In Versata Enterprises Inc. v. Selectica, Inc., No. 193, 2010 (Del. Oct. 4, 2010), the Delaware Supreme Court addressed the validity of a shareholder rights plan, or “poison pill”, for the first time in a number of years. The court upheld the adoption of a poison pill with a 4.99% trigger designed to protect a company’s net operating losses (“NOLs”) and the subsequent adoption of a “reloaded” poison pill to protect against future threats to those net operating losses.
Selectica, a micro-cap software company that had experienced losses each year following its initial public offering, had generated approximately $160 million in unused NOLs. NOLs are tax losses that are essentially a contingent asset that can be used to offset future income from taxation under certain circumstances. Section 382 of the Internal Revenue Code of 1986 provides an annual limitation on the ability of a company to use NOLs that arose before an “ownership change” to offset income that arises after such ownership change. For purposes of Section 382, one way that an “ownership change” may occur is when the percentage of stock beneficially owned by one or more of a company’s large shareholders (defined for these purposes as shareholders who own 5% or more of such corporation’s shares) increases by more than 50 percentage points at any point over a three-year rolling testing period. An NOL poison pill is designed to discourage persons from becoming 5% shareholders and to discourage existing 5% shareholders from acquiring additional stock, in an effort to prevent the company from experiencing a Section 382 ownership change that would impair the value of its NOLs.
One of Selectica’s largest shareholders was Trilogy, Inc., which, together with its affiliate Versata, had acquired 6.7% of Selectica’s shares. Trilogy was a competitor of Selectica that had expressed interest in acquiring Selectica as early as January 2005. Trilogy had also twice sued Selectica for patent infringement, and Selectica owed Trilogy millions of dollars as a result of a judgment and a settlement related to those matters. Trilogy pursued the acquisition of Selectica off-and-on through 2008, but was continuously rebuffed. The record showed that Trilogy, although aware of the NOLs, was not particularly motivated by them, and eventually decided that the threatened impairment of Selectica’s NOLs might be a useful means of coercing the company into a transaction benefiting Trilogy.
Trilogy began buying Selectica stock in early November 2008. Trilogy had acquired over 5% by November 10, filed a Schedule 13D on November 13, and acquired an additional 1% in the days thereafter. At the time of these purchases by Trilogy, Selectica had in place a traditional poison pill with a 15% trigger. In the wake of mounting losses, the discovery that prior ownership changes had resulted in an impairment of approximately $24.6 million in unused NOLs and Trilogy’s increasing ownership stake, Selectica’s board reviewed with its advisors Trilogy’s actions, Section 382 calculations and Selectica’s recent stock price activity and strategic alternatives. The board decided to amend its rights plan to reduce the triggering threshold from 15% to 4.99% to prevent additional 5% owners from emerging. The amended rights plan also allowed existing 5% shareholders, including Trilogy, to purchase an additional 0.5% without triggering the rights.
In the face of the reduced triggering threshold of Selectica’s poison pill to 4.99%, Trilogy made an informed decision to increase its ownership stake in Selectica and trigger the pill, thereby forcing Selectica’s board to decide how to respond. Trilogy informed Selectica that it had bought through the pill and proposed that Selectica repurchase Trilogy’s shares, accelerate the payment of debt, terminate its license with a client and make an additional $5 million cash payment to Trilogy to settle outstanding issues between the companies. Selectica’s board reacted by attempting to negotiate a standstill agreement with Trilogy to allow for further negotiations between the parties in exchange for the board declaring Trilogy an “Exempt” person under the terms of the pill, which would have prevented the dilution of Trilogy.
After Trilogy rejected Selectica’s standstill proposals, and based on the advice and analyses conducted by the board’s legal and financial experts, the directors of Selectica concluded that the poison pill should be applied to Trilogy because the NOLs were “an important corporate asset that could significantly enhance stockholder value” and Trilogy’s actions could materially impair the value of Selectica’s NOL assets. A special committee of the board, to whom the relevant authority was delegated, implemented the poison pill’s exchange feature, doubling the number of outstanding shares held by other Selectica shareholders and diluting Trilogy’s beneficial holdings from 6.7% to 3.3%. The special committee also adopted a “reloaded” NOL rights plan, which was a new poison pill with substantially the same terms. Selectica then sought a declaratory judgment in the Delaware Chancery Court that the actions of Selectica’s directors were valid and proper.
The Chancery Court applied the familiar test formulated in Unocal Corp. v. Mesa Petroleum Corp., 493 A.2d 946, 955 (Del. 1985): that adoption of defensive measures are protected by the business judgment rule so long as: (i) the board had reasonable grounds for believing that a danger to corporate policy and effectiveness existed and (ii) the defensive response was reasonable in relation to the threat posed. The Chancery Court found that the directors of Selectica met their burden of proof under each prong of this test, and upheld the directors’ action.
Delaware Supreme Court Opinion
The Supreme Court began its analysis by affirming the Chancery Court’s finding that “the protection of company NOLs may be an appropriate corporate policy that merits a defensive response” when threatened. The court noted that Delaware courts have approved the use of poison pills as an anti-takeover device and have applied the Unocal test to analyze a board’s response to an actual or potential hostile takeover threat. While the court noted that an NOL poison pill was not principally intended to prevent a hostile takeover, it held that “any Shareholder Rights Plan, by its nature, operates as an anti-takeover device,” and “notwithstanding its primary purpose, a NOL poison pill must also be analyzed under Unocal because of its effect and its direct implications for hostile takeovers.”
Turning to the first prong of the Unocal test, the court noted that the record showed that the Selectica board had repeatedly analyzed its NOLs and received a variety of expert advice on their value. Given these facts, the court found that the record supported the lower court’s finding that the board acted in good faith reliance on the advice of experts in concluding that the NOLs were an asset worth protecting and that their preservation was an important corporate objective.
The court also found that the record supported the reasonableness of the board’s decision to quickly reduce the trigger of Selectica’s existing poison pill from 15% to 4.99% because (i) the company’s accountant informed the board on November 16 that the change-of-ownership calculation under Section 382 already stood at 40%, (ii) the board reasonably believed Trilogy intended to continue buying more stock and (iii) nothing prevented others from acquiring stock in amounts up to the existing 15% trigger. Such additional acquisitions could push the 40% Section 382 calculation to above 50%, at which point the value of the NOLs would be permanently impaired.
Turning to the second prong of the Unocal test, the court stated that Unocal requires an initial evaluation of whether a board’s defensive response to the threat was preclusive or coercive and, if neither, whether the response was reasonable in relation to the threat identified. Taking the opportunity to clarify the test for preclusivity under Delaware law, the court held that a defensive measure is preclusive where it makes a bidder’s ability to wage a successful proxy contest and gain control “realistically unattainable.”
Trilogy claimed that Selectica’s NOL poison pill, with a 4.99% trigger, prevented a shareholder from signaling its financial commitment so as to establish sufficient credibility to win the necessary supporters in a proxy fight. The court noted that the 5% trigger necessary for an NOL poison pill to serve its objective is indeed lower than the poison pill thresholds traditionally upheld as acceptable take over defenses by Delaware courts, but concluded that the NOL pill and the reloaded NOL pill would not render a successful proxy contest realistically unattainable given the specific factual context.
Trilogy also argued that, even if a 4.99% shareholder could realistically win a proxy contest, the preclusiveness question should focus on whether a challenger could realistically attain sufficient board control to remove the pill. Trilogy asserted that because Selectica also had a staggered board of directors, Trilogy would have to win two consecutive proxy contests in order to control enough board seats to remove the pill, making the combination of the staggered board and the NOL pill preclusive. The court rejected this reasoning, noting that classified boards are permitted by the Delaware statute, and operate as a defensive mechanism by delaying but not preventing a hostile acquiror from obtaining control of the board.
The court also rejected Trilogy’s claim that the response of Selectica’s board was not reasonable. The court found that, under the circumstances, both the original and the reloaded pill were necessary to overcome the threat that Trilogy’s purchases would prevent Selectica from using its net operating losses.
The court made clear that its holding should be narrowly construed, stating that “the fact that the NOL Poison Pill was reasonable under the specific facts and circumstances of this case, should not be construed as generally approving the reasonableness of a 4.99% trigger in the Rights Plan of a corporation with or without NOLs.” The Court noted that although the Selectica board carried its burden of proof under the two part test of Unocal, the adoption of a poison pill is not absolute, and under Delaware law, “the ultimate response to an actual takeover bid must be judged by the Directors at that time.”
Takeaways from Versata and Other Recent Poison Pill Cases
- 1. Versata, the first poison pill case decided by the Delaware Supreme Court in a number of years, indicates that, despite the decreasing use of poison pills by public companies, the pill remains a sustainable defense tactic when the courts are convinced that the pill genuinely (i) protects a legitimate corporate interest, (ii) represents a disinterested business judgment, (iii) is made after a careful process is followed and (iv) does not make a successful proxy contest realistically unattainable.
- 2. The Delaware courts have indicated a willingness to uphold a poison pill in new contexts and with various features (including a relatively low 4.99% trigger (Versata) or an exempted 30% shareholder (Yucaipa American Alliance Fund II, L.P. v. Riggio, C.A. No. 5465-VCS (Del. Ch. Aug. 12, 2010)) when the requirements set forth in point 1 above are satisfied.
- 3. Delaware courts are likely to decide the validity of poison pills on a case-by-case basis, considering the specific features and purpose of the pill and the specific facts and circumstances of the case. Thorough deliberation by a board in adopting a poison pill, aided by assistance from competent advisors, is important to establish a record that the directors acted on a careful and informed basis.
- 4. The Delaware courts may not uphold a poison pill if it doesn’t satisfy the tests laid out above or is being used for punitive purposes, like the pill at issue in eBay Domestic Holdings, Inc. v. Newmark, C.A. No. 3705-CC (Del. Ch. Sept. 9, 2010).
- 5. The Delaware courts have indicated that the proper test for determining the validity of a poison pill is the Unocal standard, even where the primary objective of the pill is not to prevent a hostile takeover, such as in Versata, or where a hostile takeover is a factual impossibility, as in eBay.
- 6. The validity of the “just say no” defense – the biggest poison pill issue of all — remains unresolved.
Our prior summary of the eBay and Yucaipa cases mentioned above is available here.