Posted on March 17, 2010 by Francis G.X. Pileggi

Court of Chancery Questions Special Litigation Committee's Independence and Investigation; Denies Motion to Dismiss Litigation

In London v. Tyrrell et al., C.A. No. 3321-CC (March 11, 2010), read opinion here, the Court of Chancery denied a special litigation committee’s (“SLC”) motion to dismiss a shareholder’s lawsuit under Zapata Corp. v. Maldonado, 430 A.2d 779 (Del. 1981) because there were material questions of fact regarding: (1) the SLC’s independence, (2) the good faith of its investigation, and (3) the reasonableness of the grounds upon which the SLC recommended dismissal of the lawsuit.  A prior Chancery ruling in this case was highlighted on this blog here.

Kevin Brady, a highly regarded Delaware litigator, prepared this synopsis.

Background

In 1996, plaintiffs Craig London and James Hunt and defendants Patrick Neven and Walter Hupalo, and others founded iGov, a government contracting firm. In 2005, after changing its focus, iGov won a 5-year $300 million contract with the United States Special Operations Command (the “TACLAN” contract). Because of the expenses it incurred in reinventing itself, iGov’s CEO, Neven, hired Michael Tyrrell as a consultant (he later replaced London as CFO of iGov) to help iGov find a lender to supply it with an operating line of credit. Textron Financial surfaced as a possible candidate. Around the same time, defendants decided that it would be advisable to implement an equity incentive plan (the “2007 Plan”) for the benefit of key members of management. Chessiecap Securities, Inc. was retained to value iGov stock for purposes of setting the exercise price of options for the 2007 Plan.


The Valuation Rollercoaster

Throughout 2006, Tyrrell distributed a number of 2007 forecasts which reflected ever-changing EBITDA. On May 4, 2006, Tyrrell sent Textron a fiscal year 2007 forecast reflecting an EBITDA of approximately $3.5 million (the “First Textron Forecast”). On August 15, 2006, Tyrrell sent Textron an updated 2007 forecast showing an EBITDA of roughly $3 million (the “Second Textron Forecast”). On August 23, 2006 Tyrrell sent Chessiecap a 2007 forecast that showed an EBITDA which also had a value of approximately $3 million (the “Original Chessiecap Forecast”). On October 2, 2006, Chessiecap valued iGov equity at $5.5 million, however, Tyrrell told Chessiecap that in his view $5.5 million was “probably on the high side.” On October 18, 2006, Tyrrell sent Chessiecap a revised forecast that eliminated certain revenues and expenses and showed an EBITDA of $1.8 million (the “Revised Chessiecap Forecast”). On October 31, 2006, Chessiecap certified its Final Valuation of the equity of iGov at $4.7 million. Finally, on December 8, 2006, Tyrrell sent Textron another updated 2007 forecast that showed an EBITDA of approximately $3.1 million (the “Third Textron Forecast”).

 

London and Hunt are Removed as Directors

In January, a split in the board developed over the correct valuation to use. On January 7, 2007, Tyrrell sent an email to iGov management regarding a proposal to purchase London’s shares for $4 per share, but he wanted an updated valuation since he felt that iGov’s “valuation will likely be higher than $4.7 million [the Final Valuation]. . . .” On January 16, 2007, London objected to iGov relying on Chessiecap’s Final Valuation for purposes of the 2007 Plan because he felt the information upon which the Final Valuation was based was stale and inaccurate. On January 17, 2007, Hunt, who also believed the Final Valuation was unreliable, made an offer to buy all of Neven’s stock at $28 per share. Defendants Neven and Hupalo, who owned 42.5% of iGov’s voting stock, teamed up with iGov officer and shareholder Jack Pooley (collectively they owned 50.1% of iGov’s voting stock), and executed written stockholder consents removing London and Hunt from the board and electing Tyrrell to the board.

The 2007 Plan is Adopted

Defendants then engaged Chessiecap to prepare an addendum to its Final Valuation in which, among other things, Chessiecap concluded for the first time that the fair market value per share as of July 31, 2006 was $4.92. Defendants then held a special meeting of the iGov board on January 30, 2007 to consider the 2007 Plan under which the defendants were given 60% of the options granted and the plaintiffs were given no options or shares. The 2007 Plan also provided that the exercise price of the options could not be less than 100% of the fair market value of iGov common stock on the date the options were granted. Defendants unanimously voted as directors to approve the 2007 Plan and simultaneously adopted $4.92 per share as the fair market value of iGov shares on January 30, 2007 based on Chessiecap’s Final Valuation, dated July 31, 2006, and the associated addendum.

Former Directors File Suit

After the 2007 Plan was approved, plaintiffs filed a books and records action under 8 Del. C. § 220. Plaintiffs engaged the McLean Group, a valuation firm, to conduct separate valuations of iGov’s equity as of October 31, 2006 and December 31, 2006 (the “McLean Valuations”). In performing the McLean Valuations, McLean used the Second Textron Forecast rather than the Revised Chessiecap Forecast. The McLean Valuations placed the per share value of iGov equity at $13.32 on October 31, 2006 and $15.45 on December 31, 2006. Around this same time, iGov expanded the size of its board from three members to five, adding Vincent Salvatori and John Vinter. On October 31, 2007, after attempts to resolve the dispute failed, plaintiffs filed their complaint. In February 2008, the complaint was amended in response to defendants’ motion to dismiss. The plaintiffs claimed that the defendants breached their fiduciary duties of care and loyalty in that the defendants materially misrepresented iGov’s business prospects to Chessiecap in order to get a lower valuation for them to acquire iGov stock. The plaintiffs sought, among other things, rescission of the options granted to defendants under the 2007 Plan.

SLC Formed

On November 21, 2008, the iGov board formed a two-member SLC comprised of the two new board members (Salvatori and Vinter) to consider whether it was in iGov’s best interest to pursue the derivative claims in plaintiffs’ complaint. The SLC hired legal and financial advisors and conducted an investigation from April 2009 to July 2009. During the investigation, the SLC’s financial advisor (“SRR”) performed valuations of iGov as of October 31, 2006 and January 30, 2007 without reviewing the work done by Chessiecap and McLean. The SLC concluded that October 31, 2006 was an appropriate valuation date because it believed that Chessiecap’s Final Valuation was essentially current as of October 31, 2006, despite being dated July 31, 2006. The SLC determined that January 30, 2007 was an appropriate date because it was the date the challenged 2007 Plan was adopted. SRR also concluded that since iGov was worth $3.90 - $4.15 per share as of October 31, 2006 and $5.24 - $5.39 per share as of January 30, 2007, the $4.92 per share price was “within the range of fair market value” based on the SRR valuations.

SLC Recommends That the Lawsuit Be Dismissed

On August 5, 2009, the SLC filed a Report concluding that the suit was not in the best interests of the Company and recommending that it be dismissed. The SLC concluded that the defendants acted properly in adopting the 2007 Plan and did not breach their duties of care or loyalty. With regards to the duty of care, the SLC found that the 8 Del. C. § 102(b)(7) provision in iGov’s certificate of incorporation exculpates directors from personal liability not involving intentional misconduct or knowing violations of the law. The SLC concluded that a duty of care claim should not be pursued because any breach of care conduct, if it occurred, would be covered by the § 102(b)(7) provision. As to the duty of loyalty, the SLC concluded that defendants’ approval of the 2007 Plan and actions leading to that approval would satisfy the entire fairness standard because the process employed was fair and the $4.92 price was fair. The SLC also determined that no rescission of the options granted under the 2007 Plan was necessary because $4.92 was in the range of fair market value.

Two-Step Analysis under Zapata

Under the Delaware Supreme Court’s decision in Zapata Corp. v. Maldonado, 430 A.2d 779 (Del. 1981) there is a two-step analysis that must be applied to the SLC’s motion to dismiss. First, the Court must review the independence of SLC members and whether the SLC conducted a good faith investigation of reasonable scope that yielded reasonable bases supporting its conclusions. In the second step, the Court applies its own business judgment to the facts to determine whether the corporation’s best interests would be served by dismissing the suit.

Independence Questioned – “Caesar’s Wife” or “My Cousin Vinter”

The Court noted that an SLC member is not independent if he or she is incapable, for any substantial reason, of making a decision with only the best interests of the corporation in mind. Quoting the Supreme Court’s decision of Beam v. Stewart, 845 A. 2d 1040, 1055 (Del. 2004):

Unlike the demand-excusal context, where the board is presumed to be independent, the SLC has the burden of establishing its own independence by a yardstick that must be “like Caesar's wife”-“above reproach.” Moreover, unlike the presuit demand context, the SLC analysis contemplates not only a shift in the burden of persuasion but also the availability of discovery into various issues, including independence.

In this instance, it was undisputed that neither Salvatori nor Vinter had a personal stake in the challenged transactions and neither faced any risk of personal liability in this action. However, the Court was troubled by the fact that Vinter was related to Tyrell (Vinter’s wife was Tyrell’s cousin) and Salvatori used to work for Tyrell.

While the Court admitted that it was not possible, at this stage of the proceedings, to say unequivocally that either Vinter’s or Salvatori’s independence was impaired, the burden was on them to show no material question existed about their independence.

The Court determined that they had failed to meet that burden. Moreover, the Court noted that there was evidence to suggest that Vinter and Salvatori may not have conducted their investigation objectively after having considered plaintiffs’ claims. In concluding that the SLC failed to satisfy the independence prong of Zapata, the Court stated that members of an SLC “should be selected with the utmost care to ensure that they can, in both fact and appearance, carry out the extraordinary responsibility placed on them to determine the merits of the suit and the best interests of the corporation, acting as proxy for a disabled board.”

“Scope” of Investigation and “Bases” for Conclusion Questioned

To conduct a good faith investigation of reasonable scope, the Court stated that the SLC had to investigate all theories of recovery asserted in the plaintiffs’ complaint and explore all relevant facts and sources of information that bear on the central allegations in the complaint. If the SLC failed to do that, the result would raise a material question about the reasonableness and good faith of the SLC’s investigation.

Here the SLC concluded that § 102(b)(7) provisions such as iGov’s are routinely upheld by Delaware courts and that such a provision protects defendants from personal liability, in the form of money damages, for gross negligence. However, the Court rejected the SLC’s conclusion stating “I find this to be an unreasonable conclusion because the SLC failed to consider that the requested relief in plaintiffs’ complaint is not limited to money damages; it specifically requests that the 2007 Plan be rescinded. Under Delaware law, exculpatory provisions do not bar duty of care claims ‘in remedial contexts . . ., such as in injunction or rescission cases.’

The SLC also concluded that plaintiffs’ duty of loyalty claims should be dismissed because it believed that the 2007 Plan was entirely fair to iGov -- (1) the process defendants’ employed to secure approval of the 2007 Plan, particularly the process employed to develop the exercise price, was entirely fair, and (2) $4.92 was a fair exercise price. The Court disagreed finding that it was not acceptable for Tyrell to provide Chessiecap with the Revised Chessiecap Forecast showing an EBITDA of $1.8 million while simultaneously providing Textron with multiple iterations of EBITDA forecasts. The Court stated that this type of behavior in the current economic environment was particularly troubling:

As is evident from the SLC Report, the SLC concluded that the process of adopting the 2007 Plan was fair primarily because the SLC believes it was perfectly normal for Tyrrell to provide “optimistic” and “art of the possible” forecasts to Textron and use those forecasts internally, while at the same time providing a forecast to its valuation expert that was “substantially lower” but something the Company could “actually achieve,” rather than being “wishful.” To put it mildly, this is an interesting conclusion, especially in light of the current credit environment. One would suspect that lenders would prefer a forecast projecting what management believes is actually achievable as opposed to wishful.

The Court also identified a number of questions which were not adequately investigated by the SLC, including: (i) why did Tyrrell provide Chessiecap with the Original Chessiecap Forecast (showing an EBITDA of roughly $3 million) if he did not believe that the projections in that forecast were actually achievable? and (ii) why did Tyrrell provide Textron with the Third Textron Forecast (showing an EBITDA of 3.1 million) after he provided Chessiecap with the Revised Chessiecap Forecast (showing an EBITDA of $1.8 million)?

As to “Fair Price,” the Court questioned how the SLC could determine that both the Chessiecap Final Valuation and McLean Valuations were “tainted” and as a result, the SLC did not rely on either valuation (or any other valuation) in concluding that $4.92 was a fair price. Since the SLC had no professional valuation upon which to rely, the Court found that a material question of fact existed about whether the SLC had a reasonable basis to conclude that $4.92 was a fair price. Finally, with respect to the second prong of Zapata, since the Court found that the SLC failed the first prong of Zapata, the Court noted that it was unnecessary to continue the analysis because the result would not change.
 

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Posted on March 16, 2010 by Francis G.X. Pileggi

Chancery Changes Co-Lead Counsel in Revlon Class Action

 In Re Revlon, Inc., Shareholders Litigation, Consol. C.A. No. 4578-VCL (Del. Ch. March 16, 2010), read opinion here. This is a Court of Chancery opinion that is certain to generate copious commentary. The Court removed the original Co-Lead Counsel and appointed new Co-Lead Counsel for the class.

This is the type of major decision that warrants a short blurb to make readers aware of it, and allow them to read the whole 44-pages until we have time to provide a more complete review of this important opinion.

We will attempt to supplement this abbreviated post soon, but in the meantime a cursory review makes it clear that this opinion is destined to be cited often for several reasons. For example, it describes the practice and some history of firms who file class actions in the Court of Chancery very soon after a public announcement of a transaction and the ensuing battle for lead counsel among firms filing competing complaints involving the same contested transaction. Footnotes refer to law review articles and prior Chancery decisions that chronicle the issues that arise in this context, often involving the same firms that the Court refers to as "frequent filers" in this Court. The Court also refers to this phenomenon as the "opening steps in the Cox Communications Kabuki dance." (Slip op. at 8.)

The opinion includes scholarly analysis regarding the criteria employed by the Court in its selection of lead counsel in class actions, noting that the size of plaintiff's holding is not always determinative. Without any intent to "name names" and having no interest in identifying firms on this blog that suffered in this case, it must be noted that the Court concluded that original counsel did not "provide adequate representation."

The Court cites to many academic sources that discuss the policy issues that arise in these types of cases, as well as the "pros and cons" of what the Court refers to as "entrepreneurial litigators" who have a portfolio of class action cases. There is much more to commend this decision as must-reading for any lawyer or plaintiff who files a representative action in the Delaware Court of Chancery. A fuller synopsis will follow soon.

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Posted on March 14, 2010 by Francis G.X. Pileggi

Agreement Terminable at Will Not Subject to Statute of Frauds

Dweck v. Nasser, C.A. No. 1353-VCL (Del. Ch. March 10, 2010), read letter decision here.

Prior decisions of the Court of Chancery involving this matter have been highlighted on this blog here.

This short three-page letter decision refused to apply the Statute of Frauds to an oral agreement that was terminable by either party at any time "upon performance of an act which is within the control of one of the parties." The Court reasoned that because the "performance of the agreement could be completed within one year without breach by either party", the Statute of Frauds did not bar its enforcement. 

In a previous decision in this matter, the Court of Chancery ruled that the oral agreement still being disputed in the instant ruling, (which is based in part on an unsigned draft shareholders' agreement), could not serve the purpose of a "voting agreement" due to the requirement of DGCL Section 218(a) that voting agreements or voting trusts be in writing. Nonetheless, the Court observed, nothing prevents the application of another state's contract law, such as New York in this case, to issues such as contract formation at the same time that the DGCL governs the validity of the corporate governance implications of the contract.

 

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Posted on March 13, 2010 by Francis G.X. Pileggi

Supreme Court Decides Claim Not Covered by Arbitration Clause

Kuhn Constr. Co. v. Diamond State Port Corp., No. 124, 2009 (Del. Supr. Mar. 8, 2010), read opinion here. In this rare reversal of the Court of Chancery, the Delaware Supreme Court determined that the claims at issue were not subject to arbitration based on the wording of the arbitration provision in the agreement involved.

The Diamond State Port Corp. (DSPC) and Kuhn had disputes about a construction project. DSPC sent Kuhn a notice of intent to arbitrate and a demand for arbitration. Kuhn replied by filing a complaint for injunctive relief pursuant to Section 5703(b) of Title 10 of the Delaware Code (Delaware Uniform Arbitration Act). DSPC filed a motion to dismiss pursuant to Rule 12(b)(6). Chancery granted the motion to dismiss.

The Delaware Supreme Court reversed and began its analysis with the public policy of Delaware that supports arbitration but the predicate of that policy is that the parties have clearly and expressly agreed to arbitrate. Delaware's highest court emphasized that it would not enforce a contract that "unclearly or ambiguously reflects the intention to arbitrate." The Court then discussed basic contract interpretation principles and the standard for determining if a contract is ambiguous.

There were three primary reasons for the Court's decision. First, the applicable clause in the parties' agreement did not clearly and unambiguously indicate the intention to arbitrate the claims at issue. Second, despite isolated terms that may support the view of DSPC, the contract as a whole favored Kuhn's argument that the arbitration clause was not intended to cover all claims. Third, the trial court relied on the 1968 Delaware Supreme Court case in Ruckman that it found controlling, however, Delaware's High Court determined that Ruckman neither controls nor guides the resolution of the instant dispute.

This relatively short opinion is helpful for addressing the frequent litigation that arises in connection with the "coverage" of arbitration provisions.

 

 

 

 

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Posted on March 13, 2010 by Francis G.X. Pileggi

Citizens United and Corporate Governance

Professor J.W. Verret writes about the confluence of corporate governance and the recent SCOTUS decision in Citizens United, here, in connection with proposed federal legislation. An excerpt follows:

In short, this bill sought to hijack the securities laws to regulate campaign finance. Even worse, it sought to give Union and State Pension Funds a veto over corporate political spending. As such, my thesis today was simple: trying to achieve labor and campaign policy goals through the securities laws leaves ordinary investors, who hold shares through their 401(k)s, holding the tab for this politically motivated activity

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Posted on March 11, 2010 by Francis G.X. Pileggi

Chancery Upholds State Law Claim for Insider Trading

Pfeiffer v. Toll, C.A. No. 4140-VCL (Del. Ch. March 3, 2010), read opinion here. This scholarly decision upheld state law claims against directors for insider trading. The Court of Chancery rejected the argument that federal law preempted state law for such claims. For anyone who wants to know the latest Delaware law on insider trading claims, and the Brophy line of cases, this is must reading. The Court cited in its decision to nationally prominent corporate law professor Stephen Bainbridge. See Slip op. at 35, 36, and 41 (citing Stephen M. Bainbridge, Securities Law: Insider Trading 15-16 (2d ed. 2007)). Of course, regular readers of this blog know that the Delaware Court of Chancery and the Delaware Supreme Court have cited to Professor Bainbridge's scholarship many times in prior opinions.

The good professor has already penned thoughtful commentary on this opinion with extensive insight and analysis.We are fortunate to have this nationally recognized expert's review of this case. (It makes my job easier). Thus, I commend to you Professor Bainbridge's discussion of this case, especially  regarding the interface between state and federal law in connection with insider trading, available on his blog here and here.

P.S.  Professor Larry Ribstein, another prolific, nationally recognized expert whose scholarship is often cited by the Delaware Courts, has just provided his scholarly insights on this case here.

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Posted on March 9, 2010 by Francis G.X. Pileggi

Chancery Decides Winner in Race Car Dispute

Jarvis v. Elliott, C.A. No. 4753-CC (Del. Ch. March 5, 2010), read opinion here. This 18-page decision is as fun as it gets when it comes to reading judicial decisions.

Although the amounts involved in this case are more fitting for a small claims court, and the primary legal issues are replevin and conversion, the main reason I include this decision on this blog--which seeks to cover all the key decisions on corporate and commercial law from Delaware's Chancery Court and Supreme Court, is due to the memorable manner in which the opinion is written. It includes a combination of serious adjudication mixed with multiple references to famous race car drivers, movies about race cars and other indications that the author of this opinion is quite familiar with the industry from which the parties in this case arrive at the Court. This decision also highlights the reality that not all business disputes in Chancery are billion dollar disputes among Fortune 100 companies. The Court in this case awarded a total of $1,260.67--though the opinion is just as thoughtfully written as if it were one of the many major disputes the Court handles.

The opening line to the ruling deserves to be quoted: "Success on the track does not guarantee success off the track. With regret that a winning team fell apart, I must now sort through the wreckage of a failed relationship...."

The Court explained that replevin was typically not within its jurisdiction but that it retained it in this case under the "whole case or controversy" doctrine based on initial partnership claims. Before defining the elements of a replevin action,  the Court began its analysis thusly: "My analysis will be swifter than Richard Petty's race-clinching pit stop at the 1981 Daytona 500. The chassis of this case is a replevin action". 

The Court also referred in footnotes to famous movies featuring racing. See footnotes 50, 51 and 52. Demonstrating a firm grip on the details of the racing industry, the Court acknowledged towards the end of its decision the importance of backup engines and backup cars by the following reference: "Just ask Jimmie Johnson, who recently won one of the 2010 Daytona 500 qualifiers in a backup car."

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Posted on March 6, 2010 by Francis G.X. Pileggi

Chancery Denies Motion to Disqualify Cravath Firm in Airgas/Air Products Battle

Air Products and Chemicals, Inc. v. Airgas, Inc., No. 5249 (Del. Ch., March 5, 2010), transcript of ruling from the bench available here. For anyone who wants to know the latest iteration of law from the Delaware Court of Chancery on motions seeking to disqualify litigation counsel based on alleged conflicts of interest, this short ruling is required reading. In Delaware, such rulings from the bench can still be cited in briefs, by reference to the transcript.

We previously wrote about this high-stakes litigation concerning an unwelcomed takeover attempt and the ability of the target to "just say no". A sideshow of sorts has developed regarding the effort of the target to disqualify the distinguished counsel of the suitor, who is using the Cravath firm.

 Yesterday, Chancellor Chandler ruled from the bench that he would not disqualify the Cravath firm from serving as counsel for Air Products despite allegations by Airgas that Cravath had represented Airgas in related matters just before, allegedly, Cravath dropped Airgas in order to represent Air Products. Students of Delaware law in this area know that efforts to disqualify counsel in Delaware have not had a high success rate in the recent past. See, e.g., here (involving battle between Rohm and Haas v. Dow), here , here, here (despite possible violation of rule, no impact on the integrity of the legal proceeding), and here, for recent Delaware decisions in which the court has denied motions to disqualify counsel. For comparison purposes, see here  for a decision by a federal court in California based on different facts.

The denials of these motions should not be viewed as indicating that the Delaware courts do not take the rules of professional responsibility seriously. Rather, it should be seen as a manifestation of the concern that the courts have that litigators may try to use the Rules of Professional Conduct as a litigation tool. The argument is that transgressions of the ethics rules applicable to lawyers generally should be handled by the arm of the Supreme Court, which in Delaware is called Disciplinary Counsel, which is primarily responsible for the enforcement of those rules when alleged violations of those rules do not meet the high threshold of interfering with the administration of justice in a particular lawsuit.

Despite four separate ethics experts opining in this case, on behalf of each of the parties, on the requirements of Rules 1.7 and 1.9 of the Rules of Professional Conduct, the Court did not need to decide that issue.

Though the ruling from the bench is in the form of a transcript, which in Delaware can still be cited in briefs, it reads as if it is a carefully reasoned opinion (which it is). One should read the whole thing to appreciate it fully at the above link, but a few money quotes follow:

Before this Court may enter the Draconian order of disqualification, a moving party seeking that drastic relief must come forward with clear and convincing evidence establishing a violation of the Delaware Rules of Professional Conduct so extreme that it calls into question the fairness or the efficiency of the administration of justice. That is the holding of our Supreme Court in a case styled In Re: Dunlap.

...

Like Dow Chemical and the Rohm & Haas case, Airgas here has not demonstrated even simply persuasively, let alone clearly and convincingly, that it would be disadvantaged by the presence of its former counsel as advocate for its opponent, Air Products.

The Court found that Cravath did not have access to confidential information that it could use against Airgas in this case. Moreover, the Court observed that ethical walls had been established within the Cravath firm to separate those lawyers that had worked on the prior corporate matters from the lawyers working on the litigation. The Chancellor reasoned further that:

Given the absence of any credible threat of prejudice to Airgas from Cravath's continued participation in this lawsuit, I think the threat of harm to Air Products from disqualification far outweighs the threat of harm to Airgas from a failure to disqualify.

Postscript. The New York Times' DealBook blog wrote about yesterday's decision here.

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Posted on March 5, 2010 by Francis G.X. Pileggi

Delaware Supreme Court Asks New York Court of Appeals to Address Issue of New York Law; Re: Liability of PricewaterhouseCoopers

Teachers' Retirement System of Louisiana v. PricewaterhouseCoopers LLP,  No. 454, 2009 (Del. March 4, 2010), read opinion here.

In this short ruling, the Delaware Supreme Court used an procedure provided for under the New York Rules of Court  to certify a question of law to New York's highest court, the New York Court of Appeals. This approach was based on the following finding of Delaware's highest court:  "We have concluded that a resolution of this appeal depends on significant and unsettled questions of New York law that are properly answered, in the first instance, by the New York Court of Appeals."

This matter involves an appeal from the Delaware Court of Chancery regarding the oft-cited AIG case which denied a motion to dismiss claims against the top officials of AIG for breach of fiduciary duty based on Delaware law. However, the claims against the auditor, PwC, were dismissed based on New York law. Highlights of that AIG decision (of more than 100 pages), were provided on this blog here.  See American Int’l Group, Inc. v. Greenberg, 965 A.2d 763, 817-22, 826-27 (Del. Ch. 2009).

The Delaware Supreme Court certified the following question to the New York Court of Appeals:

Would the doctrine of in pari delicto bar a derivative claim under New York law where a corporation sues its outside auditor for professional malpractice or negligence based on the auditor’s failure to detect fraud committed by the corporation; and, the outside auditor did not knowingly participate in the
corporation’s fraud, but instead, failed to satisfy professional standards in its audits of the corporation’s financial statements?
  

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Posted on March 5, 2010 by Francis G.X. Pileggi

Court of Chancery Validates Adoption of Unique Poison Pill to Protect NOLs

On March 1, 2010, Vice Chancellor Noble issued a long-awaited post-trial decision on the validity of the implementation of a net operating loss carry forward (“NOLs”) rights plan. Selectica, Inc. v. Versata Enterprises, Inc., et al., C.A. No. 4241-VCN,  read opinion here

Kevin Brady, a highly regarded Delaware litigator, prepared this synosis.

In his 71-page opinion, Vice Chancellor Noble validated Selectica’s adoption of the NOL pill as a valid exercise of the Board’s business judgment under Unocal Corp. v. Mesa Petroleum Co., 493 A. 2d 946 (1985).

Background

Selectica provides enterprise software solutions for contract management and sales configuration systems. Trilogy, Inc. also specializes in enterprise software solutions. Versata Enterprises, Inc. a subsidiary of Trilogy, provides technology powered business services. All three are Delaware corporations. Selectica became a public company in 2003 and since that time it has failed to turn a profit. What it did generate, however, was an estimated $160 million of NOLs.

In 2008, Trilogy made three proposals to acquire Selectica; all were rejected. In October 2008, Trilogy began making open-market purchases of Selectica stock and on November 10, 2008 Trilogy informed Selectica that it had purchased more than 5% of Selectica’s outstanding stock. Within a week, Trilogy had increased it’s ownership to over 6%. On November 16, 2008, the Selectica Board met to discuss the Trilogy situation and to consider amending Selectica’s 2003 poison pill. The Board unanimously passed a resolution amending the poison pill decreasing the beneficial ownership from 15% to 4.99% “while grandfathering in existing 5% shareholders and permitting them to acquire up to an additional 0.5% (subject to the original 15% cap) without triggering the NOL pill.”

Trilogy continued making open-market purchases “buying through the NOL Pill” bringing its total ownership to 6.7%. Trilogy then proposed that Selectica agree to, among other things, buy Trilogy’s shares back, accelerate payment of its debt and pay Trilogy $5 million for settlement of outstanding issues. While the Selectica Board was considering Trilogy’s settlement offer, the Board asked Trilogy to agree to a standstill as to any additional open-market purchases by Trilogy while the Board used the ten-day clock under the NOL Pill to determine whether to consider Trilogy’s purchases as “exempt” under the rights plan, or else how Selectica would go about implementing the pill.” The NOL Pill permitted the Board to declare Trilogy an “Exempt Person” if the Board determined that Trilogy would not “jeopardize or endanger the availability to the Company of the NOLs . . . .” Another option for the Board included exchanging the rights (other than those held by Trilogy) for shares of common stock. If the Board took no action, then at the end of the ten day period, “the rights would ‘flip in’ automatically, becoming exercisable for $36 worth of newly-issued common stock at a price of $18 per right.”

Trilogy refused to enter into a standstill agreement and Selectica’s Board rejected Trilogy’s settlement offer. On December 31, 2008, the Board concluded that the NOL Pill should go into effect. On January 2, 2009, the Board delegated authority to the Independent Director Evaluation Committee (the “Committee”) “to effect an exchange of the rights under the NOL Pill and to declare a new dividend of rights under an amended rights plan (the “Reloaded NOL Pill”).”

Thereafter, the Committee determined that Trilogy should not be deemed an “Exempt Person”, and that its purchase of additional shares should not be deemed an “Exempt Transaction”, that the exchange of rights for common stock (the “Exchange”) should occur and that a new rights dividend on substantially similar terms ought to be adopted. The Committee passed resolutions adopting the Reloaded NOL Pill and instituting the Exchange, which doubled the number of shares of Selectica common stock owned by each shareholder of record, other than Trilogy and Versata. This reduced Trilogy and Versata’s beneficial holdings from 6.7% to 3.3%.

Selectica Seeks a Declaratory Judgment in the Court of Chancery

Selectica filed an action in the Court of Chancery seeking a declaratory judgment that the actions of the Board and the Committee in adopting the NOL Pill, authorizing the Exchange, adopting the Reloaded NOL Pill and issuing a new rights dividend were valid under Delaware law and were appropriate exercises of their fiduciary responsibilities under Unocal. In particular, Selectica argued that the Board acted reasonably “in concluding that the NOLs constituted a potentially valuable asset that was threatened by Trilogy’s actions, and that the adoption of the NOL Pill, implementation of the Exchange, and adoption of the Reloaded NOL Pill and declaration of a new rights dividend were not preclusive but were reasonable and proportionate responses to the identified threat.”

Trilogy counterclaimed seeking a declaratory judgment that the NOL Pill and Reloaded NOL Pill were invalid, void and unenforceable “either because (1) they are both anti-takeover devices that, either per se or on the facts of this case, preclude an effective proxy contest; or (2) they were not a reasonable and proportionate response to a reasonably perceived threat because the Board failed to establish that the NOLs had a value worth protecting and that this value was threatened by Trilogy’s purchases.” Trilogy challenged Selectica’s argument that the Unocal standard had been met by arguing that the Selectica directors “established neither that the NOLs had a value worth protecting, nor that this value was threatened by Trilogy’s purchases.” Trilogy also sought an order enjoining or rescinding the Exchange and requiring Selectica to redeem permanently the new rights dividends issued under the Reloaded NOL Pill as well as money damages for breaches of fiduciary duty. 

 Poison Pills and the Unocal Test

The issue before the Court was the reasonableness of the Board’s decision to adopt “a low-threshold poison pill in order to protect assets of speculative and questionable value absent an explicit plan for how such value might be realized.” The Court stated that under the Unocal test:

[t]here is an enhanced duty which calls for judicial examination at the threshold before the protections of the business judgment rule may be conferred. Such enhanced scrutiny operates to ‘ensure that a defensive measure to thwart or impede a takeover is indeed motivated by a good faith concern for the welfare of the corporation and its stockholders’ and that the board did not act ‘solely or primarily out of a desire to perpetuate themselves in office.’

Under the Unocal test, in order to be afforded the protection of the business judgment rule in this situation, the directors had to show that: (i) that they had reasonable grounds for believing (through good faith and reasonable investigation) that a danger to corporate policy and effectiveness existed; and (ii) the defensive measure was reasonable in relation to the threat posed and not coercive or preclusive.

First Prong of Unocal -- Preservation of NOLs as a Valid Corporate Objective

Under the first prong of Unocal, the Board had to show that it had reasonable grounds for concluding that a threat to a corporate objective existed. However, the Court first had to determine whether the preservation of NOLs was a valid corporate objective. The Court was quick to point out that an NOL Pill was not your typical poison pill designed to prevent hostile takeovers because the principal function of an NOL Pill was to prevent the inadvertent forfeiture of potentially valuable assets. Moreover, determining whether NOLs were valuable assets cannot be done in isolation because NOLs derive their value from future taxable income.

Thus, the Court stated that “[g]ranting judicial sanction to low-threshold poison pills employed for the purpose of protecting NOLs guarantees the somewhat unpalatable outcome of acquiescing to the expansion of the universe of reasonable takeover defenses in order to protect assets of questionable, even dubious, value.”

However, the Court went on to note that “as NOL value is inherently unknowable ex ante, a board may properly conclude that the company’s NOLs are worth protecting where it does so reasonable and in reliance on expert advice.” The Court found that there was ample evidence to suggest that the Board placed considerable reliance on advice of outside experts in making a determination as to the value of the NOLs and there was no evidence that the Board’s reliance on the expert advice was unreasonable. As a result, the Court concluded that “the protection of company NOLs may be an appropriate corporate policy meriting a defensive response when threatened. Indeed, the protection of corporate assets against an outside threat is arguably a more important concern of the Board than restricting who the owners of the Company might be.”

Trilogy argued that Selectica failed to satisfy the first prong because there was no expert advice as to the precise value of the NOLs to Selectica. The Court rejected that argument concluding that such evidence was not necessary because:

[i]n order to conclude that a serious threat existed, the Board needed only reasonably conclude that the NOLs were a legitimate asset worth protecting. The Board recognized that the NOLs were material relative to the then-market value of the Company, and that the NOLs, if preserved, had a long window during which they would be available for use. If perhaps somewhat optimistic, they had rational expectations for the Company’s near-term profitability.

In looking at the expert advice Selectica received, the Court concluded that “the Board was reasonable in concluding that Selectica’s NOLs were worth preserving and that Trilogy’s actions presented a serious threat to their impairment.”

Second Prong of Unocal – Reasonable Response to Perceived Threat

Under the second prong of Unocal, the Court was required to evaluate whether the board’s defensive response to the threat was preclusive or coercive and, if not, whether it was “reasonable in relation to the threat” identified. This requires an evaluation of: “(i) the importance of the corporate objective threatened; (ii) alternative methods for protecting that objective; and (iii) impacts of the ‘defensive’ action and other relevant factors.”

The Court stated that “[a] defensive measure is ‘coercive’” where it is “aimed at ‘cramming down’ on its shareholders a management-sponsored alternative” and a defensive measure is preclusive where it “operate[s] to unreasonably preclude a takeover” or “preclude[s] effective stockholder action” — specifically, where the measure “makes a bidder’s ability to wage a successful proxy contest and gain control either ‘mathematically impossible’ or ‘realistically unattainable.’”

Trilogy argued that not only is the NOL Pill more preclusive that prior pills evaluated by Delaware courts, a pill with such a low threshold in conjunction with a staggered board “renders the possibility of an effective proxy contest realistically unattainable.” In rejecting Trilogy’s argument, the Court stated that: “[t]o find a measure preclusive (and avoid the reasonableness inquiry altogether), the measure must render a successful proxy contest a near impossibility or else utterly moot, given the specific facts at hand.” The Court found that based upon the record, the NOL Pill and Reloaded NOL Pill were neither coercive or preclusive and thus do not meet that standard.

Having found that the defensive measure was neither coercive or preclusive, the Court turned to the proportionality test which “requires the focus of enhanced judicial scrutiny to shift to ‘the range of reasonableness.’” Trilogy argued that the Board failed to meet the standard because there was an inadequate assessment of the impact of the adoption of the NOL Pill and the Board failed to consider whether there were alternative more narrowly-tailored methods for protecting the NOLs. The Court, however, rejected Trilogy’s argument, finding the there was sufficient evidence that the Board met its obligations to evaluate the reasonableness of its response relative to the threat, stating that, “Unocal and its progeny require that the defensive response employed be a proportionate response, not the most narrowly or precisely tailored one.”

Postscript: The Harvard Law School Corporate Governance Forum provides commentary on the case here. Professor Steven Davidoff, writing as The Deal Professor, provides his insights and analysis about the case here. Professor Bainbridge provides insightful case analysis here.

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