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Cybersecurity liability: Delaware has good news for directors

Matt Hafter November 15, 2016

The Delaware Chancery Court just issued an opinion that will have directors breathing a sigh of relief in connection with cybersecurity risks. In its opinion – Reiter v Fairbank, C.A. No. 11693-CB (Del. Ch. Oct. 18, 2016) – the Chancery Court articulated the standards of “bad faith” that must exist in order for directors to be held liable for failing to exercise oversight with regard to the corporation’s compliance with law in a risky area.

Duty of oversight

The duty of oversight was first articulated in In re Caremark International Inc. Derivative Litigation, 698 A.2d 959 (Del. Ch. 1996). This duty arises from a director’s duty of loyalty to the corporation. This breach involves a conscious disregard by the director of his or her responsibilities; that the director “utterly failed” to implement a system of reporting of controls; or the director consciously failed to monitor operations and thereby was disabled from being informed of risks requiring the director’s attention.

In Reiter, the plaintiffs alleged that the corporation’s directors failed to implement an adequate compliance program to assure compliance with certain anti-money laundering laws. The corporation conducted the relevant business in traditionally underbanked urban areas involving “high risk products and services” for a “high risk customer base” that was well-known to present a risk of money laundering and was therefore subject to extensive regulation.

The Reiter Court emphasized two key elements that are prerequisites to finding liability:

  1. The director must have acted with scienter and must know that his or her actions are inconsistent with applicable fiduciary duties; and 

  2. There must be a causal connection between the harm to the corporation and the board’s conduct. This connection may be demonstrated if the directors knew “red flags” suggesting misconduct but consciously failed to address the problem

The evidence in Reiter showed that the Board’s Audit and Risk Committees received numerous reports explaining compliance risks related to the regulated cashing business and management’s plans to address the risk. Plaintiffs contended that these reports were “red flags” that should have motivated the directors to impose greater internal controls. The Court disagreed, holding that none of the reports showed that the corporation’s controls and procedures violated statutory requirements or that anyone at the corporation engaged in illegal conduct, nor was management indifferent to the compliance challenges. Rather, these reports show that the company was taking significant steps to deal with the issue and keep the directors informed, eventually deciding to exit the regulated business altogether.

Relevance to cybersecurity

What can this corporation’s experience with money laundering regulation teach us about cybersecurity? The Reiter Court gives directors of Delaware corporations (both public and privately held) critical guidance on how to discharge their fiduciary duties when operating in an environment fraught with legal risk.

Virtually all modern business enterprises are, to an extent, in the data business and often data is one of the business’ most valuable assets. To paraphrase bank robber Willie Sutton, hackers go after data because “that’s where the money is.” This is true for large public companies, as well as smaller privately held companies (in fact, smaller companies are at even greater risk in view of the more limited resources they are typically able to devote to cybersecurity).

Data security is more than just business risk; the protection of data from theft or misuse is the subject of extensive legal requirements at the state, federal and international levels. The duty of oversight requires that directors make sure there are appropriate controls and systems in place to provide reasonable assurance that the company complies with applicable law regarding the use and protection of information, and to address red flags indicative of violations of law.

Investors pay close attention to corporate liability resulting from data security. Although stockholder derivative claims against directors were dismissed by courts in two recent cases (involving Wyndham Worldwide and Target), derivative suits against directors are likely to increase as the regulatory environment becomes more complex and the threats become more sophisticated. Companies issuing securities must also take into consideration their cybersecurity risk when making disclosure to investors. For example, they should consider taking steps to ensure financial statements adequately reflect loss contingencies and compliance expense, as well as securities offering documents and in periodic reporting, such as the “managements’ discussion and analysis” section of certain SEC filings.

Directors should also consider the nature of the data, where it is stored, and who else may come in contact with the company’s data. So, for example, the board would take into account contractors and others in the supply chain (and depending on the circumstances, even the subcontractors of the contractors). Considerations would also include developing and enforcing policies and procedures, implementing training programs, conducting audits of information technology infrastructure, and assessing geopolitical issues (such as local country or regional laws and treaties, the prevalence of cybersecurity threats, the viability of the local courts and enforcement tools, and the like). 

Key takeaways from the Reiter decision

  • When the Delaware courts review directors’ decisions, the focus is not on business risk (where the courts typically defer to management’s judgment) but rather risks related to legal compliance

  • Directors are expected to cause the company to implement a system of reporting or controls to assure legal compliance and address compliance problems when they occur. The key is that directors do not ignore red flags indicating violation of law or fraudulent or criminal conduct. “Good faith, not a good result, is what is required of the board.”

  • The prevalence of cybersecurity risks and laws dealing with data usage and protection requires directors to at least consider their company’s profile for compliance risk. 

  • Directors should consider their company’s supply chain and take into account where business operations occur, where the data originated and where it is stored.  

  • Directors should make a clear contemporaneous record of their ongoing attention to compliance with data security laws so there is a strong argument in support of their good faith efforts to implement appropriate systems and controls.

  • If directors have made a good faith effort to carry out fiduciary duties but a compliance problem nonetheless occurs, the directors’ conduct would be evaluated under the deferential business judgment rule. For situations where directors may have liability for gross negligence (but still not a conscious disregard for duties that amounts to bad faith), most corporate charters have an exculpation provision protecting directors from personal liability. 

Matt Hafter advises clients on a wide range of business and corporate issues, including corporate governance and cybersecurity.