In my post of March 4 I noted that Vice Chancellor Noble addressed certain important doctrinal issues that I passed on to address how Trilogy’s negotiating posture with Selectica heavily influenced the Vice Chancellor’s decision to affirm the Selectica board’s adoption and triggering of a NOL pill. In this post I address two of those other issues addressed by Vice Chancellor Noble.
A. “Inside” Directors Treated as Independent
The Vice Chancellor had to review the Selectica board’s actions in light of the Unocal standard that applies enhanced scrutiny to a defensive measure adopted to thwart or impede a takeover to ensure that the action is motivated by a good faith concern for the welfare of the corporation and its stockholders and to ensure that the board did not act solely or primarily out of the desire to perpetuate themselves in office. Unocal Corp. v. Mesa Petroleum Co., 493 A.2d 946, 954 (Del. 1985). A board must also demonstrate that its defensive response was reasonable in relation to the threat posed. As clarified by the Court in Unitrin, a defensive measure is disproportionate, or unreasonable, if it is either “coercive” or “preclusive.” Unitrin, Inc. v. American General Corp., 651 A.2d 1361, 1387 (Del. 1995).
A board’s conduct is viewed more favorably by the Delaware courts if the defensive actions are taken by a majority of independent directors. So the initial fight before Vice Chancellor Noble between Selectica and Trilogy was over the independence of the four directors sitting on the Selectica board that adopted and triggered the NOL poison pill. The Vice Chancellor’s treatment of two of them attracted my attention. Directors Zawatski and Thanos both were appointed Co-Chairs of the board in August 2008 after the board terminated the CEO and elected not to replace him. (After August 19, 2009, Zawatski became the sole Chair of the board and “continued to handle the Company’s daily operations.” Slip Opinion at 5, note 10.)
Delaware law distinguishes between an “outside” director and an “independent” director. An outside director is a non-employee and a non-management director who receives no income other than usual directors’ fees. Slip Opinion at 35. Delaware applies a subjective person standard, however, in considering the question of director independence, examining the relevant facts to determine whether the director is one whose decision is based on the corporate merits of the subject before the board rather than extraneous considerations or influences, and whether the director is dominated or otherwise controlled by an individual or entity interested in the transaction.
There is little question that Zawatski and Thanos did not qualify as “outside” directors under either Delaware law or the applicable standards of the SEC and the stock exchanges. As Co-Chairs of the board, they performed duties comparable to those of the CEO, a disqualification by itself under the independence standards of the SEC and the exchanges. Moreover, while each claimed their compensation was not material to them, as Co-Chairs Thanos was paid $164,125 and Zawatski $274,273 in addition to their compensation as directors, another basis for disqualifying them as independent under SEC and stock exchange standards.
Nevertheless, Vice Chancellor Noble concluded that each, based on the record before him, were independent. As he noted:
“Both Thanos and Zawatski were retired and took on the Co-Chair position following successful careers in the private sector. Both serve on multiple boards and both have testified that the income they receive in these roles is not personally material to them, and that they hope to be able to resign these positions in the near term.”
Slip Opinion at 39 (footnote omitted).
While the Vice Chancellor could not conclude that Selectica’s board’s actions in adopting and triggering the NOL poison pill against Trilogy were entitled to “material enhancement” by reason of the independence of the board, in effect he granted the board that presumption, clearly influenced by their conduct in the situation the board found itself following the CEO’s termination. He rejected as groundless the concern that the board’s actions stemmed from a desire for entrenchment. As he noted:
“Both Zawatski and Thanos had previously been outside directors before taking over management duties and had only temporarily assumed these duties in lieu of hiring a new CEO in anticipation of the Company’s proximate sale. Further, one may readily presume that, given the financial plight of the Company, attracting additional independent and qualified directors might be difficult.”
Id. at 40.
B. Did Selectica’s Five Percent Trigger Make Its NOL Pill Preclusive?
The second topic of interest in Vice Chancellor Noble’s application of Unocal to Selectica’s board’s adoption and triggering of its NOL pill is his treatment of Trilogy’s claim that adoption of the pill was unreasonable because it was “preclusive.” A defensive measure is preclusive under Delaware law where it operates to unreasonably preclude a takeover or precludes effective stockholder action, including where a measure makes a bidder’s ability to wage a successful proxy contest and gain control either mathematically impossible or realistically unattainable. Slip Opinion at 54.
The Vice Chancellor’s treatment of Trilogy’s claim of preclusion makes clear that defensive measures must be extreme before they will be invalidated by the Delaware courts. Defensive measures that make it more difficult for an acquirer to obtain control of a board are not preclusive; preclusive measures are those that are “insurmountable” or “impossible to outflank.” Id. at 55, citing tionIn re Gaylord Container Corporation Shareholders Litigation, 753 A.2d 462, 481-482 (Del. Ch. 2000). Trilogy’s primary claim of preclusivity focused on the NOL trigger — 4.99% of Selectica’s outstanding common shares. Trilogy argued that this low trigger “renders the possibility of an effective proxy contest realistically unattainable.” Slip Opinion at 56. With such a low trigger, argued Trilogy, a challenger could not establish a sufficient foothold in the securities of the target to establish a credible threat to incumbent management. Moreover, the low trigger combined with a staggered board (such as characterized the Selectica board), further rendered a potential takeover unrealistic since a proxy contest would have to be sustained over multiple years to gain control of the board.
Selectica effectively countered by pointing to the adoption by more than 50 publicly-held companies of NOL pills with triggers of roughly 5%, and to some 15 proxy contests occurring over a three-year period where the challenger controlled less than 5.49% of the outstanding shares, with the challenger successfully obtaining board seats in ten of such contests, including five involving companies with classified boards.
Vice Chancellor Noble granted Trilogy the point that the low trigger of a NOL poison pill “has a substantial preclusive effect,” Slip Opinion at 59, but concluded that the effects were not “draconian,” and therefore not preclusive under the Unocal/Unitrin standards:
“It is not enough that a defensive measure would make proxy contests more difficult — even considerably more difficult. To find a measure preclusive (and avoid the reasonableness inquiry altogether), the measure must render a successful proxy contest a near impossibility or else utterly moot, given the specific facts at hand.”
Slip Opinion at 60 (footnote omitted).
What are examples of preclusive defensive measures? Vice Chancellor Noble cites two examples, those condemned by the Delaware Supreme Court in Omnicare, Inc. v. NCS Healthcare, Inc., 818 A.2d 914 (Del. 2003) — a no-shop, submit the agreement to the stockholders even if the board changes its recommendation, and shareholder lock-ups of more than 50% of the outstanding shares — and that condemned by Vice Chancellor Jacobs in Carmody v. Toll Brothers, Inc., 723 A.2d 1180 (Del. Ch. 1998) where the Vice Chancellor found the adoption of a “dead-hand” poison pill preclusive (the pill in Carmody could only be redeemed by the directors who adopted it or their designated successors).
The question that naturally arises from Vice Chancellor Noble’s conclusion on preclusion is whether a creative board could justify a 5% or so trigger for reasons other than preserving NOLs. If it can, then Selectica is authority for the proposition that a low-trigger pill, even when adopted by a board with staggered terms, will not be considered preclusive under Delaware law.
Wednesday, March 10, 2010
Thursday, March 4, 2010
Selectica, Inc. v. Versata Enterprises, Inc.: Delaware Chancery Court Upholds Trigger of Poison Pill
This case has already gotten lots of attention, as the first instance of the triggering of a poison pill. In his decision of February 26, 2010, 2010 WL 703062, Vice Chancellor Noble concluded that Selectica’s board acted reasonably in adopting a low-threshold (4.99%) poison pill to protect the company’s NOL. His careful decision illustrates why participants in contests for control should always ask themselves “how will this look before the Delaware Chancery Court?”
A. Bad Blood Between Selectica and Trilogy, Inc.
Both Selectica and Trilogy, Inc. provide enterprise software solutions for contract management and sales configuration systems, whatever that means. Trilogy, a private company, is controlled by Joseph Liemandt, its founder and over 85% stockholder. Trilogy had been successful in two patent infringement lawsuits against Selectica, securing a judgment in one of $7.5 million and a settlement in the other of up to $17.5 million, of which some $7.5 million was deferred. Trilogy had also made several unsuccessful runs at acquiring Selectica, which Selectica’s board rebuffed. By the end of 2006, Trilogy had disposed of its Selectica shares.
B. Selectica’s NOL
Since Selectica went public in March 2000, it had never turned a profit. By the time of the dispute before Vice Chancellor Noble in the spring of 2009, it was trading below $1 per share, and it had incurred operating losses of some $160 million. Fewer than 25 investors held some two-thirds of its outstanding stock.
Selectica’s NOL drew the attention of Steel Partners, a private equity fund specializing in smaller cap companies. Steel Partners saw an opportunity in marrying Selectica with a profitable company to exploit Selectica’s NOL. As a result of pressure from Steel Partners, Selectica retained specialists to analyze its NOL and the complicated provisions governing the loss of NOLs if a company undergoes an “ownership change” as defined in IRC Code §382, generally defined as an ownership change of more than 50 percentage points by one or more 5% shareholders within a period of three years. If such an ownership change occurs, then a substantial portion of the NOL is lost.
C. Exploration of Strategic Alternatives
By July of 2008 Selectica concluded it had to explore strategic alternatives. It retained Needham & Company to evaluate its alternatives. The evaluation included reaching out to potential buyers. By February 2009, at least half a dozen parties were seriously interested in Selectica. By April 2009, Selectica had signed a letter of intent and entered into exclusive negotiations with a potential buyer.
D. Trilogy Butts In
Trilogy resumed its interest in Selectica in the summer of 2008. Trilogy made a couple of lowball offers for Selectica, which were rejected by its board. It was invited to engage in the sale process being overseen by Needham, but it declined, apparently out of unwillingness to sign a non-disclosure agreement. Trilogy and its founder, Liemandt, commenced buying Selectica’s stock in the open market. The buying crossed the 5% threshold in November 2008, prompting Trilogy to file a Schedule 13D, in which it stated that it had acquired the Selectica shares “for investment purposes.”
E. Selectica’s Adoption of the NOL Pill
The Selectica board, concerned about the effect of Trilogy’s purchases on its NOL, arguably Selectica’s major asset, engaged its accounting and tax advisors to evaluate its NOL and its potential loss through an “ownership change.” They concluded, after extensive analysis and consultation with the board, that the NOL was valuable and that Trilogy’s actions in acquiring Selectica shares threatened it. On November 16, 2008, the board amended its previous shareholder rights plan, adopted in February 2003, with a view to protecting its NOL. The trigger was dropped from 15% to 4.99%, with existing 5% stockholders grandfathered to permit them to acquire up to an additional 0.5% of Selectica’s shares (subject to the original 15% cap) without triggering the pill. The board established a committee of independent directors to periodically review the pill to determine whether it would continue to be in the best interest of Selectica and its stockholders.
F. Trilogy Buys Through the Trigger
Adoption of the NOL poison pill apparently outraged Trilogy and its controlling stockholder, Liemandt. Liemandt promptly inquired of two of Trilogy’s officers how many shares of Selectica Trilogy and Liemandt would need to purchase “to ruin the tax attributes” of the NOL. Slip Opinion at 20. Trilogy then promptly notified Selectica that a contract it had known about for some four months between Selectica and Sun Microsystems breached the terms of the prior patent infringement settlement between Selectica and Trilogy.
By December 19, 2008, Trilogy had blown through the NOL trigger, attaining 6.7% ownership of Selectica’s outstanding common stock. Selectica then had 10 days, under the terms of the plan, to determine whether Trilogy would qualify as an “exempt person” under the plan, thus avoiding triggering the pill. What was Liemandt’s motive in blowing through the trigger?
“Liemandt testified that the rationale behind triggering the pill was to ‘bring accountability’ to the Board and ‘expose’ what Liemandt characterized as ‘illegal behavior’ by the Board in adopting a pill with such a low trigger.”
Slip Opinion at 21 (footnote omitted).
And what was Trilogy’s proposal to Selectica?
“He [an officer of Trilogy] then proposed that Selectica agree to purchase Trilogy’s shares back, accelerate the payment of its [$7 million] debt, terminate its license with Sun, and make a payment to Trilogy of $5 million ‘for settlement of basically all outstanding issues between our companies.’”
Slip Opinion at 22 (footnote omitted).
This is what one might term an “unvarnished” proposal. One suspects it was not vetted with experienced counsel.
Needless to say, the Selectica board rejected Trilogy’s settlement demands as “highly unreasonable” and “lacking any reasonable basis in fact.” No kidding.
G. After Trilogy Repeatedly Rejects Requests for a Standstill, Selectica Triggers the Pill
Selectica repeatedly requested that Trilogy agree to a standstill and not purchase any additional shares of Selectica stock. Trilogy rejected the demands. Accordingly, after extensive consultation with its tax and legal advisors, the board, on January 2, 2009, implemented the pill and authorized an exchange of rights of common stock and a reloading of the pill. As a result of the exchange, the number of outstanding shares of Selectica’s common stock was doubled, other than for Trilogy and its affiliates, whose ownership of Selectica stock dropped from 6.7% to 3.3%.
H. The Court’s View of Trilogy’s Conduct
Vice Chancellor Noble’s discussion of poison pills, Selectica’s NOL poison pill, and the standards governing the adoption and exercise of a poison pill are important and deserve attention, but not in this post. What I want to focus on is how Trilogy’s ill-advised and, frankly, off the wall conduct in negotiations (or the lack thereof) with Selectica influenced the Vice Chancellor.
At trial and in post-trial argument, Trilogy and its counsel mounted an impressive challenge to all aspects of Selectica’s board’s conduct, including the justification for any NOL pill, the processes followed by the Selectica board in adopting and implementing the pill, the board’s reliance upon experts, and the failure of the Selectica board to meet the Unocal tests for application of the business judgment rule to the adoption of a defensive measure such as a poison pill. All of these objections were carefully rejected by Vice Chancellor Noble. Trilogy’s arguments have a distinct ex post flavor. One cannot escape the conclusion that this case was decided by Trilogy’s opportunistic behavior in making a run at Selectica to coerce it into meeting demands of Trilogy that had nothing to do with Selectica’s governance or its control. As the Vice Chancellor notes at the end of his extensive opinion:
“Here, the record demonstrates that a longtime competitor sought to employ the shareholder franchise intentionally to impair corporate assets [of Selectica], or else to coerce the Company into meeting certain business demands under the threat of such impairment.”
. . . .
In this instance, Trilogy, a competitor with a contentious history, recognized that harm would befall its rival if it purchased sufficient shares of Selectica stock, and Trilogy proceeded to act accordingly.”
Slip Opinion at 65, 69.
______________________
Kudos to the Selectica directors. They served on the board of a small company that had never made money and had been pushed around by an aggressive competitor. They did something no other board had ever done, trigger a poison pill. In a risk averse world, that took courage. Their judgment and determination have been rewarded by Vice Chancellor Noble’s decision in this case.
A. Bad Blood Between Selectica and Trilogy, Inc.
Both Selectica and Trilogy, Inc. provide enterprise software solutions for contract management and sales configuration systems, whatever that means. Trilogy, a private company, is controlled by Joseph Liemandt, its founder and over 85% stockholder. Trilogy had been successful in two patent infringement lawsuits against Selectica, securing a judgment in one of $7.5 million and a settlement in the other of up to $17.5 million, of which some $7.5 million was deferred. Trilogy had also made several unsuccessful runs at acquiring Selectica, which Selectica’s board rebuffed. By the end of 2006, Trilogy had disposed of its Selectica shares.
B. Selectica’s NOL
Since Selectica went public in March 2000, it had never turned a profit. By the time of the dispute before Vice Chancellor Noble in the spring of 2009, it was trading below $1 per share, and it had incurred operating losses of some $160 million. Fewer than 25 investors held some two-thirds of its outstanding stock.
Selectica’s NOL drew the attention of Steel Partners, a private equity fund specializing in smaller cap companies. Steel Partners saw an opportunity in marrying Selectica with a profitable company to exploit Selectica’s NOL. As a result of pressure from Steel Partners, Selectica retained specialists to analyze its NOL and the complicated provisions governing the loss of NOLs if a company undergoes an “ownership change” as defined in IRC Code §382, generally defined as an ownership change of more than 50 percentage points by one or more 5% shareholders within a period of three years. If such an ownership change occurs, then a substantial portion of the NOL is lost.
C. Exploration of Strategic Alternatives
By July of 2008 Selectica concluded it had to explore strategic alternatives. It retained Needham & Company to evaluate its alternatives. The evaluation included reaching out to potential buyers. By February 2009, at least half a dozen parties were seriously interested in Selectica. By April 2009, Selectica had signed a letter of intent and entered into exclusive negotiations with a potential buyer.
D. Trilogy Butts In
Trilogy resumed its interest in Selectica in the summer of 2008. Trilogy made a couple of lowball offers for Selectica, which were rejected by its board. It was invited to engage in the sale process being overseen by Needham, but it declined, apparently out of unwillingness to sign a non-disclosure agreement. Trilogy and its founder, Liemandt, commenced buying Selectica’s stock in the open market. The buying crossed the 5% threshold in November 2008, prompting Trilogy to file a Schedule 13D, in which it stated that it had acquired the Selectica shares “for investment purposes.”
E. Selectica’s Adoption of the NOL Pill
The Selectica board, concerned about the effect of Trilogy’s purchases on its NOL, arguably Selectica’s major asset, engaged its accounting and tax advisors to evaluate its NOL and its potential loss through an “ownership change.” They concluded, after extensive analysis and consultation with the board, that the NOL was valuable and that Trilogy’s actions in acquiring Selectica shares threatened it. On November 16, 2008, the board amended its previous shareholder rights plan, adopted in February 2003, with a view to protecting its NOL. The trigger was dropped from 15% to 4.99%, with existing 5% stockholders grandfathered to permit them to acquire up to an additional 0.5% of Selectica’s shares (subject to the original 15% cap) without triggering the pill. The board established a committee of independent directors to periodically review the pill to determine whether it would continue to be in the best interest of Selectica and its stockholders.
F. Trilogy Buys Through the Trigger
Adoption of the NOL poison pill apparently outraged Trilogy and its controlling stockholder, Liemandt. Liemandt promptly inquired of two of Trilogy’s officers how many shares of Selectica Trilogy and Liemandt would need to purchase “to ruin the tax attributes” of the NOL. Slip Opinion at 20. Trilogy then promptly notified Selectica that a contract it had known about for some four months between Selectica and Sun Microsystems breached the terms of the prior patent infringement settlement between Selectica and Trilogy.
By December 19, 2008, Trilogy had blown through the NOL trigger, attaining 6.7% ownership of Selectica’s outstanding common stock. Selectica then had 10 days, under the terms of the plan, to determine whether Trilogy would qualify as an “exempt person” under the plan, thus avoiding triggering the pill. What was Liemandt’s motive in blowing through the trigger?
“Liemandt testified that the rationale behind triggering the pill was to ‘bring accountability’ to the Board and ‘expose’ what Liemandt characterized as ‘illegal behavior’ by the Board in adopting a pill with such a low trigger.”
Slip Opinion at 21 (footnote omitted).
And what was Trilogy’s proposal to Selectica?
“He [an officer of Trilogy] then proposed that Selectica agree to purchase Trilogy’s shares back, accelerate the payment of its [$7 million] debt, terminate its license with Sun, and make a payment to Trilogy of $5 million ‘for settlement of basically all outstanding issues between our companies.’”
Slip Opinion at 22 (footnote omitted).
This is what one might term an “unvarnished” proposal. One suspects it was not vetted with experienced counsel.
Needless to say, the Selectica board rejected Trilogy’s settlement demands as “highly unreasonable” and “lacking any reasonable basis in fact.” No kidding.
G. After Trilogy Repeatedly Rejects Requests for a Standstill, Selectica Triggers the Pill
Selectica repeatedly requested that Trilogy agree to a standstill and not purchase any additional shares of Selectica stock. Trilogy rejected the demands. Accordingly, after extensive consultation with its tax and legal advisors, the board, on January 2, 2009, implemented the pill and authorized an exchange of rights of common stock and a reloading of the pill. As a result of the exchange, the number of outstanding shares of Selectica’s common stock was doubled, other than for Trilogy and its affiliates, whose ownership of Selectica stock dropped from 6.7% to 3.3%.
H. The Court’s View of Trilogy’s Conduct
Vice Chancellor Noble’s discussion of poison pills, Selectica’s NOL poison pill, and the standards governing the adoption and exercise of a poison pill are important and deserve attention, but not in this post. What I want to focus on is how Trilogy’s ill-advised and, frankly, off the wall conduct in negotiations (or the lack thereof) with Selectica influenced the Vice Chancellor.
At trial and in post-trial argument, Trilogy and its counsel mounted an impressive challenge to all aspects of Selectica’s board’s conduct, including the justification for any NOL pill, the processes followed by the Selectica board in adopting and implementing the pill, the board’s reliance upon experts, and the failure of the Selectica board to meet the Unocal tests for application of the business judgment rule to the adoption of a defensive measure such as a poison pill. All of these objections were carefully rejected by Vice Chancellor Noble. Trilogy’s arguments have a distinct ex post flavor. One cannot escape the conclusion that this case was decided by Trilogy’s opportunistic behavior in making a run at Selectica to coerce it into meeting demands of Trilogy that had nothing to do with Selectica’s governance or its control. As the Vice Chancellor notes at the end of his extensive opinion:
“Here, the record demonstrates that a longtime competitor sought to employ the shareholder franchise intentionally to impair corporate assets [of Selectica], or else to coerce the Company into meeting certain business demands under the threat of such impairment.”
. . . .
In this instance, Trilogy, a competitor with a contentious history, recognized that harm would befall its rival if it purchased sufficient shares of Selectica stock, and Trilogy proceeded to act accordingly.”
Slip Opinion at 65, 69.
______________________
Kudos to the Selectica directors. They served on the board of a small company that had never made money and had been pushed around by an aggressive competitor. They did something no other board had ever done, trigger a poison pill. In a risk averse world, that took courage. Their judgment and determination have been rewarded by Vice Chancellor Noble’s decision in this case.
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