Public companies experiencing data security incidents have been largely successful in defeating derivative actions and securities class actions related to those cyber incidents. Nevertheless, some recent events may encourage shareholder attorneys to pursue securities fraud class actions after disclosure of a cyber incident, if that disclosure leads to a drop in the stock price. This article addresses two of those events: this week’s announcement of the settlement in the Yahoo!, Inc. securities fraud class action, and the SEC’s recent guidance on public company disclosures of cyber risk.

The $80 Million Yahoo Securities Class Settle Action Settlement

On March 5, Yahoo, Inc. ("Yahoo") announced a proposed settlement, in In re Yahoo Inc. Securities Litigation, which was filed in U.S. District Court in San Francisco. The $80 million proposed settlement relates to a securities class litigation stemming from Yahoo's 2013 and 2014 data breaches. While many elements of the Yahoo securities class action may be factually unique, the settlement is a milestone because it is the first significant securities fraud settlement from a cybersecurity breach.

In January 2017, the first of several securities class action lawsuits was filed against Yahoo and certain of its directors and officers in the Northern District of California. Plaintiff shareholders alleged that defendants' brazenly failed to disclose the two largest data breaches in U.S. history, in which hackers stole the records of 3 billion users in 2013, compromised the accounts of 500 million users in 2014, and caused financial harm to its investors. They further alleged that defendants failed to disclose two additional massive data breaches in 2015 and 2016, which affected approximately 32 million Yahoo users and caused financial harm to its investors.

It is also alleged that, throughout the class period, defendants continued to reassure the public that Yahoo had "physical, electronic, and procedural safeguards that comply with federal regulations to protect personal information about [its users]," that it would publicly disclose all security vulnerabilities within 90 days of discovery, and that its data security employed "best practices," among other misrepresentations. Plaintiff shareholders alleged that defendants knew but failed to disclose that Yahoo was employing grossly outdated and substandard information security methods and technologies, which had resulted in two of the largest data security breaches in history.

The complaint alleges that defendants made false or misleading statements or failed to disclose that:

• Yahoo failed to encrypt its users' personal information and/or failed to encrypt its users' personal data with an up-to-date and secure encryption scheme;
• Sensitive personal account information from more than 1 billion users was vulnerable to theft; and,
• It was foreseeable that a breach resulting in the theft of personal user data would cause a significant drop in users of Yahoo's websites and services.

The stipulation of settlement does not say how the settlement will be funded. It states only that Yahoo will "pay the settlement or cause it to be paid." The stipulation of settlement expressly includes defendants' insurers, which is not unusual. A description of how the settlement is to be funded mentions providing the insurers with information, which strongly suggests that the D&O insurers are funding at least some portion of the settlement.

To date, public companies have largely succeeded in defeating cyber-related claims against directors and officers. The Yahoo settlement, combined with recent announcements from the U.S. Securities and Exchange Commission's (SEC), discussed below, could very well change this trend.

U.S. Securities and Exchange Commission's Updated Guidance on Cybersecurity Disclosure[1]

Interestingly, the Yahoo proposed settlement was announced on the heels of the SEC's recently updated guidance on cybersecurity disclosure. On February 21, the SEC issued new guidance calling on public companies to be more forthcoming when disclosing cybersecurity risks. The 2018 guidance on cybersecurity disclosure for public companies updates the language the SEC released in 2011 regarding cyber risks and their impact on investment decisions. Under the new cybersecurity disclosure standards, SEC Chairman Jay Clayton stated that the goal is to ensure that companies provide "more complete information" to investors about cyber risks and incidents.

In its 2018 Disclosure Guidance, the SEC emphasized the importance of disclosing material cybersecurity risks, even in cases where a company has not yet suffered a cyberattack. The SEC noted that effective disclosure controls and procedures are best accomplished when directors, officers, and other key management personnel are informed about their entity's cyber risks.

The primary objective of the updated SEC guidance is for board directors and company executives to review their controls and procedures to ensure they properly discharge their cybersecurity disclosure responsibilities.

SEC Chairman Clayton stated "I believe that providing the Commission's views on these matters will promote clearer and more robust disclosure by companies about cybersecurity risks and incidents, resulting in more complete information being available to investors. . . In particular, I urge public companies to examine their controls and procedures, with not only their securities law disclosure obligations in mind, but also reputational considerations around sales of securities by executives."

The guidelines caution public companies to "take all required actions to inform investors about material cybersecurity risks and incidents in a timely fashion, including those companies that are subject to material cybersecurity risks but may not yet have been the target of a cyberattack." Additionally, the SEC guidance makes it clear that if investors are kept in the dark about security incidents, not only should companies expect class action suits, but the SEC intends to actively investigate such matters as well. In the agency's words, the SEC "continues to monitor cybersecurity disclosures carefully."

The guidelines note that the responsibility for clear and expedient disclosure falls squarely on the shoulders of board directors. The board is responsible for ensuring that the organization has appropriate disclosure controls and procedures "to make accurate and timely disclosures of material events." This includes guidance to public companies on how and when they should disclose cybersecurity risks and breaches, including potential weaknesses that hackers have not yet targeted.

The SEC's 2018 Statement and Guidance on Public Company Cybersecurity Disclosures reminds regulated entities that the federal securities laws may apply to cyber risk, cyber events, and any related disclosures or disclosure requirements. The guidelines observe that cybersecurity risk management policies and procedures are key elements of enterprise-wide risk management, including compliance with the federal securities laws. Companies are encouraged to adopt comprehensive policies and procedures related to cybersecurity and to assess their compliance regularly, including the sufficiency of their disclosure controls and procedures as they relate to cybersecurity disclosure. Companies should assess whether they have sufficient disclosure controls and procedures in place to ensure that relevant information about cybersecurity risks and incidents is processed and reported to the appropriate personnel, including up the corporate ladder. The goal is to enable senior management to make disclosure decisions and certifications and to facilitate policies and procedures designed to prohibit directors, officers, and other corporate insiders from trading on the basis of material nonpublic information about cybersecurity risks and incidents.

The message should be clear that regulated companies must be prepared for potential cybersecurity exams by the SEC, the Financial Industry Regulatory Authority (FINRA), or state regulators. Conducting comprehensive cybersecurity program assessments under privilege can help to both prepare organizations for these exams as well as mitigate risks of problematic findings and/or noncompliance.

Conclusion

In the past, public companies have defeated plaintiffs' efforts to seek recovery through securities class actions relating to cybersecurity risks and events. However, recent events suggest that may change. These types of claims likely will become a major issue for companies in 2018 and beyond. The new SEC guidelines and the Yahoo settlement may provide the necessary groundwork that enables plaintiffs' law firms to bring securities actions to pursue these claims.

In this regard, another class action securities case recently filed in the cybersecurity context may provide further guidance. Earlier this year, two class action lawsuits were filed against Intel Corporation after the vulnerabilities relating to the Meltdown and Spectre CPU flaws were publicized. The Meltdown and Spectre flaws were present in CPUs dating back to 1995 and a Google security team informed Intel about chip vulnerabilities in June 2017. According to a recent announcement by Intel, the total has grown to 32 multi-party suits by customers and two securities suits.

The shareholder actions assert that Intel violated securities laws when it assured its products were safe to use - assurances the Meltdown and Spectre flaws revealed to be untrue. Shareholders allege that "Intel and certain officers violated securities laws by making statements about Intel's products and internal controls that were revealed to be false or misleading by the disclosure of the security vulnerabilities." The plaintiffs further allege that the defendants breached their duties to Intel by failing to take action in relation to alleged insider trading."

While the facts at issue in Intel are notably different from those of Yahoo, because they relate to disclosures concerning Intel's flawed chips and not to a cybersecurity breach at Intel, it will be interesting to see if the Intel securities litigation is the next disclosure related case in a cybersecurity context that leads to a significant settlement. Also, given the unique facts involving the world's leading producer of microchips, it will also be interesting to see if the cybersecurity breaches attributed to those flawed chips lead to further litigation against Intel from customers whose data was hacked. The Intel securities actions are another indication that plaintiffs' law firms continue to pursue securities litigation relating to disclosures in the cybersecurity context which lead to a decline in a company's stock price. The Intel securities actions are still in their earliest stages. However, it will be interesting to see to what extent they are part of a trend, and impact securities litigation, in general, as it relates to cybersecurity disclosure risks and events.

[1] https://www.sec.gov/news/press-release/2018-22