Directors, directors and officers insurance, and corporate governance

Electronic copy available at: http://ssrn.com/abstract=1722289

DIRECTORS, DIRECTORS AND OFFICERS

INSURANCE AND CORPORATE GOVERNANCE

By

Professor Li‐Ming Han (deceased)

Department of Finance

The Chinese University of Hong Kong

Shatin, Hong Kong

Professor Richard MacMinn

Edmondson‐Miller Chair

Katie School of Insurance

Illinois State University

Normal, IL 61790

[email protected]

Dr. Yayuan Ren

College of Business

Illinois State University

Normal, IL 61790

[email protected]

Electronic copy available at: http://ssrn.com/abstract=1722289

Directors, D&O Insurance and Corporate Governance

2

Abstract

This article models a board of directors consisting of either pure directors or shareholder directors.

Different from pure directors, shareholder directors own equity of the firm in addition to receiving

directors’ fee. The model reaches a conclusion that if directors owe their appointments to the CEO, both

pure and shareholder directors tend to endorse CEO’s decisions unless they can form a majority to

counter‐balance the CEO. It shows that D&O insurance does not change directors’ decisions to follow the

CEO but affects their decisions to accept the job. The analysis also shows that when the board is made up

of only shareholder directors who have equal equity and liability stakes in the firm, the board will move

the CEO’s decision toward one that maximizing shareholders’ value.

Keywords: Directors, Directors and Officers insurance, Corporate Governance


3

In the abstract of their seminal paper on ownership and agency problems, Jensen and Meckling

(Jensen and Meckling 1976) write

The directors of such [joint‐stock] companies, however, being the managers rather of other

people's money than of their own, it cannot well be expected, that they should watch over it with

the same anxious vigilance with which the partners in a private copartnery frequently watch over

their own.

Shareholders of Waste Management, Enron and WorldCom, for example, apparently concur.

Waste Management and its directors and officers settled for $457 million in a securities class

action suit for misrepresenting material facts about the company’s 1998 merger with USA Waste

Services, Inc. and a 1999 accounting scandal that resulted in two revisions of the reported

earnings and taking a 1.8 billion write‐off. The directors of Enron were held liable for their role

in the Enron’s fraudulent accounting practices and settled the claims for $168 million.

WorldCom directors had to pay $36 million for their roles in WorldCom’s $11 billion accounting

fraud, which resulted in the largest bankruptcy in U.S. history. As a consequence of these

scandals, corporate governance and particularly the role of boards of directors has been the

topic of a great deal of attention in the literature. One question most asked about directors

concerns what motivations their actions. In this paper, we are particularly interested in what

motivates directors and officers actions with and without Directors and Officers (D&O)

insurance.

Much of the research, largely are empirical, has been devoted to the influence of D&O insurance

on corporate governance. A few papers (Bhagat, Brickley et al. 1987; Janjigian and Bolster 1990;

Brook and Rao 1994) find that D&O insurance has no impact on firms’ stock return, suggesting

little effect of D&O on corporate governance. Holderness (1990) and O’Sullivan (1997) suggest

that D&O insurance promotes corporate governance, as D&O insurers serve as corporate

governance monitors. Their results are supported by Core (2000), who, using Canadian data,

provides evidence that the D&O insurance premium reflects the quality of the firm’s corporate

governance. The monitoring role of D&O insurers, however, is challenged by Baker and Griffith

(2007; 2007), who investigate the D&O insurers’ underwriting process and loss prevention

services. They find that the quality of a firm’s corporate governance is reflected in a limited way

in D&O insurance pricing and that D&O insurers do not provide loss prevention services or

otherwise monitor corporate governance of the insured firm. In the abstract of Baker and

Griffith (2007), they state: “Our findings raise significant questions about the value of D&O

insurance for shareholders as well as the deterrent effect of corporate and securities liability.”


4

Core (1997) find that firms with greater litigation or financial distress risk have greater demand

for D&O insurance. Similarly, Chalmers et al. (2002) find that initial public offering (IPO) firms

with substantial D&O insurance coverage were more likely to be sued in the future for

mispricing. Hence, the literature suggests that the influence of D&O insurance on directors’

decisions and so on corporate governance remains an open one.

In this study, we contribute to the literature by developing a theoretical model to investigate the

influence of D&O insurance on directors’ decisions.

Directors and Officers Insurance

In recent years, firms and their directors and officers have seen an increasing number of claims

and increasingly large settlements. According to the Towers Perrin’s 2007 D&O Liability Survey,

(2007) public companies reported a claim frequency of 42% over a ten‐year period, and

companies with assets greater than $10 billion had a claim frequency of 115%. The survey

indicates that the average size of claims in 2007 was greater than $12 million, with average

defense costs exceeding $2 million.1 In light of these numbers, it is not surprising that 95% of

Fortune 500 companies maintain directors and officers’ insurance.

D&O Insurance, usually purchased by firms, reimburses directors and officers for the cost of

defending and settling lawsuits against them. Coverage is provided for "wrongful acts" as

defined in the policy. D&O insurance does not cover actions that are knowingly fraudulent, that

involve obvious conflicts of interest, or that should have been known to be illegal. In the United

States, firms are often mandated to indemnify directors and officers under either state

corporate law or firm bylaws. D&O insurance in turn reimburses the firm for the litigation costs,

and pays the directors’ and officers’ costs directly when the firm cannot.2 In countries where

legislation prevents firms from purchasing the insurance, a premium split between the directors

1 See Towers Perrin’s 2007 D&O Liability Survey, Exhibit 65, 68, 72 and 73.

2 For directors and officers, such firm indemnification agreement and D&O insurance are substitute or supplementary

to each other. Our analysis about D&O insurance essentially can also apply to the firm’s indemnification agreement

for directors and officers.


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and the firm is often done to demonstrate that the directors have paid a portion of the

premium.3

The major arguments in support of corporate purchase of D&O insurance include: (i) D&O

insurance can attract and retain talented individuals to serve as directors and (ii) the absence of

insurance may encourage conservative management, which is unlikely to be in the interests of

shareholders. The major criticism of D&O insurance is that it creates a moral hazard problem

and weakens the deterrence effect that shareholder litigation is supposed to provide in aligning

managers’ and directors’ incentives with those of shareholders.

Directors’ Incentives

Directors are agents of the shareholders. Their inherent interests are unlikely to be aligned with

those of the shareholders. Directors’ incentives are affected by factors such as compensation,

continuance of appointment, composition of the board and reputational concerns.4

There are two types of directors who sit on the board: pure directors and shareholder directors.

Pure directors do not own equity in the firm, and the only or major source of compensation for

them is a director’s fee. Shareholder directors hold a portion of the firm’s equity and receive a

director’s fee. These two types of directors have different interests in the firm, so they may

behave quite differently. In addition to directors’ compensation, directors are also concerned

about keeping their seats on the board. The fact that directors usually owe their appointments

to the CEO makes the monitoring role of directors problematic (Hermalin and Weisbach 2003;

Adams, Hermalin et al. 2010). Further, the board needs a majority to support any

recommendation at odds with that made by the CEO. The analysis here shows that without a

majority, directors are unlikely to oppose CEO decisions.

3 Our primary source of the description of D&O insurance is Wikipedia.

4 Fama (1980) suggests that the concern for reputation will cause directors to act more in shareholder’s interests.

However, a reputation as a director who does not make trouble for CEOs is potentially valuable to the director as well.

Because of its ambiguous role on director’s behavior, reputational concerns are left out of analysis.


6

It is generally believed that the use of equity in a manager’s compensation package can help

align managers’ interest with owners’. However, the possibility of using debt instruments in

managers’ compensation has received little attention. Sundaram and Yermack (2007) and

Gerakos (2007) find empirically that U.S. executives have substantial amounts of deferred fixed

compensation with their companies. Sundaram and Yermack suggest that executives adjust the

ratio of fixed to performance‐based compensation over time to match their firms’

debt‐to‐equity ratios as Jensen and Meckling (1976) imply without formal proof. Edmans

(2007) finds in his model that fixed compensation as a part of the CEO’s compensation can be

optimal for shareholders. Following Jensen and Meckling (1976), Edmans models the agency

costs of debt that are borne by shareholders. The CEO, having a fixed claim against the firm’s

liquidation value in bankruptcy, takes into account her interest as a liability‐holder when making

corporate decisions. In doing so, the agency costs of debt decline, thus benefiting shareholders.

MacMinn and Han (1990) come to the same conclusion in their analysis of corporate demand

for liability insurance.

This study first establishes the pure directors’ and shareholder directors’ objective functions in

the same framework as in MacMinn and Han (1990). Like the manager,5 the director’s objective

function is to maximize her respective wealth in the firm. This study shows that the manager’s

investment decision on corporate is consistent with that which maximizes shareholder wealth

when her fixed claims against the firm as a percentage of the firm’s total liabilities are equal to

her share holding as a percent of the firm’s total equity. This condition is not equivalent to the

condition that the manager’s personal debt‐to‐equity ratio against the firm equals to the firm’s

debt to equity ratio as Sundaram and Yermack (2007) and Edmans (2007) suggest because many

firms have liabilities other than debt.

Major U.S. corporations pay directors fees, ranging from US$150,000 to US$250,000 annually,

that are considered substantial by Warren Buffett.6 The director’s fee represents the only or

5 The term manager is used interchangeably with CEO.

6 The Berkshire Hathaway 2006 Annual Report, p. 18, states:

In selecting a new director, we were guided by our long‐standing criteria, which are that board

members be owner‐oriented business‐savvy, interested and truly independent. I say “truly”

because many directors who are now deemed independent by various authorities and observers

are far from that, relying heavily as they do on directors’ fees to maintain their standard of living.


7

major source of income for pure directors. Due to the fact that many directors owe their

appointments to the CEO and that directors need a majority to have their recommendations

become decisions, pure directors alone, will choose to endorse CEO’s decisions. In face of

potential litigation risk, when the composition of the board of directors is left out of analysis,

pure directors would demand, as a condition to accept the appointments, D&O insurance

coverage paid for by the firm for firms whose risks are hard to assess and potential D&O

liabilities are large. In cases where the risk and potential liabilities are low so that the director’s

fee outweighs the D&O insurance premium, pure directors would pay for the D&O insurance

from their own pockets.

Shareholder directors make decisions to maximize their wealth in the firm if they get to make

decisions. Like the CEO, shareholder directors’ decisions will be consistent with maximizing

corporate value when they have equal personal equity and liability stakes in the firm. But they,

each standing alone, are not given the authority and power to make decisions. If they dissent

from the CEO without the support of a majority of the board, they face the same fate of being

terminated as pure directors. Thus, without the support of a majority of the board, all directors

behave the same and have the same demand for D&O insurance to protect themselves from

lawsuits for rubber‐stamping CEO’s decisions.

The model here reaches a conclusion that both pure and shareholder directors tend to

rubber‐stamp CEO’s decisions unless they can form a majority and act in their own interest to

counter‐balance the CEO. Further this study shows that D&O insurance does not alter directors’

behavior but the composition of the board does. When the board is made up of shareholder

directors who have equal personal equity and liability stakes in the firm, the board will move the

CEO’s decision toward one which maximizes shareholders’ value.

These payments, which come in many forms, often range between $150,000 and $250,000

annually, compensation that may approach or even exceed all other income of the “independent’

director. And—surprise, surprise—director compensation has soared in recent years, pushed up by

recommendations from corporate America’s favorite consultant, Ratchet, Ratchet and Bingo. (The

name may be phony, but the action it conveys is not.)


8

The Model

Consider an economy operating between the dates t = 0 and 1, referred to subsequently as now

and then, respectively. All decisions are made now and all payoffs on those decisions are

received then. The economy is composed of investors, corporate managers and corporate

directors. All agents are risk averse make portfolio decisions on personal account to maximize

expected utility subject to a budget constraint. The corporate managers and directors make

decisions on personal account as investors but also make decisions on corporate account.

Let bethe state space for the economy. All risks are functions mapping from to the real

numbers. State in represents an index of economic conditions and is the set of these

index numbers. The corporate payoff or speculative risk is the random variable : R.

Suppose the financial markets are competitive. A basis stock in this economy is a promise to pay

one dollar then if state is observed then and zero otherwise; let p() be the price of the basis

stock that pays one dollar if state occurs and zero otherwise. There are as many basis stocks

as there are states in .

The following summarizes the notation used in the development of the model:

economic state variable

set of economic states

consumption now and consumption then in state

income now and then from non‐corporate sources

probability distribution function of states

N number of corporate shares of stock previously issued

m number of corporate shares of stock issued to the

manager

n number of new shares of stock issued to finance the

investment

0 1( , ( ))c c

0 1( , ( ))m m

( )F


9

b promised payment on a zero coupon bond then

c promised payment on corporate compensation then

Corporate payoff given investment I and state

p() basis stock price now

P() sum of basis stock prices ;

S Stock value of corporation now

N Number of shares previously issued

m Number of shares owned by manager now

n Number of new shared issued to finance investment

B Bond value of corporate debt now

C Creditor value now

manager’s initial proportion of corporate equity;

manager’s proportion of compensation then

director’s proportion of corporate equity

director’s proportion of compensation then

In this setting is should be noted that the stock market value of the corporation now is S where

(1)

where I is an investment decision made now. Suppose that the corporate payoff is an increasing

function of the investment. Letting D denote the value of the corporate liabilities, we note that

(2)

( , )I

0

P( ) p( )d

m

N m

max 0, ,S I I b c dP

min , ,D I I b c dP


10

It follows that the bond value and other creditor value may be expressed as

(3)

and

(4)

respectively. It follows that the corporate value is .

Manager

Consider the behavior of the corporate manager. The manager makes decisions on personal

account and corporate account now to maximize expected utility subject to a budget constraint

and a financing constraint. The financing constraint requires that the value of new shares issued

be equal to the investment. The constrained maximization problem is

(5)

The financing constraint says that the value of the new stock issue equals the investment

expenditure. It may be rewritten at

(6)

where is the value of the new issue. Similarly, the value of the existing or old stock issue

would be expressed as

min ,b bb c b c

B b dP D

min ,c cb c b c

C c dP D

V S D S B C

0 1

0 1 0 1

maximize , ( ) ( )

subject to ( ) ( ) ( ) ( )

min , ( ) max 0, ( ) ( )

and max 0, ( ) ( )

c mb c N n m

nN n m

u c c dF

c c dP m m dP

c dP b c dP

b c dP I

( ) ( )nnN n m

S I S I I

( )nS I

( ) ( )oN mN n m

S I S I


11

Note that (6) implicitly defines the number of new shares required for an investment of I dollars.

Hence, (6) implicitly defines the function ( )n I where

(7)

Using (4) and (7), the constrained maximization problem may also be expressed as

(8)

It then follows by observation and direct calculation that the corporate manager makes

decisions on corporate account to

(9)

Note that in the absence of a positive the manager would select the investment to maximize

the value of the current shareholders interest in the corporation. With a positive , however,

the manager selects the investment to maximize the weighted average of current shareholder

interests and creditor interests. The manager’s condition for an optimal investment is

(10)

Let denote the investment implicitly defined by (10). The socially optimal investment is that

which maximizes the net value of all stakeholders in the firm or equivalently the investment

such that

(11)

Let denote the investment implicitly defined by (11). If there is no insolvency risk so that the

investment does not have an impact on the bondholder or creditor values then maximization of

current shareholder value yields the socially optimal investment and (10) yields an investment

that is socially optimal, i.e., . If there is a positive probability of insolvency then the

investment and its relationship to is less clear. To make a comparison note that

( )( )

In I N m

S I I

0 1

0 1 0 1

maximize , ( ) ( )

subject to ( ) ( ) ( ) ( ) ( ) ( )

u c c dF

c c dP m m dP C I S I I

maximize ( ) ( ) ( ) ( )oS I I C I S I C I

( ) 1 ( ) 0S I C I

mI

( ) 1 0V I

vI

m vI ImI vI


12

(12)

It follows from (12) that the manager selects the value maximizing investment level if her equity

stake equals her creditor stake, i.e., if then . Since the creditor value

( )D I is an increasing function, it also follows that and

.

Directors

Next consider the directors on the firm’s board. Suppose each director is paid a fix salary that

represents a portion of the creditors’ liability c. Some directors hold a substantial number of

shares of corporate stock and others do not. The shareholder‐director owns a portion of the

firm’s equity. The directors make decisions on personal account and provide advice on

corporate account to solve the following constrained maximization problem

(13)

It follows again by direct calculation that the shareholder director provides advice on corporate

account to

(14)

( ) ( )

max 0, ,

min , ,

, min , ,

( ) ( )

S I I C I

I b c dP I

cI b c dP

b c

cI dP I I b c dP

b c

cV I I D I

b c

( )c b c m vI I

if ( )m vI I c b c

if ( )m vI I c b c

0 1

0 1 0 1

maximize , ( ) ( )

subject to ( ) ( ) ( ) ( ) ( ) ( )

u c c dF

c c dP m m dP S I I C I

maximize ( ) ( )S I I C I


13

It may be noted that if there is no insolvency risk then is a constant and shareholder

directors are motivated to advise management to select the investment that maximizes stock

value. If there is insolvency risk then it is apparent that shareholder directors are motivated to

provide advice that is consistent with the wishes of management if their ownership interests

relative to their creditor interests are the same or equivalently if

(15)

The pure directors with no stake in corporate shares, however, provide advice on corporate

account to

(16)

and so these pure directors are motivated to provide advice that increases creditor value. If

there is no insolvency risk then the pure directors are indifferent to the investment choice of

management. If there is insolvency risk then additional investment that reduces the probability

of insolvency increases the value of the director’s stake in the firm and is supported by pure

directors; hence, given financial risk, pure directors have the incentive to advise investment

levels in excess of those that maximize value, i.e., stock or corporate.

Many directors owe their positions to the CEO. They are therefore inclined to go along with the

CEO for continued appointment. Unless the CEO’s respective interests in the firm’s equity and

liability are equal, i.e., , the CEO would over or under invest. Directors’ advice to support

or oppose the CEO depend on and . To simplify, the directors who oppose the CEO are sure

to be terminated right away; and those who support keep their appointments. This timing

arrangement, the board’s decision and the director’s dismissal occur only seconds away and

simplifies the notation without compromising the results. The shareholder‐director has the

financial incentive to support the CEO if her debt/equity stake is the same as that of the CEO;

otherwise the incentive, while still financial, is to support the CEO and avoid dismissal. Recall

that the CEO under‐invests and selects ; the shareholder‐director

concurs in the under‐investment if , however the magnitude of the

under‐investment advice may be different. Similarly, the CEO over‐invests and selects

( )C I

sI

.

maxmize ( )C I

if ( )m vI I c b c

( )c b c


14

and the shareholder director concurs in the over‐investment if

; of course, the magnitude of the over‐investment advice may be different. The

pure director’s has a financial incentive to increase creditor value and so is less likely to provide

advice that supports the optimal investment but the threat of dismissal alters this incentive.

Remark 1: Given the assumption that directors’ appointments can be terminated by the CEO,

pure directors endorse the CEO’s decision; shareholder directors also endorse the CEO decisions

unless a majority of the shareholder directors have debt/equity stakes that are similar and

significantly different from that of the CEO in which case the board members would control the

vote.

Litigation and Directors’ Choices

Directors and officers have faced increasing litigation risk in recent years. According to Towers

Perrin's Directors and Officers Liability Survey in 1999 and 2007, U.S. firms paid an average of

$2.74 million to claimants in 1999 and $12.23 million in 2007. The average defense cost was

$0.7 million in 1999 and over $2 million in 2007. 7

In principle, the CEO and directors are likely to be sued so long as the CEO’s decisions deviate

from those which maximize the value of the firm. When sued, director and officer wealth is

exposed to liability claims. Let be the probability that the CEO and directors are successfully sued.8 To simplify, assume L to be the maximum judgment against each. This introduces

another source of risk and makes the specification of the budget constraint a problem. Let

7 See Towers Perrin’s D&O Liability Survey in 1999 and 2007.

8 In the model, directors are presumed to act in good faith on behalf of the company in order to be covered by D&O

insurance. As a result, the probability that directors are successfully sued for a good faith error is an objective chance

independent of director’s actions. This assumption is empirically grounded. In the today’s financial world, it has

becomes almost routine that disappointed investors charge corporations and their officers and directors with

securities fraud whenever a company’s stock drops significantly in price. Most of such litigation is nuisance and is not

much related to directors’ prior actions. Moreover, most suits against directors and managers are settled without

trial, and as Core (2000) argues, the insurance terms provide strong incentives for settlements. “No admission of bad

if ( )m vI I c b c

( )c b c


15

(17)

denote the director’s fee then. It follows that the pure director’s consumption then may be

expressed as

(18)

where the loss L is experienced with probability . It may be shown that by going long in puts

and short in calls where the puts and calls have the same exercise price equal to the expected

loss, the director may generate the expected income then. Such a scheme will not alter income

now and so Jensen’s Inequality shows that the director always prefers the hedge. The expected

income then is

where

is the sum of the basis stock prices or equivalently the price now of one dollar then. The budget

constraint for the pure director becomes

(19)

This is the same budget constraint that the director would face if she purchase full D&O

insurance at the fair price, i.e., . Since the option hedge is optimal so is full insurance if and

only if .

faith is included in the conditions of settlement. Because they cannot unreasonably withhold consent for payment of

defense and settle costs, insurers will settle claims even when they suspect, but cannot convincingly establish, bad

faith by directors and officers,” as O’Sullivan (1997) states.

( ) min ( , ),c

C I b cb c

11

1

( ) ( ) 1( )

( ) ( )

m Cc

m L C

1 1 1( ) ( ) 1 ( ) ( ) ( ) ( ) ( ) ( )m C m L C dP p L m C dP

( )p dP

0 1 0 1( ) ( ) ( ) ( ) ( )c c dP m p L m dP C I

p L

( )p L C I


16

The Pure directors will not serve in the absence of Directors and Officers (D&O) insurance if

; conversely the pure director will serve in the absence of D&O insurance if

. If the firm pays for D&O insurance, pure directors will accept the position

unconditionally.

If then pure directors have incentives to accept the job in the absence of D&O

insurance provided they are willing to go along with the CEO unconditionally. It is clear that

D&O insurance does not alter pure directors’ incentive to side with the CEO. It is also clear that

their decision to take the position hinges on and L. L depends on the seriousness of the

wrongdoing, jury judgment or out‐of‐court settlement; , on the other hand, is determined by

the likelihood that a suit is brought against directors. A firm clearly communicates with

investors and honestly reports results is less likely to be sued by its various stakeholders and is

thus safer for directors, hence a smaller .

The analysis is the same for the shareholder director if the D&O insurance must be paid on

personal rather than corporate account. If the firm purchases D&O insurance for its k directors

and officers then the stock value is

(20)

Where the stock value on the right hand side is defined by (1). The shareholder director’s

objective function is

(21)

The total premium is and the shareholder‐director pays for a portion equal to her

proportional equity stake. The shareholder‐director would prefer that the firm pay for D&O

insurance if or equivalently if ; the converse is true otherwise. Note that

the objective function in (21) shows that the shareholder director’s is motivated to give the

same advice as in the last section. Also note that controlling shareholders of small firms are

( )p L C I

( )p L C I

( )p L C I

( ) max 0, ,

( )

iS I k p L I b c dP

k p L S I

( ) ( ) ( ) ( )iS I I C I S I k p L I C I

k p L

k p L p L 1k


17

more likely to prefer to pay on their own account and let pure directors pay on their own as

well. Shareholder directors of large companies are more likely to prefer their firms to pay.

Because pure directors would want the firm to pay for D&O insurance, the firm will pay for D&O

for all.

Remark 2: Facing potential liability for endorsing CEO’s suboptimal decisions, an individual

would accept a directorship offer unconditionally if also offered D&O coverage paid by the firm;

otherwise, her decision would depend on the tradeoff between director fees and expected

liability. D&O insurance coverage does not change directors’ decisions to follow the CEO if

shareholder directors are not in the majority.

What if the board is composed of a majority of shareholder directors? As noted before,

Shareholder directors may or may not side with the CEO depending on their proportional stakes

in the firm’s equity and their proportional stakes in the firm’s liability. Like the CEO, shareholder

directors’ decisions will be consistent with maximizing corporate value when they have equal

personal equity and liability stakes in the firm. To move the CEO’s decision toward that which

maximizes corporate value, the board needs to be composed of shareholder directors who have

equal personal equity and liability stakes in the firm.

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Documents

Directors, directors and officers insurance, and corporate governance