United States: Commissioner Roisman Talks Cybersecurity

On Friday, in remarks before the L.A. County Bar Association, SEC Commissioner Elad Roisman addressed some of the challenges associated with cybersecurity and cyber breaches and similar events. In his presentation, Roisman considers cybersecurity in a variety of contexts, such as the exchanges, investment advisers and broker-dealers, but his discussion of cybersecurity in the context of public companies is of most interest here. Although the SEC has imposed some principles-based requirements and issued guidance about cybersecurity disclosure, Roisman believes that there is more in the way of guidance and even rulemaking that the SEC should consider "to ensure that companies understand [the SEC's] expectations and investors get the benefit of increased disclosure and protections by companies."

Cyber threats cover a broad territory, Roisman explains: they may involve "simple account intrusions that seek to steal assets from an investor's or customer's accounts; ransomware attacks that seek to disable business operations in order to extract payments; and even acts of 'hacktivism' that disrupt services to make a political point.  Cyber events can often be hard to detect, hard to measure quickly, and can involve reporting obligations to multiple government agencies and stakeholders." 

While public companies have general disclosure obligations under the securities laws, they may also have responsibility for "taking measures to prevent and mitigate damage from these threats." Roisman observes that "it has become increasingly important for market participants to work with counsel and other experts on preparing for potential cyber-attacks before they happen-that is, devising a plan for monitoring for cyber threats, responding to potential breaches, and understanding when information must be reported outside the company and to whom."

With regard to disclosure guidance, although there is currently no explicit disclosure mandate regarding cybersecurity risks and cyber incidents, Roisman observes, the SEC did issue guidance in 2018 that makes clear that companies may be obligated to disclose these risks and incidents under Reg S-K and Reg S-X, which require disclosure regarding risk factors, business and operations, MD&A and other matters. A "necessary prerequisite" to providing timely and adequate disclosure, according to Roisman, is the adoption and implementation of effective disclosure controls and procedures, which in turn rely on "engaged and informed officers, directors and others."

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In 2018, the SEC announced that it had adopted long-awaited new guidance on cybersecurity disclosure. With the increasing importance of cybersecurity and the increasing incidence of cyber threats and breaches, the guidance cautioned, companies need to review the adequacy of their disclosures regarding cybersecurity and consider how to augment their policies and procedures to ensure that information regarding cybersecurity risks and incidents is effectively communicated to management to allow timely decisions regarding required disclosure and compliance with insider trading policies. The guidance highlighted the pervasiveness of, and increasing reliance by companies on, digital technology to conduct their operations and engage with customers and others. That makes companies in all industries vulnerable to the threat of cybersecurity incidents, such as stolen access credentials, malware, ransomware, phishing, structured query language injection attacks and distributed denial-of-service attacks. Whether these incidents are a consequence of unintentional events or deliberate attacks, the SEC cautioned that they represent a continuous risk to the capital markets and to companies, their customers and business partners, a risk that calls for more timely and transparent disclosure.

In addition to a discussion of disclosure obligations under existing laws and regulations, the focus of the guidance was on cybersecurity policies and procedures, particularly with respect to disclosure controls and procedures and insider trading and selective disclosure prohibitions. The guidance urged companies to assess whether their disclosure controls and procedures capture information about cybersecurity risks and incidents and ensure that it is reported up the corporate ladder to enable senior management to make decisions about whether disclosure is required and whether other actions should be taken. According to the guidance, "[c]ontrols and procedures should enable companies to identify cybersecurity risks and incidents, assess and analyze their impact on a company's business, evaluate the significance associated with such risks and incidents, provide for open communications between technical experts and disclosure advisors, and make timely disclosures regarding such risks and incidents. The controls should also ensure that information is communicated to appropriate personnel to facilitate compliance with insider trading policies."  (See this Cooley Alert.)

Cybersecurity, Roisman notes, can also implicate internal control over financial reporting, pointing to the SEC's 2018 21(a) report regarding nine companies that were victims of cyber fraud as a result of their employees' wiring funds to pay phony "invoices" in response to deceptive electronic communications.

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As described in the 21(a) report, Enforcement conducted investigations of nine listed public companies in a range of industries that experienced cyber fraud in the form of "business email compromises," which involved perps sending spoofed or otherwise compromised electronic communications that purported to be from company executives or vendors.  The perps then deceived company personnel into wiring substantial sums into the perps' own bank accounts.  In these instances, each company lost at least $1 million, and two lost more than $30 million for an aggregate (mostly unrecovered) loss of almost $100 million. And these weren't one-time only scams: in one case, the company made 14 wire payments over several weeks for an aggregate loss of over $45 million, and another company paid eight invoices totaling $1.5 million over several months.

Although the SEC decided not to take any enforcement action against the nine companies investigated, the SEC determined to issue the report "to make issuers and other market participants aware that these cyber-related threats of spoofed or manipulated electronic communications exist and should be considered when devising and maintaining a system of internal accounting controls as required by the federal securities laws. Having sufficient internal accounting controls plays an important role in an issuer's risk management approach to external cyber-related threats, and, ultimately, in the protection of investors." Given our expanding reliance on electronic communications and digital technology for economic activity, the report advised companies to "pay particular attention to the obligations imposed by Section 13(b)(2)(B) to devise and maintain internal accounting controls that reasonably safeguard company and, ultimately, investor assets from cyber-related frauds." In particular, the report focused on the requirements of  Section 13(b)(2)(B)(i) and (iii) to "devise and maintain a system of internal accounting controls sufficient to provide reasonable assurances that (i) transactions are executed in accordance with management's general or specific authorization," and that "(iii) access to assets is permitted only in accordance with management's general or specific authorization." (See this PubCo post.)

And Roisman observes, Enforcement also "brought two notable settled actions this summer involving public companies' disclosures regarding cybersecurity incidents." Here, Roisman pointed to recent cases against  First American Financial Corporation and Pearson plc.

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In June, the SEC announced settled charges against a real estate settlement services company, First American Financial Corporation, for violation of the requirement to maintain adequate disclosure controls and procedures "related to a cybersecurity vulnerability that exposed sensitive customer information." According to the SEC's order, in May 2019, the company was advised by a journalist that its "EaglePro" application for sharing document images had a vulnerability that exposed "over 800 million title and escrow document images dating back to 2003, including images containing sensitive personal data such as social security numbers and financial information." That evening, the company issued a public statement and, on the next trading day, furnished a Form 8-K to the SEC.  However, as it turns out, the company's information security personnel had already identified the vulnerability in a report of a manual test of the EaglePro application about five months earlier, but failed to remediate it in accordance with the company's policies.  Importantly, for purposes of this case, they also failed to apprise senior executives about the report, including those responsible for making public statements, even though the information would have been "relevant to their assessment of the company's disclosure response to the vulnerability and the magnitude of the resulting risk." The company was found to have violated the requirement to maintain disclosure controls and procedures and ordered to pay a penalty of almost a half million dollars. (See this PubCo post.)

Then, in August, the SEC announced settled charges against Pearson plc, an NYSE-listed, educational publishing and services company based in London, for failure to disclose a cybersecurity breach. In this instance, it wasn't just a vulnerability-there was an actual known breach and exfiltration of private data.  As described in the SEC's Order, in September 2018, Pearson was advised by one of its software manufacturers of a critical vulnerability in its software and notified of the availability of a patch to fix it. Pearson, however, failed to implement the patch.  In March 2019, the company learned that a "sophisticated threat actor" used the unpatched vulnerability to access and download millions of rows of data.  After the breach, Pearson implemented the patch and engaged a consultant to conduct an investigation, but "decided that it was not necessary to issue a public statement regarding the incident." Instead, Pearson mailed a notice to its customer accounts and prepared a media statement to have ready in case of media inquiry.  Nor did Pearson disclose the breach in its Form 6-K risk factors, instead leaving its previous cybersecurity risk factor-which described the risk as purely hypothetical-unchanged. The SEC viewed that disclosure as misleading and imposed a civil penalty on Pearson of $1 million. (See this PubCo post.)

Finally, Roisman highlights the appearance on the SEC's most recent regulatory agenda of potential rulemaking regarding cybersecurity. (See this PubCo post.) While he disclaims having set eyes on any draft proposal, he has some ideas of his own that he hopes to see in the anticipated proposal, including these points:

In particular, Roisman emphasizes the importance of working with other regulators, law enforcement and the national security community to ensure that the proposal from the SEC would not conflict with their mandates, such as an admonition against disclosure by law enforcement or national security agencies.  He also cautioned that any disclosure requirements should be focused on eliciting material information and tailored to avoid disclosure of a "roadmap for how to infiltrate a registrant's systems."  

In conclusion, Roisman offers some ideas that companies could consider undertaking right now.  For example, companies might want to identify in advance experts that that they can call in the event of a cyber-incident.  In his view, that type of effort would show "prudence and diligence." Another proactive way to mitigate potential harm would be to conduct table-top exercises. While these activities will not necessarily cover every circumstance, "they offer a level of procedures and pro-active measures that a company can undertake in recognition of this potential risk."

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