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Predicting Corporate Governance Risk:
Evidence from the Directors’ & Officers’
Liability Insurance Market
Tom Baker† and Sean J. Griffith††
This Article examines how liability insurers transmit and transform the content of corporate
and securities law. Directors’ & Officers’ (D&O) liability insurers are the financiers of shareholder
litigation in the American legal system, paying on behalf of the corporation and its directors and
officers when shareholders sue. The ability of the law to deter corporate actors thus depends upon
the insurance intermediary. How, then, do insurers transmit and transform the content of corporate
and securities law in underwriting D&O coverage?
In this Article, we report the results of an empirical study of the D&O underwriting process.
Drawing upon in-depth interviews with underwriters, actuaries, brokers, lawyers, and corporate
risk managers, we find that insurers seek to price D&O policies according to the risk posed by each
prospective insured and that underwriters focus on corporate governance in assessing risk. Our
findings have important implications for several open issues in corporate and securities law. First,
individual risk rating may preserve the deterrence function of corporate and securities law by
forcing worse-governed firms to pay higher D&O premiums than better-governed firms. Second,
the importance of corporate governance in D&O underwriting provides evidence that the merits
do matter in corporate and securities litigation. And, third, our findings suggest that what matters in
corporate governance are “deep governance” variables such as “culture” and “character,” rather
than the formal governance structures that are typically studied. In addition, by joining the theo-
retical insights of economic analysis to sociological research methods, this Article provides a model
for a new form of corporate and securities law scholarship that is both theoretically informed and
empirically grounded.
I
NTRODUCTION
Liability insurers bankroll shareholder litigation in the United
States. Directors’ and officers’ (D&O) liability insurance policies
cover the risk of shareholder litigation.
1
Nearly all public corporations
purchase D&O policies.
2
And nearly all shareholder litigation settles
†
Connecticut Mutual Professor and Director, Insurance Law Center, University of Con-
necticut School of Law.
††
Associate Professor of Law, Fordham Law School. For their comments and suggestions
on earlier drafts, the authors thank Phillip Blumberg, Anne Dailey, Sean Fitzpatrick, Louis Kap-
low, Sachin Pandya, Jeremy Paul, Larry Ribstein, Steve Shavell, Peter Siegelman, Paul Vaaler,
Carol Weisbrod, and workshop participants at Harvard Law School, the University of Connecti-
cut School of Law, and the University of Illinois College of Law. For excellent research assis-
tance, thanks to Tim Burns, Josh Dobiak, and Yan Hong. The viewpoints and any errors ex-
pressed herein are the authors’ alone.
1
On the coverage of D&O policies, see Part II.B.1.
2
See Tillinghast Towers Perrin, 2005 Directors and Officers Liability Survey 20 fig 21
(2006) (reporting that 100 percent of public company respondents in both the U.S. and Canada
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within the limits of these policies.
3
As a result, the D&O insurer serves
as an intermediary between injured shareholders and the managers
who harmed them. This intermediary role has important implications
for corporate governance that have been largely overlooked by corpo-
rate and securities law scholars.
4
The primary goal of liability rules in corporate and securities law,
it is often said, is to deter corporate officers and directors from engag-
ing in conduct harmful to their shareholders.
5
Yet it is typically a third-
party insurer that satisfies these liabilities under the terms of the cor-
poration’s D&O policy.
6
The deterrence goals of corporate and securi-
purchased D&O insurance). Prior surveys report slightly lower percentages. The annual Tilling-
hast D&O survey is based on a nonrandom, self-selecting sample of companies. It is also the only
systematic source of information on D&O insurance purchasing patterns in the U.S. We there-
fore draw upon it as a source of aggregate data in spite of its methodological weaknesses.
3
See, for example, James D. Cox, Making Securities Fraud Class Actions Virtuous, 39 Ariz
L Rev 497, 512 (1997) (“[A]pproximately 96% of securities class action settlements are within
the typical insurance coverage, with the insurance proceeds often being the sole source of set-
tlement funds.”). Using U.S. data, Cornerstone Research reports that “over 65% of all [securities
class action] settlements in 2004 were for less than $10 million,” a figure within the policy limits
of most publicly traded corporations, and that only seven settlements were larger than $100
million. See Laura E. Simmons and Ellen M. Ryan, Post-Reform Act Securities Settlements: Up-
dated through December 2004 3 (Cornerstone Research 2005). Small-cap companies typically
have D&O insurance policies in excess of $20 million, and large-cap companies typically have
D&O insurance policy limits in excess of $100 million. See Tillinghast, 2005 Survey at 29 table
17C (cited in note 2). There may be a recent trend in the U.S. toward increasing (but still small)
numbers of settlements above the D&O policy limits. See Elaine Buckberg, Todd Foster, and
Ronald I. Miller, Recent Trends in Shareholder Class Action Litigation: Are WorldCom and Enron
the New Standard? 1 (NERA Economic Consulting 2005) (noting that in both the WorldCom and
the then-pending Enron case, directors were making settlement payments out of their personal
assets). Recent research demonstrates that outside directors almost never have to use their own
funds. See Bernard S. Black, Brian R. Cheffins, and Michael Klausner, Outside Director Liability,
58 Stan L Rev 1055, 1059–60 (2006) (“Since 1980, outside directors have only once made per-
sonal payments after a trial.”).
4
But see Black, Cheffins, and Klausner, 58 Stan L Rev at 1056. See also generally Roberta
Romano, Corporate Governance in the Aftermath of the Insurance Crisis, 39 Emory L J 1155
(1990) (studying the effect of the D&O insurance crisis on corporate governance); Roberta
Romano, What Went Wrong with Directors’ and Officers’ Liability Insurance?, 14 Del J Corp L 1
(1989) (exploring the causes of the D&O insurance market crisis of the mid 1980s).
5
See Reinier Kraakman, Hyun Park, and Steven Shavell, When Are Shareholder Suits in
Shareholder Interests?, 82 Georgetown L J 1733, 1738 (1994) (modeling when shareholder litiga-
tion should and should not be pursued). In this Article, we adopt the standard assumptions of
mainstream corporate and securities law scholarship—that the corporation is designed to maxi-
mize shareholder welfare (as opposed to some other constituency) and that deterrence is af-
fected principally through the costs of liability rules. See Stephen M. Bainbridge, Corporation
Law and Economics 28 (Foundation 2002). These assumptions have been critiqued. See gener-
ally, for example, Lawrence A. Mitchell, ed, Progressive Corporate Law (Westview 1995). But
that debate is beyond the scope of this Article.
6
See Sean J. Griffith, Uncovering a Gatekeeper: Why the SEC Should Mandate Disclosure
of Details Concerning Directors’ and Officers’ Liability Insurance Policies, 154 U Pa L Rev 1147,
1149–50 (2006) (describing the intermediary role of the D&O insurer and arguing for public
disclosure of D&O insurance policy premiums and contract provisions).
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Predicting Corporate Governance Risk 489
ties liability are thus achieved indirectly, through an insurance inter-
mediary, if indeed they are achieved at all.
7
The D&O insurer has several means of reintroducing the deter-
rence function of corporate and securities law and, because it is the
one ultimately footing the bill, ample incentive to do so. First, D&O
insurers may screen their risk pools, rejecting firms with the worst
corporate governance practices and increasing the insurance premi-
ums of firms with higher liability risk. Second, D&O insurers may
monitor the governance practices of their corporate insureds and seek
to improve them by recommending changes, either as a condition to
receiving a policy or in exchange for a reduction in premiums.
8
Third,
D&O insurers may manage the defense and settlement of shareholder
claims, fighting frivolous claims, managing defense costs, and withhold-
ing insurance benefits from directors or officers who have engaged in
actual fraud.
9
This Article is devoted to the first strategy for reintroducing the
content of corporate and securities law—the underwriting process. Its
core inquiry is how, in that process, D&O underwriters transfer the
impact of the law and whether, in doing so, they also transform it. This
is an empirical question. To answer it, we interviewed insurance mar-
ket participants, including underwriters, actuaries, brokers, lawyers,
and corporate risk managers, asking such questions as how underwrit-
ers evaluate the D&O liability risk of public corporations, what attrib-
utes they look for, and how these factors are taken into account in
pricing. We also allowed our participants simply to talk, to describe the
underwriting process, to tell us what they find interesting or troubling,
and to illustrate their explanations with stories and anecdotes.
Our findings shed light on several important corporate and secu-
rities law issues. First, we find that D&O insurers seek to price policies
according to the risk posed by each corporate insured and that, in do-
ing so, they make a detailed inquiry into the corporate governance
practices of the prospective insured. The underwriting process thus
7
The emotional impact of shareholder litigation and its reputational consequences, of
course, will affect directors and officers directly, but essentially all financial consequences are
mediated by the D&O insurer. See Black, Cheffins, and Klausner, 58 Stan L Rev at 1056 (cited in
note 3) (“The principal threats to outside directors . . . are the time, aggravation, and potential
harm to reputation that a lawsuit can entail.”).
8
See Tom Baker and Sean J. Griffith, The Missing Monitor in Corporate Governance: The
Directors’ and Officers’ Liability Insurer, 95 Georgetown L J (forthcoming 2007) (reporting that
D&O insurers do not provide governance services and addressing the related puzzles of why corpo-
rations buy D&O insurance and how insurers control moral hazard).
9
See Tom Baker and Sean J. Griffith, The Defense and Settlement of Shareholder Litiga-
tion (unpublished working paper 2006) (studying the role of D&O insurance in the defense and
settlement of shareholder litigation).
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transforms the insured’s expected losses from shareholder litigation
into an annual cost. Because this cost is, in part, a function of the qual-
ity of the insured’s corporate governance practices, it fulfills a neces-
sary condition for advancing the deterrence objectives of corporate
and securities law. Second, our findings also provide evidence that the
merits do matter in corporate and securities litigation. D&O insurers
have the greatest at stake in that question, and their conduct in risk
assessment and pricing demonstrates a belief that the merits matter.
Third, and finally, our findings offer a unique perspective on what (if
anything) matters in corporate governance, underscoring the role of
“deep governance” variables such as “culture” and “character” in con-
trast to the formal governance structures commonly emphasized in
previous scholarship. Our analysis of what underwriters are looking to
uncover beneath these seemingly vague concepts may illuminate new
paths for corporate governance research.
Our research also belongs to a tradition in legal scholarship that
seeks to comprehend the role of liability insurance in legal regula-
tion.
10
When the content of legal rules is transmitted through liability
insurance intermediaries—as, for example, in accident law, medical
malpractice, and products liability—we cannot understand how the
law ultimately works until we first understand how the insurance in-
termediary works: how it packages the liability risk, spreads the costs,
and transforms the law as it transfers the risk. Torts scholars have long
appreciated this role, but ours is the first empirical research project to
offer a detailed study of the role of liability insurance in corporate
governance. Our aim is to learn what D&O insurance can teach us
about corporate and securities law in action.
The Article proceeds as follows: Part I describes our empirical
methods. Part II provides a brief background, both on shareholder
litigation and D&O insurance. Part III reports our findings on what
matters to D&O insurance underwriters when they assess D&O in-
surance risk, how they gather that information, and how they translate
their risk assessments into prices. Part IV applies our findings to several
open issues in corporate and securities law scholarship.
10
The foundational empirical study is H. Laurence Ross, Settled out of Court: The Social
Process of Insurance Claims Adjustments (Aldine 1970). See also generally Tom Baker, Liability
Insurance as Tort Regulation: Six Ways that Liability Insurance Shapes Tort Law in Action, in
Gerhard Wagner, ed, Tort Law and Liability Insurance 295 (Springer 2006), also published in 12
Conn Ins L J 1 (2005–2006).
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Predicting Corporate Governance Risk 491
I.
R
ESEARCH
M
ETHOD
Our research on D&O insurance underwriting contributes to the
growing body of literature on “insurance as governance.” Prior re-
search has engaged the question of the governance function of liabil-
ity insurance from two methodologically distinct approaches. We will
refer to these as the economic and sociological approaches.
The economic approach to the study of liability and insurance is
likely to be the one most familiar to many legal scholars. The classical
economic approach to liability insurance has been to view it as a
means to further the deterrence function of law by reducing either the
cost of prevention or expected harm, or both.
11
In addition to this ap-
proach, institutional economists studying insurance have emphasized
the comparative advantages of liability insurance over other loss-
prevention institutions.
12
Thus, one might expect liability insurance to
serve a governance role not only because insurers assume responsibil-
ity for losses but also because this assumption of responsibility makes
them more credible providers of loss-prevention services than alterna-
tive governance institutions.
The second major approach is the sociology of risk and insurance.
Researchers have used sociological tools—especially qualitative inter-
views and participant observation—to explore the governance role of
insurance institutions.
13
Epitomized by the recent work of Richard
Ericson, Aaron Doyle, and Dean Barry,
14
this approach offers a nu-
11
See generally Steven Shavell, The Economic Analysis of Accident Law (Harvard 1987).
12
See, for example, George M. Cohen, Legal Malpractice Insurance and Loss Prevention: A
Comparative Analysis, 4 Conn Ins L J 305, 343–44 (1997–1998). He observes that liability insurers
in effect guarantee their loss-prevention advice by assuming responsibility for the liability losses
that result. This bundling of loss-prevention and risk-distribution services gives liability insurers
an incentive to get the loss prevention right and, thus, should make their loss-prevention services
more valuable than those of other loss-prevention services providers, such as experts, who do not
assume any of the risk.
13
For a review of this literature through 2001, see Tom Baker and Jonathan Simon, Em-
bracing Risk, in Tom Baker and Jonathan Simon, eds, Embracing Risk: The Changing Culture of
Insurance and Responsibility 1, 7–17 (Chicago 2002) (analyzing changes in the way individuals
and institutions conceptualize risk and insurance). For a general discussion, see Richard V. Eric-
son and Aaron Doyle, Uncertain Business: Risk, Insurance, and the Limits of Knowledge (Toronto
2004) (contrasting uncertainty in four fields of insurance and how the insurance industry plays
different roles in each field); Richard V. Ericson, Aaron Doyle, and Dean Barry, Insurance as
Governance (Toronto 2003); Richard V. Ericson and Aaron Doyle, eds, Risk and Morality (To-
ronto 2003). See also, for example, Tom Baker and Thomas O. Farrish, Liability Insurance and the
Regulation of Firearms, in Timothy D. Lytton, ed, Suing the Gun Industry: A Battle at the Cross-
roads of Gun Control and Mass Torts 292, 312 (Michigan 2005) (finding, in part through inter-
views with underwriters, that liability insurers practiced “selective exclusion . . . [keeping] the
costs of gun violence out from under the insurance umbrella”).
14
See generally Ericson, Doyle, and Barry, Insurance as Governance (cited in note 13) (offer-
ing an institutionally informed account of the governance role of a variety of forms of first party
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anced view inside a field that quantitative data cannot provide.
15
While
qualitative research of this sort does not provide conclusive evidence
regarding the prevalence or extent of the practices observed, it can be
used to frame more systematic quantitative analysis that may provide
that evidence.
16
In the meantime, the persuasive power of qualitative
research depends, like traditional doctrinal and policy arguments, on
the reader’s response to the coherence and plausibility of the analysis.
Our research seeks to join these two paths, analyzing the role of
D&O insurance in corporate governance in a way that is both theo-
retically informed and empirically grounded. To gather our data, we
interviewed, observed, and to a small extent even participated in the
professional development of D&O insurance specialists. Our goal was
to test the predictions of economic theory regarding the relationship
between D&O insurance and corporate governance in the U.S., a rela-
tionship that has not been studied previously and that is not amenable
to quantitative empirical research for at least two reasons. First, the
relevant quantitative data concerning D&O insurance (pricing and
limits) are not publicly available.
17
And, second, the deep governance
factors that, as we will report, matter so much to D&O insurance un-
derwriters are neither adequately specified nor publicly available.
insurance). See also Ericson and Doyle, Uncertain Business at 5 (cited in note 13) (describing the
underappreciated prominence of uncertainty, as opposed to risk, in the insurance business).
15
The techniques are, as noted, sociological. But they may be most familiar to legal schol-
ars in the law and norms literature. See generally Robert C. Ellickson, Order without Law: How
Neighbors Settle Disputes (Harvard 1991) (finding, primarily through field interviews, that
neighbors in Shasta County, California, resolve most conflicts through the use of informal norms,
rather than formal legal rules); Lisa Bernstein, Private Commercial Law in the Cotton Industry:
Creating Cooperation through Rules, Norms, and Institutions, 99 Mich L Rev 1724, 1725 (2001)
(examining, through a detailed case study of the cotton industry, how private legal systems can
reduce costs); Lisa Bernstein, Opting Out of the Legal System: Extralegal Contractual Relations in
the Diamond Industry, 21 J Legal Stud 115 (1992) (describing the private legal system at work in
the diamond industry).
16
See, for example, Kathryn Zeiler, et al, Physicians’ Insurance Limits and Malpractice
Payments: Evidence from Texas Closed Claims, 1990–2003, Journal of Legal Studies (forthcom-
ing) (“[P]hysicians rarely paid out of their own pockets to satisfy malpractice claims.”), confirm-
ing qualitative reports in Tom Baker, Blood Money, New Money, and the Moral Economy of Tort
Law in Action, 35 L & Socy Rev 275, 314 (2001) (“[T]here is a norm among tort practitioners
that tort litigation is supposed to be primarily about collecting insurance money.”). See also
Jonathan Klick and Catherine M. Sharkey, The Fungibility of Damage Awards: Punitive Damage
Caps and Substitution 18 (FSU College of Law, Law and Economics Paper No 912256, June
2006), online at http://ssrn.com/abstract=912256 (visited Apr 12, 2007), confirming the phenome-
non of “transforming punishment into compensation” reported on the basis of qualitative re-
search in Tom Baker, Transforming Punishment into Compensation: In the Shadow of Punitive
Damages, 1998 Wis L Rev 211.
17
See Griffith, 154 U Pa L Rev at 1150 (cited in note 6) (arguing for public disclosure of
D&O insurance policy premiums and contract provisions). See also note 195 (describing existing
quantitative research on this question).
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Predicting Corporate Governance Risk 493
We conducted in-depth, semistructured interviews with forty-one
D&O professionals from late 2004 to early 2006.
18
We identified pro-
spective interviewees by beginning with references from leaders of the
Professional Liability Underwriting Society,
19
then proceeded outward
to references from the initial interviewees. Our interviewees included:
twenty-one underwriters from fourteen companies (including primary,
excess, and reinsurance underwriters); three D&O actuaries from
three companies (two of whom were the chief professional lines actu-
aries in their firms); six brokers from six brokerage houses; four risk
managers employed by publicly traded corporations to purchase their
insurance coverage; three lawyers who advise publicly traded corpora-
tions on the purchase of D&O insurance; and four professionals in-
volved in the D&O claims process (two claims managers, one moni-
toring counsel, and one claims specialist from a brokerage house).
20
Because the D&O insurance market is concentrated at the top—
two insurers (AIG and Chubb) together account for more than half of
the market for primary insurance by premium volume—and because
the market is intermediated through the personal connections of a few
brokerage firms, we are confident that we can accurately describe
D&O insurance practices based on a number of interviews that may
seem very small to researchers used to working with large quantitative
data sets.
21
Clearly, this was not a random sample. The goal, however, was in-
depth exploration of the D&O underwriting process, not the meas-
urement of predefined variables. Moreover, it is clear that our sources
of information were not unbiased. We sought to interview profession-
als on every side of the insurance transaction—brokers, underwriters,
actuaries, insureds, and their advisors—in order to counteract this
problem, and, except as noted in our discussion, the participants pro-
vided consistent reports during the interviews. Thus, we are reporting
shared understandings of how the D&O insurance market operates.
18
Pursuant to a research protocol approved by the Institutional Review Board of the
University of Connecticut, we interviewed the participants under a promise of confidentiality.
The interviews were recorded and transcribed, and participant identifying information was re-
moved from the transcripts. Copies of the transcripts were provided to the editors of the Univer-
sity of Chicago Law Review for verification and returned to us.
19
The Professional Liability Underwriting Society is an association of specialists, including
underwriters, brokers, consultants, and advisors in the professional lines insurance market. The
Society’s website is available at http://www.plusweb.org (visited Apr 12, 2007).
20
These roles are described in Part II.B.2. In addition, we attended six conferences for
D&O professionals and engaged in many informal conversations, supplementing our interviews
with industry documents as well as regular reading of trade and industry publications.
21
See, for example, Tillinghast, 2005 Survey at 85 table 70 (cited in note 2).
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II.
D&O
I
NSURANCE AND
S
HAREHOLDER
L
ITIGATION
D&O insurance protects corporate directors and officers and the
corporation itself from liabilities arising as a result of the conduct of
directors and officers in their official capacity.
22
For private or non-
profit corporations, employment-related claims are the most common
source of D&O liabilities.
23
For public corporations, however, the domi-
nant source of D&O risk, both in terms of claims brought and liability
exposure, is shareholder litigation.
24
Because our research exclusively
examines D&O insurance for public corporations, we treat the central
purpose of D&O insurance as providing coverage against shareholder
litigation.
This Part provides a brief overview of covered claims and the
structure of D&O coverage. Part II.A describes the basic types of
shareholder claims and the principal liability exposures arising from
them. Part II.B describes the core features of D&O policies. We invite
readers already familiar with these matters to read selectively or to
skip ahead to the next Part.
A. Shareholder Litigation—Principal Liability Exposures
Shareholder litigation is a significant liability risk for publicly traded
corporations. Liability risk can be measured in terms of frequency and
severity. Frequency takes into account the probability of suit, and severity
takes into account the probable loss once a suit is filed.
A rough estimate of frequency—dividing all shareholder class ac-
tions by all publicly traded companies—suggests that public compa-
nies have about a 2 percent chance of being sued in a shareholder
22
See, for example, definitions of “wrongful conduct” in the following policies: AIG Speci-
men Policy 75011 § 2(z) (Feb 2002) (providing coverage for “any actual breach of duty, neglect,
error, misstatement, misleading statement, omission or act . . . by such Executive in his or her
capacity as such or any matter claimed against such Executive solely by reason of his or her
status as such”); Chubb Specimen Policy 14-02-7303 § 5 (Nov 2002), online at http://
www.chubb.com/businesses/csi/chubb2373.pdf (visited Apr 12, 2007) (“Wrongful act means . . . any
other matter claimed against an Insured Person solely by reason of his or her serving in an Insured
Capacity.”); The Hartford, Directors, Officers and Company Liability Policy, Specimen DO 00 R292
00 0696 § IV(O)(2), online at http://www.hfpinsurance.com/forms/nj85.pdf (visited Apr 12, 2007)
(defining coverage to include “any matter claimed against the Directors and Officers solely by
reason of their serving in such capacity”).
23
See Tillinghast, 2005 Survey at 5 (cited in note 2) (reporting that “92% of the claims
brought against nonprofit [participating companies] . . . were brought by employees”).
24
See id (reporting that “52% of the claims against [participating] public [companies] were
brought by shareholders”). See also Interview with D&O Advisor, Outside Counsel (unpublished
confidential transcript 2004) (confirming that for public companies, shareholder litigation is by
far the larger liability risk under a D&O policy).
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Predicting Corporate Governance Risk 495
class action in any given year.
25
The exposure for some companies, of
course, is much higher. Large companies tend to be sued more often
than small ones.
26
Companies in certain industries tend to be sued
more than others.
27
And Nasdaq companies are sued more often than
NYSE companies.
28
A rough estimate of severity can be taken by examining settle-
ment amounts.
29
The numbers are not small. Average settlement values
of shareholder class actions exceeded $24 million in 2005, up from $19
million in 2004.
30
The average settlement value for the years 2002–2005
was $22.3 million, significantly higher than the average settlement
value of $13.3 million for the years 1996–2001.
31
Comparing median
settlement values reveals a significant skew in these numbers. Median
settlements in 2005 were $7 million, and the median annual settlement
for the period 2002–2005 was $5.8 million, compared to $4.6 million
for the period 1996–2001.
32
Shareholder suits are thus characterized by
25
Cornerstone Research, Securities Class Action Filings: 2005, A Year in Review 4 (2006),
online at http://securities.stanford.edu/clearinghouse_research/2005_YIR/2006012302.pdf (visited
Apr 12, 2007) (estimating susceptibility to a federal securities class action for “companies listed on
the NYSE, Nasdaq, and Amex” at the start of 2005 at 2.4 percent). See also Ronald I. Miller, Todd
Foster, and Elaine Buckberg, Recent Trends in Shareholder Class Action Litigation: Beyond the
Mega-Settlements, is Stabilization Ahead? 3 (NERA Economic Consulting 2006), online at
http://www.nera.com/image/BRO_RecentTrends2006_SEC979_PPB-FINAL.pdf (visited Apr 12, 2007)
(estimating susceptibility of all publicly traded corporations in 2005 at 1.9 percent).
26
See Tillinghast, 2005 Survey at 99 (cited in note 2).
27
Which industries are sued most often fluctuates somewhat from year to year, suggesting
a scandal du jour pattern in securities litigation. In 2005, the three industrial sectors receiving the
most securities class action filings were consumer noncyclical, consumer cyclical, and finance. The
year before, however, the top three industries in terms of filings were consumer noncyclical,
technology, and communications. Cornerstone Research, Securities Class Action Filings at 14
(cited in note 25).
28
Id at 12 (stating that between 1996 and 2005, “there have been more class action filings
against Nasdaq firms than against NYSE/Amex firms”).
29
Because the vast majority of shareholder claims are either settled or dismissed, settle-
ment amounts may be a fair measure of the value of a claim. Settlement values, however, are a
poor measure of the total cost of shareholder litigation since they do not include defense costs,
which account for a large, but not well documented, portion of D&O loss costs. Because D&O
insurers reimburse policyholders for their defense costs as part of the indemnity coverage (as
opposed to providing a defense and paying for that defense in addition to the indemnity cover-
age), the loss data that insurers file with regulators do not distinguish between settlement pay-
ments and defense costs. At one industry conference we attended, lawyers and claims managers
disputed the total extent of the defense costs, but agreed that defense costs were at least 25
percent of a typical class action settlement. A claims manager reported that in recent years de-
fense costs that were 50 percent or even 100 percent of the settlement amounts were increasingly
common. Of course when a case is dismissed without payment the defense costs are the only
covered losses.
30
Miller, Foster, and Buckberg, Recent Trends in Shareholder Class Action Litigation at 5
(cited in note 25).
31
Id.
32
Id.
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a handful of very large settlements, while the typical case settles for a
considerably lower amount.
33
F
IGURE
1:
M
EDIAN AND
M
EAN
S
ECURITIES
L
ITIGATION
S
ETTLEMENTS
,
2000–2005
Doctrinally, shareholder suits include both corporate fiduciary
duty claims, whether derivative or direct,
34
and securities law claims.
35
The possible grounds for complaints are many.
36
However, the basic
concern underlying all such claims is a divergence between managerial
conduct and shareholder welfare—the problem, in other words, of
agency costs.
37
Whether the claim is that managers looted the company
33
Lower, but by no means insignificant. In 2005, only 27 percent of settlements were below
$3 million, compared to 45 percent in 1996. Id.
34
See Robert B. Thompson and Randall S. Thomas, The New Look of Shareholder Litiga-
tion: Acquisition-Oriented Class Actions, 57 Vand L Rev 133, 137 (2004) (finding that approxi-
mately 80 percent of all fiduciary duty claims filed in Delaware Chancery Court in 1999 and 2000
were class actions challenging board conduct in an acquisition and that only 14 percent of fiduci-
ary duty claims over the same period were derivative suits).
35
Securities litigation arises under both the Securities Act of 1933, 15 USC §§ 77a et seq
(2000), and the Securities Exchange Act of 1934, 15 USC §§ 78a et seq (2000).
36
See, for example, William E. Knepper and Dan A. Bailey, Liability of Corporate Officers
and Directors § 17.02 at 17-3 to 17-10 (Bender 7th ed 2003) (listing 170 possible grounds for
liability in shareholder litigation).
37
See generally Michael C. Jensen and William H. Meckling, Theory of the Firm: Manage-
rial Behavior, Agency Costs and Ownership Structure, 3 J Fin Econ 305 (1976) (identifying the
divergence in interests between shareholder principals and manager agents as a central feature
of the corporate form). See also Robert B. Thompson and Hillary A. Sale, Securities Fraud as
Corporate Governance: Reflections upon Federalism, 56 Vand L Rev 859, 903 (2003) (arguing that
0.00
5.00
10.00
15.00
20.00
25.00
30.00
2000 2001 2002 2003 2004 2005
Dollars
(millions)
MEDIAN
MEAN
Source: Miller, Foster, and Buckberg,
Recent Trends in Shar
e-
holder Class Action Litigation at 5 (cited in note 25).
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Predicting Corporate Governance Risk 497
or negligently managed it or lied to investors in order to inflate their
own compensation packages, the basic concern is that management
has sought to serve its own interests rather than the interests of its
investors.
38
Of all the litigation that such conduct can generate, securi-
ties law claims represent by far the greatest liability risk.
39
Securities law claims, whether brought as an enforcement action
by the Securities and Exchange Commission
40
or by private plaintiffs
through the class action mechanism,
41
are typically framed around a
misrepresentation. Most often, a company releases false or misleading
information that has the effect of inflating its share price and inducing
investors to buy; when the information is later revealed as false, the
company’s share price drops and all investors who bought in at the
artificially high price lose a portion of their investment.
42
The securities
laws create several causes of action for such situations, the most im-
portant of which is Rule 10b-5 under § 10(b) of the Exchange Act.
43
the basic corporate governance concern—the divergence between managerial interests and
shareholder welfare—has become a common underlying basis in securities fraud claims).
38
Misstatements designed to keep the firm afloat, as opposed to those designed merely to
pad executive pay packages, may not seem to arise from agency costs because they arguably
benefit the firm. However, any benefit to current shareholders—through, for example, overstated
earnings—comes at the expense of future shareholders, those who buy in under the misrepresen-
tation and therefore pay too much for their shares and also those who fail to sell prior to the
corrective disclosure. This reveals a temporal conflict between investors generally. See generally
Steven L. Schwarcz, Temporal Perspectives: Resolving the Conflict between Current and Future
Investors, 89 Minn L Rev 1044 (2005). But the securities laws do not excuse fraud designed to
benefit one class of investors (current shareholders) over another (prospective shareholders).
Instead, the securities laws adopt an ex ante perspective in order to curb managerial conduct harm-
ful to the investor class generally. See, for example, Pommer v Medtest Corp, 961 F2d 620, 623 (7th
Cir 1992) (“The securities laws approach matters from an ex ante perspective: just as a statement
true when made does not become fraudulent because things unexpectedly go wrong, so a statement
materially false when made does not become acceptable because it happens to come true.”).
39
See Tom Baker and Sean J. Griffith, D&O Interviews, Counsel #1 at 10 (unpublished
confidential transcripts 2005) (on file with authors) (“The big exposure to D&O, as I am sure
you know, is that number one head and shoulders above everything else is securities class ac-
tions.”). See also id, Counsel #3 at 5 (“[S]ecurities litigation outweighs derivative litigation by
far.”). The protocols for these interviews are explained in note 18.
40
See 15 USC §§ 77s–77t, 78u(a), (d) (2000) (empowering the SEC to investigate and seek
injunctive relief for violations of the Securities and Exchange Acts).
41
See, for example, Herman & McLean v Huddleston, 459 US 375, 380 (1983) (“[A] private
right of action under Section 10(b) . . . and . . . Rule 10b-5 has been consistently recognized for
more than 35 years. The existence of this implied remedy is simply beyond peradventure.”). See
also generally John C. Coffee, Jr., Rescuing the Private Attorney General: Why the Model of the
Lawyer as Bounty Hunter Is Not Working, 42 Md L Rev 215 (1983) (describing and critiquing
private enforcement of the securities laws).
42
See generally Louis Loss and Joel Seligman, 9 Securities Regulation 4114–54 (Aspen 3d
ed 2004) (discussing typical patterns in securities litigation).
43
15 USC § 77l (2000); 17 CFR § 240.10b-5 (2006). Rule 10b-5 claims may be brought
against a broad spectrum of defendants for any misrepresentation made “in connection with the
purchase or sale of any security.” Id. See also Blue Chip Stamps v Manor Drug Stores, 421 US
723, 753–55 (1975). Rule 10b-5 plaintiffs must show materiality, scienter, causation, and reliance. In
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Sections 11 and 12(2) of the Securities Act are a distant second and
third, respectively.
44
In 2005, 93 percent of securities class actions al-
leged violations of Rule 10b-5.
45
Only 9 percent alleged a § 11 viola-
tion, and only 5 percent alleged a § 12(2) claim.
46
In sum, D&O risk is shareholder litigation risk, which essentially in-
volves issues of shareholder (or, more generally, investor) welfare.
47
The
principal liability exposure is securities litigation and, more specifically,
10b-5 claims, typically framed around a corporate misrepresentation.
B. The Anatomy of D&O Insurance
D&O liability insurance coverage evolved from basic corporate
liability policies but was not commonly purchased by U.S. corpora-
tions until the early- to mid-1960s.
48
Although it was initially unclear
whether corporations would be legally permitted to insure directors
and officers against losses that the corporation could not legally in-
demnify,
49
the question was settled when state legislatures enacted
statutes expressly permitting D&O insurance regardless of whether
the loss was one that the corporation itself could indemnify.
50
This Part
practice, however, these elements tend to blend together, at least for actively traded securities. See
Basic Inc v Levinson, 485 US 224, 230–33, 241–48, 261 (1988) (discussing the elements of a 10b-5
claim and establishing the presumption of reliance on the basis of a “fraud on the market” theory).
44
15 USC §§ 77k, 77l(a)(2) (2000). Section 11 claims involve misrepresentations made by
the issuer, underwriter, auditors, or attorneys involved in a registered public offering of securities
and, unlike 10b-5 claims, do not require a plaintiff to show scienter, causation, or reliance. Sec-
tion 11 defendants, however, have mechanisms at their disposal to rebut scienter and reliance
and to reduce or eliminate damages by disproving causation. Loss and Seligman, 9 Securities
Regulation at 4258–62 (cited in note 42).
45
Cornerstone Research, Securities Class Action Filings at 16–17 (cited in note 25).
46
Id.
47
See Thompson and Sale, 56 Vand L Rev at 903–04 (cited in note 37) (“[T]he state law
default norm centralizes corporate power in the hands of management—more specifically, direc-
tors—and these forms of litigation check the abuse of that position.”).
48
See Joseph F. Johnston, Jr., Corporate Indemnification and Liability Insurance for Direc-
tors and Officers, 33 Bus Law 1993, 2012 (1978).
49
See Joseph W. Bishop, Jr., New Cure for an Old Ailment: Insurance Against Directors’
and Officers’ Liability, 22 Bus Law 92, 106–07 (1966) (analyzing, based on the then-current state
of the law, whether insurance companies could legally offer D&O coverage to corporations for
risks for which the insurer could not directly indemnify the director). Although corporate in-
demnification is broadly permitted under the law of most states, many states, including Delaware,
do not permit indemnification for amounts paid in settlement of derivative claims. See 8 Del
Code Ann § 145(a) (2001) (permitting indemnification for expenses, judgments, and settlements,
except for those actions “by or in the right of the corporation”). Although the SEC has long
maintained that indemnification for securities law claims is contrary to public policy, it is firmly
established that the settlement of federal securities law claims may be paid for through indemni-
fication or insurance. See, for example, Raychem Corp v Federal Ins Co, 853 F Supp 1170, 1177–78
(ND Cal 1994) (holding indemnification permissible under both federal and Delaware law).
50
For example, Delaware General Corporation Law § 145(g) provides:
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Predicting Corporate Governance Risk 499
first discusses typical coverage terms, then the basic structure of the
market for D&O insurance.
1. Coverage.
A typical D&O policy sold to a publicly traded corporation con-
tains three different types of coverage. First, there is coverage to pro-
tect individual managers from the risk of shareholder litigation.
51
This
type of coverage is typically referred to by industry professionals as
“Side A” coverage, and we believe it is what most nonspecialists think
of as D&O insurance. However, D&O policies also contain two other,
less widely known types of coverage. The second type, referred to
within the industry as “Side B” coverage, reimburses the corporation
for its indemnification payments to officers and directors.
52
And the
third, “Side C” coverage, protects the corporation from the risk of
shareholder litigation to which the corporate entity itself is a party.
53
A corporation shall have power to purchase and maintain insurance on behalf of any per-
son who is or was a director, officer, employee or agent of the corporation . . . against any li-
ability asserted against such person and incurred by such person in any such capacity, or
arising out of such person's status as such, whether or not the corporation would have the
power to indemnify such person against such liability under this section.
8 Del Code Ann § 145(g). See also Joseph Warren Bishop, Jr., The Law of Corporate Officers and
Directors: Indemnification and Insurance § 8.1 at 8-2 (West Supp Nov 2006) (“All states author-
ize the corporation to purchase and maintain insurance on behalf of directors and officers
against liabilities incurred in such capacities, whether or not the corporation would have the
power to indemnify against such liabilities.”).
51
Basic coverage terms obligate an insurer to pay covered losses on behalf of individual
directors and officers when the corporation itself cannot indemnify them. See, for example,
Hartford Specimen Policy at § I(A) (cited in note 22); Chubb Specimen Policy at § 1 (cited in
note 22); AIG Specimen Policy at § 1 (cited in note 22).
52
Typical policy language provides:
The Insurer will pay on behalf of the Company Loss for which the Company has, to the ex-
tent permitted or required by law, indemnified the Directors and Officers, and which the
Directors and Officers have become legally obligated to pay as a result of a Claim . . .
against the Directors and Officers for a Wrongful Act.
Hartford Specimen Policy at § I(B). See also Chubb Specimen Policy at § 2; AIG Specimen Policy
at § 1 Coverage B. Policies typically deem indemnification to be required in every situation
where it is legally permitted, thus preventing the corporation from opportunistically pushing the
obligation to the insurer by simply refusing to indemnify its directors and officers. See Hartford
Specimen Policy at § VI(F) (providing that if a corporation is legally permitted to indemnify its
officers and directors, its organizational documents will be deemed to require it to do so). See
also Chubb Specimen Policy at § 14; AIG Specimen Policy at § 6.
53
Typical policy language provides: “[T]he Insurer will pay on behalf of the Company Loss
which the Company shall become legally obligated to pay as a result of a Securities Claim . . .
against the Company for a Wrongful Act.” Hartford Specimen Policy at § I(C). See also Chubb
Specimen Policy at § 3; AIG Specimen Policy at § 1 Coverage B(i). A securities claim is defined
in the policy to include claims by securities holders alleging a violation of the Securities Act or
the Exchange Act or rules and regulations promulgated pursuant to either act as well as similar
state laws and includes claims “aris[ing] from the purchase or sale of, or offer to purchase or sell,
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Side A coverage typically includes no retention (deductible) or co-
insurance amount.
54
Sides B and C, however, do.
55
Covered losses in-
clude compensatory damages, settlement amounts, and legal fees in-
curred in defense of claims arising as a result of the official acts of
directors and officers—principally including, as described above,
shareholder litigation.
56
D&O policies have three principal exclusions: (1) the “Fraud” ex-
clusion for claims involving actual fraud or personal enrichment, (2)
the “Prior Claims” exclusion for claims either noticed or pending prior
to the commencement of the policy period, and (3) the “Insured v.
Insured” exclusion for litigation between insured persons.
57
The Fraud
exclusion prevents insureds from receiving insurance benefits when
they have actually committed a wrongful act, often defined as a “dis-
honest or fraudulent act or omission or any criminal act or omission
or any willful violation of any statute, rule or law.”
58
Whether an act
comes within the Fraud exclusion depends upon the wording of the
policy, which may require “final adjudication” of the fraudulent act or
merely evidence that the fraudulent act has “in fact” occurred.
59
The
any Security issued by the Company,” regardless of whether the transaction is with the company
or over the open market. Hartford Specimen Policy at § IV(M). See also Chubb Specimen Policy
at § 5 “Securities Claim”; AIG Specimen Policy at § 2(x). If the company purchases Side C cov-
erage, the definitions of “securities claim,” “loss,” and “wrongful act” expand to include the com-
pany and not just the directors and officers. Chubb Specimen Policy at § 3.
54
See Tillinghast, 2005 Survey at 52 (cited in note 2) (reporting that 98 percent of U.S. respon-
dents who purchased D&O insurance had no deductible associated with their Side A coverage).
55
For further discussion of the types of coverage and the puzzles and problems created by
each, see Baker and Griffith, 95 Georgetown L J (forthcoming 2007) (cited in note 8); Griffith,
154 U Pa L Rev at 1162–68 (cited in note 6).
56
Hartford Specimen Policy at § IV(J) (including compensatory damages, settlement
amounts, and legal fees). See also Chubb Specimen Policy at § 5 “Loss”; AIG Specimen Policy at
§ 2(p). Other important definitions in the policy include “claims,” defined as the receipt of a
written demand for relief, the filing of a civil proceeding, or the commencement of a formal
administrative or regulatory proceeding. Hartford Specimen Policy at § IV(A); Chubb Specimen
Policy at § 5 “Claim”; AIG Specimen Policy at § 2(b). Wrongful acts are defined by the policy to
include errors, misstatements, omissions, and breaches of duty committed by directors and offi-
cers in their official capacities as well as any other claim against the directors and officers solely
by reason of their position. Hartford Specimen Policy at § IV(O); Chubb Specimen Policy at § 5
“Wrongful Act”; AIG Specimen Policy at § 2(z).
57
See AIG Specimen Policy at § 4(b)–(c), (e)–(f), (i)–(j); Chubb Specimen Policy at
§§ 6(a)–(c), 7–8; Hartford Specimen Policy at §§ IV(i)–(j), V(C)–(D).
58
Executive Risk Indemnity, Inc., Broad Form Directors and Officers Liability Insurance
III.A.3. Similar language appears in both the AIG, Chubb, and Hartford policies. See also note
62. A related exclusion prevents insurers from making payments to indemnify an insured person
against unjust enrichment claims, thus preventing the insured from retaining any such gains. See
AIG Specimen Policy at § 4(a); Chubb Specimen Policy at § 7–8; Hartford Specimen Policy at
§ V(I).
59
Insureds typically seek to include “final adjudication” language to clarify that the actual
fraud only applies if there has been a final adjudication of actual wrongdoing by the insured,
while the insurer may seek less strict “in fact” language, setting a lower threshold for the deter-
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Predicting Corporate Governance Risk 501
Prior Claims exclusion carves out any claims noticed or pending prior
to the commencement of the current policy, which ordinarily would be
covered under a prior policy.
60
Finally, the Insured v. Insured exclusion
withholds insurance proceeds for losses stemming from litigation be-
tween insured parties, such as directors suing the corporation or the
officers or the corporation suing an officer or director.
61
Other com-
mon exclusions remove peripheral claims—such as environmental
claims, ERISA claims, claims alleging bodily injury or emotional dis-
tress, and claims arising from service to other organizations
62
—from
the scope of coverage, leaving shareholder litigation as the principal
covered risk.
63
The discussion above captures several key terms of D&O policies,
but it is worth noting that coverage terms can be negotiated and
therefore are difficult to generalize. Both buyers and sellers are highly
sophisticated and have legal expertise at their disposal. Moreover,
there is no standardized form to this line of insurance.
64
Shopping for
coverage thus requires comparing, and to some degree negotiating,
both prices and terms. Nevertheless, all D&O policies have the effect
of shifting the risk of shareholder litigation from individual directors
and officers and the corporation they manage to a third-party insurer.
When shareholders sue their officers or directors, it is usually an in-
surer that pays.
65
mination of actual fraud and, therefore, applicability of the exclusion. See D&O Interviews,
Counsel #3 at 2–3 (cited in note 39).
60
This exclusion plus the claims-made nature of the policy forces the insured to notify its
current insurer of any potential claims activity at the earliest possible date in order to assert its
rights prior to the expiration of the policy period because such claims are likely to be excluded
under any subsequent policy.
61
See, for example, Fidelity & Deposit Co of Maryland v Zandstra, 756 F Supp 429, 431–32
(ND Cal 1990). Like the family member exclusion in homeowners’ insurance policies, the pur-
pose is to avoid collusive litigation. See Robert H. Jerry II, Understanding Insurance Law 1030
(Bender 3d ed 2002). Derivative litigation, when successfully maintained independent of the
board—as for example, when demand has been excused—is carved out of the exclusion, with the
effect that the Insured v. Insured provision operates to exclude from coverage only those actions
that are willfully maintained by insured persons. See generally Zapata v Maldonado, 430 A2d 779
(Del 1981) (discussing the demand mechanism in derivative litigation).
62
See AIG Specimen Policy at § 4(g)–(h), (k), (m); Chubb Specimen Policy at § 6(d)–(h);
Hartford Specimen Policy at § V(A), (F)–(G).
63
All of these peripheral claims are covered by other forms of liability insurance. Why the
insurance market addresses all these risks in separate insurance products is an interesting ques-
tion that is beyond the scope of this project.
64
See generally, for example, Susan J. Miller and Philip Lefebvre, Miller’s Standard Insur-
ance Policies Annotated (1997) (collecting clause-by-clause case citations to a variety of standard
insurance policies published by the Insurance Services Office, Inc).
65
See note 3.
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2. The market for D&O insurance.
As noted, the D&O market has sophisticated parties on both the
buyer’s and seller’s side of the transaction. In addition, expert inter-
mediaries—specialized D&O insurance brokers—typically facilitate
the transaction. The D&O market thus has several key participants:
corporate buyers, insurance company sellers, and insurance brokers.
The following paragraphs describe the roles performed by each of
these three basic participants in the market for D&O insurance.
The buyers of D&O insurance that we focused on in this study
are publicly traded corporations.
66
The most commonly cited reason
for the purchase of D&O insurance is the recruitment and retention
of qualified officers and directors.
67
Corporations are eager to assure
their officers and directors that their personal assets will not be at risk
as a result of accepting a board seat or other position with the com-
pany.
68
However, as we discuss at length elsewhere, this explanation
only applies to the purchase of one of the three lines of coverage—
Side A coverage—in a typical D&O policy.
69
The actual purchase of
D&O insurance, at least for larger corporations, is likely to be handled
by the company’s “risk manager,” a management position that typi-
cally reports to the treasurer or chief financial officer.
70
As we describe
below, however, decisions on D&O insurance and assistance in the
marketing of the company to prospective underwriters often involve
the firm’s legal department and top-level management.
71
66
As we noted above, D&O insurance is also purchased by private and nonprofit corpora-
tions, but the insurance market for these organizations is distinct from the market for public corpo-
rations and therefore outside of the scope of this research. See note 23 and accompanying text.
67
D&O insurance can help corporations recruit and retain well-qualified directors:
The insurance crisis of the mid-1980s highlighted the exposure of corporate D&Os . . . .
Without adequate resources to defend increasing litigation and to protect their personal as-
sets from bankruptcy, directors of major corporations threatened mass defections from
boardroom [sic] across America. Thus, some of the most talented candidates for D&O posi-
tions became unwilling to take key leading roles within the corporate structure.
Terrence G. Stolly, Comment, Scienter Under the Private Securities Litigation Reform Act of 1995:
Unexpected Implications on Director and Officer Liability and D&O Insurance, 29 Cap U L Rev
545, 578–79 (2001). See also Tillinghast, 2005 Survey at 3 (cited in note 2) (reporting that in 2005
approximately 50 percent of for-profit survey respondents had received an inquiry from direc-
tors about the company’s D&O coverage).
68
See Black, Cheffins, and Klausner, 58 Stan L Rev at 1140 (cited in note 3) (positing that
a high level of risk “could well deter good candidates from serving”).
69
See Part II.B.1. See also Baker and Griffith, 95 Georgetown L J (forthcoming 2007)
(cited in note 8); Griffith, 154 U Pa L Rev at 1162–68 (cited in note 6).
70
The risk manager is responsible for all of a company’s insurance lines. Our participants
reported that in some cases the chief financial officer of a corporation may handle the insurance
purchasing directly. See, for example, D&O Interviews, Risk Manager #2 at 13 (cited in note 39).
71
See note 108 and accompanying text.
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Predicting Corporate Governance Risk 503
The amount of D&O insurance purchased correlates with the
market capitalization of the corporate buyer.
72
According to Tilling-
hast, in 2005, small-cap companies—defined here as those with market
capitalizations between $400 million and $1 billion—purchased an
average of $28.25 million in D&O coverage limits.
73
Mid-cap compa-
nies—those with market capitalizations between $1 billion and $10
billion—purchased an average of $64 million in limits.
74
And large-cap
companies—those with market capitalization in excess of $10 bil-
lion—purchased an average of $157.69 million in D&O coverage.
75
The
largest available coverage limit mentioned by the participants in our
study was $300 million.
76
72
This is perhaps unsurprising—the largest companies attract the most attention in the
press and also offer the highest payoffs for plaintiffs’ lawyers and therefore are more likely to
attract lawsuits. Similarly, the largest companies have the farthest to fall in terms of share valua-
tion and therefore create the highest settlements.
73
See Tillinghast, 2005 Survey at 29 table 17C (cited in note 2).
74
Tillinghast reports mid-cap limits in three categories. The first, companies with market
capitalizations between $1 billion and $2 billion, purchased mean limits of $44.88 million and
median limits of $30 million. The second, companies with market capitalizations between $2
billion and $5 billion, purchased mean limits of $83.2 million and median limits of $75 million.
Finally, the third group, companies with market capitalizations between $5 billion and $10 billion,
purchased mean limits of $79.4 million and median limits of $65 million. See id. The number
reported in the text is an average of these three categories, weighted for the number of observa-
tions in the Tillinghast sample.
75
See id. The median reported for companies with market capitalizations in excess of $10
billion was $125 million.
76
See D&O Interviews, Risk Manager #3 at 6 (cited in note 39). See also id, Underwriter
#13 at 37–38.
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F
IGURE
2:
A
NNUAL
D&O
P
OLICY
L
IMITS
B
Y
M
ARKET
C
APITALIZATION
C
ATEGORY
In general, no one insurer is willing to underwrite the entire limits
purchased by any one corporation. This is especially true for the high-
limit policies purchased by large- and mid-cap companies. Our par-
ticipants reported that $50 million was the largest limit available in the
late 1990s from a single insurer and noted that, in the late 2005 mar-
ket, few insurance carriers were offering a policy larger than $25 mil-
lion and that most policies had limits of $10 million or less.
77
As a re-
sult of these constraints, corporations must purchase several D&O
policies in order to reach the aggregate amount of insurance they de-
sire. D&O insurance packages are thus said to come in “towers”—that
is, separate layers of insurance policies stacked to reach a desired total
amount of coverage.
The bottom layer of a D&O tower is called the “primary policy,”
and the insurance company offering that policy is referred to as the
“primary insurer.” Primary insurers have the closest relationship with
the policyholder. Because the primary insurer’s policy is the first to
respond to a covered loss and therefore is the most likely to incur a
payment obligation, the primary insurer charges a higher premium
77
See, for example, D&O Interviews, Actuary #3 at 10 (cited in note 39).
0
20
40
60
80
100
120
140
160
180
SMALL CAP
($400M–1B)
MID CAP
($1–10B)
LARGE CAP
(>$10B)
Market Capitalization
Limits
($ millions)
MEDIAN
MEAN
Source: Tillinghast,
2005 Survey
at 29 table 17C (cited in note
2
)
(2005 data). We derived the “Mid Cap”
category as a weighted
average of three market capitalization classes re
ported by
Tillinghast. See note 74.
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Predicting Corporate Governance Risk 505
than those higher up in the tower of coverage. The market for primary
insurance is dominated by a small number of companies, most signifi-
cantly AIG and Chubb.
78
Excess insurers—those higher up in the tower—become respon-
sible for covered losses on a layer-by-layer basis as the limits of each
underlying policy become exhausted by loss payments.
79
Excess poli-
cies typically are sold on a “following form” basis, meaning that the
contract terms (other than limits and price) in the excess policy are
the same as those in the underlying policy. Because all excess policies
are less likely to respond to a covered loss than the primary policy and
each successive layer of excess insurance is less likely to respond to a
claim than the layer immediately beneath it, the premiums associated
with excess policies are lower the higher the policy is situated in the
tower of coverage. As a result, the total premium that a corporate in-
sured pays for its D&O coverage will be a blended amount of several
distinct premiums paid to separate insurance companies.
80
The higher
the limits a corporation buys, the more companies that are likely to
make up the tower of coverage.
It is brokers who assemble these towers of coverage. The D&O
market, like the corporate insurance market generally, is brokered.
The largest retail insurance brokers—Marsh, Aon, Willis, and other
national or large regional brokers—have in-house D&O specialists,
while smaller brokerage firms may use a specialist wholesale broker
(a broker’s broker) to shop for and assemble a client’s D&O coverage.
Recent investigations into the insurance brokerage industry suggest
that there are opportunities for brokers to abuse their role.
81
Whether
any such conduct took place in brokerage firms’ D&O lines is beyond
78
According to Tillinghast, in 2005 AIG and Chubb together controlled 53 percent of the
total U.S. market measured by premium volume and 36 percent of the total U.S. market by policy
count. Tillinghast, 2005 Survey at 86 figs 36 and 37 (2006)
(cited in note 2).
79
Although the claims process is outside the scope of this article, it is worth noting that a
settlement that involves multiple layers—commonly the case in a low frequency, high severity
line of insurance like public D&O—requires consent from all the insurers. See Black, Cheffins,
and Klausner, 58 Stan L Rev at 1100 & n 149 (cited in note 3) (“Under the terms of D&O poli-
cies, the insurer’s consent to a settlement is required for funds to be available. . . . [A]n insurer might
resist a settlement [because] multiple insurers with different layers of coverage cannot agree on
how to handle the case.”). Insurance law has mechanisms that address the hold-up problem
presented by settlements involving multiple insurers.
80
When, later in this Article, we refer to premiums, we are referring to this total premium
amount—the cost of the total coverage package, consisting of several policies and, technically,
several premiums.
81
See Sean Fitzpatrick, The Small Laws: Eliot Spitzer and the Way to Insurance Market
Reform, 74 Fordham L Rev 3041, 3043–49 (2006) (analyzing the development of unethical busi-
ness “steering” and outright bid rigging in the excess casualty insurance markets). See also gen-
erally Daniel Schwarcz, Beyond Disclosure: The Case for Banning Contingent Commissions, 25
Yale L & Policy Rev (forthcoming 2007).
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the scope of this research. What we can report, however, is that a sub-
stantial role for brokers in the D&O market seems inescapable as a
result of: (1) the nonuniform nature of D&O insurance policies; (2)
the need to assemble a tower of coverage from the policies of many
different insurance companies; and (3) the need for a trusted interme-
diary to convey information between buyer and seller.
Rounding out our list of the main participants in the D&O mar-
ket are reinsurers. Not every D&O insurer uses reinsurance—our par-
ticipants reported, in fact, that at least some of the market leaders did
not use it at all during the period of our study—but many do.
82
Rein-
surers insure the risks undertaken by insurance companies, effectively
providing a further means of risk spreading.
83
Reinsurance also pro-
vides new entrants with an easy means of accessing the D&O insur-
ance market and established insurers with a quick means of increasing
their D&O exposure. Similarly, the easiest way for an insurance com-
pany to reduce its D&O exposure without eliminating existing cus-
tomers is to reinsure a larger share of its business.
3. Market cycles.
No description of the D&O insurance market would be complete
without some mention of the insurance underwriting cycle. For rea-
sons that have yet to be fully explained, insurance markets follow a
boom and bust pattern that is similar to, but not closely correlated
with, other business cycles.
84
More specifically, the underwriting cycle
refers to the tendency of premiums and restrictions on coverage and
underwriting to rise and fall as insurers tighten their standards in re-
sponse to the loss of capital or, alternately, loosen their standards in
82
Our participants reported that most of the leading global and domestic reinsurance
companies active in the U.S. liability insurance market have provided D&O reinsurance in the
recent past and that D&O reinsurance is also offered by some Lloyds syndicates and by several of
the newer, Bermuda-based reinsurers. See, for example, D&O Interviews, Underwriter #9 at 27–29
(cited in note 39).
83
D&O reinsurance, like reinsurance generally, may be provided on either a treaty or a
facultative basis. In treaty reinsurance, the reinsurer assumes a portion of all risks underwritten
by the insurer within a defined category, such as public company D&O, and therefore evaluates
the insurer’s risk portfolio as a whole. In facultative reinsurance, the reinsurers assume a portion
of a particular policy and therefore underwrite each risk individually, typically on an excess-of-
loss basis. See generally Stanford Miller, The Working Excess of Loss Treaty in Property Insur-
ance, in Robert W. Strain, ed, Reinsurance 161 (College of Insurance 1980).
84
For a detailed examination of the underwriting cycle that reviews the literature, see
generally Tom Baker, Medical Malpractice and the Insurance Underwriting Cycle, 54 DePaul L
Rev 393 (2005) (describing the underwriting cycle as applied to medical malpractice). For a claim
that the underwriting cycle is correlated with interest movements, see generally Robert T.
McGee, The Cycle in Property/Casualty Reinsurance, 11 Fed Res Bank NY Q Rev 22 (1986)
(describing the link between interest rates and insurance cycles, and closely examining the period
from 1975 to 1984).
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Predicting Corporate Governance Risk 507
order to maintain or grow market share when new capital enters the
market.
85
The tightening of underwriting standards accompanies a
“hard market” in which premiums and, after a lag, underwriting prof-
its, rise.
86
Increased underwriting profits, of course, spur competition,
whether from new entrants or established companies seeking to in-
crease market share, and competition leads to another “soft market”
of loosening of underwriting standards and declining profits. The
process is described as cyclical because each market condition con-
tains the seed to generate the other.
87
All aspects of underwriting are affected by the cycle. In a hard
market, underwriters become more selective, more interested in
higher attachment points, less willing to offer high limits, less willing to
negotiate contract terms, and able to command dramatically higher
prices for what amounts to less coverage. The D&O insurance market
went through this “hard” phase in the mid-1980s and again in 2001–
2003.
88
More recently, the D&O insurance market has been shifting to
the “soft” phase.
89
The underwriting cycle has significant consequences for the re-
search reported in this Article. Because of the cycle, no snapshot of
the underwriting process can present an adequate basis for under-
standing insurance underwriting over time. Our snapshot of the un-
derwriting process took place at a transition period when the under-
85
See, for example, Scott E. Harrington, Tort Liability, Insurance Rates, and the Insurance
Cycle, in Robert E. Litan and Richard Herring, eds, Brookings-Wharton Papers on Financial
Services: 2004 97, 107–08 (Brookings Institution 2004). Some economists have recently suggested
that the pattern is more variable and random than the term “cycle” implies. See generally Anne
Gron and Andrew Winton, Risk Overhang and Market Behavior, 74 J Bus 591 (2001) (comparing
the liability insurance crisis of the 1980s with the catastrophe insurance crisis of the 1990s to
suggest that the “risk overhang,” or time an insurer was left with outstanding liability to claims,
affected the duration of the crises in question). Nevertheless, the concept of a “cycle” is so firmly
established within the industry that we will continue to use the term. See, for example, Matthew
Dolan, Repeating the Sins of Market Cycles, 2 Insights 1 (2003), online at http://
www.onebeaconpro.com/insights/insights_vol2_sp.pdf (visited Apr 12, 2007) (“Today, [medical
malpractice] is in the midst of a ‘hard market’ cycle.”).
86
The lag occurs because, at the start of a hard market, insurers increase the reserves set
aside to pay claims under policies previously sold, suppressing profits for a least one year. See
Baker, 54 DePaul L Rev at 400 (cited in note 84).
87
See Sean M. Fitzpatrick, Fear is the Key: A Behavioral Guide to Underwriting Cycles, 10
Conn Ins L J 255, 256 (2003–2004) (analyzing the role that underwriters, claims analysts, and
actuaries play in creating the underwriting cycle). One of our participants reported, “It is funny
how you find sometimes that questions either go away or they are not as substantial as they were
maybe in a harder insurance market where the premiums were higher and there is less capacity.”
D&O Interviews, Underwriter #14 at 17 (cited in note 39).
88
See Roberta Romano, 14 Del J Corp L at 1–2 (cited in note 4).
89
See D&O Interviews, Underwriter #4 at 4 (cited in note 39) (asserting that pricing is now
“pretty much inadequate across the sectors”). See also Tillinghast, 2005 Survey at 3 (“[T]he
market for D&O coverage has continued to soften.”).
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writing practices of the hard market were largely still in place but
prices were beginning to soften. Although we tried to compensate for
this snapshot by asking our participants to take a historical view and
not to focus only on the very recent past, it is possible that our re-
search overemphasizes practices more prevalent in a particular phase
of the underwriting cycle.
90
In a soft market, for example, D&O insur-
ers may be less selective and may give discounts that reduce the dif-
ferences in risk bases among insureds.
III.
U
NDERWRITING AND
R
ISK
A
SSESSMENT
Underwriting is the collective process that insurers use to decide
whether or not to offer coverage to a prospective insured and, if so, at
what amounts, at which layer of the tower, and, of course, at what
price.
91
Each of these basic underwriting decisions depends upon the
insurer’s assessment of the risk posed by the prospective insured. This
risk assessment is the most critical aspect of the underwriting process
and the subject of this Part.
A. Assessing the Risk of Shareholder Litigation
The underwriters we interviewed all had their own method of as-
sessing D&O risk, the precise details of which they were typically un-
willing to share.
92
Some claimed that their underwriting process was
driven by a mathematical model,
93
while others described hashing out
these decisions in discussion with colleagues around a large table.
94
All
of the underwriters we talked to, however, emphasized the importance
90
See D&O Interviews, Broker #2 at 22 (“In a soft market, you are more likely to be able to
find an insurance company that will take the chance and write the policy, you know, write cover-
age with prior acts, maybe even off the continuity and not require a warranty application. You
know, in the soft market right now one of the things that we are finding is that companies are
willing to offer nonrescindable Side A coverage. That is really something that has just sort of
happened within the last, you know, maybe 2, 3, 4 months”).
91
One of our participants abbreviated these basic underwriting tools with the acronym
“SLAP”—Selection (of risk), Limits (of coverage), Attachment point (within the tower), and
Pricing (of the policy). See D&O Interviews, Underwriter #9 at 9–11 (cited in note 39).
92
One joked, “I would have to kill you if I told you.” D&O Interviews, Underwriter #2 at 8
(cited in note 39). In the words of another, “[W]e spend a lot of time studying [what factors
correlate to D&O risk]. We know quite well, but again it is private.” Id, Underwriter #4 at 3.
93
Id, Underwriter #8 at 11–12 (discussing quantitative methods of analyzing tolerances to
stock volatility).
94
In the words of a former line underwriter:
I am not familiar with, say, auto insurance or these other lines of insurance where an un-
derwriter can actually plug in numbers into an actuarial model. . . . We didn’t do that. We
literally sat at a round table and, just based on the experience of the more senior folks, we
would say this is a great number, and we threw a number out of the hat.
Id, Underwriter #6 at 24–25.
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Predicting Corporate Governance Risk 509
of individual risk rating. This surprised us somewhat since, by analogy
to portfolio theory, we expected at least some insurers to take an in-
dex approach and seek to diversify their risks by underwriting a por-
tion of the entire D&O market.
95
None did. In fact, one of the under-
writers we interviewed sharply rebuffed the suggestion:
That is not enlightened thinking. If you followed that through to
the end, why wouldn’t you just simply regress to the mean . . . ? I
mean, if your actuary assumes that you are just going to do aver-
age and he is going to make you price the business for average,
right, how do you get more aggressive on the better business?
96
Every underwriter in our sample sought to underwrite “better
business”—that is, better D&O risks. One participant candidly de-
scribed his firm’s goal to “out-select [its] peers.”
97
Some underwriters described moving toward a more portfolio-
based approach, in which their firms attempt to balance their expo-
sure by industry sector and market cap.
98
But these insurers still stress
risk selection.
99
In other words, even as insurers seek to spread their
exposures, they nevertheless take care in the design of their risk pools
and select insureds on the basis of individual risk characteristics. D&O
insurance companies have strong incentives—avoiding losses and out-
selecting competitors—to assess the risk of shareholder litigation ac-
curately. Thus, if we want to understand shareholder litigation risk,
D&O insurance underwriting practices are a good place to start. And
if we want to find the annualized present value of shareholder litiga-
95
See generally Edwin J. Elton, et al, Modern Portfolio Theory and Investment Analysis (John
Wiley 6th ed 2003). Applying the lesson of portfolio theory, an underwriter might seek to under-
write a thin sliver of each risk and thus participate in the returns of the D&O market as a whole.
96
D&O Interviews, Underwriter #15 at 31 (cited in note 39).
97
Id, Underwriter #8 at 35. Whether, in fact, this can be done or whether, instead, D&O
underwriters simply succumb to the Lake Woebegone illusion—where all the children are above
average—we leave for another day. More generally, we discuss reasons to doubt underwriters’
ability accurately to predict D&O risk. See note 172 and accompanying text.
98
Several participants did describe their “limit management” strategy—that is, reducing
the insurer’s exposure to any one D&O risk by reducing the maximum limits available to any
one insured. See, for example, D&O Interviews, Actuary #3 at 13 (“[W]hat we try to stress in our
portfolio is diversification by industry, diversification by size, and . . . laying a good limits man-
agement strategy on top of all that.”), Underwriter #1 at 8–9 (reporting a strategy of risk pool
diversification by industry), Underwriter #9 at 24 (“[Portfolio underwriting in D&O], which is
stepping away from an individual risk and looking at a portfolio risk, is also merging into yet
other corporate finance concepts.”) (cited in note 39).
99
See id, Actuary #3 at 13–14 (stating that “most underwriters still feel that selection is
important” and describing the insurer’s efforts, within a given risk category, “to pick the best in
class within that industry”).
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tion risk for any particular corporation, D&O insurance premiums are
the only place to look.
100
In making their risk assessments, underwriters look to three prin-
cipal sources of information about the prospective insured.
101
First,
there is an application process through which underwriters elicit basic
information, including the experience of covered officers and directors
and the claims history of the corporation,
102
plans for acquisitions or
securities issuances,
103
and whether any prospective insured has “prior
knowledge” of acts or omissions likely to give rise to a claim.
104
The
written application also contains an important bonding mechanism:
forcing the prospective insured to commit to the veracity of all written
statements and documents furnished in connection with the applica-
tion.
105
Because an applicant furnishing untrue information creates the
basis for a subsequent rescission action, the credibility of information
provided through the application is enhanced.
106
100
See also Griffith, 154 U Pa L Rev at 1182–85 (cited in note 6) (arguing for public disclo-
sure of D&O insurance premiums and other policy terms on this basis).
101
D&O Interviews, Underwriter #9, Seminar Tapes 1 & 2 at 29–30 (cited in note 39) (de-
scribing the importance of “applications . . . [and] specialized questionnaires often-times focused
on specific industry categories” as well as “meetings in which underwriters are posing questions
to officers of the company in regard to business practices, in regard to their current activities, and
in regard to their future plans”).
102
Applicants are asked both to describe any claims activity under a previous carrier and
whether any covered individual has ever been involved in securities or antitrust litigation, criminal or
administrative actions, derivative claims, or such representative proceedings. See, for example,
Chubb Group of Insurance Companies, D&O Elite Directors and Officers Liability Insurance
Application 033307 § II.5 (2003), online at http://www.chubb.com/businesses/csi/chubb3495.pdf
(visited Apr 12, 2007); AIG, D&O First Main Form Application 8116 § VI (2003), online at
http://www.aignationalunion.com/nationalunion/public/natfiledownload/0,2138,1873,00.pdf
(visited Apr 12, 2007).
103
The Hartford, Proposal for Directors, Officers, and Company Liability Insurance DO 00
R288 § 3 (2003), online at http://www.hfpinsurance.com/apps/do00r288.pdf (visited Apr 12, 2007);
Chubb D&O Elite Application at § II.4; AIG D&O First Main Application at §§ IV, V.
104
See Chubb D&O Elite Application at § II.6; Hartford D&O Proposal at § 1.5(b) (cited in
note 103). This representation in the application typically interacts with the Prior Claims exclu-
sion to exclude or limit the insurer’s exposure to such claims. See sources cited in note 62 and
accompanying text.
105
For example, a Chubb D&O application provides:
The undersigned . . . declare that to the best of their knowledge and belief, after reasonable
inquiry, the statements made in this Application and in any attachments or other docu-
ments submitted with this Application are true and complete. The undersigned agree that
this Application and such attachments and other documents shall be the basis of the insur-
ance policy . . . ; that all such materials shall be deemed to be attached to and shall form a
part of any such policy; and that the Company will have relied on all such materials in issu-
ing any such policy.
Chubb D&O Elite Application at § V.
106
Basic attachments called for in the application and thereby captured in the bonding
mechanism include organizational documents, recent SEC filings, and copies of any correspon-
dence between outside auditors and management, as well as prior D&O policies. See, for exam-
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Predicting Corporate Governance Risk 511
Second, underwriters conduct their own independent research.
They use a wide variety of publicly available data sources including
SEC filings, Bloomberg reports, analyst ratings, corporate governance
reviews from specialized providers such as the Corporate Library, and
industry-specific forensic accounting studies that identify potential
problem areas for further inquiry.
107
In addition to this publicly available data, underwriters have ac-
cess to private information through a series of meetings with the pro-
spective insured’s senior managers—often the chief financial officer or
treasurer—as well as members of the accounting and legal depart-
ments and occasionally, for smaller or exceptionally risky companies,
the chief executive officer.
108
At these “underwriters’ meetings,” pro-
spective insureds present information about their business model,
strategies, and risks while underwriters ask questions and gather fur-
ther information.
109
As one corporate risk manager described the goal
of the presentation: “We don’t buy insurance. We sell risk.”
110
Much of
the information gathered during the underwriters’ meeting and in any
subsequent inquires may not be publicly available.
111
It is therefore
customary in the underwriting process for underwriters to enter into
ple, Chubb D&O Elite Application at § II.1; AIG Application at §§ IV, V. The bonding mecha-
nism would also capture written answers to interrogatories and any other information provided
in connection with the underwriting process. However, one attorney noted that it is difficult for
insurers to win rescission cases—pointing out that attempts to rescind against Dennis Kozlowski
(Tyco) and Richard Scrushy (HealthSouth) had failed. The rescission threat therefore may be an
empty one, substantially weakening the bonding mechanism. D&O Interviews, Counsel # 2 at 9–
10 (cited in note 39).
107
See, for example, D&O Interviews, Actuary #1 at 25, Underwriter #7 at 16–17, Under-
writer #8 at 19–20, Underwriter #9 at 14–16, Underwriter #12 at 8, Underwriter #10 at 3, 55 (cited
in note 39).
108
Id, Broker #5 at 11–12.
109
Describing the underwriters’ meeting, one broker said:
It is like a first date. The insured, everyone is dressed very well. Generally, an insured’s CFO
or general counsel or maybe even the [CEO] might give a presentation . . . . There will be
questions that are asked by the underwriters. Some of them may involve confidential in-
formation about a public company. . . . [T]he insurance companies will sign confidentiality
agreements . . . . I think that insureds for the most part are pretty forthcoming.
Id, Broker #2 at 16–17.
110
Id, Risk Manager #4 at 7 (elaborating further that “[t]he best way to sell risk is to bring
evidence to them . . . to reduce any uncertainty about your risk”).
111
As a risk manager described the process: “[The underwriters] look at [the publicly avail-
able information] side by side by what is the account telling us in terms of what they are doing,
and where is the evidence that they are actually doing it.” Id, Risk Manager #4 at 13.
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nondisclosure agreements with prospective insureds,
112
thus permitting
a free exchange of otherwise unavailable information.
113
Participants in our study repeatedly described the underwriting
process as onerous and detail oriented.
114
This begs the critical question
of what information underwriters seek to gather during this process:
What do underwriters ask for? What information do they value most?
What do they believe best predicts the risk of shareholder litigation?
We will now focus on those questions. Before beginning, however,
we offer an extended quotation from one of our participants—the top
D&O underwriting officer at a leading insurer—that describes the
underwriting process at his firm. In his words:
We look at the industry that the company operates in trying to
figure out if we are in a mature industry, a growth industry, a start
up section of the industry, whatever. Are we working with proven
technology, new technology, proven consumer goods, new con-
sumer goods?
. . .
We look at the history of the company and see if M&A is a
prominent part of their planning process for the future or not. We
look if there are takeover risks. We look if there is a restructuring
perhaps necessary in the future of the company. We examine the
type of securities filings they did at the [SEC] . . . . We look at any
SPEs, SPVs, joint ventures that they are using to grow strategically.
112
See, for example, id, Underwriter #1 at 17–18 (noting that most underwriters’ meetings
are subject to nondisclosure agreements that provide underwriters with access to nonpublic
information). See also Griffith, 154 U Pa L Rev at 1178 (cited in note 6) (emphasizing role of
nondisclosure agreements in the underwriting process).
113
There is some information, of course, that prospective insureds will not share even under
the terms of a nondisclosure agreement. D&O Interviews, Broker #1 at 18 (cited in note 39)
(“[T]here is going to be a certain point where . . . the company is not going to be able to release
information [to the underwriters].”).
114
See, for example, id, Risk Manager #2 at 11 (observing that “there is a very thorough
review and research into the guts of the finance [and] the guts of the operation of the com-
pany”). Another risk manager noted:
I can recall probably 15 years ago where a D&O renewal might take me a half hour to fill
out the applications. It [now] takes me about a week to do all the financial [projections], just to
get them assembled and to determine where I need to go for information . . . . They want de-
tailed information. . . . [A presentation to incumbents and potential markets] is followed by an
interview process and sometimes followed by another set of application questions.
Id, Risk Manager #4 at 3. The cyclical nature of the insurance market, however, also seems to
affect the rigor of the underwriters’ diligence process. Id, Risk Manager #3 at 13 (relating that
“prior to [the corporate] meltdowns, [D&O] was a cake coverage”). Whether the current level of
scrutiny will be a lasting feature of the marketplace therefore remains to be seen.
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Predicting Corporate Governance Risk 513
Then we dive into the corporate governance. We examine
who the directors and officers are, their applicable experience.
We look at interlocking board relationships. We actually keep a
separate database here. Since 1996 we can run our database and
tell you if any one director or officer was a defendant in a securi-
ties class action or derivative action.
. . .
[W]e record which company they were serving in when they
were sued, but what we can then do is go back and look to see if
the folks that we are underwriting now were sued in what was a
fender bender or if it was a complete corporate meltdown. So we
have a driving record in this.
We look at the organization of the corporate governance
committees and independence of those committees and how ac-
tive they are and then we look at insider ownership [and] com-
pensation packages. Then we move into a broader understanding
of the entire ownership of the company and . . . what conflicts
may or may not may exist within the ownership interest.
We take a serious look at the equity trend of the company
over recent years and what made its price earnings multiple what
it is. We examine insider trades. We look at any intellectual prop-
erty that the company may be relying upon. We look at the regu-
latory structure and who the regulators may be and how the his-
tory with the regulatory relationships were. We look at both for-
mer existing director and officer litigation as well as general liti-
gation that the corporation may be involved in that could be a
threat to the future value of the company. We look at how they
handle corporate investor communications. We look at how they
are handling legislative or environmental issues that may face the
company. We look at how they may handle employment practices
and bankruptcy of course. We have an entire dedicated review of
the bankruptcy and potential emergency or liquidation.
Then we go into a very meticulous breakdown of the finan-
cials of both the balance sheet and the cash flow statement and
profit and loss statement. You know, your typical ratio analysis is
supported by about 55 or so different ratios. Underneath those
ratios we look meticulously at who the auditors are, what the
revenue recognition policies are, how they manage accounts re-
ceivable, inventory, payables, valuing intangibles, you know, for-
mulating debt and appreciation, capital expenditures, pension ob-
ligations, and we look even at vendor financing if it exists. Then
we take all that stuff and we rate it for risk. We summarize, you
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know, what makes us want to write the account and what makes
the necessity of the insurance relevant to the risk of the company
and then we price it.
115
In the discussion that follows, we seek to analyze and elaborate as-
pects of this description.
B. Financial Analysis
Insurance underwriters think of risk in terms of frequency and
severity.
116
What is the likely frequency of an insured loss? And what is
the probable magnitude of the loss once incurred? All of the under-
writers we interviewed agreed that D&O insurance “is a high severity,
low frequency game.”
117
And all of them glean an initial estimate of
frequency and severity from financial analysis. The reason is simple.
Virtually all shareholder litigation stems from investment loss. Thus, a
major part of assessing the risk of shareholder litigation is assessing
the risk of investment loss.
Underwriters begin the process of risk assessment with an analy-
sis of basic financial information about a company. This financial
analysis includes such factors as the prospective insured’s industry and
maturity,
118
its market capitalization,
119
volatility,
120
and various account-
115
Id, Underwriter #2 at 3–6. Another leading underwriter listed a similarly broad range of
factors and described using them in a way that was somewhat “intuitive.” Id, Underwriter #7 at 6
(“[T]he public D&O business is something that to some extent you can only be taught 75 per-
cent. Zero to 25 percent has to be intuitive.”).
116
See id, Underwriter #4 at 5 (describing D&O insurance as “low frequency high severity”).
117
See, for example, id, Underwriter #1 at 8.
118
Id, Broker #1 at 3–6, Broker #2 at 15 (mentioning industry-related volatility), Under-
writer #13 at 14–15 (looking differently at, for instance, pharmaceutical companies and Midwest
manufacturers), Underwriter #2 at 3 (listing multitude of factors underwriters consider, begin-
ning with industry and maturity of the company), Actuary #1 at 24–26 (stating that “the industry
itself is a factor” in risk assessment), Underwriter #7 at 18 (“We look at the . . . industry [the
company] is in.”), Underwriter #7 at 29 (noting that “underwriters rarely offer the same kind of
limits to a company going public as they would a mature company”).
119
One participant explained how market capitalization came to be important to D&O risk
rating as follows:
[I]nitially these policies were rated by the number of people on the board. So if you had a
larger board, you had more risk. It was sort of a per person type of rating scheme. Then
people thought about it and said, well we really need a proxy for decisionmaking. What are
the size of the decisions and the frequency that decisions need to be made in a corporation?
The first proxy they came up with was assets. . . . That has evolved as we look[ed] at the tech
companies in the 90s and we said to ourselves, wait a minute. This tech company has very
little revenues, very little assets, but a huge market cap. Therefore, the potential for liability
is not necessarily correlated with assets for that industry. We saw carriers moving toward us-
ing market capitalization now as a basis for the initial premium. Once the initial premium is
determined though, we can factor out mildly or dramatically depending [upon a variety of
qualitative factors].
Id, Broker #6 at 15–16. See also id, Broker #2 at 14.
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Predicting Corporate Governance Risk 515
ing ratios.
121
Industry and volatility are associated with frequency: some
industries are sued more often than others and shareholder litigation
tends to coincide with sudden declines in share price (volatility). Mar-
ket capitalization, meanwhile, is used to predict both frequency and
severity: larger firms are sued more often, and larger-capitalization
firms have farther to fall in measuring damages. As a result, these fi-
nancial factors enable underwriters to form an initial estimate of a
prospective insured’s exposure to shareholder litigation risk.
In this regard, an underwriter’s evaluation of these financial fac-
tors differs from an equity analyst’s. Insurers, unlike investors, do not
look favorably upon high-growth companies.
122
Insurers focus more on
downside risk because they have a fixed return (the policy premium)
that is modest in relation to their exposure to loss (the policy limits),
while equity investors have a fixed exposure to loss (their initial in-
vestment) and a potentially unlimited upside (their share of the busi-
ness’s growth).
123
This makes a significant difference in risk evaluation
performed by an underwriter versus an equity analyst.
124
In the words
of an underwriter:
120
See id, Underwriter #5 at 18 (stating that pricing is initially dependent on easily ob-
served factors including volatility). See also id, Underwriter #4 at 26 (agreeing that volatility is a
risk predictor), Broker #1 at 4 (“[S]tock volatility is key.”).
121
Participants especially emphasized accounting ratios indicating volatility or stability of
cash flows and earnings. See id, Actuary #1 at 24–26 (explaining complex systems in place for
tracking volatility, especially of stock price fluctuation, which often “generate[s] a D&O claim”).
See also id, Underwriter #7 at 31 (listing cash flow as something affecting premiums), Under-
writer #13 at 14–15 (asserting the importance of PE ratios and sustainability of earnings in as-
sessing risk), Broker #1 at 4–5 (describing how a broker evaluates D&O risk), Broker #2 at 14–15
(comparing a broker’s analysis to that of a financial analyst for a mutual fund), Broker #5 at 25–26
(pointing to the use of accountants to assess problem areas of companies).
122
One D&O broker described this difference in the following exchange:
Q: So what are [underwriters] looking for? I mean I understand when I’m buying an eq-
uity investment I want the earnings to look like a hockey stick. But that’s not what an un-
derwriter cares about, right?
A: Just the opposite. They do not want the hockey stick. The hockey stick, I think, causes
them to believe that if there’s such a spike, then can a company accommodate that? Can it
grow like that without getting to the top of that hockey stick and then dropping like a rock?
So they want to make sure that the company is on a platform of sustainable growth, they feel
comfortable with the management, understand all of the compliance issues that are in place.
Id, Broker #5 at 26.
123
See generally William A. Klein and John C. Coffee, Jr., Business Organization and Fi-
nance: Legal and Economic Principles (Foundation 8th ed 2002).
124
In addition to the differences in the risks evaluated by each, the incentive structure of
analysts and insurers is different. Analysts typically operate under a fee-for-services model where
they derive income from their reputation for accuracy, while D&O underwriters stake their
firm’s capital on their judgments. Although damage to one’s reputation can certainly lead to a
loss of income, it is less immediate than, for example, paying out $10–25 million in covered losses
as a result of failing to accurately gauge governance risk. As a result, D&O insurers may be more
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[Evaluating D&O risk] is not the same as [evaluating] investment
risk . . . . [T]here are companies that would be terrific companies
[to invest in] that would be terrible D&O risks. There are com-
panies that you would never ever put a penny of investment in,
but they are great [D&O risks] because they are just not going to
have this kind of class action lawsuit.
125
For a D&O underwriter, growth prospects are largely irrelevant
or, worse, a source of volatility that may lead to disappointed share-
holder expectations and litigation. In the words of one underwriter,
“[I]t is not about picking winners as much as avoiding losers . . . . If I
avoid three or four bad claims a year, we had a great year.”
126
C. Governance Factors
As one participant in our study remarked, there are two “pillars”
of D&O underwriting: “Number one is the financial health of the
[company]. Number two is how good that company [is] at governing
itself.”
127
As just described, the financial analysis assesses the potential
for a sudden investment loss of any sort. Evaluation of corporate gov-
ernance assesses the probability that the investment loss will be linked
to corporate or securities law violations. Having discussed financial
analysis above, in this Part we turn to a discussion of corporate gov-
ernance. Before beginning, however, we pause to address the problem
of definitions.
“Corporate governance” is a broad concept that the legal litera-
ture has given a narrow definition. Scholars discuss it most often in the
context of specific regulatory reforms
128
or in terms of charter provi-
sions and other easily observable structural characteristics on which
regressions can be run.
129
But corporate governance may refer more
broadly to any aspect of the system of incentives and constraints op-
erating within a firm. Indeed, the participants in our study tended to
sensitive to errors and therefore more eager to avoid them. See Griffith, 154 U Pa L Rev at 1179
(cited in note 6) (comparing loss sensitivity of reputational capital and capital reserves).
125
D&O Interviews, Underwriter #4 at 3 (cited in note 39).
126
Id, Underwriter #7 at 6.
127
Id, Underwriter #9 at 8.
128
See, for example, Roberta Romano, The Sarbanes-Oxley Act and the Making of Quack
Corporate Governance, 114 Yale L J 1521, 1560 (2005).
129
See generally Anup Agrawal and Sahiba Chadha, Corporate Governance and Account-
ing Scandals, 48 J L & Econ 371 (2005) (analyzing the relationship between earnings restate-
ments and board and audit committee independence, the financial expertise of directors, auditor
conflicts of interest, director blockholding, and the influence of the chief executive officer on the
board). See also text accompanying note 239.
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Predicting Corporate Governance Risk 517
give corporate governance this broader definition, referring repeatedly
to the importance of “culture” and “character” in D&O underwriting.
130
Culture and character, we were regularly told, are at least as im-
portant as and perhaps more important than other, more readily ob-
servable governance factors in assessing D&O risk.
131
In the words of
one underwriter:
I don’t view my [underwriters] as financial experts to begin with,
but if I am going toe to toe with a CFO of X Corp., am I getting
to the bottom of what is going on here? The answer is no. To me,
my style in terms of underwriting has been to look for the way
people deal with certain issues and how they view their goals and
how they are going to achieve them.
132
Terms such as culture and character, however, need some decod-
ing. As described in greater detail below, we took “culture” to refer to
the system of incentives and constraints operating within the organiza-
tion, including both formal rules and informal norms. “Character” we
took to refer to the likelihood that top managers would defect from
corporate interests when given an opportunity to do so.
1. Culture: incentives and constraints.
The system of incentives and constraints operating within a firm
may be based upon formal rules, informal norms, or, as is most likely,
some combination of the two.
133
Participants in our study emphasized
each of these aspects of corporate culture. Several underwriters cited
executive compensation as a key indicator of intrafirm incentives. An
equally large number also emphasized the constraint of internal con-
trols. In their discussion of these incentives and constraints, it was
clear that underwriters looked past the formal rules, seeking a sense of
how strong the norm of compliance is within the organization or
whether, by contrast, there is a norm of defection. As one senior un-
derwriter described:
130
Culture and character were recurrent themes in our interviews. Typical remarks in-
cluded: “I believe that really what it comes down to is the culture and the people,” D&O Inter-
views, Broker #1 at 14 (cited in note 39); “[U]ltimately the insurance underwriter is really betting
on the ethics and confidence of the management of the company,” id, Broker #2 at 17; “The only
way you are ever going to be able to underwrite this stuff is through people. . . . It is your ability
to assess character,” id, Underwriter #9, Seminar Tapes 1 & 2 at 26.
131
D&O Interviews, Broker #4 at 5 (cited in note 39) (“[T]here’s one [underwriting] model
that works and it’s the best model. It’s the people. It’s simply the people. Who are you dealing
with? Who and how do they act?”).
132
Id, Underwriter #15 at 12.
133
Edward B. Rock and Michael L. Wachter, Islands of Conscious Power: Law, Norms, and
the Self-Governing Corporation, 149 U Pa L Rev 1619, 1640–47 (2001).
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[N]o company ever just dropped out of the sky. There is a history
which is a narrative of how they got in [this business]. Who are
the players? Who founded them? What is their culture? You
might get to the ethics of the culture of the company, but you
[need to] understand how it got put there, into the state it’s in
now. . . . Who are they? And where they come from? How did
they know each other? In a fraternity? Did they know each other
in business? . . . I mean, there is a story. They didn’t just all land
out of the sky, and you should understand that matters.
134
One frame through which underwriters examine corporate cul-
ture is executive compensation. In the words of this same underwriter:
You have a hard time convincing me when a guy makes a fortune
and the board signs off on the increases or the other demands or
the perks or the airplane flights or the bonus packages, severance
packages, or the balloons, or whatever it is. You have a hard time
telling me that that board has a real grip on that CEO.
135
Given recent criticism of corporate compensation practices in
both the academic and the mainstream press,
136
it is not surprising that
insurers also pay attention to compensation. However, it is worth
pointing out that there is not a shareholder cause of action for exces-
sive executive compensation. Shareholders cannot sue simply because
the CEO is making too much money but must argue instead that the
board was grossly negligent in approving the compensation package
137
or that management misstated earnings in order to maximize the
value of their option compensation.
138
Executive compensation itself,
134
D&O Interviews, Underwriter #7 at 29–30 (cited in note 39) (emphasis added).
135
Id, Underwriter #7 at 16.
136
See, for example, Arthur Levitt, Jr., Corporate Culture and the Problem of Executive
Compensation, 30 J Corp L 749, 749 (2005) (“If there is anything that engages the public today
about the business community, it is the issue of compensation.”); Lucian Bebchuk and Jesse
Fried, Pay without Performance: The Unfulfilled Promise of Executive Compensation 61–79
(Harvard 2004) (describing how managerial interests taint a variety of common forms of execu-
tive compensation); Charles M. Elson, Corporate Law Symposium: The Duty of Care, Compensa-
tion, and Stock Ownership, 63 U Cin L Rev 649, 649 n 2 (1995) (noting the public outcry over
excessive executive compensation).
137
Shareholders may sue under state corporate law for excessive executive compensation,
but such claims typically do not get very far in the absence of a clear conflict of interest due to
corporate exculpation provisions and application of the business judgment rule. See generally In
re The Walt Disney Co Derivative Litigation, 907 A2d 693 (Del Ch 2005).
138
See, for example, John Hechinger and Gregory Zuckerman, Stock-Option Grant Probes
Gain Steam As More Firms’ Practices Get Scrutiny, Wall St J C1 (May 23, 2006) (describing inves-
tigations of public companies whose option grants appear linked to share price manipulation).
See also Charles Forelle, How Journal Found Options Pattern, Wall St J A11 (May 22, 2006)
(describing statistical methodology used by the newspaper to uncover share price manipulation
surrounding option grants).
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Predicting Corporate Governance Risk 519
in other words, does not create liability risk. Rather, the liability risk
comes from what the firm’s executive compensation practices suggest
about the incentives operating within the firm.
139
For similar reasons,
our participants cited the stringency of a firm’s insider trading policies
(and the care with which they are observed) as significant factors in
risk assessment.
140
In addition to the internal incentive structure of the firm, D&O
underwriters also review a prospective insured’s internal constraints.
Indeed, if there was one central corporate governance variable that
our respondents sought to emphasize, it was the quality of the pro-
spective insured’s internal controls. In the words of a prominent risk
manager, “The one word that really captures the heart of [the] process
is evidence that there is controllership.”
141
Internal controls involve a
wide variety of industry-specific practices,
142
but revenue recognition
procedures, because they can lead to restatements and thereby to se-
curities claims, were repeatedly emphasized as a core concern.
143
One
underwriter gave the example of Harley Davidson:
Harley Davidson got sued because they were channel stuffing
motorcycles. . . . [T]hat wasn’t happening at the board level. That
was probably the VP for sales had a monthly sales target that he
was desperate about making because his [bonus] compensation
139
Compare Bebchuk and Fried, Pay without Performance at 4 (cited in note 136)
(“[D]irectors have been influenced by management, sympathetic to executives, insufficiently
motivated to bargain over compensation, or simply ineffectual in overseeing compensation.”).
140
See D&O Interviews, Broker #6 at 17 (cited in note 39) (“They certainly do put a lot of
weight on things like what are your insider trading guidelines. They want them to be fairly strin-
gent.”). Unlike executive compensation, insider trading may form the basis of a shareholder
claim. See 17 CFR § 240.10b-5. See also 15 USC § 78p (2000 & Supp 2002). But insider trading,
especially unusual trading patterns, is perhaps most important as hard evidence of securities
fraud. See Marilyn F. Johnson, Ron Kasznik, and Karen K. Nelson, Shareholder Wealth Effects of
the Private Securities Litigation Reform Act of 1995, 5 Rev Accounting Stud 217, 219 (2000)
(discussing the heightened pleading requirements of the Private Securities Litigation Reform
Act (PSLRA)); Marilyn F. Johnson, Karen K. Nelson, and A.C. Pritchard, Do the Merits Matter
More? The Impact of the Private Securities Litigation Reform Act, J L, Econ, & Org (forthcom-
ing) (finding “a significantly greater correlation between litigation and both earnings restate-
ments and abnormal insider trading after the PSLRA”).
141
D&O Interviews, Risk Manager #4 at 5 (cited in note 39).
142
One underwriter elaborated:
You need to understand some of the accounting issues that were driving claims, particularly
revenue recognition procedures at companies. . . . [E]ach of those industries had different
. . . revenue recognition issues. You need to be able to drill down, see if the answers were
there, and if not, ask the right questions to get them.
Id, Underwriter #5 at 10.
143
See note 140 (emphasizing the importance of earnings management and Rule 10b-5, and
the role of a restatement as “hard evidence” of securities fraud).
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was tied to meeting his target, and so they started [channel] stuff-
ing motorcycles.
144
Because pressures to manipulate results may exist throughout the
firm, as this example suggests, the question of internal controls is
really the question of whether the organization can constrain these
temptations throughout the firm.
The investigation into internal controls does not stop at the board
level, nor does it end once underwriters are given a corporation’s
statement of controllership principles.
145
Instead, our participants
noted that underwriters investigate how information flows throughout
the firm: “How does ‘bad news’ flow upward within the organization?
Does the corporate culture encourage such news to be brought to the
attention of senior management? Are significant developments shared
with the board of directors as they become available?”
146
Underwriters investigate who reports to whom.
147
They inquire
into the norms and actual practices underlying formal policies.
148
They
144
D&O Interviews, Underwriter #4 at 32 (cited in note 39). A manufacturer that engages
in “channel stuffing” intentionally sends its retailers more products than they are able to sell in
order to inflate (temporarily) its sales figures. Unless sales suddenly increase or, in the case of chan-
nel stuffing after a downturn, recover, the manufacturer will ultimately have to adjust its accounts
receivable, resulting in a loss. One of our participants illustrated the problem with an example:
Division president is having a bad quarter and says, you know what? We will fix it next
quarter. He brings in temps. They ship more product. Their revenue recognition, which is a
huge question in these interviews, is if it is shipped, you can book the revenue, so we make
the quarter. The next quarter we don’t recover. So we bring in the temps a little bit earlier.
Instead of just the last couple weeks, we actually bring them in 3–4 weeks. We say, we’ll
make it up next quarter. We ship more product and we make our numbers. Now we are in
quarter number 3 and I’m having trouble as division president making my numbers. Things
have not recovered in my sector, so I start to look into my reserve for returns. I say, you
know what? That’s pretty high. I am going to take down my reserves, which translates into
more dollars, which allows me to make my numbers. I tell my accountant, if anyone asks
about this, don’t talk to them. Send them to me. Well, you know then in the fourth quarter
everything blows up. That is the first time the CFO and the CEO and other people in cor-
porate find out about it.
Id, Broker #6 at 34–35 (noting that this scenario “has occurred quite a bit in corporate America”).
145
Underwriters take board independence into account as an aspect of controllership. See
id, Underwriter #7 at 14–15 (cited in note 39) (“There is a lot of cronyism still. . . . I mean, you
still have entrenched boards, boards that only work for the CEO as opposed to vice versa. It is a
fundamental underwriting question we ask people, who works for whom.”). The incremental
value of more or less independence, however, does not seem to weigh heavily. Compare id, Bro-
ker #1 at 8 (“[I]f you had a board that was, you know, one independent and [the rest] inside
directors, that is viewed as a negative.”). Instead, independence is important only insofar as it
indicates the strength of constraints operating within the organization.
146
Examples of Questions Being Asked by D&O Underwriters (undated unpublished bro-
kers’ document designed to prepare clients for underwriters’ meeting) (on file with authors).
147
To an underwriter, good governance involves centralized control and multiple levels of
review. As a leading broker described a good D&O risk: “They review everything. Everything is
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Predicting Corporate Governance Risk 521
retain forensic accounting consultants to detect inadequacies in inter-
nal controls before they lead to fraud.
149
The quality of constraints within a corporation may also be indi-
cated indirectly—as a prospective insured’s plans for mergers and ac-
quisitions activity was described to us. Of course, M&A itself is a liti-
gation risk,
150
and for this reason insurers inquire, often in both the
application and the underwriters’ meeting, about the prospective in-
sured’s M&A plans.
151
But in our interviews it became clear that D&O
insurers are not interested merely in whether a prospective insured
will engage in M&A activity, but also how it will do so.
152
M&A again
done early. . . . The CFO knows about a sale that is going on in Europe in real time and has to ap-
prove it. . . . Everything is centralized control.” D&O Interviews, Broker #6 at 33 (cited in note 39).
148
Id, Risk Manager #4 at 5–6 (“[Not only is there] a process, but how are you exercising
the process and what evidence do you have to support your controllership process? . . . [A]ll the
questions are around that subject.”).
149
According to one participant, “a whole cottage industry” has blossomed over the years
in the area of forensic accounting. The accounting focuses on business operations and how risks
are actually managing their business. See id, Underwriter #9 at 10–16.
150
See Robert B. Thompson and Randall S. Thomas, The New Look of Shareholder Litiga-
tion: Acquistion-Oriented Class Actions, 57 Vand L Rev 133, 137 (2004) (finding that approxi-
mately 80 percent of all fiduciary duty claims filed in Delaware Chancery Court in 1999 and 2000
were class actions challenging board conduct in an acquisition and that only 14 percent of fiduci-
ary duty claims over the same period were derivative suits); Elliot J. Weiss and Lawrence J.
White, File Early, Then Free Ride: How Delaware Law (Mis)Shapes Shareholder Class Actions,
57 Vand L Rev 1797,
1805 (2004) (finding evidence of litigation agency costs in acquisition-
oriented class actions).
151
D&O Interviews, Risk Manager #3 at 12 (cited in note 39) (“M&A is a bad thing when
you are talking D&O insurance. It just opens you up to potential for more claims. I mean, M&A
might be a good thing if you are talking to that equity analyst, you know, depending on their
views . . . so the emphasis is different.”), Underwriter #7 at 27 (“Frankly, most D&O claims if you
were to look into them, there was a merger.”), Underwriter #8 at 20–21 (“[W]e also look at
M&A and what is going on in their business from an M&A perspective, whether you are an
acquirer or people are acquiring . . . your business, because there is a correlation between that
and lawsuits.”), Broker #6 at 16 (“[We ask h]ave you been in any mergers and acquisitions re-
cently? What is your M&A outlook?”).
152
See id, Broker #1 at 5 (emphasizing the prospective insured’s “track record . . . with
respect to such things as mergers and acquisitions or divestitures”). Moreover, insurers limit
their exposure to acquisition-related claims in the policy itself. First, with respect to making
acquisitions, if the insured acquires a target over a threshold size (often 10–25 percent of the
total assets of the insured), the policy terminates within sixty days unless renegotiated. See AIG
Specimen Policy at § 12(b) (cited in note 22) (providing a 25 percent of assets threshold); Chubb
Specimen Policy at § 20 (cited in note 22) (providing a 10 percent of assets threshold and sixty
day notice period). See also D&O Interviews, Risk Manager #4 at 9 (cited in note 39) (“[M]ost
contracts have a threshold for additional premium as a result of acquisition, and a typical one
might be 10 percent of sales and/or 10 percent of asset value. Either one of those . . . could allow
the underwriter to assess additional premiums.”). The policy remains in effect for acquisitions
below the threshold size. Second, with respect to acquisition of the insured, the policy terminates
when the transaction closes. See AIG Specimen Policy at § 12(a); Chubb Specimen Policy at § 21.
Claims may still be litigated under the prior policy—if, for example, the claim arises upon an-
nouncement of the acquisition but prior to closing, as many such claims do. See Thompson and
Thomas, 57 Vand L Rev at 154–55 (cited in note 150) (discussing filing times for acquisition-
oriented class actions); Weiss and White, 57 Vand L Rev at 1827–28 (cited in note 150) (same).
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comes down to the question of process and controls: “[A]re you just
going to go out and buy a company, or do you have a process and what
is the process? We actually show them the process.”
153
Insurers are inter-
ested in whether acquisition activity is value enhancing or rather mere
empire building, further evidence of unconstrained management.
154
In addition, underwriters reported that they take the ownership
structure of a prospective insured into account.
155
D&O applications
typically require disclosure of insider ownership and significant out-
side blockholdings.
156
This makes sense because a controlling share-
holder may be a substitute for the governance constraints embedded
in corporate law or charters, and significant insider share ownership
may indicate an alignment of shareholder and management interests.
157
Accordingly, a prospective insured’s ownership structure is an impor-
tant factor in underwriting risk assessment.
Finally, although less often discussed in our interviews than other
risk factors, underwriters did note that they take into account such
structural governance features as state of incorporation, board inde-
pendence, committee composition, and separation of the chief execu-
tive and board chair roles.
158
Underwriters also described using third-
party governance rating services such as the Corporate Library to
identify “red flags.”
159
In addition, underwriters acknowledged that
But any future coverage for the combined company must be renegotiated. The merging compa-
nies will often purchase a “runoff D&O program” to cover premerger wrongful acts. See D&O
Interviews, Risk Manager #1 at 16 (cited in note 39). The underwriter thus crafts the policy to
respond to two threats—the acquisition itself and a larger than expected insured after the merger.
See id, Risk Manager #4 at 10 (“The event of the acquisition is one threat to them if you will, a
potential claim, and the management of that new company and the integration of that company
creates [another whole] set of probabilities or possibilities.”).
153
D&O Interviews, Risk Manager #4 at 8 (cited in note 39).
154
Id, Underwriter #2 at 22 (describing “proposed mergers that make no sense” as one
indicator of management stupidity).
155
See, for example, id, Underwriter #2 at 5 (“[We seek] a broader understanding of the
entire ownership of the company and where that is coming from and what conflicts or not may
exist within the ownership interest.”), Underwriter #8 at 21 (“We look at the equity of the com-
pany very closely. It is obviously a key driver on the rating model that we use. We look at who
owns the stock and why.”).
156
See, for example, AIG D&O First Main Application at § IV (cited in note 102).
157
See Ronald D. Gilson, Controlling Shareholders and Corporate Governance: Complicat-
ing the Comparative Taxonomy, 119 Harv L Rev 1641, 1662 (2006) (noting that blockholding and
diffuse ownership structures “may in some circumstances be functional substitutes; that is, they
may have equivalent monitoring capacity”).
158
See, for example, D&O Interviews, Broker #5 at 28 (cited in note 39) (“They’re asking—
if the [CEO and chairperson of the board] are the same person—‘Why? Have you evaluated
whether it should be split and can you help us out as to why you haven’t?’”).
159
See id, Underwriter #7 at 16. Corporate Library reports governance scores in a report-
card format, A through F. Underwriters reported offering credits and debits of up to 15 percent
based upon the governance score. See, for example, id, Underwriter #8 at 31–32 (comparing
credits for different risk ratings). Others reported that the narrative portion of the Corporate
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Predicting Corporate Governance Risk 523
they consider structural indicia of management entrenchment, such as
staggered boards and poison pills, but only in response to our direct
questioning.
160
Because entrenchment was never listed independently by
an underwriter as an important factor in D&O risk assessment, how-
ever, we hesitate to conclude that it is a key underwriting risk factor.
In summary, underwriters investigate corporate culture by uncov-
ering the buried structure of incentives and constraints operating
within the firm. They do not confine their investigations to the pres-
ence or absence of big-picture structural features, such as an inde-
pendent board or a formal controllership program. Instead they dig
between the formal rules in an effort to unearth the firm’s internal
culture of compliance or defection.
161
That they expend resources to
conduct this investigation when assessing D&O risk suggests that cor-
porate culture affects the risk of shareholder litigation.
2. Character: “It was a small aquifer.”
The other perhaps underappreciated aspect of shareholder litiga-
tion risk (at least in mainstream corporate and securities law litera-
ture) is an aspect our participants referred to as “character.”
162
“Ulti-
mately,” as one broker said, “the underwriter is really betting on the
ethics and confidence of the management of the company.”
163
Charac-
ter, of course, is an amorphous concept. When we pressed underwrit-
ers to define it, they often responded by emphasizing arrogance and
excessive risk taking.
Arrogance, our interviews suggested, may indicate individuals
who hold themselves above rules and norms.
164
Several underwriters
described warning signs, such as “a CFO who has got all the answers,
doesn’t want to listen. Or a senior management team where all you
see is the CEO and no one else. . . . [J]ust one person out front and no
Library report is as important in their risk-rating process as the score itself. See, for example, id,
Underwriter #1 at 11.
160
Id, Underwriter #5 at 48–50.
161
Compare Kenneth J. Arrow, The Economics of Moral Hazard: Further Comment, 58 Am
Econ Rev 537, 538 (1968) (“One of the characteristics of a successful economic system is that the
relations of trust and confidence between principal and agent are sufficiently strong so that the
agent will not cheat even though it may be ‘rational economic behavior’ to do so.”).
162
On the history of character-based underwriting and the contrast between character-
based underwriting and the economic understanding of insurance, see generally Tom Baker,
Insuring Morality, 29 Econ & Soc 559 (2000).
163
D&O Interviews, Broker #2 at 17 (cited in note 39). See also id, Actuary #1 at 9 (“[W]hat
you’re really underwriting when you underwrite D&O is you’re underwriting the people, you’re
underwriting the senior management, the quality of the management team.”).
164
See, for example, id, Underwriter #7 at 17 (emphasizing perks such as “country club mem-
berships, airplane travel, [and corporate] homes” as indicia of arrogance or lack of accountability).
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one else. You never see them, and it is I, I, I.”
165
Others offered anec-
dotes, including the following:
I am interviewing . . . a CFO once at a company, and they were a
manufacturing company. . . . I said, “Do you have any pollution is-
sues?” He said, “Well . . .” “You know, recent problems?” He said,
“What do you mean by problems?” Stuff like that. . . . I said,
“Have you ever polluted an aquifer?” And to my surprise he
says, “It was a small aquifer.” And then he goes on to rationalize
. . . how small three parts per billion is, or whatever the number
was. He said it was ridiculous. . . . To my way of thinking, this is a
bad insured. This is a guy who looks at his problems, [and] he
doesn’t look at solving the problems or doesn’t look at what the
law says. He is extemporizing on how he thinks the law ought to
be applied. That is very bad. Because when things go wrong,
those things will cause you to pay big time.
166
Understood in this way, arrogance indicates a lack of restraint, as well
as the ability and willingness to rationalize one’s conduct in a way that
makes the rules seem not to apply.
With regard to risk taking, insurers seek to avoid those executives
whose appetite for risk exceeds the norm. As one actuary explained:
[M]aybe the most important questions you can ask a CEO is how
many speeding tickets do you have? What kind of car do you
drive? How many times have you been married? How often do
you drink? How much do you drink? . . . [D]o you have extra-
marital affairs? Simply because you’re looking for risk takers.
Risk takers above the norm—those are the people that get in
trouble. . . . [I]n a lot of situations, [that kind of information is]
165
Id, Underwriter #8 at 27 (discussing the importance of meeting personally with company
executives).
166
Id, Underwriter #15 at 12–13. Similarly, another described ways in which managers
inadvertently reveal their own arrogance:
I met with a guy the other day. It is just amazing. He mailed me back an email to thank me
for meeting. We are supposed to have another meeting in two weeks. So he meticulously let
me know how he is going to be in Paris, London, and Brussels in the intervening two weeks
and the very important things he is doing there, and you know, when he gets back he will
definitely be looking me up. Then he went into a whole bunch of other things. . . . I never
asked this guy what he is doing for the intervening two weeks! It is nice to know he is in
Europe. I hope he enjoys himself, but does this tell us something? You get stuff like that. A
lot of times though it is more like, “I want to be king of the world and I am going to roll up
other companies” and stuff like that.
Id, Underwriter #2 at 23.
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Predicting Corporate Governance Risk 525
more important than how much cash or what their balance sheet
looks like, or what new products they have coming out.
167
What risks are excessive? Risk, after all, is a good thing in private
enterprise, and it is certainly possible to distinguish fraud (which in-
volves lying or deceit) from risk taking (which, alone, does not). Be-
cause the underlying exposure is securities fraud, not business risk, we
would expect insurers to be focused on fraud in particular, not risk
taking generally.
Pressed on these points, underwriters indicated that they look for
evidence that the company is overcommitted to growth because in such
situations there will be a strong temptation to misstate results when
reality falls behind expectations.
168
Excessive risk taking, in other words,
can lead to fraud. An underwriter illustrated this situation as follows:
[O]ne company . . . [said] they were going to grow 20 percent.
Some people [said], “I’m not sure how we are going to grow 20
percent, but the CEO said we are going to grow 20 percent.” You
know, but without that clear articulation of how we are going to
grow 20 percent, in the absence of really great controls—and
maybe they had them, maybe they didn’t—you are going to have
somebody who [when] the pressure is on [starts thinking], “I had
better make my numbers.”
169
Underwriters derive much of this information from their meet-
ings with management. “We talk to people,” one underwriter said. “We
stare down a lot of people, and if their comfort level is starting to get
very solidified with a group of [managers], we will follow them
around.”
170
In addition to meeting with top management, underwriters
also investigate the reputation, skill set, and litigation history of each
individual board member.
171
As with the evaluation of corporate cul-
ture, this character aspect of risk assessment in D&O underwriting re-
flects a broader conception of corporate governance that goes well be-
yond formal provisions such as charter terms and state of incorporation.
167
Id, Actuary #2 at 23–24 (emphasis added).
168
Character, one underwriter quipped, can best be understood in terms of the “seven
deadly sins,” of which “greed, stupidity, and ego” most often lead to D&O claims. See id, Under-
writer #2 at 18–19 (noting that greed can be detected through an analysis of compensation pack-
ages, stupidity through a history of business mistakes, and ego through meetings with management).
169
Id, Underwriter #15 at 13–14 (emphasis added).
170
Id, Underwriter #7 at 33. See also id, Underwriter #8 at 24–25 (explaining that under-
writing involves “getting a sense of . . . trust. [C]an you have confidence in what they filed in their
Qs and Ks?”).
171
Id, Underwriter #7 at 26, Underwriter #2 at 15–16 (explaining the importance of individ-
ual evaluations of management).
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3. Again, the cycle.
That underwriters screen for these factors, of course, does not
mean that they always identify and act upon the red flags. There are, in
fact, a number of reasons to doubt that they do so consistently, includ-
ing short-term pressure on underwriters to generate premium volume
notwithstanding possible long-term losses
172
and the simple likelihood
that those who are good at deceiving bosses and markets are likely to
be good at deceiving underwriters too.
173
Our answer to such objec-
tions is simply to report what underwriters reported to us—they are
indeed trying, even if they do not always succeed—and to note that
that the rewards for having only one fewer bad risk in an underwriting
portfolio, considering typical limits of $10–25 million, are great. The
evaluation of culture and character in risk assessment is a revealed
preference. Those with the most to lose are paying attention.
174
A more difficult objection for us to answer points to the cyclical
nature of the insurance market: the world as it is now has not always
been and may not be for long.
175
Indeed, participants in our study fre-
172
See, for example, id, Broker #3 at 4. Even without intrafirm pressures to generate un-
derwriting profit, underwriters may fail due to resource constraints—a finite amount of time and
attention to devote to all possible D&O risks. See, for example, id, Underwriter #5 at 12 (“[An]
analyst is following a dozen or two dozen companies max. Our underwriters are looking at com-
panies. You know, they will look at two dozen companies a month or more. So they won’t have
the in-depth knowledge.”), Broker #2 at 21 (“If an underwriter is under pressure to write a pre-
mium, he is going to deal with cognitive dissonance a lot differently than if he isn’t under pres-
sure.”), 24 (“X is a company that can be very inconsistent depending on what day of the month it
is, depending upon whether they are making their [premium] budget or not. If you come to X
with a tough account at the end of the month and they haven’t made their budget, guess what?
You can get a really good deal.”).
173
See note 231 and accompanying text (describing the role of self-deception and decep-
tion of others in corporate success).
174
It is possible, of course, that the underwriters’ claim to analyze corporate governance
variables may not point to a revealed preference of the D&O insurer. An insurance company has
several departments, and they may not be perfect agents of the company as a whole. In this
context, for example, underwriters may claim to have special expertise in evaluating corporate
governance in order to promote and protect their group in the competition for intrafirm re-
sources. Similarly, the underwriting department may resist an indexing approach to risk selection
not because it would lead to worse risk selection, but because it would end the underwriters’
claimed expertise and lead, inexorably, to the elimination of the department. See notes 95–97
and accompanying text (describing underwriters’ rejection of an indexing approach to under-
writing). Underwriters, according to this story, emphasize governance not because governance
variables lead to better risk selection but because the claim to possess governance expertise
enables them to protect their jobs. Our research does not support this hypothesis—none of our
participants (neither underwriters, risk managers, brokers, nor counsel) suggested it during the
course of our interviews—but neither can our research disprove it.
175
In the words of one underwriter:
The problem is the market the way it is, the guy who asks the hard question gets put [at] the back
of the line. And we don’t get answers that we used to get. You know, the last soft cycle, if you
asked this question and nobody else was asking it, somebody [else] would write the business.
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Predicting Corporate Governance Risk 527
quently noted that scrutiny of formal governance factors in D&O un-
derwriting is relatively new.
176
Character and culture have been peren-
nial concerns, but scrutiny tends to ebb and flow as markets harden
and soften.
177
Since, as noted above, all of our interviews occurred dur-
ing the sunset of the most recent hard market, we cannot confidently
conclude that scrutiny of corporate governance will be a lasting fea-
ture of D&O risk assessment. Indeed, one broker suggested that it has
already begun to fade:
A: In essence, [the underwriters] all got caught off guard by the
likes of Enron and had never focused really on governance. So
the reaction was very extreme.
Q: Has it started to go away?
A: Yes.
178
If, in the next soft market, D&O underwriters stop paying attention
to governance factors, our claim that corporate governance plays a mean-
ingful role in assessing the risk of shareholder litigation will be weakened.
D. From Risk Assessment to Pricing
All of the factors discussed above, our participants reported, are
considered in the risk assessment and ultimately the pricing of a pro-
spective insured. In the words of the underwriter quoted at the begin-
ning of this Part, “[w]e take all that stuff and we rate it for risk. We
summarize what makes us want to write the account and what makes
the necessity of the insurance relevant to the risk of the company. And
then we price it.”
179
Our question, of course, was how. How do D&O
underwriters derive a price from this extensive list of risk factors?
As we learned, D&O underwriters begin with a simple algorithm,
which differs from company to company, and then employ a highly
discretionary, largely unobservable (even for the companies’ own pric-
ing actuaries
180
) system of credits and debits, the application of which
D&O Interviews, Underwriter #5 at 13 (cited in note 39).
176
In the words of a D&O actuary, corporate governance “might have crossed people’s
minds, but I don’t recall it being part of the discussion [prior to 2002].” Id, Actuary #1 at 27. See
also id, Actuary #3 at 7 (dating the new focus on corporate governance at 2001).
177
See Part II.B.3.
178
D&O Interviews, Broker #1 at 12–13 (cited in note 39).
179
Id, Underwriter #2 at 6 (emphasis added).
180
A senior actuary at a leading D&O insurer described the problem as follows:
The other concern we have is just the validity of the data that is entered into our system,
particularly in this area where you have a very small group of experienced underwriters
who kind of know, who think they know what to charge for a Fortune 500 company just
based on the fact that they do the market every day, and they can probably tell you in a
couple minutes, you know, this one should be getting this much and this one over here is
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may be constrained by a competitive underwriting market. As de-
scribed by one of the underwriters in our study, “the market cap and
the volatility and some of those easily observed things will get you
your first price. [Then the question] is whether . . . the risk is ‘clean’
enough to make the next cut, [where] some of these other more quali-
tative factors will come into play.”
181
The sections that follow explore
each of these three components: the algorithm, the system of credits
and debits, and the market constraint.
1. The algorithm.
Each of the underwriters and actuaries reported to us that their
companies have developed simple algorithms to generate an initial
price. One senior executive with a long history in D&O insurance re-
ported that, in the early days, this algorithm was based on the number
of directors on the board. Later, the measure of base risk shifted to
the value of the assets of the company, and relatively recently shifted
again to market capitalization and the other factors that we are about
to describe.
182
No underwriter or actuary would provide us with their
company’s precise algorithm,
183
but they did tell us the factors used in
worth that much. So what we find is they don’t spend a lot of time making sure that the en-
tries into our system are necessarily precisely what they think about a company. You know,
they delegate it to an assistant who has to go through this rate process in order to get the
account off books, and they don’t spend a lot of time making sure that the entries are actu-
ally reflective of what they are going to feel about the company. So that is a challenge for us
internally, you know, to make this more of a priority so that we have experienced people,
you know, making those kinds of decisions about what is going into the data.
Id, Actuary #3 at 19–20.
181
Id, Underwriter #5 at 18.
182
Id, Underwriter #15 at 10 (describing algorithms and adding that previous “rating factors
were [the] number of directors and asset size”), Broker #6 at 15 (describing the move from as-
sessing the number of directors to using market capitalization).
183
Some version of the insurer’s basic pricing algorithm is disclosed to state insurance
commissioners. In a rate schedule filed in the state of California, for example, Chubb disclosed
that base rates depend first upon a combination of market capitalization and volatility (beta)
with specified increases from the base rate factored in on the basis of limits and industry. The
rate schedule then lists a large number of “Rating Modifications”—including “risk relative to
industry,” “financial trends,” “board/management architecture and controls,” “individual qualifica-
tions,” and “overall board/management quality”—most of which require a qualitative (as opposed
to quantitative) analysis. See Chubb Group of Insurance Companies, D&O Elite Directors and
Officers Liability Insurance Actuarial Memorandum, in Application for Approval of Insurance Rates
exhibit 23 at 1–3 (Cal Dept of Ins File No EO CA0019310C01, filed Dec 22, 2003). After investi-
gation, however, we concluded that the state filings are not a good source of D&O pricing infor-
mation. The plans include such a broad range of underwriter discretion that they would provide
very little guidance even if the companies actually used the plans to generate premiums. See D&O
Interviews, Actuary #3 at 7 (cited in note 39) (“[T]here is very wide latitude given to underwriters in
terms of what is filed with the state regulators.”). And, in fact, they do not use the plans to generate
their premiums. Not one underwriter that we interviewed described starting the pricing process
with the formula in the rating plan. Instead, they described a process in which premiums were
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Predicting Corporate Governance Risk 529
their algorithms: market capitalization (all insurers), industry sector
(most insurers), stock price volatility (many insurers), accounting ra-
tios (many insurers), and age/maturity of the applicant corporation
(some insurers).
184
2. Credits and debits.
All underwriters reported using some form of debit and credit
system to arrive at an ultimate price, which, as a result, can vary widely
from the output of the basic pricing algorithm. As described by one of
our participants: “[A]ctuaries set the overall rates for an insurance
company, but then within that rating system, an underwriter has a lot
of leeway. I mean, they probably have judgments that are plus or mi-
nus 40 percent.”
185
The influence of actuarial science thus declines once
underwriters begin to issue credits and debits.
Insurers differ widely on how they determine their system of
credits and debits. A small number of insurers use quantitative guide-
lines based upon the presence or absence of specific governance fea-
tures.
186
An underwriter from an insurance company with a highly
quantitative model described the process as follows: “So, for example,
if you are in a certain industry class, you are going to get debited be-
tween 5–10 percent or credited between 5–10 percent. If you have got
a very poor board score, you are going to pay anywhere from 10–20
percent more.”
187
checked against that plan after the fact (if at all), only as part of a regulatory compliance process.
Moreover, a senior underwriter at the most heavily quantitatively oriented firm said that the
algorithm that they actually use “is very different” from what is in the plan. He explained that
they file and use “a traditional rating method to see if we comply with the state or not from a
guidelines standpoint, because . . . we don’t want [our proprietary algorithm] in the public do-
main.” Id, Underwriter #8 at 33. Two of our participants were closely involved in preparing rating
schemes that are considerably more detailed than is the norm for D&O insurance. Like all the
other rating schemes we examined, these employ a debit and credit adjustment system that allows
for adjustments that, in combination, easily exceed the base premium.
184
A senior reinsurance underwriter described the evolution of the pricing algorithm as
moving toward “a merging of . . . corporate finance concepts and actuarial pricing concepts” and
pointed out that “writing a D&O insurance liability policy [is] very[,] very similar to a put option
for stock.” D&O Interviews, Underwriter #9 at 21–22 (cited in note 39). In this view, the financial
analysis underlying the pricing algorithm may address the likelihood of sudden investment loss
of any kind, while the debit and credit process described next attempts to determine the likeli-
hood that the loss will be linked to corporate or securities law violations. For excess layers, some
participants reported that they simply apply a discount factor to the premium quoted by the
primary carrier, while others reported that their company does a ground-up pricing exercise.
185
Id, Broker #2 at 18–19.
186
Id, Underwriter #8 at 20 (“We have a clear set of guidelines around pricing plus or mi-
nus on certain items.”).
187
Id. Note that the “board score” refers to the score on the company report prepared by
the Corporate Library. See note 107 and accompanying text.
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Even for this insurer, however, the range of credits and debits
grants underwriters significant discretion.
188
Most insurers allocate even
more discretion to individual underwriters in setting premiums,
189
al-
though additional layers of monitoring—committee oversight or peer
consultation—apply as account sizes increase.
190
The goal of all such
processes is to adjust premiums so that higher-risk firms pay more while
better-governed firms “instead of getting debits . . . get credits.”
191
How much influence, then, do specific corporate governance fac-
tors have in D&O pricing? We cannot say with any precision, first,
because our participants would only describe pricing in general terms,
and second, because the system is so highly discretionary that insur-
ance companies and even individual underwriters may make inconsis-
tent choices. In particular, the actuaries we interviewed doubted that
underwriters have a consistent system of evaluation that applies the
same factors in the same way over time.
192
In spite of the potential for
188
There is a debate within the D&O insurance industry about the merits of more and less
quantitative approaches to D&O insurance pricing. Our impression is that the qualitative approach
is ahead at the moment, both because of tradition and because of stories like the following:
[O]ne carrier that we know developed a very sophisticated pricing model using the Black-
Scholes formula. So they looked at it very much as volatility being the driver of loss . . . and
as they were testing the model, the guy who is doing the model, an absolute brilliant
mathematical statistical gentleman, absolutely brilliant. But he went to the underwriters,
and I thought this was clever as well, and he said, “What do you think the right price should
be on this account?” And what was surprising was . . . how often their gut instinct on the
price was close to the model.
D&O Interviews, Underwriter #10 at 20–21 (cited in note 39).
189
See id, Underwriter #9 at 19 (noting that “[a]n underwriter ultimately [either] con-
sciously or unconsciously formulates an opinion about a risk, and that opinion leads him to make
a certain decision” about the price).
190
See id, Underwriter #2 at 6 (stating that underwriters must “summarize, you know, what
makes us want to write the account and what makes the necessity of the insurance relevant to
the risk of the company and then we price it”). See also id, Risk Manager #2 at 19 (describing the
formation of underwriting committees before which individual underwriters must justify their
pricing decisions), Actuary #3 at 8–9 (“[W]e have concluded that the best thing is to let a very
small group of experienced underwriters manage [the pricing process] without giving them a lot
of constraints . . . . We have less than five underwriters who have the authority to quote [large
public company] accounts.”), Actuary #2 at 10 (“We have a centralized, one location shop here”
with “250 years of D&O experience on this 11,000 square feet.”).
191
Id, Broker #6 at 33–34.
192
Id, Actuary #1 at 28, Actuary # 3 at 3–4 (discussing the “pure crap shoot” aspect of insur-
ing Marilyn Monroe’s leg). See also William M. Grove and Paul E. Meehl, Comparative Effi-
ciency of Informal (Subjective, Impressionistic) and Formal (Mechanical, Algorithmic) Prediction
Procedures: The Clinical-Statistical Controversy, 2 Psych Pub Policy & L 293, 315 (1996) (“Hu-
mans simply cannot assign optimal weights to variables and they are not consistent in applying
their own weights.”). One innovative suggestion for improving underwriters’ risk assessments
comes from the literature on prediction markets. Prediction markets are formed by sponsors
who create tradable contracts providing for payments on specified future contingencies. Traders
then buy and sell the contracts on the basis of their estimates of the likelihood of the given con-
tingency. These markets have been used, for example, to forecast elections and to assist in inter-
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Predicting Corporate Governance Risk 531
inconsistent application and the evolving nature of the underwriting
process,
our participants reported that “there is no question . . . what-
soever” that corporate governance information “works its way into
pricing.”
193
The degree of influence and precision of the measuring sys-
tem, however, is much more debatable.
194
If the data were available,
this would be an excellent area for econometric research.
195
3. The market constraint.
Underwriters want to sell insurance and generate large premi-
ums. Their ability to do so, however, depends on the premiums
charged by their competitors.
196
An underwriter that charges signifi-
cantly more than its competitors for the same risk will find that it has
relatively few underwriting opportunities. As a result, the market for
D&O insurance operates as a constraint on the ability of underwriters
to factor risk into price. If a D&O underwriter attaches a very high-
risk premium to a particular account, it may not have the opportunity
to underwrite that account.
As they go through the debit and credit process, underwriters are
highly aware of the price the competition has quoted or is likely to
quote for the risk in question. They know historical premiums paid by
a prospective insured and are finely attuned to prevailing market con-
nal corporate decisions and have often been shown to be more accurate than individual deci-
sionmakers. See generally Michael Abramowicz and M. Todd Henderson, Prediction Markets for
Corporate Governance (University of Chicago Law School Law and Economics Olin Working
Paper No 307, Sept 2006), online at http://ssrn.com/abstract=928896 (visited Apr 12, 2007) (sum-
marizing existing literature on prediction markets and arguing that markets could be formed to
predict corporate governance risk); Michael Abramowicz, Information Markets, Administrative
Decisionmaking, and Predictive Cost-Benefit Analysis, 71 U Chi L Rev 933 (2004) (describing the
use of prediction markets in the context of agency decisionmaking).
193
D&O Interviews, Risk Manager #2 at 20 (cited in note 39). See also id, Risk Manager #4
at 12 (noting that “underwriters finally woke up that they needed to underwrite the program and
not just offer the coverage,” and as a result corporate governance and internal controls are now
central considerations in pricing).
194
Id, Risk Manager #3 at 14–15 (noting that the issue was in fact debated within his firm).
195
See, for example, John E. Core, The Directors’ and Officers’ Insurance Premium: An Out-
side Assessment of the Quality of Corporate Governance, 16 J L, Econ, & Org 449, 456–62 (2000)
(using Canadian data); Zhiyan Cao and Ganapathi Narayanamoorthy, Accounting and Litigation
Risk 24–26, 29–30 (Yale School of Management Working Paper No 47, Nov 2005), online at
http://ssrn.com/abstract=853024 (visited Apr 12, 2007) (matching Tillinghast data with publicly
available information to test the influence of corporate governance risk on D&O insurance premi-
ums on U.S. firms); George D. Kaltchev, The Demand for Directors’ and Officers’ Liability Insur-
ance by US Public Companies 34–52 (working paper, July 2004), online at http://ssrn.com/abstract=
565183 (visited Apr 12, 2007) (using privately obtained panel data). See also Griffith, 154 U Pa L
Rev at 1150 (cited in note 6) (advocating disclosure of this information).
196
Although two large insurers underwrite more than half of all primary policy limits, the D&O
market is a generally fluid market with low barriers to entry. See note 21 and accompanying text.
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ditions.
197
They can draw on their personal networks for information,
and in some cases will simply be told by the broker what other carriers
are quoting, both on the particular risk and on similar risks in the
market. Moreover, the primary insurer’s quotation is disclosed to all
excess carriers before they provide their final quote, putting them in
an even better position to predict the prices charged by their competi-
tors. As a result, underwriters may adjust their pricing on the basis of
factors not strictly relevant to the assessment of the risk.
This dynamic may contribute to the herd behavior of the D&O
market and, in conjunction with intrafirm pressures to generate un-
derwriting premiums, explain the winner’s curse scenario frequently
lamented by participants in our study.
198
Here, however, we wish only
to note that these pricing dynamics, like the cycle itself, complicate the
insurer’s ability to match premiums to risks.
IV.
C
ORPORATE
A
ND
S
ECURITIES
L
AW
A
PPLICATIONS
Having described in the last Part how the underwriting process
for D&O liability insurance interacts with corporate governance, we
now seek to apply our findings to several ongoing debates in corpo-
rate and securities law. In this Part, we describe what our findings sug-
gest about the deterrence effect of shareholder litigation, the question
of whether the merits matter in corporate and securities litigation, and
the question of which corporate governance terms or practices matter
most. As we describe below, our qualitative research offers a unique
contribution to each of these debates.
197
As we witnessed at the industry conferences we attended, D&O brokers and underwrit-
ers talk constantly about the market.
198
See note 172 and accompanying text (noting that pressures within insurance companies
to generate premium volume may lead them to underwrite policies even when the premium does
not fully compensate the insurer for the risk undertaken). See generally Richard Thaler, Anoma-
lies: The Winner’s Curse, 2 J Econ Perspectives 191 (1988) (explaining the winner’s curse, a ten-
dency for the winning bidder in an auction to overpay). See also Scott E. Harrington and Patricia
M. Danzon, Price Cutting in Liability Insurance Markets, 67 J Bus 511, 520–21 (1994) (introduc-
ing the concept of the winner’s curse into analysis of the insurance underwriting cycle). When
considering the importance of the winner’s curse, it is worth noting the following:
The obvious question is this: “Why do insurers not protect themselves against the winner’s
curse?” Insurers have a good understanding of their market and the institutional incentives.
We should not lightly expect that they would tolerate below-cost pricing, unless it is benefi-
cial to them in the long run. It is possible that there are benefits to market share, such that it
is rational to “spend” capital by maintaining market share during the soft market in order
to reap the high profits of the hard market and, therefore, there is in fact no “curse.” For the
moment, this is an important, open question.
Baker, 54 DePaul L Rev at 421 n 97 (cited in note 84).
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Predicting Corporate Governance Risk 533
A. Does D&O Insurance Diminish the Deterrent Effect of
Corporate and Securities Law?
Because virtually all corporations purchase D&O insurance to
cover the risk of shareholder litigation, and because virtually all share-
holder litigation settles within the D&O insurance limits,
199
the D&O
insurance premium represents the insurer’s best guess of the insured’s
expected liability costs.
200
The D&O premium, in other words, repre-
sents an insured’s expected corporate and securities law liability
charged as an annual fee. One of our first research questions was
whether this transformation of the liability rules of corporate and se-
curities law into an annual fee alters the deterrent effect of the law.
Does this annual fee increase the deterrence of fraud? Does it stimu-
late the improvement of corporate governance?
201
Our research supports the proposition that D&O insurers seek to
price policies according to the risk posed by each corporate insured,
which, if successful, would fulfill a basic requirement of deterrence
theory—that the burden of liability fall more heavily on bad actors.
202
As described in detail above, we find that insurers actively seek to
distinguish good companies from bad ones. They gather information
through detailed applications and personal meetings with top-level
management. They analyze a variety of factors, focusing on the ac-
counting risk and governance practices of the prospective insured.
Underwriters report that all of these factors influence D&O pricing, at
least since the most recent hard market cycle. Ideally, then, we can
expect worse-governed firms to pay more for an equivalent amount of
D&O insurance than their better-governed peers.
203
They will have
systematically higher operating costs than peer firms, making it more
difficult for them to compete in product and capital markets, poten-
tially driving bad firms to seek to reduce the annual D&O fee by im-
199
See notes 2–3 and accompanying text.
200
Premium amounts also include a loading fee reflecting the expenses and profits of the
insurance company. Griffith, 154 U Pa L Rev at 1168 (cited in note 6).
201
We address other approaches to managing the moral hazard of D&O insurance in Baker
and Griffith, 95 Georgetown L J (forthcoming 2007) (cited in note 8).
202
See generally Steven Shavell, On the Social Function and the Regulation of Liability
Insurance (Geneva Papers on Risk and Insurance Theory, March 2000), online at http://ssrn.com/
abstract=224945 (visited Apr 12, 2007).
203
Shareholder litigation and corporate governance are substitutes. We would therefore
expect firms with stronger ex ante corporate governance to experience less ex post shareholder
litigation. See Eric Talley and Gundrun Johnsen, Corporate Governance, Executive Compensa-
tion and Securities Litigation 15 (University of Southern California Law School, Olin Research
Paper No 04-7, May 2004), online at http://ssrn.com/abstract=536963 (visited Apr 12, 2007)
(“[C]orporate governance and litigation are policy substitutes: the less invasive a firm’s corpo-
rate governance regime, the greater the likelihood that the firm will face securities litigation as a
form of ex post discipline.”).
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proving the quality of their corporate governance.
204
In this way, the
annual cost of liability insurance would carry forward the deterrence
function of corporate and securities law.
There is, of course, ample reason to doubt that this theoretical
ideal works in practice. Most basically, D&O expenses may not be
large enough to change corporate behavior, either because D&O ex-
penses are an insignificant portion of a large corporation’s total costs
or because the marginal difference in D&O expense between good
firms and bad firms may not be large enough for bad firms to change
their ways. We deal below with each of these bases for skepticism.
First, D&O insurance expenses might be so small, given a corpo-
ration’s overall costs and cash flows, that companies fail to take them
into account as a significant source of cost savings. Without firm-
specific information, we cannot comment on whether D&O insurance
costs are large enough, relative to market capitalization or cash flows,
to affect firm behavior. We can, however, point out that D&O premi-
ums are nontrivial. Average annual premiums are summarized in the
table below. These costs may be large enough to affect the behavior of
some firms.
Second, even if D&O expenses are nontrivial and therefore no-
ticeable to corporations, the difference between the premiums paid by
good and bad firms may not be sufficiently large to force bad firms to
improve. Good firms might pay too much while bad firms pay too little.
This could be because underwriters make mistakes or the liability sys-
tem makes mistakes or, as is most likely, both do. As a result, although
there may be some difference in the prices charged to firms with differ-
ing corporate governance practices, good firms would cross-subsidize
bad firms to some degree and deterrence would therefore be blunted.
204
Higher costs must either reduce profit margins or be passed on to consumers. If profit
margins are reduced, capital market participants will prefer the firm’s higher-profit rivals, leading
to higher costs of capital for the worse-governed firm. Conversely, if costs are passed on to con-
sumers, the firm will be at a disadvantage in price competition with its rivals and may lose mar-
ket share. Either way, a bad firm will face strong incentives to reduce annual D&O costs.
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Predicting Corporate Governance Risk 535
F
IGURE
3:
A
NNUAL
P
REMIUMS BY
M
ARKET
C
APITALIZATION
C
ATEGORY
Interestingly, liability insurers may play a part in the failings of
the liability system by keeping the costs of shareholder litigation arti-
ficially low. If this seems counterintuitive, recall that securities claims
almost always settle within the limits of available insurance.
205
This,
alone, is unsurprising since plaintiffs’ lawyers typically prefer to be
paid by an insurance company that is contractually obliged to pay
them rather than to expend extra effort seeking recovery from indi-
viduals who will do everything they can do to protect their personal
assets.
206
Now consider what happens if the real cost of securities litiga-
tion grows at a faster rate than insurance limits, which, by some ac-
counts at least, seems to have occurred in the 1990s when market capi-
talizations grew exponentially but D&O limits remained relatively
stable.
207
Because plaintiffs’ lawyers would prefer to settle for insur-
ance proceeds only, settlements will not reflect the real cost of liability
but rather a lower amount—the growth rate of insurance limits.
208
In
205
See note 3.
206
See Baker, 12 Conn Ins L J at 6–7 (cited in note 10); Baker, 35 L & Socy Rev at 289–93
(cited in note 16).
207
See Miller, Foster, and Buckberg, Recent Trends at 7 (cited in note 25) (providing data
that shows expected settlements have risen more slowly than investor losses).
208
See James D. Cox and Randall S. Thomas, Letting Billions Slip through Your Fingers:
Empirical Evidence and Legal Implications of the Failure of Financial Institutions to Participate in
Securities Class Action Settlements, 58 Stan L Rev 411, 450 (2005) (“[W]e suspect that settlements
are fixed . . . by the amount of available insurance or cash from the issuer.”).
5.0
0.5
0.0
1.5
1.0
2.5
2.0
3.5
3.0
4.5
4.0
SMALL CAP
($400M–$1B)
MID CAP
($1–10B)
LARGE CAP
(>$10B)
Market Capitalization
Pre
mium
($ millions)
MEDIAN
MEAN
Source:
Tillinghast,
2005 Survey
at 72 table 61C (cited in
note 2
). We derived the “Mid Cap” category as a
weighted average of three market capitalization classes
reported by Tillinghast. See note 74.
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this situation, bad actors will pay significantly less in liability costs
than the harm they cause. They will, in other words, be underdeterred.
As importantly, damages will be effectively capped at typical policy
limits.
209
And this compression of damages may lead to an inadequate
spread between the liability costs of good and bad actors. When these
liability costs are converted into an ex ante insurance premium, they
will be similarly compressed, leading to further cross-subsidization of
bad firms by good firms and therefore less deterrence.
If, as a result of any of these mechanisms, the liability fee falls too
evenly on both good and bad firms, the deterrence objectives of the
law can be expected to fail. All, however, is not lost. Our research sup-
ports the proposition that there is at least some deterrence value em-
bedded in the D&O premium. Even if it is not large enough to affect
the behavior of corporate insureds, it may be large enough to signal
which firms are governed well and which firms are governed poorly.
As one of us has argued at length elsewhere, a corporation’s
D&O premium, if disclosed, would reveal valuable information about
the corporation’s governance quality to capital market participants.
210
Because underwriters seek to assess the risks posed by insureds and to
charge an appropriate premium for different degrees of risk, the price
of a firm’s D&O policy represents the insurer’s assessment of the gov-
ernance quality of the insured,
211
taking into account, of course, the
deductibles, limits, and other terms of the policy (which also would
have to be disclosed).
212
Armed with this signal of governance quality,
capital market participants may adjust their reservation values, dis-
counting the share price of firms whose D&O premiums reveal low-
209
As reported earlier, there are a small number of highly visible settlements in excess of
the policy limits. See note 3. See also Baker, 12 Conn Ins L J at 6–7 & n 13 (cited in note 10)
(using the Texas Department of Insurance commercial liability claims database to report “that
there was a payment in excess of policy limits in only 31 out of 9723 [commercial] liability insur-
ance paid claims in 2002 and that the total amount paid above the limits in those cases was $9
million, as compared to $1.8 billion in total [commercial] liability payments in Texas in 2002”);
Zeiler, et al, Physicians’ Insurance Limits at 3 (cited in note 16) (using the Texas Department of
Insurance medical liability claims data to report an even smaller ratio of above-limit payments
and that medical malpractice insurance settlements cluster at the policy limits).
210
See Griffith, 154 U Pa L Rev at 1150 (cited in note 6).
211
Because of D&O pricing competition in cyclical insurance markets, the signal of the
D&O premium should not be taken as an absolute measure of governance quality but rather as
a relative measure. Firms’ D&O premiums should not be compared to each other across markets
but, because insurers face similar underwriting pressures in a given market, only within that
market. In other words, comparisons should be made only among firms whose policies were
underwritten at approximately the same time. Id.
212
In order for the premium to have this signaling effect, market analysts would have to
control for the financial and industry factors that predict the likelihood of investment loss gener-
ally. These adjustments would control for each of the factors in the base price algorithm, leaving
only the governance variables. See note 183.
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Predicting Corporate Governance Risk 537
quality corporate governance, thereby reintroducing the deterrence
function of corporate and securities law.
213
B. Do the Merits Matter in Securities Litigation?
Corporate and securities law scholars have extensively debated
the question of whether outcomes in shareholder litigation are related
to the underlying merits of claims or whether such claims are, in fact,
largely frivolous.
214
The principal argument is that shareholder litiga-
tion is driven by plaintiffs’ lawyers whose incentives are so weakly
correlated with shareholder interests that claims are both brought too
often and settled too cheaply.
215
Supporting this argument, scholars
have shown that shareholder claims have settled for relatively small
amounts, often for attorneys’ fees alone.
216
Others have sought to show
that settlements tend to cluster around nonmeritorious factors, such as
a “going rate” demanded by plaintiffs’ lawyers to settle such claims.
217
These arguments were influential in the passage of the PSLRA in
1995.
218
Since then, research has shown that settlements have corre-
213
It is worth pointing out again that what equity analysts are looking for (predictors of
future performance) is not exactly the same as what D&O underwriters are screening for (pre-
dictors of future litigation). See note 124. However, litigation activity has a significant negative
effect on shareholder returns. See Sanjai Bhagat, John Bizjak, and Jeffrey L. Coles, The Share-
holder Wealth Implications of Corporate Lawsuits, 27 Fin Mgmt 5, 6 (1998) (finding that corpo-
rate defendants lose nearly 1 percent of their value on the day a lawsuit is filed and almost 3
percent when the lawsuit alleges securities fraud). Equity analysts and other capital market
participants therefore have strong incentives to take into account the information revealed by
the D&O premium.
214
See generally Johnson, Nelson, and Pritchard, J L, Econ, & Org (forthcoming) (cited in
note 140); Steven J. Choi, Do the Merits Matter Less after the Private Securities Litigation Reform
Act? (NYU Law and Economics Research Paper No 03-04, Feb 2005), online at http://ssrn.com/
abstract=558285 (visited Apr 12, 2007).
215
See John C. Coffee, The Unfaithful Champion: The Plaintiff as Monitor in Shareholder
Litigation, 48 L & Contemp Probs 5, 8 (1985). See also Kraakman, Park, and Shavell, 82 Geo L J
at 1736–37 (cited in note 5) (“[I]nitiators of shareholder litigation . . . are . . . likely to be attor-
neys . . . in search of legal fees.”).
216
See Roberta Romano, The Shareholder Suit: Litigation without Foundation?, 7 J L, Econ,
& Org 55, 61 (1991) (finding that although only half of the settlements in her sample resulted in
any recovery to shareholders, 90 percent awarded attorneys’ fees).
217
See Janet Cooper Alexander, Do the Merits Matter? A Study of Settlements of Securities
Class Actions, 43 Stan L Rev 497, 500 (1991) (concluding that the merits do not matter). But see
Cox, 39 Ariz L Rev at 503–04 (cited in note 3) (disputing Alexander’s conclusion by, inter alia,
pointing out her failure to control for market events that may have explained some of her re-
sults); Elliott J. Weiss and John S. Beckerman, Let the Money Do the Monitoring: How Institu-
tional Investors Can Reduce Agency Costs in Securities Class Actions, 104 Yale L
J 2053, 2084
(1995) (recalculating settlement amounts as a function of potential damages and finding that
Alexander’s 25 percent “going rate” can no longer be supported).
218
See, for example, Private Litigation Under the Federal Securities Laws, Hearings before
the Subcommittee on Securities of the Senate Committee on Banking, Housing and Urban Af-
fairs, 103d Cong, 1st Sess 302–08 (1993) (statements of Ralph V. Whitworth, President of the
United Shareholders Association, and A.A. Sommer, Jr., Chairman, Public Oversight Board of
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lated more closely with evidence of fraud, such as accounting restate-
ments and abnormal insider trading.
219
The merits, in other words, seem
to matter more than they once did.
220
But the extent to which the mer-
its matter in shareholder litigation remains an open question.
Our research supports the proposition that the merits somewhat
matter. We found that D&O insurers do indeed inquire into a host of
governance factors that are likely to be related to the merits of share-
holder litigation.
221
We have been careful to emphasize that these are
not the only factors that they examine, nor can we evaluate whether
D&O insurers correctly weigh these factors in their risk assessment.
Nevertheless, D&O underwriters do report that they take merits-
related factors into consideration. Because this is a revealed prefer-
ence of D&O insurers—the party with the most to lose in the event
that its risk assessments are incorrect—our findings provide evidence
that these factors do affect the risk of shareholder litigation.
C. What Matters in Corporate Governance?
Similarly, corporate and securities law scholars have also long
sought to determine which corporate governance variables are most
important either in terms of firm performance or litigation risk. Nu-
merous studies examine factors such as board independence,
222
committee
the SEC Practice Section of the AICPA) (discussing the problems of frivolous lawsuits and
opportunistic attorney practices in D&O litigation); William S. Lerach, Securities Class Action
Litigation under the Private Securities Litigation Reform Act’s Brave New World, 76 Wash U L Q
597,
598–601 (1998) (stating that Congress “relied heavily upon Professor Janet Cooper Alexan-
der’s article” in enacting the PSLRA). On the PSLRA in general, see note 140.
219
See Johnson, Nelson, and Pritchard, J L, Econ, & Org (forthcoming) (cited in note 140).
220
See Stephen J. Choi, The Evidence on Securities Class Actions, 57 Vand L Rev 1465, 1498
(2004) (“[T]he existing literature on filings and settlements in the post-PSLRA time period
provide[s] evidence that frivolous suits existed prior to the PSLRA and that a shift occurred in
the post-PSLRA period toward more meritorious claims.”).
221
We are not seeking here to furnish a theory of what should count as “merit” in share-
holder litigation. Because corporate governance and shareholder litigation are substitutes and well-
governed firms ought therefore to be sued less often than poorly governed firms, the conventional
approach in the literature is to treat corporate governance variables as proxies for merit. See id at
1489–91. That corporate governance variables weigh in the underwriters’ assessment of D&O risk,
therefore, provides indirect support for the proposition that the merits do matter.
222
See Bernard S. Black and Sanjai Bhagat, The Non-Correlation between Board Independ-
ence and Long-Term Firm Performance, 27 J Corp L 231, 231 (2002) (finding that firms with
more independent boards do not perform better than other firms); Eric Helland and Michael
Sykuta, Who’s Monitoring the Monitor? Do Outside Directors Protect Shareholders’ Interests?, 40
Fin Rev 155, 171 (2005) (finding that, from 1988 to 2000, firms with more independent boards
were less likely to be sued by their shareholders). But see Johnson, Nelson, and Pritchard, J L,
Econ, & Org (forthcoming) (cited in note 140) (finding no greater ability to predict securities
litigation on the basis of a handful of governance factors including average board tenure, average
number of additional directorships held by outside directors, percentage of outside directors,
number of audit committee meetings, percentage of independent members of the audit commit-
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Predicting Corporate Governance Risk 539
composition,
223
executive compensation,
224
and management entrench-
ment
225
for their effects on firm performance or litigation risk. Scholars
have also constructed various governance indices to test correlation of
corporate governance variables and firm performance. Using their
“Governance Index,” Paul A. Gompers, Joy L. Ishii, and Andrew Met-
rick found that firms with more promanagement governance terms
perform significantly worse than firms with more proshareholder gov-
ernance terms.
226
Seeking to discard noise variables, Lucian A.
Bebchuk, Alma Cohen, and Allen Ferrell narrowed the Governance
Index to a six-factor “Entrenchment Index” and found these six fac-
tors in fact drove the results of the Governance Index.
227
Meanwhile,
Lawrence D. Brown and Marcus L. Caylor broadened the number of
factors under consideration and found that a number of variables not
included on other indices—including management compensation
practices, meeting attendance, board independence, and committee
composition—were significantly correlated with performance.
228
Our findings suggest that these easily observable factors may be
overemphasized in the corporate and securities law literature. We
found, instead, that D&O underwriters base a large amount of their
risk assessment on the deep governance of a prospective insured,
tee, separation of the chief executive and board chair functions, whether the CEO was a firm
founder, and whether the firm had a 5 percent or greater blockholder).
223
See Agrawal and Chadha, 48 J L & Econ at 371 (cited in note 129) (finding that the
probability of a restatement is lower for companies whose boards or audit committees have an
independent director with financial expertise and higher for companies in which the chief execu-
tive officer belongs to the founding family).
224
See Talley and Johnsen, Corporate Governance at 4 (cited in note 203) (finding a close
relationship between incentive compensation and securities litigation and estimating that “each
1% increase in the fraction of a CEO’s contract devoted to medium- to long-term incentives . . .
predicts a 0.3% increase in expected litigation and a $3.4 million dollar increase in expected
settlement costs”) (emphasis omitted).
225
See, for example, K.J. Martijn Cremers and Vinay B. Nair, Governance Mechanisms and
Equity Prices, 60 J Fin 2859, 2870 (2005) (treating the Gompers, Ishii, and Metrick index, dis-
cussed in note 226 and accompanying text, as an entrenchment index to compare the interaction
of internal versus external governance constraints).
226
See Paul A. Gompers, Joy L. Ishii, and Andrew Metrick, Corporate Governance and
Equity Prices, 118 Q J Econ 107, 107 (2003) (using the twenty-four corporate governance vari-
ables tracked by IRRC, most of which related to takeover preparedness, to develop a govern-
ance rating system and comparing the performance of the most highly rated firms against the
lowest scoring firms throughout the 1990s).
227
See Lucian A. Bebchuk, Alma Cohen, and Allen Ferrell, What Matters in Corporate
Governance? 2–4 (Harvard Law School John M. Olin Center Discussion Paper No 491, Mar 2005),
online at http://ssrn.com/abstract_id=593423 (visited Apr 12, 2007). The six entrenchment factors
were: (1) staggered boards, (2) limitations on shareholders’ ability to modify bylaws, (3) limitations
on shareholders’ ability to modify the charter, (4) supermajority voting provisions, (5) golden para-
chutes, and (6) poison pills. Id at 2.
228
See Lawrence D. Brown and Marcus L. Caylor, Corporate Governance and Firm Performance
21–22 (unpublished draft, Dec 2004), online at http://ssrn.com/abstract=586423 (visited Apr 12, 2007).
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weighing both the culture of the firm (the system of incentives and
constraints embedded within the firm) and the character of its man-
agement (its ability to rationalize its way around rules and whether it
is likely to be made up of “risk-takers above the norm”).
229
Culture and character do not make sense within a theory where
the primary corporate governance concern is board entrenchment—a
factor in which D&O underwriters are relatively uninterested.
230
They
do, however, comport with a broader theory of corporate governance
that recognizes aspects of organizational behavior. In recent years,
several scholars have sought to erect this new framework of corporate
governance.
For example, Donald C. Langevoort has argued that in order to
survive the tournament-style promotion structure within firms, execu-
tives must cultivate traits such as “over-optimism, an inflated sense of
self-efficacy and a deep capacity for ethical self-deception.”
231
Yet
these very traits that enable executives to succeed also put the firms
they manage at greater risk of fraud and failure, a dynamic exempli-
fied by Enron itself:
Enron was filled with people who [were] optimistic, aggressive,
and focused. The culture quickly identified itself as special and
uniquely competent, believing that special skill rather than luck
(or just being first) was responsible for the early victories. That
self-definition then set a standard for how up-and-coming people
acted out their roles: Enron was a place for winners. With this—
and the stock market's positive feedback—the company's aspira-
tion level rose.
This aspiration level required a high level of risk-taking by
the firm . . . . [T]he compensation and promotion structure at En-
ron . . . harshly penalized the laggards at the firm, which, on aver-
age, tends to lead to herding behavior (risk aversion). To coun-
teract this, the company had to magnify the reward structure con-
229
See Parts III.C.1–2.
230
Underwriters acknowledged takeover protections as a relevant risk assessment factor
only when asked directly and, even then, they did not emphasize them or discuss them at length.
See note 160 and accompanying text.
231
Donald C. Langevoort, Resetting the Corporate Thermostat: Lessons from the Recent
Financial Scandals about Self-Deception, Deceiving Others and the Design of Internal Controls,
93 Geo L J 285, 288 (2004). Langevoort elaborates, noting that “the luckier risk-takers will out-
perform more risk-averse realists on average, and the positive feedback will enhance their self-
efficacy.” Id at 299.
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Predicting Corporate Governance Risk 541
siderably for those who ended up as stellar performers—a win-
ner-take-all kind of tournament.
232
Hypercompetition, in other words, exacerbates the familiar problem
of the winner’s curse, as executives must make more and greater
promises—and take more and greater gambles to succeed.
This hypercompetitive culture breeds a certain kind of charac-
ter—one with a tendency to equate what is self-serving with what is
right, what Langevoort refers to as “ethical plasticity.”
233
In his words:
The person who most likely strikes the right competitive balance
in a high-stakes promotion tournament is the one who best con-
ceals from others the inclination to defect when necessary—
extremely difficult in a corporate setting where one is being
closely observed by subordinates, peers and superiors—yet does
so nimbly. People who best deceive others are usually those who
have deceived themselves, for they can operate in a cognitively
unconflicted way. The Machiavellian with the best survival pros-
pects in the corporate tournament is especially adept at rationali-
zation: convincing himself as well as others that what is self-
serving is also right.
234
Executives with this type of character in this kind of culture are
among the most likely to lead their organizations into a spiral of ever
greater risk taking and, when their luck finally sours, to convert risk
taking into fraud.
235
Other scholars make similar arguments. In seeking to predict
which firms are most likely to restate their earnings, Stanford’s Wil-
liam H. Beaver identified the following set of factors: (1) a company has
experienced unusually high growth, (2) management attributes this
growth to skill rather than luck, (3) management has made continued
232
Donald C. Langevoort, The Organizational Psychology of Hyper-Competition: Corpo-
rate Irresponsibility and the Lessons of Enron, 70 Geo Wash L Rev 968, 973–74 (2002).
233
Langevoort, 93 Geo
L
J at 299 (cited in note 231). A reinsurance underwriter similarly
observed:
I was looking up the other day a “sociopath,” which changed to “antisocial disorder” or
something like that, anyway, sociopath. And it turns out that in the American population, in
the general population, the expectation is somewhere between 3–4 percent is so-
ciopathic. . . . Now, when you read the definition of sociopath, it reads pretty similar to sen-
ior corporate exec. So, my expectation is that as we go into the higher ranks of an organiza-
tion, the distribution is actually going to be greater than the 3–4 percent that we would ex-
pect in the random population.
D&O Interviews, Underwriter #10 at 55 (cited in note 39).
234
Langevoort, 93 Geo
L
J at 303 (cited in note 231).
235
Langevoort, 70 Geo Wash L Rev at 974 (cited in note 232) (summarizing this cycle by noting
that “overconfidence commits them to a high-risk strategy; once committed to it, they are trapped”).
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[74:487
growth an integral part of corporate strategy, (4) management is arro-
gant or naïve about their prospects for sustaining such growth, and (5)
management perceives the financial reporting and internal controls as
a nuisance or subservient to entrepreneurial goals.
236
Similarly, Howard
M. Schilit, a leading expert in forensic accounting, calls special atten-
tion to firms with weak internal controls, intense competition, and man-
agers with questionable ethical judgment, sounding a particular alarm
on high-growth companies whose growth is beginning to slow (Enron)
and companies that are struggling to survive (WorldCom).
237
Finally,
David Skeel has found evidence of this same pattern of destructive risk
in a series of major corporate scandals going back over a century.
238
D&O underwriters, it would seem, are screening for precisely
these traits. Their unease with “risk takers above the norm”
239
and
managers who are “not sure how we are going to grow 20 percent, but
. . . we are going to grow 20 percent”
240
is based on suspicion of over-
optimistic promises and over-committed managers. Similarly, disquiet
concerning executives who rationalize their pollution issues by noting
that “[i]t was a small aquifer”
241
is consistent with Langevoort’s de-
236
See William H. Beaver, What Have We Learned from the Recent Corporate Scandals that
We Did Not Already Know?, 8 Stan J L, Bus & Fin 155, 163 (2002) (further noting that “based
upon the information disseminated in the financial press, the [corporate scandals] appear to fit
these conditions quite well”). See also Nassim Nicholas Taleb, Fooled by Randomness: The Hid-
den Role of Chance in Life and in the Markets 161 (West 2d ed 2005) (discussing the tendency to
mistake luck for skill).
237
See Howard M. Schilit, Financial Shenanigans: How to Detect Accounting Gimmicks and
Fraud in Financial Reports 32 (McGraw-Hill 2d ed 2002). Management teams in this situation
face a kind of final period problem, in which fraudulent risk taking and possible success may
appear preferable to truthful disclosure and certain failure, whether failure means termination of
employment, takeover, or bankruptcy. See generally Jennifer H. Arlen and William J. Carney,
Vicarious Liability for Fraud on Securities Markets: Theory and Evidence, 1992 U Ill L Rev 691
(1992). In the words of Arlen and Carney:
[A]n agent generally will not commit Fraud on the Market so long as his future employ-
ment seems assured. When the firm is ailing, however, an agent’s expectations of future em-
ployment no longer serve as a constraint on behavior. In this situation a manager may view
securities fraud as a positive net present value project. Aside from criminal liability, in a last
period the expected costs of fraud (civil liability and job loss) are minimal, while the ex-
pected benefits of fraud may have increased. As remote as the prospects for success may
seem, these benefits include possible preservation of employment as well as the value of the
manager’s assets related to the firm’s stock, if by committing fraud he is able to buy suffi-
cient time to turn the ailing firm around.
Id at 702–03.
238
See David Skeel, Icarus in the Boardroom: The Fundamental Flaws in Corporate Amer-
ica and Where They Came From 16 (Oxford 2005). See also generally Sean J. Griffith, Daedalean
Tinkering, 104 U Mich L Rev 1247 (2006) (reviewing Skeel).
239
See note 167 and accompanying text.
240
See note 169 and accompanying text.
241
See note 166 and accompanying text.
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Predicting Corporate Governance Risk 543
scription of ethical plasticity and Beaver’s concern for those who view
compliance with rules as subservient to entrepreneurial goals.
That underwriters screen for deep governance, again, is a re-
vealed preference. We cannot say how important deep governance
variables are in comparison with other aspects of corporate govern-
ance, nor can we evaluate whether underwriters are adept at measur-
ing these variables.
242
But we can say that underwriters report that
deep governance variables are an important part of assessing D&O
risk. That these variables are largely missing from mainstream scholar-
ship on corporate governance is, thus, a bit of a puzzle.
243
Our study
thus suggests an important area of further research—specification and
econometric testing of deep governance variables.
C
ONCLUSION
Insurance companies transmit, via D&O premiums, the liability
content of corporate and securities law to American corporations. This
Article has described how D&O insurers evaluate risk in order to ar-
rive at that premium number. We found that, in addition to perform-
ing a basic financial analysis of the company, underwriters focus a
large part of their efforts on understanding the corporate governance
of the prospective insured, especially nonstructural “deep govern-
ance” variables such as culture and character.
Our findings have significant implications for corporate and secu-
rities law. First, they suggest that underwriters, at least, believe that
governance matters. This, by implication, suggests that the merits do
matter in corporate and securities litigation. But, interestingly, our
findings also suggest that what matters in corporate governance are
not the structural governance variables most often tested in main-
stream scholarship on corporate governance. Our findings thus sug-
gest “deep governance” variables as a promising direction for future
research.
Finally, we contribute to the economic analysis of law by provid-
ing an insurance market case study that is both theoretically informed
and thoroughly grounded. Such theoretically informed qualitative
research should serve to advance the economic understanding of how
242
Underwriters do, however, have special access to information—direct access to top
managers at the underwriters’ meeting—that might enhance their ability to make such determi-
nations. See notes 111–113 and accompanying text.
243
One explanation may be, to borrow from Archilochus, that economists are hedgehogs
and the large dataset regression is their one big trick. See Anne Pippin Burnett, Three Archaic
Poets: Archilochus, Alcaeus, Sappho 60 (Harvard 1983) (“The fox knows many tricks, the hedge-
hog just one—but his is a good one.”).
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law works.
244
It provides a reality check on the model-building and
quantitative research methods on which law and economics scholars
increasingly rely. Law, after all, is a social field, and a considerable
amount of explanatory power may be lost in abstractions that fail to
reflect how the world in fact works. Our alternative is to test the in-
sights of economic research in its social context, to provide a thick
description of the actors in a social field and their understanding of
what they do and how and why they do it. Such research ought to play
a large role in the design of economic models as well as their critique
and ultimate improvement. In addition, qualitative methods allow
researchers to explore questions for which there are no quantitative
data available and to investigate fields that are not yet sufficiently
understood to model. Our ultimate goal is thus not to replace eco-
nomic modeling or quantitative research methods but rather to sug-
gest a means of improving them.
244
Our approach to qualitative research, of course, is not without precursors. In this regard
we follow in some large footsteps. See sources cited in note 13. See also generally Gideon Par-
chomovsky and Peter Siegelman, Selling Mayberry: Communities and Individuals in Law and
Economics, 92 Cal L Rev 75 (2004) (describing American Electric’s buyout of Cheshire, Ohio, as
a case study for nuisance disputes and the resulting holdouts, bargaining, and community dynam-
ics); Eric A. Feldman, The Tuna Court: Law and Norms in the World’s Premier Fish Market, 94
Cal L Rev 313 (2006) (describing Japanese tuna merchants’ use of a specialized court for conflict
resolution and evaluating its efficacy through qualitative metrics).
