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

by Blake, Cassels & Graydon LLP
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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 and In 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.

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.

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