On February 26, 2010, the Delaware Court of Chancery, in an opinion addressing the first modern triggering of a shareholdder rights plan, upheld (1) the validity of a “NOL” shareholder rights plan that contained a 4.99% “flip-in” triggering threshold, (2) the directors’ decision to lower the triggering threshold in light of recent acquisitions, and (3) the board’s subsequent decision to dilute an acquiring person who deliberately crossed the pill’s threshold.
Traditionally, shareholder rights plans are adopted to provide a company leverage to defend itself against a coercive and/or inadequate hostile takeover offer. Therefore, most rights plans have a 15% - 20% triggering threshold, similar to the 15% ownership threshold utilized in Delaware General Corporation Law Section 203. Recently, however, a number of companies have adopted “NOL pills,” which are intended not to protect the company from an unsolicited takeover or change of control, but rather to protect a valuable corporate asset – its net operating loss (NOL) carryforwards – which could be jeopardized if there is an ownership change under Section 382 of the Internal Revenue Code. Under Section 382, an ownership change is generally defined as a change in ownership of more than 50% of the company’s shares, counting only shareholders holding 5% or greater positions. Consequently, NOL pills typically have triggering thresholds of just under 5%.
The case arose from a decision made by the Board of Directors of Selectica Inc. when they were advised that a third party had filed a Schedule 13D disclosing a 5.1% ownership position in the company. The board, after reviewing the potential impact of further share accumulations on its NOLs, voted to amend its shareholder rights plan to reduce the triggering threshold from 15% to 4.99%; holders who already held more than 4.99% were exempted, so long as they didn’t thereafter acquire an additional .5%. The third party subsequently acquired additional shares, surpassing the additional .5% threshold.
Traditionally, when a potential acquirer crosses a rights plan threshold, a target’s board will exempt the acquiring person from the rights plan so long as no additional shares are purchased, thereby affording the parties an opportunity to negotiate a peaceful resolution. However, in this case after the acquiror rebuffed Selectica’s approaches, the Selectica board elected to exercise the pill’s “exchange” feature, in which each outstanding right (other than rights held by acquiror) would not become exercisable by the holder, but would instead be exchanged for one new share of Selectica common stock. This exchange resulted in the issuance of shares to all holders other than the potential acquiror and thereby caused the potential acquiror’s ownership percentage to be diluted from 6.7% to 3.3%. At the same time, Selectica declared a new rights dividend (with the same 4.99% threshold, exempting holders with a greater ownership position so long as they don’t acquire an additional .5%), essentially “reloading” the original rights plan.
In upholding the actions of the Seletica board, the Delaware Chancery Court employed a very straightforward Unocal analysis. The Court found that the NOLs were a valuable corporate asset and, therefore, an “ownership change,” which might jeopardize their value, constituted a valid threat to corporate policy and effectiveness. On this point, the Court concluded that even though the value of NOLs is inherently incapable of being determined, and might ultimately be zero if a company fails to realize future profits, the board may nevertheless determine they are worth protecting where it does so reasonably and in reliance on expert advice. Indeed, the Court notes that “the protection of corporate assets . . . is arguably a more important concern of the Board than restricting who the owners of the Company might be.”
The Court then moved to the second prong of the Unocal test – whether the Selectica board’s actions were a reasonable response to the threat of impairing the company’s NOLs. On this point, the Court stated that a defensive measure is disproportionate and therefore unreasonable if it is draconian, being either coercive or preclusive. The Court confirmed that the rights plan with a 4.9% trigger was not preclusive as it does not strip stockholders of the right to receive tenders, does not provide an impenetrable barrier to control acquisitions, nor does it restrict proxy contests. The Court explained that “[t]o find a measure preclusive..., the measure must render a successful proxy contest a near impossibility or else utterly moot....”
Finally, the Court addressed the reasonableness of the actions taken by the board. On this point, the Court found that the use of the rights plan fell within Unocal’s “range of reasonableness.” The Court noted that the 4.99% trigger was a response to the 5% standard imposed by the Internal Revenue Code, and not arbitrarily chosen by Selectica. The Court also stated that the use of the exchange feature was, in fact, less onerous on the potential acquiror than the dilution that would have occurred under the rights plan’s flip-in mechanism. In this regard, the Court noted that the potential acquiror repeatedly refused to enter into a standstill in exchange for an “Exempt Person” determination, which would have avoided the pill being triggered. In rejecting the acquiring person’s argument that a more narrowly tailored response was possible, the court stated, “once a siege has begun, the board is not constrained to repel the threat to just beyond the castle walls.” It concluded that “[w]ithin this context, it is not for the Court to second-guess the board’s efforts to protect Selectica’s NOLs.” Further, the Court found that the board conducted its decision-making process in good faith and with reasonable investigation (having met seven times to discuss the appropriate defensive response), and that it discharged its fiduciary duty of due care, in part by relying reasonably on expert opinions in analyzing the potential value of its NOLs.
Selectica, Inc. v. Versata, Inc., C.A. No. 4241-VCN (Feb. 26, 2010).