Delaware Court of Chancery Validates Use of a Net Operating Loss Poison Pill

March 3, 2010

On February 26, 2010, the Court of Chancery of the State of Delaware issued an important opinion validating the use of a net operating loss (NOL) shareholder rights plan or poison pill.[1]  The case, Selectica, Inc. v. Versata, Inc.,[2] arose out of the intentional triggering of Selectica’s NOL rights plan in December 2008 by its competitor Trilogy and Trilogy’s subsidiary, Versata Enterprises.  The decision provides boards of directors of Delaware corporations with guidance as to the steps they should take in adopting and implementing an NOL rights plan.  It also reflects Delaware courts’ continuing deference to well-informed boards that run a methodical and well-reasoned process, even in the face of the so-called Unocal enhanced standard of review.

Background

Trilogy and Selectica had a tumultuous relationship in the five-year period leading to the December 2008 triggering of Selectica’s rights plan.  Among other things, Trilogy or its affiliates brought two patent infringement lawsuits against Selectica and made a number of unsolicited bids to acquire control of Selectica.  Around the time of Selectica’s rejection of Trilogy’s most recent takeover overture in October 2008, Trilogy began accumulating Selectica common stock and by November 10 had purchased more than 5% of Selectica’s outstanding shares.

In light of its history with Trilogy and the threat that Trilogy’s stock accumulation presented to the preservation of Selectica’s substantial NOLs, the Selectica board decided to amend its long-standing rights plan to reduce its trigger threshold from 15% to 4.99%.  The amended rights plan also contained a grandfathering clause stating that beneficial owners who held in excess of the newly lowered 4.99% threshold at the time of the amendment would not trigger the rights plan, but further provided that such holders may suffer the dilutive consequences of the rights plan if they increased their holdings by 0.5% of the outstanding common stock.  In addition, the amendment gave the board sole discretion to exempt an acquirer under the rights plan during the ten-day period following the triggering of the rights plan if the board determined that such ownership "will not … jeopardize or endanger the availability to the Company of the NOLs."

After the amendment to the rights plan, Trilogy purchased shares increasing Versata’s and its joint beneficial ownership from 6.1% to 6.7% of Selectica’s outstanding shares in an apparent effort to trigger the rights plan intentionally.  Thereafter, Selectica and its advisors engaged in various efforts to reach a settlement with Trilogy during the ten-day period that the board had to exempt Trilogy under the terms of the rights plan.  Unable to reach such settlement, Selectica activated the rights plan, exchanging each outstanding right held by shareholders other than Trilogy and Versata for one share of common stock, as permitted by the terms of the rights plan (in lieu of allowing a more dilutive flip-in of the rights).  Because of the rights exchange, the joint beneficial ownership of Versata and Trilogy was diluted from 6.7% to approximately 3.3%.  To deter further acquisitions, Selectica "reloaded" its rights plan by amending and restating its rights plan on substantially similar terms. 

Selectica filed suit, seeking a declaratory judgment with respect to the validity of: (1) the implementation of its NOL rights plan, (2) certain actions taken by Selectica’s board in response to the triggering, and (3) the reloading of the rights plan.  Trilogy and Versata counterclaimed, seeking: (a) to have the rights plan and other actions by Selectica’s board declared invalid, and (b) damages for alleged breaches of fiduciary duty.

Decision

The Court conducted a review of the Selectica board’s actions under the enhanced Unocal standard of review, which we recently explored in our January 2010 client alert "Poison Pills Revisited."  To pass the Unocal test, and fall within the deferential protection of the business judgment rule, a board must show that, in adopting a defensive measure such as a rights plan, (1) there were reasonable grounds to believe that a danger to corporate policy and effectiveness existed and (2) the adoption of the defensive measure was neither preclusive nor coercive, and was otherwise reasonable in relation to the threat identified.

In deciding the Selectica case, the Court first found that the board had reasonable grounds for concluding that a threat to a valid corporate asset existed.  In this regard, the Court noted that, although the value of an NOL is, ex ante, inherently unknowable, a board might properly conclude that a company’s NOLs are worth protecting where it does so reasonably and in reliance upon expert advice. 

Turning to the second prong of the Unocal analysis, the Court first noted that, although the NOL rights plan had a substantial preclusive effect, the Court could not conclude that the NOL rights plan, rights exchange and reloaded rights plan were in fact preclusive.  The Court’s analysis was based in part on evidence that a rights plan with a low 4.99% trigger would not render a successful proxy contest "a near impossibility or else utterly moot."  The Court went on to conclude that there was sufficient evidence that the Selectica board had met its obligation to evaluate the reasonableness of its response relative to the danger it faced, such that the board had satisfied its Unocal burden.

Significance

On one level, the Selectica decision validates the notion that Delaware courts will uphold NOL right plans, when properly implemented.  More generally, the Selectica decision reaffirms the broad deference Delaware courts give to decisions made by well-informed boards that create an appropriate record of their deliberations and receive and consider the advice of qualified experts.  Moreover, the decision provides additional points of significant interest:

• Importance of Creating the Right Record of Deliberations:  The Selectica board met seven times in the two-week period leading up to the triggering of the rights plan.  These meetings, in part, created a record that was replete with evidence indicating that the board had ample reason to conclude, and did conclude, that Selectica’s NOLs were an asset worth protecting and, thus, that their preservation was an important corporate objective.  The Court repeatedly cited, and appeared to credit, this record.
• Reliance on Experts:  The board solicited and received expert advice on numerous occasions–from both investment banking and accounting professionals–that supported the board’s ultimate findings that: (1) the NOLs were a company asset worth protecting, (2) the NOLs were at risk as a result of Trilogy’s actions, and (3) the steps that the board ultimately took were reasonable in relation to that threat.  The Court specifically noted that, under Section 141(e) of the Delaware General Corporation Law, where a board has relied on an expert’s advice in making a decision, a due care claim challenging that decision must establish such facts as would make reliance on the expert opinion unreasonable.
• Importance of Independent Directors:  The Court noted that proof of a board’s good faith and reasonable investigation is "materially enhanced" under Unocal where the defensive actions were taken by a majority of outside independent directors.  Although the Court did not conclude as a matter of law that a majority of the Selectica directors were "outside directors," the Court went to great lengths to analyze the independence of the Selectica directors and concluded that "any concern that the Board’s actions stem from a desire for entrenchment [was] seemingly groundless."
• Broad Definition of Threat:  The Court noted that, "the board needed only [to] reasonably conclude that the NOLs were a legitimate asset worth protecting," in order to conclude that a threat existed under the first prong of Unocal.  The Court further noted, "NOLs, by their very nature, have the potential of ultimately providing zero value to the company," and that such assets are "of questionable, even dubious, value."  In spite of these findings and the board’s "somewhat optimistic" expectations, the Court determined that the Selectica board had rationally concluded that its NOLs were an asset worthy of protection.
• Importance of Timing of Implementation:  Any Delaware company with significant NOLs should strongly consider implementing an NOL rights plan before there is even a hint of an acquirer on the scene, in order to avoid the appearance that the rights plan is an entrenchment device.

This decision provides a process roadmap for boards of directors facing an unsolicited offer, and should provide increased comfort to directors when taking appropriate defensive measures.  However, the Court noted that the threat faced here–the loss of NOLs–was qualitatively different from the normal corporate control dispute that leads to the adoption or maintenance of a rights plan.  Thus, the parties to more customary corporate control contests will battle over the exact contours of the Selectica decision.