The Delaware Supreme Court, in Versata Enterprises, Inc. and Trilogy, Inc. v. Selectica, Inc., No. 193, 2010 (Del. Oct. 4, 2010), acting en banc, has affirmed a prior Delaware Chancery Court ruling and upheld the use of what is known as a section 382 poison pill (or, more commonly, a net operating loss, or NOL, pill).
An NOL pill is designed to protect the company's net operating loss carryforwards, which can be used to offset future tax liability to the extent that the company (or an acquiror) has such tax liability in the future. Section 382 of the Internal Revenue Code limits the amount of NOLs that can be used following certain changes in ownership. Generally, a section 382 ownership change occurs if, on any testing date, the 5 percent shareholders of a company have increased their aggregate percentage ownership of the company by more than 50 percentage points over their respective lowest levels of percentage ownership during the three years prior to the testing date. Therefore, NOL pills generally contain 5 percent thresholds which seek to prevent a person who is not a 5 percent shareholder from becoming one, subject to certain exemptions, and also place strict limits on acquisition of additional shares by incumbent greater than 5 percent shareholders.
Through its October 4 ruling, the Delaware courts again confirmed the legality of the use of rights plans as a takeover defense under Delaware law and expressly acknowledged the validity of an NOL rights plan.
Prior to the Chancery Court's ruling in Selectica and the Supreme Court's subsequent en banc affirmation of that ruling, Delaware courts had only examined the appropriateness of poison pills in the context of hostile change-of-control transactions. The Chancery Court upheld the validity of Selectica's NOL pill, the adopted replacement NOL pill, and the exchange. Trilogy subsequently appealed.
The Delaware Supreme Court upheld the validity of Selectica's NOL pill, the adopted replacement NOL pill, and the exchange under Delaware's Unocal standard, which is used to address defensive actions taken by a board in connection with a possible change of control, such as the adoption of a poison pill. Under Unocal Corp. v. Mesa Petroleum Co., 493 A.2d 946 (Del. 1985), in order to be afforded the protections of the business judgment rule, a company's board must show it had reasonable grounds for believing that a danger to corporate policy and effectiveness existed and demonstrate that the defense response was reasonable in relation to the specific threat. Delaware courts have stated that a response is not reasonable if it is either coercive or preclusive.
Addressing the first prong of Unocal, the Supreme Court found that Selectica's board had reasonable grounds for concluding that a threat existed. Justice Holland noted that Selectica's board met often and that the record supports a factual finding that Selectica's board "acted in good faith reliance on the advice of experts," which included receiving advice from legal counsel and an investment banker and conducting a thorough review of a financial expert's analyses of the NOLs in November 2006 and again in each of March 2007, June 2007, and July 2008. The court concluded that Selectica's board followed a "logical deductive reasoning process" and reasonably determined that "[its] NOLs were worth preserving and Trilogy's actions represented a serious threat of [Selectica's NOL's] impairment."
Similarly, the Supreme Court found that the decision of the board to act promptly to reduce the trigger on the rights plan from 15 percent to 4.99 percent was reasonable on the record, noting that the change in ownership calculation under Section 382 stood at approximately 40 percent, Trilogy's ownership had climbed to over 5 percent in just over a month and that Trilogy intended to buy more stock. Not only was there nothing to prevent Trilogy from continuing to buy Selectica stock, but the board understood that once the section 382 limitation was tripped, it could not be undone. The Supreme Court also noted the creation of the Review Committee with a "mandate to conduct a periodic review of the continuing appropriateness of the NOL Poison Pill." The Supreme Court upheld the Chancery Court's findings and held that the Selectica directors had showed that they had reasonable grounds for believing that a danger to corporate policy and effectiveness existed because of another person's stock ownership."
The Supreme Court also determined that Selectica's NOL pill was not preclusive. The court stated that a defensive measure is preclusive where it "makes a bidder's ability to wage a successful proxy contest and gain control either 'mathematically impossible' or 'realistically unattainable'" given the specific factual context. The Supreme Court held that there is really only one test of preclusivity: that it is "realistically unattainable." Further, based on expert testimony, the Supreme Court concluded Selectica's NOL pill and the newly adopted replacement pill were not preclusive. The Supreme Court was clear that the "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." In addition, the Supreme Court unambiguously held that "the combination of a classified board and a rights plan do not constitute a preclusive defense."
The court then evaluated the NOL rights plan under the standard of reasonableness and noted that the exchange of the rights employed by Selectica's board of directors was a more proportionate response than the flip-in mechanism provided in the rights plan, and, therefore, Trilogy experienced less dilution than it would have had the flip-in mechanism been permitted to operate. The court found that after three failed attempts to negotiate with Trilogy, it was reasonable for Selectica's board to determine there was no other option than to implement the NOL pill. The court also determined that it was reasonable for Selectica's board to adopt the reloaded pill based on the board's ultimate findings that the NOLs were a corporate asset worth protecting and the fact that a threat still existed under section 382 with respect to the loss of the NOLs.
The Supreme Court was careful to point out, however, that the reasonableness of a board's response to a "specific threat" is determined in relation to that threat "at the time it was identified." The Supreme Court cautioned that the adoption of a rights plan is not absolute and noted that the court had "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 explained that "[i]f and when Selectica "is faced with a tender offer and a request to redeem the reloaded 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."
The Supreme Court thus provided significant and welcome guidance to boards of directors that are considering a rights plan. It upheld the use of a rights plan, including an NOL pill such as that adopted by Selectica, in cases where the board of directors has reasonably determined that it is a reasonable response to a threat reasonably perceived. The court also reminded directors that the reasonableness of a board's decision with respect to antitakeover measures will be judged in context at the time the directors make the determination to implement or continue the measure under challenge.