Controlling-minority shareholder incentive conflicts and directors’ and officers’ liability insurance: Evidence from China

Abstract

a b s t r a c tThis paper examines the demand for directors' and officers' liability insurance (D&O insurance) by Chinese listed companies where controlling-minority shareholder incentive conflicts are acute due to the concentrated and split ownership structure. We hypothesize and find evidence that the incidence of seeking D&O insurance is positively related to the extent of controlling-minority shareholder incentive conflicts -a finding not previously documented in the literature. Using an event study, we find that the announcements of D&O insurance decisions in firms that engage in earnings management, and/or are controlled by a local government (such firms tend to have stronger incentives to tunnel), seem to have a negative wealth effect. In addition, the incidence of the D&O insurance decision is positively related to the proportion of independent directors and several litigation risk proxies. Therefore, the breakthrough in corporate governance and judicial reforms has created non-negligible perceived securities litigation risks in China.

Recent Developments in Corporate Sustainability Reporting in China

“…According to Pistor and Xu (2005), the legal environment is beginning to change in China. A newer insight is provided by Zou et al (2008). They confirm the existence of a weak legal framework in China, especially for investors.…”

Implementation of “audit committee” and “independent director” for financial reporting in China

“…The newly created Chinese corporate sector has many agency problems, for example, the expropriation of minority interests by controlling shareholders (in many cases, the government is the controlling shareholder) within the concentrated ownership structure (Su, Xu, & Phan, 2008;Zou, Wong, Shum, Xiong, & Yan, 2008). The multiple roles played by government, for example, as regulator and as controlling shareholder, encourage and enable politicians to intervene in listed companies (Lindbeck, 2008;Liu, 2006).…”

“…Laws and regulations in relation to accounting, including Accounting Law, Law of Certified Public Accountants, and Securities Law, were developed following the economic reforms of the 1980s. Furthermore, the newly developed legal system offers little protection to investors and to minority shareholders in particular (Wang & Chen, 2008;Zou et al, 2008), and CSRC actions and court enforcement in this regard are not effective (Anderson, 2000;Cai, 2007;Liebman & Milhaupt, 2008). The Supreme People's Court (SPC) has been reluctant to open its doors to civil securities claims.…”

“…(CM2) Coffee (2006) indicates that, in concentrated ownership settings in which the controlling shareholder controls the board, it is difficult to restructure the relationships among management, external auditors, and ACs to ensure proper functioning of the AC in upholding auditor independence. Given the highly concentrated ownership in Chinese listed companies (Su et al, 2008;Zou et al, 2008), ACs are likely to be subject to the influence of controlling shareholders and management. In cases of dispute between the external auditor and management, the view shared by AC members and management suggested that they tended to believe that the AC should back up management, for the sake of the company, thus casting doubt on the AC's oversight role.…”

Structural Changes in the Chinese Stock Market: A Review of Empirical Research

“…In China, directors and managers are required by the CSRC to seek shareholders' approval for purchasing D&O insurance. Zou et al (2008) identify 53 such cases during 2000-2004 and find that firms with more acute controlling-minority shareholder incentive conflicts are more likely to consider purchasing D&O insurance. Figure 2 presents a timeline of the important laws and regulations associated with firms' litigation risk.…”