Selectica, Inc. v. Versata Enterprises, Inc.: The Court's Treatment of Director Independence & the Preclusivity of Defensive Measures

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.