Uncovering a gatekeeper: why the SEC should mandate disclosure of details concerning directors' and officers' liability insurance policies.

• Author: Griffith, Sean J.

This Article explores the connection between corporate governance and D&O insurance. It argues that D&O insurers act as gatekeepers and guarantors of corporate governance, screening and pricing corporate governance risks to maintain the profitability of their risk pools. As a result, in a well-working insurance market, D&O insurance premiums would convey the insurer's assessment of a firm's governance quality. Simply stated, firms with better corporate governance would pay relatively low D&O premiums, while firms with worse corporate governance would pay more. This simple relationship could signal important information to investors and other capital market participants. Unfortunately, the signal is not being sent. Corporations lack the incentive to disclose this information on their own initiative, and U.S. securities regulators do not require registrants to do so. This Article therefore advocates a change to U.S. securities regulation, making mandatory the disclosure of D&O policy details--specifically, premiums, limits, and retentions under each type of coverage, as well as the identity of the insurer.

1. GATEKEEPING II. SHAREHOLDER LITIGATION AND CORPORATE GOVERNANCE III. THE ROLE AND FUNCTION OF D&O INSURANCE A. How D&O Insurance Works B. Why Corporations Buy D&O Insurance IV. D&O INSURANCE AND CORPORATE GOVERNANCE A. Pricing the Policy: Correlating Corporate Governance and D&O Liability Risk B. Incentive Effects C. Signaling Effects V. SENDING THE SIGNAL A. Explaining the Absence of Voluntary Disclosure B. U.S. Law on the Disclosure of D&O Insurance Information 1. State Law Governing D&O Insurance 2. Federal Law and D&O Insurance C. A Canadian Comparison D. The SEC Should Mandate Disclosure of D&O Insurance Details CONCLUSION I. GATEKEEPING

   Much of the blame for the recent spate of corporate governance scandals has fallen on gatekeepers. Soon after the collapse of Enron and WorldCom, a leading corporate law scholar remarked that "Enron is more about gatekeeper failure than board failure." (1) Moreover, although gatekeepers can include a variety of third-party intermediaries--including auditing firms, debt rating agencies, equity analysts, investment bankers, and lawyers (2)--most of the post-Enron attention has been focused on the failings of the outside auditor. (3) Yet for all of the focus on the shortcomings of the outside auditor, another potential gatekeeper has escaped notice--the directors' and officers' (D&O) liability insurer. (4)

   Although their primary role is to spread the risk of loss from shareholder litigation, and not necessarily to provide the verification and certification services expected of third-party gatekeepers, D&O insurers have strong incentives to act as corporate governance gatekeepers. Because the D&O insurer assumes an insured's risk of shareholder litigation, the insurer must have a means of assessing that risk in order to determine an appropriate premium. Insofar as the risk of shareholder litigation is related to the quality of a firm's corporate governance, D&O insurers will use corporate governance assessments to screen prospective insureds and to quantify the risk of loss. In a well-working insurance market, the D&O insurer will thus serve as an accidental gatekeeper, guarding the entrance of its risk pool by evaluating the governance quality of prospective insureds.

   The D&O insurer's incentive to serve as a corporate governance gatekeeper produces a simple but powerful hypothesis concerning the relationship of D&O insurance to corporate governance: firms with worse corporate governance pay higher D&O premiums than firms with better corporate governance. Details from a firm's D&O policy should thus convey important information about the firm. By examining an insured firm's premiums, limits, and retentions, and by controlling for such variables as market capitalization, volatility, and industry, investors and other capital market participants should be able to glean the insurer's assessment of the quality of the firm's corporate governance. (5)

   This Article develops the governance-insurance link and explores its implications and limitations. Part II examines the connection between corporate governance and shareholder litigation. It argues that better corporate governance ought to lower a firm's total costs from shareholder litigation, thus providing ample incentive for D&O insurers to evaluate a firm's corporate governance. Part III reviews the role and function of D&O insurance in corporations, describing how D&O insurance works and why corporations buy it. Part IV then considers the relationship between corporate governance and D&O insurance, arguing that D&O insurers should and in fact do take corporate governance into account when writing (and pricing) D&O policies. As a result, Part IV ultimately concludes that a firm's D&O coverage ought to convey an important signal to investors and other capital market participants. Unfortunately, as discussed in Part V, this signal is not reaching the market. Corporations typically do not disclose the details of their D&O policies and, in the United States at least, there is no generally applicable rule forcing them to do so.

   There should be. Because basic D&O policy details could signal important information to investors and thereby improve the efficiency of the capital markets, this Article argues that U.S. securities regulation should be changed to require the disclosure of such information. The SEC has sufficient authority to make this change, which, as described in Part V, would be technically simple and unlikely to incur principled opposition. Moreover, the benefits of this change are potentially large: it will effectively uncover a new gatekeeper in American corporate governance and unleash a flood of useful information into the market. The Article concludes that the SEC should change the law and require D&O insurance disclosure.

2. SHAREHOLDER LITIGATION AND CORPORATE GOVERNANCE

   The hypothesis that D&O insurers function as corporate governance gatekeepers depends, first, on the relationship between shareholder litigation and corporation governance. As used in this Article, "shareholder litigation" refers to all claims covered under a D&O policy, whether brought by a shareholder or a regulatory agency, for which the resolution depends upon corporate or securities law. (6) The Article gives a similarly expansive definition to "corporate governance," defining it broadly to refer to any policies or structural mechanisms affecting management of a firm. (7) If there were no relationship between shareholder litigation and corporate governance, then the D&O insurer could not improve the quality of its risk pool by evaluating a firm's corporate governance. As a result, insurance premiums would have nothing more than a random, accidental relationship to corporate governance. This Part argues, however, that the relationship between corporate governance and shareholder litigation is strong enough to support the insurer-as-gatekeeper hypothesis.

   Shareholder litigation typically involves three types of claims: shareholder derivative actions, shareholder direct actions, and securities fraud claims. Derivative suits--actions brought by shareholders on the corporation's behalf to recover for a manager's breach of duty--were once thought to exert an important constraint on managerial agency costs. (8) Now, however, a wide variety of procedural mechanisms enables boards to terminate such claims early and at relatively low cost. (9) In addition to the derivative suit, state corporate law also allows shareholders to sue individually or as a class when they can allege an injury that is not derivative of an injury to the corporation. (10) These direct claims, typically brought as class actions challenging board conduct in the context of takeovers or acquisition transactions, have come to dominate state corporate law filings. (11) They are not as easily terminated as derivative claims and, according to some commentators, target precisely those transactions in which agency costs are potentially highest. (12) Finally, securities litigation may be brought in many of the same situations that give rise to state corporate law claims. (13) Although such claims must be framed around misrepresentations or inadequacies in corporate disclosure, (14) the basic concern--that company managers have misused their positions to the disadvantage of their shareholders--is the same whether the complaint is framed under corporate or securities law. (15) The biggest difference, it seems, is the potential for damages, with securities litigation presenting by far the greatest liability threat to corporations and their managers. (16)

   A long list of actions may give rise to one or more of these forms of shareholder litigation. A leading treatise provides a 170-item checklist of potential bases for liability with category headings including "Governance, Management and Business," "Informed Business Judgment," "Unauthorized or Ultra Vires Actions," "Self-Dealing and Conflicts of Interest," "Change of Control Situations," and "Disclosures." (17) The common theme underlying all of these liability threats, however, is a corporate structure that enables managers to act selfishly and contrary to the best interests of their shareholders. (18) Whether shareholders bring a derivative claim alleging a wealth transfer from shareholders to management, a direct action claiming that an entrenched board has not acted to maximize shareholder wealth in the context of a takeover, or a securities claim alleging that managers misstated earnings in order to protect their incentive compensation packages, the underlying issue is the failure of the corporation to design a structure to constrain its managers from acting to benefit themselves at the expense of shareholders. (19) Much shareholder litigation, in other words, arises as a result of managerial agency costs. (20)

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