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Cybersecurity: When Guidelines Become Rules

So much media attention was paid to the spectacular collapse of U.S. Senate deliberations on a cybersecurity bill in August — and the Obama Administration’s controversial move to fashion an Executive Order on the subject — that few if anyone focused on the biggest change affecting the data protection landscape. The Securities & Exchange Commission (SEC) guidelines on disclosure of cyber attacks by publicly traded corporations have become de facto rules for at least six companies, including Google Inc. and Amazon.com Inc., according to recent agency enforcement letters.

virusspot.jpgLast fall, the SEC completed a long process of issuing staff “guidance” on when cybersecurity risks must be disclosed in public company securities filings (annual reports, 10Qs, etc.). The sensible conclusion was that if a hack or intrusion would be “material” to an ordinary investor, corporations need to disclose the cyber risk and discuss their actions to ameliorate or prevent it. Unlike Y2K, however, these guidelines, released by the SEC’s corporate finance section, did not come with a “safe harbor” for disclosing companies. In 1999, congressional legislation created a legal safety zone for Y2K disclosures, avoiding liability under the Securities Act of 1934, that has not been replicated with respect to more general cybersecurity risks.

The recent SEC enforcement steps also have taken place at the corporate finance division level, but presumably with the informal approval at least of SEC Chair Mary Schapiro. In these cases, the agency “requested” that a number of large Internet companies clarify or modify their SEC filings to disclose cyber incidents that previously had not been reported to investors. In April, the SEC asked Amazon to disclose in its next quarterly filing that hackers had raided its Zappos.com unit, stealing addresses and some credit card digits from 24 million customers in January, which Amazon did.  Google likewise agreed in May to put a previously disclosed cyber atack in its formal earnings report. AIG, Hartford Financial Services Group, Eastman Chemical and Quest Diagnostics were also asked to improve disclosures of cyber risks, according to agency staff correspondence reported by Bloomberg News.

As one example, here is the relevant excerpt from the corporate finance staff’s May 2, 2012 letter to Google CEO Larry Page:

We note your disclosure that if your security measures are breached, or if your services are subject to attacks that degrade or deny the ability of users to access your products and services, your products and services may be perceived as not being secure, users and customers may curtail or stop using your products and services, and you may incur significant legal and financial exposure. We also note your Current Report on Form 8-K filed January 13, 2010 disclosing that you were the subject of a cyber attack. In order to provide the proper context for your risk factor disclosures, please revise your disclosure in your next quarterly report on Form 10-Q to state that in the past you have experienced attacks. Please refer to the Division of Corporation Finance’s Disclosure Guidance Topic No. 2 at http://www.sec.gov/divisions/corpfin/guidance/cfguidance-topic2.htm for additional information.

The difference between fall 2011 and spring 2012 is that, irrespective of the formal legal effect of staff guidance, the SEC is using its administrative processes to produce a disclosure result not specifically compelled by the agency’s rules for corporate securities filings. That in itself is not surprising, since the securities laws and implementing SEC regulations are broad enough to encompass any factor, whether financial or otherwise, that could affect stock prices. Here, the SEC staff opined in its guidance that basic SEC rules about market manipulation, insider trading and misleading shareholders (e.g., Rule 10b-5) required disclosure of cyber incidents and cybersecurity risks by any business potentially affected by hacking. And that’s obviously not confined to online retailers or Web-centric businesses.

The bigger question is how businesses can protect themselves from the embarrassment of such compelled, government-mandated cyber disclosures and the even greater potential for fines and formal enforcement actions the SEC may utilize in the  IT security realm going forward. Here are a few pointers:

  • Do not assume that merely because your business is not online, cybersecurity cannot affect the company. Hundreds of “brick and mortar” retailers, for instance, have had consumer credit card records breached.
  • Treat data security just like your securities lawyers treat any other risk to the business’s future, since that is how federal regulators view cyber risks.
  • Do not assume the SEC’s focus on cybersecurity is limited to public companies, because the underlying rules cited by its corporate finance division apply just as much to private placements as they do to proxy solicitations and 10K reports.
  • When disclosing IT security risks, make sure they are balanced by something concrete and proactive to prevent, or diminish the severity of, cyber attacks. Otherwise diclosures may have the opposite effect of encouraging shareholder class action litigation.
  • Work closely with compliance counsel, IT technology experts and your insurance carriers to develop workable cybersecurity assessment and intrusion notification regimes, internally and externally. This should not only reduce legal exposure, but going forward lower the company’s costs for cyber insurance. Periodic outside reviews should provide both comfort and legal protection to CEOs or CFOs signing SEC submissions.

These SEC staff actions were balanced by the traditional caveat that “our comments or changes to disclosure in response to our comments do not foreclose the Commission from taking any action with respect to the company or the filings and the company may not assert staff comments as a defense in any proceeding initiated by the Commission or any person under the federal securities laws of the United States.”  But the chances the full SEC would prosecute a public company for following staff suggestions are remote. On the other hand, for public corporations that ignore this lesson, and fail to disclose cybersecurity risks, we suspect only pain and expense — most likely in a Commission prosecution or fine — lie in their SEC futures. So rules are really rules, even when they are not.

Note: Originally written for and reposted with permission of my law firm’s Information Intersection blog.