Originally published Law360, Securities Law and Corporate Finance Law, May 14, 2010
Since their appearance about 30 years ago, shareholder rights plans – so-called poison pills, or pills – have been the subject of much debate. In a recent Delaware Chancery Court decision, Selectica, Inc. v. Versata Enterprises, Inc. and Trilogy, Inc., 2010 WL 703062 (Del. Ch., Feb. 26, 2010) (Selectica), a Delaware court yet again upheld the legitimacy of a poison pill in the face of a recalcitrant shareholder's unwelcome takeover advances. The central question addressed by Vice Chancellor Noble in Selectica is whether a target board's adoption of a low-threshold poison pill with a 4.99% trigger (NOL Pill) is reasonable in order to protect corporate assets of speculative and questionable value like a company's net operating loss carryovers (NOLs), absent an explicit plan for achieving that value.
Since becoming a public company in March 2000, Selectica incurred substantial operating losses, so that by the spring of 2009, its value consisted primarily of cash reserves and its accumulated NOLs. In the spring of 2008, Selectica's board of directors, after terminating its CEO and receiving five unsolicited takeover offers within a few weeks, hired an investment banker to assist with its review of the company's strategic alternatives. Selectica received offers from a half-dozen parties, including two proposals from Trilogy, which the board rejected. Trilogy then embarked on a share accumulation program, buying Selectica stock in a series of open-market purchases that threatened to cause Selectica to lose its accumulated NOLs. The Selectica board responded by amending the company's poison pill to reduce the trigger to 4.99%, from 15%. Trilogy had already purchased more than 5% of Selectica's outstanding stock, and the board believed that reducing the threshold trigger would prevent other 5% owners from emerging and causing a change of control of the company under federal NOL tax rules, which could result in the loss of the company's accumulated NOLs. Although Trilogy and other 5% holders were "grandfathered" under the amendments to the pill, they were limited to purchasing up to an additional 0.5% interest without triggering Selectica's NOL Pill, to avoid severe dilution of their ownership interest.
Trilogy elected to buy through the poison pill, purchasing an additional 30,000 Selectica shares in the market. Trilogy asserted that Selectica's board had acted illegally in breach of its fiduciary obligations by amending its pill to include such a low trigger and then reloading its pill so that it would continue to deter large holders from buying additional shares. Selectica's board filed a lawsuit after repeatedly unsuccessful offers to exempt Trilogy from the pill in return for a standstill agreement during the permitted 10-day window in which the board could designate Trilogy as an "exempt person." The board requested the Chancery Court to declare its NOL Pill valid. Selectica's board also opted to let the 10-day period expire, after which the shareholder rights automatically "flipped in" and became exercisable for $36 worth of newly issued common stock at a price of $18 per right. As the "triggering" shareholder, Trilogy was ineligible to participate in the flip-in event (the Exchange). As a result of the Exchange, Trilogy's beneficial equity interest in Selectica was reduced to 3.3%, from 6.7%.
Trilogy counter-sued Selectica, arguing that the court should declare the NOL Pill invalid on two grounds: the pill is an anti-takeover device that precludes an effective proxy contest; and the pill is not a reasonable and proportionate response to a reasonably perceived threat because the board failed to establish that Selectica's NOLs have a value worth protecting that was being threatened by Trilogy's purchases.
Under the Unocal "enhanced scrutiny" standard applied by the court, the action taken by Selectica's board to amend the pill to lower the flip-in trigger is not automatically protected under the business judgment rule. Rather, to receive the protection afforded by the business judgment rule, the directors must show that they had reasonable grounds for believing that a danger to corporate policy and effectiveness existed and that the defensive response to the perceived threat was reasonable. A defensive measure that, for example, is disproportionate – because it is either coercive or preclusive – will not be upheld under a Delaware court's business judgment procedural rules.
The court found that the presence of a majority of outside directors, coupled with evidence of the board's reliance on the advice of outside legal and financial advisers, constituted a prima facie showing of good faith and reasonable investigation by Selectica's board. The court noted that any concern about the board's actions arising out of a desire for retrenchment seemed groundless because at the time the board adopted the NOL Pill, the company had been actively seeking suitors for almost six months and was continuing the sale process. Further, the court noted that Selectica's board ultimately delegated final decision-making authority over the adoption of the NOL Pill and implementation of the Exchange to a committee comprising only outside independent directors.
The Unocal test requires a board to show that it had reasonable grounds to conclude that a threat to a corporate objective existed. The court noted the uniqueness of this case because the board's action was not in response to a hostile takeover but was aimed at preventing the inadvertent forfeiture of potentially valuable NOLs. Consequently, the 5% trigger, according to the court, imposes a much greater cost on shareholders than the pill thresholds traditionally employed to prevent a hostile acquiror from establishing a control position. Nonetheless, noting that Delaware corporate law is not static and must grow to accommodate evolving concepts and needs, the court found that there was ample evidence that Selectica's board reasonably concluded that, on the basis of expert advice, NOLs were an asset worth protecting.
Although the Selectica board did not commission a formal study to consider the probability that the value of the NOLs would be realized, the court determined that the board had reasonably concluded that the NOLs were worth preserving and that Trilogy's actions posed a serious threat to their impairment. In response to Trilogy's argument that the Selectica board failed to properly consider the negative consequences of the NOL Pill, the reloaded NOL Pill and available alternatives or to demonstrate any real benefit achieved by the pills, the court concluded that the pills were neither preclusive nor a disproportionate response to the perceived threat posed by Trilogy's open-market purchase program. Nor was the court persuaded by Trilogy's expert witness who testified that Selectica's NOL Pill, in conjunction with the company's charter-based staggered board, effectively removed the ability of acquirors like Trilogy to launch a takeover bid conditional on the election of a slate of insurgent directors. For such a bid to be successful, the expert correctly opined that the bid would have to remain outstanding across multiple director election cycles.
After holding that the NOL Pill and reloaded NOL Pill were neither preclusive nor coercive, the court concluded its Unocal analysis, finding that Selectica's board had acted within the range of reasonableness in adopting the pills. Accordingly, the directors were afforded the protection of the business judgment rule, and the burden of proof shifted to Trilogy to identify a meaningfully different approach that the Selectica board could have taken to protect the company's NOLs. The court determined that Trilogy had failed to meet this burden and declared that the adoption of the pills by Selectica's board constituted a valid exercise of its business judgment.
In the past few years, the number of NOL Plans adopted by U.S. companies has increased. This trend will no doubt continue in the wake of the Selectica decision. Historically, companies whose management has been unable to achieve financial success have been taken over either by other companies or, eventually, by their creditors in bankruptcy. The NOL Plan represents a unique threat to any would-be acquiror who is unable to successfully negotiate a takeover with a failed management team. Perhaps the Delaware courts are leaning too far in the direction of incumbent management by upholding NOL Plans even where those plans, in conjunction with other shark repellants like staggered boards, effectively preclude dissatisfied shareholders from effecting a change of control.
The content of this article does not constitute legal advice and should not be relied on in that way. Specific advice should be sought about your specific circumstances.
