Cybersecurity Risks: Directors and Officers Should Stop, Collaborate and Listen

[Audrey McNeil <audrey () riskbasedsecurity com>]

http://www.jdsupra.com/legalnews/cybersecurity-risks-directors-and-11551/

The risks associated with cyber-attacks and data breaches are growing in
Canada and internationally and the costs associated with an organization
preventing, detecting, responding to and recovering from such an incident
can be considerable.

The Ponemon Institute’s May 2015 “2015 Cost of Data Breach Study: Canada”,
its inaugural report on actual data breaches of Canadian companies, found
the average cost of such an occurrence to be C$5.32-million with an average
cost of C$250 per compromised record. However, these figures exclude the
costs of “catastrophic or mega data breaches” of more than 100,000 records,
which can result in significantly greater expenses and losses of revenue.

Directors and officers must also consider the potential for further related
legal implications for the organization and personally. In particular,
there are growing trends of shareholder litigation against directors and
officers and the termination or resignation of senior management in the
wake of data breaches as senior management and directors are being held
accountable for perceived failures to oversee corporate cybersecurity. In
the aftermath of several recent data breaches, shareholders have taken
action against individual board members and senior management claiming that
they knew or should have known that the company’s customer information was
vulnerable to attack and yet failed to implement appropriate security
measures including, in the United States, actions involving T.J. Maxx,
Heartland Payment Systems, Target, Wyndham Hotels and Resorts and Home
Depot.

Additionally, in August 2015, the CEO of the parent company of the
Toronto-based infidelity website AshleyMadison.com resigned following the
announcement of a data breach in which hackers released details of millions
of email addresses, billing information and account details tied to the
website. In 2014, Target’s board of directors removed the company’s CEO
following a data breach and Institutional Shareholder Services recommended
that the shareholders of Target withhold their votes from the directors who
were on the company’s audit and corporate responsibility committees on the
basis that they failed to properly manage the cyber risks faced by the
company. Although Target’s management nominees were elected to the board,
in general TSX-listed issuers are required to have majority voting
policies, meaning that a withhold recommendation from proxy advisers risks
a director nominee having to tender his or her resignation upon election.
Also, in July 2015, the director of the United States Office of Personnel
Management stepped down from that position in the wake of a massive data
breach that compromised the personal information of more than 20 million
U.S. federal employees.

Clearly cybersecurity is not just an information technology or a legal
issue and there is an expectation that it be prudently monitored by senior
management and boards.

Duty of Care and the Business Judgment Rule

The Canada Business Corporations Act (CBCA) and comparable corporate law
statutes require that every director and officer of a corporation — in
exercising their powers and discharging their duties — exercise the care,
diligence and skill that a reasonably prudent person would exercise in
comparable circumstances. In interpreting compliance with this standard,
courts recognize that business decisions will usually involve some degree
of risk and that it would be inappropriate to subsequently apply 20/20
hindsight to past decisions.

Pursuant to this “business judgment rule”, judges are generally reluctant
to substitute their own judgment over the business decisions taken by a
board or management, provided that such decisions were made independently
without conflict of interest, in good faith, on a reasonably informed
basis, based on information available at the time, with an appropriate
degree of prudence and diligence, and provided that the decision falls
within a range of reasonable alternatives available at the time.

The U.S. Experience

As yet, there has been no reported shareholder litigation in Canada in
connection with a data breach, although this is unlikely to persist given
the constant threat of cyber-attacks. However, the Canadian Securities
Administrators (CSA) have issued CSA Staff Notice 11-326 – Cyber Security
to highlight their view that, among other things, “issuers, registrants and
regulated entities should be aware of the challenges of cyber crime and
should take the appropriate protective and security hygiene measures
necessary to safeguard themselves and their clients or stakeholders”.

In the absence of Canadian case law on director liability in the context of
a data breach, it is instructive to review the existing U.S. judicial and
regulatory guidance on the duties of boards with respect to cybersecurity.
Palkon v. Holmes et al. is a federal New Jersey court decision dismissing,
with prejudice, a shareholder derivative action arising out of data
breaches at the Wyndham hotel chain. Between April 2008 and January 2010,
cybercriminals hacked into the corporate computer network of Wyndham Hotels
and Resorts and the networks of the hotels themselves, stealing personal
and financial data of hotel customers. The plaintiff alleged that the
defendants failed to implement adequate data security controls, failed to
disclose the data breaches in a timely manner and thus had wrongfully
refused his previous demand to investigate the conduct of the Wyndham board.

The court in Palkon ultimately agreed with the Wyndham defendants that the
board’s refusal to pursue the plaintiff’s demand was a “good-faith exercise
of business judgment, made after a reasonable investigation.” The court
found that the board had “ample information” when it rejected the
plaintiff’s demand and had taken many steps to familiarize itself with the
subject of the demand. Specifically, the court noted that prior to its
receipt of the plaintiff’s demand letter, the board had already discussed
the cyber-attacks at 14 meetings, its audit committee discussed the data
breaches in at least 16 meetings, the board was already knowledgeable about
the cyber-attacks as a result of the prior Federal Trade Commission
investigation and litigation, and the board had already received and
investigated an early demand letter that was “virtually identical” to this
demand letter. The court concluded: “These earlier investigations, standing
alone, would indicate that the Board had enough information when it
assessed Plaintiff’s claim.” In addition, the court noted that the board
took the additional step of specifically discussing the plaintiff’s demand
before unanimously voting not to pursue it. As a result, the court held
that the board “had a firm grasp of Plaintiff’s demand when it determined
that pursuing it was not in the corporation’s best interest.”

Even though the court did not pronounce on the merits of the case (the
court only needed to address whether the defendants had met the
requirements to dismiss the case), the court stated in a footnote that the
plaintiff had “potential weaknesses” in his case and referred to Stone v.
Ritter andIn re Caremark International Inc. Derivative Litigation, two
landmark Delaware decisions on director oversight liability. Quoting Stone
v. Ritter, the Palkon court noted that “Caremark requires that a
corporation’s ‘directors utterly failed to implement any reporting or
information system . . . [or] consciously failed to monitor or oversee its
operations thus disabling themselves from being informed.’” By contrast,
the court noted in Palkon that the plaintiff had conceded that Wyndham had
security measures in place at the time of the first breach and had conceded
that the board had addressed this issue several times. The Palkon decision
suggests that where a board has monitored, been engaged with and formally
discussed corporate cybersecurity through a reporting or information
system, it may be able to successfully defend itself against a claim for
director oversight liability arising from a data breach.

What Can Directors and Officers Do?

Stop: While preventing all data breaches is a laudable goal, given the
complexity of information systems and the ever-evolving ingenuity employed
by cyber-attackers, such a goal may be impossible or impractical and it is
not the standard to which directors and officers should expect to be held
accountable. Consistent with their duty of care, the board and management
should practise prudent cybersecurity risk oversight fundamentals including
ensuring that their organization has an enterprise-wide cybersecurity
strategy and program that incorporates cyber risk identification,
measurement, mitigation, monitoring, reporting and enables compliance with
applicable regulatory standards.

According to the Ponemon Institute’s report, one factor that reduces the
cost of a data breach is board-level involvement in cybersecurity matters.
Other factors that reduce the cost of data breach, according to the study,
are having an incident response team and plan in place, extensive use of
encryption, employee training programs, appointment of a chief information
security officer, business continuity management and insurance protection.

In its National Policy 58-201 – Corporate Governance Guidelines, the CSA
also recommends, as a non-prescriptive best practice, that a public
company’s board adopt “a written mandate in which it explicitly
acknowledges responsibility for the stewardship of the issuer, including
responsibility for: [. . .] the identification of the principal risks of
the issuer’s business, and ensuring the implementation of appropriate
systems to manage these risks”. In addition, management should have clearly
defined responsibilities relating to the management of cybersecurity risks.

Collaborate: While some boards have placed responsibility for cybersecurity
matters within their audit committee, increasingly cybersecurity
cross-organizational “tiger teams” that include senior executives are being
established as a separate sub-committee to be responsible for
enterprise-wide cybersecurity oversight. In a June 2014 speech by former
U.S. Securities and Exchange Commission commissioner Luis Aguilar, he said
that “such committees can foster a ‘big picture’ approach to company-wide
risk that not only may result in improved risk reporting and monitoring for
both management and the board, but also can provide a greater focus — at
the board level — on the adequacy of resources and overall support provided
to company executives responsible for risk management.” While the CBCA
generally permits most board matters to be delegated to committees, in such
cases the duty of care still applies to all directors, so it is important
that appropriate board briefings concerning the matters faced by any such
committee are sufficiently frequent.

Listen: The Palkon decision underscores the need for corporations to have
policies and procedures in place for regular reporting up to senior
management, directors and officers on cybersecurity issues, as well as a
forum for them to meaningfully engage with these issues. Corporations also
need to ensure that the necessary expertise are in place in management
(e.g., consider appointing a chief information security officer) and on the
board (e.g., consider employing a skill matrix and/or engaging external
experts) in order to understand the enterprise-wide risk management and
business issues and implications associated with cybersecurity. However,
the CBCA provides that a director has complied with the duty of care if he
or she relied in good faith on a report of a person whose profession lends
credibility to a statement made by the professional person. Therefore, the
board should not focus on technical issues but rather address issues
related to policies and processes including efforts to educate employees,
compliance and appropriate deployment of corporate resources. Finally, in
order to benefit from the business judgment rule it is particularly
important that — as was the case in Palkon — the board’s oversight role is
evidenced by appropriately drafted minutes.

Will It Ever Stop?

Senior management and directors need to be aware of the importance of
monitoring corporate cybersecurity issues. This is acutely highlighted by
the shareholder derivative complaint in Bennek v. Ackerman et al. against
Home Depot and its board filed in August 2015 in the United States wherein
the plaintiffs alleged that “cyber attacks on major retailers, including
Target and Neiman Marcus, alerted the individual defendants to the
heightened probability that Home Depot would also be attacked.” The court
has not yet issued any decisions on the merits in the Home Depot
shareholder derivative litigation. However, the shareholder complaint
itself is a clear signal that, despite the plaintiffs not succeeding in the
Palkon shareholder derivative claim, boards can expect to face scrutiny and
be subject to shareholder litigation following data breaches.

Since cyber-attacks are not going to stop, senior management and boards
need to be mindful of actively exercising prudence and diligence in
monitoring corporate cybersecurity matters on an ongoing basis in order to
fulfil their corporate duties and mitigate their risk of liability.

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