Directors, Directors and Officers Insurance, and Corporate Governance

Abstract

This article models a board of directors consisting of either pure directors or shareholder directors. Pure directors only receive a fee for their service to the board, while shareholder directors receive corporate equity in addition to the fee. The analysis shows that: (1) compensation-maximizing pure directors and shareholder directors are unlikely to act in the best interests of shareholders; (2) if the appointment of directors is controlled by the CEO, directors choose to concur with the CEO’s decisions unless they can form a majority to control the vote; (3) when a board is dominated by shareholder directors who only have equity stakes in the firm, the board will advise the CEO to maximize shareholder value. We also show that it is optimal for directors to be fully insured against the liability risk for endorsing CEO’s suboptimal decisions. If a firm does not offer D&O coverage, directors will pay for the insurance themselves or decline the directorship. The corporate purchase of D&O insurance, therefore, does not change directors’ monitoring actions but does influence their decisions to accept the position. These results have important implications for board composition, director appointment, and the design of director compensation.