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

21 act less responsibly in carrying out the fiduciary duties on behalf of minority shareholders, we expect D&O insurance to weaken the effectiveness of their monitoring. 5.1 Governance Effectiveness of Independent Director Dissent In this subsection, we examine how D&O insurance coverage affects the governance effectiveness of independent director dissent. Tang et al., (2013) show that independent director dissenting has real governance effect. In particular, they find that independent director dissent is effective in mitigating controlling shareholder expropriation of minority shareholder interests as evidenced by a reduction in other receivables in the following year after independent directors cast a dissenting opinion. Reduction in other receivables is indicative of controlling shareholder repayment of the funds extracted from listed firms (Tang et al., 2013). Moreover, they find that independent director dissent has a disciplining effect on management as evidenced by an improvement in future firm performance. To test how D&O insurance coverage affects the governance effectiveness of independent director dissent, we estimate the following model: Change_OtherReceivables (Change_ROA_Adj) = α + β 1 Dissent + β 2 D&O Dissent + β 3 D&O + λ Firm Control +δ Board Control + Year + Industry + ε (3) where the dependent variable is either (i) Change_OtherReceivables, measured as defined as change in other receivables between next year and current year, scaled by book value of total assets measured at the end of current year, or (ii) Change_ROA_Adj, measured as change in industry adjusted return on assets between next year and current year. The main variable of interest in this analysis is the interaction term D&O Dissent. Firm Control and Board Control are vectors of firm and board characteristics that could affect change of controlling shareholder expropriation or firm performance. Detailed definitions of control variables are provided in Appendix 1. Year and Industry capture year and industry fixed effects, respectively. Again, we cluster standard errors at the firm level. Table 4 presents the regression results of Model (3). The dependent variable in Columns (1) and (2) is Change_OtherReceivables. We begin with an assessment of the direct effect of independent director dissent on mitigating the tunneling activities of controlling shareholders. Consistent with the finding of Tang et al., (2013) we also document a negative and significant 19

22 relation between Dissent and Change_OtherReceivables with an coefficient estimate of (t-statistics=-3.026), suggesting that independent director dissent can successfully reduce the level controlling shareholder expropriation. In Column (2), we add D&O and the interaction term D&O Dissent into the model. The coefficient estimate on Dissent remains negative and significant at the 1% level. While the coefficient estimate on D&O itself is not significant, which means D&O insurance has no direct effect on deterring controlling shareholder s tunneling activities, the coefficient estimate on the interaction term D&O Dissent is positive and significant at the 1% level. This finding suggests that D&O insurance adversely affects the effectiveness of independent director dissent in resolving agency conflicts between controlling and minority shareholders. Columns (3) and (4) of Table 4 report results on change in firm performance. Again, we start out in Column (3) with an assessment of the direct effect of independent director dissent on change in firm performance. We document a positive and significant relation between Dissent and Change_ROA_Adj, suggesting that independent director dissent can successfully discipline management that leads to enhanced future firm performance. In Column (4), we add D&O and the interaction term with dissent D&O Dissent into the model. The coefficient estimate of Dissent remains positive and significant at the 1% level. The coefficient estimate on D&O itself is also significantly positive. More importantly, the coefficient estimate on the interaction term D&O Dissent is negative and significant at the 1% level, suggesting that D&O insurance adversely affects the effectiveness of independent director dissent in improving future firm performance. 5.2 Executive Compensation Policy In this subsection, we examine how D&O insurance affects the quality of executive compensation policy. Similar to the U.S. practice, board of directors of Chinese companies is responsible for determining and reviewing compensation arrangements with the senior executives. To the extent that lax monitoring by insured independent directors contributes to poor governance and leads to more agency problems, we expect the executive pay-for-performance sensitivity is lower for firms with D&O insurance than firms without it. To test whether D&O insurance coverage is associated with lower pay-for-performance 20

23 sensitivity, we estimate the following model: Mgmt Comp = α + β 1 Past Performance + β 2 Past Performance D&O + β 3 D&O + λ Firm Control + δ Board Control + Year + Industry + ε (4) where the dependent variable is Mgmt Comp, defined as total compensation that a firm pays out to the top three managers in a given year scaled by the book value of total assets. The variable Past Performance is a dummy variable that equals 1 if a firm s industry adjusted ROA in the previous year is below the sample median, and zero otherwise. The main variable of interest in this analysis is the interaction term between D&O insurance and past performance Past Performance D&O. Firm Control and Board Control are vectors of firm and board characteristics that could affect management compensation. Detailed definitions of control variables are provided in Appendix 1. Year and Industry capture year and industry fixed effects, respectively. Again, we cluster standard errors at the firm level. We begin our analysis with an examination of the relation between management compensation and firm performance using our sample of firms. Column (1) of Table 5 presents the regression results. As expected, senior executives are compensated based on firm performance as evidenced by a significantly negative coefficient estimate on Past Performance, suggesting that poorer firm performance is associated with lower executive compensation. To examine the impact of D&O insurance on the quality of executive compensation policies set by the board, In Column (2), we add D&O and Past Performance D&O into the model. While the coefficient estimate of D&O insurance is insignificant, suggesting that D&O insurance has no direct impact on senior executive compensation, the coefficient estimate of the interaction term Past Performance D&O is and significant at the 5% level (t-statistics=2.103). This finding supports the conjecture that to the extent that lax monitoring by insured independent directors contributes to poor governance and leads to more agency problems, the executive pay-for-performance sensitivity is lower for firms with D&O insurance than firms without it. Among control variables, we find that director compensation, board size, financial expertise, chairman/ceo duality, number of institutional investors, state ownership, H/B share positively affect executive compensation while director location, number of board meetings, and shareholding of largest shareholders negatively affect executive compensation. 21

24 5.3 CEO Turnover In addition to setting executive compensation policies, the boards are also responsible for evaluating the quality of CEO and determine whether to retain or replace the CEO (Hermalin and Weisbach, 1998). In this subsection, we examine how D&O insurance coverage affects the effectiveness of directors in disciplining poorly performing CEOs. Prior research finds that poorly governed firms characterized by, for example, less independent boards (Weisbach, 1988) and busier boards (Fich and Shivdasani, 2006), geographically remote boards (Masulis et al., 2013) are less likely to terminate poorly performing CEOs. We conjecture that to the extent that D&O insurance coverage reduces monitoring and disciplining effort of independent directors, we expect boards with D&O insurance are less responsive and effective in replacing underperforming CEOs. To test our conjecture, we estimate the following model: CEO Turnover = α + β 1 Past Performance + β 2 Past Performance D&O + β 3 D&O + λ Firm Control + δ Board Control + Year + Industry + ε (5) where the dependent variable is CEO Turnover, defined as a dummy variable that equals one if a firm changes its CEO in the next year. The data on CEO turnover is obtained from CSMAR. 8 Firm Control and Board Control are vectors of firm and board characteristics that could affect CEO turnover. Detailed definitions of control variables are provided in Appendix 1. Year and Industry capture year and industry fixed effects, respectively. Standard errors are clustered at the firm level. Table 6 presents regression results of Model (5). Given the dichotomous nature of dependent variable, we perform a Logit regression analysis. We begin with an examination of the relation between poor firm performance and CEO turnover using our sample of firms. Column (1) of Table 6 presents regression results. As expected, we document a significantly positive association between poor firm performance and the likelihood of CEO turnover with an estimated coefficient of To examine the moderating effect of D&O insurance coverage, we add D&O and the interaction term Past Performance D&O in Column (2). As 8 Ideally we would want to focus only on forced CEO turnover. However, information on whether the CEO voluntarily resigns or is forced to leave is not available. Some prior studies attempt to circumvent this issue by searching through related press release or new articles to identify the cause of CEO turnover. However, in China for political and cultural reasons, often times even forced CEO turnover may be announced as voluntary resignation. 22

25 shown, the coefficient estimate on Past Performance remains significantly positive. More importantly, the coefficient of the interaction term Past Performance D&O is and significant at the 5%. This finding supports the conjecture that D&O insurance coverage reduces the monitoring and disciplining effort of directors, and as a result, they are less responsive and effective in replacing underperforming CEOs. In summary, in this section we find that D&O insurance coverage reduces the effectiveness of director monitoring and disciplining as manifested in a lower power to curb controlling shareholder expropriation and enhance future firm performance, a lower executive pay-for-performance sensitivity, and a lower CEO performance-turnover sensitivity. 6. Additional Analyses In this section, we conduct several additional analyses to further corroborate the main findings reported so far. We first attempt to address the endogeneity concern that omitted variables correlated with both D&O insurance purchase decision and independent director behavior could bias our results. Reverse causality may be another concern. It is possible that the demand for D&O insurance is higher for firms with lax board monitoring and poor corporate governance that expose firm insiders to higher litigation risk. We address endogeneity in Section 6.1 using the instrumental variable approach with two-stage least squares (2SLS). Apart from endogeneity, one may also be concerned with self-selection bias to the extent that a firm s decision to purchase D&O insurance is non-random. We address this concern in Section 6.2 with Heckman (1979) two-stage approach. Results reported in the main tests are based on firm-year observations and do not take into consideration independent director personal characteristics. In section 6.3, we collect information on individual director characteristics and repeat all analyses at the directorship level. Finally, to gauge the net merits of D&O insurance as perceived by shareholders, in section 6.4, we examine the stock market reaction to the announcement of D&O insurance purchase using the event study methodology. 6.1 Instrumental Variable Approach In this subsection, we address the endogeneity concern that omitted variables correlated with both D&O insurance purchase decision and independent director behavior could bias our 23

26 results. To that end, we construct an instrument for D&O insurance coverage and use the 2SLS approach to correct for the potential bias due to endogeneity in independent director behavior and governance effects. The ideal instrument should help to capture the variation in D&O insurance coverage that is exogenous to the behavior of independent directors. Our instrumental variable is Coast that equals one if a firm is headquartered in one the coastal areas of China, and zero otherwise. According to the Seven Five Plans passed by the fourth Session of the sixth National People s Congress of China in 1986, coastal areas in China include Beijing, Tianjin, Hebei, Liaoning, Shandong, Jiangsu, Shanghai, Zhejiang, Fujian, Guangdong, and Hainan, respectively. Compared to inland and western regions, coastal regions of eastern China enjoy faster economic growth that benefits from market-oriented economic reforms and liberalization. They are often chosen as the pilot sites for national-level economic reforms and new regulations, such as the launch of special economic zones and the formation of China s insurance sector. Ping An Insurance Company in Shenzhen was the first to launch the D&O insurance in January 2002 (Zou et al., 2008). Coastal regions have the highest concentration of insurance companies. In contrast, the number of insurance companies in the inland and the western market has not experienced much growth. As such, firms located in the coastal areas where the insurance market is more sizable and mature tend to have greater awareness of the D&O insurance and higher demand for it. While a firm s location in coastal areas is expected to relate to D&O insurance coverage, it is unlikely to be related to the personal behavior of independent directors. Panel A of Table 7 shows the first-stage regression results with D&O insurance coverage as the dependent variable to check the relevance of the instrument Coast. We include firm and board characteristics that may affect firm s decision to purchase D&O insurance. Year and industry fixed effects are included, and the standard errors are clustered at the firm level. The coefficient estimate of Coast is positive and significant at the 10% level (z-statistics=1.933), suggesting that the instrument variable is highly correlate with D&O insurance coverage. Based on the rule of thumb with one instrument (for one endogenous variable), we reject the null hypothesis that the instrument is weak. Therefore, the coefficient estimates reported in the second stage are likely to be unbiased and inferences based on them are reasonably valid. 24

27 Panel B of Table 7 reports the results from the second stage regressions on board meeting attendance and opinions of independent directors with the main variable of interest replaced by the fitted value of insurance coverage Exp D&O from the first stage regression. To save space, we report only the coefficient estimates related to Exp D&O and suppress those of all other controls. Columns (1)-(3) present the results on board meeting attendance. The dependent variable is Personal Attendance in Column (1), Proxy Attendance in Column (2), and Attendance Problem in Column (3), respectively. Consistent with the findings from the OLS analysis, the coefficient estimate on Exp D&O is negative and significant at the 1% in Column (1), positive and significant at the 5% in Column (2), positive and significant at the 1% in Column (3), respectively. Columns (4) and (5) report the regression with the likelihood of a dissenting opinion, Dissent, as the dependent variable. Agency conflict is measured by controlling shareholder expropriation in Column (4) and underperformance against industry peers in Column (5). Consistent with results from the main tests, the coefficient estimates on Other Receivables and Underperform are significantly positive. More importantly, the coefficient estimate on Other Receivables Exp D&O is significantly negative, suggesting that D&O insurance weakens the inclination of independent directors to voice an opposing opinion to confront management and to protect minority shareholder interests. The coefficient estimate on Underperform Exp D&O is no longer significant, suggesting that the result is affected by endogeneity to some extent. Panel C of Table 7 reports the results from the second stage regressions on governance effect with the main variable of interest replaced by the fitted value of insurance coverage Exp D&O from the first-stage regression. As shown, results are qualitatively the same as those reported in the main tests. In summary, the instrumental variable approach reported in this subsection suggest that there appears to be a negative causal effect of D&O insurance coverage on independent director monitoring efforts and the effectiveness of their governance role. 6.2 Self-selection Bias In this subsection, we attempt to address the concern that the purchase decision of D&O insurance is non-random and may lead to a self-selection bias in our findings. To that end, we use the Heckman (1979) two-stage approach that first estimates a Probit model on the 25

28 likelihood of D&O insurance coverage. We then calculate the inverse Mills ratio (IMR) and include this ratio in second stage regression analyses to help control for the likelihood of self-selection in firms with D&O insurance coverage. Panel A of Table 9 presents results of the first stage regression. Director compensation, number of institutional investors, government ownership, H/B share, leverage, and assets positively affect the insurance purchase decision while ROA has a negative impact. Panel B and Panel C report the results of second stage regressions on independent director behavior and governance effectiveness that incorporate IMR from the first stage regression. Results are qualitatively the same as those in Section 4 and 5, implying that our results are not affected by the self-selection bias. 6.3 Director-Level Analysis Empirical findings reported so far are based on firm-year observations that do not take into consideration independent director personal characteristics. To corroborate our findings, we collect information on individual director characteristics that may affect their board meeting attendance and/or voting behavior. DeFond et al. (2005) suggest that directors with greater professional ability are more likely to blow the whistle within the board, so we include a financial expertise variable, Financial Expertise_Dir, that equals one if the director has financial expertise, i.e., experience as a public accountant, auditor, principal or chief financial officer, controllers, or principal or chief accounting officer, and zero otherwise. Masulis et al., (2013) find that longer director tenure is associated with lower likelihood of missing board meetings, we therefore include a director tenure variable Tenure_Dir, measured as the natural logarithm of (1+ number of years the director has served on the board). Adam and Ferreira (2008) find that director effort level is driven by financial incentives and document a positive relation between director compensation and board meeting attendance. We therefore include a director compensation variable, Compensation_Dir, which is measured as the natural logarithm of (1 + annual director pay in RMB ten thousands). It is also plausible that the opportunity cost of attending meetings increases as directors accumulate more directorships in other firms (see e.g. Ferris et al., 2003; Fich and Shivdasani, 2006). Consistent with this conjecture, Adams and Ferreira (2008) document a positive relationship between a director s attendance problems and 26

29 the number of directorships he or she has. We therefore include Num Directorship_Dir to measure the number of independent directorships a director holds in other firms. Masulis et al., (2013) argue that director s geographic remoteness to the firm increases logistical difficulties in traveling and document a negative effect physical distance to the firm on board meeting attendance. We therefore include Location_Dir, an indicator variable that equals one if the independent director resides in the same province as the firm. Following Adams and Ferreira (2009), Srinidhi et al. (2011) and Larcker et al. (2007), we also include Gender_Dir in the analyses and whether the director is older than 70 (Age_Dir > 70). Detailed variable definitions are provided in Appendix 1. After obtaining information in individual director characteristics, we repeat all analyses at the director level and the results are reported in Table 9. The main variable of interest is still D&O insurance coverage. We also include the same set of firm characteristics as those in the main analyses. Board characteristics that we control for include number of board meetings, percentage of independent directors, board size, and Chairman/CEO duality. We exclude Director Comp, Director Location, Financial Expertise as they are now replaced by director-level measures. To save space, we suppress the coefficient estimates of all firm and board controls and only report the coefficient estimate of the main variable of interest and individual director characteristics. Year and industry fixed effects are included, and the standard errors are clustered at the director level. Panel A of Table 9 reports regression results on board meeting attendance using director-firm-year level observations. The dependent variable in Column (1) is Personal Attendance_Dir, which is the percentage of board meetings that a director personally attends in a given year. The dependent variable in Column (2) is Proxy Attendance_Dir, which is the percentage of board meetings that the director appoints an authorized representative to attend in a given year. The dependent variable in Column (3) is Attendance Problem_Dir, A dummy variable that equals one if the director personally attends fewer than 75% of the board meetings he/she is supposed to in a given year. We observe very similar results for the coefficient estimates on the key variable of interest D&O as those in firm-level analyses when we control for individual director characteristics in director-level analyses. Specifically, the coefficient estimate on D&O 27

30 insurance coverage is significantly negative in Column (1) and significantly positive in Columns (2) and (3), suggesting that compared to directors without D&O insurance, directors with D&O insurance tend to personally attend fewer meetings and appoint representatives to attend board meeting on their behalf, and they generally incur a greater attendance problem. As for control variables on director characteristics, we find that number of directorships have a negative relation with personal meeting attendance and a positive relation with proxy meeting attendance. These findings suggest that busy directors tend to personally attend fewer meetings due to time and energy constraint. Instead, they would appoint representatives to attend board meeting on their behalf so that they do not appear to skip more meetings. We also find that directors with financial expertise tend to have less attendance problem and they tend to personally attend board meetings. Consistent with the finding of Masulis et al., (2012), we find that geographic proximity between independent director and the firm is conducive to better attendance records and more personal meeting attendance. We also find evidence that independent directors are motivated by financial incentives that a higher compensation leads to less attendance problem. These results are in line with the findings of Adams and Ferreira (2008). Lastly, we find that director tenure has a negative impact on personal meeting attendance and overall attendance records. Panel B of Table 9 reports regression results on independent director dissenting in the face of heightened agency problems using director-firm-year level observations. The dependent variable is Dissent_Dir that equals one if the independent director issues at least one dissenting opinion in a given year. Proxy for agency conflict is expropriation of minority shareholder wealth by controlling shareholders in Column (1) and firm underperformance in Column (2). Again, we observe very similar results as those in firm-level analyses when we control for individual director characteristics. Specifically, the coefficient estimate on Other Receivables and Underperform are both positive and significant at the 1%, suggesting that independent directors are more inclined to confront and discipline controlling shareholders and management in the face of severe agency conflicts. More importantly, the coefficient estimates on the interaction term between D&O insurance 28

31 coverage and adverse firm events in both columns are negative and significant at the 1% level, suggesting that D&O insurance coverage demotivates independent directors to voice a dissenting opinion in the boardroom. Among control variables, consistent with the findings of DeFond et al. (2005), we find that independent directors with financial expertise are more likely to dissent. Moreover, independent directors who reside farther away from the firm are less likely to dissent. Higher compensation is conducive to independent director voicing an opposing opinion in the boardroom, another manifestation of greater effort level as these directors do not herd with management and other directors. We also find evidence that directors with longer tenure are more likely to dissent. One possible explanation is tenure is a measure of director s firm-specific monitoring experience, expertise, and relationship with the management. As such, independent directors who are veterans of the board are more likely to raise an opposite voice than newly appointed independent directors. Panel C of Table 9 reports regression results on the effectiveness of independent director monitoring using director-firm-year level observations. Columns (1) and (2) examine the effectiveness of independent director dissent in resolving agency conflicts. The dependent variable is Change_OtherReceivables in Column (1) and Change_ROA_Adj in Column (2), respectively. Consistent with findings reported in the main tests, while independent director dissent is able to mitigate controlling shareholder expropriation and enhances future firm performance, such disciplining effect is significantly reduced when the director is covered by the D&O insurance. We also find some support for a negative relation between number of outside directorships and firm future performance, and a positive effect of independent director s financial expertise, compensation, and tenure on deterring controlling shareholder expropriation of minority shareholder interest. Columns (3) and (4) aim to examine the impact of D&O insurance on the quality of executive compensation and turnover policy, two areas under the direct purview of the boards. Again, consistent with findings reported in the main tests, we find that D&O insurance coverage lowers executive pay-for-performance and turnover-performance sensitivities. Overall, our findings based on firm-level analyses remain robust after controlling for individual director characteristics and conducting director-level analyses. 29

32 6.4 Announcement Effects of D&O Insurance Purchase As our final test of the net effect of D&O insurance coverage, we examine how the stock market reacts to the announcement of D&O insurance purchase using the event study methodology. For D&O firms in our sample, we identify the year in which they first announced the D&O insurance purchase plan and search the annual reports, resolutions of shareholders and/or board meetings around that time for the first public disclosure date of the D&O purchase plan. After excluding firms without sufficient stock price information to calculate returns, we obtain 45 first-time announcements of D&O coverage between We follow the event study methodology in Ball and Brown (1968) and estimate the average cumulative abnormal returns (CARs) for [-20, +20] days surrounding the announcement of D&O insurance purchase. The choice of a 41-day event window reflects a trade-off between relevance and accuracy. On the one hand, choosing too wide an event window could incorporate too much noise irrelevant to the events. On the other hand, prior studies on the efficiency of China s stock market find evidence that investors may not incorporate new information into the stock prices on a timely manner. A wider event window allows for the possibility of pre-announcement information leakage and post-announcement drift. Abnormal returns are calculated using the market model, where the market beta is estimated using daily stock return data over the [-120, -21] day estimation window. The market return is composite index return of the Shanghai Stock Exchange and Shenzhen Stock Exchange. Figure 1 presents the event study results. On average market reacts negatively to firms decision to purchase D&O insurance, as the 41-day CARs have a mean of -5.6% and is significant at the 5% level (t-statistics = -2.07). As a robustness check, we also examine a [-10, +10] and [-5, +5] day event window, and the corresponding average CARs are -3.8% and -2.3%, respectively. These findings are consistent with the expectation by shareholders that the costs generated by D&O insurance in the form of weakened internal corporate governance and increased agency problems exceed the benefits that they bring to the firm. 7. Conclusion 30

33 In this paper, we examine the effect of D&O insurance coverage on the level of monitoring effort of independent directors and the effectiveness of their governance role. Using detailed director-level data on board meeting attendance records and opinions of a sample of Chinese companies, we find 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 of D&O insurance on 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 incentives of independent directors to confront controlling shareholders and management by raising a dissenting opinion in the face of controlling shareholder expropriation and firm underperformance. Moreover, we find that D&O insurance coverage reduces the effectiveness of director monitoring as manifested in a lower power to curb controlling shareholder expropriation and enhance future firm performance, a lower executive pay-for-performance sensitivity, and a lower CEO performance-turnover sensitivity. We use the instrumental variable approach to address endogeneity problem and Heckman (1979) two-stage approach to address self-selection bias. In addition, we repeat all firm-level analyses at the director-level controlling for an array of individual director characteristics. Finally, we also 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 perform their fiduciary duties in a less diligent and responsible manner. It is worth to note that despite limited breadth of D&O coverage and deficiencies in China s legal infrastructure, we still document a significant negative influence of D&O insurance on independent directors effort level and the effectiveness of their governance role. 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. 31

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36 Appendix 1 Variable Definition Variable Definition Firm Characteristics D&O t A dummy variable that equals 1 if a firm is covered by the D&O insurance in year t; Other Receivables t Other receivables scaled by book value of total assets measured at the end of year t; Change_OtherReceivables t+1 Change in other receivables between year t+1 and year t, scaled by book value of total assets measured at the end of year t; Mgmt_Comp t Total compensation that a firm pays out to the top three managers scaled by book value of total assets measured at the end of year t; CEO Turnover t+1 A dummy variable that equals 1 if a firm changes its CEO in year t+1; Assets t Natural logarithm of book value of total assets, measured at the end of year t; Leverage t Book value of debt divided by book value of total assets measured at the end of year t; ROA t Net income divided by book value of total assets measured at the end of year t; Change_ROA_Adj t+1 Change in firm s industry adjusted return ROA between year t+1 and year t, where industry adjusted return ROA is calculated as firm s ROA minus the industry average; Underperform t Industry average ROA minus the firm s ROA in year t; Past_Performance t-1 A dummy variable that equals 1 if a firm s industry adjusted ROA in year t-1 is below the sample median; H/B Share t A dummy variable that equals 1 if a firm has H shares and/or B shares in year t; Share Issue t+1 A dummy variable that equals 1 if a firm issues additional shares in year t+1; SOE t A dummy variable that equals 1 if a firm is a state-owned enterprise in year t; Inst Investors t Natural logarithm of number of institutional investors in year t; Inst Ownership t Institutional holdings (%) for a firm over year t, Largest Shareholder t Shareholdings (%) of largest shareholder divided by the sum of shareholdings (%) by the second to fifth largest shareholders for over year t, Related Party t Amount of related party transactions scaled by book value of total assets measured at the end of year t; Penalty t-1 A dummy variable that equals 1 if a firm was penalized by the CSRC in year t-1; Coast A dummy variable that equals 1 if a firm is located in coastal areas, including Beijing, Tianjin, Hebei, Liaoning, Shandong, Jiangsu, Shanghai, Zhejiang, Fujian, Guangdong, and Hainan, respectively; Board Characteristics Personal Attendance t Percentage of board meetings that independent directors personally attend in year t, averaged across independent directors; Proxy Attendance t Percentage of board meetings that independent directors appoint a proxy or nominee to attend in year t, averaged across independent directors; Attendance Problem t A dummy variable that equals 1 in fiscal year t if a firm has at least one independent director who personally attends fewer than 75% of the board meetings he/she is supposed to during that year; Dissent t A dummy variable that equals 1 if a firm has at least one independent director who issues an opposing opinion in year t; Board Meetings t Natural logarithm of number of board meetings held by a firm in year t; 34

37 Director_Comp t Compensation that a firm pays out to its directors in year t, averaged across independent directors; Director Location t Percentage of directors who reside in the same province as the firm in year t; Financial Expertise t Percentage of independent directors with financial expertise (experience as a public accountant, auditor, principal or chief financial officer, controllers, or principal or chief accounting officer) in year t; % Independent Directors t Percentage of independent directors at a firm in year t; Board Size t Natural logarithm of number of directors at a firm in year t; Duality t A dummy variable that equals 1 if a firm s CEO is also the chairman of the board in year t; Director Characteristics Personal Attendance_Dir t Percentage of board meetings that a director personally attends in year t; Proxy Attendance_Dir t Percentage of board meetings that a director appoints a proxy to attend in year t; Attendance Problem_Dir t A dummy variable that equals 1 if a director personally attends fewer than 75% of the board meetings he/she is supposed to in year t; Dissent_Dir t A dummy variable that equals 1 if a director issues at least one opposing opinions in year t; Financial Expertise_Dir t A dummy variable that equals 1 if a director has financial expertise (experience as a public accountant, auditor, principal or chief financial officer, controllers, or principal or chief accounting officer) in year t; Location_Dir t A dummy variable that equals 1 if a director resides in the same province as the firm; Gender_Dir A dummy variable that equals 1 if a director is a male; Age_Dir t A dummy variable that equals 1 if a director is above 70 years old by the end of year t; Compensation_Dir t Natural logarithm of (1+ compensation that a director receives) in year t; Tenure_Dir t Natural logarithm of (1+ number of years a director has served on the board) by the end of year t; Num Directorship_Dir t Number of independent directorships a director holds in year t; 35

38 Table 1 Summary Statistics and Correlation Matrix This table reports sample distribution and descriptive statistics of key variables in the paper. Panel A reports the number of observations by year and by D&O insurance coverage. Panel B reports the number of observations by industry and by D&O insurance coverage. Panel C reports summary statistics of key variables and Pearson correlation with D&O insurance coverage. Definitions of variables are provided in Appendix 1. ***, **, and * denote significance at the 1, 5, and 10 percent levels, respectively. Panel A: Sample distribution by year Year D&O Insurance Coverage = 1 D&O Insurance Coverage = 0 No. of Obs. Percentage No. of Obs. Percentage % 1, % % 1, % % 1, % % 1, % % 1, % % 1, % % 2, % % 2, % % 2, % Total % 16, % Panel B: Sample distribution by industry D&O Insurance Coverage = 1 D&O Insurance Coverage = 0 Industry Description No. of Obs. Percentage No. of Obs. Percentage Agriculture, Forestry, Animal Husbandry and Fishery % % Commercial Service % % Communication and Culture % % Construction % % Electric Power, Heat, Gas and Water % % Electronics % % Financial and Insurance % % Food and Beverage % % IT and Software % 1, % Machinery, Equipment, and Instrument % 2, % Metal and Non-metal % 1, % Mining % % Other Manufacturing Industries % % Papermaking and Printing % % Petroleum, Chemical, Rubber and Plastic Products % 1, % Pharmaceutical and Bio Products % 1, % Textile, Garment, and Apparel % % Transportation, Storage and Postal Service % % Real Estate % % Wholesale and Retail % % Wood and Furniture % % Others % % Total % 16, % 36

39 Panel C: Summary statistics Variable Obs. Mean Std. Dev. Min Max Correlation with D&O D&O 16, Personal Attendance 16, *** Proxy Attendance 16, *** Attendance Problem 16, *** Dissent 15, Other Receivables 16, *** Change_Other Receivables 14, Mgmt Comp 16, *** CEO Turnover 16, * ROA 16, ** Underperform 16, *** Change_ROA_Adj 15, Past_Performance 15, *** H/B Share 16, *** Share Issue 14, * SOE 16, *** Inst Investor 16, *** Inst Ownership 16, *** Largest Shareholding 16, * Penalty 15, * Related Party 16, *** Leverage 16, *** Assets 16, *** Board Meetings 16, *** Director Comp 15, *** Director Location 15, *** Financial Expertise 15, * % Independent Directors 16, Board Size 16, *** Duality 16, *** 37

40 Table 2 D&O Insurance Coverage and Board Meeting Attendance This table reports pooled regression results of D&O insurance coverage on board meeting attendance. The dependent variable in Column (1) is Personal Attendance, defined as percentage of board meetings that independent directors personally attend in a given year, averaged across independent directors. The dependent variable in Column (2) is Proxy Attendance, defined as percentage of board meetings that independent directors appoint a proxy to attend in a given year, averaged across independent directors. The dependent variable in Column (3) is Attendance Problem, a dummy variable that equals one if a 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. Columns (1) and (2) display results of the OLS regressions. Column (3) displays results of the Logit regression. Definitions of other variables are provided in Appendix 1. Year and industry fixed effects are included in all regressions but the coefficients are not reported. Robust t-statistics or z-statistics clustered by firm are displayed in parentheses. ***, **, and * denote significance at the 1, 5, and 10 percent levels, respectively. Dependent Variable = Personal Attendance Dependent Variable = Proxy Attendance Dependent Variable = Attendance Problem (1) (2) (3) D&O *** 0.018*** 0.557*** (-3.201) (3.113) (2.641) Board Meetings 0.014*** *** *** (6.554) (-8.424) ( ) Director Comp * *** (-0.620) (1.770) (-3.283) Director Location (-0.071) (0.058) (-0.404) Financial Expertise 0.004* ** (1.890) (-1.618) (-2.168) % Independent Directors 0.033** ** (2.080) (-2.024) (-0.745) Duality (0.959) (-0.970) (-0.550) Mgmt Comp *** 0.008*** 0.255*** (-3.852) (3.781) (2.771) Inst Investor * 0.002* 0.113** (-1.820) (1.656) (2.304) Inst Ownership 0.000* * ** (1.772) (-1.781) (-2.069) Largest Shareholding 0.000*** ** ** (2.615) (-2.071) (-2.023) Leverage ** *** (-1.980) (1.193) (3.423) Assets ** 0.003** 0.139** (-2.048) (2.461) (2.278) ROA 0.046*** ** * (3.248) (-2.104) (-1.924) Related Party ** 0.056** 2.381** (-2.157) (2.056) (1.980) SOE *** 0.005*** 0.194** (-3.311) (3.048) (2.567) H/B Share (-0.198) (0.255) (0.698) Penalty * * (-1.957) (1.337) (1.706) Share Issue (-0.674) (1.609) (-0.150) Constant 0.954*** 0.043***

41 (70.019) (3.244) (-0.222) Year and Industry Fixed Effects Included Included Included Method OLS OLS Logit Observations 12,289 12,289 12,289 Adjusted R 2 / Pseudo R

42 Table 3 D&O Insurance Coverage and Independent Director Opinion This table reports Logit regression results of D&O insurance coverage on independent director opinion. The dependent variable is Dissent, a dummy that equals one if a firm has at least one independent director who issues an opposing opinion in a given year. The independent variable Other Receivables is defined as other receivables scaled by book value of total assets measured at the end of a year. The independent variable Underperform is defined as industry average return on assets ratio minus firm s own return on assets ratio in a given year. Definitions of other variables are provided in Appendix 1. Year and industry fixed effects are included in all regressions but the coefficients are not reported. Robust z-statistics clustered by firm are displayed in parentheses. ***, **, and * denote significance at the 1, 5, and 10 percent levels, respectively. Dependent Variable = Dissent (1) (2) (3) (4) Other Receivables 4.877*** 4.979*** (4.110) (4.197) Other Receivables D&O ** (-2.344) Underperform 5.297*** 5.449*** (3.196) (3.261) Underperform D&O ** (-2.083) D&O (0.690) (-0.356) Board Meetings 0.767*** 0.778*** 0.808*** 0.814*** (2.625) (2.661) (2.797) (2.811) Director Comp (1.050) (1.017) (1.189) (1.225) Director Location (-1.230) (-1.231) (-1.460) (-1.461) Financial Expertise (0.788) (0.799) (0.665) (0.677) % Independent Directors (-0.670) (-0.683) (-0.662) (-0.676) Board Size (1.624) (1.616) (1.547) (1.578) Duality (1.217) (1.233) (1.279) (1.258) Mgmt Comp 0.401* 0.409* 0.465* 0.470** (1.716) (1.746) (1.954) (1.968) Inst Investor *** *** ** ** (-2.692) (-2.705) (-2.267) (-2.289) Inst Ownership (0.180) (0.189) (0.162) (0.178) Largest Shareholding ** ** ** ** (-2.023) (-2.028) (-2.114) (-2.109) Leverage 1.490*** 1.459*** 1.680*** 1.675*** (3.124) (3.070) (3.313) (3.302) Assets (-0.157) (-0.151) (-0.597) (-0.572) Related Party (-0.249) (-0.263) (-0.448) (-0.453) SOE 0.332* 0.330* (1.799) (1.789) (1.246) (1.218) H/B Share (-1.081) (-1.109) (-0.751) (-0.756) Constant *** *** *** *** 40

43 (-4.866) (-4.872) (-4.797) (-4.842) Year and Industry Fixed Effects Included Included Included Included Observations 13,810 13,810 13,915 13,915 Pseudo R

44 Table 4 D&O Insurance Coverage and Governance Effect of Independent Director Dissent This table reports pooled OLS regression results of D&O insurance coverage on the governance effect of independent director dissent. The dependent variable in Columns (1) and (2) is Change_OtherReceivables, defined as change in other receivables between year t+1 and year t, scaled by book value of total assets measured at the end of year t. The dependent variable in Columns (3) and (4) is Change_ROA_Adj, defined as change in industry adjusted return on assets between year t+1 and year t. The independent variable Dissent is a dummy variable that equals one if a firm has at least one independent director who issues an opposing opinion in year t. Definitions of other variables are provided in Appendix 1. Year and industry fixed effects are included in all regressions but the coefficients are not reported. Robust t-statistics clustered by firm are displayed in parentheses. ***, **, and * denote significance at the 1, 5, and 10 percent levels, respectively. Dependent Variable = Change_Other Receivables Dependent Variable = Change_ROA_Adj (1) (2) (3) (3) Dissent *** *** 0.016*** 0.016*** (-3.026) (-3.103) (4.672) (4.711) Dissent D&O 0.019*** ** (5.073) (-2.488) D&O *** (-1.263) (2.662) Board Meetings (-1.544) (-1.511) (-0.124) (-0.106) Director Comp *** *** (-1.329) (-1.304) (-3.445) (-3.520) Director Location (-0.241) (-0.260) (-0.502) (-0.425) Financial Expertise * * (-1.722) (-1.729) (0.274) (0.256) % Independent Directors (0.510) (0.511) (0.733) (0.702) Board Size (1.529) (1.528) (-0.117) (-0.126) Duality (0.360) (0.367) (-1.308) (-1.298) Inst Investor *** *** (-1.091) (-1.056) ( ) ( ) Inst Ownership (-0.920) (-0.989) (-0.414) (-0.356) Largest Shareholding *** 0.000*** (1.595) (1.582) (2.817) (2.835) Leverage *** *** 0.061*** 0.061*** (-5.180) (-5.165) (21.365) (21.325) Assets 0.002*** 0.002*** *** *** (6.767) (6.781) (-2.628) (-2.667) ROA 0.042*** 0.042*** 0.628*** 0.628*** (5.505) (5.489) (43.222) (43.261) SOE *** 0.002*** (0.871) (0.884) (3.341) (3.258) H/B Share ** ** 0.004** 0.003** (-2.043) (-1.990) (2.390) (2.166) Constant *** *** ** * (-4.107) (-4.125) (-1.999) (-1.936) Year and Industry Fixed Effects Included Included Included Included Observations 9,152 9,152 12,872 12,872 Adjusted R

45 Table 5 D&O Insurance Coverage and Executive Pay-For-Performance Sensitivity This table reports pooled OLS regression results D&O insurance coverage on executive pay-for-performance sensitivity. The dependent variable is Mgmt Comp, defined as total compensation that a firm pays out to the top three managers in a given year scaled by book value of total assets measured at the end of the year. The independent variable Past Performance, a dummy variable that equals one if a firm s industry adjusted ROA in year t-1 is below the sample median, and zero otherwise. Definitions of other variables are provided in Appendix 1. Year and industry fixed effects are included in all regressions but the coefficients are not reported. Robust t-statistics clustered by firm are displayed in parentheses. ***, **, and * denote significance at the 1, 5, and 10 percent levels, respectively. Dependent Variable = Mgmt Comp (1) (2) Past Performance *** *** ( ) ( ) Past Performance D&O 0.107** (2.103) D&O (-0.835) % Independent Directors (1.554) (1.535) Financial Expertise 0.035** 0.035** (2.383) (2.380) Board Meetings (-0.670) (-0.684) Board Size 0.114*** 0.114*** (3.711) (3.712) Duality 0.047*** 0.047*** (2.970) (2.977) Largest Shareholding *** *** (-3.237) (-3.211) Inst Ownership (-0.576) (-0.531) Inst Investor 0.041*** 0.041*** (6.367) (6.349) Penalty (-1.416) (-1.397) SOE (1.338) (1.339) H/B Share 0.145*** 0.144*** (5.531) (5.520) Assets *** *** ( ) ( ) Leverage ** ** (-2.283) (-2.282) Constant 2.728*** 2.732*** (23.249) (23.289) Year and Industry Fixed Effects Included Included Observations 14,407 14,407 Adjusted R

46 Table 6 D&O Insurance Coverage and CEO Turnover-Performance Sensitivity This table reports Logit regression results of D&O insurance coverage on CEO turnover-performance sensitivity. The dependent variable is CEO Turnover, a dummy variable that equals one if a firm changes its CEO in year t+1. The independent variable Past Performance, a dummy variable that equals one if a firm s industry adjusted ROA in year t-1 is below the sample median, and zero otherwise. Definitions of other variables are provided in Appendix 1. Year and industry fixed effects are included in all regressions but the coefficients are not reported. Robust z-statistics clustered by firm are displayed in parentheses. ***, **, and * denote significance at the 1, 5, and 10 percent levels, respectively. Dependent Variable = CEO Turnover VARIABLES (1) (2) Past Performance 0.232*** 0.240*** (5.340) (5.474) Past Performance D&O ** (-1.975) D&O 0.417** (2.508) % Independent Directors 1.078** 1.082** (2.159) (2.169) Financial Expertise (0.644) (0.621) Board Meetings 0.509*** 0.511*** (7.401) (7.414) Board Size ** ** (-2.424) (-2.432) Duality *** *** (-6.103) (-6.096) Largest Shareholding 0.004* 0.004* (1.669) (1.663) Inst Ownership *** *** (-4.284) (-4.294) Inst Investor (0.396) (0.358) Penalty 0.300*** 0.300*** (4.050) (4.045) SOE 0.115** 0.113** (2.574) (2.516) H/B Share (1.146) (1.002) Assets *** *** (-4.327) (-4.342) Leverage 0.669*** 0.667*** (5.465) (5.446) Constant *** *** (-3.250) (-3.249) Year and Industry Fixed Effects Included Included Observations 14,469 14,469 Pseudo R

47 Table 7 Instrumental Variables Approach This table reports the two stage least squares regression results of D&O insurance coverage on independent director behavior and governance effects. The instrumental variable is Coast, a dummy variable that equals one if the firm is located in the coastal areas. Definitions of other variables are provided in Appendix 1. Panel A reports first-stage regression that generates the fitted (instrumented) value of Exp D&O for use in the second-stage regressions. Panel B reports results of second-stage regressions on independent director behavior. Panel C reports results of second-stage regressions in independent director governance effects. Each regression includes year and firm fixed effects but the coefficients are not reported. Robust t-statistics or z-statistics clustered by firm are displayed in parentheses. ***, **, and * denote significance at the 1, 5, and 10 percent levels, respectively. Panel A: First stage of 2SLS regressions Dependent Variable = D&O Instrumental Variables Coast 0.314* (1.933) Control Variables Director Compensation 0.869*** (4.888) % Independent Directors (0.290) Duality (-1.384) Inst Ownership (1.537) Leverage (1.544) Assets 0.490*** (6.580) ROA ** (-2.521) SOE 0.610*** (4.631) H/B Shares 1.211*** (7.348) Constant *** (-8.304) Year and Industry Fixed Effects Included Observations 14,754 Pseudo R

48 Panel B: Second stage of 2SLS regressions Independent director behavior Dependent Variable = Personal Proxy Attendance Attendance Attendance Problem Dissent Dissent (1) (2) (3) (4) (5) Exp D&O *** 0.188** *** (-3.221) (2.462) (2.763) (0.594) (-0.587) Other Receivables 6.080*** (4.338) Other Receivables Exp D&O ** (-2.075) Underperform 5.824*** (2.668) Underperform Exp D&O (0.333) Firm and Board Characteristics Included Included Included Included Included Year and Industry Fixed Effects Included Included Included Included Included Observations 10,597 10,597 10,597 13,347 13,455 Pseudo R Panel C: Second stage of 2SLS regressions Governance effect Dependent Variable = Change Other Receivables Change_ROA_Adj Mgmt Comp CEO Turnover Exp D&O *** (0.383) (1.309) (10.064) (-0.839) Dissent *** 0.020*** (-3.390) (4.423) Dissent Exp D&O 0.301** *** (2.141) (-2.727) Past Performance *** 0.297*** ( ) (4.874) Past Performance Exp D&O 1.640*** * (3.200) (-1.757) Firm and Board Characteristics Included Included Included Included Year and Industry Fixed Effects Included Included Included Included Observations 8,821 12,397 13,514 13,554 Adjusted R

49 Table 8 Heckman Two-Stage Approach This table reports results of Heckman (1979) two-stage analyses on the relationship between D&O insurance coverage and independent director behavior and governance effect. Panel A reports results of first-stage regression of a probit model for D&O insurance purchase decision. The inverse mills ratio (IMR) from the first stage is used in the send-stage regressions. Panel B reports results of second-stage regressions on independent director behavior. Panel C reports results of second-stage regressions in independent director governance effects. Definitions of other variables are provided in Appendix 1.Each regression includes year and firm fixed effects but the coefficients are not reported. Robust t-statistics or z-statistics clustered by firm are displayed in parentheses. ***, **, and * denote significance at the 1, 5, and 10 percent levels, respectively. Panel A: First stage Probit model Dependent Variable = D&O % Independent Directors (0.134) Board Size (0.297) Duality (-1.147) Director Comp 0.328*** (4.439) Largest Shareholder (-0.835) Inst Investor 0.092*** (2.987) Inst Ownership (-0.573) Mgmt Comp (0.739) Related Party (0.322) Share Issue (-1.631) SOE 0.267*** (4.490) H/B Share 0.610*** (8.663) Leverage 0.274* (1.724) Assets 0.156*** (3.188) ROA *** (-3.295) Constant *** ( ) Year and Industry Fixed Effects Included Observations 14,897 Pseudo R

50 Panel B: Second stage regressions Independent director behavior Dependent Variable = Personal Proxy Attendance Attendance Attendance Problem Dissent Dissent (1) (2) (3) (4) (5) D&O *** 0.018*** 0.561*** (-3.209) (3.113) (2.641) (0.688) (-0.386) Other Receivables 4.203*** (3.531) Other Receivables D&O ** (-2.372) Underperform 7.527* (1.741) Underperform D&O ** (-2.147) IMR 0.029** ** * *** (2.396) (-2.001) (-1.835) (-2.659) (0.378) Firm and Board Characteristics Included Included Included Included Included Year and Industry Fixed Effects Included Included Included Included Included Observations 12,014 12,014 12,014 13,517 13,625 Adjusted R 2 / Pseudo R Panel C: Second stage regressions Governance effect Dependent Variable = Change_ Other Receivables Change_ ROA_Adj Mgmt Comp CEO Turnover D&O *** ** (-1.272) (2.582) (-1.261) (2.415) Dissent *** 0.016*** (-3.235) (4.544) Dissent D&O 0.022*** * (3.479) (-1.797) Past Performance *** 0.241*** ( ) (5.263) Past Performance D&O 0.093** * (2.179) (-1.822) IMR *** *** (0.435) (4.169) ( ) (-0.123) Firm and Board Characteristics Included Included Included Included Year and Industry Fixed Effects Included Included Included Included Observations 8,926 12,543 13,707 13,707 Adjusted R

51 Table 9 D&O Insurance and Independent Director Behavior - Director Level Analysis This table reports pooled regression results of D&O insurance coverage on board meeting attendance, dissent, and governance effects using director level data. Panel A reports results of D&O insurance coverage on board meeting attendance. The dependent variable in Column (1) is Personal Attendance_Dir, defined as percentage of board meetings that the independent director personally attends in a given year. The dependent variable in Column (2) is Proxy Attendance_Dir, defined as percentage of board meetings that the independent director appoints a proxy to attend in a given year. The dependent variable in Column (3) is Attendance Problem_Dir, a dummy variable that equals one if the independent director personally attends fewer than 75% of the board meetings in a given year. Columns (1) and (2) display results of the OLS regressions. Column (3) displays results of the Logit regression. Panel B reports results of D&O insurance on independent director dissent. The dependent variable is Dissent_Dir, a dummy variable that equals one if the independent director issues at least one dissenting opinion in a given year. The independent variable Other Receivables, defined as other receivables scaled by book value of total assets measured at the end of a given year. The independent variable Underperform, defined as industry average return on assets ratio minus firm s return on assets ratio in a given year, measures firm performance relative to industry peers. Panel C reports results of D&O insurance coverage on governance effects of independent directors. The dependent variable in Column (1) is Change_OtherReceivables, defined as change in other receivables between year t+1 and year t, scaled by book value of total assets measured at the end of year t. The dependent variable in Column (2) is Change_ROA_Adj, defined as industry adjusted return on assets in year t+1 minus industry adjusted return on assets in year t. The dependent variable in Column (3) is Mgmt Comp, defined as total compensation that a firm pays out to top three managers in a given year divided by book value of total assets. The dependent variable in Column (4) is CEO Turnover, a dummy variable that equals one if a firm changes its CEO in year t+1. Definitions of other variables are provided in Table 1. Firm and board characteristics are included in all regressions but the coefficients are not reported. Year and industry fixed effects are included in all regressions but the coefficients are not reported. Robust t-statistics or z-statistics clustered by director are displayed in parentheses. ***, **, and * denote significance at the 1, 5, and 10 percent levels, respectively. Panel A: Attendance Dependent Variable = Personal Attendance_Dir Dependent Variable = Proxy Attendance_Dir Dependent Variable = Attendance Problem_Dir (1) (2) (3) D&O *** 0.016*** 0.418*** (-3.127) (3.276) (3.033) Num Directorship_Dir *** 0.002*** (-2.767) (3.439) (1.376) Financial Expertise_Dir 0.012*** *** *** (8.170) (-7.736) (-5.831) Location_Dir 0.013*** *** *** (8.580) (-8.708) (-7.428) Gender_Dir (0.309) (-0.194) (-0.288) Age_Dir (0.404) (-0.263) (0.256) Compensation_Dir * *** (1.623) (1.953) (-5.317) Tenure_Dir *** 0.005*** 0.146*** (-6.240) (4.814) (3.695) Firm and Board Characteristics Included Included Included Year and Industry Fixed Effects Included Included Included Observations 41,007 41,007 41,007 Adjusted R 2 / Pseudo R

52 Panel B: Opinion Dependent Variable = Dissent (1) (2) Other Receivables 5.099*** (6.374) Other Receivables D&O *** (-2.842) Underperform 6.443*** (5.337) Underperform D&O *** (-3.988) D&O (0.911) (-0.987) Num Directorship_Dir (0.285) (0.036) Financial Expertise_Dir 0.233* 0.252** (1.939) (2.125) Location_Dir * ** (-1.806) (-2.184) Gender_Dir (-0.836) (-0.841) Age_Dir (-0.335) (-0.286) Compensation_Dir 0.228* 0.254** (1.829) (2.065) Tenure_Dir 0.497*** 0.476*** (4.373) (4.274) Firm and Board Characteristics Included Included Year and Industry Fixed Effects Included Included Observations 47,111 47,870 Pseudo R Panel C: Governance Effect Dependent Variable = Change_ Change_ CEO OtherReceivables ROA_Adj Mgmt Comp Turnover (1) (2) (3) (4) Dissent_Dir *** 0.016*** (-4.086) (6.578) Dissent_Dir D&O 0.017*** *** (5.193) (-7.522) Past Performance *** 0.239*** ( ) (10.277) Past Performance D&O 0.078*** ** (3.641) (-2.412) D&O *** ** 0.311*** (-1.208) (4.259) (-2.433) (3.138) Num Directorship_Dir 0.000** *** 0.008*** (2.001) (-2.625) (3.048) (0.039) Financial Expertise_Dir ** (-2.247) (1.204) (1.238) (-0.648) Location_Dir *** ** (-0.790) (-0.801) (-5.017) (-2.326) 50

53 Gender_Dir (-1.258) (-1.591) (-0.461) (-0.227) Age_Dir (-0.352) (0.736) (1.294) (0.804) Compensation_Dir *** *** 0.098*** *** (-3.761) (-7.740) (22.667) (-8.656) Tenure_Dir *** *** (-0.940) (0.058) (-7.279) ( ) Firm and Board Characteristics Included Included Included Included Year and Industry Fixed Effects Included Included Included Included Observations 31,037 44,532 48,278 48,488 Adjusted R 2 / Pseudo R

54 Cumulative Abnormal Returns Figure 1 Stock Market Reaction to the Announcement of D&O Insurance Purchase This graph plots the average cumulative abnormal returns (CARs) for [-20, +20] days surrounding the announcement of D&O insurance purchase. Abnormal returns are calculated using the market model, where the market beta is estimated using daily stock return data over the [-120, -21] day estimation window. The market return is composite index return of the Shanghai Stock Exchange and Shenzhen Stock Exchange Days Relative to the Announcement Date 52