On October 16, 2018, the Securities and Exchange Commission (SEC) issued an investigative report signaling its intent to use sections 13(b)(2)(B)(i) and (iii) of the Securities Exchange Act of 1934 (the “Exchange Act”) to pursue enforcement actions against public companies that fail to tailor their internal controls to evolving cyber threats and technology.
Relying on the Exchange Act, the SEC could bring an enforcement action even in the absence of a security incident or unauthorized access to information.
The SEC’s approach creates a new avenue and new risk of enforcement arising from a much broader category of cyber incidents – namely those that cause companies financial loss or disruption of accounting systems, even when the incidents do not touch personal or business information. Today, regulators routinely investigate companies in connection with data breaches that result in unauthorized access to personal information (e.g., under the Gramm-Leach-Bliley Act, Health Information Portability and Accountability Act (HIPAA), or state breach notification laws) or business information (e.g., under the New York Department of Financial Services cybersecurity regulations). Relying on the Exchange Act, the SEC could theoretically bring these actions even in the absence of a security incident altogether. However, the SEC’s past practice suggests that it would be unlikely to do so unless the safeguards are utterly lacking and there are other egregious circumstances to justify such an enforcement action.
The SEC has identified public companies’ failure to detect and mitigate effects of cyber fraud as a significant compliance issue warranting robust enforcement.
The SEC’s announcement reflects an escalation of its cyber enforcement efforts. The report articulates the SEC’s new strategy to enforce the Exchange Act’s internal control provisions against public companies that fail to adjust their controls to account for the pervasive use of digital technology that has increased the risk of cyber fraud. Until now, the SEC has used these provisions primarily to prosecute companies that fail to put financial systems and controls in place to prevent accounting and disclosure fraud and Foreign Corrupt Practices Act violations. The provisions of the Exchange Act at issue – sections 13(b)(2)(B)(i) and (iii) – require public companies 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.”
The SEC’s new approach was prompted by its examination of nine public companies that suffered significant cyber fraud that resulted from both sophisticated stealth attacks as well incidents the companies could have easily detected. The SEC found that each of the companies had (a) inadequate internal controls, including controls to detect and prevent cyber fraud, and (b) inadequate employee training on the requirements of controls already in place, and that these inadequacies caused or contributed to the cyber fraud. The SEC concluded that the companies’ inability to detect and stop the attacks presents a significant compliance issue.
The SEC has expressed significant concern that companies failed to detect and mitigate effects of even unsophisticated cyber fraud schemes.
The report identifies two cyber fraud schemes that leverage compromised emails: spoofed executive accounts and hacked vendor accounts.
In the first scheme, perpetrators “spoofed” a company executive’s email account (using an email address that looked similar to the executive’s legitimate email account) to send an email to the company’s mid-level finance personnel directing them to transfer funds from the company to a foreign account. The spoofed emails often described a purported time-sensitive foreign transaction, the need for secrecy from other company employees, and a request for a transaction typically beyond the recipient’s scope of responsibilities. Some emails referred to the company’s or a transaction counterparty’s outside lawyers, but the contact details connected company personnel with the perpetrators. The SEC determined that this scheme – which was technically unsophisticated and relatively easy to identify – nevertheless defrauded companies out of substantial revenues. Indeed, one company suffered over $45 million in losses as a result.
In the second, more sophisticated scheme, perpetrators hacked into a target company’s third-party vendor’s email account and inserted illegitimate requests for payment (and payment processing details) into otherwise legitimate transaction requests submitted to the company. To tailor the scheme to each company, the perpetrators communicated with company personnel responsible for procuring goods from the vendor to learn about actual purchase orders and invoices. Since the perpetrators used the vendor’s email account, the fraudulent payment requests mirrored legitimate requests, which made it difficult for the compromised company to identify the scheme. Often, companies did not learn of the fraud until the vendors sought overdue payments.
The SEC has found that companies fell victim to cyber fraud because their controls failed to keep up with changes in technology.
The report concludes that the companies’ failure to adapt their general systems of internal controls to keep up with changes in technology and new cyber threats caused the companies’ failure to detect and mitigate the effects of these cyber incidents. Furthermore, in several of these cases, personnel (including two chief accounting officers) did not understand or follow the controls that the companies already had in place. The SEC clearly designed its investigative report – signaling its intention to prosecute companies that fail to implement adequate cyber controls – to motivate public companies to remedy this systemic issue.
Although the SEC chose not to pursue enforcement actions against the companies identified in the report — and clarified that not all victims of cyber fraud have necessarily violated the internal control requirements — the SEC’s prior practice strongly suggests the report was intended as a warning and that enforcement is likely to follow. The SEC considers proper internal controls necessary to minimize cyber fraud and comply with the Exchange Act.
Public companies should review and update their relevant controls and train personnel to help protect against cyber fraud and mitigate the risk of SEC enforcement.
The report makes clear that public companies should create and maintain an appropriate system of internal controls designed to detect and mitigate the effects of cybersecurity incidents. The controls should be based on a company-specific assessment of the company’s transaction and vendor processes. Companies should continuously reassess these controls as cyber risks emerge and ensure they are comprehensive and take into account a holistic review of the risks a company faces.
The SEC offers a non-exhaustive list of controls it deems relevant to mitigating cyber threats: employee training, payment authorization procedures, verification requirements for vendor information changes, account reconciliation procedures, and outgoing payment notification processes. Although companies may already have such controls in place, they must review and augment the controls to verify that they are responsive to emerging cyber threats. Companies must also train employees to understand and follow the controls they have in place. The SEC put a special emphasis on implementing controls that mitigate the effects of human error, a factor common in many security incidents. For example, IBM’s 2018 security threats report found that inadvertent actors, such as employees, present a constant security threat to companies, and in its 2017 data breach report, the New York Attorney General’s Office found that human error caused 25% of data breaches reported to the office. As a result, controls for limiting human error (e.g., mock emails or “phish tests” and data handling procedures to prevent information leakage with respect to vendor relationships) are critical to mitigating cyber risks.
As companies reassess their internal controls in the context of evolving cyber risks, they may initially focus on insuring that the controls reflect some of the basic building blocks:
- Clear and direct delineations of responsibility for cyber incidents to specific compliance personnel;
- Straightforward cyber-threat escalation channels articulated to the entire firm;
- Clear supervisory responsibilities and controls delegated among senior staff including business/division leaders, compliance managers, and in-house counsel;
- Collection and preservation of attendance records for employee training, including records of follow-up attempts for delinquent employees;
- Roll-out plans to update employees on new cybersecurity threats (including periodic emails or downloadable videos whereby the company tracks readership and viewership for key employees);
- Periodic and regular updates to relevant written policies and procedures addressing cyber risk, including written supervisory procedures (WSPs) and supervisory control policies and procedures (SCPs);
- Systematic surveillance, follow-up, and testing of breaches/issues/control systems, including understanding new technologies and new trends in cyber fraud;
- Understanding the cyber-risk profiles and controls at third-party vendors, particularly those that handle the company’s sensitive, confidential, or financial information; and
- Potentially consulting with outside experts to assist with additional internal assessments and/or managing cybersecurity programs and controls.
Following an initial assessment and remediation, companies should undertake a more in-depth review to align the controls with emerging cyber threats and implement a periodic or continuous review process designed to maintain the controls’ responsiveness to technological change.