As derivative actions against the principals of corporate targets of cyber attacks are in their infancy in Canada, there is relatively little to guide an understanding of the magnitude of threat they pose to Canadian directors and officers. Recent case law in the U.S. may well provide Canadian companies—and courts—with a glimpse of the future. For example, in early July 2016 a U.S. derivative action against Target Corporation was dismissed, joining a short list of failed U.S. actions against directors and officers for breaches of corporate cybersecurity.1 In addition to highlighting the difficulty of advancing derivative actions for such breaches, the Target case offers some interesting insights into how companies, directors and officers should behave in anticipating and responding to probably-inevitable cyber breaches.
The Breach and Action
Target shareholders brought a derivative action in Minnesota following a massive data breach in 2013 that resulted in the theft of up to 40 million customers’ personally identifiable information including names, addresses, email addresses, and phone numbers. The Target breach fits the typical profile of such attacks in many respects: it went undetected for weeks; the company found out only because it was brought to its attention by outside sources (the Secret Service, in this case), and the hackers were foreign nationals (Eastern Europeans).2
Derivative actions for cyber breaches are virtually unknown in Canada. In the U.S., derivative actions have often been launched in tandem with class proceedings in cases where there is a clear drop in share price following a misrepresentation, to name just one example. Derivative actions have often piggy-backed on class actions because each has certain procedural advantages. A derivative action has more relaxed pleadings standards (making them less vulnerable to motions to dismiss), and allows plaintiffs to get to the discovery phase more quickly than in class actions. In Canada, however, the use of derivative actions in tandem with direct class actions has not become common practice. The strict pleading standards that exist in the U.S. for class actions are not present in the Canadian context, so the need to buttress the class action with a companion derivative action is absent.
However, in cyber breach cases, derivative actions may become a more attractive option for plaintiff-side counsel in Canada, for much the same reason as it has in the U.S. Namely, cyber breaches have become so common place, U.S. companies’ share prices are relatively unaffected by breaches; this makes proving damages or even losses in a class proceeding difficult.3
The Target action has now been dispensed with via a brief court order following several unopposed motions by the defendants.4
The Investigation and Committee Report
The defendants’ motions5 were premised on the recommendations of Target’s Special Litigation Committee (“SLC”).6 Pursuant to Minnesota law, the SLC was struck for the purpose of making a recommendation to Target as to whether it should pursue the plaintiff’s derivative action. The SLC’s Report considered myriad factors in arriving at its recommendation not to pursue the action. These included the following very revealing factors:7
- the financial expenditures required to litigate the claims, including Target's obligations to indemnify and advance defense costs;
- the existence of network-security insurance coverage that mitigated Target's exposure to data-breach-related losses;
- the applicability of the business judgment rule protecting reasonably prudent, good faith business decisions;
- the overall cost of the breach, including direct and indirect expenses associated with the breach;
- the pre-breach existence and content of Target's policies and procedures designed to establish a reasonable information security program that incorporated technical, administrative, and physical controls for data security;
- the pre-breach existence and content of Target's compliance policies and procedures and audit procedures designed to test and to assure adherence to those policies and procedures;
- management's reports to the Board's Audit and Corporate Responsibility Committees covering Target's data security program, including compliance efforts and assessments of Target's data security and privacy programs;
- the competence and engagement of Target data security management and employees pre-and post-breach;
- the history of reports that demonstrate that Target had been assessed as PCI DSS8 compliant each year since 2008;
- the reports that were made to Target's officers and directors that it had been assessed as PCI DSS compliant, including to the Audit Committee of the Board;
- the reports of the independent auditors from Ernst & Young to the Audit Committee and Target management that prior to the breach there were no significant deficiencies or material weaknesses in the information technology general controls, which included security-related information technology general controls;
- Target's post-breach efforts to mitigate the cost and inconvenience of the breach to its customers;
- Target's post-breach remediation of data security vulnerabilities exposed by the breach;
- the resignations of the CEO and CIO in the months following the breach and other personnel changes;
- Target's post-breach corporate governance changes related to risk in general and data security risk in particular, including making the CISO a Senior Vice President position and hiring and installing a Corporate Risk and Compliance Officer who reports to the CEO and to the Board's Risk and Compliance Committee;
- the rights of officers and directors to reasonably rely on the information and opinions of others, including other officers and directors, committees of the Board, employees, and advisors; [and]
- the recognition by the FTC9 that the mere fact that a breach occurred does not mean that a company has violated the law.
Implications for Cyber Security Breach Cases
Many of these factors could have easily been cribbed from headings in a robust cyber security or cyber breach response plan. The complete list highlights the importance of, among other things:
- cyber security insurance coverage;
- robust and pro-active policies, procedures and monitoring to ensure proper data security and employee adherence;
- adherence to generally recognized cyber security technical standards;
- post-breach remediation of security problems, and mitigation of impacts on customers; and
- Board-level awareness and active involvement in data security issues on an ongoing basis, including the appointment of officers specifically tasked with dealing with data security and cyber breach planning and response.
Directors and officers will take comfort in the Target SLC Report’s nod to the business judgment rule and to the principle—now widely accepted in the data security industry—that a company can do everything right and still fall victim to a cyber attack.
Implications for Derivative Actions
It is important to recall that the factors considered by the Target’s SLC were chosen by the SLC, not the court, and that the court’s order is a consent dismissal. As Target’s lawyers note in their filings, Minnesota courts defer to SLC recommendations so long as they are satisfied that the SLC is independent and carried out its investigation in good faith.10
The Target SLC Report—and the plaintiffs’ consent to the dismissal of their actions in light of the report—highlight the difficulty of addressing consumer complaints regarding cyber breaches via derivative action. In the face of evidence of adequate pre-and post-breach diligence by a Board and officers, the business judgment rule, and a weak business case for a lawsuit,11 Canadian shareholders and other stakeholders will have trouble recovering against directors and officers of targeted companies.