In two recent decisions, the Court of Chancery and then the Delaware Supreme Court approved the use of a poison pill with a 4.99% trigger. Versata Enterprises, Inc., et al. v. Selectica, Inc., No. 193, 2010 (Del. Oct. 4, 2010); Selectica, Inc. v. Versata Enterprises, Inc., et al., C.A. No. 4241-VCN, (Del. Ch. Feb. 26, 2010). Under the standard set forth in Unocal Corp. v. Mesa Petroleum Co., 493 A. 2d 946 (1985), the exercising of the poison pill was determined to be a proper exercise of business judgment.
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 its 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,’ that its purchase of additional shares should not be deemed an ‘Exempt Transaction, that an 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.
On March 1, 2010, Vice Chancellor Noble issued a post-trial decision on the validity of the implementation of a net operating loss carry forwards (“NOLs”) rights plan. Selectica, Inc. v. Versata Enterprises, Inc., et al, C.A. No. 4241-VCN. 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).
Trilogy and Versata Appeal to Delaware Supreme Court
On appeal, Trilogy and Versata claimed the Court of Chancery erred in applying the Unocal test of enhanced judicial scrutiny. Instead of applying Unocal, Trilogy and Versata claimed that the correct question before the Court was one of first impression: “what are the minimum requirements for a reasonable investigation before the board of a never-profitable company may adopt a [Rights Plan with a 4.99% trigger] for the ostensible purpose of protecting NOLs from an ‘ownership change’ under Section 382 of the Internal Revenue Code?” Second, Trilogy and Versata argued that the Court of Chancery “erred in holding that the two NOL poison pills, either individually or in combination with a charter-based classified Board, did not have a preclusive effect on the shareholders’ ability to pursue a successful proxy contest for control of the Company’s board.” The Delaware Supreme Court dismissed both of Trilogy and Versata’s arguments.
Court Affirms Application of Unocal Standard
The Supreme Court agreed with the Court of Chancery’s decision that “the protection of company NOLs may be an appropriate corporate policy that merits a defensive response when they are threatened.” Even though a NOL poison pill is primarily designed to prevent the forfeiture of potentially valuable assets, it also has the effect of acting as an anti-takeover device. Thus, the Unocal test of enhanced judicial scrutiny was the appropriate test.
Threat Reasonably Identified
In considering the first prong of the Unocal standard, the Supreme Court noted that the Selectica Board had concluded that NOLs were important to protect, that the appellants’ actions posed a threat to the corporate enterprise, that their protection was an important corporate objective and that the board properly conducted an investigation. The Supreme Court agreed that the record was “replete with evidence” that the Board acted reasonably. The Board had met for a number of hours, with legal and investment banking experts in attendance to educate the Board. In addition, the Supreme Court pointed to: 1) Trilogy’s status as “a competitor with a contentious history;” 2) the potential harm to Selectica if the requisite amount of shares were purchased; and 3) the fact that the threshold for the pill was driven by Section 382 of the IRC – “an external standard, one created neither by the Board nor by the Court [of Chancery].” Accordingly, the Supreme Court determined that the Court of Chancery’s findings were not clearly erroneous.
Selectica Defenses Not Preclusive
In considering the second prong of the Unocal standard, the Court, citing Unitrin, Inc. v. American General Corp., 651 A. 2d 1361, 1383, 1387 (Del. 1995), held that the Selectica Board’s response was not preclusive or coercive. A board’s defensive measure is preclusive when it “makes a bidder’s ability to wage a successful proxy contest and gain control either ‘mathematically impossible’ or ‘realistically unattainable.’” Similarly, a measure is coercive when it “is aimed at ‘cramming down’ on its shareholders a management-sponsored alternative.” Trilogy asserted that the Rights Plan rendered a potential proxy contest “realistically unattainable.”
Here, the record supported the Court of Chancery’s conclusion that that the NOL Poison Pill and Reloaded NOL Poison Pill were not preclusive. Trilogy’s argument that “the 4.99% pill trigger prevents a potential dissident from signaling its financial commitment to the company so as to establish . . . credibility” was to no avail. Rather, the Supreme Court held that the 5% trigger for a NOL poison pill is necessarily lower than the triggers for rights plans that have traditionally been adopted and upheld as acceptable anti-takeover defenses by the courts because of the objective to protect NOLs. Selctica’s expert corroborated this conclusion – identifying more than fifty publicly held companies with NOL poison pills with similar triggers. Another Selectica expert testified that in 10 of 15 proxy solicitations where a challenger controlled approximately 5% of the shares in micro-cap companies the challenger was able to get a seat on the board.
The Supreme Court also rejected an argument from Trilogy that preclusivity exists unless a successful proxy contest is both reasonably attainable and will result in gaining control of the board. The Supreme Court disagreed: “[t]he fact that a combination of defensive measures makes it more difficult for an acquirer to obtain control of a board does not make such measures realistically unattainable, i.e., preclusive.”
Range of Reasonableness
The Supreme Court also affirmed the Court of Chancery’s holding that all of the Board’s defenses, taken as a whole, were reasonable in relation to the perceived threat. In particular, the Supreme Court noted that the Selectica Board on three separate occasions attempted to negotiate and reach a settlement with Trilogy. On each occasion, Trilogy rebuked the offers leaving the Selecta Board with no choice but to implement the NOL Poison Pill.
Likewise, the implementation of the Reloaded NOL Poison Pill was also reasonable. When implemented, Selectica still faced a potential ownership change under Section 382. Plus, the Rights Plan was no longer in place to deter acquisitions. Given the value with which Selectica viewed the NOLs, its defenses were reasonable.
Context Determines Reasonableness
While the Supreme Court held that the Selectica Board carried its burden under Unocal, that does not mean the poison pills will always satisfy Unocal. As the Court noted, “we have upheld the adoption of Rights Plans in specific defensive circumstances while simultaneously holding that it may be inappropriate for a Rights Plan to remain in place when those specific circumstances change dramatically.” The Supreme Court made clear that it was not generally approving a 4.99% trigger in the rights’ plan of a corporation with or without NOLs. Rather, reasonableness is dependent on the particular circumstances. “If and when the Selectica Board ‘is faced with a tender offer and a request to redeem the [Reloaded NOL Poison Pill], they will not be able to arbitrarily reject the offer. They will be held to the same fiduciary standards any other board of directors would be held to in deciding to adopt a defensive mechanism.’”
This summary was prepared by Kevin F. Brady and Ryan P. Newell.