A recent decision by the Delaware Supreme Court, In re Investors Bancorp, Inc. Stockholder Litigation (“Investors Bancorp”), increased the risk of litigation against directors, bucking a decEdit visibilityades-long trend. The decision reversed a Chancery Court ruling and substantially changed the standard that Delaware courts use to review shareholder derivative litigation dealing with director equity grants (Skadden 2017). We use the decision to examine two related issues: (1) is litigation risk a material issue in the independent director employment market and (2) is there an optimal level of litigation risk as a corporate governance mechanism that varies by firm? We focus on changes in firm and director behavior, testing whether director-specific litigation risk affects firm value, board composition, director compensation, and insider trading.
Unsurprisingly, directors express concern about litigation risk after increases in litigation, such as the sharp rise in the early 1980s and after the Enron-WorldCom scandals in the early 2000s. These events led to press coverage, calls for legal reform, and crises in the directors’ and officers’ (D&O) insurance market. However, because D&O insurance covers settlements and related expenses, out-of-pocket payments by independent directors are very rare (Black et al. 2006). Furthermore, most legal changes affect both directors and officers. Thus, it is unclear how much increases in director-specific litigation will affect firm and director behavior.
In most cases where directors transact with the corporation, the “entire fairness” standard applies. Under this standard, directors must prove fairness to shareholders in both the bargaining process and the transaction terms. Prior to Investors Bancorp, Delaware firms were allowed an exemption to this rule if compensation packages were ratified by a majority of disinterested shareholders. However, in a ruling that surprised many legal experts, the Delaware Supreme Court disallowed application of this exception in Investors Bancorp. Thus, the ruling represents a significant change in derivative litigation relating to director equity compensation. Cases that have arisen after Investors Bancorp illustrate how the decision has increased the difficulty of dispensing with challenges to discretionary director compensation awards on a motion to dismiss (Greco 2019). Further validating that the decision resulted in concerns about director liability, we observe a significant increase in Google searches of “Investors Bancorp” and “director liability” around the ruling. Nevertheless, the effects of Investors Bancorp may be limited because it only affects derivative litigation, equity compensation cases are generally small as only excess compensation is recoverable, and the alleged case facts were extreme.
Important for our analyses, U.S. corporations are subject to the laws of the state in which they are incorporated, which allows us to use all non-Delaware firms as counterfactuals. To further the similarity between Delaware firms and control firms, we match Delaware firms to non-Delaware firms by size in the same industry, year, and headquarters region.
The study has four main findings, the first two of which are concentrated among relatively higher risk firms (those likely to be more affected by the decision). First, we find a significant negative market reaction upon the announcement of the Investors Bancorp decision for Delaware firms. This effect is concentrated in firms with high research and development (R&D) and stock return volatility, where we expect equity compensation to be more important. We then find that Delaware firms add independent members to the compensation committee, and new members are more qualified as measured by their number of degrees and certifications or network size. This effect is also concentrated in firms with high R&D and stock return volatility. These results are consistent with a desire by firms to avoid litigation by adding members of higher quality, individuals being unwilling to serve without expertise, or a combination of these factors.
For results concentrated among lower risk firms (those less likely to be affected by the decision), we find a significant decrease in total compensation for the average Delaware firm, and we find larger and more significant decreases in both total and equity compensation in Delaware firms with lower R&D and stock return volatility. Thus, relatively lower-risk Delaware firms respond by decreasing director compensation while directors of higher risk firms may have been unwilling to accept similar cuts. An alternative explanation for this finding is that, given that relatively higher-risk Delaware firms appear to respond by adding new and more qualified independent directors, the new directors may either demand higher compensation, or the higher risk firms may believe decreases in compensation are unnecessary to further lower litigation risk due to increased oversight.
Finally, again concentrated in relatively lower risk firms, we find that directors of Delaware firms with lower R&D and stock return volatility decrease the percentage of total firm equity traded after Investors Bancorp, consistent with these directors avoiding scrutiny. However, Delaware firms with lower operating cash flows, an alternative measure of technology firms (Denis and McKeon 2018), have a higher number of directors trading after Investors Bancorp, consistent with these directors replacing other compensation with profits from insider trading as predicted in prior research (Manne 1966; Roulstone 2003).
This study makes two primary contributions. First, despite the Delaware Supreme Court’s intention to protect shareholders, this study provides evidence that the ruling reduced firm value. Combined with the findings in prior studies that decreases in legal liability also lower firm value, the results are consistent with any changes in director litigation risk decreasing firm value, suggesting an optimal liability level. Thus, when litigation is viewed as a corporate governance mechanism, deviations from an optimal level of litigation risk harm shareholders (Gillan et al. 2011; Larcker et al. 2011). Second, this study shows how changes in the legal environment for directors can affect labor market outcomes and director behavior. Specifically, some firms appear to increase the quality of their oversight to reduce litigation risk by changing the compensation committee composition, while others reduce compensation and insider trading, which may trigger litigation.
Black, B., B. Cheffins, and M. Klausner. 2006. Outside director liability. Stanford Law Review 58: 1055–1160.
Denis, D.J., and S.B. McKeon. 2018. Persistent operating losses and corporate financial policies. Working Paper.
Gillan, S.L, J.C. Hartzell, and L.T. Starks. 2011. Tradeoffs in corporate governance: Evidence from board structures and charter provisions. Quarterly Journal of Finance 1 (4): 667–705.
Greco, R.B. 2019. Chancery addresses director compensation under “Investors Bancorp” in “Stein.” Law.com (June 12). Available at: https://www.law.com/delbizcourt/2019/06/12/chancery-addresses-director-compensationunder-investors-bancorp-in-stein/.
Larcker, D.F., G. Ormazabal, and D.J. Taylor. 2011. The market reaction to corporate governance regulation. Journal of Financial Economics 101 (2): 431–448.
Manne, H.G. 1966. Insider Trading and the Stock Market. New York, New York. Free Press.
Roulstone, D.T. 2003. The relation between insider-trading restrictions and executive compensation. Journal of Accounting Research 41 (3): 525–551.
Skadden, Arps, Slate, Meagher & Flom (Skadden). 2017. Boards beware. Delaware Supreme Court limits application of deferential standards for reviewing director equity awards. Skadden Insights (December 19). Available at: https://www.skadden.com/insights/publications/2017/12/boards-beware.
This post comes to us from Professor Dain C. Donelson at the University of Texas at Austin’s McCombs School of Business, doctoral student Elizabeth Tori at Texas A&M University, and Professor Christopher G. Yust at Texas A&M University. It is based on their recent article, “Litigation Risk and the Independent Director Labor Market,” available here.