Impact of D&O Insurance on the Disciplinary Effects of Litigation: Insights From China's Special Representative Litigation

Research Question/Issue: This study examines the extent to which directors' and officers' liability insurance (D&O insurance) mitigates the disciplinary impact of litigation, potentially leading to firm value depreciation. Research Findings/Insights: This research is based on the 2021 Kangmei Pharmaceutical case, which introduced special representative litigation in China. The results reveal that D&O insurance substantially reduces the positive stock market reaction to the litigation reform. Tests reveal that various factors moderate this negative correlation, including ownership structure (state ownership and tunneling effects), internal governance features (independent directors' incompetence, executive reputation, and board committee oversight), and the external governance environment (monitoring by analysts and media). The negative association between D&O insurance and cumulative abnormal returns during the event is greater among firms with higher D&O insurance premiums, highlighting the complex dynamics between D&O insurance, governance mechanisms, and litigation risk. Theoretical/Academic Implications: This study highlights that D&O insurance weakens the disciplinary effects of litigation, affirming its role as an effective risk-transfer mechanism, even in emerging markets like China. It provides fresh insights into the influence of D&O insurance amid China's recent litigation reforms, particularly the 2019 revision of the Securities Law and implementation of special representative litigation. Practitioner/Policy Implications: This study provides evidence that D&O insurance may weaken the value-enhancing effects of litigation system reforms, emphasizing the need for companies to exercise caution when adopting D&O insurance as a risk management tool. It underscores the significant role of D&O insurance in corporate governance during periods of judicial transformation in emerging markets.