On November 13, 2015, the chief administrative law judge (“ALJ”) handling the Federal Trade Commission’s (“FTC” or “Commission”) complaint against LabMD Inc. (“LabMD”) dismissed the case in its entirety. As we previously reported, following two data security incidents involving the disclosure of personal information, the FTC brought an action against LabMD, a clinical testing laboratory, alleging that LabMD was liable for “unfair” acts or practices under Section 5(a) of the FTC Act for failing to provide “reasonable and appropriate” security for personal information maintained on LabMD’s computer networks. In a 92-page opinion, which could influence future FTC data security cases, the ALJ held not only that the FTC failed to proffer any evidence that a consumer suffered actual injury, but also that unfair conduct liability under the FTC Act cannot be based upon proof of a generalized, unspecified risk of a future data breach, without regard to the probability of its occurrence, and without proof of actual or likely substantial consumer injury.

Background

The FTC began investigating LabMD’s data security practices in 2010, when a whistle-blower, Tiversa Holding Company (“Tiversa”), a cybersecurity consulting firm, informed the FTC that personal information from an insurance aging report held by LabMD may have been disclosed on a peer-to-peer (“P2P”) file-sharing network. The insurance aging report allegedly contained names, dates of birth, Social Security numbers, and procedural terminology codes as well as health insurance company names, addresses, and policy numbers for approximately 9,300 patients of LabMD’s physician clients. The second security incident asserted in the FTC’s complaint alleged that in October 2012, more than 35 day sheets and a small number of copied checks were found in the possession of individuals who subsequently pleaded no contest to identity theft charges. These day sheets and checks were alleged to have included Social Security numbers, which were purportedly used for identity theft.

Tiversa’s role in the FTC’s LabMD case was itself fraught with controversy. Tiversa’s supposed evidence of LabMD’s lax data security practices, which formed the basis for the FTC’s investigation, was held to be unreliable after a former Tiversa employee testified that Tiversa manipulated or falsified data in order to sell its data security remediation services. Before this revelation occurred, then-Commissioner Rosch cautioned FTC staff from relying on Tiversa for evidence or information, noting that after Tiversa’s discovery of the sensitive file on a P2P network, Tiversa “repeatedly solicited LabMD, offering investigative and remediation services regarding the breach, long before Commission staff contacted LabMD.”

LabMD engaged in extensive pretrial maneuvering against the FTC, with mixed results. For example, early on, LabMD asserted five defenses in a pretrial motion to dismiss, including that the FTC lacked statutory authority to regulate the acts and practices alleged in the complaint, and that the enforcement action violated LabMD’s due process rights because the FTC had not provided fair notice of the data security standards that the FTC believes Section 5 of the FTC Act prohibits or requires. Because the full Commission has authority under its Rules of Practice “to decide legal questions and articulate applicable law when the parties raise purely legal issues,” the motion was not heard by the ALJ, but was heard and denied by the Commission. Later, LabMD filed a motion to disqualify Commissioner Brill from participating in the administrative hearing based on her comments in two public speeches, arguing that Commissioner Brill had prejudged the facts in the case. Although Commissioner Brill denied that she prejudged the case, she recused herself to avoid “undue distraction.”

The ALJ’s Decision

The FTC brought the administrative action against LabMD under Section 5 of the FTC Act, which prohibits unfair acts or practices if: (1) the act or practice causes or is likely to cause substantial injury to consumers, (2) which is not reasonably avoidable by consumers themselves, and (3) not outweighed by countervailing benefits to consumers or to competition. Ultimately, according to the ALJ, the FTC failed to prove the substantial injury prong of the three-part test.

With respect to the first incident, the ALJ held that the FTC failed “to prove that the limited exposure of the [personal information] has resulted, or is likely to result, in any identity theft-related harm.” There was simply no evidence that anyone other than the FTC and Tiversa viewed the personal information on the P2P network. The FTC then argued that even if there was no evidence of actual identity theft-related harm, the exposure of personal information alone is likely to cause reputational or other harms to those consumers. The ALJ rejected this argument, holding that “subjective feelings such as embarrassment, upset, or stigma, standing alone, do not constitute ‘substantial injury.’”

Regarding the second incident, the ALJ found that the FTC failed to show a causal connection between the exposure of the documents and LabMD’s purported failure to protect its data on its network. Importantly, LabMD introduced evidence that the day sheets and copies of checks were not electronically stored or maintained on its computer systems. The ALJ further held that even if there was a causal connection, “the evidence fails to prove that the disclosure of the [day sheets and checks] has resulted, or is likely to result, in any identity theft harm,” finding that the FTC’s experts’ opinions on the general risk of harm from identity crimes “describe little more than the possibility of future harm, or an unquantified, inchoate ‘risk’ of future harm.”

Lastly, the FTC argued that identity theft-related harm was likely for all consumers whose personal information is maintained on LabMD’s computer networks, even if their information has been not exposed in a data breach, on the theory that LabMD’s computer networks are at risk of a future data breach. The ALJ rejected this argument, holding that the FTC’s evidence failed “to assess the degree of the alleged risk, or otherwise demonstrate the probability that a data breach will occur.” After reviewing the legislative history of the FTC Act, the chief ALJ held that “[t]o impose liability for unfair conduct under Section 5(a) of the FTC Act, where there is no proof of actual injury to any consumer, based only on an unspecified and theoretical ‘risk’ of a future data breach and identity theft injury, would require unacceptable speculation and would vitiate the statutory requirement of ‘likely’ substantial consumer injury.”

Implications

Given this opinion, the chief ALJ’s decision will likely not be the last word. The ALJ’s decision can be appealed to the full Commission, which would conduct a de novo review, and the Commission’s decision can be appealed to the D.C. Circuit.

But there are several takeaways from the LabMD decision. First, unreasonable or inadequate data security alone is not enough. The Commission itself acknowledges that there is no such thing as perfect computer security. According to the ALJ, the degree of risk of injury posed by data security practices is the critical issue, which requires an assessment of “the probability or likelihood that [a company]’s alleged unreasonable data security will result in a data breach and identity theft injury.”

Further, allegations of consumer injury, especially reputational and emotional harm, must be supported by evidence and cannot be based merely on the possibility of harm or an increased risk of harm. Notably, in the several years following the two security incidents, the FTC could not identify a single individual who was actually harmed as a result of those incidents. To find likely substantial consumer injury on the basis of theoretical, unspecified risk that a data breach will occur in the future, with resulting identity theft, would require reliance upon a series of unsupported assumptions and conjecture, per the ALJ.

Finally, it is worth highlighting the chief ALJ’s commentary on the FTC’s enforcement process. At times, the chief ALJ seemed critical of the FTC’s own Rules of Practice, which allow the Commission to circumvent independent ALJs on questions of law and compromise the Commission’s dual roles as prosecutor and adjudicator.