The market for internet-connected devices (often referred to as the Internet of Things, or IoT) is growing rapidly. Investment in this burgeoning space can be attractive, and according to research firm IDC, the worldwide spending on IoT could reach up to $1.4 trillion in 2021. There are unique risks associated with IoT investments, however, and potential investors should assess certain privacy and data protection issues when considering potential opportunities.

As the variety of connected products expands and IoT devices proliferate in homes and businesses, lawmakers and regulators—and cybercriminals—have taken note. IoT devices can be vulnerable to hackers or other security breaches, potentially exposing personally identifiable information (PII) collected from users. A recent survey conducted by Aruba Networks of over 3,000 companies in a variety of jurisdictions found that the vast majority of companies—84% - had experienced an IoT breach. A study recently released by HP found that 70% of the common IoT devices it reviewed had vulnerabilities that rendered them susceptible to attack.

The number of IoT devices in use worldwide is expected to reach 20 billion by 2020, and given the potential for damaging data breaches and associated consumer harm, lawmakers have taken a growing interest in developing a legal framework for the regulation of IoT devices. For example, a bill was introduced in the California state legislature earlier this year that would significantly increase requirements on manufacturers of such devices. SB 327, which is currently on hold in the California Senate, would compel manufacturers to ensure that IoT devices are equipped with “reasonable security features appropriate to the nature of the device and the information it may collect, contain or transmit.” The bill would also mandate that manufacturers obtain consent from the consumer prior to collecting or transmitting any information “beyond what is necessary to fulfill a transaction or to offer the stated functionality of the connected device” and use appropriate mechanisms to regularly alert consumers about the data that is being collected.

The California proposal is the first of its kind in the US and goes beyond Federal law, which does not currently set specific standards for manufacturers, but it is consistent with the Federal Trade Commission’s (FTC) emphasis on “reasonable security” for IoT devices, and may provide an indication as to the direction Federal lawmakers and regulators might take. The FTC has taken a primary role in the Federal regulation of IoT devices, and has signaled an intent to take increasingly aggressive enforcement action against IoT companies that have suffered data breaches or been found to have inadequately secured PII. For example, in January 2017 the FTC brought an enforcement complaint against D-Link Systems Corporation, a computer networking equipment manufacturer, for failing to protect against “widely known and foreseeable” risk of unauthorized access to customer data after certain of D-Link’s wireless routers and Internet Protocol cameras were found to be vulnerable to hackers.

In another sign of increased legislative interest in regulating IoT device security, several members of the US Senate, including the co-chairs of the Senate Cybersecurity Caucus, Senators Mark Warner and Cory Gardner, recently introduced the Internet of Things Cybersecurity Improvements Act of 2017. It remains to be seen whether the bill will become law and, if so, what modifications the final bill might have, but as introduced, it would use the government’s purchasing power to impose certain cybersecurity requirements on IoT devices sold to the Federal government and strengthen protections for research into IoT vulnerabilities.

In the current environment of substantial risk of data breaches for IoT devices and an inchoate legal and regulatory framework, there are a number of specific issues that a potential investor in the space should consider when conducting due diligence on a potential acquisition target, including the following:

• Do the target’s devices incorporate “reasonable security features?”

  • Although there is no clear authority as to what constitutes reasonable security, security features commonly deployed on IoT devices include encrypted data transmission, two-factor login authentication or segmentation of data.

• How much and what types of data are collected by the target’s devices?

  • The amount of data collected should be reasonably limited to the requirements for the device’s operation.

  • To the extent possible, anonymization of data should be preferred over collecting PII to reduce risk.

  • If particularly sensitive types of PII are being collected (health or financial information, for example), reasonable steps should be taken to secure and limit retention of the data.

• Do the target’s devices provide reasonable notice to the consumer about the data being collected?

  • Depending on the type of device and the data being collected, it may be appropriate to provide notice at the point of sale or on a periodic, ongoing basis. For example, if the device is designed to collect data from third-party consumers or guests, there is a possibility of third-party liability if the initial device purchaser is not properly warned about their duty to notify such third parties.

  • In certain instances, such as devices that are designed to interact with children, it may be necessary or appropriate for consent to be obtained prior to data collection.

• Is the data collected by the target’s devices shared with any third parties?

  • If data is being shared with third parties, it is important to ensure that the data shared is limited in scope and that the target has adequate contractual protections in place in the event that the third party fails to adequately secure the data or uses it inappropriately.

• Additional considerations include:

  • Whether the target’s device infringes on any third-party intellectual property;

  • Whether any data collected might be discoverable or usable in litigation;

  • Whether PII is retained by the target and the general level of security of the target’s systems;

  • Whether the target has incurred any contract liability or duties when the device is sold to the consumer; and

  • Whether the use of the target’s device (whether or not it is used as intended) might give rise to tort liability based on physical harm or products liability.

The above are a few of the most important issues that a potential investor should evaluate when considering the acquisition of an IoT company, and additional matters might be applicable as the Internet of Things landscape evolves and the regulatory framework that governs it develops.

If you wish to receive more information, you may contact the Shearman & Sterling Global Privacy and Data Protection Practice.