Andrew Verstein

Almost all public companies buy insurance for their directors and officers. D&O insurers should be active gatekeepers for the corporation, since they lose money if executives misbehave, but all available evidence suggests the opposite: insurers protect executives from liability for bad management, and they encourage wasteful settlement of even meritless lawsuits.

This Article diagnoses the failure of D&O insurance as a form of pernicious relational contracting. Insurers ignore even the worst corporate governance because they can recoup losses in the years to come. This recognition unlocks a potential solution: mandatory rotation. If insurers had only a few years to recoup any losses, they would seek to limit those losses by serving as an active gatekeeper.

Introduction

In a typical year, managers of corporations representing about 10% of America’s big public corporations are sued by their investors.¹ 1.Securities Class Action Filings: 2019 Year in Review, Cornerstone Research 13, https​://securities.stanford.edu/research-reports/1996-2019/Cornerstone-Research-Securities-Class​-Action-Filings-2019-YIR.pdf [https://perma.cc/PD8P-YL84] (reporting 10% of S&P 500 by market cap was sued for securities violations in 2019). Last year brought slightly fewer. Securities Class Action Filings: 2021 Year in Review, Cornerstone Research 15, https://www.cornerstone.com/wp-content/uploads/2022/02/Securities-Class-Action-Filings-2​021-Year-in-Review.pdf. [https://perma.cc/4JGL-35SH]. This 10% figure plainly understates the scope of litigation, since many investors’ suits are derivative actions with no securities violation component, but comprehensive data for derivative suits are not available.In this Article, I use the word “manager” to refer to both officers and directors.Show More These suits cost billions of dollars to litigate and settle.² 2.Alice Uribe & Leslie Scism, Companies Are Paying a Lot More to Insure Their Directors and Officers, Wall St. J. (June 21, 2020, 5:30 AM), https://www.wsj.com/articles/companies-are-paying-a-lot-more-to-insure-their-directors-and-officers-11592731801?mod=hp_listc_po​s2 [https://perma.cc/93HE-LMK9] (reporting that D&O litigation expenses are approaching $1 billion annually, not including jury verdicts or settlements).Show More Proponents of shareholder litigation argue that America’s corporate directors and officers are prone to gross negligence, bad faith, and self-dealing.³ 3.E.g., Eugene V. Rostow, To Whom and For What End is Corporate Management Responsible?, in The Corporation In Modern Society 48 (Edward S. Mason ed., 1959) (characterizing derivative suits as “the most important procedure the law has yet developed to police the internal affairs of corporations”); Robert B. Thompson & Randall S. Thomas, The Public and Private Faces of Derivative Lawsuits, 57 Vand. L. Rev. 1747, 1786–87 (2004) (finding data that derivative suits play a valuable monitoring role in duty of loyalty cases and that the tool combats unscrupulous directors); see also Jill E. Fisch, Teaching Corporate Governance Through Shareholder Litigation, 34 Ga. L. Rev. 745, 746 (2000) (explaining how the rules of shareholder litigation can “deter[] corporate misconduct”).Show More Critics argue that these are attorney-driven “strike suits.”⁴ 4.See Rostow, supranote 3; Stephen M. Bainbridge, Fee-Shifting: Delaware’s Self-Inflicted Wound, 40 Del. J. Corp. L. 851, 852–53 (2016); Roberta Romano, The Shareholder Suit: Litigation without Foundation?, 7 J.L. Econ. & Org. 55, 84 (1991); Sean J. Griffith, Correcting Corporate Benefit: How to Fix Shareholder Litigation by Shifting the Doctrine on Fees, 56 B.C. L. Rev. 1, 2 (2015).Show More

Nearly everyone agrees that directors’ and officers’ insurance (“D&O insurance”) is part of the problem.⁵ 5.Dain C. Donelson, Justin J. Hopkins & Christopher G. Yust, The Role of Directors’ and Officers’ Insurance in Securities Fraud Class Action Settlements, 58 J.L. & Econ. 747, 748 (2015); see Sean J. Griffith, Uncovering A Gatekeeper: Why the SEC Should Mandate Disclosure of Details Concerning Directors’ and Officers’ Liability Insurance Policies, 154 U. Pa. L. Rev. 1147, 1189 (2006).Show More

Essentially all public companies buy insurance to protect their managers from the cost of shareholder litigation, and it is easy to see how widespread insurance can cause problems.⁶ 6.Griffith, supra note 5, at 1168.Show More Insured officers and directors are protected against the legal consequences of their mismanagement and recklessness.⁷ 7.Id. at 1163.Show More They can behave badly without ever seeing the bill. The insurance company pays the bill. Indeed, managers may ask insurers to pay lucrative settlements, even in meritless cases, just to minimize the hassle and cost of litigation.⁸ 8.Tom Baker & Sean J. Griffith, How the Merits Matter: Directors’ and Officers’ Insurance and Securities Settlements, 157 U. Pa. L. Rev. 755, 797–98 (2009).Show More And it is insurers’ reputation as honeypots that draws plaintiffs’ lawyers to concoct meritless suits.⁹ 9.See Richard M. Phillips & Gilbert C. Miller, The Private Securities Litigation Reform Act of 1995: Rebalancing Litigation Risks and Rewards for Class Action Plaintiffs, Defendants and Lawyers, 51 Bus. Law. 1009, 1014–15 (1996).Show More Thus, D&O insurance serves to clog up dockets with stories of misbehavior, both encouraged and imagined.

This critique is strange because it is at odds with a plausible theory of gatekeeper behavior.¹⁰ 10.The “gatekeeper” idea is that trusted professionals near the corporation can be used as external checks on fraud and mismanagement. See John C. Coffee, Jr., The Acquiescent Gatekeeper: Reputational Intermediaries, Auditor Independence and Governance of Accounting 11–13 (Colum. L. Sch., Ctr. For L. & Econ. Stud., Working Paper No. 191, 2001), http://papers.ssrn.com/sol3/papers.cfm?abstract_id=270944 [https://perma.cc/LM3D-3T6H].Show More Why would insurers sign up to be punching bags?¹¹ 11.See Joseph A. Grundfest, Punctuated Equilibria in the Evolution of United States Securities Regulation, 8 Stan. J.L. Bus. & Fin. 1, 7–8 (2002) (“D&O insurers could today easily make the retention of insurer-approved auditors a condition of coverage. They could today also require an element of control over the audit process. Yet they don’t. Why?”).Show More Insurers have strong incentives to watch for warning signs and drop customers before the hammer drops, or at least to increase insurance premiums vividly when clients stand on the precipice of trouble.¹² 12.Such responses were once common. Roberta Romano, What Went Wrong With Directors’ and Officers’ Liability Insurance?, 14 Del. J. Corp. L. 1, 12 (1989). Professor Romano’s article diagnosed insurer responses to a sudden increase in liability exposure, so it is unsurprising that insurers reacted in this way. Id. at 13. There is no indication that this tendency to withdraw is still commonplace.Show More They have strong incentives to monitor their insureds for dangerous risk. They have strong incentives to retain control of individual suits to fight meritless ones. All of these risk-controlling practices are commonplace when insurers offer nearly any other kind of multi-million-dollar coverage. ¹³ 13.Richard V. Eicson & Aaron Doyle, Uncertain Business: Risk, Insurance and the Limits of Knowledge 94–211 (2004) (reporting research from a variety of contexts including building construction and disability management); Steven Shavell, On Liability and Insurance, 13 Bell J. Econ. 120, 121–22 (1982) (modeling the relationship between liability and insurance and concluding that, “[a]lthough the purchase of liability insurance changes the incentives created by liability rules, the terms of the insurance policies sold in a competitive setting would be such as to provide an appropriate substitute (but not necessarily equivalent) set of incentives to reduce accident risks”).Show More Critics of D&O insurance tacitly assume that these insurers are uniquely negligent in protecting themselves from moral hazard, adverse selection, and predation.¹⁴ 14.Moral hazard is the tendency of insured parties to engage in riskier conduct. Kenneth J. Arrow, Uncertainty and the Welfare Economics of Medical Care, 53 Am. Econ. Rev. 941, 961 (1963); Daniel Schwarcz, Reevaluating Standardized Insurance Policies, 78 U. Chi. L. Rev. 1263, 1283 (2011). With respect to health insurance, smoking has been described as the “classic moral hazard.” Thomas R. McLean, International Law, Telemedicine & Health Insurance: China as a Case Study, 32 Am. J.L. & Med. 7, 25 (2006). Adverse selection is the tendency of the costliest clients to seek out coverage offered at a given price. Cf. George A. Akerlof, The Market for “Lemons”: Quality Uncertainty and the Market Mechanism, 84 Q.J. Econ. 488, 488 (1970) (setting out a canonical adverse selection model in a non-insurance commercial setting); Peter Siegelman, Adverse Selection in Insurance Markets: An Exaggerated Threat, 113 Yale L.J. 1223, 1223 (2004) (explaining that adverse selection is a process where “insureds utilize private knowledge of their own riskiness when deciding to buy or forgo insurance”).Show More

For now, it appears the critics are right and theory is wrong. D&O insurers do not drop their clients regularly; instead, renewal rates approach 100%.¹⁵ 15.Aon, Quarterly D&O Pricing Index: Fourth Quarter and Full Year 2018, at 9 (2018), https://www.aon.com/getmedia/20bfac85-dce6-4902-91cb-c61265abcd7e/2018-Q4-DO-Pric​ing-Index.aspx [https://perma.cc/PR58-CPUT] (95.7% annual retention); Aon, Quarterly D&O Pricing Index: Fourth Quarter and Full Year 2017, at 9 (2017), https://ww​w.aon.com/attachments/risk-services/d-o_pricing_index/2017_Q4_DO_Pricing_Index.pdf [h​ttps://perma.cc/V33R-ZY9U] (93.2% annual retention); Aon, Quarterly D&O Pricing Index: Fourth Quarter and Full Year 2016, at 8 (2016), https://www.aon.com/attachme​nts/risk-services/d-o_pricing_index/2016_Q4_DO_Pricing_I​ndex.pdf [https://perma.cc/HRY​4-4HTA] (95.3% annual retention); Aon, Quarterly D&O Pricing Index: Fourth Quarter and Full Year 2015, at 8 (2015), https://www.aon.com/attachments/risk-services/d-o_pricing_index​/2015_Q4_DO_Pricing_Index.pdf [https://perma.cc/J5WG-K6QQ] (95% annual retention); Aon, Quarterly D&O Pricing Index: Fourth Quarter and Full Year 2014, at 8 (2014), https://www.aon.com/attachments/risk-services/d-o_pricing_index/201​4_Q4_DO_Pricing_I​ndex.pdf [https://perma.cc/8CDA-MSYG] (93.7% annual retention); Aon, Quarterly D&O Pricing Index: Fourth Quarter and Full Year 2013, at 3 (2013), https://www.aon​.com/attachments/risk-services/d-o_pricing_index/2013_Q4_DO_P​ricing-Index.pdf [https://​perma.cc/22DW-YDPB] (94.9% annual retention) Aon, Quarterly D&O Pricing Index: Fourth Quarter and Full Year 2012, at 3 (2012), https://www.aon.com/attachments/risk-services/d-o_pricing_index/2012_4Q_DandOPricingI​ndex.pdf [https://perma.cc/4GJU-4PKG] (94% retention for Q4).Show More D&O insurers do not penalize risky clients with much higher premiums; instead, premium increases are almost lockstep.¹⁶ 16.Alicia Davis Evans, The Investor Compensation Fund, 33 J. Corp. L. 223, 261 (2007) (“Currently, competitive pressures appear to make it impossible for D&O insurer premium prices to reflect governance risk fully.”).Show More D&O insurers do not monitor clients’ quality of governance and risk-exposure; instead, insurers devote essentially zero effort to monitoring existing clients.¹⁷ 17.Infra Section II.C.Show More Insurers do not fight weak claims; instead, they cede control over litigation to the client and agree to settle essentially every well-pleaded complaint.¹⁸ 18.Baker & Griffith, supra note 8, at 797–804.Show More Far from gatekeepers, insurers have become cheerful doormen for those who would cart the insurer’s wealth, and that of the corporate client, out the door.¹⁹ 19.Cf. Grundfest, supra note 11, at 7 (noting that “the current structure of D&O insurance and auditor liability has failed to give rise to incentives” to address fraud risks even though “D&O insurers could today easily make the retention of insurer-approved auditors a condition of coverage”).Show More

Why? And what can be done to fix it? This Article explains the failure of the D&O insurance market and a solution. The analysis is moderate in that it accepts the good and bad of D&O insurance and tries to tilt the balance,²⁰ 20.See Shauhin A. Talesh, Insurance Companies as Corporate Regulators: The Good, The Bad, and the Ugly, 66 DePaul L. Rev. 463, 467 (2017) (“The debate going forward is not whether insurers are good risk regulators as prior scholars theorize, but more precisely, examining under what conditions can insurers make positive regulatory interventions into corporate behavior and nudge corporations toward a governance structure in line with societal values of fairness, equality, transparency, and safety.”); Chen Lin, Micah S. Officer, Thomas Schmid & Hong Zou, Is Skin in the Game a Game Changer? Evidence from Mandatory Changes of D&O Insurance Policies, 68 J. Acct. & Econ. 1–2 (2019) (arguing that the structure of insurance policies matters).Show More rather than, say, banning D&O insurance altogether.²¹ 21.See, e.g., Merritt B. Fox, Civil Liability and Mandatory Disclosure, 109 Colum. L. Rev. 237, 288–89 (2009) (calling for an end to D&O insurance for certain securities violations).Show More This Article’s argument contains four premises.

First, insurance (D&O and otherwise) can be operated in an “active” or “passive” fashion.²² 22.Most insurers do not embrace a purely active or passive strategy, and it can be difficult to distinguish them in many cases. An insured who makes a costly claim may see her future premium rise from either an active or passive insurer, but for very different reasons. The active insurer raises the rate insofar as the claim signals information about the client’s type and future riskiness. The passive insurer raises the rate simply because that is the deal: the insurer pays now and recoups later, even if the claim was a fluke and signals nothing about the insured’s risk.Show More An active insurer seeks to address clients’ risks by discovering current risk level, setting premiums that reflect it, and discouraging excessively risky behavior.²³ 23.Daniel Schwarcz, Coverage Information in Insurance Law, 101 Minn. L. Rev. 1457, 1487 (2017) (“[T]he risk of moral hazard only exists when the insurer does not observe policyholder levels of activity or care after purchase . . . .”).Show More By contrast, a passive insurer does little vetting, risk-pricing, or monitoring. Instead, the passive insurer just seeks to recoup losses on a costly client by charging that client more in the future.²⁴ 24.Infra Section III.A.Show More

Second, active insurance is socially preferable at the margin. Active insurers encourage least-cost avoiders to avoid risks. They force their customers to internalize their expected costs.²⁵ 25.Omri Ben-Shahar & Kyle D. Logue, Outsourcing Regulation: How Insurance Reduces Moral Hazard, 111 Mich. L. Rev. 197, 228 n.102 (2012).Show More And they generate information about the magnitude of risks.²⁶ 26.See Tom Baker & Sean J. Griffith, Predicting Corporate Governance Risk: Evidence from the Directors’ and Officers’ Liability Insurance Market, 74 U. Chi. L. Rev. 487, 489–90 (2007) (arguing that insurance premiums can publicize problematic governance).Show More At a minimum, the board may ask the chief executive officer (“CEO”) for an explanation if insurance costs treble. Conversely, passive insurers are more problematic. They protect bad managers from the cost of their bad conduct, and muddy the signal litigation might otherwise send, by spreading the cost of managerial malfeasance into distant future periods. For that reason, society will tend to be better served by relatively more active insurance and managers will tend to prefer relatively more passive insurance.

Third, the passive method is viable only if the market for insurance is rather uncompetitive and illiquid, because it requires customers to submit themselves to years of premiums that exceed the actuarially fair rate.²⁷ 27.Infra Sections III.B. & C.Show More If the insureds often switched under those circumstances, the passive insurance model would collapse. Passive insurance requires enduring relationships between insured and insurer, but it can thrive under those conditions.

Fourth, the existing insurance market is consistent with an excessive degree of passive insurance, owing to agency costs and transaction costs.²⁸ 28.Infra Sections II.C. & III.D.Show More Insurance relationships are long-lasting; switching insurers is rare. For a firm to switch from its longstanding passive insurer to a lower-priced active insurer, directors and officers must approve the change. But directors and officers would be exposed to greater pressure and transparency from an active insurer. At the same time, contracting conventions and market structure impose frictions on competition. Managers can cite these frictions as a reason to retain the passive insurer they like best.

These premises lead to the descriptive conclusion that insufficient client turnover has led D&O insurance to insufficiently address client risk. The normative conclusion is that we should impose mandatory D&O insurance rotation.

Insurers should be permitted no more than five years with a given client, at which time they must take their underwriting elsewhere. Mandatory rotation renders the passive insurance model impractical. Insurers can never hope to insure passively and then recoup their losses down the line. Every insurer will have to actively vet insureds for risks pending over the next few years, to monitor for abrupt changes during that period, and to take steps to limit a corporation’s slide toward increased risk; the result is that corporations and their managers will be more likely to internalize the expected cost of their harmful behaviors and, thus, take those harms more seriously.

Mandatory rotation has been used in other areas of law to destabilize corrupt relationships that compromise gatekeepers and fiduciaries. Auditing partners must rotate every five years.²⁹ 29.Infra Subsection IV.B.1.Show More The theory is that genuine auditing can jeopardize a long relationship, but auditors who know they will soon lose their client anyway are freer to audit honestly. Similar intuitions drive term limits for elected officials.³⁰ 30.Infra Subsection IV.B.2.Show More The temptation to buckle to special interests is greater if it secures reelection. If reelection is impossible, the politician is freer to act according to her best judgment of the public interest. Likewise, career diplomats with the foreign service are permitted only three years in a given foreign country.³¹ 31.Infra Subsection IV.B.3.Show More While these changes may diminish some country-specific expertise, the alternative of long-service may tempt foreign service officers to strike implicit bargains with their host country that undermine America’s interests.

The deep economic intuition behind mandatory insurance rotation is that passive D&O insurance is a relational contract.³² 32.See Jay M. Feinman, The Insurance Relationship as Relational Contract and the “Fairly Debatable” Rule for First-Party Bad Faith, 46 San Diego. L. Rev. 553, 556–57 (2009) (“The insurance contract is a relational contract par excellence. The relation created by the contract extends over time; although a typical policy term is a year, the rate of renewal is very high, often in the order of ninety percent, so a typical relation extends over years or even decades.”). Note that Feinman was not addressing D&O insurance.Show More Relational contracts are agreements that motivate cooperation without recourse to legal enforcement, but are instead embedded in a relationship.³³ 33.See Robert E. Scott, Conflict and Cooperation in Long-Term Contracts, 75 Calif. L. Rev. 2005, 2007–08 (1987); Morten Hviid, Long-Term Contracts and Relational Contracts, in 5The Encyclopedia of Law and Economics 54 (Boudewijn Bouckaert & Gerrit De Geest eds., 1999) (“Relational contract theory can be seen as an attempt to generate a model able to explain when transacting parties do not resort to contracts and by what means they ensure that each party fulfils their obligations. The theory focuses on the relationship between the ‘contracting’ parties and posits that this leads to cooperation and to implicit obligations being self-enforcing.”); Benjamin E. Hermalin, Avery W. Katz & Richard Craswell, Contract Law, in 1 Handbook of Law and Economics 123 (A. Mitchell Polinsky & Steven Shavell eds., 2007) (“Within the literature, self-enforcing contracts are often known as relational contracts.” (emphasis omitted)).Show More For example, a long-term supply agreement may include an unwritten term that the seller may sometimes deliver goods late or mark up prices to reflect rising costs, and the buyer may happily honor that agreement even if no court would enforce it, because the buyer wants to preserve an ongoing profitable relationship.³⁴ 34.For examples of this kind, see, e.g., Stewart Macaulay, Non-Contractual Relations in Business: A Preliminary Study, 28 Am. Socio. Rev. 55, 61–67 (1963); Ian R. MacNeil, The Many Futures of Contracts, 47 S. Cal. L. Rev. 691, 721, 732 (1974); H. Beale & T. Dugdale, Contracts Between Businessmen: Planning and the Use of Contractual Remedies, 2 Brit. J.L. and Soc’y 45, 45–46, 51, 53 (1975).Show More Relational contracts are widespread, but they only succeed when certain fragile conditions are met.³⁵ 35.E.g., Hviid, supra note 33, at 55 (“Repeated interaction may enable cooperation, because of the potential for a current deviation to be punished in the future. For this to work, four conditions must be met.”).Show More Importantly, relational contracts require some mechanism for overcoming the “last period problem.”³⁶ 36.Sean J. Griffith, Afterward and Comment: Towards an Ethical Duty to Market Investors, 35 Conn. L. Rev. 1223, 1239 (2003) (“The last period problem is a concept drawn from game theory and experimental economics to explain individual defections from cooperative enterprises in the last period of a repeated situation.”).Show More

In relational contracts, enforceable contract rights underdetermine the parties’ relationship.³⁷ 37.Charles J. Goetz & Robert E. Scott, Principles of Relational Contracts, 67 Va. L. Rev. 1089, 1091 (1981) (“A contract is relational to the extent that the parties are incapable of reducing important terms of the arrangement to well-defined obligations.”).Show More Cooperation is possible nevertheless because one party can detect and subsequently penalize defection by the other.³⁸ 38.Hviid, supra note 33, at 55 (“Any deviation must be observable and it must be punishable. This punishment must be credible so that it is clear that when required the punishment will be carried out, and the parties must be patient in the sense that the future matters to them.”).Show More Fear of reprisal keeps both parties cooperative. However, defection again becomes rational in the last period of a long game because reprisal becomes impossible.³⁹ 39.Christine Jolls, Contracts as Bilateral Commitments: A New Perspective on Contract Modification, 26 J. Legal Stud. 203, 231–32 (1997).Show More Passive insurance is a relational contract in which the managers agree (on behalf of the entity) to pay a higher-than-competitive rate in the future, and the insurer agrees to cover claims without any effort to expose or reduce governance problems. If both parties knew that the relationship was going to end soon, the insurer would have reason to breach the informal agreement by reducing its costs through monitoring and increasing its premiums now. And since they know they won’t get the cozy treatment that they want anyway, managers will no longer cheerlead an overpriced premium.

Part of what is interesting about this project is exploring the dark side of relational contracts. Most often, scholars of relational contracts adopt a laudatory tone: Is it not amazing that parties can accomplish their goals without much law?⁴⁰ 40.See, e.g., Robert C. Ellickson, Order Without Law: How Neighbors Settle Disputes 1, 1 (1991); Lisa Bernstein, Beyond Relational Contracts: Social Capital and Network Governance in Procurement Contracts, 7 J. Legal Analysis 561, 561–62 (2015) (discussing how master supply agreements, a type of relational contract between business firms, are designed to “keep the law . . . largely out of their relationship” and can “create a space in which private order can flourish.”).Show More But parties’ ability to informally secure a result is only laudatory if we would have been happy to honor their agreement had they made it formal. And not all contracts are of this sort. Business cartels use relational contracts to tacitly enforce restraints of trade that we would never countenance as formal contracts.⁴¹ 41.Hermalin et al., supra note 33, at 122 (“It has long been understood from the repeated games literature that some agreements are self enforcing in the context of an ongoing relationship. The most prominent example of such ‘agreements’ is tacit collusion among competing firms.”).Show More Mob bosses use relational contracts to reward and govern their lieutenants.⁴² 42.Curtis J. Milhaupt & Mark D. West, The Dark Side of Private Ordering: An Institutional and Empirical Analysis of Organized Crime, 67 U. Chi. L. Rev. 41, 43, 66 (2000).Show More And D&O insurers promise to help paper over managers’ mistakes and abuses in return for wastefully large insurance premiums. Relational contracts can allow parties to coordinate in ways we would never tolerate from formal contracts.

The structure of this Article is as follows. Part I introduces the practice and industrial organization of D&O insurance. Part II discusses the link between insurance and risk: while insurance can reduce riskiness, D&O insurers actually appear to exacerbate client risks, doing almost no monitoring or vetting. Part III provides a stylized introduction to two ways that D&O insurance business can operate—actively and passively. That Part shows that the market likely operates to generate excessive levels of passive insurance, and it explains that manager opportunism is central to the problem. Accordingly, Part IV presents a solution intended to increase the proportion of active D&O insurance: mandatory rotation of D&O insurers. It also explains analogies to other domains of law and addresses objections.

1. Securities Class Action Filings: 2019 Year in Review, Cornerstone Research 13, https​://securities.stanford.edu/research-reports/1996-2019/Cornerstone-Research-Securities-Class​-Action-Filings-2019-YIR.pdf [https://perma.cc/PD8P-YL84] (reporting 10% of S&P 500 by market cap was sued for securities violations in 2019). Last year brought slightly fewer. Securities Class Action Filings: 2021 Year in Review, Cornerstone Research 15, https://www.cornerstone.com/wp-content/uploads/2022/02/Securities-Class-Action-Filings-2​021-Year-in-Review.pdf. [https://perma.cc/4JGL-35SH]. This 10% figure plainly understates the scope of litigation, since many investors’ suits are derivative actions with no securities violation component, but comprehensive data for derivative suits are not available.In this Article, I use the word “manager” to refer to both officers and directors. ↑
2. Alice Uribe & Leslie Scism, Companies Are Paying a Lot More to Insure Their Directors and Officers, Wall St. J. (June 21, 2020, 5:30 AM), https://www.wsj.com/articles/companies-are-paying-a-lot-more-to-insure-their-directors-and-officers-11592731801?mod=hp_listc_po​s2 [https://perma.cc/93HE-LMK9] (reporting that D&O litigation expenses are approaching $1 billion annually, not including jury verdicts or settlements). ↑
3. E.g., Eugene V. Rostow, To Whom and For What End is Corporate Management Responsible?, in The Corporation In Modern Society 48 (Edward S. Mason ed., 1959) (characterizing derivative suits as “the most important procedure the law has yet developed to police the internal affairs of corporations”); Robert B. Thompson & Randall S. Thomas, The Public and Private Faces of Derivative Lawsuits, 57 Vand. L. Rev. 1747, 1786–87 (2004) (finding data that derivative suits play a valuable monitoring role in duty of loyalty cases and that the tool combats unscrupulous directors); see also Jill E. Fisch, Teaching Corporate Governance Through Shareholder Litigation, 34 Ga. L. Rev. 745, 746 (2000) (explaining how the rules of shareholder litigation can “deter[] corporate misconduct”). ↑
4. See Rostow, supra note 3; Stephen M. Bainbridge, Fee-Shifting: Delaware’s Self-Inflicted Wound, 40 Del. J. Corp. L. 851, 852–53 (2016); Roberta Romano, The Shareholder Suit: Litigation without Foundation?, 7 J.L. Econ. & Org. 55, 84 (1991); Sean J. Griffith, Correcting Corporate Benefit: How to Fix Shareholder Litigation by Shifting the Doctrine on Fees, 56 B.C. L. Rev. 1, 2 (2015). ↑
5. Dain C. Donelson, Justin J. Hopkins & Christopher G. Yust, The Role of Directors’ and Officers’ Insurance in Securities Fraud Class Action Settlements, 58 J.L. & Econ. 747, 748 (2015); see Sean J. Griffith, Uncovering A Gatekeeper: Why the SEC Should Mandate Disclosure of Details Concerning Directors’ and Officers’ Liability Insurance Policies, 154 U. Pa. L. Rev. 1147, 1189 (2006). ↑
6. Griffith, supra note 5, at 1168. ↑
7. Id. at 1163. ↑
8. Tom Baker & Sean J. Griffith, How the Merits Matter: Directors’ and Officers’ Insurance and Securities Settlements, 157 U. Pa. L. Rev. 755, 797–98 (2009). ↑
9. See Richard M. Phillips & Gilbert C. Miller, The Private Securities Litigation Reform Act of 1995: Rebalancing Litigation Risks and Rewards for Class Action Plaintiffs, Defendants and Lawyers, 51 Bus. Law. 1009, 1014–15 (1996). ↑
10. The “gatekeeper” idea is that trusted professionals near the corporation can be used as external checks on fraud and mismanagement. See John C. Coffee, Jr., The Acquiescent Gatekeeper: Reputational Intermediaries, Auditor Independence and Governance of Accounting 11–13 (Colum. L. Sch., Ctr. For L. & Econ. Stud., Working Paper No. 191, 2001), http://papers.ssrn.com/sol3/papers.cfm?abstract_id=270944 [https://perma.cc/LM3D-3T6H]. ↑
11. See Joseph A. Grundfest, Punctuated Equilibria in the Evolution of United States Securities Regulation, 8 Stan. J.L. Bus. & Fin. 1, 7–8 (2002) (“D&O insurers could today easily make the retention of insurer-approved auditors a condition of coverage. They could today also require an element of control over the audit process. Yet they don’t. Why?”). ↑
12. Such responses were once common. Roberta Romano, What Went Wrong With Directors’ and Officers’ Liability Insurance?, 14 Del. J. Corp. L. 1, 12 (1989). Professor Romano’s article diagnosed insurer responses to a sudden increase in liability exposure, so it is unsurprising that insurers reacted in this way. Id. at 13. There is no indication that this tendency to withdraw is still commonplace. ↑
13. Richard V. Eicson & Aaron Doyle, Uncertain Business: Risk, Insurance and the Limits of Knowledge 94–211 (2004) (reporting research from a variety of contexts including building construction and disability management); Steven Shavell, On Liability and Insurance, 13 Bell J. Econ. 120, 121–22 (1982) (modeling the relationship between liability and insurance and concluding that, “[a]lthough the purchase of liability insurance changes the incentives created by liability rules, the terms of the insurance policies sold in a competitive setting would be such as to provide an appropriate substitute (but not necessarily equivalent) set of incentives to reduce accident risks”). ↑
14. Moral hazard is the tendency of insured parties to engage in riskier conduct. Kenneth J. Arrow, Uncertainty and the Welfare Economics of Medical Care, 53 Am. Econ. Rev. 941, 961 (1963); Daniel Schwarcz, Reevaluating Standardized Insurance Policies, 78 U. Chi. L. Rev. 1263, 1283 (2011). With respect to health insurance, smoking has been described as the “classic moral hazard.” Thomas R. McLean, International Law, Telemedicine & Health Insurance: China as a Case Study, 32 Am. J.L. & Med. 7, 25 (2006). Adverse selection is the tendency of the costliest clients to seek out coverage offered at a given price. Cf. George A. Akerlof, The Market for “Lemons”: Quality Uncertainty and the Market Mechanism, 84 Q.J. Econ. 488, 488 (1970) (setting out a canonical adverse selection model in a non-insurance commercial setting); Peter Siegelman, Adverse Selection in Insurance Markets: An Exaggerated Threat, 113 Yale L.J. 1223, 1223 (2004) (explaining that adverse selection is a process where “insureds utilize private knowledge of their own riskiness when deciding to buy or forgo insurance”). ↑
15. Aon, Quarterly D&O Pricing Index: Fourth Quarter and Full Year 2018, at 9 (2018), https://www.aon.com/getmedia/20bfac85-dce6-4902-91cb-c61265abcd7e/2018-Q4-DO-Pric​ing-Index.aspx [https://perma.cc/PR58-CPUT] (95.7% annual retention); Aon, Quarterly D&O Pricing Index: Fourth Quarter and Full Year 2017, at 9 (2017), https://ww​w.aon.com/attachments/risk-services/d-o_pricing_index/2017_Q4_DO_Pricing_Index.pdf [h​ttps://perma.cc/V33R-ZY9U] (93.2% annual retention); Aon, Quarterly D&O Pricing Index: Fourth Quarter and Full Year 2016, at 8 (2016), https://www.aon.com/attachme​nts/risk-services/d-o_pricing_index/2016_Q4_DO_Pricing_I​ndex.pdf [https://perma.cc/HRY​4-4HTA] (95.3% annual retention); Aon, Quarterly D&O Pricing Index: Fourth Quarter and Full Year 2015, at 8 (2015), https://www.aon.com/attachments/risk-services/d-o_pricing_index​/2015_Q4_DO_Pricing_Index.pdf [https://perma.cc/J5WG-K6QQ] (95% annual retention); Aon, Quarterly D&O Pricing Index: Fourth Quarter and Full Year 2014, at 8 (2014), https://www.aon.com/attachments/risk-services/d-o_pricing_index/201​4_Q4_DO_Pricing_I​ndex.pdf [https://perma.cc/8CDA-MSYG] (93.7% annual retention); Aon, Quarterly D&O Pricing Index: Fourth Quarter and Full Year 2013, at 3 (2013), https://www.aon​.com/attachments/risk-services/d-o_pricing_index/2013_Q4_DO_P​ricing-Index.pdf [https://​perma.cc/22DW-YDPB] (94.9% annual retention) Aon, Quarterly D&O Pricing Index: Fourth Quarter and Full Year 2012, at 3 (2012), https://www.aon.com/attachments/risk-services/d-o_pricing_index/2012_4Q_DandOPricingI​ndex.pdf [https://perma.cc/4GJU-4PKG] (94% retention for Q4). ↑
16. Alicia Davis Evans, The Investor Compensation Fund, 33 J. Corp. L. 223, 261 (2007) (“Currently, competitive pressures appear to make it impossible for D&O insurer premium prices to reflect governance risk fully.”). ↑
17. Infra Section II.C. ↑
18. Baker & Griffith, supra note 8, at 797–804. ↑
19. Cf. Grundfest, supra note 11, at 7 (noting that “the current structure of D&O insurance and auditor liability has failed to give rise to incentives” to address fraud risks even though “D&O insurers could today easily make the retention of insurer-approved auditors a condition of coverage”). ↑
20. See Shauhin A. Talesh, Insurance Companies as Corporate Regulators: The Good, The Bad, and the Ugly, 66 DePaul L. Rev. 463, 467 (2017) (“The debate going forward is not whether insurers are good risk regulators as prior scholars theorize, but more precisely, examining under what conditions can insurers make positive regulatory interventions into corporate behavior and nudge corporations toward a governance structure in line with societal values of fairness, equality, transparency, and safety.”); Chen Lin, Micah S. Officer, Thomas Schmid & Hong Zou, Is Skin in the Game a Game Changer? Evidence from Mandatory Changes of D&O Insurance Policies, 68 J. Acct. & Econ. 1–2 (2019) (arguing that the structure of insurance policies matters). ↑
21. See, e.g., Merritt B. Fox, Civil Liability and Mandatory Disclosure, 109 Colum. L. Rev. 237, 288–89 (2009) (calling for an end to D&O insurance for certain securities violations). ↑
22. Most insurers do not embrace a purely active or passive strategy, and it can be difficult to distinguish them in many cases. An insured who makes a costly claim may see her future premium rise from either an active or passive insurer, but for very different reasons. The active insurer raises the rate insofar as the claim signals information about the client’s type and future riskiness. The passive insurer raises the rate simply because that is the deal: the insurer pays now and recoups later, even if the claim was a fluke and signals nothing about the insured’s risk. ↑
23. Daniel Schwarcz, Coverage Information in Insurance Law, 101 Minn. L. Rev. 1457, 1487 (2017) (“[T]he risk of moral hazard only exists when the insurer does not observe policyholder levels of activity or care after purchase . . . .”). ↑
24. Infra Section III.A. ↑
25. Omri Ben-Shahar & Kyle D. Logue, Outsourcing Regulation: How Insurance Reduces Moral Hazard, 111 Mich. L. Rev. 197, 228 n.102 (2012). ↑
26. See Tom Baker & Sean J. Griffith, Predicting Corporate Governance Risk: Evidence from the Directors’ and Officers’ Liability Insurance Market, 74 U. Chi. L. Rev. 487, 489–90 (2007) (arguing that insurance premiums can publicize problematic governance). ↑
27. Infra Sections III.B. & C. ↑
28. Infra Sections II.C. & III.D. ↑
29. Infra Subsection IV.B.1. ↑
30. Infra Subsection IV.B.2. ↑
31. Infra Subsection IV.B.3. ↑
32. See Jay M. Feinman, The Insurance Relationship as Relational Contract and the “Fairly Debatable” Rule for First-Party Bad Faith, 46 San Diego. L. Rev. 553, 556–57 (2009) (“The insurance contract is a relational contract par excellence. The relation created by the contract extends over time; although a typical policy term is a year, the rate of renewal is very high, often in the order of ninety percent, so a typical relation extends over years or even decades.”). Note that Feinman was not addressing D&O insurance. ↑
33. See Robert E. Scott, Conflict and Cooperation in Long-Term Contracts, 75 Calif. L. Rev. 2005, 2007–08 (1987); Morten Hviid, Long-Term Contracts and Relational Contracts, in 5 The Encyclopedia of Law and Economics 54 (Boudewijn Bouckaert & Gerrit De Geest eds., 1999) (“Relational contract theory can be seen as an attempt to generate a model able to explain when transacting parties do not resort to contracts and by what means they ensure that each party fulfils their obligations. The theory focuses on the relationship between the ‘contracting’ parties and posits that this leads to cooperation and to implicit obligations being self-enforcing.”); Benjamin E. Hermalin, Avery W. Katz & Richard Craswell, Contract Law, in 1 Handbook of Law and Economics 123 (A. Mitchell Polinsky & Steven Shavell eds., 2007) (“Within the literature, self-enforcing contracts are often known as relational contracts.” (emphasis omitted)). ↑
34. For examples of this kind, see, e.g., Stewart Macaulay, Non-Contractual Relations in Business: A Preliminary Study, 28 Am. Socio. Rev. 55, 61–67 (1963); Ian R. MacNeil, The Many Futures of Contracts, 47 S. Cal. L. Rev. 691, 721, 732 (1974); H. Beale & T. Dugdale, Contracts Between Businessmen: Planning and the Use of Contractual Remedies, 2 Brit. J.L. and Soc’y 45, 45–46, 51, 53 (1975). ↑
35. E.g., Hviid, supra note 33, at 55 (“Repeated interaction may enable cooperation, because of the potential for a current deviation to be punished in the future. For this to work, four conditions must be met.”). ↑
36. Sean J. Griffith, Afterward and Comment: Towards an Ethical Duty to Market Investors, 35 Conn. L. Rev. 1223, 1239 (2003) (“The last period problem is a concept drawn from game theory and experimental economics to explain individual defections from cooperative enterprises in the last period of a repeated situation.”). ↑
37.  Charles J. Goetz & Robert E. Scott, Principles of Relational Contracts, 67 Va. L. Rev. 1089, 1091 (1981) (“A contract is relational to the extent that the parties are incapable of reducing important terms of the arrangement to well-defined obligations.”). ↑
38. Hviid, supra note 33, at 55 (“Any deviation must be observable and it must be punishable. This punishment must be credible so that it is clear that when required the punishment will be carried out, and the parties must be patient in the sense that the future matters to them.”). ↑
39. Christine Jolls, Contracts as Bilateral Commitments: A New Perspective on Contract Modification, 26 J. Legal Stud. 203, 231–32 (1997). ↑
40. See, e.g., Robert C. Ellickson, Order Without Law: How Neighbors Settle Disputes 1, 1 (1991); Lisa Bernstein, Beyond Relational Contracts: Social Capital and Network Governance in Procurement Contracts, 7 J. Legal Analysis 561, 561–62 (2015) (discussing how master supply agreements, a type of relational contract between business firms, are designed to “keep the law . . . largely out of their relationship” and can “create a space in which private order can flourish.”). ↑
41. Hermalin et al., supra note 33, at 122 (“It has long been understood from the repeated games literature that some agreements are self enforcing in the context of an ongoing relationship. The most prominent example of such ‘agreements’ is tacit collusion among competing firms.”). ↑

42. Curtis J. Milhaupt & Mark D. West, The Dark Side of Private Ordering: An Institutional and Empirical Analysis of Organized Crime, 67 U. Chi. L. Rev. 41, 43, 66 (2000). ↑