The ‘Unthinkable' May Need Board Attention

[Audrey McNeil <audrey () riskbasedsecurity com>]

http://www.bna.com/unthinkable-may-need-n17179891721/

As the Target massive data breach illustrates, plaintiffs' lawyers are
increasingly filing derivative and securities fraud lawsuits against
companies and their directors based on claims that the board should have
recognized and acted on certain risks associated with the company's
business. The lawsuit alleges that Target's board breached its fiduciary
duties to the company by ignoring the warning signs that a data breach
could occur and participated in the maintenance of inadequate
cyber-security controls by the company. Target is not unique, as similar
suits for data security and privacy breaches have been filed against Google
and others. The basis for liability revolves around whether the event could
not have been reasonably anticipated by the directors--i.e., was it a
“black swan” event--or if there were warning signs that were ignored or
inadequately pursued by the board.

Before the 9/11 terrorist attacks or the financial meltdown resulting from
the subprime crisis, a court was not likely to hold a board legally
responsible for failing to recognize these events as risks which the
company needed to address; today such risks are no longer black swans. An
increasing number of events could impact a company operating in the current
environment and, as their complexity continues to rise, the dissemination
of information in crisis situations has become more widespread and
instantaneous, and the level of scrutiny of the board by an ever-expanding
group of constituencies has increased. Indeed, proxy advisory firm
Institutional Shareholder Services has even gotten involved in this realm
by including risk oversight in its recommendation criteria.

While a board cannot be expected to foresee every potential disaster that
might befall the company, it can, in fulfilling its oversight function,
ensure that management has adequately taken account of those events that
are foreseeable. Natural disasters such as floods or earthquakes, the
sudden death of a CEO, “bad acts” by rogue employees, cyber-attacks, data
security breaches and other misfortunes are no longer so uncommon as to be
unforeseeable.

As the recent Target cyber penetration showed, a breach of cyber security
can wreak havoc on a company's business and profitability and engender
multiple lawsuits from customers and governmental bodies. Similarly, should
banks with ATMs have foreseen that Microsoft would abandon Windows XP,
leaving the machines that were not upgraded facing significant security
vulnerabilities? In light of the magnitude of recent crisis events, boards
need to spend time with management to ensure that the risks facing the
company are identified and assessed and plans to manage and investigate
these risks are formulated, including plans to deal with foreseeable crises.

As a general proposition, the board of directors is legally obligated to
discharge its duties in good faith and in accordance with the best
interests of the corporation, acting with appropriate loyalty and care.
While it is not sufficient to focus solely on the company's financial
performance, the board is not required to micromanage the company's
operations in fulfilling its oversight obligations. The board should
assume, however, that while it need not address events that would not have
a significant impact on the company or that are too remote to require
attention, its oversight does include an obligation to ensure that
safeguards have been implemented to address foreseeable events. In the end,
boards are facing risk management decisions--i.e., how much focus, time and
money to devote to the oversight of specific risks which they have
identified as warranting more attention.

As a starting point, the board should have management identify significant
risks to the company's business and operations and present the particular
safeguards the company has established to mitigate those risks. Management
should present existing crisis management plans to the board so directors
can assess their scope and adequacy. As a company's size and complexity
change, existing plans may be materially deficient. Therefore, the board or
its designated committee needs to review these plans periodically and have
management update them regularly.

In performing its oversight of risk, it is critically important that the
board ensure that the risk management framework management uses evaluates
risks in the context of its assessment of the company's strategic business
objectives, as opposed to evaluating risks in isolation. Risk assessment
should be “strategy-centric” as opposed to “risk-centric”--i.e., the
company's strategic business objectives should be evaluated for the risks
that they present, rather than identifying risks and then determining the
extent to which they could impact the company. A few of the more common
areas that boards now review include the following:

• IT Infrastructure-- In addition to cybersecurity, does the company
adequately address data privacy and IT security, including issues created
by the increase in the use of cloud computing, social media and a multitude
of mobile platforms, as well as the proliferation of personal devices used
by employees in the workplace? In addition, does the board understand their
company's disaster recovery plan and the potential impacts it may have on
the company's business?

• Regulatory Landscape -- The number of regulations companies are subject
to, especially those doing business overseas, has risen dramatically in the
past several years. In addition, regulators, ever seeking increased
revenues through fines and settlements, are more aggressively enforcing
regulations, thereby increasing the importance of having an effective
compliance program.

• IP/Confidential Information -- In today's global economy, a company's
intellectual property and confidential information are key ingredients to
its value. Does the company have an adequate program to protect its
intellectual property?

• Corporate Social Responsibility -- How will the company's reputation or
brand identity be negatively impacted if the company does not adequately
address social issues such as the environment?

• Product Recalls -- Product recalls or defects not only have an immediate
impact on a company's earnings, but could also subject it to liability to
consumers and governmental bodies, as illustrated by the recent $1.2
billion fine the Justice Department levied against Toyota for withholding
information related to its products' safety. The proper handling of a
recall, as the J&J Tylenol cyanide tampering example indicates, can avert a
major reputational disaster. The recent General Motors handling of its
fatal accident cases is another example of the need to have an effective
crisis management plan in place. Fatalities associated with a company's
products or disasters present many challenges. However, some fundamental
procedures should be in place to avoid publicity blunders. For example, it
does not take a PR guru to tell a company not to inform families of loved
one's death by text messaging, as Malaysia Airlines is reported to have
done following the recent loss of one of its planes.

• Executive Compensation -- Does the structure of the company's executive
compensation program appropriately balance the incentives given to senior
management with the risks embedded in the company's corporate strategy?

• Shareholder Activism -- In the past several years, an increasing number
of hedge funds and other institutional investors have engaged in
shareholder activism with an expanding group of companies. Given the
sophistication and breadth of activist's toolboxes, no company is immune to
an approach by an activist investor. Each company should analyze its
business, financial affairs and governance practices to assess which areas
are at risk for attack and should develop action plans that could be used
if such an attack materializes to avoid adversely impacting the company's
business and shareholder value.

• Employee Matters -- Does the company have adequate policies and
procedures in place regarding the use of social media by employees and
restrictions on the communication of confidential information to third
parties? If the company has employees who are unionized, what is the nature
of the relationship with the union and when is their contract up for
renegotiation?

• Political Contributions -- As the constraints on political contributions
by corporations have decreased, companies are becoming more engaged in the
political arena. However, such involvement is not without its risks if
management takes a stand on, or directs funds to, controversial issues that
can impact its reputation. As a recent example, the CEO of Mozilla resigned
after employees complained about his $1,000 contribution to support a 2008
California ballot initiative to ban gay marriage. Boards also need to be
vigilant that the company's attempts to influence legislation or
regulations, or support candidates, are appropriate to avoid tarnishing the
company's reputation.

• Insider Trading -- Dealing with analysts and investors in the current
environment is also not without risks, as regulators are increasingly
focused on trading on inside information. The board should inquire if the
company has the requisite policies in place to minimize the likelihood an
insider trading problem would occur as well as to assist the company in
defending against an enforcement action by the Securities and Exchange
Commission, potential lawsuits and an attack on its reputation.

• Insurance-- Are the scope, exclusions and amounts of insurance coverage
adequate for the company's operations? Does the insurance cover business
interruption? Is the Directors and Officers insurance policy adequate in
light of the legal exposure?

• Reputational Risks -- Does the company understand any reputational risks
associated with working with the company's business partners, including
with respect to its supply chain?

• Disclosure of Significant Risks -- Does the company disclose material
risks in public filings to avoid potential lawsuits?


Some practical steps that boards can take to deal with the ever-increasing
need for risk oversight include:

• Tone at the top -- The board should make management aware of the
seriousness with which the board views its risk oversight function. It
needs to make clear to management that it expects accurate assessments of
the risks in the business, that they are being adequately addressed, and
that any material issues that arise are brought promptly to the board's
attention.

• Benchmarking and best practices -- There are a number of publications
that focus on risk oversight by boards, such as the report issued by the
National Association of Corporate Directors's Blue Ribbon Commission on
Risk Governance and the Governance Center of the Conference Board entitled
“Risk Oversight: Evolving Expectations for Boards.” These and other sources
can assist boards in benchmarking against peers and discerning best
practices. In addition, outside consultants can be engaged, if necessary,
to assist the board in identifying risks and establishing appropriate
oversight functions.

• Allocation of oversight responsibilities-- Some financial institutions
are by regulation required to have risk management committees. Other
companies need to clearly delineate which committee of the board is
responsible for which risk identified by the board as warranting board
attention. While the audit committee will be responsible for many of the
risks discussed above, other committees may have better insights into the
risks and should be clearly allocated the responsibility.

• Annual review by board or committees -- There should be a report from
management on risk and whether developments in the company's business or
the environment in which it operates have changed the risks associated with
its business to an extent that it requires a change in the board's
oversight role.

As the above examples indicate, it does not take a disaster of major
proportions to have an adverse impact on a company's business, financial
performance or reputation. In the exercise of their oversight obligations
and to avoid potential liability, directors should at least assure
themselves that the company's management is prepared for events that are
reasonably foreseeable. The fact that an event had a major negative impact
on a company is not in and of itself a basis to hold directors liable. A
court may absolve directors for failing to anticipate a risk where there
weren't enough red flags associated with such a risk.

But if, for example, a foreign governmental authority starts to target
companies in an industry for bribery by its employees, should boards of
companies in other industries perceive such action as a red flag and have
management address this type of risk? The Chinese authorities investigated
a number of pharmaceutical companies for bribery charges relating to their
sales operations in China. What if the Food and Drug Administration starts
to step up treating violations of manufacturing problems as criminal
offenses; should the board take this as a foreseeable event and start to
get involved? These situations present an important reminder that the board
needs to be vigilant so it will not be caught as having ignored red flags
and be at risk for not having taken appropriate measures to address them.

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