Directors’ and Officers’ Legal Liability Insurance, Audit Pricing, and Litigation Risk

Abstract

Directors’ and Officers’ (D&O) legal liability insurance is a common component of CEO compensation packages. We expect managers are more willing to engage in opportunistic behaviors when their personal assets are protected from litigation risk. Therefore, information about D&O policy details is potentially useful in assessing the degree of managerial opportunism. However, US firms are not required to disclose this information. We provide evidence on this issue by first examining the association between excess D&O coverage limits and audit fees. We hypothesize that external auditors charge higher fees for audit clients with excessively high legal liability insurance coverage. Using excess Directors’ and Officers’ (D&O) insurance coverage for Canadian firms as a composite measure of managerial opportunism, we find a positive association between excess D&O coverage limits and audit fees after controlling for numerous other audit fee determinants. Additional analyses indicate that auditors are more concerned about managerial opportunism in those firms where the potential costs (to the auditor) of opportunism are expected to be higher. Second, we find a positive association between excess D&O coverage limits and the likelihood of shareholder litigation. Our findings suggest that D&O insurance disclosures convey useful information to shareholders and other capital market participants.