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 (pictured, left) and Fordham law professor Sean Griffith (pictured, right).


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 shareholder litigation.


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 function.


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 securities lawsuits.


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. My apologies to Professor Griffith for my not being able to figure out how to make his picture the same width as that of Professor Baker.



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.