Selectica, Inc. v. Versata Enterprises, Inc., C.A. No. 4241-VCN (Del. Ch. Feb. 26, 2010) (Noble, V.C.)
In the first court review of a shareholder rights plan (commonly referred to as a “poison pill”) designed to protect the corporation’s net operating losses (“NOL”), the Court of Chancery applied enhanced scrutiny review under the Unocal standard and held that the adoption of a low-trigger NOL poison pill and the decisions to authorize the exchange of rights for common stock following a deliberate triggering of the plan and to renew the NOL poison pill (thereby “reloading” the pill) were entitled to deference under the business judgment rule. Vice Chancellor Noble also provided helpful guidance on the protections arising out of a board’s reliance on expert advice under Section 141(e) of the Delaware General Corporation Law.
NOLs are tax losses realized and accrued by corporations that can be utilized to shelter future or immediate past income from taxation. Recently, shareholder rights plans with a lower trigger threshold have been deployed to protect a corporation’s NOLs against the threat that changes in share ownership could inadvertently limit the corporation’s ability to use the NOLs to reduce future income taxes. Plaintiff Selectica, Inc. (“Selectica” or the “Company”), a microcap company that provides enterprise software solutions for contract management and sales configuration systems, accumulated an estimated $160 million in NOLs over the past several years. In late July 2008, defendant Trilogy, Inc. (“Trilogy”), Versata Enterprise, Inc.’s parent company and Selectica’s competitor in the “relatively narrow market space of contract management and sales configuration,” made an offer to purchase Selectica. The Selectica board of directors (the “Selectica board” or the “board”) rejected this proposal and a second proposal by Trilogy in October 2008, at which time Trilogy declined to participate in the sales process the board had initiated. Trilogy began to purchase Selectica stock in October 2008, and on November 10, 2008, contacted Selectica’s co-chairman to inform her that Trilogy had acquired more than 5% of Selectica’s outstanding stock and would be filing a Schedule 13D shortly.
The Selectica board met on November 16, 2008, to gauge the impact of the Trilogy acquisitions on the Company’s NOLs and to determine if mitigating efforts should be enacted. After hearing presentations by the Company’s investment banker, its CFO, the accountant retained to analyze the NOLs, and Delaware counsel, the Selectica board unanimously passed a resolution amending the Company’s existing shareholder rights plan by decreasing the 15% beneficial ownership trigger to 4.99% while grandfathering in existing 5% shareholders and allowing them to acquire up to an additional 0.5% without triggering the NOL pill. Trilogy ceased buying Selectica stock after the Company announced the NOL pill, but demanded a meeting with Selectica to discuss an alleged breach of an October 2007 settlement agreement between the two companies.
After the requested meeting, Trilogy bought additional shares of Selectica stock, bringing its ownership share to 6.7% and thereby becoming an “Acquiring Person” under the Company’s NOL pill. Under the NOL pill, the rights would “flip in” automatically after ten business days unless the Selectica board either granted Trilogy an exemption based on a finding that Trilogy’s ownership of more than 4.99% of the common stock would not “jeopardize or endanger the availability to the Company of the NOLs,” or exchanged the rights for common stock. The Selectica board met seven times between December 19, 2008 and January 2, 2009, and offered an exemption to Trilogy in exchange for a standstill three times during that period. Trilogy refused to agree to a standstill each time.
On January 2, 2009, the Selectica board reiterated its delegation of authority to an Independent Director Evaluation Committee (consisting of two Selectica directors) to make recommendations regarding the implementation of the NOL pill, including the authority to effect an exchange of rights for common stock under the NOL pill (the “Exchange”) and to declare a new dividend of rights under an amended rights plan (the “Reloaded NOL pill”). After meeting with legal and financial advisors that same day, the committee decided that Trilogy should not be granted an exemption. The committee further concluded that the Exchange should occur (which would reduce defendants’ beneficial holdings from 6.7% to 3.3%), and that the Reloaded NOL pill with substantially similar terms be adopted.
Selectica sought a declaratory judgment in the Delaware Court of Chancery upholding the board’s and committee’s actions. Trilogy counterclaimed, seeking a declaratory judgment that the NOL pill and Reloaded NOL pill were invalid.
After a weeklong trial, the Court evaluated the board’s actions under the enhanced scrutiny standard set forth in Unocal Corp. v. Mesa Petroleum Co. The first part of the Unocal test requires a board to show that it had reasonable grounds to believe that a threat to a corporate objective existed. The Court acknowledged that this case presented “unique grounds” for establishing the first prong of the test because “employing a poison pill for the ostensible purpose of protecting NOLs is a distinct departure from the poison pill’s originally intended use: the prevention of hostile takeovers.” Nonetheless, Vice Chancellor Noble found that the “protection of company NOLs may be an appropriate corporate policy meriting a defensive response when threatened.” The Court determined that “a board may properly conclude that the company’s NOLs are worth protecting where it does so reasonably and in reliance upon expert advice.” Observing that the board received advice from advisors with substantial experience in valuing NOLs, the Court held that the board was “reasonable in concluding that Selectica’s NOLs were worth preserving and that Trilogy’s actions presented a serious threat to their impairment,” satisfying the first prong of Unocal.
The Court then considered the board’s actions under the second prong of Unocal, which requires an evaluation of whether the directors’ response to the threat was preclusive or coercive, and if not, whether it was “reasonable in relation to the threat” identified. Vice Chancellor Noble rejected Trilogy’s argument that the NOL pill was preclusive, observing that even though Trilogy’s expert testimony suggested that a poison pill with a low trigger had a “substantial preclusive effect,” “the Court cannot conclude that the NOL Pill, Exchange, and Reloaded NOL Pill were preclusive, and thereby draconian.” The Court noted that the applicable standard “operates to exclude only the most egregious defensive responses,” and a preclusive 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 and Reloaded NOL pill did not meet that standard.
Unocal requires “the focus of enhanced judicial scrutiny to shift to ‘the range of reasonableness’” upon a finding that a defensive measure is neither coercive nor preclusive. Vice Chancellor Noble found that there was sufficient evidence that the board’s action fell within such a range, relying on extensive testimony concerning the board’s deliberative process, on evidence that Trilogy sought “intentionally to impair corporate assets, or else to coerce the Company into meeting certain business demands,” and on Trilogy’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 NOL by Trilogy.” The Court emphasized that Unocal and its progeny allow directors substantial freedom in fashioning an appropriate response, noting that “the defensive response employed [must] be a proportionate response, not the most narrowly or precisely tailored one.”
The Court also recognized the risk that NOLs could “provide a convenient pretext for perpetuating a board-preferred shareholder structure” and concluded that “shareholder rights plans, such as the ones adopted by Selectica, must be subject to careful review.” However, the Court found that the board “reasonably believed, based on the guidance of appropriate experts, that the NOLs had value, a value worth protecting,” and indicated that the Court should not “substitute its judgment for the reasonable conclusions of the Board[,] protected as they are by 8 Del. C. § 141(e).” Accordingly, the Court concluded that the adoption of the NOL pill and the Reloaded NOL pill and the implementation of the Exchange were “valid exercises of the Board’s business judgment,” and granted Selectica’s request for declaratory relief.