Evan Schuman's StorefrontBacktalk

In other cases of data breaches (or even vulnerabilities), the test for public disclosure to shareholders is whether the breach itself would materially affect the share price or the decision of whether to invest. If a breach compromised a key manufacturing plant or a critical trade secret or if it disrupted manufacturing or production of either a key component or for a significant period of time, then a disclosure would be warranted.

Similarly, if a company discovered that the cost of responding to a breach (including investigation, response, forensics and remediation) would be significant, then a disclosure probably should be made. If a company finds a serious vulnerability (even if there is no exploit yet) and determines it will have to spend a billion dollars next year to fix the problem, then for almost any company that information would be on the list for possible disclosure. The test is materiality, and the SEC guidance says as much.

For some companies, the problem is reputational risk. Although a breach to a major bank or brokerage house of even 1 million, or even 10 million, dollars may not begin to make a dent to that company’s bottom line, the fact that the bank or brokerage had a vulnerability might, in and of itself, be considered significant. Banks aren’t supposed to be able to be broken into, right?

The problem in such cases is that the disclosure itself might cause the loss of confidence in the bank. (The truth is that disclosures rarely cause such loss of confidence over time, but that is the fear anyway.) The loss of confidence might lead to loss of sales/investors and, therefore, might lead to a drop in share price. Indeed, the disclosure of the breach might cause a more material drop in share price than the breach itself.

Unfortunately (or fortunately), companies subject to SEC rules have little leeway. If the breach or vulnerability is material, it should be disclosed under SEC guidance, even if the loss of confidence resulting from the breach will cause even greater loss. The poor shareholders who continue to hold the stock after the disclosure may suffer a double whammy of loss from the breach and loss from the disclosure.

There are footnotes galore here. First, the law enforcement exemption lends itself to abuse. If any company executive asks a criminal investigator (be it Secret Service, FBI, local police, etc.) whether or not it would make things easier for their probe to keep the details quiet, the answer will invariably be “sure.” The less a suspect knows about what law enforcement knows, the better.

There is no criteria to differentiate between a true need for secrecy—such as a suspect in the middle of a sting operation—and one where secrecy is convenient. In short, if a retailer wants an excuse to keep the breach quiet, all the company needs is one of the investigators to offer up that “sure.” It doesn’t cost those folks anything, and they generally have to answer to no one about it.

Without limitations, such law enforcement exemptions make many data breach rules close to meaningless. That’s true if the intent is to force a retailer to disclose that which it does not want to disclose. The SEC’s rules go to the other extreme.

Materiality specifically refers to likely and foreseeable stock price impact. But the intent of SEC disclosures goes beyond that. Would it be useful for a potential investor in a major retail chain to know that the chain suffered nine significant data breaches this year? Consumers tend to be apathetic about such matters, but investors might feel differently. Would not a more reasonable SEC definition be “information that would likely cause an investor or a potential investor to act differently?”

If you disagree with me, I’ll see you in court, buddy. If you agree with me, however, I would love to hear from you.