On February 26, 2010, the Delaware Court of Chancery upheld Selectica, Inc.'s adoption and use of its shareholder rights plan with a 4.99% trigger designed to protect Selectica's ability to use its significant net operating losses (NOLs) (Selectica, Inc. v. Versata Enterprises, Inc., C.A. No. 4241-VCN (Del. Ch. Feb 26, 2010)). The Court found that, in this instance, the protection of NOLs was an appropriate corporate policy, Selectica had reasonable grounds for believing that a danger to that corporate policy existed, Selectica's adoption and use of an NOL rights plan were reasonable and proportionate responses in relation to the threat posed and, therefore, the adoption and use of the rights plan were valid exercises of the Selectica board's business judgment.
Since becoming public in 2000, Selectica, a microcap enterprise software company, had failed to be profitable and had generated an estimated $160 million in NOLs for U.S. federal tax purposes. U.S. Internal Revenue Code Section 382 limits the use of NOLs to reduce U.S. federal tax in periods following an "ownership change". Although a complex determination, an ownership change essentially occurs under Section 382 when greater than 50% of a company's stock ownership changes over a three-year period. Only shareholders owning 5% or more of a company's outstanding shares are considered in determining whether an ownership change has occurred for purposes of Section 382.
After receiving five unsolicited acquisition offers in July 2008, Selectica engaged an investment bank that approached potential acquirors. Trilogy, Inc., a Selectica competitor that had a "complicated and often adversarial" relationship with Selectica (which included patent infringement judgments and settlements in favor of Trilogy), also offered to purchase some or all of Selectica's business in July 2008, but Selectica's board rejected the offer. Trilogy made a second offer in October 2008 and was invited to participate in Selectica's sale process, but did not do so (Trilogy was apparently unwilling to sign a non-disclosure and standstill agreement). Trilogy began accumulating Selectica's shares and, on November 10, 2008, informed Selectica that it had purchased more than 5% of Selectica's shares.
Selectica's board met to consider the situation and review its NOLs and determined, with outside expert advice, that an acquisition of 10% of its shares in the near term by current and new 5% shareholders would materially limit Selectica's ability to benefit from its NOLs. As a result, the board, after consultation with its Delaware counsel and other advisors, amended its existing rights plan to lower the trigger from 15% to 4.99%. The amended rights plan grandfathered existing 5% or greater shareholders and allowed those shareholders to purchase an additional 0.5% of Selectica's shares. The board also established an "Independent Director Evaluation Committee" to periodically review the rights plan and the appropriate percentage trigger.
In December 2008, after Selectica refused to agree to Trilogy's various demands, Trilogy intentionally acquired additional Selectica shares and triggered the rights plan. Under the terms of the rights plan, the board had ten business days to determine whether to exempt Trilogy or exchange the rights for shares before the rights would automatically flip in. During this period, the board and the independent committee, in consultation with their advisors, discussed the situation on numerous occasions. After Trilogy repeatedly refused to agree to Selectica's request to enter into a standstill agreement, the independent committee determined to exchange the rights, other than the rights held by Trilogy, for new shares rather than to permit a flip-in and to adopt a "reloaded" NOL rights plan. The exchange diluted Trilogy's holdings from 6.7% to 3.3%. Trilogy is the first entity to intentionally trigger a Delaware corporation's rights plan with a modern flip-in trigger.
The Court reviewed the actions of Selectica's board and independent committee under the Unocal1 test, which provides that, in connection with the adoption of defensive measures, a board will be given the benefit of the business judgment rule if the board had reasonable grounds for believing that a danger to corporate policy existed. In making such a determination, the board must act in good faith and make a reasonable investigation. In addition, in order to satisfy the Unocal test, the defensive response must be reasonable in relation to the threat posed. Under Delaware law, a defensive response is unreasonable if it is either coercive or preclusive.
The Court found that even though "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", and, given the Selectica board's in-depth deliberations and reasonable and substantial reliance on outside expert advice, the board was reasonable in determining that Selectica's NOLs were worth preserving and that Trilogy's threats to the NOLs merited a defensive response.
In determining that the 5% trigger was not preclusive or coercive in relation to the threat posed, the Court noted that while a 5% trigger "has a substantial preclusive effect", the 5% trigger "must render a successful proxy consent a near impossibility or else utterly moot, given the specific facts at hand", in order to be considered preclusive. A preclusive response to a posed threat requires "the mathematical impossibility or realistic unattainability of a proxy contest". Despite Selectica having a staggered board and blank check preferred stock (in addition to the 4.99% NOL rights plan and other defensive measures in place), the Court found that the NOL rights plan did not constitute a preclusive defense mechanism.
The reasonableness of a board's response must be considered in relation to a specific threat. The Court determined that Trilogy's actions were a specific threat to the utility of Selectica's NOLs rather than being a general threat resulting from an inadvertent ownership change for purposes of Section 382. While Trilogy argued that the Selectica board's response should have been more narrowly tailored, the Court found that the board had no other plausible option, absent a standstill agreement (which Trilogy refused to sign), and that the use of an exchange mechanism, rather than a flip-in, was a more proportionate response because Trilogy experienced less dilution. Emphasizing a board's broad discretion in formulating a reasonable response, the Court stated that "the defensive response employed [must] be a proportionate response, not the most narrowly or precisely tailored one". In summarizing Delaware law, the Court noted:
Noting that the 4.99% trigger is the result of an external standard based on U.S. federal tax laws rather than a standard created by the board, the Court found that the adoption and use of the NOL rights plan "were valid exercises of the [b]oard's business judgment".
The Court cautioned, however, that NOL rights plans "could provide a convenient pretext for perpetuating a board-preferred shareholder structure. For this reason, NOL rights plans, such as the ones adopted by Selectica, must be subject to careful review". The Court emphasized the Selectica board's considerable deliberations, analysis and use of outside experts. While Selectica's adoption and use of its NOL rights plan were upheld in the first review of an NOL rights plan by a Delaware court, companies considering adopting an NOL rights plan should be aware that any review by a Delaware court will be fact-specific and made on a case-by-case basis.
Footnote
1. Unocal Corp. v. Mesa Petroleum Co., 493 A.2d 946 (Del. 1985).
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