from litigation risk and personal financial liability, it could

undermine corporate governance in that directors may reduce their monitoring

efforts and managers may pursue personal interests at the expense of shareholders

(Chung and Wynn, 2008). An opposite view is that D&O insurance is beneficial to

corporate governance because it allows competent professionals to serve as monitors

of companies without fear of personal financial loss (Core, 1997). Moreover, scrutiny

of a firm’s corporate governance by insurance companies before and after D&O

insurance purchase provides monitoring of directors and managers, and forces them

to engage in responsible conduct and deter wrong doings (O’Sullivan, 1997; Core,

2000; Boyer and Stern, 2014).

There is a growing literature on the governance effect of D&O insurance, but the

evidence remains inconclusive.One stream of studies show that a higher level of D&O

insurance coverage is associated with greater financial reporting aggressiveness

(Chung and Wynn, 2008; Kim, 2015), higher cost of equity (Chen, Li, and Zou, 2016),

higher loan spreads (Lin et al., 2013), greater risk taking (Boyer and Tennyson, 2015),

overinvestment (Li and Liao, 2014), a higher likelihood of lawsuits (Gillan and

Panasian, 2015), greater tax avoidance (Zeng, 2014), lower analyst forecast optimism

(Boubakri and Bouslimi, 2016),higher audit fees (O’Sullivan, 2009; Chung, Hillegeist,

and Wynn, 2015), and poorer post-IPO stock performance (Chalmers, Dann, and

Harford, 2002; Boyer and Stern, 2014). In mergers and acquisitions (M&As)settings, a

higher level of D&O insurance coverage has been found to be associated with lower

announcement-periodabnormal stock returns of acquirers(Lin, Officer, and Zou, 2011)

and a lower bid premium (Aguir et al., 2013). Collectively these evidencesupport the

view of negative governance effects of D&O insurance. In contrast, O’Sullivan (1997)

finds that D&O insurance reduces agency costs and improves corporate governance.

Donley and Kent (2008) conclude that D&O liability insurancehas become an integral

part of corporate governance in Canada. Yuan, Sun, and Cao (2016) find evidence

that D&O insurance in China is effective in reducing the stock price crash risk.

A potential limitation of these prior studies is that they draw inferences on the

governance implications of D&O insurance based on indirect evidence (e.g., how

D&O insurance coverage is perceived by corporate stakeholders, or affects firm

performance). A more direct approach would be to examine how D&O insurance

actually affects the personal behavior of managers and directors, who are the main

beneficiaries of such insurance. In this study, we provide direct evidence on how D&O

insurance coverage affects the actions of independent directors—a major class of

beneficiaries of this insurance.

As first line of defense for minority shareholders, independent directors are a critical

element of a firm’s corporate governance system. As they do not work in the company

on a daily basis, the main channel through which they devote effort to the company

and carry out their governance responsibilities is through the attendance of board

meetings and issuing opinions on key corporate decisions (Adams and Ferreira,

2008). However, a common challenge facing board-related research is that director

behavior is rarely observable by outsiders (Adams, Hermalin, and Weisbach, 2010;

Adams, Lin, and Zou, 2011). As a result, the empirical literature has not advanced

1014 THE JOURNAL OF RISK AND INSURANCE

much beyond surveying the impact of board composition on observable corporate

outcomes such as firm performance (Bebchuk and Cohen, 2005), prevention of

accounting fraud (Beasley, 1996; Klein, 2002), and decisions on executive compensa-

tion and turnover (Weisbach, 1988). Only several studies have attempted to “look

inside the boardroom” to better understand the inner dynamics of boards.

1

In this article, we are able to take a closer look at the impact of D&O insurance on the

behavior of independent directors by taking advantage of China’s regulatory setting

that requires public companies to disclose every independent director’s board

meeting attendance records and opinions on key corporate matters. This research

setting offers several distinct advantages. First, unlike the United States where

researchers are only able to observe board meeting attendance at the 75 percent

threshold, we are able to obtain data on the exact attendance rate for every director.

Second, U.S. corporations only disclose meeting attendance in a binary form—either

attendance or absence—whereas Chinese corporations disclose the specific type of

attendance—personal attendance, attendance by representatives appointed by the

independent director (proxy attendance), and absence. Distinguishing between

personal attendance and proxy attendance is important as Chou, Chung, and Yin

(2013) find personal board meeting attendance enhances firm performance, while

proxy attendance has an adverse performance implication. Third, U.S. firms do not

disclose independent directors’ opinions. In contrast, the Chinese Securities and

Regulatory Commission (CSRC) mandates that independent directors of listed

companies publicly issue opinion reports on major corporate events, including the

appointment and dismissal of senior managers, material intercorporate loans to

shareholders, and other events that independent directors consider to be detrimental

to the interests of minority shareholders (Tang, Du, and Hou, 2013).

2

Detailed quantitative and qualitative director behavioral data disclosed by public

Chinese companies therefore provide us a rare opportunity to observe the behavior of

independent directors and assess the impact of D&O insurance coverage on their

effort level. Specifically, we examine three measures of a director’s expenditure of

effort—board meeting attendance, diligence level as reflected in independent director

opinion reports, and busyness.

The first measure of director effort that we examine is board meeting attendance.

Based on a sample of Chinese firms between 2004 and 2012 and a matched-pair design

1

Adams and Ferreira (2008) study board meeting attendance and its association with director

compensation using a sample of U.S. firms. Schwartz-Ziv and Weisbach (2013) analyze board

meetings minutes of 11 Israeli government-owned companies and find that boards spend most

of their time supervising management rather than dictating how the company should be run.

2

Each opinion report generally contains a description of the subject matter and the associated

independent directors’ opinions. However, those reports vary significantly in additional

qualitative information disclosed, including how independent directors formed their

opinions, and/or any actions they have taken about the subject matter. Information disclosed

in the opinion reports are perceived to be objective and credible as these reports are subject to

review by the CSRC and other relevant regulatory bodies, and independent directors are held

accountable for the content.

D&O INSURANCE AND INDEPENDENT DIRECTOR BEHAVIOR 1015