The Delaware Court of Chancery Upholds Adoption and Use of NOL Pill as Proper Exercise of Directors’ Business Judgment Under Unocal
March 1, 2010
In Moran v. Household Int’l, the Delaware Supreme Court approved the adoption of the first stockholder rights plan but cautioned that the use of such plans would be subject to careful scrutiny under Unocal. A quarter century later, on February 26, 2010, the Delaware Court of Chancery issued an opinion sustaining under the Unocal standard a board’s decision to adopt, and then a special committee’s decision to use, a poison pill rights plan with a 4.99% flip-in trigger, designed to protect the usability of the corporation’s net operating losses (“NOLs”). In its post-trial opinion in Selectica, Inc. v. Versata, Inc., C.A. No. 4241-VCN (Feb. 26, 2010), the first court review of the use of an NOL pill, the Delaware Court of Chancery held that the board of directors had valid reasons to believe that the triggering stockholder’s acquisitions posed a threat to the usability of the corporation’s NOLs under Section 382 of the Internal Revenue Code, that protection of the NOLs was a valid corporate objective, that the NOL pill was not an unlawfully preclusive defensive measure (either per se or as applied) and that the decisions to exchange the rights for newly-issued shares and to issue a new rights dividend (thereby “reloading” the pill) were proportionate and entitled to deference under the business judgment rule.
Selectica is a microcap enterprise software company that accumulated substantial NOLs over the years. At the end of July 2008, Versata, a competitor whose relationship with Selectica the Court characterized as “complicated and often adversarial,” made a proposal to acquire some or all of Selectica’s business. The board rejected Versata’s proposal, and a second proposal in early October. In October 2008, Versata began buying Selectica stock, and on November 10, Versata’s CFO called Selectica’s co-chairman to advise that Versata had acquired over 5% of Selectica’s outstanding stock, and would shortly file a Schedule 13D.
On November 16, 2008, the Selectica board met and, after hearing presentations from the company’s Delaware counsel, its investment banker, its CFO and the accountant retained to analyze the NOLs, amended the company’s existing stockholder rights plan (which had a 15% flip-in trigger) by lowering the trigger to 4.99%, while grandfathering in existing 5%-or-greater stockholders and permitting them to acquire up to an additional 0.5% without triggering the pill. After Selectica announced the NOL pill, Versata ceased buying, but demanded a meeting with Selectica management to discuss an asserted breach of the terms of an intellectual property licensing agreement.
After the requested meeting was held, Versata bought a sufficient number of shares to exceed the 0.5% “cushion” and become an “Acquiring Person” under the rights plan. Under the NOL pill, the rights would flip in ten business days after Versata became an Acquiring Person, unless the board either granted Versata an exemption or exchanged the rights for common stock. The pill conditioned the board’s ability to grant “Exempt Person” status on a finding that the person’s ownership of more than 4.99% of the common stock would not jeopardize or endanger the availability to the corporation of the NOLs. The board met seven times between December 19, 2008 and January 2, 2009, and received updated presentations from its investment banker, the accountant retained to evaluate the NOLs and Delaware counsel. Three times during this period, Selectica offered Versata an exemption in exchange for a standstill, and three times Versata declined.
On January 2, 2009, a committee of two directors, after consultation with the board’s legal and financial advisors, decided that Versata could not be granted an exemption. The committee decided, rather than allow a flip-in, to exchange the rights (other than those belonging to Versata and its affiliates) for new common stock, thereby reducing Versata’s proportionate interest in the company by approximately half. The committee also recommended (and the board subsequently approved and declared) a dividend of new rights, thereby keeping a pill with a 4.99% trigger in place.
Selectica sued Versata in the Delaware Court of Chancery, seeking declaratory judgment upholding the board’s and the committee’s actions. Versata counterclaimed, seeking invalidation of those actions on legal and equitable grounds, including on the grounds that a 4.99% trigger was per se invalid.
In its decision after trial, the Court evaluated the board’s and the committee’s actions under the standard set forth in Unocal Corp. v. Mesa Petroleum Co. The Court first held that, because the value of NOLs is “inherently unknowable ex ante, a board may properly conclude that the company’s NOLs are worth protecting where it does so reasonably and in reliance upon expert advice.” The Court therefore concluded that protection of NOLs “may be an appropriate corporate policy meriting a defensive response when threatened.” Noting that the board and the committee had received advice from advisors with substantial experience in valuing NOLs, the Court held that the board and the committee were “reasonable in concluding that Selectica’s NOLs were worth preserving and that [Versata’s] actions presented a serious threat to their impairment.” Accordingly, the Court determined that the directors had acted reasonably in identifying a threat to corporate policy and effectiveness.
The Court next considered whether the directors’ response was reasonable. The Court rejected Versata’s argument that a 4.99% pill was preclusive, writing that the applicable standard “operates to exclude only the most egregious defensive responses…. To find a measure preclusive … the measure must render a successful proxy contest a near impossibility or else utterly moot, given the specific facts at hand.” Relying in part on expert evidence provided by a proxy solicitor concerning the concentration in Selectica’s stockholder base, the Court determined that the NOL pill did not meet this standard.
The Court also held that the board’s and the committee’s actions fell within a range of reasonableness. In making this finding, the Court relied on extensive testimony about the board’s deliberative process, on evidence that Versata, “a longtime competitor sought…intentionally to impair corporate assets, or else to coerce the Company into meeting certain business demands” and on Versata’s failure “to suggest any meaningfully different approach that the Board could have taken in November and December 2008 to avoid the seemingly imminent impairment of Selectica’s NOLs” by Versata. The Court reemphasized that the Unocal test provides the directors with substantial latitude in fashioning an appropriate response, writing that, “once a siege has begun, the board is not constrained to repel the threat to just beyond the castle walls.”
The Court concluded by warning that its holding was fact-specific and dependent upon a record developed during a weeklong trial. The Court recognized the risk that NOLs could “provide a convenient pretext for perpetuating a board-preferred shareholder structure. For this reason, shareholder rights plans, such as the ones adopted by Selectica, must be subject to careful review.” However, the Court concluded that the board “reasonably believed, based on the guidance of appropriate experts, that the NOLs had value, a value worth protecting…. It is not for the Court … to substitute its judgment for the reasonable conclusions of the Board, protected as they are by 8 Del. C. § 141(e).” Accordingly, the Court concluded, the board’s and the committee’s actions — adoption of the NOL pill, the exchange of the rights for common stock, and the renewing of the rights plan — “were valid exercises of the Board’s business judgment.”
The Court’s thorough opinion provides extensive analysis of the careful process followed by the Selectica directors and underlines the importance of using expert advisors where a board is faced with new and challenging decisions.