The missing monitor in corporate governance: The directors' & officers' liability insurer

Georgetown Law Journal

Volumn 95, Issue 6, 2007, Pages 1795-1842

  Baker, Tom ^a   Griffit, Sean J ^b  

^a UNIVERSITY OF CONNECTICUT   (United States)

^b Fordham Law School ^*

Author keywords

[No Author keywords available]

Indexed keywords

EID: 34548349188     PISSN: 00168092     EISSN: None     Source Type: Journal    
DOI: None     Document Type: Review

References (207)

1. See generally DAVID SKEEL, ICARUS IN THE BOARDROOM: THE FUNDAMENTAL FLAWS IN CORPORATE AMERICA AND WHERE THEY CAME FROM (2005) (placing the Enron and WorldCom scandals in historical context).
2. Donald C. Langevoort, Managing the "Expectations Gap" in Investor Protection: The SEC and the Post-Enron Reform Agenda, 48 VILL. L. REV. 1139, 1139 (2003).
3. See generally HOWARD M. SCHILIT, FINANCIAL SHENANIGANS: How TO DETECT ACCOUNTING GIMMICKS & FRAUD IN FINANCIAL REPORTS (2d ed. 2002) (identifying each of these financial reporting techniques and providing examples of their use).
4. See generally JOHN C. COFFEE, JR., GATEKEEPERS: THE PROFESSIONS AND CORPORATE GOVERNANCE (2006) (attributing the recent corporate scandals to failures of various "Gatekeepers," such as lawyers and accountants).
5. See TILLINGHAST TOWERS PERRIN, 2005 DIRECTORS AND OFFICERS LIABILITY SURVEY 20 fig.21 (2006) (reporting that 100% of public company respondents in both the United States and Canada purchased D&O insurance) [hereinafter TILLINOHAST, 2005 SURVEY]. Prior surveys reported slightly smaller percentages of companies purchasing D&O insurance. Although the annual Tillinghast D&O survey is based on a nonrandom, self-selecting sample of companies, it is the only systematic source of information on D&O insurance purchasing patterns in the United States. The information that it provides is consistent over the years, and the D&O insurance professionals we interviewed reported that they rely on the survey. We therefore draw upon it as a source of aggregate data in spite of its methodological weaknesses.
6. See, e.g., James D. Cox, Making Securities Fraud Class Actions Virtuous, 39 ARIZ, L. REV. 497, 512 (1997) ("[Approximately 96% of securities class action settlements are within the typical insurance coverage, with the insurance proceeds often being the sole source of settlement funds."). Using U.S. data, Cornerstone reports that "[o]ver 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. SMMONS & ELLEN M. RYAN, POST-REFORM ACT SECURITIES SETTLEMENTS: UPDATED THROUGH DECEMBER 2004, at 3 (Cornerstone Research ed. 2005).
7. See generally 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 (2006) (pointing out the intermediary role of the D&O insurer and advocating disclosure of D&O premiums in order to preserve the deterrence function of shareholder litigation).
8. See Tom Baker & Sean J. Griffith, Predicting Corporate Governance Risk: Evidence from the Directors' & Officers'Liability Insurance Market, 74 CHI. L. REV. (forthcoming 2007).
9. Id.
10. See Donald R. Deere, Note, On the Potential for Private Insurers to Reduce the Inefficiencies of Moral Hazard, 9 INT'L REV. L. & ECON. 219, 220-21 (1989) (describing insurer loss prevention practices).
11. See Jonathan Simon, In the Place of the Parent: Risk Management and the Government of Campus Life, 3 SOC. & LEGAL STUD. 15, 29-31 (1994) (describing the role of liability insurers in governing fraternities). Whether the insureds comply is, of course, another matter. On insurance and governance generally, see RICHARD V. ERICSON, AARON DOYLE & DEAN BARRY, INSURANCE AS GOVERNANCE (2003) (investigating the governance role of insurance companies in a variety of first party insurance contexts).
12. We describe our qualitative research methods in our companion article. See Baker & Griffith, supra note 8. In brief, we used a snowball recruitment technique and conducted semi-structured interviews with twenty-one underwriters from fourteen companies, three D&O actuaries from three companies, 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 corporations on the purchase of D&O insurance, and four professionals involved in the D&O claims process (two claims managers, one monitoring counsel, and one claims specialist from a brokerage house). In addition, we attended six conferences for D&O professionals (participating as moderators in two of them) and engaged in many informal conversations, supplementing our interviews with industry documents as well as regular reading of trade and industry publications. Because of the concentrated, highly networked nature of the D&O insurance market we are confident that we are reporting shared views despite the small number of interviews. See TILLINGHAST, 2005 SURVEY, supra note 5, at 84-93 (describing industry concentration). We observed the highly networked nature of the industry by attending conferences and by conducting interviews.
13. Our interviews focused exclusively on publicly traded corporations. Our findings do not generalize to D&O insurance sold to private or nonprofit corporations. Indeed, participants who are knowledgeable about the private and nonprofit D&O insurance markets report that D&O insurers provide considerably greater governance services-both ex ante and ex post-in those other markets. See E-mail from Underwriter #4 to Tom Baker, (Feb. 2, 2007, 12:53:00 EST) (on file with author).
14. See John C. Coffee, Jr., Reforming the Securities Class Action: An Essay on Deterrence and Its Implementation, 106 COLUM. L. REV. 1534, 1549-56 (2006) (arguing that, because the bulk of class action liability falls on corporations-and therefore on innocent shareholders-securities class actions do not promote the deterrence goals of securities law). We do not in this Article consider public law enforcement. D&O insurance policies generally exclude "fines," such as those assessed by the SEC. In addition, public enforcement agencies have the ability to specify in settlement agreements that amounts paid may not be recovered from insurance companies, even if the payment is not designated in the agreement as a fine or penalty. See, e.g., Agreement Between the Attorney General of the State of New York and American International Group, Inc. and its Subsidiaries (collectively "AIG") dated January 18, 2006 ¶ 66, http://www.oag.state.ny.us/press/2006/feb/signedSettlement.pdf (last visited Feb. 4, 2007) ("AIG shall not seek or accept, directly or indirectly, indemnification pursuant to any insurance policy, with regard to any or all of the amounts payable pursuant to this Agreement."). D&O insurance policies do provide for the payment of criminal and regulatory defense costs, however. See, e.g., AM. INT'L GROUP (AIG), EXECUTIVE AND ORGANIZATION LIABILITY INSURANCE POLICY § 2(V), (f) (2000) [hereinafter AIG SPECIMEN POLICY] (including a "criminal ... proceeding" within the definition of "claim" and providing that "defense costs means reasonable and necessary fees, costs, and expenses . .. resulting solely from the ... defense of... a claim").
15. "Moral hazard" is the term economists and insurers alike use to describe "the effect of insurance on incentives," namely, that insurance against loss reduces the incentive to take care to prevent loss. See Kenneth J. Arrow, Uncertainty and the Welfare Economics of Medical Care, 53 AM. ECON. REV. 941, 961 (1963); see also CAROL A. HEIMER, REACTIVE RISK AND RATIONAL ACTION: MANAGING MORAL HAZARD IN INSURANCE CONTRACTS (1985) (studying the use of insurance contract provisions to control moral hazard); Tom Baker, On the Genealogy of Moral Hazard, 75 TEX. L. REV. 237 (1996) (describing the evolution and uses of the term and discussing the empirical literature testing moral hazard); Steven Shavell, On Moral Hazard and Insurance, 93 Q.J. ECON. 541 (1979) (modeling the impact of moral hazard on insurance offerings).
16. Cf. Steven Shavell, On Liability and Insurance, 13 BELL J. ECON. 120, 121-22 (1982) (modeling the relationship between liability and insurance and concluding that, "[a]lthough the purchase of liability insurance changes the incentives created by liability rules, the terms of the insurance policies sold in a competitive setting would be such as to provide an appropriate substitute (but not necessarily equivalent) set of incentives to reduce accident risks").
17. Entity-level D&O insurance spreads the risk of corporate and securities litigation, but shareholders do not necessarily benefit from this form of insurance because they can spread these risks costlessly themselves by holding a diversified portfolio of equity securities. See infra text accompanying notes 132-35; see also BURTON G. MALKIEL, A RANDOM WALK DOWN WALL STREET 224 (2d ed. 2001) (including accounting fraud in a list of firm-specific risks that investors can reduce through diversification: "The whole point of portfolio theory is that, to the extent that stocks don't move in tandem all the time, variations in the returns from any one security tend to be washed away or smoothed out by complementary variation in the returns from other securities"); Coffee, supra note 14, at 1558 (illustrating how a diversified investment strategy spreads shareholder litigation costs). See generally EDWIN J. ELTON ET AL., MODERN PORTFOLIO THEORY AND INVESTMENT ANALYSIS (6th ed. 2002) (providing a general overview of portfolio theory).
18. See, e.g., Clifford Holderness, Liability Insurers as Corporate Monitors, 10 INT'L. REV. L. & ECON. 115, 116 (1990) (claiming that D&O insurers provide monitoring services); David Mayers & Clifford W. Smith, Jr., On the Corporate Demand for Insurance, 55 J. BUS. 281, 294 (1982) ("[I]nsurance purchases by large corporations with diffuse ownership largely eliminates risk aversion as the source of the demand for insurance and allows us to highlight other incentives, such as the real-service efficiencies provided by the insurance companies."). For a detailed discussion of the reasons corporations buy insurance, see infra text accompanying notes 142-61.
19. See Paul Rose, The Corporate Governance Industry, 32 J. CORP. L. (forthcoming 2007) (examining the increasing influence of the "corporate governance industry").
20. See, e.g., AIG SPECIMEN POLICY, supra note 14, § 2(z) (stating that the policy provides coverage for "any actual or alleged 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 CORP., EXECUTIVE PROTECTION PORTFOLIO: EXECUTIVE LIABILITY AND ENTITY SECURITIES LIABILITY COVERAGE 7 (2002), http://csi.chubb.com/products/pdf-files/14027303.pdf [hereinafter CHUBB SPECIMEN POLICY] ("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 FIN. SERVS. GROUP, DIRECTORS, OFFICERS AND COMPANY LIABILITY POLICY § IV.O (1996), http://www.hfpinsurance.com/forms/nj85.pdf [hereinafter HARTFORD SPECIMEN POLICY] (defining coverage to include "any matter claimed against the Directors and Officers solely by reason of their serving in such capacity").
21. See TILLINGHAST TOWERS PERRIN, 2004 DIRECTORS AND OFFICERS LIABILITY SURVEY 4 (2005) (reporting that "57% of the claims against [participating] public [companies] were brought by shareholders").
22. CORNERSTONE RESEARCH, SECURITIES CLASS ACTION CASE FILINGS, 2005: A YEAR IN REVIEW 4 (2006) [hereinafter CORNERSTONE] (reporting that in 2005 class action lawsuits were filed against 2.4% of the "companies [that were] listed on the NYSE, Nasdaq, and Amex at the start of the year"); RONALD I. MILLER ET AL., RECENT TRENDS IN SHAREHOLDER CLASS ACTION LITIGATION: BEYOND THE MEGA-SETTLEMENTS, IS STABILIZATION AHEAD? 3 (NERA Econ. Consulting, 2006), available at http://www.nera.com/image/ BRO_RecentTrends2006_SEC979_PPB-FINAL.pdf (estimating susceptibility of all publicly traded corporations to federal class action lawsuits in 2005 at 1.9%). The exposure of some companies, of course, is higher than others. Larger companies are sued more often than small ones and certain industries are sued more often than others. See CORNERSTONE, supra, at 14.
23. See MILLER, supra note 22, at 5. Median settlements, however, are considerably lower-$7 million in 2005-demonstrating that average settlement is driven by a small number of very large settlements. Id.
24. 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 HARTFORD SPECIMEN POLICY, supra note 20 § I.A; see also AIG SPECIMEN POLICY, supra note 14, § I.A; CHUBB SPECIMEN POLICY, supra note 20, all.
25. Typical policy language provides: The Insurer will pay on behalf of the Company Loss for which the Company has, to the extent 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, supra note 20, § I.B; see also AIG SPECIMEN POLICY, supra note 14, § 1.B(ii) (providing similar language); CHUBB SPECIMEN POLICY, supra note 20, at 2 (same). 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, supra note 20, § 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 AIG SPECIMEN POLICY, supra note 14, § 6; CHUBB SPECIMEN POLICY, supra note 20, at 12.
26. 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, supra note 20, § I.C; see also AIG SPECIMEN POLICY, supra note 14, § 1.B(i); CHUBB SPECIMEN POLICY, supra note 20, at 2. A securities claim is defined in the policy to include claims by securities holders alleging a violation of the Securities Act of 1933 or the Securities Exchange Act of 1934, or rules and regulations promulgated pursuant to either act as well as similar state laws. The policy also includes claims "aris[ing] from the purchase or sale of, or offer to purchase or sell, any Securit[y] issued by the Company" regardless of whether the transaction is with the company or over the open market. HARTFORD SPECIMEN POLICY, supra note 20, § IV.M; see also AIG SPECIMEN POLICY, supra note 14, § 1(y); CHUBB SPECIMEN POLICY, supra note 20, at 6. If the company purchases Side C coverage, the definitions of "claim," "loss," and "wrongful act" expand to include the company and not just the directors and officers.
27. See HARTFORD SPECIMEN POLICY, supra note 20, § I.A; see also AIG SPECIMEN POLICY, supra note 14, § 1.A; CHUBB SPECIMEN POLICY, supra note 20, at 2.
28. Dan A. Bailey, Side-A Only D&O Insurance, Feb. 2004, at 4, http://www.baileycavalieri.com/CM/Articles-SECTTON_II_OF_365747.pdf (reporting that "the vast majority of Claims covered under a D&O Policy are indemnified by the Company").
29. Most policies contain a "financial insolvency" exception moving the insurer's obligation to Side A of the policy when the corporation is financially unable to indemnify them. See HARTFORD SPECIMEN POLICY, supra note 20, § VI.F (providing Financial Insolvency exception); id. § IV.G. (defining financial insolvency as the status resulting from the appointment of a receiver, liquidator, or trustee to supervise "or liquidate the Company, or the Company becoming a debtor in possession"); see also AIG SPECIMEN POLICY, supra note 14, § 6 (providing that "[n]o retention amount is applicable to Crisis Loss"); CHUBB SPECIMEN POLICY, supra note 20, at 12 (providing a financial impairment exception); id. at 4 (defining financial impairment).
30. See DEL. CODE ANN. tit. 8, § 145(a) (2001) (permitting indemnification for judgments and settlements except for those actions "by or in right of the corporation"). Derivative suits are corporate lawsuits initiated by shareholders on the corporation's behalf. Direct suits are corporate lawsuits initiated by shareholders on their own behalf. See Robert B. Thompson & Randall S. Thomas, The New Look of Shareholder Litigation: Acquistion-Oriented Class Actions, 57 VAND. L. REV. 133, 137 & n.12 (2004) (finding that approximately 80% 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% of fiduciary duty claims over the same period were derivative suits).
31. See Interview with Underwriter #13 (Nov. 2005), at 16 (transcript on file with author) ("Side A is predominantly a derivative action or an insolvency exposure[;] you have a very solvent company, and you are looking at derivative territory and derivative claims [that] for the most part have been contained in lower limits certainly relative to overall security claims."); see also Interview with Underwriter #15 (Nov. 2005), at 40 (transcript on file with author) ("I think Side A ... has been viewed by the risk management community as a more inexpensive way or a more affordable way to buy D&O insurance, to give the directors the limits they need without spending as much for it.").
32. The possible grounds for shareholder complaint are many. See, e.g., WILLIAM E. KNEPPER & DAN A. BAILEY, LIABILITY OF CORPORATE OFFICERS AND DIRECTORS, § 17.02 (7th ed. 2002) (listing 170 possible grounds for liability in shareholder litigation). The basic concern underlying all of these, however, is the problem of divergence between managerial concerns and shareholder welfare-that is, "agency costs." See generally Michael C. Jensen & William H. Meckling, Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure, J. FIN. ECON., Oct. 1976, at 305 (identifying the divergence in interests between shareholder principals and manager agents as a central feature of the corporate form).
33. See Interview with Counsel #1, at 11 (Aug. 4, 2005) (transcript on file with author) ("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 actions ...."); see also Interview with Counsel #3, at 5 (Oct. 12, 2004) (transcript on file with author) ("[S]ecurities litigation outweighs derivative litigation by far.")• These arise under the Securities Act of 1933, see 15 U.S.C.A. §§ 77a-77aa (West 1997 & Supp. 2006), and the Securities Exchange Act of 1934, see 15 U.S.C.A. §§ 78a-78mm (West 1997 & Supp. 2006).
34. 15 U.S.C. § 77(1)(2) (2000); 17 C.F.R. § 240.10b-5 (2006). Sections 11 and 12(2) of the Securities Act are a distant second and third, respectively. In 2005, 93% of securities class actions alleged violations of Rule 10b-5. Only 9% alleged a section 11 violation, and only 5% alleged a section 12(2) claim. See CORNERSTONE, supra note 22, at 16-17.
35. See Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723, 749-55 (1975) (holding that only purchasers and sellers can sue for damages under Rule 10b-5).
36. See 15 U.S.C. §§ 77k, 771 (establishing "scienter" requirement); Basic Inc. v. Levinson, 485 U.S. 224, 230-32, 247 (1988) (discussing elements of a 10b-5 claim and establishing presumption of reliance on basis of "fraud-on-the-market" theory). In recent years, securities class actions have increasingly been dominated by claims involving fraud in financial reporting. See Coffee, supra note 14, at 1545 ("[A]lthough it would be an overstatement to say that the securities class action exclusively polices fraud in financial reporting, this seems to be its primary role.").
37. See HARTFORD SPECIMEN POLICY, supra note 20, § IV.J (including compensatory damages, settlement amounts, and legal fees); see also AIG SPECIMEN POLICY, supra note 14, § 1(p); CHUBB SPECIMEN POLICY, supra note 20, at 5.
38. See sources cited supra note 6. For a discussion of deductibles under Side B and C coverage, see infra note 114. Side A coverage typically has a very low deductible, if it has a deductible at all. See Richard S. Betterley, Side A D&O Liability Insurance Market Survey 2006: A Larger Market Then Expected, THE BETTERLEY REPORT, Oct. 2006, at 4, available at www.betterley.com/adobe/ SADO_06_NT.pdf (reporting that deductibles in Side A only policies "tend to be nil since board members are accustomed to a no-deductible coverage").
39. See Interview with Monitoring Counsel #1, at 13 (Jan. 24, 2006) (transcript on file with author) ("[It] tends to be only in extremely unusual cases [that] the corporation has to kick in its own money because of the application of some exclusion.").
40. This is the "fraud" exclusion. See AIG SPECIMEN POLICY, supra note 14, § 4(b)-(c); CHUBB SPECIMEN POLICY, supra note 20, at 8-9; HARTFORD SPECIMEN POLICY, supra note 20, § V.J.
41. This is the "prior claims" exclusion. See AIG SPECIMEN POLICY, supra note 14, §§ 4(d)-(e); CHUBB SPECIMEN POLICY, supra note 20, at 7 cls. 6(a)-(b); HARTFORD SPECIMEN POLICY, supra note 20, § V.C.
42. This is the "insured versus insured" exclusion. See AIG SPECIMEN POLICY, supra note 14, § 4(i); CHUBB SPECIMEN POLICY, supra note 20, at 7 cl. 6(c); HARTFORD SPECIMEN POLICY, supra note 20, § V.D.
43. See JOHN H. MATHIAS, JR. ET AL., DIRECTORS AND OFFICERS LIABILITY: PREVENTION, INSURANCE AND INDEMNIFICATION § 8.04 (4th ed. 2003) (collecting cases holding that "[i]f the exclusion requires a final adjudication, that adjudication must take place in the underlying action for which coverage is sought"); see also Little v. MGIC Indem. Corp., 836 F.2d 789, 794 (3d Cir. 1987) (noting that the final adjudication language requires an insurance company to "pay loss as the insured incurs legal obligation for such loss, subject to the requirement that the insured reimburse any monies received if it is subsequently determined in a judicial proceeding that he engaged in active and deliberate dishonesty")
44. MATHIAS ET AL., supra note 43 (noting that the application of the final adjudication provision "drastically diminishes the force and effect of the [actual fraud] exclusion"). Some more recent policies contain broader fraud exclusions, but these exclusions have not yet been tested. Id.
45. See E-mail from Underwriter #4 to Tom Baker, supra note 13 (stating that "it is pretty standard now for the carriers to agree to final adjudication").
46. Corporate fiduciary duty claims must often be brought as shareholder derivative actions. Derivative suit procedures require that shareholder plaintiffs first demand that the corporation's board of directors pursue the claim on their behalf and, if the board elects not to do so, also bind the shareholders to the board's decision. Only where the board itself is conflicted will demand be excused, thus allowing shareholders to pursue the suit without consent of the board. See generally Grimes v. Donald, 673 A.2d 1207 (Del. 1996) (discussing derivative suit procedures); Zapata Corp. v. Maldonado, 430 A.2d 779 (Del. 1981) (same). Derivative suits proceeding without the consent of the board are carved out of the insured v. insured exclusion.
47. See AIG SPECIMEN POLICY, supra note 14, § 4(k); CHUBB SPECIMEN POLICY, supra note 20, at 7 cl. 6(d); HARTFORD SPECIMEN POLICY, supra note 20, § V.E.
48. See AIG SPECIMEN POLICY, supra note 14, § 4(m); CHUBB SPECIMEN POLICY, supra note 20, at 7 cl. 6(f); HARTFORD SPECIMEN POLICY, supra note 22, § V.G.
49. See AIG SPECIMEN POLICY, supra note 14, §§ 4(h), 4(l); CHUBB SPECIMEN POLICY, supra note 20, at 7 cl. 6(e); HARTFORD SPECIMEN POLICY, supra note 20, § V.A.
50. See AIG SPECIMEN POLICY, supra note 14, §§ 4(f)-(g); CHUBB SPECIMEN POLICY, supra note 20, at 7 els. 6(g)-(h); HARTFORD SPECIMEN POLICY, supra note 20, § V.F.
51. Each of these types of peripheral claims is covered by another form of liability insurance.
52. See ELAINE BUCKBERG ET AL., NERA ECON. CONSULTING, RECENT TRENDS IN SHAREHOLDER CLASS ACTION LITIGATION: ARE WORLDCOM AND ENRON THE NEW STANDARD? 5 (2005), as reprinted in SECURITIES LITIGATION & ENFORCEMENT INSTITUTE 405, 409 (PLI ed., 2005) ("[S]ettlements on behalf of directors are typically wholly paid by D &O insurers ....").
53. TILLINGHAST, 2005 SURVEY, supra note 5, at 29 tbl.17C.
54. Tillinghast reports mid cap limits in three categories: 1) companies with market capitalizations between $1 billion and $2 billion, which purchased mean limits of $44.88 million and median limits of $30 million; 2) companies with market capitalizations between $2 billion and $5 billion, which purchased mean limits of $83.2 million and median limits of $75 million; and 3) companies with market capitalizations between $5 billion and $10 billion, which 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 observations in the Tillinghast sample.
55. See id. The median reported for companies with market capitalizations in excess of $10 billion was $125 million.
56. See Interview with Risk Manager #3, at 6 (Dec. 15, 2005) (transcript on file with author) ("[T]he most that we could purchase for the corporate side was in the 200 to absolute maximum 300 million available."); see also Interview with Underwriter #13, at 37-38 (Nov. 2005) (transcript on file with author).
57. See Coffee, supra note 14, at 1543 tbl.3 (listing settlements in recent notable cases, including settlements in excess of $300 million); see also Bernard S. Black et al., Outside Director Liability, 58 STAN. L. REV. 1055, 1118-25 (2006) (describing the Enron and WorldCom settlements in excess of policy limits).
58. See SIMMONS & RYAN, supra note 6, at 3.
59. Our research methods are described in our companion article, Baker & Griffith, supra note 8. For a brief description of the methods, see supra note 12.
60. See, e.g., George M. Cohen, Legal Malpractice Insurance and Loss Prevention: A Comparative Analysis of Economic Institutions, 4 CONN. INS. L.J. 305, 324-27 (1997-98) (providing an institutionalist account of this assertion); Shavell, supra note 17, at 121-22 (providing the standard account of this assertion).
61. See, e.g., HAKON WITH ANDERSEN & JOHN PETER COLLETT, ANCHOR AND BALANCE: DET NORSKE VERTTAS, 1864-1989 (1989) (providing a historical account linking the insurance industry and ship construction); RICHARD V. ERICSON & AARON DOYLE, UNCERTAIN BUSINESS: RISK, INSURANCE AND THE LIMITS OF KNOWLEDGE 94-211 (2004) (reporting research from a variety of contexts including building construction and disability management); Elizabeth O. Hubbart, When Worlds Collide: The Intersection of Insurance and Motion Pictures, 3 CONN. INS. L.J. 267, 272-74, 276-79 (1996-97) (reporting research on motion picture production); Pat O'Malley, Legal Networks and Domestic Security, in 11 STUDIES IN LAW POLITICS, AND SOCIETY 171 (Austin Sarat & Susan S. Silbey eds., 1991) (reporting research on theft prevention in private homes); Simon, supra note 11, at 27-28 (reporting research on fraternities); see also Tom Baker, Risk, Insurance, and the Social Construction of Responsibility, in EMBRACING RISK: THE CHANGING CULTURE OF INSURANCE AND RESPONSIBILITY 33 (Tom Baker & Jonathan Simon eds., 2002) (placing loss prevention into a larger context of the social construction of responsibility by insurance organizations).
62. Clifford Holderness asserts: Insurance companies monitor their customers' directors and top managers in a number of ways. When it decides to issue a policy, the insurer investigates the firm's past actions, occasionally requires changes in the board, and sets conditions for directors and officers to observe. When allegations of misconduct arise, the insurer through its defense efforts can serve as an independent external investigator of not only the accused official but the entire board and top managerial team. Clifford G. Holderness, Liability Insurers as Corporate Monitors, 10 INT'L REV. L. & ECON. 115, 116 (1990). In 1997, Noel O'Sullivan reported that he had supported Holderness's monitoring thesis in the United Kingdom (which, unlike the United States, had required corporations to disclose the purchase of D&O insurance). Finding a correlation between the number of outside directors and the likelihood that the corporation purchased D&O insurance, O'Sullivan reasoned that inside directors are better able to monitor the corporation and, thus, do not need the D&O insurer to serve that role. Noel O'Sullivan, Insuring the Agents: The Role of Directors' and Officers' Insurance in Corporate Governance, 64 J. RISK & INS. 545 (1997).
63. Holderness did not provide any empirical evidence in support of his assertion that insurance companies monitor customers' managers. See Holderness, supra note 62. Although Noel O'Sullivan's study did offer empirical evidence, his correlation between the number of outside directors and the purchase of D&O insurance does not confirm Holderness's hypothesis. See O'Sullivan, supra note 62. That correlation is more likely to reflect the outside directors' demand for risk distribution services to protect themselves than their demand for monitoring to protect shareholders (especially because, as we report, the insurance that the corporation does buy does not provide monitoring). The only other reported research on D&O insurance monitoring found that English D&O insurers were not providing monitoring services in the early 1990s. See Vanessa Finch, Personal Accountability and Corporate Control: The Role of Directors' and Officers' Liability Insurance, 57 MOD. L. REV. 880, 908 (1994) ("United Kingdom insurers have not to date, however, developed systems that routinely give attention to individual directors.").
64. Interview with Underwriter #5, at 30 (Dec. 2005) (transcript on file with author).
65. By contrast, loss prevention conditions and advice are frequently provided in the private and non-profit D&O insurance market. In that market, D&O insurance is sold as part of a package policy that also insures against employment liability risks. Employment liability is a more significant risk in that market and is the main subject of the insurers' loss prevention efforts. See, e.g., Nancy H. Van der Veer, Note, Employment Practices Liability Insurance: Are EPLI Policies a License to Discriminate? Or Are They a Necessary Reality Check For Employers?, 12 CONN. INS. L.J. 173, 194-204 (2005-2006) (reporting that EPLI insurance was a byproduct of D&O insurance and describing the loss prevention aspects of EPLI underwriting and the risk management services offered to insureds).
66. Interview with Underwriter #8, at 50-51 (Dec. 15, 2005) (transcript on file with author).
67. See Tom Baker, Medical Malpractice and the Insurance Underwriting Cycle, 54 DEPAUL L. REV. 393, 396 (2005) (reviewing literature on the liability insurance underwriting cycle); see also Baker & Griffith, supra note 8 (addressing the cycle in D&O underwriting specifically).
68. Interview with Underwriter #5, supra note 64, at 29.
69. Interview with Underwriter #7, at 11 (Nov. 2005) (transcript on file with author). The product manager is the individual with overall responsibility for the profitability of a particular line of business in a company with multiple business areas.
70. Interview with Underwriter #4, at 15 (Aug. 4, 2005) (transcript on file with author).
71. Id. at 16.
72. Id.
73. Id.
74. E-mail from Underwriter #4 to author (July 30, 2006, 12:26:00 CST) (on file with author). In a follow-up communication, the product manager explained that "[t]he prices were undercut just because of the competitive nature of the marketplace" and that "the competition did not relate in any economic way to the loss prevention services, but rather to the abundance of carriers willing to write the risk and hungry for premium." E-mail from Underwriter #4 to author (Feb. 2, 2007, 12:37:00 EST) (on file with author). But even if the provision of loss prevention services did make the primary layer of insurance more expensive, this would not mean that the cost of the loss prevention services exceeded the benefits. As reported in our companion article, D&O insurance programs consist of layers of insurance policies, typically sold by different insurance companies. See Baker & Griffith, supra note 8. The value of the loss prevention services accrues to all of the insurers in the program (as well as the insured corporation); it is to be expected that the insurer in the program that is providing the loss prevention services will expect to be paid more than the other insurers.
75. Interview with Underwriter #4, supra note 70, at 16.
76. See infra text accompanying note 197 (addressing the public good nature of best practices type advice).
77. Interview with Broker #1, at 7-8 (Sept. 2005) (transcript on file with author). The D&O product manager of yet another leading D&O insurer explained his understanding of this situation as follows: [Y]ou're dealing with, generally, a lot of times the CEO, the general counsel, and these guys have egos to fill this room. You're a thirty or forty year old underwriter in the insurance business, and although your policy is very important to them and has been the last couple of years, since they've all been kind of crucified, you're going to have a hard time saying, you know, "You need one more outside director." Interview with Actuary #2, at 27 (joint interview with chief actuary and D&O product manager) (Feb. 2006) (transcript on file with author).
78. Interview with Underwriter #7, at 11-12 (Nov. 2005) (transcript on file with author).
79. See supra note 12 (explaining our methodology).
80. See Baker & Griffith, supra note 8.
81. Id. While we cannot evaluate whether this claim is correct, we can observe that insurers have a strong incentive to price in this manner and they regularly receive feedback on how well they are doing. Id.
82. Cohen, supra note 60, at 325; see also Mayers & Smith, supra note 18, at 285 (noting that ""[i]nsurance firms develop a comparative advantage in processing claims because of economies of scale and ... specialization").
83. See KENNETH S. ABRAHAM, THE LIABILITY CENTURY (forthcoming 2007) (describing history of defense coverage in liability policies).
84. For individuals, this coverage is provided as part of the homeowners or renters insurance package policies. For small businesses, this coverage is provided as part of the business owners or farmers package policies. For larger businesses, this coverage is purchased separately as commercial general liability insurance.
85. See Tom Baker, Liability Insurance Conflicts and Defense Lawyers: From Triangles to Tetrahedrons, 4 CONN. INS. L.J. 101, 107-08 (1998) (explaining why "[a] rational prospective insured would prefer a liability insurance contract giving the company [control over the defense] ... [o]therwise the insured would demand at the point of claim a level of defense that he would not be willing to pay for at the time of purchasing the policy").
86. See supra note 38 and accompanying text.
87. See id. As discussed infra text accompanying notes 101-04, two leading D&O insurers do maintain lists of preferred counsel, but this practice does not appear to hold down defense costs.
88. See supra text accompanying notes 52-58.
89. See Tom Baker & Sean J. Griffith, Directors' and Officers' Insurance in the Defense and Settlement of Shareholder Litigation (work in progress) (studying the role of D&O insurance in the defense and settlement of shareholder litigation).
90. See, e.g., Mark V. Pauly, The Economics of Moral Hazard: Comment, 58 AM. ECON. REV. 531, 535-36 (1968) (explaining in the health insurance context how service providers are affected by ex post moral hazard).
91. For a structural analysis of the dynamics of settlements within limits, see Baker, supra note 85.
92. See, e.g., A.M. BEST CO., AGGREGATES AND AVERAGES PROPERTY/CASUALTY (2005 ed.) (separately reporting indemnity and defense components of losses for medical malpractice, general liability, and auto liability insurance).
93. TILLINGHAST, 2005 SURVEY, supra note 5, at 112 tbl.106.
94. Id. at 111 tbl.103.
95. This is a conservative estimate. At a D&O industry conference, one senior underwriter reported that defense costs commonly were twenty-five to thirty-five percent of the settlement amount and sometimes as high as fifty percent. Transcript of New York Seminar #1 (name withheld for confidentiality), at 7 ("We are seeing some abuses but, even where you don't have abuses, we are seeing defense costs not just 25 to 35% of the settlement,... but sometimes 50% or 100% of the settlement").
96. Interview with Claims Manager #1, at 10 (Dec. 2005) (transcript on file with author).
97. Transcript of Conn. D&O Insurance Seminar #1 (name withheld for confidentiality), at 8-9.
98. Id.
99. Indeed, at least some of the increased costs are likely to be a rational response to the increased damage claims.
100. See Douglas R. Richmond, The Business and Ethics of Liability Insurers' Efforts to Manage Legal Care, 28 U. MEM. L. REV. 57, 80 (1997) ("By establishing relationships with select firms, insurers can negotiate reduced hourly fees and special fee arrangements in exchange for continuing business. Controlling the defense also allows an insurer to participate in strategic decisions and to seize settlement opportunities.") .
101. The first list that we obtained contains 552 law firms, 257 of which are multiple offices of the same national firms. The second list we obtained contains 182 firms, of which 77 are multiple offices. Of note, both lists contain prominent New York firms such as Sullivan & Cromwell and Cravath, Swaine & Moore.
102. See also Christopher W. Martin, Directors and Officers Insurance, HOUSTON LAW, Mar.-Apr. 2004, at 38, 41 (reporting that "the corporate policyholder may be able to negotiate with the insurer to add the insured's preferred firm").
103. Interview with Claims Manager #2, at 20 (Jan. 30, 2006) (transcript on file with author).
104. Interview with Monitoring Counsel #1, supra note 39, at 11.
105. See Rose, supra note 19.
106. As discussed in the gatekeeper literature, accounting firms, law firms and other "reputational intermediaries" bond their services through their reputation. See, e.g., Stephen Choi, Market Lessons for Gatekeepers, 92 Nw. U. L. REV. 916, 942 (1998) ("To avoid the collapse of the certification market due to certifier infidelity, certifiers may bond themselves to remaining faithful•in their screening role."); John C. Coffee, Jr., Gatekeeper Failure and Reform: The Challenge of Fashioning Relevant Reforms, 84 B.U. L. REV. 301, 302 (2004) (defining gatekeepers as "independent professionals who pledge their reputational capital"); John C. Coffee, Jr., Understanding Enron: "It's About the Gatekeepers, Stupid," 57 BUS. LAW. 1403, 1405 (2002) ("[A reputational gatekeeper's] relative credibility stems from the fact that it is in effect pledging a reputational capital that it has built up over many years of performing similar services for numerous clients."); Assaf Hamdani, Gatekeeper Liability, 77 S. CAL. L. REV. 53, 93 n.94 (2004) ("It is commonly assumed, for example, that underwriters' concern for their reputation would make them investigate the quality of prospective issuers even in the absence of liability."); Frank Partnoy, Barbarians at the Gatekeepers?: A Proposal for a Modified Strict Liability Regime, 79 WASH. U. L.Q. 491, 495 (2001) ("The arguments in favor of gatekeeper liability assume that when it is too costly for the issuer to bond itself... one or more third party intermediaries will be able to step in and offer their reputation as a replacement for the issuer's bond.").
107. See Griffith, supra note 7, at 1179-80.
108. See sources cited supra note 15.
109. See Baker, supra note 15, at 276.
110. See id. at 276 n.186 (restating the conditions for moral hazard in the ex post context).
111. See id. at 286 (finding that "increasing [workers' compensation] benefits provides limited incentive for workers to be careless" because "[m]oney does not fully compensate workers for bodily injury, and ... workers do not control ... their working environment").
112. See Marc Galanter, Planet of the APs: Reflections on the Scale of Law to its Users, 53 BUFF. L. REV. 1369, 1373 (2006) (reviewing literature supporting the claim that, "[t]o a far greater extent than natural persons, [corporations] may be capable of acting in the purposeful, rational, calculating fashion that the legal system prefers to ascribe to actors").
113. See supra text accompanying notes 62-75.
114. See TILLINGHAST, 2005 SURVEY, supra note 5, at 59 tbl.47. The most recent Tillinghast D&O survey contains information on the deductibles for B and C side coverage organized by asset size of the survey respondents. Corporations with $50 to $100 million assets reported median and mean deductibles of approximately $300,000 and $500,000, respectively. By contrast, corporations with over $10 billion assets reported median and mean deductibles of $5 million and $8.9 million. See id. at 112 tbl.107.
115. See Shavell, supra note 15, at 541 (noting that incomplete coverage is a partial solution to the problem of moral hazard).
116. EXECUTIVE RISK INDEM., INC., EXECUTIVE LIABILITY POLICY III.A.1. Similar language appears in the AIG, Chubb, and Hartford policies. See supra note 42. 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, supra note 14, § 4(a); CHUBB SPECIMEN POLICY, supra note 20, §§ 7-8; HARTFORD SPECIMEN POLICY, supra note 20, § V.I.
117. See supra text accompanying note 45.
118. See supra note 45.
119. See Interview with Monitoring Counsel #1, supra note 39, at 13 (explaining that the "severability of exclusions" means that "there always is an individual for whom the exclusion won't apply"); see also AIG SPECIMEN POLICY, supra note 14, at 7 (providing that "the facts pertaining to and knowledge possessed by any Insured shall not be imputed to any other Insured Person" for purposes of the dishonest or fraudulent act exclusion). Note that there is no good research on the frequency of out of pocket payments by insiders; this is a topic addressed in our ongoing D&O insurance claims research.
120. For example, the D&O insurers for Enron paid notwithstanding the eventual criminal convictions of corporate officers. Indeed, the Washington Post reported that the D&O insurance payments included $17 million to Jeffrey Skilling's criminal defense lawyers. See Carrie Johnson, After the Enron Trial, Defense Firm is Stuck with the Tab, WASH. POST, June 16, 2006, at D1.
121. See supra text accompanying notes 82-104.
122. See supra note 52 and accompanying text.
123. See Baker & Griffith, supra note 8.
124. See id.
125. See Griffith, supra note 7.
126. See id. (arguing, on the basis of this reasoning, that they should be).
127. See, e.g., Randy Parr, Directors and Officers Insurance, in D&O LIABILITY INSURANCE 2004: DIRECTORS AND OFFICERS UNDER FIRE 14 (Practicing L. Inst. ed. 2004) (referring to D&O liability insurance and "providfing] the protection directors and officers demand and require"); see also Finch, supra note 63, at 880 ("Balancing such potential personal liability is the availability of company funded directors' and officers' insurance ....").
128. Commentators recognized long ago that D&O insurance coverage represents a form of compensation for directors and officers. See, e.g., Joseph F. Johnston, Jr., Corporate Indemnification and Liability Insurance for Directors and Officers, 33 BUS. LAW. 1993, 2013 (1978) (stating that the fact that the corporation paid D&O premiums "was nothing more than another form of compensation for the executives and a way of attracting capable managers"). Early D&O policies required individual officers and directors to pay a portion of the premium, usually 10%. See Wallace, More on Sitting Ducks: (Officers and Directors, That Is), INSURANCE, Apr. 16, 1966, at 32, 36 (describing then-typical "ratio of 90% of the premium to the corporation and 10% to the officers and directors"). Insurers have discontinued this aspect of the policy, presumably because individual directors and officers asked for and received corporate payment of the full premium.
129. KARL BORCH, ECONOMICS OF INSURANCE 13-15, 163 ( Knut K. Aase & Agnar Sandmo eds., 1990) (describing the insurance premium as the sum of the expected claim payment under the insurance contract, the administrative expenses of the insurance company, and the reward to the insurer for bearing the risk, and later referring to the difference between expected claims payments and the insurance premium as the "loading" of the contract). Due to the limits of publicly available data, these loading costs cannot be computed with precision, but they are reported to be somewhere between twenty and thirty percent. Marc Siegel, The Dilemmas in the D&O Market: Where Do We Go from Here?, Presentation at 2006 D&O Symposium of the Professional Liability Underwriting Society, at slides 3 and 4 (Feb. 1,2006), http://www.plusweb.Org/Downloads/Events/ Dilemmas_in_The_DO_Market.ppt (assuming an average expense ratio of 23% for all D&O insurance).
130. As a result, individuals ought to purchase insurance only against large potential losses that, if incurred, would significantly diminish their quality of life and not against small losses-through extended consumer warranties, for example-that one could easily bear oneself. See ROBERT I. MEHR & EMERSON CAMMACK, PRINCIPLES OF INSURANCE 35 (6th ed. 1976) ("Insurance for small losses which can be absorbed is uneconomical because the insurance premium includes not only the loss cost but also an expense margin.").
131. See generally ELTON ET AL., supra note 17.
132. Some portion of securities fraud surely is systemic. For one thing, securities fraud losses are likely to be biased in one direction-that is, the losses are typically incurred when an artificially inflated price deflates. In addition, asset bubbles may increase the likelihood of securities violations, and the bursting of a bubble surely increases the likelihood that violations will be detected, suggesting not only that the losses are biased in one direction, but also that they are correlated to at least some degree. Nevertheless, unless there is reason to believe that D&O insurance can spread these systemic risks better than holding a diversified portfolio, and we can think of no such reason, the systemic aspect of securities fraud does not provide a justification for D&O insurance.
133. Cf. Zohar Goshen & Gideon Parchamovsky, The Essential Role of Securities Regulation, 55 DUKE L.J. 711 (2006) (suggesting that "information traders," because of their important role in maintaining the efficiency of capital markets and their constant exposure to misinformation risk, represent the rare case of non-diversified investors who might justifiably benefit from the compensation provided by securities liability). Goshen and Parchamovsky define "information traders" as investors who "specialize in gathering and analyzing general market and firm-specific information." Id. at 714. Whether pure risk distribution D&O insurance provides sufficient benefit to "information traders" to justify the costs to other, diversified shareholders is an empirical question that we leave for later work.
134. Cf. TOM BAKER, TASK FORCE TO MODERNIZE SECURITIES LEGISLATION IN CANADA, INSURANCE AGAINST MISINFORMATION IN THE SECURITIES MARKET (2006), available at http://www.tfmsl.ca/docs/V2(4)%20Baker.pdf (evaluating a proposal for first party insurance against misinformation losses and rejecting the compensation justification even for non-diversified investors); Sean J. Griffith, Daedalean Tinkering, 104 U. Mich. L. Rev. 1247, 1254-58 (2006) (critiquing proposal for an investor insurance scheme).
135. We do not address in this Article forms of insurance other than D&O insurance, but it is clear that some of these same concerns apply to all corporate insurance. Our intuition is that D&O insurance differs from most other traditional forms of corporate insurance in terms of the moral hazard that is presented, because the behavior that leads to securities class actions is more likely to be the behavior of the senior executives than the behavior that leads to many other large insured losses, such as factory fires or mass tort actions.
136. See Bailey, supra note 28 (reporting that Side A coverage is becoming more prevalent). But see TILUNGHAST, 2005 SURVEY, supra note 5, at 47 (reporting that about 2% of all insured participants purchased side A coverage only).
137. Interview with Risk Manager #3, supra note 56, at 3.
138. The transition took place within the last five years. In his words: [T]here is probably 25% or maybe even less of the large corporate buyers have evolved to [Side-A-only coverage]. And again, ... this is a relatively recent ... occurrence for us. If you look in the rearview mirror, four years ago we were buying insurance similar to the way a lot of our peers still buy it, which is ... A, B, C coverages. Id. at 4.
139. On this last point, he said: "the value of the B and C coverage was not nearly as great [as the value of the A coverage], because ... the size of the limits that we are purchasing didn't really protect our [balance sheet] adequately." Id. at 5.
140. Id. at 7-8.
141. Id. at 9.
142. See Bailey, supra note 28, at 7 (describing a recent case where a corporation settled its securities claim for the limits of its traditional D&O policy, leaving the directors and officers potentially exposed to an unsettled derivative claim).
143. See La. World Exposition v. Federal Ins. Co., 832 F.2d 1391, 1401 (5th Cir. 1987) (holding that the proceeds of Side A coverage is not the property of the corporation while not deciding the allocation issues raised by the existence of Side B coverage); see also In re First Cent. Fin. Corp., 238 B.R. 9, 17 (Bankr. E.D.N.Y. 1999) (reviewing case law and noting that Side B and Side C coverage raise allocation issues).
144. Bailey, supra note 28, at 4 ("Since the vast majority of Claims covered under a D&O policy are indemnified by the Company, a Side-A only D&O Policy allows Insurers to afford much broader coverage terms than reasonably possible under a Side-B policy.").
145. Mayers and Smith addressed this puzzle in a series of articles. See e.g., David Mayers & Clifford W. Smith, Jr., Corporate Insurance and the Underinvestment Problem, 54 J. RISK & INS. 45 (1987) [hereinafter Underinvestment]; Mayers & Smith, supra note 18; David Mayers & Clifford W. Smith, Jr., On the Corporate Demand for Insurance: Evidence from the Reinsurance Market, 63 J. BUS. 19 (1990) [hereinafter Reinsurance]; see also Richard MacMinn & James Garven, On Corporate Insurance, in HANDBOOK OF INSURANCE 541 (George Dionne ed., 2000) (summarizing prior literature).
146. See Mayers & Smith, supra note 18, at 289-91, 294-95 (describing and modeling tax incentives for corporate insurance purchases); MacMinn & Garven, supra note 145, at 557-60 (same).
147. See Mayers & Smith, supra note 18, at 284-85; MacMinn & Garven, supra note 145, at 548-55.
148. See Mayers & Smith, supra note 18, at 287 (noting that "[b]ond indentures frequently contain covenants requiring the firm to maintain certain types of insurance coverage"); MacMinn & Garven, supra note 145, at 550-57 (modeling corporate insurance as a means to mitigate agency problems between corporate managers and bondholders).
149. See generally Kenneth A. Froot, David S. Scharfstein & Jeremy C. Stein, Risk Management: Coordinating Corporate Investment and Financing Policies, J. FIN., Dec. 1993, at 1629 (reviewing prior explanations for corporate insurance and identifying the external cost of capital as an important additional explanation).
150. See Mayers & Smith, supra note 18, at 286. See also Mayers & Smith, Underinvestment, supra note 145, at 46 (summarizing the monitoring services).
151. See Rev. Rul. 80-211, 1980-2 C.B. 57 (concluding that even "[a]mounts paid as punitive damages incurred by the taxpayer in the ordinary conduct of its business operations are deductible as an ordinary and necessary business expense under section 162 of the Code").
152. See MacMinn and Garven, supra note 145, at 559-60.
153. See John Core, On the Corporate Demand for Directors' and Officers' Insurance, 64 J. RISK & INS. 63, 68 n.10 (1997) (arguing that "any tax effects are at most second-order in magnitude").
154. See MacMinn and Garven, supra note 145, at 548-50.
155. See supra note 114 (summarizing relationship between deductibles and asset size); Interview with Risk Manager #3, supra note 56, at 6 ("[T]he most we could purchase for the corporate side was in the 200 to absolute maximum 300 million available. I mean our balance sheet is billions of dol· lars.... [E]xcess of 300 million or whatever insurance we could buy, we were self-assuming that."). By contrast, insurance limits of $1 billion or more are relatively common in the property and general liability insurance programs of large corporations.
156. Mayers & Smith, Underinvestment, supra note 145, at 51-52.
157. Froot et al., supra note 149, at 1631.
158. Froot and colleagues also observed that hedging can provide private benefits to managers and, thus, managers may act as if the cost of external capital is more costly than it is. Id. at 1634. We regard this as an example of an agency cost, an explanation that we address more fully infra, text accompany· ing notes 174-85.
159. For present purposes it is immaterial whether the corporation sets up an internal reserve or, instead, sets up a captive insurance company or a trust. All three options receive essentially the same tax treatment. See generally Richard M. Cieri & Michael J. Riela, Protecting Directors and Officers of Corporations That Are Insolvent or in the Zone or Vicinity of Insolvency: Important Considerations, Practical Solutions, 2 DEPAUL BUS. & COMM. L.J. 295 (observing the comparable taxability of these three mechanisms). However, "captured" insurance companies may not be classified as being in the business of insurance if they are wholly owned by one corporation. This is due largely to the absence of risk-spreading. As a consequence, unrelated corporations have begun to pool their assets to create group captured insurance companies that would side-step this particular limitation. Id. at 337.
160. This will be especially true for companies that fuel growth by reinvesting cash flows into the business.
161. See generally Richard L. Shockley & Anjan V. Thakor, Bank Loan Commitment Contracts: Data, Theory, and Tests, 29 J. MONEY CREDIT & BANKING 517 (1997) (theoretically and empirically examinining the contract design features of bank loan commitments). Among other differences between loan commitments and D&O insurance policies, "virtually all [loan] commitments contain an escape clause that allows the issuing bank to deny credit if the borrower's financial condition has changed in a material way." Id. at 518.
162. See Mayers & Smith, supra note 18, at 285.
163. Mayers and Smith use the example of property insurers that require the installation of sprinkler systems to reduce the risk of fire. Id. at 286.
164. See id. at 287-88.
165. Id. See also MacMinn & Garven, supra note 145, at 542-44 (supporting these arguments as sound theoretical bases for corporate insurance).
166. See Interview with Risk Manager #1, at 33-34 (Jan. 25, 2006) (transcript on file with author).
167. Id. at 34 (concluding that "the knock I have heard in panel discussions, things like that, is that the credit that you get for dropping [B and C Side coverage] is not worth what you are actually getting if you are losing coverage"). Complicating this analysis is the fact that Side-A-only policies may offer broader protection for the directors and officers. See supra text accompanying notes 141-43.
168. Interview with Risk Manager #2, at 33 (Feb. 13, 2006) (transcript on file with author).
169. Interview with Risk Manager #4, at 15 (Jan. 25, 2006) (transcript on file with author).
170. See Sean M. Fitzpatrick, Fear Is the Key: A Behavioral Guide to Underwriting Cycles, 10 CONN. INS. L.J. 255 (2004) (providing a behavioral explanation for cyclical mispricing).
171. See generally Kenneth S. Abraham, The Rise and Fall of Commercial Liability Insurance, 87 VA. L. REV. 85, 99-105 (2001) (describing the "era of the big claim exclusion" that began in the 1980s).
172. Interview with Associate General Counsel #1 (May 6, 2006) (documentation on file with author).
173. D&O insurance policies are "claims made" policies, meaning that they apply to claims made during the policy period regardless when the underlying injury took place. By contrast, the commercial general liability insurance policies typically apply to injury during the policy period, regardless when the claim eventually is made. See generally Bob Works, Excusing Nonoccurrence of Insurance Policy Conditions in Order to Avoid Disproportionate Forfeiture: Claims-Made Formats as a Test Case, 5 CONN. INS. L.J. 505, 513-49 (1999) (providing a taxonomy of claims made policies).
174. See infra text accompanying notes 201-03.
175. See generally Jensen & Meckling, supra note 32, at 5-6 (describing agency costs as the divergence in interests between shareholder principals and manager agents).
176. See generally LUCIAN BEBCHUK & JESSE FRIED, PAY WITHOUT PERFORMANCE: THE UNFULFILLED PROMISE OF EXECUTIVE COMPENSATION (2004) (explaining excessive compensation as an example of agency costs imposed by management on shareholders).
177. The investment of human capital, in other words, is not easily diversified. See Mayers & Smith, supra note 18, at 283.
178. See generally BEBCHUK & FRIED, supra note 176 (detailing defects in the design of executive compensation packages that lead to similarly distorted incentives).
179. See Griffith, supra note 7, at 1172-73.
180. Cf. Froot et al., supra note 149, at 1634 (describing potential private benefits to hedging).
181. John M. Chalmers, Larry Y. Dann, & Jarrad Harford, Managerial Opportunism? Evidence from Directors'and Officers'Insurance Purchases, 57 J. FIN. 609, 609-10 (2002).
182. Id. at 611.
183. Core, supra note 153, at 81.
184. Id.
185. Interview with Risk Manager #2, at 34-35 (Feb. 13, 2006) (transcript on file with author).
186. Interview with Claims Manager #1, supra note 96, at 27.
187. Cohen, supra note 60, at 343.
188. As reported in our companion article, no single D&O insurer is willing to sell very high limits to any single corporation, with the result that D&O insurers hold a large portfolio of D&O risks. See Baker & Griffith, supra note 8 (reporting $50 million as the largest limit available from any one insurer and noting that in the recent hard market, no insurance company offered a policy larger than $25 million, with most policy limits set at $10 million or less). Corporate governance rating firms, by contrast, may have conflicts of interest because they provide consulting services to corporations. See Rose, supra note 19 (noting this conflict of interest with reference to Institutional Shareholder Services).
189. See Roberta Romano, The Sarbanes-Oxley Act and the Making of Quack Corporate Gover¶ nance, 114 YALE L.J. 1521, 1528-29 (2005) (describing how corporate governance entrepreneurs have advocated governance innovations that make little or no difference in a corporation's susceptibility to risk). Because the insurer ultimately bears corporate governance risk, it is unlikely to be fooled by merely cosmetic governance features.
190. See, e.g., Janet Cooper Alexander, Do the Merits Matter? A Study of Settlements in Securities Class Actions, 43 STAN. L. REV. 497, 499-500 (1991) (arguing that the merits of securities claims do not drive outcomes in settlements); see also William S. Lerach, The Private Securities Litigation Reform Act of 1995-27 Months Later: Securities Class Action Litigation Under the Private Securities Litigation Reform Act's Brave New World, 76 WASH. U. L.Q. 597, 598 (1998) (stating that Congress "relied heavily upon Professor Janet Cooper Alexander's article" in its 1995 reform of the securities laws). But see, e.g., James D. Cox, Making Securities Fraud Class Actions Virtuous, 39 ARIZ. L. REV. 497, 503-04 (1997) (critiquing Alexander's methodology and conclusions); Elliott J. Weiss & John S. Beckerman, Let the Money Do the Monitoring: How Institutional Investors Can Reduce Agency Costs in Securities Class Actions, 104 YALE L.J. 2053, 2084 (1995) (disputing Alexander's findings).
191. See, e.g., Marilyn F. Johnson et al., Do the Merits Matter More? The Impact of the Private Securities Litigation Reform Act, J.L. ECON. & ORG. (forthcoming), available at http://ssrn.com/abstract=883684 (finding "a significantly greater correlation between litigation and both earnings restatements and abnormal insider selling after the PSLRA."); see also Baker & Griffith, supra note 8 (explaining that the use of corporate governance factors in D&O insurance risk-based pricing suggests that the merits matter); Stephen J. Choi, The Evidence on Securities Class Actions, 57 VAND. L. REV. 1465 (2004) (summarizing recent empirical work on the question of whether the merits matter).
192. See Baker & Griffith, supra note 8.
193. See id.
194. See Lawrence A. Cunningham, Choosing Gatekeepers: The Financial Statement Insurance Alternative to Auditor Liability, 52 UCLA L. REV. 413 (2004) (elaborating the FSI concept first suggested by Ronen); Joshua Ronen, Post-Enron Reform: Financial Statement Insurance and GAAP Re-visited, 8 STAN. J.L. BUS. & FIN. 39 (2002) (describing the FSI concept); see also Lawrence A. Cunningham, Too Big to Fail: Moral Hazard in Auditing and the Need to Restructure the Industry Before it Unravels, 106 COLUM. L. REV. 1698, 1738 (2006) (arguing that FSI should be mandatory).
195. See Joseph A. Grundfest, Punctuated Equilibria in the Evolution of United States Securities Regulation, 8 STAN. J.L. BUS. & FIN. 1,7 (2002) (describing FSI with approval but noting "that the current structure of D&O insurance and auditor liability has failed to give rise to incentives comparable to those [Ronen] predicts would arise under his FSI proposal7quot; even though "D&O insurers could today easily make the retention of insurer-approved auditors a condition of coverage"); David B. Kahn & Gary S. Lawson, Who's the Boss?: Controlling Auditor Incentives through Random Selection, 53 EMORY L.J. 391, 424-25 (2004) (noting that "Professor Ronen is on the right track" but arguing that insurers would not be willing to serve the role that Ronen envisions); Patricia A. McCoy, Realigning Auditors' Incentives, 35 CONN. L. REV. 989, 1010-12 (2003) (discussing the various advantages and disadvantages of FSI); Larry E. Ribstein, Market vs. Regulatory Resposes to Corporate Fraud: A Critique of the Sarbanes-Oxley Act of 2002, 28 J. CORP. L. 1, 55 (2002) (same); Amy Shapiro, Who Pays the Auditor Calls the Tune? Auditing Regulation and Clients' Incentives, 35 SETON HALL L. REV. 1029, 1085-86 (2005) (endorsing FSI).
196. Because the accounting firm would simply be providing a warranty of the audit, we do not believe that this warranty would violate the Sarbanes-Oxley prohibition on the provision of nonaudit services. See 15 U.S.C. §78(j)-(I)(g) (2000 & Supp. 2004). The warranty would not contravene the three principles that the SEC has stated that it will use in defining nonaudit services: "an auditor cannot (1) audit his or her own work, (2) perform management functions, or (3) act as an advocate for the client." Strengthening the Commission's Requirements Regarding Auditor Independence, 67 Fed. Reg. 76,780, 76,783 (Dec. 13, 2002) (to be codified at 17 C.F.R. pts. 210, 240, 249, 274).
197. See supra text accompanying notes 71-76.
198. A public good will not assure its own supply because individuals fail to contribute to its production. Lighthouses are the classic example. Because one person's consumption of the light does not reduce the resource available for others and the light cannot be parsed and given only to those who pay, an individual may reason that he harms no one by making use of the light without paying for it. Accordingly, a variety of institutions have arisen to require the beneficiaries of the lighthouse to contribute to the cost. See generally R.H. Coase, The Lighthouse in Economics, 17 J.L. & ECON. 357 (1974) (providing institutional and historical account that confirms the public good nature of the lighthouse but does not support the claim by other economists that a lighthouse is a service which can only be supplied by the government).
199. See Baker & Griffith, supra note 8.
200. See Baker, supra note 85, at 114-18 (explaining the low limits conflict).
201. The excess of loss structure might similarly be misunderstood to be an obstacle to monitoring ex ante because, as in the ex post situation, the benefits of the monitoring would accrue to the insurance program as a whole while the costs would likely be imposed on a single monitoring insurer (most likely the insurer first on the risk). Yet insurers would predictably incur ex ante monitoring costs in all cases, so the insurer responsible for monitoring
202. E-mail from Sean Griffith, Associate Professor of Law, Fordham Law School, to Tom Baker, Connecticut Mutual Professor of Law, University of Connecticut School of Law, (June 22, 2006, 6:15:08 EST).
203. See Baker, supra note 67 (synthesizing economic literature on the insurance underwriting cycle); Fitzpatrick, supra note 170 (providing a participant observation account of a behavioral explanation for the underwriting cycle) (note that this author was at the time the Chief Underwriter for Chubb's specialty lines insurance business, one of the leading providers of D&O insurance); Matthew Dolan, Repeating the Sins of Market Cycles, Insights, Oct. 2003, http://www.onebeaconpro.com/insights/ insights_vol2_sp.pdf (providing a participant observation account of the underwriting cycle) (note that this author was a former Chubb underwriter and, at the time, the CEO of a specialty lines insurer active in the D&O business).
204. See Baker, supra note 67.
205. We are not suggesting that Side A coverage be tightly linked to monitoring services. Individual loss aversion provides sufficient justification for Side A coverage; obligating individual directors and officers to follow the insurance company's loss prevention advice on pain of losing their insurance coverage could well lead to behavior that was too cautious from the shareholders' perspective.
206. Habit may also be an explanation, but the profit motive would likely change this habit absent the agency cost problem. See, e.g., M. Martin Boyer, Is the Demand for Corporate Insurance a Habit? Evidence of Organizational Inertia from Directors' and Officers' Insurance (CIRANO Working Papers, Paper No. 2004s-33, 2004).
207. See sources cited supra notes 11 and 62.