Three Ways a New SEC Rule Increases Risk for Public Companies
Cybersecurity exposure is about to get even more dangerous for public companies.
In late July, the Securities and Exchange Commission approved a new rule that requires publicly traded companies to report any data or cybersecurity breach within four days of determining the incident’s materiality.
“Cyber incidents are still incredibly frequent. Ransomware events continue to creep up and become more and more expensive. And public companies now have a very real exposure in respect to this new SEC rule,” said Ray Ash, EVP and head of management liability, Westfield Specialty Insurance.
There are few ways the new rule presents heightened risk to companies:
1) Determination of “Materiality”
The determination of materiality itself is uncharted territory. Some cases will be obvious. Theft of social security numbers or bank account information, for example, is clearly material. Other events might not be so clear-cut. As the SEC hasn’t offered definitive criteria for a “material” breach, this definition will likely be shaped by the courts.
“The crux of materiality is really going to be tested by the plaintiff’s bar in court,” Ash said.
“We saw a similar situation 10-plus years ago out of the Dodd-Frank Act, which gave shareholders the opportunity to vote on executive compensation practices. The vote was nonbinding and suggested to have no legal recourse, but that didn’t stop the plaintiff’s bar from testing it. All suits filed in regard to executive pay were dismissed in the end, but they nonetheless incurred defense costs, which ultimately get passed on to insurance companies.
“I think we will see the same here. Regardless of whether plaintiffs win their cases, they will still drive up legal costs. Until we really get a feel for how companies are responding in the event of a breach and determining materiality, it definitely is a new front in the D&O world,” he said.
2) A Challenging Timeframe
A four-day turnaround time will be very tight for most companies. Meeting such a quick deadline turns up the pressure to a degree that some boards of directors and cybersecurity teams are simply not prepared to face.
“Even in the most high-profile breaches where PII [personal identifiable information] was stolen — social security numbers, passport numbers — even those companies took months to disclose the incident,” Ash said.
Equifax, for example, took roughly two months to announce a data breach after it was discovered. The breach that took place from mid-May to July of 2017 was not disclosed until September 2017. Yahoo did not disclose a significant data breach until about two years after it occurred. The hack itself took place in 2014 and was not discovered immediately. Disclosure did not come until 2016.
Some of the delay can be attributed the process of uncovering exactly what and how much data was compromised. Companies may want to ensure the breach is contained and a remediation plan is in place before disclosing an incident. Sometimes, law enforcement requests that breaches not be publicly disclosed while investigations are underway.
In any case, a four-day window will force companies to direct more time and resources to the identification and containment of a breach.
3) Stock Hits and Shareholder Suits
Stricter regulation will also increase the downstream risk of private shareholder lawsuits that can stem from noncompliance. SEC action on top of the breach itself could cause share prices to drop, potentially triggering a wave of litigation. Equifax, for example, saw its stock price fall more than 30% after its breach disclosure. The private class action suits that followed cost just under $150 million.
“You have that additional layer of exposure when you have public shareholders, and there is a microsecond-by-microsecond valuation of a company based on its current news. In terms of D&O claims, the SEC exposures, while severe, generally have not been tower-burners. It is the knock-on effect of the private security class actions. That’s where losses jump into the tens of millions. And the plaintiff’s bar does a good job of finding shareholders that support lawsuits,” Ash said.
It’s not yet clear just how severely the new SEC rule will impact public companies’ risk profiles — or shape their risk mitigation strategies. Will companies be quick to report any breach, big or small, out of fear that the jury will not agree with its determination of materiality? Is it worth the extra effort and cost to disclose first and investigate later?
“No one knows where this is ultimately going to go. Maybe it will become similar to the excessive compensation environment of 10 years ago, which turned out to be a lot of sound and fury that ultimately amounted to nothing. Or it could be a new front in the world where everything is securities fraud, which only exacerbates the event-driven litigation concept,” Ash said.
“In some of the high-profile breaches, the suits that followed were prime examples of event-driven litigation. Some turned out to be severe, some did not. But in our current world of cybersecurity threats, this rule has the potential to really reshape the severity — and certainly the frequency — of shareholder class actions.”
What should public companies do to prepare for the implementation of this new rule and reduce their exposure to regulatory action and subsequent shareholder suits?
“The good news is that cybersecurity has been a topic at the forefront of organizations’ enterprise risk management strategies for years. So, the idea of hiring a CISO or CIO — someone in charge of cybersecurity and data management — the framework already exists,” Ash said. “It will likely have to be built out more to support what the SEC is asking for.”
Cybersecurity staff might typically report to the board of directors and executive team quarterly, but now it may be prudent to build a special committee within the board itself that is dedicated to cyber security risk mitigation, breach identification and reporting. Engaging outside counsel early to help establish this framework is also likely worth the investment.
“The more effort you can put into strong governance practices now will really pay off in the future, as far as your ability to respond to a breach and defend from private action,” Ash said. “Prevention is the best practice here. Bolstering good corporate governance is always going to be the best defense.” &