All too often, the securities class action litigation
process seems like a complicated and costly mechanism for transferring large
amounts of money to the lawyers involved but only small amounts to the
aggrieved investors, all at the expense of the D&O insurers. It is hard not
to wonder sometimes what the whole process accomplishes, other than making
D&O insurance indispensible and expensive.
Even worse, the deterrent effect that securities
litigation is supposed to have is undermined because the presence of insurance
insulates companies and their managers from any consequences for their alleged
misconduct, at least according to a new book by Penn law professor Tom Baker
and Fordham law professor Sean Griffith.
The irony is that D&O insurers are in a
position from which, at least in theory, they could positively influence
corporate conduct and advance the regulatory goals of the securities laws. In
their book, "Ensuring Corporate Misconduct: How Liability Insurance
Undermines Shareholder Litigation," Baker and Griffith explore the
ways D&O insurers might provide a "constraining influence" on
their policyholders. The authors conclude that as a result of actual
practices and processes insurers do not in fact perform that role.
Rather, the authors conclude, D&O insurance
"significantly erodes the deterrent effect of shareholder litigation,
thereby undermining its effectiveness as a form of regulation." In order
to try to "rehabilitate the deterrent effect of shareholder litigation,
notwithstanding the presence of liability insurance," the authors propose
three regulatory reforms, as discussed in detail below.
To understand how D&O insurance works and how it
affect securities litigation, the authors interviewed over 100 professionals
from across the D&O insurance industry, as well securities litigators from
both the plaintiffs and defense side. (Full disclosure: I was one of the people
interviewed.) The authors previously published interim assessments of their
research in three separate law review articles, about which I previously
commented here, here and here. This new book pulls their prior publications together
in a single volume comprehensively presenting their research and the bases for
their reform proposals.
D&O Insurers' Three Opportunities to
Advance Securities Litigation Deterrence Goals
The authors postulate that there are three ways
D&O insurers might, in theory, preserve the deterrence function of
First, insurers might use insurance pricing as a way to
motivate corporate behavior, by forcing companies engaging in riskier behavior
to pay more for insurance.
Second, the insurers might monitor their policyholders
and force them to avoid risky conduct or adopt governance reforms.
Third, the insurers could control claim defense and
settlement to insure that settlements reflect the merits of the claim and force
defendants to pay more toward the defense and settlement when there is evidence
of actual wrongdoing.
The D&O Insurers Failure to Pursue
Opportunities to Advance the Deterrence Goals
The authors found from the interviews, however, that
D&O insurers do not take advantage of these opportunities, despite the
seeming financial incentives to do so.
What they found is that the pricing mechanism does not
affect policyholder conduct, in part because the insurance cost is a very small
part of most companies' overall cost structure, and in part because the
difference between the premiums riskier companies pay and the premiums less
risky companies pay is relatively slight.
The authors also found that D&O insurers do almost
nothing to monitor their policyholders or to try to influence their conduct.
The authors puzzled over this issue at length, because insurers not only have
an incentive to try to improve conduct but also because insurers effectively
and positively influence their policyholders' behavior with respect to other
hazards and other lines of insurance.
Ultimately the authors concluded that monitoring and loss
prevention services related to D&O insurance are not valued by corporate
managers, and that in a competitive insurance environment it is hard to charge
a price that supports the costs associated with delivering these services.
(When the authors previously published their research pertaining to this
particular topic, I wrote a lengthy blog post, here, discussing my views on why D&O insurers do not
offer monitoring and loss prevention services.)
Finally, the authors found that, as a result of the way
that D&O policies are structured, D&O insurers have little control over
defense costs, and that insurers' authority over settlements is constrained by
the dynamics of the claims process - in particular, by the fact that the
plaintiffs' theoretical damages usually so far exceed the policy limits. The
authors also found that insurers have some ability to use coverage defenses to
insist on greater contributions to defense and settlements from defendants when
there is greater evidence of actual wrongdoing, but that insurers' ability to deploy
these influences is limited.
The Authors' Three Proposed Reforms
The authors concluded that each of these problems
"increases the likelihood that insurance substantially mutes the
deterrence effect of shareholder litigation." But rather than jumping to
the extreme position of suggesting the abolition of D&O insurance, the
authors suggest three reforms they contend would reinvigorate the deterrence
First, the authors suggest that the SEC require reporting
companies to disclose their D&O insurance information (premium, limits,
retentions, and the identity and attachment point of various insurers). The
authors contend that these details "will convey an important signal
concerning the quality of the firm's governance," and that changes in
premiums will alert investors to changes in the risk. The limit selected, the
authors contend, would signal the managers' belief about their companies'
relative risk of serious securities litigation, and the identity of carriers
(and in particular whether the carrier is "a market leader" or a
"cut-rate insurer") could "signal governance quality."
Second, in order to ensure that corporate defendants have
"skin in the game" and therefore become more deeply invested in
avoiding litigation and more deeply involved in managing defense costs and
settlement amounts, the authors propose the mandatory requirement of
coinsurance. By ensuring that the settlement of a securities lawsuit would
produce a loss for the company, coinsurance would reduce the "moral
hazard" of D&O insurance.
Third, in order to "provide capital market
participants a window onto the merits of claims," the authors propose that
the SEC require the disclosure of information about settlements, including the
extent to which insurance funded the settlement and defense costs.
Baker and Griffith have written a readable, interesting
and important book. Their discussion of the actual role of D&O insurance in
the securities litigation process is enhanced by their research methodology.
All too often, theoreticians postulating about D&O insurance lack any
understanding of the way things actually work. Because the authors took the
time to interview the marketplace participants, their analysis is grounded in
the practical realities of the real world.
As a result, the authors bring an informed outsider
perspective to their discussion of the D&O insurance industry. The authors
are painfully successful in highlighting the peculiar pathologies of the
D&O insurance industry and the ways that D&O insurers and other
marketplace participants systematically undermine both the insurers' financial
interests and the regulatory goals of the securities litigation system.
I am grateful to the authors for not just coming right
out and advocating the abolition of D&O insurance - the career change I
would face would be rather unwelcome at this point in my work life.
The authors do propose some regulatory alternatives. Some
of the authors' proposed reforms have substantial merit. In particular, I agree
with the authors' suggestion that the entire process would be improved if
corporate defendants were required to have "skin in the game" in some
form. The threat that companies would have to contribute to defense and
settlement would encourage companies to try to avoid risky behavior. It would
also provide a healthy influence both on the defense and settlement of
I know that many companies and their advocates will
object to the idea of requiring companies to participate financially
in the lawsuit. Companies clearly would prefer to avoid that cost. But the
benefits that would follow from greater company participation will ultimately
inure to the benefit of everyone, and ultimately lead to a more disciplined,
more rational and less costly system.
There might be ways other than coinsurance to bring about
this reform. One possibility has already been implemented in Germany, where
D&O insurance is now required to include a self-insured retention for
individual liability. This is a more extreme version of the solution Baker and
Griffith have proposed, but it undeniably has the potential to motivate
corporate officials to avoid misconduct and risky behavior. My lengthy
discussion of the new German requirement can be found here. (I am not advocating the German alternative, merely
pointing out there there are alternatives to coinsurance.)
The authors' proposal to require the disclosure of
settlement and defense cost information also has some merit. At a minimum,
investors are entitled to know the actual financial impact the litigation has
had on the company. Investors would be astonished to learn how much these cases
cost to defend, and the extent of insurance contribution to the defense and
settlement is also highly relevant in order to understand the financial impact
of the litigation on the company.
The availability of defense cost and settlement
information would also be enormously helpful to companies themselves when
deciding how much insurance to buy. As it stands, the settlement information
that companies rely on to decide how much insurance to buy lacks any connection
to insurance contribution toward settlements, and also lacks the vital detail
regarding the costs of defending these cases. This kind of information would be
valuable for everyone.
I am less persuaded by the authors' proposal that
reporting companies should have to disclose their D&O insurance
information. I do not believe the publication of insurance information would
provide the marketplace "signal" the authors think it would. I also
think that requiring this disclosure could also could distort corporate behavior
in ways that would be harmful to shareholders.
The analytic flaw with the authors' proposal is that it
treats D&O insurance as if it were a fungible commodity, like wheat. The
fact is that these days, every single public company D&O policy is heavily negotiated.
In the process of negotiation, it frequently happens that buyers will have to
make a choice of whether or not to incur the cost required in order to obtain a
particular term -- say, for example, adding increased limits with or without
full past acts coverage. The insurance the company winds up with is the product
of a host of these kinds of decisions.
As a result, every policy is different and those
differences have important pricing implications. If you were to go down your
street and find out how much each one of your neighbors paid for their car, you
still wouldn't know everything you need to know. I drive a small compact, my
neighbor across the street has a squadron of kids and so he drives a Yukon. If
you didn't know about the differences between the vehicles, and also the reason
for these differences, you wouldn't understand the meaning of the differences
in what we paid for our vehicles. The same goes for D&O insurance.
The authors give a nod to the notion that D&O
policies are not standardized by suggesting that public companies should be
required to publish their policies on their website. (As a person who makes his
living off of policy wording expertise, I find this suggestion absolutely
loathsome.) But even this extreme step would not supply the necessary
information to explain the tradeoffs and choices the company went through in
order to make its insurance purchase. The bare policy alone would not, for
example, reveal what selections the company did not make or how those choices affected
the final policy and the policy's ultimate price.
The bottom line is that companies that make prudent,
conservative choices sometimes pay more for D&O insurance that provides
better protection. Moreover, there are other important considerations that
would distort the author's postulated signal. For example, many buyers attach
value to stability in their insurance relationship. These buyers bypass
opportunities to reduce their insurance costs in exchange for stability and
continuity. Other buyers who have had positive claims experiences feel loyalty
to their carrier (yes, that really does happen) and even recognize the
carrier's need to try to recoup claims costs in higher premiums.
In other words, premium levels reflect a host of considerations
that have nothing to do with the governance signaling assumptions
underlying the authors' proposal. But on the other hand, if companies
nevertheless had to confront the possibility that investors and analysts might
downgrade them because of the amount they pay for D&O insurance, the
companies inevitably would cut corners to bring costs down, for example by
buying less or narrower coverage. This could leave both executives and the
company's balance sheet exposed to losses that could financially harm the
company and thereby harm investors' interests.
In the end, whatever else might be said, Baker and
Griffith have certainly raised a host of issues meriting further discussion.
Indeed, Professor Baker will be participating in a panel to discuss the impact
of D&O insurance on securities litigation this upcoming Thursday, November
11, 2010, at the PLUS International Conference in San Antonio. I suspect
this will be the first of many industry discussions about the authors' book.
Professor Griffith's prior guest post on this blog in
which he defended the authors' suggestion of requiring companies to disclose
their insurance information can be found here.
See You in San Antonio: I will also be in
San Antonio for the PLUS Conference, and I look forward to seeing and greeting
readers of The D&O Diary while I am there. I hope readers who see me
will say hello, particularly if we have never met before.
other items of interest from the world of directors & officers liability,
with occasional commentary, at the D&O Diary, a blog by Kevin LaCroix.
For More Information:
D&O Insurance is discussed in greater detail
in 7 A.A. Sommer Jr., Securities Law Techniques, Ch. 122 § 122.03
(Matthew Bender Rev. Ed.), "D&O Insurance," which can be accessed online by subscribers of lexis.com. This
treatise is also available in the LexisNexis online store.