One of the least understood and least studied features of the world of corporate and securities law is the impact that directors’ and officers’ liability insurance has on companies’ conduct. A new article by two University of Connecticut Law School professors, Tom Baker and Sean Griffith, represents an ambitious attempt to understand the impact of D & O insurance on corporate governance. The article, entitled "Predicting Corporate Governance Risk: Evidence from the Directors’ and Officers’ Liability Insurance Market" presents the authors’ theory that D & O insurance provides a deterrence function within corporate governance and securities law by forcing worse-governed firms to pay higher premiums than better-governed firms. Because the authors joined their analysis to detailed interviews of key players in the D & O insurance industry, the article does a praiseworthy job describing the industry and the broad outlines of the D & O underwriting process. The article’s insights into the D & O underwriting process alone reward close reading.
However, The D & O Diary questions the article’s authors’ premise concerning D & O insurance underwriters’ ability to accurately segment securities litigation risk based upon the underwriters’ assessment of various companies’ corporate governance practices. The premise derives from some underwriters’ own statements of their belief in their ability to differentiate "deep governance" variables such as "culture" and "character." Some underwriters may well believe they have those differentiation capabilities, but the reality is that D & O underwriters necessarily have only limited and brief access to senior company management and rarely see management engaged in unrehearsed activity. Underwriters who believe they truly can discern culture and character on this necessarily limited basis are, in reality, doing little more than their version of Johnny Carson’s old Carnac the Magnificent routine, without the humor (or, one hopes, without the costume). In addition, even if D & O insurance rates may be adjusted at the margins for governance factors, the rates themselves are largely driven by the insurance cycle, which for most companies is a much more important factor than corporate governance practices in determining the ultimate price that the companies will pay for its D & O insurance. Because of the impact of the cycle and the level of competition within the D & O insurance industry, it would be difficult to quantify any cost savings a company could realize through better corporate governance. Because the financial link between premium levels and governance practices is so indeterminate, the deterrence role of D & O insurance in corporate governance is theoretical at best. Finally, The D & O Diary questions whether D & O insurance premiums alone could be sufficient to perform the significant role that the article’s authors postulate; for most companies, their D & O insurance premium is just another cost of doing business. Companies who can be persuaded to improve their corporate governance practices will do so out of fear of litigation or of government regulators, or because they simply want to do the right thing; the expectations or requirements of D & O underwriters, by comparison, are unlikely to be as important –with all due respect to my many good friends in the D & O underwriting community. (In fairness to the article’s authors, the D & O Diary acknowledges that the article recognizes all of the considerations raised in this post; the article simply draws different conclusions. )
All of these concerns notwithstanding, the article does represent an unprecedented and important academic attempt to understand how D & O insurance really works, and in particular, the article’s authors’ methodology of developing a deeper understanding of the D & O insurance industry through interviews with industry professionals represents an important academic innovation. The D & O Diary suggests that this methodology could very productively be used to develop a better understanding of the true role of D & O insurance in the settlement of shareholders’ securities fraud claims.
Full disclosure: the author of The D & O Diary was interviewed by one of article’s authors in connection with the empirical research on which their article is based.
Aux Armes, Citoyens! Formez Vos Bataillons! Given the level of media coverage, it is hardly surprising that plaintiffs’ lawyers have sought to secure their place in the options backdating litigation battlefield by announcing, for example, that they have formed an "Options Backdating Investigation Division", or that they are investigating 48 different companies or "over 50 companies." Perhaps inevitably, the first entrant from the defense bar into this escalating press release arms race has now appeared. On July 10, 2006, the Proskauer Rose law firm announced that it has formed a "Stock Options Task Force," which, their press release explains, is a special multidisciplinary group of over 20 lawyers that will work with companies on stock option timing issues. None of this is surprising to The D & O Diary, since I predicted in my very first post on options backdating that the issue would be "this year’s model" of the Lawyers’ Relief Act.
In a much more ominous development on the options backdating front, Kevin Ryan, U. S. Attorney’s Office in San Francisco announced on July 13, 2006 that his office has formed its own stock options backdating task force. The team is responsible for investigating companies and individuals in Northern California who retroactively changed the dates of stock options with the intent to defraud. According to this post in the wsj.com law blog, the Mr. Ryan’s office’s press release stated that the task force "will bring criminal charge when appropriate."
Head Case: On the theory that anything that is the subject of a front page article in the Wall Street Journal (subscription required) is a suitable topic for this Internet weblog, The D & O Diary has decided to weigh in on the Zidane head butt controversy — possibly the only story this year that has gotten more widespread media coverage than options backdating. First, we would like to introduce as Defense Exhibit No. 1 the following link to an extensive video portfolio of the misbehavior of Marco Materazzi on prior occasions, which may explain what may have preceded Zidane’s now infamous head butt of Signore Materazzi. Second, in the interests of world peace and understanding, The D & O Diary would like to introduce as Defense Exhibit No.2 the following link as proof that there are a lot of people out there with a lot of time on their hands to exploit the humor in any situation, even the video footage of Monsieur Zidane’s head butt. (Does anyone remember who won the game?)