03/22/2010
The Delaware Court of Chancery recently issued an opinion that validated the use of a shareholder rights plan for a purpose other than as a takeover defense. On February 26, Vice Chancellor Noble issued his opinion in Selectica, Inc. v. Versata Enters., Inc., (C.A. No. 4241-VCN (Del. Ch. Feb. 26, 2010)), upholding the use of a net operating loss (NOL) shareholder rights plan or poison pill, suggesting that shareholder rights plans serve as viable mechanisms for boards of directors to respond to perceived threats not only to a company as a whole, but also to a company's individual assets. Although rights plans will continue to be subject to careful review, as noted in the decision, the opinion provides a level of comfort and guidance to directors of Delaware corporations who may consider implementing such plans.
Background and DecisionSelectica had shared a contentious relationship with its competitor and shareholder Trilogy and Trilogy's subsidiary, Versata Enterprises, which included Trilogy bringing patent infringement lawsuits against Selectica and numerous unsolicited bids by Trilogy to acquire control of Selectica. After Selectica rejected Trilogy's most recent takeover attempt in October 2008, Trilogy began purchasing an increasing number of shares of Selectica common stock, eventually purchasing more than 5% of Selectica's outstanding shares.
A small micro-cap company that survived the dot.com bubble, Selectica had never achieved an operating profit and had generated approximately $160 million of NOLs. In response to its adverse history with Trilogy and the threat that Trilogy's accumulation of Selectica common stock posed to the preservation of its NOLs in accordance with applicable tax laws, Selectica decreased the trigger threshold on its shareholder rights plan from 15% to 4.99%. This threshold was selected because Section 382 of the Internal Revenue Code limits the use of NOLs if, in general, there is a more than 50% increase in the ownership of stock of a company by 5% or more shareholders during a three-year period. Trilogy thereafter purchased additional shares of common stock in an attempt to intentionally trigger the rights plan. The Selectica board ultimately decided to activate the rights plan after extensive meetings with its advisors and failed settlement attempts with Trilogy during the ten day period the board had to exempt Trilogy from the terms of the plan.
Selectica brought an action for declaratory judgment with respect to the validity of (i) the implementation of its NOL rights plan; (ii) certain actions taken by its board in response to Trilogy's purposeful trigger of the plan; and (iii) the reloading of the plan. Trilogy countersued, seeking (a) to have the rights plan and the board's actions declared invalid; and (b) damages for alleged breaches of fiduciary duty by Selectica's board.
The Court applied the enhanced standard of review as set forth in Unocal Corp. v. Mesa Petroleum Co. (493 A.2d 946 (Del.1985)) and its progeny. Under Unocal, in order for a board's actions to be afforded the protection of the business judgment rule, a board must establish that (1) reasonable grounds for believing that a danger to corporate policy and effectiveness existed (which necessarily includes elements of good faith and reasonable investigation); and (2) the board's actions in adopting the defensive measure were reasonable in relation to the threat identified, and the defensive measure was neither preclusive nor coercive.
The Court found that the adoption and trigger of the NOL rights plan was appropriate because the board had ample reason to conclude that the NOLs were an asset worth protecting, noting, "as NOL value is inherently unknowable ex ante, a board may properly conclude that the company's NOLs are worth protecting where it does so reasonably and in reliance upon expert advice."
Applying the second prong of the Unocal test, the court concluded the 4.99% threshold was not preclusive of a change in board control, noting that a successful proxy contest in light of the threshold was not a "near impossibility or else utterly moot." It is noteworthy that the fact that the company had a staggered board did not alter the Court's analysis in this regard. The Court explained that the defensive response employed must be a "proportionate response, not the most narrowly or precisely tailored one," finding that the NOL plan and the board's actions were proportionate relative to the threatened loss of the company's NOLs. The Court further noted the 4.99% threshold was driven by applicable tax laws and regulations and, therefore, was measured by reference to an external standard which was created neither by the board nor the Court. The Selectica board thus had satisfied its Unocal burden in a decision that reaffirmed the broad deference Delaware courts afford to well-informed boards.
Significant TakeawaysIn addition to the Delaware Chancery's informative application of the Unocal standard to the use of NOL rights plans, the Selectica decision provides the following significant takeaways:
The Selectica decision should provide increased comfort to boards considering implementing shareholder rights plans for purposes other than takeover defenses. After finding the board's actions satisfied the Unocal standard, the Court noted that it was "not for the Court to second-guess the Board's efforts to protect Selectica's NOLs." However, it is also important to note that applying the Unocal analysis to the adoption and implementation of shareholder rights plans will depend on the facts specific to each company.
For more information on this e-Alert, contact John Granda at 816.691.3188.