Accounting and Litigation Risk

The following post comes to us from Zhiyan Cao, Assistant Professor of Accountancy at the University of Washington Tacoma, and Ganapathi S. Narayanamoorthy, Assistant Professor of Accountancy at the University of Illinois at Urbana-Champaign.

In our paper, Accounting and Litigation Risk: Evidence from Directors’ & Officers’ Insurance Pricing, forthcoming in the Review of Accounting Studies, we study whether and how financial reporting concerns and traditional measures of corporate governance are priced by insurers that sell Directors’ and Officers’ (D&O) insurance to public firms. As D&O insurers typically assume the liabilities arising from shareholder litigation, the insurance premiums they charge for D&O coverage reflect their assessment of a company’s litigation risk.

Estimation of ex-ante litigation risk has always been a challenge for empirical research. Past studies employ ex-post lawsuits to derive an ex-ante measure of litigation risk. In such studies, a litigation risk prediction model is first estimated with the dependent variable being whether the firm got sued ex-post. The predicted values of the probability of getting sued are then used as ex-ante measures of litigation risk in an empirical model. Such measures ignore lawsuits filed in other jurisdictions and also cannot distinguish between frivolous and serious lawsuits. We employ a market-based measure of ex-ante litigation risk; that is, the D&O liability insurance premium, which incorporates the ex-ante expectation of both the likelihood of lawsuits and the magnitude of damages. In the U.S., public firms routinely purchase D&O insurance coverage for their directors and officers for reimbursement of defense costs and settlements arising from shareholder litigation. Most shareholder litigation is settled within policy limits, with the D&O insurers primarily footing the bill. Therefore, we expect the D&O insurers to price financial reporting risk and corporate governance risk efficiently in order to compensate for their expected payout obligations in the case of lawsuits.

Using a sample of 152 U.S. public firms in the Tillinghast D&O insurance surveys conducted between 2001 and 2004, we find that firms with restatements of accounting numbers prior to the effective date of D&O coverage pay higher insurance premiums after controlling for other economic factors that shape a firm’s litigation environment. This evidence suggests that D&O insurers view the restatements as indicative of chronic problems in the financial reporting process rather than as a corrective action that signals better accounting quality (and, in turn, lower litigation risk) in the future. This is because current D&O insurance premiums do not reflect the risk of lawsuits pertaining to specific past restatements, as the payouts for these lawsuits would typically be covered by prior D&O insurance contracts effective at the time of the restatement announcement due to the common use of provisions such as “notice of circumstances”. They reflect, instead, insurers’ concerns about financial reporting going forward. In addition, we find that insurers’ concerns about financial reporting appear to be most evident for firms with “non-core” restatements not involving revenue or expense recognition issues rather than for firms with “core” restatements involving such issues. This finding indicates that core restatements likely lead to an effective disciplining of a firm’s accounting practices and hence do not raise future litigation risk. Prior studies provide mixed results as to whether the stock market’s concern about a firm’s financial reporting is transitory or long-term following accounting restatements. Our finding based on the unique perspective of the D&O insurers, an import market participant, adds new evidence to this literature.

We also study the effect of corporate governance on D&O insurance premiums. Whether litigation risk should be positively or negatively associated with corporate governance is theoretically an open question, given that both litigation risk and corporate governance are elements of a broad system of control mechanisms. Romano (1991) argues that certain “good” corporate governance mechanisms make litigation easier. Imposing personal liability on corporate officers and directors for breach of duties of care (negligence) and loyalty (conflict of interest) facilitates litigation and can help align the interests of the managers with those of the shareholders. This suggests a positive association between good governance and litigation risk. However, poor corporate governance that leads to ineffective disciplining of managers can imply higher litigation risk, which indicates a negative relation between corporate governance and litigation risk. Empirically, we follow prior research in examining the structural characteristics of boards such as board size, board independence and CEO duality, equity incentives of insiders, institutional shareholdings and audit committee characteristics. We find that adding the corporate governance variables contributes little additional explanatory power in the litigation risk models after we control for financial reporting risk, business risk and risk arising from the Private Securities Litigation Reform Act of 1995. This finding points to the lack of importance given by insurance industry professionals to structural governance characteristics that are commonly used in empirical research in the pricing of litigation risk.

The full paper is available for download here.

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