Category Archives: Accounting Firm

File Your Beneficial Ownership Information Report

Found in the nearly 1,500-page National Defense Authorization Act of 2021, is the 21-page Corporate Transparency Act (“CTA”), 31 U.S.C. § 5336.  The CTA currently requires most entities incorporated or doing business under State law to disclose personal stakeholder information to the Treasury Department’s criminal enforcement arm, Financial Crimes Enforcement Network (“FinCEN”), including Tax ID numbers, date of birth, government identification number and copies of government identification documents of all beneficial owners and company state formation applicants (collectively a Beneficial Ownership Information Report or “BOI Report”).

According to Congress, this law is intended to prevent financial crimes such as money laundering and tax evasion committed using shell corporations.  The relevant Constitutional question recently put before an Alabama federal court was whether Congress’ broad powers to regulate commerce, oversee foreign affairs and national security, and impose taxes and related regulations were enough to power such a massive information grab. 

In a 53-page opinion, Judge Liles C. Burke of the Northern District of Alabama answered this question in the negative and struck down the CTA as unconstitutional.  See Mem. Op. at 3 (“Because the CTA exceeds the Constitution’s limits on the legislative branch and lacks a sufficient nexus to any enumerated power to be a necessary or proper means of achieving Congress’ policy goals, the Plaintiffs are entitled to judgment as a matter of law.”).   As recognized by Judge Burke, there was no comparable State or federal law to the CTA.  Mem. Op. at 35.

As a result of Judge Burke’s March 1, 2024 ruling – which began its appellate journey on March 11, 2024, all the plaintiffs in that case are for the time being exempt from filing a BOI Report – including the over 65,000 businesses and entrepreneurs located in all 50 states who are members of Plaintiff National Small Business Association (“NSBA”).  As for everyone else who may be a Reporting Company, the CTA very much still applies.

By way of background, FinCEN issued a final rule implementing the CTA on September 29, 2022 and made that rule effective as of January 1, 2024.  87 Fed. Reg. 59498.  Because only the plaintiffs in the Alabama action are safe from the CTA’s reporting reach all other businesses operating in the United States who are considered Reporting Companies will have to comply with the Rule. 

More specifically, the CTA requires disclosures from “reporting company[ies],” defined as “corporation[s], limited liability company[ies], or other similar entit[ies]” that are either “(i) created by the filing of a document with a secretary of state or a similar office under the law of a State or Indian Tribe, or (ii) formed under the law of a foreign country and registered to do business in the United States.” 31 U.S.C. § 5336(a)(11)(A). The CTA exempts twenty-four kinds of entities from its reporting requirements, including banks, insurance companies, and entities with more than twenty employees, five million dollars in gross revenue, and a physical office in the United States. 31 U.S.C. § 5336(a)(11)(B).  In other words, this statute not only targets shell companies involved in criminal conduct or fraud, it expressly hits most small business owners in the country as well.

“FinCEN estimates that there will be approximately 32.6 million reporting companies in Year 1, and 5 million additional reporting companies each year in Years 2–10.”   87 Fed. Reg. at 59549. The CTA requires these millions of entities to disclose the identity and information of any “beneficial owner.” 31 U.S.C. § 5336(b)(1)(A). A beneficial owner is defined as “an individual who . . . (i) exercises substantial control over the entity; or (ii) owns or controls not less than 25 percent of the ownership interests of the entity,” with some exceptions for children, creditors, and a few others. 31 U.S.C. § 5336(a)(3).

For new entities formed or operating in the United States after January 1, 2024, the CTA requires them to disclose the identity and information of both Beneficial Owners and “Applicants,” defined as “any individual who files an application to form a corporation, LLC, or other similar entity under the laws of a State or Indian Tribe; or registers [a foreign entity] to do business in the United States.” 31 U.S.C. § 5336(a)(2).  Such filings must be made within 90 days of the relevant state filings and those companies formed or operating in the United States prior to January 1, 2024 have until year end.

Reporting entities must give FinCEN a Beneficial Owner or Applicant’s full legal name, date of birth, current address, and identification number from a driver’s license, ID card, or passport. 31 U.S.C. § 5336(a)(1), (b)(2)(A).   Under the final rule, reporting entities are also required to submit an image of the identifying document. 31 C.F.R. § 1010.380(b)(1)(ii)(E). If any of that information changes, the reporting company must update FinCEN, 31 U.S.C. § 5336(b)(1)(D), and FinCEN retains Applicant and Beneficial Owner information on an ongoing basis for at least five years after the reporting company terminates. 31 U.S.C. § 5336(c)(1).  Determining whether someone is a Beneficial Owner can be somewhat difficult given it requires a determination of who “has substantial influence over important decisions made by the reporting company” among other potentially vague criteria.  31 C.F.R. § 1010.38 (d)(1)(i)(C).

A willful provision of false or fraudulent beneficial ownership information or failure to report “complete or updated beneficial ownership information to FinCEN” by “any person” is punishable by a $500 per day civil penalty and up to $10,000 in fines and 2 years in federal prison, 31 U.S.C. § 5336(h)(1), (3)(A); a knowing and unauthorized disclosure or use of beneficial ownership information by “any person” is punishable by a $500 per day civil penalty, along with a $250,000 fine and 5 years in federal prison, 31 U.S.C. § 5336(h)(2), (3)(B); and a knowing and unauthorized use or disclosure while violating another federal law “or as part of a pattern of any illegal activity involving more than $100,000 in a 12-month period” by “any person” is punishable with a $500,000 fine and 10 years in federal prison, 31 U.S.C. § 5336(h)(3)(B)(ii)(II).

As recognized by Judge Burke, “[t]he ultimate result of this statutory scheme is that tens of millions of Americans must either disclose their personal information to FinCEN through State-registered entities, or risk years of prison time and thousands of dollars in civil and criminal fines.”  Mem. Op. at 8.  Given the importance of this information, FinCEN already compels banks and other financial institutions to obtain nearly identical information from State entity customers and provide it to FinCEN.  

More specifically, FinCEN’s 2016 Customer Due Diligence rule requires “covered financial institutions” to “identify and verify beneficial owners of legal entity customers.” 31 C.F.R. § 1010.230(a).   As with the CTA, this rule defines a “legal entity customer” as “a corporation, limited liability company, or other entity that is created by the filing of a public document with a Secretary of State or similar office, a general partnership, and any similar entity formed under the laws of a foreign jurisdiction that opens an account,” unless the entity fits into one of sixteen exemptions – eight less than the CTA exemptions. 31 C.F.R. § 1010.230(e)(1)-(2).

The CDD rule also defines beneficial owners in the same manner: “Each individual . . . who owns, directly or indirectly, 25 percent or more” of the entity; has “significant responsibility to control, manage, or direct a legal entity,” including “a Chief Executive Officer, Chief Financial Officer, Chief Operating Officer, Managing Member, General Partner, President, Vice President, or Treasurer)” and “[a]ny  other  individual  who  regularly  performs  similar  functions.”  31 C.F.R. § 1010.230(d)(1)-(2).

In other words, FinCEN’s CDD rule and the CTA provide FinCEN with nearly identical information.  The CTA itself acknowledges the similarity. See 31 U.S.C. § 5336(b)(1)(F) (requiring the Secretary of the Treasury to promulgate regulations that “collect [beneficial owner and applicant] information . . . in a form and manner that ensures the information is highly useful in . . . confirming beneficial ownership information provided to financial institutions.” (emphasis added).  See also Pub. L. 116-283 § 6402 (6)(B) (134 STAT. at 4604 – 4605) (“It is the sense of Congress that . . . [collection of] beneficial ownership information . . . [will] confirm beneficial ownership information [already] provided to financial institutions.”).

According to FinCEN’s compliance with the Paperwork Reduction Act of 1995: “The estimated average burden associated with this collection of information from Reporting Companies is 90 to 650 minutes per respondent for reporting companies with simple or complex beneficial ownership structures, respectively. The estimated average burden associated with Reporting Companies updating information previously provided is 40 to 170 minutes per respondent for reporting companies with simple or complex beneficial ownership structures, respectively.”

Given the appellate route will likely take well over a year to resolve and the NSBA plaintiffs no longer have any injury to adjudicate – which might have expedited an appeal if they had, it is incumbent on business owners to take the CTA at its face value and comply with the implemented regulations of FinCEN.

The NFT Growth Tax

Between Amazon launching next month its NFT Marketplace – tentatively called the “Amazon Digital Marketplace”, Sotheby’s already launched high-end secondary marketplace for “digital artwork”, and Christie’s launching last year its Christie’s 3.0 – a platform allowing for fully on-chain sales that demonstrates “the auction house’s commitment to both artists and collectors in the Web3 space”, programmable digital assets/NFTs are simultaneously entering both ends of the mainstream market.     

Probably the most important takeaway from such broad initiatives turns on the fact foundational brands have decided to supplant the prior NFT free-for-all initiated by PFP projects, artists and collectors.  Despite potentially risking the same fate of Dapper Labs, Amazon will rely on a private blockchain that takes credit cards while Sotheby’s eliminates “NFTs” from the equation altogether to focus on what it calls “digital artwork” even though digital art has already been around for decades.  What is clear is that Amazon’s use of its own “brand worthy” naming convention – “Amazon Digital”, elevates rather than hinders this new ecosystem. 

Being swept aside by this establishment wave is OpenSea – the newly-displaced old guard and wild-west pioneer who likely never contemplated insider trading as a risk until a former OpenSea Manager was recently convicted of it.  Not surprisingly, OpenSea offloads tax obligations and refers its users to CoinTracker for tax calculations.  OpenSea even explicitly points out to users of the marketplace that “[y[ou are responsible for determining what, if any, taxes apply to your purchases, sales, and transfers of NFTs. If you have specific questions regarding taxes, please consult with a professional tax advisor.”  OpenSea’s sole Help Center entry regarding taxes further drives home the point:  “Users are responsible for determining what, if any, taxes apply to their purchases, sales, and transfers of NFTs. If you have questions about taxes, please consult with a professional tax advisor.”

In sharp contrast, the government is certainly rooting for reliable tax collectors such as Amazon, Christie’s and Sotheby’s to enter the NFT sandbox.  Since 2018 – when the Supreme Court overruled decades of precedent, taxation of online sales no longer depends on physical presence within a particular state.  The new guard will create the proper recipe for mass profitable usage, namely removing tech geek elements, improving user interfaces, adding brand allure, and ensuring government is happy and remaining on the right side of the regulatory fence. 

As Grace Kyne of EY informed attendees at the April 13, 2023 NFT.NYC session “NFTs and Marketplaces: Opening Pandora’s Box”, there are state-specific marketplace facilitator rules that make most marketplaces subject to state tax.  Not surprisingly, Amazon is front and center in pointing that hard fact out to its market participants: “Marketplace Facilitator legislation is a set of laws that shifts the sales tax collection and remittance obligations from a third party seller to the marketplace facilitator. As the marketplace facilitator, Amazon will now be responsible to calculate, collect, remit, and refund state sales tax on sales sold by third party sellers for transactions destined to states where Marketplace Facilitator and/or Marketplace collection legislation is enacted.”

In other words, pushing digital asset sales to Amazon is really every state treasurer’s dream.

This should not come as any surprise.  Ever since the 2019 tax year, IRS Form 1040 has included a question regarding a taxpayer’s cryptocurrency activity. In 2021, the IRS slightly broadened the scope of its inquiry:  “At any time during 2021, did you receive, sell, exchange, or otherwise dispose of any financial interest in any virtual currency?”  In 2022, the scope of the latest IRS Form 1040 broadened yet again: “At any time during 2022, did you: (a) receive (as a reward, award, or payment for property or services); or (b) sell, exchange, gift, or otherwise dispose of a digital asset (or a financial interest in a digital asset)?

In other words, the IRS expressly seeks disclosure of all digital asset transactions and not merely those involving cryptocurrencies.  The IRS now wants to know about a taxpayer’s NFT sales and any income generating activities where digital assets are received as payment.  On April 5, 2023, the IRS released its IRS Tax Tip 2023-45 which elaborated on this new position regarding a taxpayer’s obligation to report digital asset transactions – including citation to applicable supplemental forms.  By informing taxpayers of their new obligations – by way of tax forms and “tax tips”, it becomes increasingly difficult for them to argue any lack of knowledge on the topic.   The easiest approach will always be one which just assumes all realized digital asset gains are taxable.   

And, to the extent there was any ambiguity regarding more specific tax treatment of NFTs, that might soon evaporate given the IRS – in its March 13, 2023 Notice 2023-27, seeks to classify most NFTs as “collectibles” – a lesser form of asset for purposes of capital gains and other tax purposes.

Specifically, Notice 2023-27 – which seeks comments before June 19, 2023, announces the IRS’s and Treasury’s intention to issue guidance as to whether certain NFTs are “collectibles” under IRS Section 408(m).  Currently, the only available categories of “collectibles” under this section are:  “(A) any work of art, (B) any rug or antique, (C) any metal or gem, (D) any stamp or coin, (E) any alcoholic beverage, or (F) any other tangible personal property specified by the Secretary for purposes of this subsection.”  See 26 USC § 408(m)(2).  The IRS recognizes that NFTs do not presently constitute any of the above – including “art” given an NFT is not the art itself, it is a digital file pointing to the actual digital art typically found using an IPFS gateway such as Pinata.  Moreover, Section (F) expressly references “tangible personal property” so that catchall also does not squarely fit. 

While waiting for comments, the IRS will deploy a “look-through” analysis:  “Under the look-through analysis, an NFT constitutes a section 408(m) collectible if the NFT’s associated right or asset is a section 408(m) collectible. For example, a gem is a section 408(m) collectible under section 408(m)(2)(C), and therefore an NFT that certifies ownership of a gem constitutes a section 408(m) collectible. Similarly, an NFT does not constitute a section 408(m) collectible if the NFT’s associated right or asset is not a section 408(m) collectible. For example, a right to use or develop a “plot of land” in a virtual environment generally is not a section 408(m) collectible, and therefore, an NFT that provides a right to use or develop the “plot of land” in the virtual environment generally does not constitute a section 408(m) collectible.”  See IRS Notice 2023-27.

It is not clear whether the “look-through” approach would be limited to an underlying physical asset tied to the NFT or whether it might include potential money-generating components of an NFT.  More than likely, however, the relevant IRS section could not be broadly interpreted to include future gains unrelated to specific associated assets.  Moreover, earning rewards by way of an NFT should not be taxable given rewards are generally treated as a rebate or discount on purchases – that should be treated no differently than frequent flyer miles.

The lesson learned for businesses seeking to grow NFT adoption is that market validation and future growth opportunities are now inevitable given the tax hounds have gotten the scent.  To the extent there were any previous regulatory barriers to growth opportunities, those will be lifted so long as the government gets it take.

B2 – B1 < (P x H)1 – (P x H)2

On February 16, 2021, The Sedona Conference (TSC) – a nonpartisan, nonprofit research and educational institute “dedicated to the advanced study of law and policy in the areas of antitrust law, complex litigation and intellectual property rights”, released its final “Commentary on a Reasonable Security Test“.  TSC is well known for previously helping Courts around the country determine the proper contours of e-discovery.  

Recognizing that cybersecurity reasonableness crosses both legal and technology domains, TSC sought a reasonableness test that would help bridge that divide.  Accordingly, the proposed test for reasonable security was designed to be consistent with “models for determining reasonableness that have been used in various other contexts by courts, in legislative and regulatory oversight, and in information security control frameworks.” The Sedona Conference, Commentary on a Reasonable Security Test, 22 SEDONA CONF. J. 345, 358 (forthcoming 2021).  To that end, this test is ultimately based on the landmark Learned Hand negligence test in United States v. Carroll Towing Co., 159 F.2d 169, 173 (2nd Cir. 1947).  

The Sedona Conference Reasonable Security Test consists of “B2 – B1 < (P x H)1 – (P x H)2” where B represents the burden, P represents the probability of harm, H represents the magnitude of harm, subscript 1 represents the controls (or lack thereof) at the time the information steward allegedly had unreasonable security in place, and subscript 2 represents the alternative or supplementary control.  22 SEDONA CONF. J. at 360.  

TSC’s Commentary should be carefully studied for numerous reasons, including the fact TSC applies it to actual recent enforcement actions and provides solid arguments for its judicial application.  No different than its highly cited e-discovery initiatives, this new TSC approach may very well be relied on by courts tackling the important question of what constitutes reasonable security in the context of a data breach litigation or enforcement action.

Ransomware Has Officially Become a D&O Problem

On April 30, 2020, ZDNet reported that there have been more than 1,000 SEC filings over the past 12 months listing ransomware as a risk factor – with more than 700 in 2020 alone.  These filings include annual reports (10K and 20F), quarterly reports (10Q), and registration forms (S1). 

Even the most sophisticated technology companies now insert the word “ransomware” into their Risk Factors section. See Alphabet, Inc., Form 10-Q, dated April 28, 2020, at 50  (“The availability of our products and services and fulfillment of our customer contracts depend on the continuing operation of our information technology and communications systems. Our systems are vulnerable to damage, interference, or interruption from terrorist attacks, natural disasters or pandemics (including COVID-19), the effects of climate change (such as sea level rise, drought, flooding, wildfires, and increased storm severity), power loss, telecommunications failures, computer viruses, ransomware attacks, computer denial of service attacks, phishing schemes, or other attempts to harm or access our systems.”).   

As reported by ZDNet, companies as varied as American Airlines, McDonald’s, Tupperware, and Pluralsight also list ransomware as a potential risk to their business. 

By inserting the word “ransomware” into a Risk Factors section, reporting companies may have elevated the relevant standard for companies who do not reference ransomware.  By way of background, in October 2011, the SEC began planting cyber risk disclosure seeds when it issued non-binding disclosure guidance regarding cybersecurity risks and incidents.  Back in 2011, the SEC wrote:  “Although no existing disclosure requirement explicitly refers to cybersecurity risks and cyber incidents, a number of disclosure requirements may impose an obligation on registrants to disclose such risks and incidents.” Seven years later, this non-binding guidance became binding.

On February 26, 2018, the SEC issued binding guidance that recognizes:  “Companies face an evolving landscape of cybersecurity threats in which hackers use a complex array of means to perpetrate cyber-attacks, including the use of stolen access credentials, malware, ransomware, phishing, structured query language injection attacks, and distributed denial-of-service attacks, among other means.”   By expressly listing ransomware two years ago in its Statement, the SEC was making it quite clear that the current threat landscape includes the risk of ransomware and that directors and officers have to address this likely risk.

More to the point, the Statement and Guidance on Public Company Cybersecurity Disclosures instructs “that the development of effective disclosure controls and procedures is best achieved when a company’s directors, officers, and other persons responsible for developing and overseeing such controls and procedures are informed about the cybersecurity risks and incidents that the company has faced or is likely to face.” 

Not surprisingly, the failure to disclose a prior ransomware attack would also be actionable.  See SEC Statement at 14 (“In meeting their disclosure obligations, companies may need to disclose previous or ongoing cybersecurity incidents or other past events in order to place discussions of these risks in the appropriate context.  For example, if a company previously experienced a material cybersecurity incident involving denial-of-service, it likely would not be sufficient for the company to disclose that there is a risk that a denial-of-service incident may occur.”).

If ransomware incidents were avoided altogether, however, there would be no liability attached to associated filings no matter what was communicated to the market. Moreover, even when attacks were not avoided, little disclosure risk would exist if the company applied best practices to avoid such an incident and provided an accurate accounting of what took place when an incident did take place. To that end, deploying proactive approaches considered state-of-the-art when dealing with ransomware risk will naturally mitigate against any potential SEC disclosure risk.

For example, there is at least one novel solution that can reduce ransomware attacks by anticipating when a compromised system’s ransomware package will be released and then neutralizing the ransomware threat before any ransomware release actually takes place.  By evaluating and deploying such cutting-edge solutions, companies will be well positioned to neutralize any potential shareholder claims – as well as satisfying the much more important task of protecting corporate data and other digital assets.  Thankfully, “it is never too late to begin importing a more robust security and privacy profile into an organization – which is the only real way to diminish the risk of a ransomware attack.”  As with most successful corporate endeavors, management buy-in will typically be the necessary first step.

WannaCry provides a wakeup call for more training on email exploits

On May 12, 2017, WannaCry ransomware infections reportedly took hold of 200,000 computer systems in 150 countries.  The rise of ransomware has been a function of how cheap financial data has become to obtain on the dark web and the desire of criminals to branch out with other sources of income.

Ransomware is quite effective given it purposefully seeks to panic victims into clicking additional links thereby causing a user’s system to become infected with more pernicious malware.  For example, after seeing a screen blink on and off several times ransomware victims may next see the following message on their screen:  “Your computer has been infected with a virus. Click here to resolve the issue.”  Clicking on that link, however, will download additional malware to the system – thereby precluding possible quick fixes to the initial exploit.  It is such additional malware – coupled with very vulnerable legacy systems and procedures, that likely helped WannaCry promulgate so quickly.

Given slow patching and continued widespread use of legacy Windows products, Microsoft sought to slow the spread of WannaCry by offering free patches for its older Windows systems such as Windows XP.  Although helpful in curtailing replication, timely patching will not completely stem this threat.   Newer exploits such as WannaCry likely exist – and will continue to exist for some time, given the underlying code was reportedly created by the National Security Agency and is only a small sample of the “treasure trove” of spying tools released by WikiLeaks in March.  In fact, the WikiLeaks released material includes the source code used to evade anti-virus detection so entry-level hackers apparently now have the ability to immediately up their game.

Given that healthcare data is now considered the most valuable data by thieves, it is no surprise that the healthcare industry was especially hit hard by the WannaCry ransomware exploit.  Succumbing to WannaCry, Britain’s hospital network canceled or delayed treatments for thousands of patients.   In an effort to stem the tide in the US, HHS quickly offered covered entities access to loss prevention resources – including a link to its ransomware fact sheet and a link to the US-CERT response to WannaCry.  US-CERT offered last year helpful tips regarding ransomware loss mitigation techniques.

It is suggested that covered entities take to heart HHS’s desire to warn regarding ransomware exploits.  Given that OCR recently fined a covered entity $2.4 million simply for placing the name of a patient on a press release, ignoring HHS warnings regarding ransomware will likely result in significant penalties to HIPAA covered entities should they fall prey to such an exploit.

In addition to security procedures and implementations – such as whitelisting acceptable programs, aggresive email settings, and limiting user permissions, proper training remains the best antidote to both an exploit as well as an OCR or some other regulatory fine if an exploit ultimately succeeds.  And, the best training remains having users react to a continuous barrage of decoy exploits aimed at sharpening their skills.

Today’s phishing exploits that are being used to transmit ransomware often rely on some other person’s scraped contact information so that they can appear to come from known associates of the user.  These exploits may also use content that appear relevant to the user – such as a bar association communication.    And, finally the links themselves are masked so that it is not even possible to accurately determine where a link takes the user.   Given these indicia of authenticity, users often click on the embedded link rather than hit the delete button.  After exposure to numerous training exploits users are in a much better position to make sound decisions on how to treat actual exploits.  During the course of security training, it is suggested that some form of reward be given to those users who score the highest on the phishing training exercises – any money spent today to build an effective training program will pay significant dividends down the road.

The rise of Ransomware

Given credit card data and account information is now dirt-cheap to buy on the dark web; it no longer makes much sense for criminals to exclusively target financial information – especially since the data must also be sold after it’s stolen. Much more lucrative – and quicker to obtain, are the bitcoins deposited by ransomware victims into a thief’s account.

Welcome to the hottest cyber-criminal activity of today – ransomware.  Although ransomware such as PGPCoder has been around for a decade, this exploit only gained wide traction during the past several years. Combining the best of social engineering, e.g., well-crafted spear phishing using publicly available information, including emails of licensed professionals, with botnets usually tasked with promulgating spam, criminals have been able to re-purpose the latest Trojans for a much more lucrative job.

The most recent crop of ransomware scams have successfully targeted professionals. The Florida Bar recently warned its members these phishing exploits can use various subject lines, including “Florida Bar Complaint – Attorney Consumer Assistance Program”.   A scam email with “Lawyers and judges may now communicate through the portal” in the subject line uses information found in a June 1, 2016 Florida bar article. Preying on many lawyers’ natural tendency to help, the email asks recipients to “test the portal and give feedback.”

Florida Scam Email

During the past several weeks, Florida lawyers clicking on the masked link found in the above email notice were surprised to learn their entire computer network was held for ransom – automatically encrypted in one fell swoop by criminals half way across the world. Users only become aware of this exploit when they can no longer access their data and see a message on their screen demanding a ransom payment in exchange for a decryption key. The message also includes instructions on how to pay the ransom, usually with a widely traded anonymous digital currency such as Bitcoin or anonymous pre-paid cash vouchers such as MoneyPak and Ukash.

In the same way the IRS would never cold call you about an audit, no bar association would ever deliver a complaint simply by email.   Nevertheless, these scams succeed with a good number of professionals who are pressed for time, have computers systems that do not automatically filter executable content or simply just don’t have adequate training. Indeed, even if there is adequate training and sophisticated IT personnel running a firm’s network, law firms are never immune to hacking incidents.   This past March, it was reported by The Wall Street Journal that two blue chip firms, Cravath Swaine & Moore LLP and Weil Gotshal & Manges LLP, were among a number of law firm hacking victims.  Law firms will always be vulnerable to a direct attack by a sophisticated hacker.  A panel of law enforcement specialists in 2015 put it best when they said law firms are seen as “soft, ripe targets for hackers.”

As reported by the Wisconsin Bar Association, the ABA’s Division for Bar Services has been monitoring a rise in ransomware exploits, with recent confirmations of scam emails also sent to lawyers in Alabama, Georgia, and California. The ABA has been working with the FBI to get the word out regarding ransomware – leading to state bars pushing out the message via newsletters and blog posts. In fact, the ABA has been warning lawyers for years regarding data security. Indeed, there is an argument that improved data security helps with the marketing of a law firm.

Although recent attacks have fed on a lawyer’s publicly accessible email address, these very same attacks also go after other professionals. For example, targets include hospitals – where patient information can ill afford to stay locked for a very long time.  As well, a growing number of accounting firms are falling prey to ransomware.   Ransomware is especially damaging to accounting firms given accountants hold critical financial data of clients that is often deadline-focused. Indeed, there may be significant penalties accessed against clients for untimely filings.

The threats have become more pronounced as criminals realize the benefit of redirecting resources to ransomware aimed at professionals such as lawyers and accountants. A consultant who assists accounting firms guard against ransomware attacks warned accountants last year of the polymorphic Virlock that spawns unique versions after every use so antivirus programs cannot recognize it as well as TeslaCrypt that uses file names associated with well-known online games found on a child’s computer – which can spread to other computers attached to a home network, including an office PC.

As set forth in a 2014 CERT notice, destructive and lucrative ransomware variants include: Xorist, CryptorBit, CryptoLocker, CryptoDefense, and Cryptowall. All of these exploits encrypt files on the local computer, shared network files, and removable media. Although the private decryption keys for CryptoLocker, Xorist, CryptoDefense have since become available – rendering these exploits defensible, recent ransomware variants with no available decryption keys continue to launch.  For example, in June 2015, the ABA warned about the CryptoWall ransomware exploit.  And, a March 9, 2016 blog post from the security firm TrustWave details a major botnet operator moving from spam campaigns to delivering a new ransomware exploit deploying malicious javascript – the Locky ransomware.   Kaspersky Labs also wrote about the Locky ransomware – and its successful targeting of several hospitals.   If it has not already done so, it is only a matter of time before the Locky ransomware migrates to lawyers and accountants.

 

FBI April 2016 Report

The FBI has addressed ransomware exploits for some time now – likely given it was inadvertently a participant in one such exploit. In 2012, the FBI was spoofed in a Reveton ransomware attack activated when a user visited a compromised website. Once infected, the victim’s computer immediately locks, and the monitor displays a screen stating there has been a violation of federal law. The bogus message goes on to say that the user’s Internet address was identified by the FBI as having been associated with child pornography sites or other illegal online activity. To unlock their machines, users are required to pay a fine using the MoneyPak prepaid money card service.

According to an April 29, 2016 FBI Bulletin, the FBI saw a pronounced increase in ransomware attacks in 2015 – with a projection that it will grow a great deal more during 2016. Despite the fact it will always be easy to pay ransom given the instructions are explicit and the amount sought can be in the $400 range, the FBI doesn’t support paying a ransom in response to a ransomware attack: “Paying a ransom doesn’t guarantee an organization that it will get its data back [and] not only emboldens current cyber criminals to target more organizations, it also offers an incentive for other criminals to get involved in this type of illegal activity. And finally, by paying a ransom, an organization might inadvertently be funding other illicit activity associated with criminals.”

Instead, the FBI suggests the key areas to focus on with ransomware are prevention, business continuity, and remediation. Given that ransomware techniques are rapidly evolving, business recovery and continuity become even more crucial. More to the point, as recognized by the FBI: “There’s no one method or tool that will completely protect you or your organization from a ransomware attack.”   Instead, the FBI suggests firms focus on a variety of prevention efforts – in terms of awareness training for employees and technical prevention controls, as well as the creation of a solid business continuity plan in the event of a ransomware attack.  Planning for disaster can never be considered wasted time. And, after a ransomware attack is suspected, victims should immediately contact the local FBI field office and report the incident to the Bureau’s Internet Crime Complaint Center.

If a firm has a proactive approach, there are certainly some basic things that can be done today to avoid a ransomware exploit. In an effort to help its constituency, the ABA has conveyed some basic technical defenses against ransomware:

  • Block executable files (such as “.exe” files) and compressed archives (such as zip files) containing executable files before they reach a user’s inbox.
  • Keep operating systems, browsers and browser plug-ins, such as Java and Silverlight, fully updated.
  • Program hard drives on your computer network to prevent any unidentified user from modifying files.
  • Regularly back up data with media not connected to the Internet.

As for the most basic of “basic training”, law firm administrators are being awakened to this threat with some sound advice that never gets old: “Be smart. Be aware. Don’t open or click on anything that looks suspicious. They won’t come in if you don’t open the door.” In other words, never click on a link, file or image from an untested source or untrusted URL. The extra seconds it takes to confirm the actual sender of an email message or owner of a website is well worth the time.

Given that business continuity best practices should mesh with IT security best practices, backups should obviously be stored outside the network. And, if you are forced to restore from a backup it is never wise to restore your data over existing production data. Consulting with a disaster recovery specialist before disaster strikes probably is a good idea.

Professionals – especially lawyers and accountants should also consider purchasing insurance that covers ransomware losses – including the related IT expenses.  Such insurance is typically purchased using a standalone policy that has been around for years. There are some malpractice insurers, however, e.g., CPAGold, who provide such coverage directly in the policy. Tech vendors and legal counsel associated with these carriers typically have years of experience handling these incidents and can be rapidly deployed to address any situation.

Given the serious threat of ransomware, businesses large and small are reminded to at least do the basics – train staff regarding email and social media policies, implement minimum IT security protocols, regularly backup data, plan for disaster, and regularly test your plans.

CyLab Survey: Corporate Protection of Digital Assets Not a Priority

The recently released Carnegie Mellon CyLab 2010 Corporate Governance survey confirms that there is little change in senior management’s views towards data security – it’s not really a priority.   The CyLab annual survey, which measures board and management attitudes towards the protection of digital assets, is based upon results received from respondents at the board or senior executive level from Fortune 1000 companies.   Given public filing requirements, you would think protection of digital and related intangible assets – which now comprise the bulk of a firm’s value – would be a top of mind issue.  It’s not. 

When asked to identify their boards’ three top priorities, “improving computer and data security” was not selected by 98% of the respondents.  The respondents also indicated that their boards were not “actively addressing” IT operations or vendor management.  In essence, privacy and security of data inside or at outside vendors is receiving little oversight from management.  

Interestingly, 65% of the respondents also indicated that their boards were not reviewing their companies’ insurance coverage for data risks even though most standard policies offer little or no coverage.   Standing alone, this approach may not be an example of sound business judgment given the availability of specific insurance policies able to cover loss or destruction of digital assets. 

Not quite sure if this survey is a real wake up call or not.  The only thing for certain is that these attitudes are hardly what one would consider a best practice.  Sarbanes Oxley Section 404 requires a “top down” audit on internal controls which should provide some guidance on how digital assets are protected.  Indeed, under 15 U.S.C. § 7262(a), the Section 404 report must “contain an assessment, as of the end of the most recent fiscal year of the Company, of the effectiveness of the internal control structure and procedures of the issuer for financial reporting.”  It is difficult to see how management can in good conscious sign off on these assessments while still maintaining that “improving computer and data security” is not a priority.  

Notwithstanding how firms may perceive their Section 404 obligations, recognizing the potential “materiality” of computer security failings, Google, Intel, Symantec and Northrop Grumman recently added new warnings to their SEC filings informing investors of such risk.  The fact that some companies have come forward to detail recent breaches and the possibility of future breaches should indicate to other companies the need to address this reporting issue in a more proactive manner.  And, once risk disclosures are publicly made, the next obvious step is to ensure that proper protections are in place to address the risk.   Reporting uncoupled with affirmative preventive action is simply fodder for class action litigation the next time an event takes place.  What may be even worse is completely turning a blind eye to the entire problem.

Lehman, D&O Liability and Mark-to-Market Reporting

The Devil’s Casino, Vicky Ward’s first book, is the latest account of the fall of Lehman Brothers.  Released in April, this Lehman tome applies  a gossipy approach to storytelling.  Although we learn much about the shopping habits of some Lehman wives, repo transactions are nowhere to be found.   The book, however, becomes noteworthy when Ward details a September 9, 2008 meeting between JPMorgan’s Jamie Dimon and the Fed’s head Ben Bernake (on page 200) that purportedly directly led to JPMorgan’s request that Lehman provide $5 billion more in collateral. Less than a week later, Lehman filed its bankruptcy petition (the largest in US history) ostensibly given its lack of liquidity brought on by the collateral call of its clearing bank, JPMorgan. 

In a Report by Lehman’s bankruptcy examiner, dated March 11, 2010, the issue of JPMorgan’s collateral demand was analyzed and determined to be barely actionable.  The Report states: 

the Examiner concludes that the evidence may support the existence of a colorable claim – but not a strong claim – that JPMorgan breached the implied covenant of good faith and fair dealing by making excessive collateral requests to Lehman in September 2008.  A trier of fact would have to consider evidence that the collateral requests were reasonable and that Lehman waived any claims by complying with the requests.  

(Report of Anton R. Valukas, Examiner at page 1073)

On the heels of this Report and the Ward book, on May 27, 2010, the Lehman estate sued JPMorgan.  The suit takes a different position regarding the relationship between JPMorgan and Lehman by alleging that JPMorgan’s breach of duty was actionable. 

Unlike JPMorgan, Lehman’s board and officers were essentially given a free pass by Lehman’s bankruptcy estate as well as all regulators.  The Lehman Examiner’s Report actually spends much ink analyzing Delaware fiduciary law yet concludes numerous potential fiduciary lapses were not colorable claims.   On the other hand, a bank that potentially obtains crucial information from a third party (a governmental third party with a near real-time raw account of Lehman’s financial status) and merely seeks to protect its own interests, is forced to defend itself in a costly legal battle.   To many, it makes little sense that Lehman’s directors and officers were exonerated by regulators and Lehman’s bankruptcy Examiner.  Although the existing shareholder suits and claims made by those who sustained direct harm may eventually hit their mark, it is just not the same as potential jail time or a large personal SEC fine.  Not even close.  It is easy to argue that some Lehman folks should have paid with more than the inconvenience of a deposition.

If FASB had acted a bit more aggressively two years ago, maybe none of this would have even happened.  It would have been interesting to have seen FASB actually go through with its Exposure Draft of two years ago regarding FASB Statement 5 (loss contingency accounting) and FASB Statement 133 (hedging strategy accounting).  The vast opposition to the drafts caused FASB to abandon its plans.   Much of the opposition was typified in the McDermott Will & Emery letter that opined if the suggested changes to FASB Statement 5 were made, the opposing side to a filing entity would be able to learn litigation strategy.  If the proposed changes had matured (FASB Statement 5 has not changed since 1975) some of the decisions made by Lehman may have been altered or some of the actions may have been more cleanly delineated as wrongful.  Either way, there would have been more clarity regarding the propriety of their actions. 

As it stands, the Lehman saga provides some guidance to directors and officers looking to see how insulated they are from their financial accounting decisions.  They are pretty insulated given current standards. 

FASB may now be ready to change that dynamic.  It will revive the FASB Statement 5 Exposure Draft in the second quarter of 2010 – now with only a 30-day comment period.  And, FASB issued on May 26, 2010 an Exposure Draft that provides guidance regarding the financial reporting of derivative instruments and hedging strategies.  The overall approach taken moves towards a “mark-to-market” approach for derivative instruments that will have a “seismic effect” on how banks value loan portfolios beginning in 2013 (for large banks) and 2017 (for regional and community banks).  It remains to be seen what FASB will ultimately do given the negative comments it is certain to receive prior to the September 30, 2010 comment deadline.   The takeaway is that FASB  is finally taking a serious look at how companies report on loss contingencies and asset valuations.

All reporting companies – not just financial institutions – should obviously monitor how this and other related financial reporting initiatives evolve.   To a large degree, these accounting standards dictate the extent to which firms such as Lehman can push the envelope.  Although a widening of the reporting net may bring with it a separate set of problems, the change will certainly cause executives to think twice before being coy about a lack of liquidity.  As seasoned investors themselves, reporting officers should probably apply a “Would I want to know this information?” test the next time they are on the fence about the materiality of an item.  True mark-to-market reporting (not Lehman’s “mark-to-make believe” strategy) may bring on headaches for companies with many assets  having big value swings.  Nevertheless, it certainly seems to be part of the reporting standard of the future so you might as well get used to it.

Small Professional Service Firms Put Implementation of FTC Red Flags Regs on Hold

According to a recent article in Lawyers USA, small and middle market business owners are so jaded by the number of times the FTC has delayed enforcement of its Red Flags Regulations, they have pushed compliance to the back burner.  Tanya Forsheit, of InformationLawGroup, is quoted in the article as saying, “I suspect a lot of small businesses were hoping this ultimately wouldn’t happen.”   As it stands, all businesses that bill for goods and services and accept payment on a deferred basis are covered by these regulations.  Unfortunately, most such firms do not have any sort of written procedure or policy specifically dealing with identity theft — a main requirement of these regulations.   Moreover, as recognized in the article, “[s]mall businesses without extensive in-house resources have found it challenging to comply with the specifics of the rules, such as the recommendations for data encryption, regular review and annual updates of the policy, procedures for responding to red flags, training of staff, and approval of the policy by the company’s board of directors.” 

Professional service firms have been fighting hard to avoid compliance.  Lawyers successfully challenged the applicability of the regulations to law firms with an appeal currently pending.  Accountants filed suit last year and are still waiting for a decision.   Doctors and dentists have sought a legislative answer by seeking a statutory exemption.    Come the date of enforcement – June 1st- only law firms currently have a free pass.

It is recommended that all professional or consulting businesses who defer payment should immediately consult with their professional advisers to see how a cost effective compliance solution can be implemented.

NJ Supreme Court Sides with Employee on Email Privacy Case

On March 30, 2010, the New Jersey Supreme Court issued its opinion in Stengart v. LovingCare Agency, Inc., 2010 WL 1189458 (N.J. March 30, 2010).  This hotly anticipated ruling was a clear win for employee privacy rights.  It was also clearly the right decision given the facts.  

In its decision, the Court affirmed the Appellate Court’s ruling that an employer was precluded from accessing  attorney-client privileged email.  The email was deemed protected by way of the attorney-client privilege even though the employee accessed the email during work hours using an employer’s laptop.  The key factor in creating a reasonable expectation of  privacy was the plaintiff’s use of her personal Yahoo! webmail service to send and receive the email.   In other words, although the laptop computer used was employer property, the information remained “employee property” given it was password protected via the Yahoo! website.   Moreover, she never stored the password on the company laptop.   The Appellate Divison and Supreme Court were likely also swayed by the fact the attorney-client privileged email in question were used by the employer’s counsel in a pending litigation involving plaintiff.

The Court went into detail regarding how the employer’s Electronic Communications Policy (which was part of its employee handbook) did not provide notice regarding any lack of privacy in a webmail service.  Specifically, the Court ruled:

It is not clear from that language whether the use of personal, password-protected, web-based e-mail accounts via company equipment is covered. The Policy uses general language to refer to its “media systems and services” but does not define those terms. Elsewhere, the Policy prohibits certain uses of “the e-mail system,” which appears to be a reference to company e-mail accounts. The Policy does not address personal accounts at all. In other words, employees do not have express notice that messages sent or received on a personal, web-based e-mail account are subject to monitoring if company equipment is used to access the account.

 The Policy also does not warn employees that the contents of such e-mails are stored on a hard drive and can be forensically retrieved and read by Loving Care.

 The Policy goes on to declare that e-mails “are not to be considered private or personal to any individual employee.” In the very next point, the Policy acknowledges that “[o]ccasional personal use [of e-mail] is permitted.” As written, the Policy creates ambiguity about whether personal e-mail use is company or private property.

Id. at 13 – 14.

A more carefully crafted employee manual would have not likely led to a different result.  It appears as if the Court  provides a roadmap for employers but one in which attorney client communications would always remain sacrosanct.   For example, although many employee manuals already outright preclude employees from accessing webmail via company computers, such a blanket prohibition would likely not be enough going forward given this ruling.  See Id. at 28 – 29 (“[E]mployers have no need or basis to read the specific contents of personal, privileged, attorney-client communications in order to enforce corporate policy.  Because of the important public policy concerns underlying the attorney – client privilege, even a more clearly written company manual  – that is, a policy that banned all personal computer use and provided unambiguous notice that an employer could retrieve and read an employee’s attorney client communications, if accessed on a personal, password protected e-mail account using the company’s computer system – would not be enforceable.”).

It appears as if the correct approach for employers looking to access certain employee email exchanged via a webmail service is to  provide even more specific guidance regarding what may or may not be done by the employee.   For example, it may help to provide an explicit warning that all email exchanged via a webmail service is subject to the general email policy of the firm.  Banning pornography and “hate speech” email would clearly not be a problem under this ruling.  When it comes to attorney-client material, a warning regarding the insecure nature of such  communication may be warranted as well as a reminder that non-business communications are deemed inappropriate and can possibly lead to termination.  Nothing in the ruling would preclude using non-business activity against an employee.  As well, transmitting proprietary company material with insecure, un-archived, and non-sanctioned forms of communication such as webmail services would likely still be considered against corporate policy under this ruling.  Finally, when drafting a policy, it should be made clear that the company cannot and will not guarantee the confidentiality of any communications made using a webmail service. 

Given many employees blur personal and company time, it is often the case that employees are checking their personal email on company time.  Indeed, the advent of webmail services from Yahoo!, Google, Microsoft and others makes it an almost a trivial task to check personal email on company PCs, laptops, and smart phones.  Given the Stengart decision, New Jersey employers should evaluate their current procedures regarding use of webmail services with an understanding that attorney-client email may be strictly off limits to corporate eyes.