Shareholder Derivative Suit against Wyndham Worldwide Implicates D&O Coverage

A shareholder of Wyndham Worldwide Corp. (“Wyndham”) recently filed a derivative action against Wyndham’s board of directors arising out of three high profile data breaches occurring from 2008 to 2010. Dennis Palkon filed suit against members of Wyndham’s board in the United States District Court for the District of New Jersey.

In April 2008, Wyndham sustained a series of “brute force attacks” on its network, resulting in the breach and theft of customer’s payment and financial data including payment card account numbers, expiration dates and security codes. Similar attacks occurred twice more in 2009. Overall, 619,000 customer payment card accounts were compromised, allegedly resulting in $10.6 million or more in fraud loss.

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The shareholder’s derivative action follows the recent decision issued by U.S. District Court Judge Esther Salas in FTC v. Wyndham Worldwide Corp. The FTC Action alleged unfair and deceptive trade practices arising out of the data breach. There, the Court unequivocally confirmed the FTC’s authority to investigate and prosecute companies that fail to protect consumers’ privacy by failing to maintain appropriate data security standards.

Mr. Palkon’s derivative action centers on the fiduciary liability of Wyndham’s board of directors for the data breaches themselves as well as the ensuing FTC Action.  The Complaint seeks resultant damages for Wyndham and its shareholders and alleges (1) Breach of Fiduciary Duty; (2) Waste of Corporate Assets; and (3) Unjust Enrichment of Wyndham’s board members.

The complaint faults Wyndham’s board for “[failing] to ensure that the Company and its subsidiaries implemented adequate information security policies and procedures prior to connecting their local computer networks to other computer networks.” Mr. Palkon further alleges the property management system server used an out of date operating system, and charges that Wyndham’s IT vendors stopped providing security updates for the operating system more than three years prior to the intrusions.

Finally, Plaintiff asserts that Wyndham’s board also failed to timely disclose the three data breaches in financial filings, waiting until July 25, 2012 to first disclose the breaches. In relation to this delay, the SEC allegedly sent a “comment” to Wyndham demanding Wyndham timely disclose such incidents in future SEC filings, allegedly resulting in further damages.

Like similar derivative actions filed against Target, the Palkon lawsuit carries major implications for cyber-risk, for both first party and third party issues. This law suit asserts Wyndham’s board of directors personally responsible for the internal failure in preventing, responding to and reporting the data breach (highlighting the importance of adequate cyber security practices in the first instance as well as incident response planning).

Such allegations raise questions for both insurers and policyholders relating to insurance coverage for cyber-risk. This blog previously discussed the impact of the Zurich v. Sony case in New York on commercial general liability (“CGL”) coverage for similar data breaches. Shareholder derivative actions are precisely the type of lawsuit that a traditional Directors & Officers (“D&O”) liability insurance policy is designed to cover. If derivative lawsuits relating to cyber-risk increase in number in proportion to the number of reported data breaches, it will be interesting to note the reaction of D&O insurers and policyholders in negotiating policy terms and price of premiums. CGL underwriters are already beginning to routinely include endorsements, excluding coverage for cyber loss. D&O underwriters may choose a similar path.



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