Friday, October 22, 2010

Adoption of Poison Pill to Protect Net Operating Loss Carryforwards Protected by Business Judgment Rule

In a case involving a profitless company’s fight to preserve valuable net operating loss carryforwards, the board of director’s adoption of a poison pill to protect the NOLs bestowed on the company by the federal tax code was protected by the business judgment rule even under the heightened Unocal test. While the value of net operating loss carryforwards is inherently unknowable before they are used, ruled the full Delaware Supreme Court, a board may properly conclude that NOLs are worth protecting when it does so reasonably and in reliance on expert advice. The board here had ample reason to conclude that the NOLs were an asset worth protecting and that their preservation was an important corporate objective. Versata Enterprises, Inc. v. Selectica, Inc., Del Supreme Court, No. 193, Oct 4, 2010.

By consistently failing to achieve positive net income, the company generated $160 million in NOLs for federal tax purposes. NOLs are tax losses realized by a company that can be used to shelter future, 20 years, or immediate past, 2 years, income from taxation. But NOLs are a contingent asset and, if a company fails to realize a profit, they can expire worthless. In order to prevent corporate taxpayers from benefiting from NOLs
generated by other entities, Section 382 of the Internal Revenue Code establishes limitations on the use of NOLs in periods following an ownership change. If Section 382 is triggered, the law restricts the amount of prior NOLs that can be used in subsequent years to reduce the firm’s tax obligations. Once NOLs are so impaired, a substantial portion of their value is lost. The company’s NOL poison pill was designed to prevent that from happening.

Applying the Unocal test to the pill, the en banc Supreme Court concluded that the protection of company NOLs may be an appropriate corporate policy that merits a defensive response when they are threatened. Unocal is a two-part test under which a board’s defensive response must be reasonable in relation to a reasonably identified threat to the company.

The Unocal is usually employed when a poison pill is adopted as an antitakeover Device. The main intent of a NOL poison pill is to prevent the inadvertent forfeiture of potentially valuable assets, not to protect against hostile takeover attempts. In fact, companies with large NOLs are not at risk of takeover since the change of control would impair the asset. Even so, said the Court, any poison pill, by its nature, operates as an antitakeover device. Thus, despite its primary purpose, a NOL poison pill must also be analyzed under Unocal because of its effect and its direct implications for hostile takeovers.

The Unocal test was met here because the board reasonably concluded that the NOLs were worth preserving and the acquirer’s actions posed a serious threat to their impairment. The Court ruled that the directors satisfied the first part of the Unocal test by showing that they had reasonable grounds for believing that a danger to corporate policy and effectiveness existed because of another person’s stock ownership. The en banc Court then ruled that the second part of the test was satisfied in that defensive response was reasonable relative to the threat of a longtime competitor seeking to increase the percentage of its stock ownership to intentionally impair corporate assets, the NOLs, or else coerce the company into meeting its business demands under the threat of such impairment.