Oversight of a company’s tone at the top and the compliance program designed to establish and maintain that tone and detect problems is an important board responsibility. As fiduciaries, directors are required to assess the company’s compliance program in light of the legal and regulatory compliance framework and ensure that the company has appropriate compliance-related reporting and information systems and internal controls in place. It is a business judgment for the board to determine what compliance program best suits the company’s needs and the level of compliance risk it is willing to take. Each company should, at a minimum, have a basic effective compliance program in place. A program that exists “on paper” but is not effective is not sufficient. As well as making good business sense for a range of reasons, having an effective compliance program can influence a federal prosecutor’s decision on whether to charge a company for the bad acts of its employees or officers and the extent to which the company may receive credit for cooperation in a settlement. Having an effective compliance program can also help mitigate penalties if corporate wrongdoing is found. The standard for effectiveness in compliance program design is set forth in Chapter 8 of the United States Federal Sentencing Guidelines, which provides that a company must: ■ Establish standards and procedures to prevent and detect criminal conduct ■ Ensure board oversight of the compliance program ■ Appoint a high-level individual (such as a chief compliance officer) who has overall responsibility for the compliance program ■ Exercise due diligence to exclude unethical individuals from positions of authority ■ Communicate information about the compliance program to employees and directors ■ Monitor the compliance program’s effectiveness ■ Promote and consistently enforce the compliance program ■ Respond to violations and make necessary modifications to the compliance program (U.S. Sentencing Commission Guidelines Manual §§ 8B2.1(b), 8C2.5(f)) The Principles of Federal Prosecution of Business Organizations in the U.S. Attorneys’ Manual provide that prosecutors should consider specific factors (known as the “Filip Factors”) in conducting corporate investigations, determining whether to bring charges and negotiating plea or other agreements. These factors include “the existence and effectiveness of the corporation’s pre-existing compliance program” and the corporation’s remedial efforts “to implement an effective corporate compliance program or to improve an existing one.” The Department of Justice (DOJ) emphasizes that critical factors in evaluating a compliance program are “whether the program is adequately designed for maximum effectiveness in preventing and detecting wrongdoing by employees and whether corporate management is enforcing the program or is tacitly encouraging or pressuring employees to engage in misconduct to achieve business objectives.” U.S. Attorneys’ Manual § 9-28.300, General Principle; § 9-28.800, Comment (2015). In February 2017, the Fraud Section of the DOJ issued a resource entitled Evaluation of Corporate Compliance Programs. The document provides more specific examples of how federal prosecutors will evaluate a company’s compliance program in the process of 1 Holly J. Gregory is a partner in Sidley’s New York office and a co-leader of the firm’s global Corporate Governance and Executive Compensation practice. Rebecca Grapsas is counsel in Sidley’s Corporate Governance and Executive Compensation practice who works from both the firm’s New York and Sydney offices. The views expressed in this article are those of the authors and do not necessarily reflect the views of the firm. It is a business judgment for the board to determine what compliance program best suits the company’s needs and the level of compliance risk it is willing to take. SidleyPerspectives ON M&A AND CORPORATE GOVERNANCE Sidley Perspectives | JUNE 2017 • 3 investigating and resolving an enforcement matter. The document emphasizes that “the Fraud Section does not use any rigid formula to assess the effectiveness of corporate compliance programs.” The document is the latest communication forming part of the Fraud Section’s Compliance Initiative, which began with the Fraud Section’s hiring of Hui Chen as full-time compliance counsel in November 2015. The document contains probing questions regarding the following eleven “sample” topics: 1. Analysis and remediation of underlying misconduct (including root cause analysis and prior indications) 2. Senior and middle management (including conduct at the top, shared commitment and oversight) 3. Autonomy and resources (including compliance function stature, experience, qualifications, empowerment, funding and outsourcing) 4. Policies and procedures (including design, applicability, gatekeepers, accessibility, operational integration, controls and vendor management) 5. Risk assessment (including methodology, information gathering and analysis, and manifested risks) 6. Training and communications (including form, content and effectiveness, communications about misconduct and availability of guidance) 7. Confidential reporting and investigation (including reporting mechanism effectiveness, investigation scope and response to investigations) 8. Incentives and disciplinary measures (including accountability, process and consistency) 9. Continuous improvement, periodic testing and review (including internal audit, control testing, interviews and evolving updates) 10. Third-party management (including risk-based and integrated processes, controls, relationship management and misconduct consequences) 11. Mergers and acquisitions (including due diligence process, integration in the M&A process and process connecting due diligence to implementation) The questions are designed to look behind a company’s compliance program “on paper” and evaluate how the program has been implemented, updated and enforced in practice. Although some of the questions focus on the effectiveness of a company’s compliance program in the context of specific misconduct (for example, what caused the misconduct, whether there were prior indications of the misconduct and which controls failed), many of the questions focus on the compliance program more broadly, including, for example, whether compliance personnel report directly to the board, what methodology the company uses to identify, analyze and address the risks it faces, and how the company incentivizes compliance and ethical behavior. Compliance program assessment is a key element of the board’s oversight of compliance programs. Boards should conduct such assessments periodically to identify areas for improvement in light of the company’s evolving risks and regulatory preferences with respect to compliance structures and practices. Periodic assessment of the compliance program, in a process overseen by the board or a board committee, helps ensure that the program continues to be “fit for purpose” by identifying areas for improvement, while also creating evidence of the company’s commitment to compliance for use in any future regulatory enforcement actions. Assessments should be risk-based to reflect the company’s changing risk environment and to help ensure that limited compliance resources are prioritized to focus on the most significant risks. The assessment criteria should be based on the elements of an effective compliance program as described in DOJ guidance discussed above, including specific guidance from The DOJ’s recent guidance for evaluating corporate compliance programs is also discussed in the most recent issue of Sidley’s Anti-Corruption Quarterly. SidleyPerspectives ON M&A AND CORPORATE GOVERNANCE Sidley Perspectives | JUNE 2017 • 4 regulators regarding the company’s industry. The assessment criteria should also reflect trends in settlement agreements, developing notions of recommended practices (both generally and within the company’s specific industry), and the practices of peer companies, to the extent that benchmarking data is available. In conducting its assessment, the board should evaluate the following and consider how it would answer the specific questions set forth in the DOJ’s recent guidance: ■ The board’s level of oversight including availability of compliance expertise, private sessions with compliance personnel and information ■ Reporting lines and related structures ■ Experience, qualifications and performance of the chief compliance officer and compliance function ■ Compliance function responsibilities, budget and budget allocation (including employees, outside advisors and other resources), staff turnover rate and outsourcing ■ Written corporate policies and procedures regarding ethics and compliance (including legal and regulatory risks), and the process for designing, reviewing and evaluating the effectiveness of policies and procedures ■ Internal controls to reduce the likelihood of improper conduct and compliance violations ■ Ongoing monitoring, control testing and auditing processes to assess the effectiveness of the program and any improper conduct ■ Role of compliance in strategic and operational decisions ■ Key compliance risks, risk assessment processes and risk mitigation ■ Senior management conduct and commitment to compliance, and how the company monitors this ■ Communication efforts by the board, CEO, other senior executives, and middle management regarding expectations and tone ■ Education and training regarding compliance generally and the company’s program, policies and procedures at all levels ■ Understanding of corporate commitment to compliance at all levels ■ Awareness and use of mechanisms to seek guidance and/or to report possible compliance violations, and fear of retaliation ■ Specific problems that have arisen, why they arose and how they were identified and resolved ■ Investigation protocols and experiences ■ Performance incentives, accountability, disciplinary measures and enforcement ■ Remediation and efforts to apply lessons learned The DOJ’s recent guidance should help boards determine the assessment process that is appropriate for the company, evaluate whether the company’s program continues to be effective and fit for purpose, and consider appropriate modifications to the program. Boards should consider assessing the effectiveness of their compliance programs now in light of the DOJ’s recent guidance on evaluating compliance programs — whether or not the company currently has any compliance issues. SidleyPerspectives ON M&A AND CORPORATE GOVERNANCE Sidley Perspectives | JUNE 2017 • 5 NEWS2 JUDICIAL DEVELOPMENTS Two Delaware Appraisal Rulings Peg Fair Value at or Below Merger Price As noted in these pages and elsewhere, appraisal proceedings in M&A transactions have received increased attention in Delaware in recent years. Currently, two closely watched appraisal cases are on appeal to the Delaware Supreme Court. The debate there centers on what weight, if any, merger price should be accorded when a court is seeking to determine the appraised fair value of a company’s stock under Delaware’s appraisal statute, or whether other valuation methodologies, including a discounted cash-flow analysis, should be relied upon instead. While the M&A community awaits the Supreme Court’s rulings, the Court of Chancery recently issued two additional appraisal rulings. In re Appraisal of PetSmart, Inc. (Del. Ch. May 26, 2017) arose from a financial sponsor’s 2015 leveraged acquisition of PetSmart for $83 per share ($8.7 billion). Valuation experts for petitioners argued that, using a discounted cash-flow analysis, management projections justified a $128.78 per share appraisal value. Vice Chancellor Slights found, however, that those projections were “saddled with nearly all of the…telltale indicators of unreliability.” Those included management’s inexperience in creating multi-year projections; the company’s historical failure to achieve short-term projections; the board instructing management to create more aggressive projections; and the fact that the projections were prepared solely for the sale process and not in the ordinary course. That led the Vice Chancellor to characterize the projections as “at best fanciful.” The Vice Chancellor also found PetSmart had conducted a “robust pre-signing auction among informed, motivated bidders” (albeit mostly private equity), and there was no evidence market conditions impeded the auction, all of which led him to conclude there was no “basis to accept [p]etitioners’ flawed, post-hoc valuation and ignore the deal price” as the best determinant of fair value. The Vice Chancellor also observed that petitioners’ valuation would be “tantamount to declaring that a massive market failure occurred causing PetSmart to leave nearly $4.5 billion on the table.” Elsewhere in the ruling, the Vice Chancellor noted that “[i]n the wake of this well-constructed and fairly implemented auction process, [p]etitioners are left to nitpick at the details and to invent certain prevailing market dynamics” they assert undermined the result, including PetSmart’s pursuit of a sale at a low point in its performance and advisor conflicts. The Vice Chancellor also rejected petitioners’ claim that a financial sponsor’s “LBO [pricing] model will rarely if ever produce fair value because the model is built to allow the funds to realize a certain internal rate of return that will always leave some portion of the company’s going concern value unrealized.” This concept first arose in the Court’s ruling in In re Appraisal of Dell Inc. (Del. Ch. May 31, 2016), and has been referenced in its subsequent appraisal rulings. Vice Chancellor Slights noted, however, that “while it is true that private equity firms construct their bids with desired returns in mind, it does not follow that a private equity firm’s final offer at the end of a robust and competitive auction cannot ultimately be the best indicator of fair value.” Vice Chancellor Slights noted in closing that he was “‘defer[ing]’ to deal price, not to restore balance after some perceived disruption in the doctrinal Force, but because that is what the evidence presented in this case requires.” He also observed that, in an arm’s-length transaction (as here), buyer and seller will both be incented to value the company as accurately as they can, knowing they will be penalized in the marketplace for failing to do so, whereas paid experts testifying with respect to valuation analyses have very different incentives. Citing an article by former Chancellor Allen, the Vice Chancellor cautioned that, 2 The following Sidley lawyers contributed to the research and writing of the pieces in this section: Sara B. Brody, Stephen Chang, Jennifer F. Fitchen, Claire H. Holland, John K. Hughes and Kelly L.C. Kriebs. For discussions of important Delaware appraisal decisions in previous issues of Sidley Perspectives, see Shifting Winds in Delaware Appraisal Proceedings in our August 2016 issue, Delaware Appraisal Developments– Lessons Old and New in our December 2016 issue and Delaware Court of Chancery Provides Appraisal Proceedings Primer in our February 2017 issue. Vice Chancellor Slights in the PetSmart appraisal case: “In the wake of a robust pre-signing auction among informed, motivated bidders, and in the absence of any evidence that market conditions impeded the auction, I can find no basis to accept Petitioners’ flawed, post-hoc valuation and ignore the deal price.” SidleyPerspectives ON M&A AND CORPORATE GOVERNANCE Sidley Perspectives | JUNE 2017 • 6 given this dynamic, “Delaware courts must remain mindful that the DCF method is subject to manipulation and guesswork [and that] the valuation results that it generates in the setting of a litigation [can be] volatile…” On the other hand, “merger price, negotiated at arm’s length, in real time, after a well-run pre-signing auction that takes place in the midst of a fully functioning market, is not burdened by such litigation-driven confounding influences.” In re Appraisal of SWS Group, Inc. (Del. Ch. May 30, 2017) arose when bank holding company Hilltop Holdings, Inc. acquired SWS, a small, publicly traded, bank holding company, in a 2015 merger where SWS stockholders received a mix of cash and stock worth $6.92 per share (or $350 million). Post-announcement, seven SWS stockholder groups raised funds, acquired 15% of SWS’ stock and sought appraisal. Petitioners’ valuation expert claimed SWS was on the verge of a turnaround and used a DCF analysis and a comparable company analysis that pegged appraised fair value at $9.61 per share (50% above the merger price). Respondents claimed the company faced significant challenges and used a DCF analysis to set appraised fair value at $5.17 per share (50% below the merger price). Neither side claimed the merger price was the most reliable evidence of fair value, with petitioners arguing the sales process was so flawed that the deal price was irrelevant, and respondents arguing deal price was the wrong metric because it included a large synergy component that had to be deducted in order to calculate fair value under Delaware’s appraisal statute. The Court rejected petitioners’ turnaround narrative given SWS consistently underperformed management projections and the narrative otherwise lacked support. The Court also determined the alleged comparable companies petitioners sought to use in their comparable company analysis were not, in fact, comparable to SWS. Vice Chancellor Glasscock acknowledged that, in the past (including in PetSmart just four days earlier), the Court had on occasion concluded that a merger price derived from a public sales effort is often the best evidence of statutory fair value, and further acknowledged that SWS had been exposed to the market via a public sales process. But the Vice Chancellor determined that, unlike in PetSmart, conditions surrounding SWS’ sale made using merger price as either the or a determinant of appraised fair value “unreliable.” Importantly, the Court found that Hilltop was also a substantial creditor of SWS, and that the credit arrangement gave Hilltop partial veto power over competing offers such that it likely affected the sales process and deal price. In rejecting petitioners’ valuation, the Court instead adopted a DCF analysis largely consistent with that proposed by Hilltop and SWS and, after making certain adjustments, determined fair value was $6.38 per share, or approximately 8% below the merger price at closing (and 19% below the merger price at announcement). Vice Chancellor Glasscock concluded that such a result was “not surprising” given SWS had demonstrated that its acquisition was a “synergies-driven transaction whereby the acquirer shared value arising from the merger.” The Vice Chancellor underscored a key aspect of Delaware’s appraisal statute in noting that “when the merger price represents a transfer to the sellers of value arising solely from a merger, these additions to deal price are properly removed from the calculation of fair value.” Vice Chancellor Glasscock in the SWS Group appraisal case: “[W]hen the merger price represents a transfer to the sellers of value arising solely from a merger, these additions to deal price are properly removed from the calculation of fair value.” SidleyPerspectives ON M&A AND CORPORATE GOVERNANCE Sidley Perspectives | JUNE 2017 • 7 Delaware Court of Chancery Further Clarifies What Constitutes a “Proper Purpose” for Demands to Inspect Corporate Records The Delaware Court of Chancery recently found in favor of allowing former Cypress Semiconductor CEO T.J. Rodgers to inspect certain categories of corporate records of Cypress Semiconductor Corp. holding that as long as the requesting stockholder has articulated a genuine and credible proper purpose, the existence of other reasons for the request are not grounds to deny the request. T.J. Rodgers v. Cypress Semiconductor Corp. (Del. Ch. Apr. 17, 2017). Rodgers sought books and records to investigate alleged conflicts of interest arising from the “dual hats” worn by Ray Bingham who was the chairman of Cypress, as well as a founding partner of Canyon Bridge Capital Partners, a private equity firm that allegedly competed with Cypress for semiconductor industry acquisition opportunities. The Court determined that Rodgers had established a proper purpose for his demand since he had a credible basis to infer that Bingham may have violated Cypress’ Code of Business Conduct and Ethics. The Court noted that Cypress did not dispute Bingham’s “dual hats” at Cypress and Canyon Bridge. Further, Canyon Bridge had recently acquired Lattice, a company that Cypress previously targeted for acquisition. Cypress relied on Southeastern Pa. Transportation Authority v. AbbVie, Inc. (Del. Jan. 20, 2016), to argue that the DGCL Section 102(b)(7) exculpatory provision in its bylaws required Rodgers to set forth a credible basis that the board, not just Bingham, had breached its duty of loyalty or acted in bad faith. The Court rejected this argument and distinguished AbbVie— where the DGCL Section 220 request was denied since the “sole motivation” for that demand was investigating exculpated derivative claims — stating that here Rodgers had established several proper purposes for his demand. These purposes included: “to communicate with stockholders of the Company regarding matters of common interest,” “to evaluate the suitability of all current members of the board serving as directors of the Company,” and “to evaluate possible litigation or other corrective measures.” Further, the Court rejected Cypress’ argument that Rodgers’ real purpose for the demand was to pursue a personal vendetta against Bingham or that the demand was merely a tactic in an ongoing proxy contest Rodgers was sponsoring. The Court noted that the case’s confidentiality order would prevent Rodgers from freely using the Section 220 materials in the upcoming proxy contest. On April 24, 2017, Rodgers filed suit against Bingham and the other Cypress directors alleging a breach of the fiduciary duty of candor. Delaware Court of Chancery Continues to Refine the Parameters of Corwin In Corwin v. KKR Fin. Holdings LLC, 125 A.3d 304 (Del. 2015), the Delaware Supreme Court held that when a transaction has received “a fully informed, uncoerced vote of the disinterested stockholders,” the business judgment rule will apply instead of enhanced scrutiny. The Corwin holding has touched off a series of important developments in Delaware law recently. In particular, two cases decided this year have further refined the application of the Corwin ruling. The first, In re Saba Software, Inc. S’holder Litig. (Del. Ch. Mar. 31, 2017), appears to be the first case in which the Court of Chancery did not apply the Corwin cleansing to permit the plaintiff’s claims of bad faith and breach of duty of loyalty to survive defendants’ motion to dismiss. While the decision seems predicated on a set of relatively unusual facts, it does demonstrate that there are limits to the application of the Corwin standard, even if just in extraordinary circumstances. Vice-Chancellor Slights’ decision helpfully includes a detailed analysis of the Delaware law governing the determination of stockholder coercion. SidleyPerspectives ON M&A AND CORPORATE GOVERNANCE Sidley Perspectives | JUNE 2017 • 8 Saba was a public company that engaged in fraud resulting in an overstatement of its pretax earnings. Saba made repeated representations that it would restate its financial statements to correct the overstatement, but failed to do so for more than three years. Ultimately, Saba reached a settlement with the SEC while simultaneously exploring strategic alternatives, but subsequently missed the SEC’s deadline for the filing of restated financials. Just before the filing deadline, Saba entered into a merger agreement with a private equity buyer (at a $9/ share price, which represented a 2% discount to the then-trading price of the stock). When the deadline passed, the Saba stock was deregistered, thereby rendering the shares illiquid and permitting Saba to accelerate its stockholder approval process because its proxy and financials were not subject to the SEC’s prior review. The transaction was approved by Saba’s stockholders 44 days after the announcement of the merger and closed four days after that approval. The Court of Chancery found that the stockholder vote regarding the merger transaction was neither fully informed nor uncoerced, so did not provide the cleansing under Corwin and required the application of enhanced scrutiny. Failing to disclose the reasons the company repeatedly failed to restate its financials deprived the stockholders of material information about the viability of Saba as a stand-alone company absent the merger and about the credibility of the projections included in the proxy. Furthermore, the vote was subject to “situationally coercive factors” created by the company’s failure to restate its financials and, as such, “forced stockholders to choose between a no-premium sale or holding potentially worthless stock.” Thus, the stockholders were not afforded the requisite “free choice” of an uncoerced vote. Without a fully informed and uncoerced vote, the defendants were not entitled to the application of the business judgment rule and many of the plaintiff’s claims survived defendants’ motion to dismiss. Conversely, in In re Paramount Gold and Silver Corp. S’holders Litigation (Del. Ch. Apr. 13, 2017), the Delaware Court of Chancery did grant the defendants’ motion to dismiss fiduciary breach claims arising from a $146 million merger of Paramount Gold and Silver Corp. with Coeur Mining Inc. The plaintiffs argued that enhanced scrutiny, and not the business judgment rule per Corwin, should be applied because the transaction included unreasonable deal protections that rendered the majority stockholder vote coerced and the disclosure was not sufficient to permit a fully-informed vote. The Court found that the deal protections were not unreasonable and the disclosure was sufficient, such that the stockholder vote was properly informed and not coerced. However, in so ruling, the Court highlighted the as yet unresolved issue of whether less clearly reasonable deal protections could be “cleansed” by a fully-informed and uncoerced stockholder vote under Corwin. Delaware Court of Chancery Holds That Stockholder Approval of Equity Incentive Plan Ratifies Subsequent Awards The Delaware Court of Chancery recently held that approval of an equity incentive plan by fully-informed stockholders also ratified subsequent equity awards made to directors that were within the bounds of the “meaningful, specific limits on awards to all director beneficiaries” set forth in the plan. In re Investors Bancorp, Inc. S’holder Litig. (Del. Ch. Apr. 5, 2017). This case follows two other significant decisions in recent years in which the Court of Chancery denied the defendants’ motions to dismiss based on the absence of “meaningful limits” on director equity compensation in the equity incentive plans at issue and sheds more light on what the Court will consider a “meaningful limit.” Calma v. Templeton (Citrix) (Del. Ch. Apr. 30, 2015) and Seinfeld v. Slager (Del. Ch. Jun. 29, 2012). The Court noted that approval of plans with broad parameters and “generic” limits applicable to all plan beneficiaries will not extend to subsequent grants of awards made pursuant to the The Saba court did dismiss the plaintiff’s claim against the private equity buyer of aidingand-abetting a breach of fiduciary duty, noting that neither the mere receipt of confidential information by the buyer or “conclusory allegations” that the buyer got “too good of a deal,” without more, was sufficient to successfully plead an aiding-andabetting claim. In Paramount, the Court of Chancery noted, without resolving, a possible conflict between Corwin and an earlier Delaware Supreme Court case (In re Santa Fe Pacific Corp. S’holder Litigation, 669 A.2d 59 (Del. 1995)) that found a fully-informed stockholder vote approving a merger did not preclude enhanced scrutiny of certain defensive measures taken by the board in response to a hostile bid. SidleyPerspectives ON M&A AND CORPORATE GOVERNANCE Sidley Perspectives | JUNE 2017 • 9 plan. On the other hand, approval of plans with “specific limits” will be deemed to ratify awards that are consistent with those limits. In In re Investors Bancorp, the Court of Chancery dismissed a derivative suit alleging that the directors awarded themselves “grossly excessive” compensation following the company’s mutual-to-stock public offering. The plan imposed the following ceiling on director-specific awards: “The maximum number of shares that may be issued or delivered to all nonemployee directors, in the aggregate, pursuant to the exercise of stock options or grants of restricted stock or restricted stock units shall be 30% of all option or restricted stock shares available for awards, ‘all of which may be granted in any calendar year’.” Consistent with this limit, the directors awarded themselves the full 30% of available shares (with a grant date fair value of approximately $51.5 million) in the calendar year following the offering. Even though this resulted in the directors receiving significantly more compensation than in prior years and significantly more than directors at peer companies, the Court dismissed the claim that the directors received excessive compensation because the plan included a “meaningful, specific” limit on director equity awards. The Court found that the stockholder ratification defense was available because (1) the plan included director-specific limits that differed from the limits applicable to other plan participants and (2) the limits were fully disclosed and approved by over 96% of the shares voted at the stockholder meeting. Therefore, the propriety of the awards would be reviewed under the business judgment rule which defaults to a waste standard and plaintiffs did not plead a claim for waste. In light of this decision, companies putting new or existing equity incentive plans to a stockholder vote should consider adding to those plans a separate, explicit ceiling on the number of shares that non-employee directors may receive as compensation. The decision suggests that the ceiling may be framed as either an individual or collective limit. Delaware Court of Chancery Uses Context to Interpret Term That Would Trigger Milestone Payment Acquisition agreements with “milestone” (or “earnout”) provisions that provide for postclosing payments based on specified potential future events or results are prone to disputes due to their very nature. Such was the case in Shareholder Representative Services (SRS) v. Gilead Sciences, et al. (Del. Ch. Mar. 15, 2017), a case arising out of Gilead’s 2011 acquisition of Calistoga Pharmaceuticals and, in particular, whether Gilead owed the former stockholders of Calistoga (represented by SRS) a $50 million milestone payment following the EU’s approval for Calistoga’s Zydelig drug to be used to treat chronic lymphocytic leukemia (CLL) in a subset of the population of patients with CLL that possessed a particular genetic mutation. The dispute revolved around the meaning of the word “indication.” The contract provided that the milestone payment would be owed upon regulatory approval in the European Union “as a first-line drug treatment…for a Hematologic Cancer Indication” with “Hematologic Cancer Indication” defined as “any indication within the following tumor types” which referenced various diseases, including CLL. Gilead and SRS agreed on two key points: (1) the term “indication” has at least four different meanings in the oncology industry depending on the context and (2) its meaning in the contract at issue was unambiguous. However, the parties did not agree on the meaning itself. SRS took the position that the use of “indication” meant that if Zydelig was approved for use in any patient with CLL, the milestone was met, whereas Gilead took the position that Zydelig must be approved for “indication” of the disease of CLL more broadly, and not for a subset of that patient population. See our previous Sidley Update entitled Delaware Courts Tighten Their Scrutiny of NonEmployee Director Compensation Awards for more information on the Citrix and Seinfeld decisions. The parties agreed that the meaning was unambiguous but did not agree on the meaning itself. The Delaware Court of Chancery stated “a contract is not rendered ambiguous simply because the parties do not agree upon its proper construction.” SidleyPerspectives ON M&A AND CORPORATE GOVERNANCE Sidley Perspectives | JUNE 2017 • 10 Addressing the question of whether the meaning of “indication” was ambiguous, the Court stated “a contract is not rendered ambiguous simply because the parties do not agree upon its proper construction. Rather, a contract is ambiguous only when the provisions in controversy are reasonably or fairly susceptible to different interpretations or may have two or more different meanings.” With the parties having agreed that the word could have different meanings in different contexts, the Court considered whether its use in the context of the contract was ambiguous. In the course of that examination, the Court addressed SRS’s claim that reading “indication” to mean “disease” would violate the concept of contractual interpretation that all provisions of any agreement should be given meaning, as interpreting “indication” to mean “disease” would render the word “disease” superfluous where used in the contract with the word “indication.” While acknowledging that principle of contract construction, the Court cited the arguably superfluous use in the oncological community of the phrase “cancer disease” to describe the disease of cancer. In this case, the Court was “not persuaded that it would be unreasonable to construe ‘indication’ to mean ‘disease’ based on SRS’s surplusage argument.” Finding that the use of the term was ambiguous in the context used, the Court then turned to extrinsic evidence to determine the parties’ intent. Ultimately, the Court found, after a four-day trial involving the examination of evidence including multiple versions of the draft contract, internal and external email communications, testimony as to the potential meanings of the word “indication” and the meaning given to it by the parties in their discussions, negotiations and drafting, as well as the economic impact of different interpretations relative to a reasonable business intent, that Gilead’s interpretation was correct—the parties mutually understood “indication” to mean “disease.” Delaware Superior Court Finds a Bankruptcy Trustee’s Fiduciary Duty Claim a Covered “Securities Claim” Under D&O Insurance Policy The Delaware Superior Court ruled, on summary judgment, in favor of Verizon Communications Inc. finding that a prior lawsuit involving a bankruptcy trustee was a “Securities Claim” as defined in Verizon’s Executive and Organizational liability insurance policies. Verizon Communications Inc. v. Illinois Nat’l Insurance Co., et. al. (Del. Super. Mar. 2, 2017). In 2006, Verizon spun off its paper and electronic directories business into a stand-alone company, Idearc, Inc. Idearc filed for bankruptcy in 2009. A number of suits were filed following the bankruptcy. The central lawsuit pertinent to this insurance dispute was filed by the Idearc estate’s litigation trustee, U.S. Bank, against Verizon, among others, for promoter liability and breach of fiduciary duty, payment of an unlawful dividend and fraudulent transfer. Verizon obtained a dismissal of the lawsuit after five years of litigation, accruing legal costs of approximately $48 million. Verizon sued its insurers seeking reimbursement of these legal fees and expenses. The insurers conceded that Verizon was entitled to reimbursement of defense costs if the U.S. Bank litigation fit within the policy’s definition of “Securities Claim.” The portion of the definition at issue was the meaning of “rule” as used in the phrase “alleging a violation of any federal, state, local or foreign regulation, rule or statute regulating securities…” Verizon asserted that the word “rule” as used in the policy’s “Securities Claim” definition included “judicial rules of law or common law rules such as those governing the conduct of fiduciaries.” In contrast, the insurers argued for a narrow, technical interpretation limited to claims “expressly alleging violations of federal securities and state Blue Sky laws.” The Court emphasized the doctrine of contra proferentum— where the language of an insurance contract be construed most strongly against the drafting party—to find that the definition of “Securities Claim” was standard form language drafted unilaterally by the insurers that would be construed in favor of Verizon. The Delaware Court of Chancery turned to extrinsic evidence to determine the parties’ intent and ultimately found that “the parties mutually understood “indication” to mean “disease.” As noted by the Delaware Court of Chancery, “the reality of life is that human language is not perfect,” but the Gilead Sciences decision reminds that seeking precision is a key goal in contract drafting. SidleyPerspectives ON M&A AND CORPORATE GOVERNANCE Sidley Perspectives | JUNE 2017 • 11 The Court was further persuaded by the drafting history of the policy, finding that the 2000 form did not explicitly exclude common law claims pointing to inconsistent prior drafts. A 1995 form used narrow language to exclude common law claims, but an intervening 1998 form included common law claims. Further, the Court noted that one of the insurers in the Verizon program had taken an inconsistent coverage position in a prior 2009 action. Thus, the insurers were liable for Verizon’s cost of defense. The Court cautioned that this decision was specific to the language in the policies at issue, did not dictate the proper scope of coverage for all such liability policies, and did not reflect a shift in present law. LEGISLATIVE DEVELOPMENTS House of Representatives Approves Revised Dodd-Frank Repeal Bill On June 8, 2017, the House of Representatives, by a 233-186 vote, passed the Financial CHOICE Act of 2017, the controversial legislation first introduced in 2016 which would make sweeping changes to the current financial regulatory environment. Among other things, the bill would repeal or amend several provisions of the Dodd-Frank Act relating to corporate governance and executive compensation, including: ■ a repeal of the CEO pay ratio disclosure requirement; ■ a repeal of the requirement to disclose whether directors and employees may hedge company stock; ■ an amendment to only require a say-on-pay vote to be held if there was a “material change” in executive compensation compared to the prior year; and ■ an amendment to limit the executive officers from whom compensation may be clawed back to only such officers with control or authority over the financial reporting that resulted in the accounting restatement that triggered the clawback. The proposed legislation would also prohibit the SEC from mandating the use of universal proxy ballots and make the requirements to submit a shareholder proposal more onerous. The bill will now advance to the Senate where it is unlikely to pass because a 60-vote majority will be required for approval. Senate Banking Committee Chairman Mike Crapo has signaled a focus on smaller, bipartisan legislation rather than taking up the Financial CHOICE Act. Even though the CEO pay ratio disclosure requirement could potentially be repealed under the Financial CHOICE Act, public companies should continue to prepare for compliance with the rule. For calendar-year companies, the first disclosure will typically be required in their 2018 annual meeting proxy statements and will be based on 2017 compensation. SidleyPerspectives ON M&A AND CORPORATE GOVERNANCE Sidley Perspectives | JUNE 2017 • 12 CORPORATE GOVERNANCE DEVELOPMENTS Virtual-Only Annual Meetings Gain Traction but Face Some Investor Backlash There has been a significant increase in the number of public companies holding “virtualonly” annual meetings in the recent years. According to Broadridge, only 28 companies held such meetings in 2010 compared to 187 in 2016. Proponents cite the primary benefits as efficiency and reduced costs and the potential to increase stockholder participation. Despite these benefits, some institutional investors have spoken out against virtual-only annual meetings. CalPERS and the Council of Institutional Investors have suggested that such meetings should supplement— rather than replace — in-person stockholder meetings. Opponents argue that virtual-only annual meetings deprive stockholders of the right to face-to-face interaction with management and directors and allow companies to dodge difficult questions received from stockholders. In the spring of 2017, the New York City Comptroller announced a letter-writing campaign to more than a dozen S&P 500 companies urging them to host in-person annual meetings. Under their updated proxy voting guidelines, the New York City Pension Funds “may oppose all incumbent directors of a nominating committee subject to election at a ‘virtualonly’ annual meeting.” The revised policy will apply only to S&P 500 companies in 2017 and will expand to cover all U.S. portfolio companies in 2018. Nominating committee members can avoid negative votes during 2017 if their companies agree to hold in-person or hybrid annual meetings beginning in 2018. ISS has indicated that it may recommend votes against directors if a company is using a virtual meeting to impede stockholder discussion on a particular proposal. We may see ISS and Glass Lewis adopt further proxy voting policies on the subject. Companies may also be at risk of receiving stockholder proposals requesting in-person stockholder meetings but, to date, the SEC has permitted exclusion of such proposals on “ordinary business” grounds. The manner in which virtual-only annual meetings are conducted is continuing to evolve. The recent opposition may encourage companies to use technology that provides stockholders with a similar level of transparency and interaction as an in-person meeting such as allowing them video (rather than audio-only) access to the meeting and the ability to ask questions real time, or posting a list of all questions submitted by stockholders (rather than a subset selected by management). SIDLEY RESOURCES An article entitled Assessing Corporate Compliance Programmes by Holly Gregory, a partner in Sidley’s New York office, and Rebecca Grapsas, counsel in Sidley’s New York/ Sydney offices, was published in the Spring 2017 edition of Ethical Boardroom, a leading subscription-based magazine and website that focuses on global governance issues. An article entitled Post-Closing Liability Risks For Private Equity Firms by Sara Garcia Duran and Sacha Jamal, lawyers in Sidley’s Dallas office, was published by Law360 on April 27. The article discusses a recent decision involving a fraud-in-the-inducement claim brought against a PE seller and proposes ways in which PE sellers may try to limit their exposure to post-closing liabilities. SidleyPerspectives ON M&A AND CORPORATE GOVERNANCE Sidley Perspectives | JUNE 2017 • 13 Sidley Austin provides this information as a service to clients and other friends for educational purposes only. It should not be construed or relied on as legal advice or to create a lawyer-client relationship. Attorney Advertising - Sidley Austin LLP, One South Dearborn, Chicago, IL 60603. 312 853 7000. Sidley and Sidley Austin refer to Sidley Austin LLP and affiliated partnerships as explained at sidley.com/disclaimer. AMERICA • ASIA PACIFIC • EUROPE sidley.com An article entitled What M&A Financial Advisors Need to Know About Delaware’s Business Judgment Rule by Andrew Stern, James Heyworth and Benjamin Burry, lawyers in Sidley’s New York office, was published in Bloomberg BNA’s Mergers & Acquisitions Law Report on April 24. The article discusses financial advisor liability in light of recent Delaware Supreme Court guidance on the limitations on post-closing fiduciary duty claims. It also sets forth several takeaways for financial advisors working on significant corporate transactions, including the paramount importance of disclosing all material facts, including potential conflicts of interest. An article entitled In Support Of Delaware’s Merger Litigation Jurisprudence by Andrew Stern, Alex Kaplan and Jon Muenz, lawyers in Sidley’s New York office, was published by Law360 on April 21. The article responded to a recent piece from members of the plaintiffs’ bar on the topic. In the authors’ view, Delaware courts have taken appropriate steps to incentivize full and fair disclosure —fair to all — while at the same time minimizing frivolous litigation that harms both companies and stockholders. An article entitled New NACD Cyber-Risk Handbook a Reminder of Critical Board Oversight Duties by Alan Raul, Colleen Brown and Dean Forbes, lawyers in Sidley’s Washington, D.C. office, was published in Bloomberg BNA’s Corporate Law & Accountability Report on February 23. The article examines board obligations for cyber-risk oversight and recently updated guidance by the National Association of Corporate Directors (NACD).