European Union: Dynamic Regulations And Shareholder Actions Guide The Board's Shifting Role In Cyber (Part One Of Two)

Last Updated: 1 March 2018
Article by Jeewon Kim Serrato, Marc Elzweig and David Lee

One well-known cost of breaches is post-breach litigation. A growing trend that merits further attention is the rise of shareholder derivative suits filed against boards of directors of companies that suffered data breaches. Moreover, regulatory changes, including the GDPR, may make such suits more frequent in addition to creating other data-breach- response expenses. Boards of directors need to take note and understand these increasing costs and risks.

In part one of this two-part article series, we review the evolving understanding of the board of directors' responsibility for cybersecurity and consider several shareholder derivative suits filed in the wake of data breaches as case studies. In part two, we will consider some of the lessons that boards may learn from these suits.

Rising Costs and Regulatory Shifts

Not only are data breaches expensive in direct costs, but they may also have a persistent or permanent negative impact.

A recent CGI and Oxford Economics study found an average permanent loss of nearly 2% of a company's value resulting from a severe data breach, and that the impact is likely increasing. In addition, data breach reporting requirements in the E.U. GDPR are reasonably expected to increase the global reporting of and scrutiny on data breaches after the GDPR becomes effective on May 25, 2018. We may learn that data breaches are even more common and expensive than our current understanding.

Consumer class actions typically follow a breach, and there may be litigation with other third parties, such as credit card processers if payment card systems are compromised. Such suits often lead to significant expenses for the company, and the impact of consumer class actions and suits filed by financial institutions have received wide coverage.

In addition to class actions, in several recent large-scale data breach incidents, shareholders have filed suits against the executives and directors for various theories including breach of fiduciary duties, mismanagement and material omissions.

With the GDPR on the one hand mandating data breach notifications and on the other explicitly allowing for private claims and group action claims – where individuals may mandate a not-for-profit body, organization or association to exercise their rights and bring claims on their behalf – we expect to see an increased awareness of data breaches and resulting claims against companies.

See "Key Post-Breach Shareholder Litigation, Disclosure and Insurance Selection Considerations" (Aug. 3, 2016).

Board Considerations

Increased regulatory obligations, alongside media reporting on data breaches that have led to the ouster of CEOs and shakeups of boards, have made cybersecurity threats a top concern for boards of directors. The new GDPR breach notification rules and the specter of fines and private claims will also dramatically increase the need for board oversight in handling E.U. resident data. Shearman & Sterling's 2017 Corporate Governance & Executive Compensation Survey, an annual survey of the 100 largest U.S. public companies, showed that 15% of the companies' shareholder engagement disclosures in their 2017 proxy statements included risk management and oversight, cybersecurity and compliance issues, compared to 7% in 2016.

An increase in knowledge and awareness of cybersecurity issues may be prompting more disclosures. The 2017 BDO Cyber Governance Survey reports that more than three- quarters (79%) of public company directors report their board is more involved with cybersecurity than it was 12 months ago. Given the exposure, we anticipate more companies will add cybersecurity statements in their proxy statements.

See "A CSO/GC Advises on How and When to Present Cybersecurity to the Board" (Feb. 22, 2017).

The following are some of the notable regulatory developments – through the GDPR and U.S. regulatory efforts – that boards should keep in mind.

GDPR's Breach Notification Provision

In the E.U., the GDPR is slated to be one of the most significant pieces of legislation in decades and presents ambitious and comprehensive changes to data protection rules that will surely be tested in court. Intended to harmonize E.U. member state legislations and increase data subjects' rights, the GDPR not only requires companies handling E.U. resident data to comply with privacy principles, but it also includes the first E.U.-wide mandatory data breach notification rule. Under Article 33, companies are required to report to the data protection supervisory authority within 72 hours all breaches leading to destruction, loss, alteration or unauthorized access to personal data that is likely to result in a risk to the rights and freedoms of the affected data subjects. Further, under Article 34, when a data breach is likely to result in a "high risk" to the rights and freedoms of natural persons, notification to data subjects is required without undue delay.

See "A Practical Look at the GDPR's Data Breach Notification Provision" (Jan. 17, 2018).

GDPR's Right of Compensation

In addition to this mandatory breach notification rule, which is similar to rules the U.S. has had for over a decade,1 the GDPR also gives individuals a right to compensation from a data breach. Under Article 79, individuals may bring private claims for any infringement of the GDPR relating to the processing of their personal data. Article 82(1) expands the scope of liability for infringement so that anyone who has suffered material or non-material damage shall have the right to compensation.

It is important to note that the injured person no longer needs to prove financial loss to recover from the lawsuit, as damages may be awarded to a person who suffered distress due to the breach. The GDPR also allows third party not-for-profit public interest bodies to bring claims on data subjects' behalf (Article 80(1)). These new rules significantly expand the pool of claimants who may seek damages against a company in the case of a data breach.

Not only will data breaches result in private claims, failures to comply with the GDPR can result in fines of up to 4% of global revenue. As a result, this legislation will likely place cybersecurity and personal data issues at the top of the board agenda.

See "A Discussion With Ireland's Data Protection Commissioner Helen Dixon About GDPR Compliance Strategies (Part One of Two)" (Mar. 22, 2017); Part Two (Apr. 5, 2017).

U.S. Regulators' Views on Board Behavior

In the U.S., there is no national data protection or cybersecurity law, but a patchwork of state and federal regulations have sought to address cybersecurity threats and privacy issues, with regulators increasingly signaling that the board has oversight responsibilities. In a 2014 speech to the New York Stock Exchange, then-SEC Commissioner Luis Aguilar noted that "boards must take seriously their responsibility to ensure that management has implemented effective risk management protocols. ... and there can be little doubt that cyber-risk also must be considered as part of boards' overall risk oversight."

Similarly, Jay Clayton, during 2017 confirmation hearings to become Chairman of the SEC, signaled his support for a Senate bill that would increase disclosure about directors' roles and expertise in cybersecurity. Mr. Clayton stated, "I believe that is something that investors should know, whether companies have thought about the [cybersecurity] issue, whether it's a particular expertise the board has," and further added, "It's a very important part of operating a significant company."These statements reflect the SEC's position that "the greatest threat to our markets right now is the cyber threat," as stated by Steven Peikin, SEC's co-director of enforcement.

See also "SEC Officials Flesh Out Cybersecurity Enforcement and Examination Priorities (Part One of Two)" (May 3, 2017); Part Two (May 17, 2017).

Originally published in www.cslawreport.com

To view the article please click here.

Footnotes

1 The first such law, the California data security breach notification law was enacted in 2002 and became effective on July 1, 2003. See SB 1386, Cal. Civ. Code 1798.82 and 1798.29

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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