Serenity Now!

Board members worried about compliance-related lawsuits may want to revisit their D&O policies.

You could see this one coming.

On May 3, 2005, management at Cray Inc. notified the Securities and Exchange Commission that it had uncovered material deficiencies in eight of its internal controls over key financial systems. In the disclosure (an amendment to the company’s 10-K), Cray also indicated that the business’s external auditor, Deloitte & Touche LLP, had concluded that many of the supercomputer maker’s internal controls demonstrated a “material weakness.”

Predictably, when word about the problems got out, the company’s share price took a nosedive, dropping nearly 30 percent. Even less surprising: about two months later, directors and officers at Cray were socked with a class-action lawsuit filed by disgruntled shareholders. Among several charges, the suit alleges that Cray’s audit committee violated sections of the Sarbanes-Oxley Act. The litigants claim that directors knew about the problem with the company’s internal controls but did not report it. For its part, Cray’s management denies any wrongdoing.

As of press time, the lawsuit had not been settled. But the imbroglio at the Seattle-based company is just another example of the perils of board duty in a post-Enron world. Indeed, the various provisions of Sarbox afford class-action lawyers a veritable smorgasbord of actionable material. So far, most of the Sarbox-related suits — such as those filed against WatchGuard Technologies Inc., The Tribune Co., and Countrywide Financial — have centered on directors’ and officers’ assessment of internal controls, as mandated by Section 404 of the law.

But other sections, such as 204 (auditor reports to audit committees) and 302 (corporate responsibility for financial reports), could also leave directors open to investor lawsuits. And these days, a shareholder suit is no small matter. Cornerstone Research estimates the median settlement value of securities class-action cases topped $7.5 million last year, up from an average of $6.3 million in the previous post-Sarbox years. That’s the single largest increase in median settlement Cornerstone has ever recorded.

Numbers like that no doubt explain why so many board members have been scrambling for copies of their directors’ and officers’ insurance policies. The Tillinghast business of Towers Perrin reports that half of all public and private companies received inquiries about D&O policies from their board members last year. Betsy Atkins, who sits on several boards, including Reynolds American Inc., the parent company of RJ Reynolds, has witnessed this trend firsthand. Atkins says directors used to delegate responsibility for insurance to the general counsel or company CFO. No longer. Notes Atkins: “Directors are understanding that they’d better read and understand the D&O policies.”

Those doing the reading may not like what they find. Currently, no major insurance carrier markets compliance-specific insurance products. What’s more, despite directors’ newfound compliance burdens — aka, liabilities — carriers do not appear to be grafting compliance-related riders onto existing policies. Notes William Passannante, co-chair of the insurance-coverage practice at Anderson Kill & Olick LLC in New York: “There’s nothing that says, ‘If you violate such-and-such provision of Sarbanes-Oxley through a negligent act, there’s coverage — or an exclusion of coverage — under this policy.’”

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