Abstract
This study examines whether the required disclosure of directors’ and officers’ (D&O) insurance premiums leads to nonmeritorious securities litigation. Our research setting uses a proprietary D&O insurance database that includes New York and non-New York firms, combined with the fact that New York firms must disclose D&O insurance premiums. We thus can exploit a natural experiment based on inter-state variation in disclosure regulation. Disclosed premiums may influence case selection in two ways. First, higher premiums signal higher limits, which plaintiffs’ lawyers likely believe enable higher settlements. Second, higher premiums indicate higher risk assessments from insurers and thus a higher likelihood that stock price drops signal misconduct rather than bad luck. We find that D&O insurance premiums for New York firms are associated with a higher dismissal rate. Offsetting this higher dismissal rate, plaintiffs’ lawyers can achieve higher settlements in the relatively few successful cases.
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Notes
Securities class action filings are dominated by a handful of large firms (e.g., Choi and Thompson 2006). After the PSLRA, few firms can finance these cases or have the expertise to run the investigations necessary to build cases (Ratner 2015). Also, there is relatively little variation in the number of traditional cases filed per year (Cornerstone 2017), although this varies based on case complexity, as cases such as Enron consume substantial resources (Toobin 2002). It thus seems reasonable that there are capacity constraints in the plaintiffs’ bar.
Asthana and Balsam (2001) show that the SEC EDGAR system increased the market reaction to the 10-K by making it more readily available to investors. Christensen et al. (2017) show that incorporating publicly available mine-safety records into financial reports had effects on injuries and productivity.
The most common way to establish loss causation and damages is to tie a stock price drop to a firm disclosure. However, not all such firms are sued: less than 5% of firms with large stock price drops (a one-day decline of over 10%) are subject to securities litigation (see Seligman 1994).
Specifically, D&O insurance covers settlements and defense costs for directors and officers when not indemnified by the company (side A), reimburses the company for indemnification payments to directors and officers (side B), and covers the corporation itself (side C). Many policies include a “retention” (deductible) amount.
New York Business Corporation Law, Section 726(d), Insurance for Indemnification of Directors and Officers, provides: “The corporation shall … mail a statement in respect of any insurance it has purchased or renewed under this section, specifying the insurance carrier, date of the contract, cost of the insurance, corporate positions insured, and a statement explaining all sums, not previously reported in a statement to shareholders, paid under any indemnification insurance contract.” Firms often provide this information in the shareholder proxy.
We use these three well-known firms as examples, but none of these firms have cases in our primary analysis.
There were over 600 comment letters on the two proposals, and over 20% explicitly discuss insurance information with respect to estimating contingent liabilities, disclosure, or both, indicating it was a significant area of attention. Consistent with the concerns that this information, if disclosed, would be exploited by plaintiffs’ lawyers, “counsel for plaintiffs could be subject to malpractice claims if they did not aggressively track and isolate such information for the benefit of their clients” (American Council of Life Insurers et al. 2008, p. 5).
SOX provides multiple examples of this behavior. First, internal control auditing had been proposed previously but had never received sufficient support outside financial institutions, the subject of a previous crisis. After WorldCom collapsed, Congress passed the bill quickly (Ball 2009). Second, audit firms resisted non-audit service limits for years, despite SEC pressure on the issue. However, Congress moved quickly to ban certain non-audit services for audit clients after Enron’s consulting fees were publicized (Eichenwald 2005).
Voluntary disclosure is lower in concentrated industries, where proprietary costs are greater (Ali et al. 2014). This concern carries over to mandatory disclosure, where Hughes et al. (2002, p. 459) report that firms using derivatives argue “that disclosure of contract terms would reveal proprietary information.” In addition, some firms have delisted (Bushee and Leuz 2005) or avoided market capitalization thresholds (Gao et al. 2009) to avoid disclosure mandates.
Many firms privately provide D&O insurance information to the RIMS® survey to receive information on the commercial insurance market and industry litigation trends. The data are not in a balanced panel because firms do not participate in the survey each year.
Advisen has unique policy-level IDs, and we ensure there are no duplicate policies before aggregating. Policies may not coincide perfectly with fiscal years, so we use the Compustat convention to assign policies to fiscal years. Thus, if the expiration date (the policy year-end) is between June and December, we assign it to the same fiscal year. If the expiration date is January through May, we assign it to the prior year. We combine policies by fiscal year, as the effective dates of policies do not always align cleanly between multiple policies. Thus we aggregate premiums and limits at the firm-year level, so the insurance data for each year comprises the most recent insurance information that corresponds roughly to the fiscal year. Roughly 95% of the policies have a term of approximately one year, while the remainder have a term that is either two or three years (1.5%) or cover a period less than one year or greater than one year but are not two- or three-year policies (3.5%). For policies that are less than a year, we try to append it to an adjacent policy and, if none is available, drop the observations. For policies that are greater than a year but are not two- or three-year policies, we round the term length down one year and annualize the total premium and limit to get approximate amounts to correspond to an annual policy. If policies are two- or three-year policies, we evenly divide the premiums and limits over two or three years, respectively, to correspond to an annual policy each year. Results are similar if we drop all policies that are not approximately one year (untabulated).
We exclude IPO suits (which are subject to different legal standards) because we require at least five years of data to calculate accrual quality. Requiring accrual quality as a control variable also excludes most financial institutions and thus excludes mutual fund suits and makes results less sensitive to the effects of the financial crisis.
Notably, both our definitions of “current” and “future” events could represent events after the date of disclosure, depending on disclosure timing. Results based on our definition of “future” (the three fiscal years after the year the policy covers) imply that disclosure would be informative, even if made after the fiscal year, for instance in the 10-K. We refer to this as “future” because it would represent future litigation under any disclosure policy. In addition, results based on our definition of “current” (the fiscal year covered by the policy) would represent future litigation, if disclosure were made at the time of policy purchase, for instance by filing an 8-K near the start of the year.
Premiums scaled by market value or net sales are highly skewed, but the log premium variable is not. Inferences are similar if we scale premiums by limits, market values, or sales before taking the natural logarithm (untabulated).
The New York and non-New York firms are not concentrated in any given years. There are no fewer than 5% (5%) and no more than 11% (9%) of the New York (non-New York) firm years in each sample year (untabulated).
A regression of logged premiums on lagged logged premiums in our New York sample yields an R-squared of 0.899, indicating that premiums are very sticky over time, so the disclosure of high premiums in a prior year would be extremely informative to plaintiffs’ lawyers about D&O insurance coverage in a future year (untabulated).
Consistent with recent research (e.g., Hanlon and Hoopes 2014; Lamoreaux 2016) and as discussed by Angrist and Pischke (2009), we use a linear estimation model to facilitate interpretation and reduce potential bias from including fixed effects in a nonlinear estimation model. As shown by Greene (2004), the use of a linear estimation model with a dichotomous dependent variable does not result in bias or inconsistency on the coefficients or standard errors. A potential bias exists using a nonlinear model with small samples, as is the case in our analysis of New York firms.
For example, using the estimated coefficient on Log Premium, a one standard deviation change in Log Premium for New York firms increases the chance of a dismissed securities class action by roughly 5.6 percentage points.
A potential alternative explanation is that firms that face higher litigation risk (and are targeted more frequently in securities litigation) are charged higher premiums. In other words, the premiums of New York firms may simply reflect their actual litigation risk. This may be true if, for example, insurers anticipate more litigation claims from New York firms. We thus test whether New York firms pay higher overall premiums, relative to firms matched by industry, year, and ex ante litigation risk to non-New York firms (following Kim and Skinner 2012). We find no significant difference in overall premiums (untabulated), suggesting insurance pricing does not drive results.
Nelson and Pritchard (2016, p. 275) find that roughly ten percent of firms “have any substantive risk of being sued.”
Results are similar if we estimate these and all other tests in Table 4 using model (3), further indicating it is nonmeritorious litigation driving these results (untabulated).
The crisis periods include the Internet stock crash, the Enron and WorldCom scandals leading to SOX, and the financial crisis. During crisis periods, the difference between the coefficients on premiums between New York and non-New York firms for current litigation is 0.03 (p = 0.12). During noncrisis periods, the comparable difference is 0.04 (p < 0.10). We find similar results if we define the crisis only as 2007–2010 (untabulated).
In untabulated tests, we find similar results if we perform the falsification test using Delaware firms, the most common state of incorporation and accordingly the state with the most firms in our sample.
It may seem that this difference could occur by chance. However, we believe it is unlikely that chance would result in the concentration in nonmeritorious cases or a significant difference in the relation between the D&O insurance premium and nonmeritorious cases in multiple regression tests. Nonetheless, readers may place greater confidence in the analysis we report in Table 6, using the full sample of securities class actions with available data for case merits, damages, and control variables, excluding D&O insurance information.
We use all New York firm-year observations in our tests as plaintiffs’ lawyers should be able to obtain New York D&O premiums, regardless of the disclosure method. We find similar inferences if we restrict our analyses to New York firms that disclose this information in their proxy statements and their non-New York matches (untabulated).
Specifically, Log Premium has a positive and statistically significant relation to SCA Current for New York incorporated firms (0.08, p < 0.05), while there is no statistically significant relation for Second Circuit firms not incorporated in New York, and the difference between the two subsamples is statistically significant (0.07, p < 0.05). Further, the significant difference in dismissed cases remains as all five cases against non-New York firms in this sample are settled, while four of seven cases are dismissed for the New York firms (p < 0.05, untabulated).
We obtain similar results if we also control for insurance limits and premiums in this analysis (untabulated).
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Acknowledgements
We thank Patricia Dechow (the editor), two anonymous referees, Bill Baber, Jim Blinn, Khrystyna Bochkay, Jen Glenn, Stuart Gillan, Ross Jennings, Todd Kravet, Paul Ordyna, Kimberly Reilly, Ed Swanson, Jake Thornock and David Weber. We also thank workshop participants at the University of Chicago, the University of Connecticut, Georgetown University, the University of Pennsylvania (Wharton) and the University of Virginia (Darden Graduate Business School) and conference participants at the 2015 AAA Annual Meeting. We gratefully acknowledge research support provided by the Red McCombs School of Business, Darden Graduate Business School and the Mays Business School. All errors are our own.
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Appendices
Appendix 1 Concerns requiring disclosure of insurance information
1.1 American bar association (2008, p. 15)
Requiring disclosure of potential insurance and indemnity recoveries could be prejudicial to reporting entities and raise the cost of settlements. Such potential recoveries are excludable under the rules of evidence for the very reason that they can be prejudicial. They can, for example, raise the cost of resolution if a plaintiff believes that the defendant will not bear the full cost of the settlement or judgment.
1.2 American electric power (2008, p. 1)
New qualitative disclosures will be prejudicial, may negatively influence the results of cases (resulting in more cost) and adversely affect the rights of other parties to those cases and their insurance companies. These problems will be magnified in class action lawsuits. The Board should avoid requiring disclosures that will suggest a negotiating floor to claimants and risk materially affecting the outcome of the contingency by providing a window into the reporting company’s confidential claims analysis that will give claimants an unacceptable advantage in settlement negotiations, trial preparations and at trial.
1.3 Bank of America (2008, p. 2)
[D]isclosures [on insurance coverage] may prejudice a company’s case by providing detailed information about the case which will give the plaintiff an advantage as the case proceeds. It is also likely that there will be an increased level of “nuisance” lawsuits filed by plaintiffs.
1.4 Stewart Information Services Corporation (2008, p. 3)
Requiring the disclosure of insurance coverage—the qualitative and quantitative terms—could be another damaging piece of information if provided to the plaintiff. Based on such knowledge, a jury may be more generous in its awards in a lawsuit.
1.5 American financial services association (2010, p. 3)
The information [about insurance coverage] … could be used by plaintiffs to increase their leverage over entity’s reporting the information because the plaintiffs would be able to target their damage requests to the maximum amount of coverage allowed under the entity’s insurance plan. This will lead to many new, and much larger, lawsuits. Plaintiffs will claim excessive damages in order to gain larger settlements. Plaintiffs could also use the disclosed information to file new lawsuits when they learn that more insurance money remains. Many judges realize that putting this information in plaintiffs’ hands will lead to such a result and so typically insist that coverage only be divulged under a secrecy order. … As companies settle more frivolous lawsuits, plaintiffs will file an increased number of them, an outcome that FASB surely wants to avoid.
1.6 Association of corporate counsel (2010, p. 8)
In addition, even if discoverable, insurance information often is subject to confidentiality protections once it is provided to plaintiffs. This procedure is premised on the simple fact that disclosure of sensitive information about insurance coverage could lead plaintiffs’ attorneys to parse the insurance coverage information for their benefit in other litigation matters. Thus, the proposed disclosure requirement in the Exposure Draft could unfairly prejudice companies in unrelated litigation disputes by giving plaintiffs’ attorneys valuable information about the company’s liability coverage.
1.7 Business roundtable (2010, p. 6)
Even when such information [on insurance coverage] has been produced or is clearly discoverable, it is often produced under seal or pursuant to a confidentiality agreement or court order and is not available to third parties. The ED would make such information available to other plaintiffs’ attorneys who may bring claims they believe will be covered under a disclosed insurance policy in the hope of getting a quick settlement from the insurer.
1.8 Citigroup (2010, p. 8)
Requiring disclosure of this information [on insurance coverage] in a public document is tantamount to requiring reporting entities to advertise their insurance program to the plaintiffs’ bar so that the depth of the reporting entity’s pockets can be assessed.
1.9 Group of general counsels (2010, p. 10)
Such disclosure [of insurance coverage] may often have the perverse effect of whetting the appetite of a company’s potential litigation adversaries, attracted by the potential for a big insurance-funded recovery.
1.10 National association of manufacturers (2010, p. 3)
The NAM also has serious concerns about the required disclosure of potential insurance or other indemnification arrangements, which would provide non-public information to both current and potential plaintiffs. In particular, information about insurance held by a company could encourage plaintiffs to file frivolous or “copy cat” suits in hopes of an entity being more willing to settle a covered claim.
1.11 PNM resources (2010, p. 3)
We also have the same concern regarding revealing specific insurance or other related recoveries as other companies do, in that it may reveal sensitive company information as well as potentially cause an increase in the number or amount of claims when this type of information is known by the claimant.
1.12 PricewaterhouseCoopers (2010, p. 6)
We have also been informed that disclosure of this information may encourage additional claims to be asserted against a company if potential plaintiffs are made aware of a company’s insurance coverage. … Further, disclosure in the financial statements of the claim amount may encourage claims to be inflated to pressure a company to enter into settlement negotiations.
1.13 Stanford University (2010, p. 4)
[T]he value of the insurance might act as a floor for the plaintiffs in the settlement negotiation. This would be a serious disadvantage for us in settlement negotiations. Finally, we are afraid that disclosures of insurance amounts would encourage new claims against us by plaintiffs who would not otherwise have brought lawsuits.
1.14 tw telecom (2010, p. 2)
[W]e believe disclosure of the existence and levels of insurance coverage will increase the number of lawsuits companies face. … [it] would require disclosure of insurance information more broadly to those who would not otherwise have access to such information. Confirmation of the existence and extent of insurance coverage may embolden potential adversaries to file litigation since they now have a confirmed source of potential payment—insurance.
Appendix 2 Examples of D&O Insurance Disclosures
1.1 Xerox 2014 Proxy Statement (New York Incorporation)
On August 11, 2013, the Company renewed its policies for directors and officers [sic] liability insurance. The policies are issued by Federal Insurance Company, XL Specialty Insurance Company, St. Paul Mercury Insurance Company, Twin City Fire Insurance Company, Houston Casualty Company, Arch Specialty Insurance Company, ACE American Insurance Company, Allied World Assurance Company, Axis Reinsurance and Illinois National Insurance Company. The policies expire August 11, 2014, and the total annual premium is approximately $3.0 million.
1.2 Facebook registration statement (IPO)
We have entered, and intend to continue to enter, into separate indemnification agreements with our directors, executive officers and other key employees, in addition to the indemnification provided for in our restated bylaws. These agreements, among other things, require us to indemnify our directors, executive officers and other key employees for certain expenses, including attorneys’ fees, judgments, penalties fines and settlement amounts actually and reasonably incurred by a director or executive officer in any action or proceeding arising out of their services as one of our directors or executive officers, or any of our subsidiaries or any other company or enterprise to which the person provides services at our request, including liability arising out of negligence or active or passive wrongdoing by the officer or director. We believe that these charter provisions and indemnification agreements are necessary to attract and retain qualified persons such as directors, officers and key employees. We also maintain directors’ and officers’ liability insurance. (emphasis added)
1.3 Royal Bank of Canada 2014 Proxy Statement
RBC has purchased, at its expense, directors’ and officers’ liability insurance. This insurance provides protection for directors and officers against liability incurred by them in their capacities as directors and officers of RBC and its subsidiaries. The directors’ and officers’ liability insurance has a dedicated policy limit of $300,000,000 for each claim and as an aggregate for the 12 months ending June 1, 2014. There is no deductible for this coverage. The insurance applies in circumstances where RBC may not indemnify its directors and officers for their acts or omissions. Premiums paid by RBC relating to directors’ and officers’ liability insurance are approximately $1.0 million per annum.
Appendix 3 Examples of New York D&O Insurance Disclosures over Time
1.1 General Electric 2014 Proxy Statement
GE has provided liability insurance for its directors and officers since 1968. Ace Bermuda Insurance Ltd., Allied World Assurance Company, Ltd. and XL Insurance are the principal underwriters of the current coverage, which extends until June 11, 2014. The annual cost of this coverage is approximately $8.7 million.
1.2 General electric 1998 proxy statement
GE has had directors’ and officers’ liability insurance in effect since 1968. GE also has fiduciary liability insurance covering fiduciaries of GE’s employee benefit plans. Zurich Insurance Company and American International Specialty Lines Company are the principal underwriters. The directors’ and officers’ liability insurance covers directors and officers of GE and its subsidiaries. The fiduciary liability insurance covers, among others, directors, officers and employees who may be fiduciaries of any of GE’s employee benefit plans. The current policies expire on June 11, 2002. The total annual premium is approximately $4.3 million.
1.3 IBM 2014 proxy statement
The Company has renewed its directors and officers [sic] indemnification insurance coverage. This insurance covers directors and officers individually where exposures exist other than those for which the Company is able to provide indemnification. This coverage runs from June 30, 2013 through June 30, 2014, at a total cost of approximately $6.7 million. The primary carrier is XL Specialty Insurance Company.
1.4 IBM 1998 proxy statement
The Company has renewed its directors and officers [sic] indemnification insurance coverage. This insurance covers directors and officers individually where exposures exist other than those for which the Company is able to provide direct indemnification. These policies run from June 30, 1997, through June 30, 1998, at a total cost of $576,192. The primary carrier is Federal Insurance Company.
1.5 American express 2014 proxy statement
Effective from November 30, 2013 to November 30, 2014, this insurance is provided by a consortium of insurers. ACE American Insurance Company is the lead insurer. XL Specialty Insurance Company, Illinois National Insurance Company, Allied World Assurance Company, Freedom Specialty Insurance Company, Continental Casualty Company, Everest National Insurance Company, American International Reinsurance Company Ltd., Markel Bermuda Ltd., Starr Indemnity and Liability Company and National Liability & Fire Insurance Company provide excess coverage. The program also includes supplemental layers dedicated exclusively to providing coverage for directors and officers when we cannot indemnify them. The supplemental layers are provided by XL Specialty Insurance Company, Zurich American Insurance Company, Federal Insurance Company, Freedom Specialty Insurance Company, Continental Casualty Company, Everest National Insurance Company, U.S. Specialty Insurance Company, St. Paul Fire & Marine Insurance Company, Starr Indemnity and Liability Company, Allied World Assurance Company, American International Reinsurance Company Ltd. and ACE Bermuda Ltd. We expect to obtain similar coverage upon expiration of the current program. The annual premium for the program is approximately $5.8 million.
1.6 American express 1998 proxy statement
The Company has obtained a multi-risk liability insurance policy (the “Policy”) that provides coverage for, among other things, (i) directors and officers liability (“D&O Liability”) and (ii) fiduciary liability arising from employee benefits plans sponsored by the Company (“Fiduciary Liability”). The D&O Liability coverage provided by the Policy includes (i) reimbursement of the Company in situations where it is permitted to indemnify directors or officers and (ii) payment of loss, including settlements, judgements, and legal fees, on behalf of directors or officers when the Company is not permitted to indemnify them under applicable law. The Fiduciary Liability coverage provided by the Policy includes coverage for directors and employees who are fiduciaries of the Company’s employee benefits plans against losses, including settlements, judgments, and legal fees as a result of alleged breaches of fiduciary duty as defined in the Employee Retirement Income Security Act of 1974, as amended. The.
Policy is issued by Executive Risk Indemnity Company (“ERIC”) and is effective from November 30, 1997 to November 30, 2000. Excess coverage is provided by two additional policies issued by the Federal Insurance Company (“Federal”) and various other insurers led by Lloyd’s of London. The annualized premium attributed to D&O Liability and Fiduciary Liability coverages is approximately $640,000.
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Donelson, D.C., Hopkins, J.J. & Yust, C.G. The cost of disclosure regulation: evidence from D&O insurance and nonmeritorious securities litigation. Rev Account Stud 23, 528–588 (2018). https://doi.org/10.1007/s11142-018-9438-2
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DOI: https://doi.org/10.1007/s11142-018-9438-2