Cybersecurity 2018 – The Year in Preview: Financial Institutions and the SEC

The U.S. Securities and Exchange Commission has made no secret about the gravity of the cybersecurity threat facing the investment community.  Since at least 2014, the SEC has made a point in emphasizing the cyber threat through enforcement actions, inspections and examinations, roundtables, and policy speeches.  While the change in administration brought new leadership to the Commission, that group has made clear at every possible opportunity that combatting the cyber threat will be a top SEC priority in 2018 and beyond.  For example, Enforcement Division co-director Steve Peikin, a former federal prosecutor and partner at Sullivan & Cromwell, referred to cyber attacks as the “greatest threat to our markets right now.”  His co-director Stephanie Avakian, an SEC Enforcement veteran, similarly called the cyber threat “among the greatest risks facing investors and the securities industry.”  The import of their message is clear – the investment community, and, in particular, SEC-regulated entities, should be on alert in the coming year.

Historically, the SEC has addressed the cyber threat through enforcement actions aimed at entities and individuals that threaten market integrity, either by failing to take necessary cyber precautions or engaging in cyber-related misconduct, and through regular cyber examinations of registered entities by the SEC’s Office of Compliance Inspections and Examinations (“OCIE”).

SEC Cyber-Enforcement

On the enforcement front, the Commission’s Enforcement Division created a new Cyber Unit in September 2017.  This unit has a broad mandate to target all forms of cyber-related misconduct, including market manipulation schemes involving false information spread through electronic and social media, hacking to obtain material nonpublic information, violations involving distributed ledger technology and initial coin offerings (more on that to follow), misconduct involving the dark web, intrusions into retail brokerage accounts and cyber-related threats to trading platforms and other market infrastructure.  The Market Abuse Unit previously handed the SEC’s cyber investigations, but the Commission deemed the threat important enough to create a separate unit (the Enforcement Division’s first newly created unit since 2010).

Beyond press releases and policy statements, the Enforcement Division has offered some guidance on the Cyber Unit’s focus in 2018.  Focus areas include: (1) cyber-related misconduct that is used to gain an unlawful market advantage, (2) the failure of registered entities to appropriately safeguard information or ensure system integrity, and (3) cyber-related disclosure failures by public companies.

The first area – cyber-related misconduct – has historically been the SEC’s primary cyber enforcement focus area.   During the past year, SEC enforcement actions have targeted: (1) hacking to access material, nonpublic information in advance of a material announcement or event; (2) an account intrusion in order to conduct manipulative trading; and (3) disseminating false information electronically, including through EDGAR, in order to manipulate stock prices.

With respect to the second area – the failure of registered entities to appropriately safeguard information – the SEC has often handled such failures through the OCIE examination process.  Avakian has indicated that while the SEC will continue to do so in appropriate cases, it will consider enforcement action if warranted.  The final area identified by Avakian – the failure by a public company to make a cyber-related disclosure (i.e., disclosure of a cyber breach or other event in SEC reporting) – is a new area of enforcement for the SEC.  While the SEC will not look to second guess reasonable, good-faith disclosure decisions, it will take enforcement action if an appropriate case presents itself.  Regardless of whether the SEC ultimately takes enforcement action, the SEC’s message to regulated entities going forward is clear – closely guard confidential information from cyber attack, and if an attack happens, determine whether some form of public disclosure is required.

More recently, on December 11, 2017, the Cyber Unit directly confronted a new and growing cyber risk, halting an initial coin offering by California-based Munchee Inc.  Munchee was seeking $15 million in capital for its blockchain-based food review service.  In selling digital tokens, the company and promoters emphasized that the tokens could increase in value, which the SEC concluded could cause investors to reasonably believe that they could generate a return on investment.  The SEC thus determined that the coin offering constituted an unregistered securities offering.  Further emphasizing the SEC’s focus on this new technology, on the same day that the SEC announced the Munchee enforcement action, SEC Chairman Jay Clayton provided a statement on cryptocurrencies and initial coin offerings.  He offered warnings to both investors and market professionals.  This should serve as a clear signal that the SEC will not hesitate to conduct additional enforcement activity in this arena.

OCIE Cyber Exams

Outside of the Enforcement Division, OCIE continues to make cybersecurity a prominent aspect of its examinations of registered entities, including broker-dealers, investment advisers and investment companies.  OCIE conducted its first targeted cybersecurity sweep in 2014.  It followed up with a Cybersecurity 2 Initiative, the results of which were released in August 2017.

The exams focused on how written policies and procedures addressed: (1) governance and risk assessment; (2) access rights and controls; (3) data loss prevention; (4) vendor management; (5) training; and (6) incident response.   The good news is that registered entities have made vast improvements since 2014.  In particular, of the 75 firms examined, almost all of them had adopted written policies and procedures concerning the protection of customer and/or shareholder data.  The bad news is that many of these policies were either not sufficiently robust or not routinely followed.

OCIE identified a number of common deficiencies, including: (1) policies and procedures provided employees only with general guidance rather than specific examples of safeguards; (2) firms either did not adhere to the policies or the policies did not reflect their actual practices; and (3) firms did not adequately conduct system maintenance, such as the installation of software patches to protect against vulnerabilities.

OCIE also provided guidance on best practices for developing and implementing appropriately robust policies and procedures.  These best practices include: (1) maintaining an inventory of all data, information and vendors, including a classification of risks regarding each; (2) detailed cybersecurity-related instructions for penetration tests, security monitoring and system auditing, access rights and reporting; (3) maintenance of schedules and processes for testing data integrity and vulnerabilities; (4) established and enforced controls to access data and systems; (5) mandatory information security employee training; and (6) vetting and approval of procedures by senior management.

The weaknesses and best practices identified by OCIE should provide clear guidance to registered entities on how to implement effective cyber policies going forward.  Like the SEC’s top officials, OCIE has made clear that cybersecurity is one of top compliance risks for financial firms, and, as a result, OCIE will continue to make it a key aspect of its annual examination process.  MORE