Tuesday, October 19, 2010

DE Supreme Court Reaffirms Selectica's "NOL" Shareholder Rights Plan

On October 4, 2010, the Supreme Court of Delaware upheld the Court of Chancery’s prior decision in favor of Selectica, Inc.—reaffirming the validity of Selectica’s NOL Poison Pill under state law.


Selectica (SLTC) is a currently profitless Delaware public corporation that provides sales configuration systems and enterprise software solutions for management. Trilogy—which operates in the same industry as Selectica—owns Versata Enterprises as a subsidiary. Versata, in turn, specializes in technology powered business services.

Since going public in March 2000, Selectica has consistently experienced annual losses. Consequentially, the company has accumulated approximately $160 million in net operating loss carryforwards (NOLs). NOLs are tax losses that can be used by a corporation for a limited time to offset taxes to be paid on operating profits. NOLs can be used to refund prior taxes, or be used to shelter future income from taxation. Their value, therefore, is contingent upon the company either having immediate past profit or reporting future profit. Finally, NOLs become worthless if the company fails to generate profit after twenty years.

A rather specific stipulation held in the Internal Revenue Code ultimately exacerbated the long-standing adversarial relationship between Selectica and Trilogy. Section 382 of the Internal Revenue Code triggers a decrease in value of a company’s NOLs in the event of “ownership change”. The purpose of this rule is to prevent taxpayers from benefiting from other company’s NOLs. Justice Randy J. Holland clarifies that for the “purposes of [Versata Enterprises, Inc. v. Selectica, Inc.] the only shareholders considered when calculating… ownership change… are those who hold, or have obtained during the testing period, a 5% or greater block of [Selectica’s] shares outstanding”. Selectica ultimately determined that it was necessary to take measures to protect the NOLs value after 30% beneficial ownership changed hands—problematic, since over the past three years 5%+ holders experienced about a 40% ownership change.

The measure that Selectica took to thus protect its most valuable assets was namely to implement a NOL Poison Pill. The pill was an amendment to a previous Shareholder Rights Plan.  It would decrease “the beneficial ownership trigger from 15% to 4.99%, while grandfathering in existing 5% shareholders and permitting them to acquire up to an additional 0.5% [the 0.5% permissible increase being contingent on the original 15% cap] without triggering the NOL Poison Pill”. On December 18, 2009, Trilogy— which has been trying for five years now to buyout Selectica—accumulated even more shares of Selectica, growing its ownership to 6.7% and thus triggering the NOL Poison Pill. Trilogy states that it did this intentionally to “’bring accountability’ to the Board and ‘expose’… the ‘illegal behavior’ by the Board in adopting a pill with such a low trigger”. Ultimately, Selectica’s Shareholder Rights Plan instituted an Exchange that diluted Trilogy’s ownership from 6.7% to 3.3% whilst doubling other SLTC shareholders’ common stock. Selectica then reloaded its poison pill back to the 4.99% trigger.

In reviewing the validity of the NOL Poison Pill, the Exchange, and the Reloaded NOL Poison Pill under state law, the Delaware Supreme Court applied the Unocal test. Under Delaware law, the adoption of a poison pill is valid as an anti-takeover measure so long as it meets three stipulations.  To pass the Unocal test, the Shareholder Rights Plan must be both a reasonable and proportionate response to a threat, and not be preclusive or coercive toward that threat. A defensive measure is preclusive where it renders a bidder “mathematically” unable to “realistically… wage a proxy contest and gain control”.

Believing that Selectica’s actions were proportionate and reasonable, while not precluding Trilogy’s ability to wage a successful proxy context, the Delaware Supreme Court reaffirmed the validity of the NOL Poison Pill, the Exchange, and the Reloaded Poison Pill. (Selectica’s cross-appeal for a refund of attorney fees under the bad faith exception to the American Rule was dismissed.) 

Interestingly, near the decision’s closing, the Court had some scathing words to say about Trilogy. The Court described Trilogy as a belligerent force “act[ing] in bad faith” to “harm… a competitor with a contentious history”. Shareholder activists have had some equally harsh words for Delaware corporate law. In particular, they have criticized Delaware for having what they perceive to be a bias in favor of companies’ board of directors, whilst consequentially depressing the rights of shareholders. As evidence, activist investors point out that more than half of US public companies are incorporated there. Ultimately, Versata Enterprises, Inc. v. Selectica, Inc. is particularly significant in that it is representative of some of the tension between companies and their shareholders.

Posted by David Schatz