"The Emerging Need for Cybersecurity Diligence in M&A"

by Skadden, Arps, Slate, Meagher & Flom LLP
Contact

Skadden, Arps, Slate, Meagher & Flom LLP

Cybercrime has emerged as one of the foremost threats a company faces. As a result of a few keystrokes, a company may find its customers’ data sold on the dark web, its intellectual property in the hands of a competitor or its operations paralyzed by ransomware. It should come as little surprise, then, that cybersecurity has become a key risk factor in mergers and acquisitions.

A 2016 survey by West Monroe Partners and Mergermarket found that 77 percent of top-level corporate executives and private equity partners reported that the importance of cybersecurity at M&A targets had increased significantly in recent years. Given this trend, executives and directors contemplating acquisitions should consider the following cyber-related issues when conducting due diligence.

Key Considerations

Most companies depend on digital assets, whether in the form of customer data, trade secrets or business plans. Those assets are not only vulnerable to theft or destruction, they also may trigger complicated and evolving cybersecurity and privacy mandates from a variety of regulators in the United States and abroad. As a result, an acquiring company risks buying a company whose digital assets have already been compromised or assuming liabilities for past noncompliance with cybersecurity and data privacy laws. The latter could mean the acquiring company would take on potential fines, damages from private actions and lengthy consent decrees.

Cybersecurity due diligence cannot be one-size-fits-all. As with any diligence effort, the scope will depend on the transaction timeline as well as the target company’s industry, the value of its digital assets, its regulatory environment and its cyberrisk profile.

Key areas to consider in cybersecurity due diligence are:

Industry Standards. One threshold question for the diligence team is whether the target company meets the relevant industry standards for cybersecurity practices and procedures. That assessment should involve interviews of key staff at the target company and a review of relevant documents, such as reports of vulnerability assessments, penetration testing, vendor audits and any resulting remedial measures, incident response plans and incident reports. Special attention should be paid to the maturity of the company’s cybersecurity governance and vendor management, the terms of any indemnification and cyber insurance policies, the existence of any past cybersecurity incidents and how they were handled, and whether the company has interacted with regulators, law enforcement or other third parties regarding potential cybersecurity and data privacy incidents.

Target Company’s Network Security. The diligence team cannot simply rely on a target company’s assurances without verification because organizations with serious security gaps seldom recognize the problem. According to a report by cybersecurity firm FireEye, companies more frequently find out about a data breach from an outside source (e.g., law enforcement or a security vendor) than internally, and the median time to discover an incident is 146 days. If the target has never engaged a third-party forensic firm to conduct vulnerability assessments and penetration testing — a scenario that is becoming less common in many industries — the acquirer may want to retain a firm to undertake its own testing on the target company’s network and perhaps even conduct searches on the dark web (the part of the internet that may only be reached with anonymization tools and where many hackers sell their spoils) to see whether the target’s customer data or intellectual property is already compromised and available for sale. The acquirer should be aware, however, that the target will likely opt to conduct its own testing and provide a report rather than allow the acquirer to do so.

In an extreme scenario, the diligence investigation may uncover hackers lurking in the target company’s network, but more likely the result will be a risk calculation based on the target company’s governance and the administrative, technical and physical information security controls it uses to protect digital assets.

Deal Terms. The diligence results should inform deal terms, costs to remediate gaps in compliance or risk management, and any post-deal indemnity claims. One way to try to verify a target’s representations about its cybersecurity and allocate potential liabilities is through well-crafted representations and warranties. Those provisions should be tailored to the target company’s industry and regulatory environment, any risks identified in the diligence process and the acquirer’s risk tolerance. At a minimum, representations and warranties should cover compliance by the target (and its affiliates and vendors) of applicable cybersecurity and data privacy laws, its own internal and external privacy policies, and the absence of unauthorized access to the target’s network.

Acquirers should be prepared for the target company to request qualifications to these representations and warranties, limiting them to the knowledge of the target’s management, imposing a materiality threshold or drafting exceptions in the disclosure schedule regarding the inability to know with certainty about cyber intrusions. An acquirer’s willingness to acquiesce to such qualifications will depend in part on what the diligence investigation revealed. Indemnity may also be used to hold the target responsible for its representations and liable for hidden or undisclosed cybersecurity and data privacy liabilities that arise after closing. The parameters for these indemnity provisions should likewise flow from the diligence findings.

Cyber Insurance. The payoff for cybersecurity due diligence comes not only in deal negotiation but also in securing insurance, whether that be standalone cyber insurance or representation and warranty insurance, which has become commonplace in M&A transactions. In either case, in deciding whether to insure for cyberrisk, an underwriter likely will consider the quality and depth of the acquirer’s diligence review. Thus, a robust cybersecurity diligence investigation will likely pave the way for more favorable insurance policy terms.

Conclusion

Mergers and acquisitions due diligence has long been a critical tool for uncovering and protecting against key risks in a transaction. In our data-driven economy, cyberrisk must not be overlooked. Given the operational, financial and reputational costs at stake, cybersecurity should join the ranks of other traditional due diligence inquiries in deal practice.

Download PDF

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© Skadden, Arps, Slate, Meagher & Flom LLP | Attorney Advertising

Written by:

Skadden, Arps, Slate, Meagher & Flom LLP
Contact
more
less

Skadden, Arps, Slate, Meagher & Flom LLP on:

Readers' Choice 2017
Reporters on Deadline

"My best business intelligence, in one easy email…"

Your first step to building a free, personalized, morning email brief covering pertinent authors and topics on JD Supra:
Sign up using*

Already signed up? Log in here

*By using the service, you signify your acceptance of JD Supra's Privacy Policy.
Privacy Policy (Updated: October 8, 2015):
hide

JD Supra provides users with access to its legal industry publishing services (the "Service") through its website (the "Website") as well as through other sources. Our policies with regard to data collection and use of personal information of users of the Service, regardless of the manner in which users access the Service, and visitors to the Website are set forth in this statement ("Policy"). By using the Service, you signify your acceptance of this Policy.

Information Collection and Use by JD Supra

JD Supra collects users' names, companies, titles, e-mail address and industry. JD Supra also tracks the pages that users visit, logs IP addresses and aggregates non-personally identifiable user data and browser type. This data is gathered using cookies and other technologies.

The information and data collected is used to authenticate users and to send notifications relating to the Service, including email alerts to which users have subscribed; to manage the Service and Website, to improve the Service and to customize the user's experience. This information is also provided to the authors of the content to give them insight into their readership and help them to improve their content, so that it is most useful for our users.

JD Supra does not sell, rent or otherwise provide your details to third parties, other than to the authors of the content on JD Supra.

If you prefer not to enable cookies, you may change your browser settings to disable cookies; however, please note that rejecting cookies while visiting the Website may result in certain parts of the Website not operating correctly or as efficiently as if cookies were allowed.

Email Choice/Opt-out

Users who opt in to receive emails may choose to no longer receive e-mail updates and newsletters by selecting the "opt-out of future email" option in the email they receive from JD Supra or in their JD Supra account management screen.

Security

JD Supra takes reasonable precautions to insure that user information is kept private. We restrict access to user information to those individuals who reasonably need access to perform their job functions, such as our third party email service, customer service personnel and technical staff. However, please note that no method of transmitting or storing data is completely secure and we cannot guarantee the security of user information. Unauthorized entry or use, hardware or software failure, and other factors may compromise the security of user information at any time.

If you have reason to believe that your interaction with us is no longer secure, you must immediately notify us of the problem by contacting us at info@jdsupra.com. In the unlikely event that we believe that the security of your user information in our possession or control may have been compromised, we may seek to notify you of that development and, if so, will endeavor to do so as promptly as practicable under the circumstances.

Sharing and Disclosure of Information JD Supra Collects

Except as otherwise described in this privacy statement, JD Supra will not disclose personal information to any third party unless we believe that disclosure is necessary to: (1) comply with applicable laws; (2) respond to governmental inquiries or requests; (3) comply with valid legal process; (4) protect the rights, privacy, safety or property of JD Supra, users of the Service, Website visitors or the public; (5) permit us to pursue available remedies or limit the damages that we may sustain; and (6) enforce our Terms & Conditions of Use.

In the event there is a change in the corporate structure of JD Supra such as, but not limited to, merger, consolidation, sale, liquidation or transfer of substantial assets, JD Supra may, in its sole discretion, transfer, sell or assign information collected on and through the Service to one or more affiliated or unaffiliated third parties.

Links to Other Websites

This Website and the Service may contain links to other websites. The operator of such other websites may collect information about you, including through cookies or other technologies. If you are using the Service through the Website and link to another site, you will leave the Website and this Policy will not apply to your use of and activity on those other sites. We encourage you to read the legal notices posted on those sites, including their privacy policies. We shall have no responsibility or liability for your visitation to, and the data collection and use practices of, such other sites. This Policy applies solely to the information collected in connection with your use of this Website and does not apply to any practices conducted offline or in connection with any other websites.

Changes in Our Privacy Policy

We reserve the right to change this Policy at any time. Please refer to the date at the top of this page to determine when this Policy was last revised. Any changes to our privacy policy will become effective upon posting of the revised policy on the Website. By continuing to use the Service or Website following such changes, you will be deemed to have agreed to such changes. If you do not agree with the terms of this Policy, as it may be amended from time to time, in whole or part, please do not continue using the Service or the Website.

Contacting JD Supra

If you have any questions about this privacy statement, the practices of this site, your dealings with this Web site, or if you would like to change any of the information you have provided to us, please contact us at: info@jdsupra.com.

- hide
*With LinkedIn, you don't need to create a separate login to manage your free JD Supra account, and we can make suggestions based on your needs and interests. We will not post anything on LinkedIn in your name. Or, sign up using your email address.