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).
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.