Directors and Officers Liability Insurance, Independent Director Behavior. and Governance Effects

Transcription

1 Directors and Officers Liability Insurance, Independent Director Behavior and Governance Effects Ning Jia School of Economics and Management Tsinghua University Beijing, P.R. China Xuesong Tang School of Accounting Southwestern University of Finance and Economics Chengdu, P.R. China This Draft: February 2014 * We remain responsible for any remaining errors or omissions.

2 Directors and Officers Liability Insurance, Independent Director Behavior and Governance Effects Abstract: We examine the effect of directors and officers liability insurance (D&O insurance) on the behavior of independent directors and the effectiveness of their governance role. Using director-level data on board meeting attendance and opinions of a sample of Chinese companies, we document a negative relation between D&O insurance and personal meeting attendance by independent directors and a positive relation between D&O insurance and meeting attendance by authorized representatives. The net effect on board meeting participation is negative as insured independent directors tend to experience greater attendance problem than their uninsured peers. We also find that D&O insurance reduces the willingness of independent directors to confront controlling shareholders and management in the face of heightened agency conflicts by issuing a dissenting opinion. Moreover, we find that D&O insurance reduces the effectiveness of independent director monitoring as manifested in a lower power to curb controlling shareholder expropriation and to improve future firm performance, a lower executive pay-for-performance sensitivity, and a lower CEO performance-turnover sensitivity. Finally, we document a negative stock market reaction to the announcement of D&O insurance purchase. Overall, our findings suggest that D&O insurance introduces unintended moral hazard into the boardroom and encourages independent directors to behave less responsibly. Our paper provides new evidence for the debate of the governance effect of D&O insurance, provides new insights into the incentives and behavior of independent directors, and highlights the role of personal legal liability in disciplining the board. Keywords: directors and officers liability insurance; independent director; meeting attendance; dissent; corporate governance JEL Classification: G34; G22; M41

3 1. Introduction Directors and officers liability insurance (hereafter referred to as D&O insurance ) is a liability cover for company directors and managers to protect them from claims which may arise from the decisions and actions taken within the scope of their regular duties. D&O insurance is now a common part of risk management of public companies in North America and Europe, and is becoming popular in emerging economies as well. Despite of increasing prevalence, there is an ongoing debate about the merits of D&O insurance, especially its role in corporate governance. One view is that because D&O insurance shields directors and officers away from litigation risk and personal financial liability, it could undermine corporate governance by introducing unintended moral hazard such that directors may reduce their monitoring efforts and managers may pursue personal interests at the expense of shareholders. An opposite view is that D&O insurance is provided so that competent professionals can serve as monitors of companies without fear of personal financial loss (Core, 1997). Moreover, scrutiny of a firm s corporate governance by insurance companies before and after D&O insurance purchase provides monitoring on directors and managers and forces them to engage in responsible conduct and deter wrong-doings (Holderness, 1990; Core, 2000). Existing literature on the governance effect of D&O insurance is relatively sparse and empirical evidence remains inconclusive. Several studies provide indirect evidence by examining the merits of D&O insurance as perceived by creditors (e.g., Lin et al., 2013), shareholders (e.g., Lin et al., 2011), or as manifested in observable firm performance (Chalmers et al., 2002). A more direct way to approach this question would be to examine how D&O insurance actually alters managers and directors incentives and behavior. Chung et al., (2008) shed early light by documenting a negative relation between D&O insurance coverage and managerial choice of financial reporting conservatism. Lin et al., (2013) document a positive relation between D&O insurance premium and managerial risk taking and financial reporting aggressiveness. In this study, we focus on another important class of beneficiaries of D&O insurance and a core component of corporate governance structure board of directors. Taking advantage of detailed board meeting attendance and voting records of a sample of independent directors of publicly traded Chinese firms, we provide direct evidence on whether and how D&O insurance coverage affects the incentives and behavior of directors and the 1

4 effectiveness of their governance role. As a critical element of a firm s corporate governance system, independent directors are entrusted by shareholders to advise and monitor the management on their behalf (Duchin et al., 2010; Masulis et al., 2012). Since independent directors do not work in the company on a daily basis, the main channel through which they carry out their governance responsibilities is through the attendance of board meetings and casting votes on key corporate decisions at those meetings (Adams and Ferreira, 2008). Therefore, an examination of how D&O insurance coverage alters those two actions of independent directors speaks directly to the alleged criticism that D&O insurance adversely affects firm s internal corporate governance by reducing the effort level of directors and encouraging them to behave less responsibly. Such examination can also advance our understanding of independent director incentives and what motivates or demotivates them to perform monitoring duties carefully (Masulis and Mobbs, 2014). To our knowledge no prior studies have explored the impact of D&O insurance coverage on directors personal behavior, due largely to empirical challenges in observing the actual behavior of directors and quantify them for analyses (Adams et al., 2011). 1 Securities regulation in China provides us a unique opportunity to conduct such analysis. In an effort to improve internal corporate governance and highlight the importance of independent director oversight, since 2001, the Chinese Securities and Regulatory Commission (CSRC) has mandated listed companies in China to publicly disclose information on independent director board meeting attendance as well as their opinions on major corporate events such as the appointment and dismissal of senior managers, material inter-corporate loans to shareholders, and any events that independent directors consider to be detrimental to the interests of minority shareholders. Board meeting attendance is classified into three types: personal attendance, attendance by representatives appointed by independent director (proxy attendance), and absence. As stipulated by the CSRC, independent directors shall provide one of the following four types of opinions: a consent opinion, a reserved opinion, a negative opinion, or a 1 For example, in the U.S., the Securities Exchange Act of 1934 only requires listed companies to disclose in their proxy statements the name of each incumbent director who during the previous fiscal year attended fewer than 75% of the board meetings. No disclosure of each director s detail attendance records and his/her opinion is required. 2

5 non-comment opinion. 2 The latter three types are generally viewed as a dissenting opinion (Tang et al., 2013). Availability of detailed attendance and voting data enables us to observe the actual behavior of independent directors and directly assess whether D&O insurance introduces moral hazard into the boardroom. Our sample includes publicly traded Chinese firms between 2004 and Since D&O insurance provides equal coverage for all independent directors in a firm as a collective body and the purchase decision is made at the firm level, we do not explicitly consider inter-director differences in the main tests and conduct analyses at the firm level by aggregating director level data. As a robustness check, we collect data on individual director characteristics and repeat all analyses at the director-firm-year level, and the results are qualitatively the same. We begin our investigation with an assessment of the impact of D&O insurance coverage on board meeting attendance, controlling for an array of firm and board characteristics. 3 We document a negative relation between D&O insurance coverage and personal meeting attendance by independent directors and a positive relation between D&O insurance coverage and proxy attendance, suggesting that insured independent directors tend to delegate board meeting attendance to authorized representatives. To evaluate the net effect on board meeting participation, we follow Adam and Ferreira (2008) to construct a dummy variable Attendance Problem that equals one if a firm has at least one independent director who attends less than 75% of board meetings in a given year. The test shows a significantly positive relation between D&O insurance coverage and Attendance Problem. Together, these findings are consistent with the conjecture that D&O insurance coverage reduces the effort level of independent directors. We then explore the voting behavior of independent directors during board meetings. Exercising voting power on the board is a major channel through which independent directors carry out their fiduciary duties to induce behavior in compliance with shareholder value maximization. Given a major responsibility of independent directors is to protect the interests of minority shareholders, they are expected to serve as a check on management (and on 2 See the Guidance Opinion on the Establishment of an Independent Director System in Listed Companies, issued by the CSRC in Aug. 16, Unlike Canada, Chinese companies are not required to disclose the actual amount of D&O insurance premium. Therefore throughout this paper, we define D&O insurance coverage as a dummy variable that equals one if a firm has D&O insurance coverage in a given year, and zero otherwise. 3

6 controlling shareholders in the case of China where firm ownership is concentrated) and deter wrongdoing by expressing a dissenting opinion in the face of heightened agency problems (Lin et al., 2012; Tang et al., 2013). However, to the extent that D&O insurance shields independent directors away from litigation risk and personal financial liability, they may be less willing to confront management and controlling shareholders that may endanger their board seats or the chance of re-appointment (Jiang et al., 2012). We examine two measures of agency conflicts. Our first measure is expropriation of minority shareholder interests by controlling shareholders through tunneling activities. Following Jiang et al. (2010), we measure the level of expropriation by other receivables reported on the balance sheet. Our second measure of agency conflicts is firm underperformance against industry peers as poor firm performance may be indicative of managerial moral hazard. We measure underperformance as industry average return on assets minus the firm s own return on assets. Our tests show a positive and statistically significant relation between the likelihood of independent director dissenting and the two measures of agency conflicts, supporting the monitoring and disciplining role of independent directors. More importantly, we find that the interaction term between D&O insurance coverage and agency conflicts is significantly negative, suggesting that D&O insurance reduces the willingness of independent directors to confront and discipline management and controlling shareholders in the face of heightened agency conflicts in order to protect minority shareholders. Having documented the impact of D&O insurance on independent director behavior, we next turn our attention to the impact of D&O insurance on independent director monitoring effectiveness. Specifically, we examine three areas that are under the direct purview of independent directors curbing expropriation by controlling shareholders, determining executive compensation policies, and disciplining poorly performing CEOs, respectively. Using a sample of independent director opinions of Chinese companies, Tang et al., (2013) show that independent director dissent can successfully mitigate rent-seeking activities by controlling shareholders as evidenced by a reduction in other receivables in the following year when controlling shareholders are under pressure to repay funds extracted from listed firms. We document similar findings using our sample of firms. More importantly, we find that the coefficient estimate on the interaction term between D&O insurance coverage and independent 4

7 director dissent is positive and statistically significant at the 1% level, suggesting that D&O insurance coverage reduces independent director effectiveness in deterring controlling shareholder expropriation of minority shareholder interests. We next examine how D&O insurance affects the quality of executive compensation policies. To the extent that lax director monitoring and reduced willingness to dissent with management contributes to poor governance and leads to grater agency problems, we expect firms with D&O insurance coverage to exhibit lower executive pay-for-performance sensitivity. Consistent with this conjecture, our analysis shows that ceteris paribus, the presence of D&O insurance significantly reduces the pay-for-performance sensitivity in executive compensation. We then examine how D&O insurance impact board effectiveness in disciplining poorly performing CEOs. We find that D&O insurance coverage significantly reduces the sensitivity of CEO turnover to performance. Taken together, our findings suggest that D&O insurance coverage not only reduces the effort level of independent directors, but also weakens their governance effectiveness. Like most corporate governance research, our analyses also suffer from potential endogeneity problem. Specifically, one might be concerned that the decision to purchase D&O insurance and independent director behavior may be spuriously related because they are both driven by some unobserved firm characteristics. Reverse causality may be another concern. It is possible that the demand for D&O insurance is higher for firms with poor internal governance that exposes firm insiders to higher litigation risk. We address endogeneity using two-stage least squares (2SLS) with an instrumental variable Coast, a dummy variable that equals one if the firm is located in the coastal areas of China. The 2SLS results confirm the negative effect of D&O insurance coverage on the effort level of independent directors and the effectiveness of their governance role. Apart from endogeneity, one may also be concerned with self-selection bias in firm s D&O insurance purchase decision. We address this concern with Heckman (1979) two-stage approach and find that the results are qualitatively the same as those reported in the main tests. Results reported in the main tests are based on firm-year observations and therefore do not take into account independent director personal characteristics. To corroborate our findings, we collect information on individual director characteristics and repeat all analyses at the director 5

8 level. Individual director characteristics that we control for include: gender, age, compensation, tenure, financial expertise, geographic proximity to the firm, and number of independent directorships, respectively. Results are robust to controlling these characteristics. As our final test of the net effect of D&O insurance, we examine how the stock market reacts to the announcement of D&O insurance purchase using our sample of firms. We document a significantly negative market reaction to firm announcement of D&O insurance purchase as evidenced by a -5.6% average cumulative abnormal return (CARs) over a [-20, 20] day event window. Our study contributes to the growing literature on the corporate governance role of D&O insurance and is the first to conduct a direct assessment of whether and how D&O insurance affects the behavior of independent directors as well as their governance effectiveness. While prior studies focus predominantly on Canada due to public availability of data on purchases of D&O insurance, we provide evidence on China as an emerging economy where institutional and legal environments are vastly different. Chung et al., (2008) find that the corporate governance implications of D&O insurance vary significantly with the legal regime. Our findings suggest that in China, D&O insurance tends to induce greater agency problems on the part of directors and officers, and impair the quality of internal corporate governance. Our study also adds to the emerging literature on the incentives of outside directors to devote time and resources to their governance task. Adam and Ferriera (2008) examine financial incentives of outside directors and find that higher monetary rewards are able to attract outside directors to attend more board meetings. Masulis et al., (2013) find reputation concern is another important incentive of outside directors. Chou et al., (2013) find that concentrated firm ownership and director s own qualification have a positive impact on behavior. We complement those earlier studies by highlighting a positive role of personal liability exposure in disciplining outside directors. Our findings suggest that hedging against litigation risk and personal wealth loss through D&O insurance appears to demotivate outside directors and weaken their monitoring efforts and effectiveness. Finally, our study adds to the large literature on corporate boards. The extant literature tends to leave boards as a black box (Adams, et al., 2010). Since firms in many countries are not required to publicly disclose director meeting attendance and voting records, researchers 6

9 rarely are able to actual observe director behavior and the inner dynamics of boards. As a result, the empirical literature has not advanced much beyond surveying the impact of board composition on observable corporate outcomes. One exception is a recent study by Schwartz-Ziv and Weisbach (2013) that analyzes minutes of board meetings and board-committee meetings of a sample of Israeli governments, and finds boards spend most of their time monitoring management. By taking advantage of a comprehensive and detailed sample of individual director s board meeting attendance and voting records, we shed additional light on the inside of boardroom. The remainder of the paper proceeds as follows. Section 2 provides institutional background and reviews the related literature. Section 3 describes the data and presents descriptive statistics. Section 4 reports main empirical results. Section 5 presents results of additional analyses. Section 6 concludes the paper. 2. Institutional Background and Literature Review 2.1 Regulations of Independent Directorship in China Over the course of China s capital markets development since 1991, corporate governance has been a central issue for listed Chinese companies that are often characterized by government ownership and a concentrated ownership structure. In the absence of proper governance mechanisms and regulations, managers and controlling shareholders have incentives to extract rents from the firm and its minority shareholders. Such agency conflict is further exacerbated by a split share structure of non-tradable shares held by controlling shareholders and tradable shares held by minority shareholders (Zhou et al., 2008; Firth et al., 2010). To combat those corporate governance weaknesses and particularly to resolve conflicts of interests between controlling and minority shareholders, Chinese regulators borrowed western governance practices that highlight the use of independent directors to represent the interests of minority shareholders and to prevent managerial opportunism. The CSRC subsequently issued several regulations that are intended to enhance the role of independent directors in corporate governance and the visibility of their monitoring efforts. Guidelines for Establishing Independent Director System for Listed Companies issued in August 2001 [CSRC No. 102], 7

10 stipulates that independent directors should represent at least one-third of the board, of which at least one independent director must be an accounting professional. The regulation also stipulates that independent directors shall express unbiased opinions on major corporate events, including among others the nomination, appointment, and dismissal of directors; the appointment or dismissal of senior management; the remuneration of directors and senior management; material inter-corporate loans to shareholders, controlling shareholders, and other affiliated entities; and events that the independent director considers detrimental to the interests of the minority shareholders. This regulation was revised in 2004 to further encourage the issuance of unbiased independent director opinions. Specifically, it requires that when one or more independent directors disagree on board proposals, the firm must disclose the name of the dissenting directors, titles of the proposals, and directors opinion (in the annual reports). In addition to disclosure requirement on independent director opinion, the CSRC also promulgated the Code of Corporate Governance in 2002 that requires listed companies to disclose detailed information on meeting attendance records of independent directors. Independent directors who do not personally participate in board meetings for three consecutive times are required to step down and be replaced. 2.2 Development of the D&O Insurance in China CSRC regulations on independent directorship served as a catalyst for the development of D&O insurance market in China (Zou et al., 2008). Article 39 of the Code of Corporate Governance sets forth that listed companies can purchase D&O insurance for their directors and officers upon the approval of the general meeting of the shareholder. The first D&O policy in China was launched in 2002 through joint efforts by China's largest insurance company, China Ping An Insurance Co., Ltd., and Chubb Insurance Group. In the meantime, China s securities law was revised to empower shareholders to take legal action against directors and managers for their misconduct. The most noticeable provision is Some Provisions on Trying Cases of Supreme People's Court (SPC) on Civil Compensation Arising from False Statement in Securities Market issued in It provides that "a case of civil compensation arising from false statement in securities market mentioned in the present provisions shall refer to a case of civil compensation for which an investor in securities market 8

11 brings a lawsuit to the people's court against the obligor for information disclosure who violates legal provisions by making false statement and thus causing losses to him. For the first time, public investors are provided substance and procedures for seeking civil damages against directors and managers of a listed company that made false statements. Securities Law (revised in 2005) also stipulates that where the prospectus, measures for financing through issuance of corporate bonds, financial statement, listing report, annual report, midterm report, temporary report or any information as disclosed that has been announced by an issuer or a listed company has any false record, misleading statement or major omission, and thus incurs losses to investors in the process of securities trading, the issuer or the listed company shall be subject to the liabilities of compensation. Any director, senior manager or any other person of the issuer or the listed company directly responsible shall be subject to the joint and several liabilities of compensation, except for anyone who is able to prove his exemption of any fault. Under certain conditions, the investor subject to the loss has the right to sue either the company or the responsible director or officer for the compensation. As a result, securities lawsuits were on the rise, leading to greater demand for D&O insurance. 4 Recent surge of securities class actions against overseas-listed Chinese companies alleging non-disclosure of material information and accounting fraud brought D&O insurance into the center stage of directors and managers attention. 5 Despite increasing popularity, D&O insurance market in China is still in a nascent stage compared to western countries such as Canada or U.S. Our summary statistics show that at present, only less than 5% of listed companies in China are under the coverage. Challenges facing D&O insurance include deficiencies in current Chinese legal system of civil liability, security civil indemnification, and lawsuit costs. However, to the extent that those limitations may downplay the governance impact of D&O insurance in China, they would only bias 4 On December 28, 2004, the Yinguangxia Listed Company (Ticker: ) was sued before Yinchuan Intermediate People s Court by investor Bo Songhua for exaggerating profits and disclosing false annual reports since August 5, Bo has purchased 5,500 shares of Yinguangxia from April 23, 2001 to July 4, However, the company s stock price has declined significantly since due to its financial statement fraud. The judge concluded the Yinguangxia shall pay RMB 110,000 to compensate Bo s damages. In 2012, the management of nearly 30 listed companies was sued for filing false statements. There has also been a trend among law firms to fight class action suits in court against companies. 5 D&O premiums skyrocket after US lawsuits, China Daily, access on October 31,

12 against finding significant differences in the incentives and behavior of independent directors with and without the coverage. 2.3 Literature on the Governance Role of D&O Insurance Existing literature on the governance effect of D&O insurance is relatively sparse and empirical evidence remains inconclusive. A stream of research examines the merits of D&O insurance as perceived by company stakeholders. Bhagat et al. (1987) use a sample of 11 New York-based firms and document a positive and marginally significant market reaction to the announcement of D&O insurance purchase. In contrast, Zou et al., (2008) investigate the determinants of D&O insurance purchase of Chinese firms, and document a negative market reaction to purchase announcements for firms controlled by local government or with severe earnings management. Lin et al. (2011) examine the effect of D&O insurance in the context of mergers and acquisitions, and find that acquirers with a higher level of D&O insurance coverage experience significantly lower announcement-period abnormal stock returns and higher acquisition premiums. Using a sample of Canadian firms, Lin et al., (2013) document a positive association between level of D&O insurance coverage and loan spreads, a proxy for the cost of debt. They interpret their findings as suggesting that lenders view D&O insurance coverage as increasing credit risk potentially via moral hazard or information asymmetry. Another stream of research provides more direct evidence on the corporate governance role of D&O insurance by examining its impact on managerial incentives and corporate decisions. Much evidence has pointed to a heightened agency problem induced by D&O insurance coverage. Chung and Wynn (2008) examine financial reporting practices and find that D&O insurance is associated with less conservative reporting choices. This relationship is more pronounced for Canadian companies cross-listed in the U.S.. Wynn (2008) examine managerial disclosure behavior and find that the liability coverage proxied by a firm s excess cash holding appears to affect a firm s disclosure of bad news in US-listed Canadian companies. Lin et al., (2013) find that higher levels of D&O insurance coverage are associated with greater managerial risk taking and higher probabilities of financial restatement due to aggressive financial reporting. Using a proprietary sample of 72 initial public offerings (IPOs) in the U.S., Chalmers et al., (2002) find a negative relation between the amount of D&O 10

13 insurance purchased at the time of the IPO and three-year post-ipo stock returns. While prior studies have explored the determinants of D&O insurance, its perceived merits, and impact on managerial decision-making and performance outcomes, no prior studies have examined how D&O insurance affects the behavior of board of directors - a major class of beneficiaries of this insurance and the core of internal corporate governance. In this paper, we are able to empirically investigate this question by taking advantage of China s disclosure requirements of D&O insurance purchase as well as detailed meeting attendance and voting records of independent directors. 3. Data and Sample 3.1 Sample Selection Our sample construction begins with Chinese firms that are publicly traded on the A-share board between 2004 and We choose year 2004 as the beginning of our sample period because the first record on one of important independent director s behaviors (namely, board meeting attendance) appeared in that year in CSMAR. Our empirical tests call for classification of sample firms based on whether or not they have D&O insurance coverage. Since listed firms are required to disclose information about the purchase of D&O insurance in board and shareholders meeting minutes and annual reports, we manually search through those documents to obtain the date of approval of first-time purchases as well as the effective date. 6 We collect independent director behavioral data, including board meeting attendance records and opinion reports from the CSMAR database. 7 Unlike the U.S. where the level of disclosure on board meeting attendance is limited to whether a director attends less than 75% of board meetings during a fiscal year, we are able to obtain detailed information on the frequency as well as type of board meeting attendance of every director using Chinese firms. Board meeting attendance is classified into three types, personal attendance by independent directors, attendance by authorized representatives appointed by 6 Data on actual purchase date are not publicly available. Since firms do not always disclose information on the renewal of D&O insurance in board and shareholders meeting minutes and annual reports, we assume a continued coverage unless the firm explicitly states coverage termination in a given year. 7 In CSMAR, first record for board meeting attendance appears in 2004 and first record of independent director s dissenting opinion appears in

14 independent director (i.e., proxy attendance), and absence. We collect independent director opinions from the opinion reports in CSMAR. Independent directors issue a joint opinion report following a board meeting. Each joint opinion report contains multiple director-opinion pairs, clearly stating the opinion of each independent director - a consent opinion, a reserved opinion, a negative opinion, or a non-comment opinion. An opinion report could be released as a stand-alone report, or as the last section of the board meeting announcement. Finally, we obtain financial statement information, board and director characteristics, and other corporate governance information from CSMAR. 3.2 Descriptive Statistics Panel A of Table 1 reports the sample distribution by year and by D&O insurance coverage. Number of firms with D&O insurance coverage is on the rise during our sample period, from 17 in 2004 to 62 in As discussed in Section 2, given that China s D&O insurance market is still in a nascent stage, the breadth of coverage remains limited. As of 2012, only 2.4% (62 out of 2,577) firms in our sample are insured. Panel B reports the sample distribution by industry and by D&O insurance coverage, where industry classification is based on the CSRC industry classification guide. There does not appear to be a high industry concentration among our sample of firms or significantly different industry clustering between firms with and without D&O insurance. Panel C of Table 1 provides summary statistics of key variables used in this study as well as their correlation with the main variable of interest, D&O insurance coverage. We provide detailed variable definitions in Appendix 1. Percentage of board meetings that independent directors personally attend in a given year (averaged across independent directors) varies from 77.8% to 100%, with an average of 95.6%. Percentage of board meetings that independent directors appoint a representative to attend in a given year (averaged across independent directors) varies from 0% to 16.7%, with an average of 4%. The average of Attendance Problem where at least one independent director attends less than 75% of board meetings in a given year is 16.3%. The average of independent director dissenting is 1.4%, suggesting that independent directors do not vote against management proposals in most cases. With regards to the Pearson correlation with D&O insurance coverage, we document a 12

15 significantly negative correlation of between Personal Attendance and D&O insurance, and a significantly positive correlation of (0.023) between Proxy Attendance (Attendance Problem) and D&O insurance coverage. To minimize the effect of outliers, we winsorize all continuous variables at the 5th and 95th percentiles. 4. Effect of D&O Insurance Coverage on Independent Director Behavior We begin our analyses with a direct assessment of the effect of D&O insurance on the behavior of independent directors. Since the main channel through which independent directors carry out their governance responsibilities is through the attendance of board meetings and casting votes on key corporate decisions at those meetings, we therefore focus on meeting participation and voting behavior of independent directors. 4.1 Analysis of Board Meeting Attendance In this subsection, we examine the effect of D&O insurance on the board meeting attendance of independent directors. Board meetings are the primary mechanism for outside directors to keep informed of a firm s operations, business conditions and managerial decision making, so that they can effectively participate in a firm s governance (Masulis et al., 2012). Consistent with the importance of board meetings, Vafeas (1999) finds that stock price declines tend to prompt a higher frequency of board meetings that subsequently lead to an improvement in firm performance. Institutional investors and governance activists have used board meeting attendance records to evaluate director performance, and directors who frequently miss board meetings are often criticized as being ineffective monitors and receive significantly fewer votes for their re-election (Cai et al., 2009). To test how D&O insurance affects the board meeting attendance of independent directors, we estimate the following model: Meeting Attendance=α+βD&O+λ Firm Control+δ Board Control+Year+Industry+ ε (1) where the dependent variable is either (i) Personal Attendance, measured as the percentage of board meetings that independent directors personally attend in a given year, averaged across all independent directors in a firm, or (ii) Proxy Attendance, measured as the percentage of board meetings that independent directors appoint a proxy to attend in a given year, averaged across 13

16 all independent directors in a firm. We explicitly distinguish between personal attendance and proxy attendance not only because of data availability, but also because prior studies (e.g., Chou et al., 2013) find that personal board meeting attendance enhances firm performance, while proxy attendance has an adverse performance implication. To further evaluate the net impact of D&O insurance on attendance and to make our results comparable to prior studies, we following Adams and Ferriera (2008) to construct a third dependent variable (iii) Attendance Problem that equals one if the firm has at least one independent director who personally attends fewer than 75% of the board meetings he/she is supposed to in a given year. The main variable of interest of this analysis is D&O, a dummy variable that equals one if a firm is covered by D&O insurance in a given year. Firm Control and Board Control are vectors of firm and board characteristics that could affect board meeting attendance. Detailed definitions of control variables are provided in Appendix 1. Year and Industry capture year and industry fixed effects, respectively. We cluster standard errors at the firm level. Table 2 presents the regression results of Model (1). The dependent variable is Personal Attendance in Column (1), Proxy Attendance in Column (2), and Attendance Problem in Column (3), respectively. Columns (1)-(2) are estimated using the ordinary least squares (OLS). Coefficient estimate on the key variable of interest D&O in Column (1) is and is significant at the 1% level (t-statistics= ), suggesting a negative association between a firm s D&O insurance coverage and personal board meeting attendance by its independent directors. The coefficient estimate on D&O in Column (2) is 0.018, which is significant at the 1% level (t-statistics=3.113), suggesting a positive association between a firm s D&O insurance coverage and board meeting attendance by authorized representatives appointed by independent directors. To evaluate the net impact of D&O insurance on independent director attendance behavior, we replace Attendance Problem as the dependent variable in Column (3) and conduct a Logit regression. The coefficient estimate on D&O is 0.557, and is significant at the 1% level (z-statistics=2.641), suggesting firms with D&O insurance experience more severe independent director meeting attendance problem compared to firms without insurance. Among control variables, we find that number of board meetings is positively related to personal attendance and negatively related to proxy attendance and attendance problem. One possible explanation is that frequency of board meetings is an indicator of poor performance 14

17 (Vefeas, 1999) and independent directors are likely to exert tighter monitoring of management when past firm performance is unsatisfactory. Consistent with Adams and Ferriera (2008), we also find evidence of a negative relation between director compensation and attendance problem. In addition, we find that percentage of independent directors, institutional ownership, financial expertise, largest shareholder dominance, and firm profitability are all positively related to personal meeting attendance and are negatively related to attendance problem. In contrast, management compensation, number of institutional investors, firm leverage, size, related party transaction, state ownership, prior penalty by the CSRC are negatively related to personal meeting attendance and are positive related to attendance problem. In summary, our examination of board meeting attendance records of independent directors yields results indicative of moral hazard and reduced director effort associated with the D&O insurance. Specifically, we find that D&O insurance is associated with less personal meeting attendance by independent directors and an increasing use of authorized representatives to attend board meetings on their behalf. Overall, firms with D&O insurance experience more severe independent director meeting attendance problem compared to firms without insurance. This is one potential channel through which D&O insurance weakens internal corporate governance and exacerbates agency problems. 4.2 Analysis of Independent Director Opinion In addition to attending board meetings, independent directors also exercise their governance role through voting on strategically important agenda. As the first line of defense for minority shareholders, independent directors are expected to discipline managers and controlling shareholders to act in the best interest of minority shareholders by expressing dissenting opinions in the face of heightened agency conflicts (Bushman and Smith, 2001; Tang et al., 2013). If independent directors fail to exercise their fiduciary duties, they may face reputation loss and even the risk of litigation and personal wealth loss if the proposals turn out to cause damage to minority shareholders that are serious enough to invite legal actions (Jiang et al., 2012). However, it is not clear ex ante whether this is indeed the case as confronting management or controlling shareholders may reduce the chance of independent director re-appointment, and in some extreme cases, leads to the loss of current board seats (Lin et al., 15

18 2012). Ma and Khanna (2013) find that dissent significantly increases a director s likelihood of exiting the director labor markets that results in a more than 10% estimated loss of annual income. We conjecture to the extent that D&O insurance shields independent directors away from personal wealth loss in the event of litigation, independent directors incur lower costs of not performing in the best interest of minority shareholders, and therefore, they may be less willing to confront and discipline management and controlling shareholders by blowing the whistle in the boardroom. Our first proxy for agency conflict is expropriation of minority shareholder interests by controlling shareholders. Unlike firms in western countries with a diffuse ownership structure, Chinese firms generally have a concentrated ownership structure that is often dominated by a large shareholder. In pursuit of private benefits, controlling shareholders have incentives to expropriate the wealth of minority shareholders through tunneling activities that results in a severe agency conflict between controlling and minority shareholders (Jiang et al., 2010; Tang et al., 2013). As stated in the Guidelines for Introducing Independent Directors to the Board of Directors in Listed Companies promulgated by the CSRC, independent directors shall protect the overall interests of the company, and shall be especially concerned with protecting the interests of minority shareholders from being infringed. Jiang et al. (2010) document that controlling shareholders in China often engage in tunneling activities and extract funds from listed firms through inter-corporate loans, which are typically reported as other receivables on the balance sheet. Following Jiang et al. (2010), we use other receivables to measure the level of minority shareholder wealth expropriation by controlling shareholders. Our second proxy for agency conflict is firm underperformance against its industry peers, measured as industry average return on assets minus the firm s own return on assets at the end of fiscal year. Consistent with tighter monitoring by the boards when the firm experiences poor performance, Vafeas (1999) find that frequency of board meetings increases following stock price declines. A content analysis of independent director opinions of a sample of Chinese companies by Ma and Khanna (2013) shows that one of the justifications offered by independent directors for dissenting is poor firm performance, suggesting that voicing an opposing opinion is one way for independent directors to discipline management in an effort to improve future performance. 16

19 To assess how D&O insurance affects the voting behavior of independent directors, we estimate the following model: Dissent = α + β 1 D&O + β 2 D&O Agency Conflict+ β 3 Agency Conflict + λ Firm Control +δ Board Control + Year + Industry + ε (2) where the dependent variable is Dissent, a dummy variable that equals one if the firm has at least one independent director who issues an dissenting opinion in a given year. Agency Conflict is either (i) the level of controlling shareholder expropriation Other Receivables, measured as other receivables scaled by book value of total assets measured at the end of year, or (ii) Underperform, measured as industry average return on assets minus the firm s own return on assets in a given year where industry classification is provided by the CSRC. The main variable of interest in this analysis is the interaction effect between D&O and agency conflict D&O Agency Conflict. Firm Control and Board Control are vectors of firm and board characteristics that could affect independent director s propensity to issue a dissenting opinion. Detailed definitions of control variables are provided in Appendix 1. Year and Industry capture year and industry fixed effects, respectively. We cluster standard errors at the firm level. Table 3 presents the regression results of Model (2). Columns (1) and (2) examine the effect of D&O insurance on independent director s propensity to issue a dissenting opinion in the face of heightened agency conflicts between majority and minority shareholders. In column (1), we start with a baseline analysis as the benchmark by focusing on the direct relation between agency conflicts and independent director dissent. Consistent with the findings of Tang et al., (2013), the coefficient estimate on Other Receivables is positive and significant at the 1% level, suggesting that independent directors are more likely to deter controlling shareholder rent-seeking behavior by voicing a dissenting opinion in the boardroom. To test the moderating effect of D&O insurance, we include D&O in Column (2) as well as the interaction term D&O Other Receivables. While the coefficient estimate on D&O itself is not significant, the coefficient estimate on D&O Other Receivables is and significant at the 1% level. This finding suggests that ceteris paribus, D&O insurance has an adverse impact on the willingness of independent directors to confront and discipline controlling shareholders in order to protect minority shareholders. 17

20 Columns (3) and (4) examine the effect of D&O insurance on independent director s propensity to monitor and discipline management by voicing a dissenting opinion in the face of poor firm performance. Again, we start with an assessment of the direct relation between firm underperformance and independent director dissent in Column (3). The coefficient estimate on Underperform is and significant at the 1%, indicative of a higher likelihood of independent director dissent in the face of unsatisfactory firm performance. We then examine the moderating effect of D&O insurance by including D&O in Column (4) as well as its interaction term with firm performance D&O Underperform. While the coefficient estimate on D&O itself is insignificant, the coefficient estimate on D&O Underperform is negative and significant at the 5%, suggesting that ceteris paribus, independent directors at firms with D&O insurance are less willing to monitor and discipline management in the face of poor firm performance. Among control variables, we find that number of board meetings, management compensation, leverage, and state ownership are positively related to the propensity of dissenting while number of institutional shareholders and dominance of largest shareholder are negatively related to the propensity of dissenting. Overall, our examination of independent directors voting behavior also yields results indicative of moral hazards associated with D&O insurance. Our findings are consistent with the conjecture that to the extent D&O insurance shields directors and officers away from litigation risk and personal financial liability, it undermines the monitoring effort of independent directors and encourages them to behave less responsibly in protecting the interests of minority shareholders. 5. Corporate Governance Implications In section 4, we examine whether and how D&O insurance coverage alters the behavior and level of effort of independent directors. In this section we turn our attention to the impact of D&O insurance coverage on independent directors governance effectiveness. Specifically, we examine three areas that are under the direct purview of independent directors deterring expropriation by controlling shareholders, determining executive compensation policies, and disciplining poorly performing CEOs, respectively. To the extent that D&O insurance introduces unintended moral hazard into the boardroom and encourage independent directors to 18