Managerial Opportunism? Evidence from Directors' and Officers' Insurance Purchases

Abstract

We analyze a sample of 72 IPO firms that went public between 1992 and 1996 for which we have detailed proprietary information about the amount and cost of D&O liability insurance. If managers of IPO firms are exploiting superior inside information, we hypothesize that the amount of insurance coverage chosen will be related to the post-offering performance of the issuing firm's shares. Consistent with the hypothesis, we find a significant negative relation between the three-year post-IPO stock price performance and the insurance coverage purchased in conjunction with the IPO. One plausible interpretation is that, like insider securities transactions, D&O insurance decisions reveal opportunistic behavior by managers. This provides some motivation to argue that disclosure of the details of D&O insurance decisions, as is required in some other countries, is valuable. CORPORATE INSIDERS ARE WIDELY ACKNOWLEDGED to possess superior information about future prospects for the firms they manage, and to some degree to utilize that information to their private benefit. One well-known example that helps to establish this inference is that insider trades have been shown to contain information that helps to predict security returns. We refer to insiders' use of corporate information for private benefit as managerial opportunism. The managerial opportunism hypothesis says that rational managers, armed with superior information, choose to sell shares when the public valuation of the company's shares exceeds management's valuation estimate. In the context of insider trades, evidence by Seyhun~1986!, Lee~1997!, and Kahle~2000! provides support for the managerial opportunism hypothesis.We test the managerial opportunism hypothesis in another context. We examine the decision that informed insiders make concerning the purchase of directors' and officers'~D&O! liability insurance around the time when a company is preparing to sell its initial public offering~IPO! of stock. If managers are behaving opportunistically and taking the company public when the IPO shares are overvalued, then we posit that rational managers will adjust other decisions they make to balance the costs and benefits of ex-

Directors׳ and officers׳ liability insurance and the cost of equity

“…While prior studies have examined the economic determinants of D&O insurance purchases (Boyer, 2005;Chalmers et al, 2002;Core, 1997;O'Sullivan, 1997; and the effect of D&O insurance on accounting restatements (Kim, 2006), reporting conservatism (Chung and Wynn, 2008), management forecasts (Wynn, 2008), investment decisions (Lin et al, 2011) and loan financing (Lin et al, 2013), we document how D&O insurance affects the cost 2 This point is echoed by Warren Buffet, Chairman of Berkshire Hathaway. For example, in a shareholder meeting in 2003, he said: "People would behave a lot better if D&O insurance were scrapped altogether."…”

“…DOICOV is the D&O insurance coverage ratio. Following Chalmers et al (2002) and Lin et al (2011), we define DOICOV as the amount of personal coverage scaled by the average market value of equity of the year. If a firm does not purchase D&O insurance, DOICOV is zero.…”

Directors’ and officers’ legal liability insurance and audit pricing

“…Other studies come to similar conclusions while studying non-accounting related opportunistic outcomes thought to be associated with opportunism. Using proprietary U.S. data, Chalmers et al (2002) find that three-year post-IPO performance is negatively associated with excess D&O insurance coverage purchased at the time of the IPO. Since poor post-IPO performance increases the likelihood of shareholder litigation, their results indicate that managers tend to purchase D&O insurance when they are aware their firms are overvalued at the time of the IPO.…”

“…While D&O insurance provides firms with a valuable recruiting and retention tool, excessive amounts of D&O coverage potentially exacerbates moral hazard problems and leads to more opportunistic behavior by executives as their personal wealth is insulated from the consequences of these behaviors. Evidence in Chalmers et al (2002), Chung and Wynn (2008), among others, indicates excess D&O coverage limits are associated with opportunistic ex post outcomes. Accordingly, Griffith (2006) argues that disclosing D&O insurance policy details could provide important additional information concerning the firm's governance quality and overall risk to investors and other capital market participants.…”

“…Accordingly, we follow Chalmers et al (2002) and others and proxy for managerial opportunism using the excess level of D&O insurance coverage beyond the coverage a firm would be expected to carry based on its economic characteristics. In this way, we attempt to isolate the information about managerial opportunism contained in the D&O disclosures.…”