On Monday, in Versata Enterprises, Inc. and Trilogy, Inc. v. Selectica, Inc., the Delaware Supreme Court addressed for the first time the validity of a net operating loss shareholder rights plan (“NOL poison pill”) and affirmed the Delaware Court of Chancery’s ruling upholding the adoption of an NOL poison pill, rejecting the application of the business judgment rule but nevertheless setting a high bar for shareholders seeking to challenge the adoption and implementation of such pills as a breach of fiduciary duty. (Haynes and Boone, LLP acted as counsel for defendants/appellants in this matter).
Background. Three days after Trilogy, Inc. announced that it had become a 5% owner of Selectica (an enterprise software company with whom Trilogy had a contentious history), Selectica’s board of directors amended its poison pill, lowering a pre-existing cap on shareholding from 15% to 4.99%, and setting a further cap of .5% on additional purchases by existing shareholders above 5%. The ostensible purpose of this amendment was the protection of Selectica’s NOLs. Section 382 of the Internal Revenue Code limits (but does not eliminate) the yearly use of NOLs where there has been a statutorily defined “ownership change,” i.e., a fifty percent change in the ownership by stockholders holding 5% or more of the company’s equity over a three-year period.
After Selectica amended its pill, Trilogy made further Selectica stock purchases beyond the limits set by the amendment. Selectica implemented the pill in response, issuing additional stock to all shareholders except Trilogy, thereby diluting its position by roughly half. Selectica also filed a suit for declaratory judgment in the Delaware Chancery Court suit against Trilogy and Versata, Inc. (a subsidiary of Trilogy), asking the court to uphold the 4.99% pill and its implementation. Trilogy filed counterclaims seeking to invalidate the pill and to restore Trilogy to its pre-dilution ownership holdings. After a one-week trial, the Chancery Court, applying Unocal (a heightened standard of review which has been applied to the adoption of traditional anti-takeover poison pills) upheld Selectica’s NOL poison pill as a valid exercise of director authority.
On appeal, Trilogy raised two points of error. First, Trilogy asserted that the trial court erred in concluding that Selectica’s directors had conducted a reasonable investigation as required by Unocal concerning the need to protect the NOLs, particularly where Selectica had never had net taxable income in its history and the directors received no information regarding what amount of the NOL would be limited in the event of the “ownership change” they purportedly sought to avoid. Second, Trilogy asserted that the trial court erred in concluding that the 4.99% NOL pill in combination with Selectica’s charter-based staggered board terms did not render a proxy contest for change of control “realistically unattainable” under Unocal’s “preclusiveness” test for defensive devices.
Unocal Applies. Although Selectica belatedly sought to challenge the application of Unocal, the Delaware Supreme Court confirmed that this standard of review applies to the adoption of an NOL poison pill because such pills operate as anti-takeover devices even if put in place for reasons other than fending off a hostile acquisition attempt.
Reasonable Director Investigation. The Delaware Supreme Court held that the Chancery Court’s finding that Selectica’s directors had reasonably identified a threat to its NOLs was not clearly erroneous. The Court noted that Selectica funded NOL studies a few times in the two years before adopting the NOL poison pill (although the Court recognized that this work was instigated by Selectica’s largest shareholder, not the board itself). The court also noted that the board meeting where the NOL poison pill was adopted was attended by outside advisors who told the board that NOLs were an asset worth protecting. Although Trilogy argued that identifying a threat to NOLs entails considering how much of the NOLs would be limited in the event of an “ownership change” under § 382 of the Internal Revenue Code, the Supreme Court did not address this issue, implying that boards need not even consider the measurable impact of a § 382 ownership change to identify the existence of a “threat.” The Court also highlighted Selectica’s proximity to an ownership change at 40% (leaving a 10% cushion before hitting the statutory 50% “ownership change” threshold), but acknowledged that Selectica had been at the 40% level for months.
Selectica had never reported a profit in its ten-year history (and thus never needed NOLs), had experienced “ownership changes” in the past without taking action, and its directors never considered the likely future utility of the NOLs or how much might be lost in the event of an “ownership change”. In fact, Selectica had consistently taken a full valuation allowance for its NOLs (which under GAAP means the company determined it was more likely than not it would never use even $1 of the NOLs). The Court’s holding that the directors nevertheless had satisfied Unocal’s “reasonable investigation” requirement indicates that it will be very difficult for shareholders to challenge the adoption of an NOL poison pill on this basis. If a company has large NOLs, is relatively close to an ownership change under § 382, and hears from experts opining that NOLs have potential unspecified value, the NOL pill will likely be impervious to attack under the reasonable investigation prong of Unocal.
No Preclusive Effect on Proxy Contests for Control. The Delaware Supreme Court also held that the record supported the Chancery Court’s conclusion that Selectica’s NOL poison pill did not make a successful proxy contest for control “realistically unattainable” under the Court’s prior decision in Unitrin. Trilogy had argued that, due to Selectica’s charter-based staggered board, an insurgent would need to successfully launch two separate proxy contests in succession before gaining control of the board – a relatively expensive endeavor for a stockholder of a micro-cap company held to holdings below 5%. In addition, no party was able to identify any instance in corporate history in which a holder of less than 5% of a company’s stock was able to gain control of a board through successive proxy contests. The Court, however, indicated that the “realistically attainable” analysis need not take into account the effect of a staggered board on a proxy contest. Thus, the “realistically unattainable” test is not tied to ultimate change of control, but rather to the possibility of winning a single proxy contest (regardless of whether board control will actually change). The Court cited data suggesting that holders of less than 5% do at times win proxy contests for a board seat (or a few board seats) where the company has a staggered board (though it cited no data showing that holders under 5% eventually gained control through successive contests). The Court also was persuaded that Selectica’s concentrated shareholder base meant that a shareholder insurgent would not need to incur all of the normal costs of a proxy contest if the insurgent were able to persuade some of the largest shareholders of the superiority of the proposed slate of directors.
Case-by-Case Analysis. The Court found that Trilogy increased its holdings “not for the purpose of conducting a hostile takeover” but to achieve other business objectives. The Court cautioned that “[t]he fact that the NOL Poison Pill was reasonable under the specific facts and circumstances of this case should not be construed as generally approving the reasonableness of a 4.99% trigger in the Rights Plan of a corporation with or without NOLs.”