Much discussion in the corporate blawgosphere of Selectica, Inc. v. Versata Enterprises, Inc. VC Noble's opinion for the Delaware Chancery Court involved what Steven Davidoff calls "frankly odd" facts:
They arose out of Versata’s acquisition of 5.2 percent of Selectica and Versata’s accompanying offer to acquire Selectica. (Both companies produce business software.) In response, Selectica adopted a low-threshold, net-operating-loss poison pill that would be triggered when someone acquired 4.99 percent of its stock, rather than the more typical 15 percent trigger. Versata was exempted from this threshold to the extent that it did not subsequently acquire Selectica shares.
The net operating loss poison pill is a new development. The lower triggering threshold is adopted to conform with Section 382 of the Internal Revenue Code and protect the company’s net operating losses, which can be used to lower future taxes to the extent a company accrues profits. According to Factset Sharkrepellent, 41 companies including Citigroup and Pulte Homes adopted these types of pills last year. Selectica itself is a microcap survivor of the dot.com bubble with $160 million of net operating losses, a market capitalization of about $11 million, little revenue and no profits. It is uncertain whether Selectica will ever return to profitability in order to use these net operating losses, or N.O.L.s, as the court refers to them.
A post by Kevin Brady reviews the facts in much greater detail and also provides a through review of the legal analysis.
How does the NOL pill work? A Wachtell Lipton client memo explains that:
Although Selectica never achieved an operating profit, it had generated NOLs of approximately $160 million. These NOLs could have substantial value in the event the company becomes profitable or merges with a profitable company, but under IRC § 382 they can be adversely affected if the company experiences an “ownership change” of over 50% during a three-year period (measured by reference to holders of 5% or larger blocks). ...
During 2008, the Selectica board considered and rejected several asset purchase and takeover proposals from Trilogy, a long-time corporate rival. After Trilogy then purchased some 6% of Selectica’s shares, Selectica reviewed its NOL status and learned that additional acquisitions of roughly 10% of the float by new and existing 5% holders would significantly impair the NOLs. The Selectica board responded by amending the company’s rights plan to lower the trigger from 15% to 4.99% (with a grandfather clause allowing preexisting 5% holders to purchase another 0.5%). The board also created an “Independent Director Evaluation Committee” to periodically review the new NOL plan and its trigger level. Shortly thereafter, Trilogy purposely bought through the NOL pill’s limit, with the stated rationale of bringing “accountability” to the Selectica board and “expos[ing]” its “illegal behavior” in adopting the lowtrigger NOL plan. After Trilogy repeatedly refused to enter into a standstill agreement to allow the board more time to review the matter, the Selectica board determined to allow the pill’s exchange feature to trigger, doubling the number of outstanding shares held by holders other than Trilogy and diluting Trilogy from 6.7% to 3.3%.
Davidoff found the opinion uninspiring:
Given the long delay in its issuance, what is surprising about this opinion is how matter of fact Delaware Chancery Court treats this extraordinary event. The court could have dug deep into the jurisprudence of the pill and the recent comments by Vice Chancellor Leo E. Strine Jr. and others about its applicability, but instead it simply performs a straight-forward analysis of this pill trigger under the Unocal standard. Unocal requires that a board adopting defensive measures show that it had reasonable grounds for concluding that a threat to a corporate objective existed and that its response be neither preclusive or coercive and reasonable in relation to the threat posed.
The court begins its analysis by concluding that a N.O.L. poison pill can be adopted and that “the protection of company N.O.L.s may be an appropriate corporate policy meriting a defensive response when threatened.” In the particular case of Selectica, the N.O.L. pill adoption and trigger was appropriate because the board had ample reason to conclude that the net operating losses were worth protecting and in doing so relied in good faith upon advice of outside experts.
The court stated that “[t]he Board recognized that the N.O.L.s were material relative to the then-market value of the company, and that the N.O.L.s, if preserved, had a long window during which they would be available for use. If perhaps somewhat optimistic, they had rational expectations for the company’s near-term profitability.” The court concluded that since the value of the net operating losses is “inherently unknowable ex ante, a board may properly conclude that the company’s net operating losses are worth protecting where it does so reasonably and in reliance upon expert advice.”
The Wachtell client memo analyzed the opinion as follows:
Vice Chancellor Noble further found that the pill’s dilutive effect is not impermissibly “preclusive” under Unocal, and that even a combination of defenses that makes control acquisitions more difficult passes muster provided the defensive measures are not “insurmountable.” Harking back to Moran v. Household, the Court noted that a rights plan may permissibly discourage proxy fights so long as it does not limit the voting power of individual shares or preclude successful proxy contests altogether. On this point, Trilogy had asserted that a 4.99% ownership limit coupled with Selectica’s staggered board rendered a change in board control unrealistic. The Court found that while a trigger under 5% may suggest a “substantial preclusive effect” it does not establish actual preclusion, holding that the “high standard” required to invalidate a defensive measure excludes only “the most egregious defensive responses”—and that the “requirement of either the mathematical impossibility or realistic unattainability of a proxy contest reinforces the exactness of the preclusiveness standard.” In terms likely to inform takeover debates in a variety of contexts, the Court stated:
It is not enough that a defensive measure would make proxy contests more difficult—even considerably more difficult. To find a measure preclusive (and avoid the reasonableness inquiry altogether), the measure must render a successful proxy contest a near impossibility or else utterly moot, given the specific facts at hand.
The Vice Chancellor then found that the Selectica board had properly evaluated the reasonableness of its response in light of the danger the company faced, rejecting Trilogy’s argument that the company should have adopted less powerful defensive measures. Importantly, the Court noted that “Unocal and its progeny require that the defensive response employed be a proportionate response, not the most narrowly or precisely tailored one.” The Court concluded that “it is not for the Court to second-guess the Board’s efforts to protect Selectica’s NOLs.”
Wachtell then celebrated the pill's survival:
The Selectica decision is an important statement of Delaware takeover law. While rooted in the special circumstances necessary for the protection of NOLs, Vice Chancellor Noble’s opinion represents a timely meditation on the poison pill and its place in Delaware fiduciary duty doctrine. The decision constitutes a powerful rejoinder to those who have claimed that the pill has been weakened in recent years by newly emerging fiduciary constraints, or that bidders could simply trigger pills intentionally and then count on the courts to bail them out. Vice Chancellor Noble’s decision demonstrates the continued vibrancy of the pill — 25 years after Household — to defend a well-advised company against threats to corporate policy and effectiveness.
This decision illustrates the Court's limited role in reviewing board's decisions that are not affected by any conflict of interest on the part of directors. Briefly, unless there is a duty of loyalty issue involved, directors just will not be second guessed in Delaware.
I find that a very telling insight. In my article Unocal at 20: Director Primacy in Corporate Takeovers, I argued that "that Unocal strikes an appropriate balance between two competing but equally legitimate goals of corporate law: on the one hand, because the power to review differs only in degree and not in kind from the power to decide, the discretionary authority of the board of directors must be insulated from shareholder and judicial oversight in order to promote efficient corporate decision making; on the other hand, because directors are obligated to maximize shareholder wealth, there must be mechanisms to ensure director accountability. The Unocal framework provides courts with a mechanism for filtering out cases in which directors have abused their authority from those in which directors have not. " Specifically, I argued that:
In its takeover jurisprudence, Delaware typically has balanced the competing claims of authority and accountability by varying the standard of review according to the likelihood that the target board of directors’ actions will be tainted by conflicted interests in a particular transactional setting and the likelihood that nonlegal forces can effectively constrain those conflicted interests in that setting. As a result, the Delaware cases tend to focus, albeit often implicitly, on the board’s motives. …
… If the conflict of interest inherent in such resistance has matured into actual self-dealing, the court will invalidate the defensive tactics. If the board acted from proper motives, even if mistakenly, the court will leave the defenses in place.
For additional blog commentary by yours truly on poison pills go here. For the definitive treatment (if I may say so myself), see my book Mergers and Acquisitions (University Textbook Series).