Business Law Developments
Article Date: Tuesday, February 15, 2011
Written By: Thomas J. Molony
After You Die, It May Be Too Late for Redemption
The North Carolina Business Court considered whether the estate of a deceased shareholder of three North Carolina corporations, each with 25 or more shareholders and significant numbers of employees, was entitled to judicial dissolution when the corporations refused to redeem the shares of the deceased at fair value following her death. High Point Bank & Trust Co. v. Sapona Mfg. Co., 2010 NCBC 11 (June 22, 2010). The court concluded that the framework in Meiselman v. Meiselman, 309 N.C. 279, 307 S.E.2d 551 (1983) for determining the right to judicial dissolution was not limited to small, closely-held corporations, but that one previous repurchase of a deceased shareholder’s shares and three previous offers to all shareholders to repurchase limited numbers of shares, without more, are not sufficient to create an enforceable right to redemption that would justify judicial dissolution under Meiselman.
Elizabeth Simmons was a minority shareholder of Sapona Manufacturing Company, Inc., Acme-McCrary Corporation and Randolph Oil Company, all of which are North Carolina corporations in which Simmons’s family had been involved for many years. Following Simmons’s death, High Point Bank & Trust Co., the executor of her estate, requested that the corporations redeem her shares at fair value. After the corporations refused, the bank filed a lawsuit seeking judicial dissolution of the corporations under N.C. Gen Stat. § 55-14-30(2)(ii).
N.C. Gen Stat. § 55-14-30(2)(ii) provides that a “superior court may dissolve a corporation . . . in a proceeding by a shareholder if it is established that . . . liquidation is reasonably necessary for the protection of the rights or interests of the complaining shareholder.” Under Meiselman, whether liquidation is reasonably necessary to protect the rights and interests of a complaining shareholder depends on whether the reasonable expectations of the complaining shareholder or shareholders have been frustrated.
High Point Bank & Trust claimed that, based on actions of Sapona and Acme-McCrary in the past, Simmons had a reasonable expectation that her shares would be redeemed by Sapona, Acme-McCrary, and Randolph Oil at fair value upon her death. The bank pointed to the fact that Sapona and Acme-McCrary over a decade ago had purchased a shareholder’s shares following his death and, shortly after purchasing those shares, had offered to repurchase shares from all of the corporations’ other shareholders. The bank also cited the fact that Sapona on another occasion had made an offer to all of its shareholders to repurchase shares.
The Business Court noted that the bank’s case for judicial dissolution was unusual because, with 51, 81 and 25 shareholders, Sapona, Acme-McCrary and Randolph Oil had substantially more shareholders than the corporations involved in Meiselman and its progeny. Nevertheless, the court declined to hold that Meiselman applied only to corporations with fewer than a certain number of shareholders. It did, however, state that “the number, composition, and rights and interests of the non-complaining shareholders . . . are important considerations.”
Applying Meiselman, the Business Court concluded that the actions the bank had identified were not sufficient to create an expectation that Simmons’s shares would be redeemed at fair value upon her death and that, even if they did create such an expectation, it was not a reasonable one. The court detailed a number of facts in support of its conclusion. First, the corporations had not adopted any redemption plan and had not set aside funds to redeem shares. Second, with only one exception, the corporations previously had not allowed for the redemption of shares of shareholders who had died. Third, in the single instance in which Sapona and Acme-McCrary had repurchased the shares of a deceased shareholder, they did so voluntarily and because of unique circumstances surrounding his death, not based of any expectation or demand. Fourth, the single repurchase of the shares of a deceased shareholder was followed by a general offer to repurchase shares, so if an expectation was created that the shares of a deceased shareholder would be redeemed, an expectation also was created that the shares of all shareholders were subject to redemption on a pro rata basis following the death of shareholder. Such a broad obligation, in the opinion of the court, would be unreasonable because it would pose a serious hardship on the corporation. Fifth, no facts indicated that Simmons had a personal right to redemption of her shares, and the boards of directors would face fiduciary duty claims if they redeemed her shares without offering to repurchase the shares of other minority shareholders. Sixth, the previous offers that Sapona and Acme-McCary had made to all shareholders were for the repurchase of limited numbers of shares at specific prices and did not mention the purchase of shares of deceased shareholders. Finally, Randolph Oil had never repurchased the shares of a deceased shareholder and had not otherwise offered to repurchase shares of its shareholders.
According to the Business Court, in Royals v. Piedmont Elec. Repair Co., 137 N.C. App. 700, 529 S.E.2d 515 (2000), the North Carolina Court of Appeals had recognized that, for a complaining shareholder to have a reasonable expectation that his or her shares would be purchased at fair value, the other shareholders must have known or assumed that to be the case. The Business Court observed that, for a corporation with a large number of shareholders, it is difficult to determine the expectations of each shareholder and, in this case, the bank had not offered any evidence that the other shareholders knew or assumed that Simmons expected that her shares would be redeemed upon her death. In addition, the court was “troubled” that Simmons had not communicated to any officer, director or shareholder of the corporations that she expected her shares to be redeemed upon her death.
In its opinion, the Business Court noted that a right of redemption “generally [is] spelled out in an agreement that specifically sets out when the right is triggered, what the purchase price will be, and how the purchase price will be paid.” For those like Simmons who inherit their shares, such an agreement may be difficult, if not impossible, to obtain. The Business Court’s opinion in High Point Bank & Trust highlights the importance of addressing (and, if appropriate, documenting) at the outset of a close business arrangement the circumstances under which any redemption rights should apply.
You Need More than a Receipt for this Return
The North Carolina Court of Appeals considered whether an oral agreement for the return of goods is enforceable against a seller, or can operate as a waiver by a seller, when the original purchase agreement requires modifications to be approved in writing by a specified person. Thermal Design, Inc. v. M&M Builders, Inc., ___ N.C. App. ___, 698 S.E.2d 516 (2010). The court concluded that an oral agreement with respect to the return of goods (i) is not valid as a new agreement or as a modification if the original purchase agreement requires written authorization of a specified person and the oral agreement does not satisfy the statute of frauds under the North Carolina Uniform Commercial Code (the “UCC”) and (ii) does not operate as a waiver against the seller if the specified person is not involved in the oral agreement.
M&M Builders, Inc. entered into a contract with Thermal Design, Inc. under which M&M agreed to purchase a custom-manufactured roofing and insulation system. After Thermal delivered the roofing system to M&M and M&M accepted it, M&M’s vice president contacted a Thermal salesman and told him that the system was not suitable for M&M’s purposes. M&M’s vice president claimed that, during a later conversation with the Thermal salesman in which a Thermal customer service manager participated, the parties had agreed that M&M could return the roofing system if it paid a restocking fee equal to 35% of the purchase price. About two weeks after that conversation, M&M sent Thermal’s salesman a fax that referred to a 35% restocking fee, but did not indicate that the parties had agreed to it. Both Thermal’s salesman and its customer service manager denied that any agreement had been reached. Thermal’s vice president later offered to accept a return in exchange for a credit of a portion of the purchase price. M&M declined the offer and sent Thermal a check for 35% of the purchase price. Thermal refused the check and filed a lawsuit against M&M for breach of contract and unjust enrichment.
In an appeal of summary judgment granted in favor of Thermal, M&M argued that the telephone conversation between M&M’s vice president and Thermal’s salesman and customer service manager resulted in a new contract for return of the roof, a modification of the terms of the original purchase contract or a waiver of the terms of the original contract. The Court of Appeals rejected all three of M&M’s theories.
The court concluded that the conversation did not result in a new contract or a modification of the original contract because of the terms of the original contract and the statute of frauds under the UCC. The original contract expressly provided that it could “not be altered except with the written authorization of a corporate officer of Thermal Design[,] Inc.” The court observed that, not only had no written authorization been given, none of Thermal’s officers participated in the conversation between M&M’s vice president and Thermal’s salesman and customer service manager. Therefore, according to the court, any oral agreement was unenforceable under the terms of the original contract.
M&M argued that, because it had sent a fax to Thermal referencing the restocking fee and Thermal failed to object in writing within 10 days, the alleged oral contract or modification met the requirements of the merchant’s exception to the statute of frauds under N.C. Gen. Stat. § 25-2-201(2). For merchant’s exception to apply, “within a reasonable time [after an oral contract is made] a writing in confirmation of the contract and sufficient against the sender must be received.” Citing the official comment to N.C. Gen. Stat. § 25-2-201, the Court of Appeals stated that, to be a sufficient confirmatory writing, M&M’s fax must have (i) “evidence[d] a contract for the sale of goods,” (ii) “be[en] ‘signed’” and (iii) “specif[ied] a quantity.” According to the court, M&M’s fax did not meet the first element because it did not reference any previous oral agreement and it did not meet the third element because, unlike the purchase order for the roofing system which had listed its components in detail, the fax did not address quantity at all. The court noted that the fax might have met the third element if it merely had stated that “all” of the roofing system was to be returned.
The Court of Appeals also concluded that the alleged oral agreement did not operate as a waiver because of the terms of the contract and because an effective waiver requires more than a mere promise. The terms of the original contract specified that the authorization of a Thermal corporate officer was required for an alteration. According to the court, because the Thermal salesman and customer service manager were not corporate officers, they could not effect a waiver on behalf of Thermal. In addition, the court indicated, a waiver under N.C. Gen. Stat. § 25-2-209 requires not only a promise, but also “(1) additional consideration; (2) material change in position by the promisee based on the alleged oral contract; or (3) conduct on the part of the party offering the statute of frauds as a defense sufficient to show that an oral agreement was reached.” M&M argued only that it materially changed its position by purchasing a substitute roofing system. The Court of Appeals rejected M&M’s argument because M&M’s vice president had told its architect the day before the alleged waiver occurred that a substitute system was to be used.
The Thermal Design opinion is significant because it suggests that a practitioner can protect a client against inadvertent waivers by specifying in waiver/modification provisions who must authorize waivers and modifications on behalf of the client. Unfortunately, the opinion is less than clear regarding the effect of a waiver/modification provision on an oral modification that satisfies the statute of frauds under the UCC, but not the provision’s requirement that modifications be signed and in writing. Because N.C. Gen. Stat. § 25-2-209(2) provides that “[a] signed agreement which excludes modification . . . except by a signed writing cannot be otherwise modified . . . ,” it appears that an oral modification would be invalid in such a circumstance and that the Court of Appeals was offering the failure to satisfy the requirements of the contract and the failure to satisfy the statute of frauds as alternative reasons for why M&M’s alleged oral agreement was invalid. The court would have done a better service if it had said so.
Preliminary Injunction? Not Exactly.
The Delaware Chancery Court evaluated the validity of a termination fee in a merger transaction. In re Dollar Thrifty S’holder Litig., 2010 WL 350471 (Del. Ch. Sept. 8, 2010). The court concluded that the magnitude of a termination fee must be considered in light of the total value to be received by the shareholders, not the total consideration to be paid by the purchaser.
On April 25, 2010, Hertz Global Holdings, Inc. entered into a merger agreement to acquire Dollar Thrifty Automotive Group, Inc., a Delaware corporation, for a combination of cash and Hertz stock that represented a 5.5% premium over Dollar Thrifty’s stock price on the day before the parties signed the agreement. The merger agreement contained several deal protection measures. Specifically, it provided that, if the merger did not close and Dollar Thrifty entered into a higher valued transaction within one year, Dollar Thrifty would pay Hertz a $44.6 million termination fee and would reimburse Hertz for up to $5 million in expenses. The agreement also prohibited Dollar Thrifty from seeking higher bids, but included a “fiduciary out” and gave Dollar Thrifty substantial latitude to share confidential information if another bidder came forward with a superior proposal. If a superior proposal was made, however, Hertz had the right to match the proposal.
Shortly after Hertz and Dollar Thrifty entered into the merger agreement, Dollar Thrifty shareholders filed a class action lawsuit seeking to enjoin the merger. The plaintiffs claimed that the board had breached its obligations under Revlon v. MacAndrews & Forbes Holdings, Inc., 506 A.2d 173 (Del. 1986) by failing to “draw Avis [Budget Group, Inc.] into a bidding contest with Hertz” before signing the Hertz merger agreement. The plaintiffs also complained that the deal protection measures substantially discouraged superior proposals and were inappropriate in light of the small premium being paid by Hertz. The Delaware Chancery Court determined that the record did not support the plaintiffs’ claims and denied a preliminary injunction.
The court explained that, under Revlon, “[w]hen the Dollar Thrifty Board decided to enter into a transaction that involved the sale of the company in a change of control transaction, it was charged with the obligation to secure the best value reasonably attainable for its shareholders, and to direct its fiduciary duties to that end.” According to the court, Revlon does not require any particular course of action, only that the directors act reasonably to obtain the best deal available.
The Chancery Court concluded that, for a number of reasons, the board’s decisions not to promote an immediate auction and not to contact Avis before signing the Hertz merger agreement were reasonable under the circumstances. First, the board appeared honestly concerned that a public sale process might distract Dollar Thrifty’s employees and affect their productivity. Second, the board had considered contacting Avis and had good reasons for deciding not to do so. Specifically, the court highlighted that Dollar Thrifty had a history of failed negotiations with Avis and that Dollar Thrifty’s board had been advised that Avis might have financial difficulties in making a bid and presented a greater antitrust risk than Hertz. Third, the board was justifiably anxious about the effect of a public auction on Hertz’s bid.
The court pointed out that, although a public auction might have encouraged a “heated contest” between Avis and Hertz, it also might have had negative effects, such as causing Hertz to drop out of the process and leaving Avis with little motivation to move forward with a transaction on favorable terms. Finally, the board had made sure that any deal with Hertz would leave open the possibility of entertaining and accepting a higher bid.
The court also determined that the Dollar Thrifty board’s decision to authorize the Hertz merger agreement was reasonable. The plaintiffs complained that the Hertz bid represented only a modest premium over market price. The Chancery Court rejected the notion that the market price for a company’s stock always is a reliable measure of its value and observed that, consistent with Smith v. Van Gorkom, 488 A.2d 858 (Del. 1985), the board had appropriately focused on fundamental value when it analyzed Hertz’s bid.
The court stressed that, because Dollar Thrifty’s board entered into the merger agreement without first testing the market, “it [had been] incumbent upon the Board to consider . . . whether it was ensuring the viability of a post-signing market check.” The plaintiffs calculated the $44.6 million termination fee as 5.1% of the total deal value and asserted that the fee, together with Hertz’s right to match superior proposals, deterred a post-signing market check. In evaluating the plaintiffs’ claim, the court corrected the plaintiffs’ calculation. The court noted that the plaintiffs’ calculation incorrectly had excluded from the total deal value a $200 million special dividend that Dollar Thrifty was to pay if and only if the Hertz merger were to occur. The court insisted that the termination fee must be measured against the entire value of the deal, not just the consideration to be paid by the purchaser, because another bidder would need to offer value in excess of the entire value if it wanted to be successful. Adjusting for the special dividend and for another error the plaintiffs had made, the court determined that the termination fee itself represented approximately 3.5% of total deal value and, when combined with the up to $5 million of expenses for which Hertz was to be reimbursed if the termination fee was paid, represented approximately 3.9% of the total deal value. Although “robust,” the court found that the fee was “a relatively insubstantial barrier” to a superior bid.
The court concluded that the termination fee and the other deal protection measures were not unreasonable. Aided by the fact that, after the plaintiffs had filed their lawsuit, Avis made a proposal to acquire Dollar Thrifty for a higher price, the court determined that the measures were neither preclusive nor coercive. They were not preclusive because they allowed Dollar Thrifty to entertain a superior bid and because a serious bidder only would have to bear “modest compensation” to Hertz. They were not coercive because they left Dollar Thrifty’s shareholders with the opportunity to accept the Hertz deal or to decide that the corporation should remain independent. The court asserted that the termination fee would not impede the shareholders’ decision because Dollar Thrifty would bear the fee only if the shareholders accepted another proposal within a year.
The Dollar Thrifty opinion offers important guidance as to what the board of a Delaware corporation should consider when deciding whether to enter into a merger agreement without first testing the market. In particular, the opinion is significant because it highlights the impact of market premiums on board decision-making and because it describes how appropriately to measure the magnitude of termination fees.
A Staggering Response to the Competition
The Delaware Chancery Court considered the propriety of defensive measures adopted by the board of a closely-held corporation. eBay Domestic Holdings, Inc. v. Newmark, 2010 WL 3516473 (Del. Ch. Sept. 9, 2010). The court concluded that the requirement in Unocal Corp. v. Mesa Petroleum Co., 493 A.2d 946 (Del. 1985) that defensive measures be considered collectively did not apply outside the takeover context, but that individual measures, including rights plans, still may be subject to Unocal enhanced scrutiny.
James Buckmaster and Craig Newmark are directors of craigslist, Inc., a Delaware corporation. They also are its controlling stockholders; eBay Domestic Holdings, Inc. is the only other stockholder. craigslist’s charter provides for a three-person board and cumulative voting, which initially guaranteed eBay a seat on the board.
When e-Bay purchased its stock, it entered into a stockholders’ agreement with Buckmaster, Newmark, and craigslist. The agreement specifically permitted eBay to compete with craigslist, but provided that if eBay did so, it would lose preemptive rights, a right of first refusal for Buckmaster’s and Newmark’s stock, and the right to vote on certain corporate actions. Interestingly, under the agreement, competing with craigslist also would result in the release of eBay’s stock from a right of first refusal in favor of Buckmaster and Newmark.
On June 29, 2007, eBay launched a website that competes with craigslist’s website. A few days later, eBay’s representative on the craigslist board resigned. His replacement was never seated. After eBay refused a request by Buckmaster and Newmark that eBay sell its craigslist stock either to craigslist or to a suitable third party, Buckmaster and Newmark, as the sole directors of craigslist, (i) adopted a rights plan, (ii) instituted a staggered board with one director in each class and (iii) authorized the company to offer additional shares to each shareholder in exchange for a right of first refusal in favor of the company. When Buckmaster and Newmark accepted the offer for the additional shares and eBay declined, eBay’s percentage ownership dropped from 28.4% to 24.9%. eBay then sued, claiming that Buckmaster and Newmark breached their fiduciary duties as directors and controlling stockholders by taking the actions they did.
Although craigslist’s board took all three actions on the same date, the Chancery Court analyzed them one by one and applied a different standard of review to each. The court acknowledged the Delaware Supreme Court’s determination that, in the takeover context, “[w]here . . . defensive actions are inextricably related, the principles of Unocal require that [they] be scrutinized collectively as a unitary response to the perceived threat.” The court concluded, however, that the actions taken by craigslist’s board were not “an ‘inextricably related set of responses to a takeover threat’” and therefore did not require review as a whole.
Notwithstanding the fact that craigslist is a closely-held corporation, the Chancery Court applied the Unocal standard of review to the craigslist rights plan, explaining that fiduciary duties apply regardless of the characteristics of the corporation and that rights plans raise Unocal concerns because they “fundamentally are defensive devices that . . . can entrench management and deter value-maximizing bidders.” The craigslist rights plan included two triggers: the acquisition of 0.01% of additional craigslist stock by an existing stockholder or the acquisition by anyone else of 15% or more of craigslist’s outstanding shares.
Employing the Unocal standard, the Chancery Court considered (i) whether, in adopting the rights plan, Buckmaster and Newmark “properly and reasonably perceive[d] a threat to craigslist’s corporate policy and effectiveness” and (ii) whether the rights plan was a proportional response. The Chancery Court struck down the rights plan under both prongs. As to the first prong, Buckmaster and Newmark claimed that eBay posed a threat to craigslist’s public-service-focused culture. The court noted that, although a board may undertake defensive measures to protect corporate culture, the ultimate end must be the protection of stockholder value. According to the court, craigslist’s practice of giving away services did not constitute a “distinctive ‘culture’” and that, even if it did, Buckmaster and Newmark failed to establish a link between craigslist’s culture and shareholder profits. Buckmaster’s and Newmark’s disdain for profit maximization, the court stated, was incompatible with the for-profit corporate form, and “culture” does not eviscerate the duties associated with that form. As to Unocal’s second prong, the court determined that, although not fully preclusive (eBay could sell its shares, albeit only blocks of 14.99% or less), the rights plan was not a reasonable response to the threat Buckmaster and Newmark perceived because, before their deaths, Buckmaster and Newmark themselves could protect craigslist’s culture without the rights plan and, after their deaths, the rights plan did not protect craigslist’s culture.
By implementing a classified board, Buckmaster and Newmark eliminated eBay’s ability to appoint a director because cumulative voting is effective only when more than one director is being elected. Nevertheless, the Chancery Court applied the business judgment rule to the implementation of the classified board. The court explained that the Unocal test did not apply because the action did not represent a defensive measure in the traditional sense – in terms of board control. The court noted that, regardless of the implementation of a classified board, Buckmaster and Newmark would control the board because of a voting agreement between the two and because of the board’s size.
The court also explained that the entire fairness standard did not apply to the implementation of the classified board. The court rejected eBay’s argument that the entire fairness test applied because the action benefited Buckmaster and Newmark and harmed eBay. The court noted that entire fairness applies in the case of classic self-dealing or when a fiduciary expects to obtain a personal benefit which the corporation and the other stockholders do not also enjoy. According to the court, neither of those circumstances existed. The court determined that Buckmaster and Newmark received no financial benefit by virtue of the classified board. In addition, the court observed, under Delaware law, majority shareholders are entitled to elect the entire board, minority shareholders have no guaranteed right to cumulative voting, and classified boards specifically are permitted.
eBay argued that the business judgment rule did not apply because Buckmaster and Newmark implemented the classified board in bad faith. The court dismissed eBay’s argument, finding instead that they had acted for the appropriate purpose of protecting confidential information. The court went on to explain that Buckmaster’s and Newmark’s stated purpose of keeping a competitor from having access to confidential information to which the board is privy was a rational one and, because the business judgment rule applied, the court would not disturb Buckmaster’s and Newmark’s decision.
The Chancery Court applied the entire fairness test to craigslist’s offer of additional shares in exchange for a right of first refusal. The court concluded that entire fairness was appropriate because the offer involved a classic case of self-dealing, with Buckmaster and Newmark on both sides of the transaction – as directors of craigslist, which would receive the right of first refusal, and as stockholders, who would receive additional stock in exchange. The court then determined that the offer did not satisfy the requirements of entire fairness because, among other reasons, the “price” that eBay would be required to pay was higher than the one Buckmaster and Newmark were required to pay. When Buckmaster and Newmark entered into the new right of first refusal, their shares already were subject to a right of first refusal in favor of each other under the stockholders’ agreement. eBay’s shares, on the other hand, no longer were subject to that right of first refusal because of eBay’s competitive activity. Therefore, the court concluded, the price of the additional shares was higher to eBay because it was giving up an unfettered right to transfer its stock, while Buckmaster and Newmark were giving up a right with respect to stock that already was encumbered.
The eBay opinion is an important one because it offers guidance as to how Delaware courts will evaluate defensive measures adopted outside the takeover context and by closely-held Delaware corporations. In addition, the opinion provides a helpful summary of the requirements of, and the considerations involved in, the three levels of review applied by the Delaware courts: business judgment rule, Unocal enhanced scrutiny, and entire fairness.
A Trigger-Happy Board
The Delaware Supreme Court considered the validity of a shareholder rights plan with a 4.99% trigger that was adopted by a Delaware corporation to protect its net operating losses (“NOLs”) from impairment. Versata Enters., Inc. v. Selectica, Inc., 5 A.3d 586 (2010). The court held that the plan at issue was valid in light of the circumstances under which it was adopted, but did not generally approve rights plans – whether intended to protect NOLs or not – with 4.99% triggers.
Selectica, Inc., a Delaware corporation, had been unprofitable since going public in 2000. In July 2008, it engaged an investment banker to evaluate its strategic options, including a sale of the company. Trilogy, Inc., one of Selectica’s competitors, was interested in acquiring Selectica, but refused to sign the nondisclosure agreement required for participation in the investment banker’s sale process. From July 2008 to October 2008, however, Trilogy made three acquisition proposals. After Selectica rejected all three, Trilogy acquired more than six percent of Selectica’s outstanding stock.
Selectica had amassed substantial NOLs because of its poor financial performance. Concerned that Trilogy’s stock purchases might result in an “ownership change” that would irreparably impair Selectica’s NOLs under Section 382 of the Internal Revenue Code, Selectica’s board amended its 2003 shareholder rights plan. The amended plan (the “NOL Poison Pill”) reduced the trigger from 15% to 4.99%, but provided that additional acquisitions by existing holders with 5% or more of Selectica’s outstanding shares would not trigger the NOL Poison Pill so long as they acquired no more than an additional 0.5%.
After Selectica announced the NOL Poison Pill, Trilogy demanded a meeting to discuss Selectica’s alleged breach of a settlement agreement it had entered into with Trilogy in connection with a patent infringement suit. Representatives of Selectica and Trilogy met on Dec. 17, 2008. By December 19, Trilogy had purchased enough additional shares to trigger the NOL Poison Pill. Trilogy’s CFO claimed that it triggered the poison pill intentionally to accelerate discussions about the “complicated relationship” between Selectica and Trilogy.
After Trilogy triggered the NOL Poison Pill, Selectica’s board had ten days to decide whether to exempt Trilogy, exchange the rights under the poison pill for Selectica common stock, or allow the rights to “flip in” and become exercisable for the purchase of Selectica common stock. An external accountant specializing in NOL analysis advised the board that exchanging the rights for common stock would not have a material negative effect on Selectica’s NOLs, but that a “flip-in” might itself impair them. Selectica’s investment banker opined that impairment of the NOLs would reduce Selectica’s value. After hearing from its advisors and discussing Trilogy’s actions, the board concluded that Trilogy’s actions posed a threat to Selectica by endangering the NOLs and that implementing the exchange was a reasonable response to the threat. The board confirmed that an independent committee it had appointed when the NOL Poison Pill was adopted had the power to implement the exchange and to amend Selectica’s rights plan to include new rights. After obtaining additional assurances of the value of the NOLs and the continuing risk of their impairment, the committee implemented the exchange and adopted new rights with a 4.99% trigger (the “Reloaded NOL Poison Pill”) to protect the NOLs.
Selectica sought a declaratory judgment that the NOL Poison Pill, the exchange, and the Reloaded NOL Poison Pill were valid. The Delaware Supreme Court analyzed the three measures under the two-part Unocal test. The first part of the Unocal test “requires a board to show that it had reasonable grounds for concluding a threat to the corporate enterprise existed.” The second part requires the court to evaluate “whether a board’s defensive response to the threat was preclusive or coercive and, if neither, whether the response was ‘reasonable in relation to the threat identified.” A response is “coercive” if it seeks to force a management-sponsored option on the shareholders. A response is preclusive if it would make a successful proxy contest to seize control “realistically unattainable.”
The supreme court concluded that Selectica’s defensive measures survived the Unocal test. As to the first prong of the test, the court observed that Selectica’s board had analyzed the NOLs for a number of years and had received expert advice that the NOLs had significant value and would be beneficial in efforts to sell the company. In addition, according the court, the record indicated that Trilogy intended to buy more stock and that continued acquisitions by Trilogy and others up to the 15% threshold jeopardized the NOLs. Based on these facts, the supreme court held that the board had reasonable grounds for believing that Trilogy’s actions posed a threat to Selectica’s enterprise.
With respect to the second prong of the Unocal test, Trilogy argued that the NOL Poison Pill and the Reloaded NOL Poison Pill were preclusive because the 4.99% trigger, either alone or when coupled with Selectica’s classified board, makes a successful proxy contest “reasonably unattainable.” The supreme court observed that a 5% trigger was lower than that traditionally upheld by Delaware courts, but disagreed that the trigger in Selectica’s poison pills was preclusive. In support of its conclusion, the court cited expert testimony that 50 publicly-held companies had NOL rights plans with triggers around 5% and that, over a three-year period, challengers “controll[ing] less than 5.49% of the outstanding shares” were successful in 10 of 15 micro-cap company proxy contests. In addition, the court highlighted one expert’s opinion that, with 7 shareholders controlling 55% of Selectica’s common stock and 22 controlling 62%, the costs of a Selectica proxy contest would be considerably lower than those of a typical contest.
Trilogy claimed that Selectica’s 4.99% trigger, when combined with its classified board, is preclusive because it inhibits Trilogy’s ability to obtain control of the board to dispose of the poison pill. According to the court, if it were to accept Trilogy’s argument, it would mean that having both a rights plan (regardless of the trigger percentage) and a classified board always would be preclusive. The court held otherwise, indicating that, although the combination makes obtaining board control more difficult, it does not make success “realistically unattainable.”
Because Trilogy did not challenge Selectica’s defensive measures as coercive, after the supreme court determined that the measures were not preclusive, it turned to the reasonableness of Selectica’s board’s response and determined that it was indeed reasonable. According to the court, Selectica repeatedly tried to get Trilogy to enter into a standstill during the 10-day period after Trilogy triggered the NOL Poison Pill, but Trilogy refused unless Selectica agreed to repurchase its stock and, among other things, pay millions of dollars. In addition, the court noted that Selectica’s implementation of the exchange was less dilutive of Trilogy’s ownership interest than allowing the flip-in would have been.
Furthermore, the court determined that the Reloaded NOL Poison Pill was reasonable because the NOL Poison Pill and the exchange, while “effectively thwart[ing] Trilogy’s immediate threat to Selectica’s NOLs, . . . did not eliminate the general threat” of a change in ownership that would impair the NOLs.
The Selectica opinion is important because it validates the preservation of NOLs as a corporate interest that a board legitimately may take reasonable action to protect. It is also important because it declares that having both a rights plan and a classified board is not ipso facto preclusive and therefore invalid under the Unocal test. Practitioners, however, should be aware of the limitations of Selectica and bear in mind the Delaware Supreme Court’s warning that the case “should not be construed as generally approving the reasonableness of a 4.99% trigger in the Rights Plan of a corporation with or without NOLs.”
No, “Annual” Still Means One Year
The Delaware Supreme Court interpreted a provision of a Delaware corporate charter that provides for a classified board. Airgas, Inc. v. Air Prod. & Chem., Inc., 2010 WL 4734305 (Del. Nov. 23, 2010). The court determined that, if a charter states that the term of each class of directors expires “at the annual meeting of the stockholders held in the third-year following the year of their election” or something similar, it means that the directors hold their offices for three-year terms, and a bylaw provision that materially shortens the time between annual meetings for the purpose of shortening directors’ terms is invalid.
Since early 2010, Air Products and Chemicals, Inc. has been trying to take over Airgas, Inc., a Delaware corporation. To that end, Air Products engaged in a proxy contest at Airgas’s last annual meeting, which was held on Sept. 15, 2010. Airgas has a classified board which, at the time of the annual meeting, consisted of nine directors, with three directors up for election at each meeting. At the 2010 meeting, the Airgas stockholders approved Air Products’s proposed slate of three directors and an amendment to Airgas’s bylaws that Air Products had proposed. The amendment, which was approved by 45.8% of the shares entitled to vote, provided that annual stockholders’ meetings would held in January of each year, with the next annual meeting in January 2011 (the “January Bylaw”). The January Bylaw was significant because, if the provisions of Airgas’s charter and bylaws regarding its classified board were interpreted literally, the January Bylaw would enable Air Products to replace three more of Airgas’s directors just four months after Air Products’s first slate was elected.
Airgas’s charter and bylaws provide that “[a]t each annual meeting of the stockholders . . . , the successors to the class of Directors whose term expires at that meeting shall be elected to hold office for a term expiring at the annual meeting of the stockholders held in the third-year following the year of their election.” Airgas challenged the January Bylaw as inconsistent with its charter and Del. Code tit. 8, § 141. The Delaware Supreme Court agreed with Airgas and held that the January Bylaw impermissibly shortened the terms of directors under Airgas’s charter and Del. Code tit. 8, § 141(d) by eight months and represented a “de facto removal” of the directors inconsistent with a provision in Airgas’s charter that requires 67% shareholder approval to remove a director without cause.
In reaching its conclusion, the Delaware Supreme Court looked beyond the language regarding Airgas’s board in the charter (which the court determined was ambiguous) to what the court described as “overwhelming and uncontroverted extrinsic evidence” of the provision’s meaning. The court noted that there are two customary formulations (each with some variations) of charter clauses implementing classified boards. One formulation explicitly provides that the term of each class of directors is three years. The other formulation, the one used by Airgas and 58 of 89 Delaware corporations with classified boards, provides that each term ends at the “third succeeding annual meeting following the year of election.” The court determined that the two formulations mean the same thing. According to the court, in Airgas’s charter and in Del. Code tit. 8, § 141(d), the term “annual” means one year and, therefore, directors of a classified board serve for three-year terms. With respect to the January Bylaw, the court “safely concluded” that “annual” does not mean four months, though the court did note that directors’ terms need not “be measured with mathematical precision.”
The court cited multiple sources of extrinsic evidence in support of its conclusion. The court pointed to opinions that it, the chancery court, and the United States District Court for the District of Delaware had issued which involved corporations with charter provisions similar to Airgas’s formulation and noted that the opinions reflect “the understanding . . . that directors of staggered boards serve a three year term.”
The court also observed that a significant number of Delaware corporations that use or have used similar formulations state in their proxy statements that their directors serve three-year terms. Moreover, the court indicated that current and historical commentary suggests that the formulation intends that each class serve terms of three years.
The Airgas case is important because it provides certainty with respect to the meaning of language commonly used in Delaware charters. It also serves as a good reminder to be precise when drafting articles of incorporation and bylaws and not to rely blindly on “go-bys.”
Molony, an assistant professor of law at Elon University School of Law, previously focused on corporate and commercial law, public finance and bankruptcy for Robinson, Bradshaw & Hinson in Charlotte.
Views and opinions expressed in articles published herein are the authors' only and are not to be attributed to this newsletter, the section, or the NCBA unless expressly stated. Authors are responsible for the accuracy of all citations and quotations.