Why do firms purchase directors and officers liability insurance? – a perspective from short selling threats

Abstract

This study examines the role of increased short selling threats in firms’ directors and officers liability insurance (D&O insurance) purchase decision against the backdrop of the Chinese deregulation of short sale. Using a difference-in-differences (DiD) research design, we demonstrate a positive effect of short selling threats on firms’ likelihood of purchasing D&O insurance policies after controlling for the known determinants of D&O insurance. We then perform tests to validate the DiD analysis result, including a test of the parallel trend assumption and placebo tests. To shed light on the mechanism through which the effect of short selling takes place, we perform a path analysis. The results reveal that firms’ litigation risk explains the effect of short selling pressure on D&O insurance purchase decision. Further cross-sectional analyses show that the positive effect of short selling threats on D&O insurance is ameliorated when firms have strong internal control or have great analyst coverage.