A synopsis of the use and breadth of hostile poison pills under Delaware Law

1. The Hostile
Poison Pill
Authored By: Christine Hurt
J. Reuben Clark Law School, BYU
Presented by: Dominic Lovotti

2. Main Problem of Corporate Law
 Agency cost problem between shareholder-owners and
managers.
 Corporate statutes & common law use fiduciary duties
in an attempt to restrict managers
 But, the Business Judgment Rule and other hurdles,
insulate directors from claims of substituting their
decisions for the will of the shareholders
 I.e. Managers have more power, but there are attempts
to balance the two sources of power

3. What’s this mean?
 The fiduciary duties (care, loyalty) that
historically have protected the will and rights
of shareholders have been eroded
 The duty of care has been gutted by Del.
caselaw and Del. 102(b)(7) – opt out of duty
of care
 What’s left: Duty of loyalty claims arguing 1)
self-dealing or 2) entrenchment

4. This affects the M&A arena
 An M&A transaction is one of the biggest events
for a company, comparable to it’s IPO.
 The 1980’s saw a rash of M&A activity
 To gain control, large players employed tactics
such as the hostile takeover, two-tier tender offer,
and proxy fight.
 In response, Management created defensive
tactics to hold off unwanted M&A activity.

5.  M&A activity has the highest risk of loyalty
violations because management is looking to
keep itself in power over what is generally a
premium offer by bidder.
 Entrenching v. selling over the market price
 Loyalty problem – conflict of interest

6. Therefore
 Because of these developments, Del courts
have created an intermediate level of scrutiny
to test board decisions involving these
presumed loyalty claims
 Under Unocal and its progeny, Del courts first
look to 1) the reasonableness of the board’s
identified threat and 2) the reasonableness of
the response in relation to the threat
 This 2-prong test comes before deciding if
decision should be scrutinized under BJR

7. If a corporate transaction gets BJR…
 What’s likely to happen?
 The board’s defensive tactic will almost always stand as
being within the board’s discretion
 Why does this make sense?
 Because a board must report to the shareholders its
reasons for turning down some M&A activity or to ask to
implement defensive tactics, so they must explain their
decision and operate under their fiduciary duty
 Also, it provides the shareholders with something tangible
to go after management now if they feel the outcome was
in the shareholder’s best interest

8. So what are corporate boards
doing to protect themselves now?
 Poison Pills
 Pac Man
 Dead Hand
 No Hand
 Shareholder Rights Plan
 Voting Rights Plan
 Staggered Board
 Increasing Debt
 Flip In/Flip Out Provisions

9.  Usually, poison pills do their job.
 Would-be acquirers make tender offers subject to
revocation of the poison pill
 The board digs in
 Some shareholders sell to speculators as offers increase
or attract higher competing offers
 And the board is legally justified in choosing the highest
bidder or even none at all.

10. Scholars disagree on whether poison
pills are value-reducing to
shareholders in robbing them of higher
premiums paid by either the first or
subsequent acquirers.

11.  Against a backdrop of growing deference to
management in implementing poison pills, a new threat
to board authority has emerged: the activist shareholder
 Activist shareholders are not looking for control of a
corporation, but for access to the board to argue for
changes in strategy

12.  Those defensive tactics I mentioned earlier do not work
on them because they are not looking for total control.
 Most “garden variety” poison pills have a 15-20% trigger.
 Activist shareholders are only looking to hold stock in the
5-10% range.

13.  Del Case Law has provided boards with power against
these large blockholders though
 Airgas allowed a company’s board to keep a poison pill
in place for a year even though there wasn’t much of a
threat
 Selectica allowed a poison pill that triggered at 4.99%,
the lowest yet, under only the threat that the “ownership
change” would trigger loss of a corporate asset, NOL
carryovers, and not a loss of true control/ownership

14. So what happened in Selectica?
 Over time, management has gotten better at
fashioning creative defensive measures.
 Here comes the NOL poison pill.
 Under IRS Code 382 when a shareholder
purchases shares in an amount that would
trigger an “ownership change” ~5%, a
company can lose the use of it’s NOL
carryvers

15. Selectica
 Management, under threat that they were
going to lose their NOL’s, a basically
invaluable corporate asset, went to the
shareholders and asked to amend their
charter to allow the shareholder rights plan to
trigger at 4.99% from 15%.
 Del Supreme Court upheld this defensive
tactic

16.  It is the Selectica case that is the focus of this paper
because of the use of the NOL poison pill.
 The author argues that the NOL poison pill is the newest
and most threatening defensive tactic employed that is
unreasonable to the threat posed
 Because it really only wards of activist shareholders
 And it is ineffective at holding off 3 other characters: the
Hostile Acquirer, the Bad Faith Saboteurs, and the
Accidental Bungler

17. NOL’s
 NOL = Net Operating Loss under Tax Code
section172
 NOL = Deductions > Taxable Income

18. NOL’s
 If you, corporation, made $1,000 but had
$3,000 in deductions, you’d be bummed
because you’d waste $2,000 of those
deductions
 IRS doesn’t want you to be bummed
 They allow you to carryover those losses for
20 years.
 Thus you could be in biz for a long time
operating on debt/equity financing and not
earn a lot of profits, causing you to accrue
large losses over the years

19. NOL’s
 Take Selectica for example.
 They had $165 mil in NOL carryovers yet only
had a market worth of $23 million
 If a bidder comes in who made $300 mllion
this year and only has $100 million in
deductions.
 Bidder would want to buy Selectica because
the additional $165 mil will boost his
deductions to $265 mil.

20. Section 382
 However, the IRS has created rules that
acquisitions are supposed to be tax-neutral
 I.e. corporations aren’t supposed to think of tax
consequences in mind when making an
acquisition.
 As such, there are penalties if Bidder does exactly
what we said in last slide.
 IRS is a tricky group…doesn’t want you to be
bummed…but still bums you out in the end

21. Consequences
 If the business is no longer a going concern
within 2 years after acquisition, then the NOL
carryovers are reduced to zero.
 If the business continues, the NOL’s still suffer
a limitation:
 Can only claim-
 Value of company as calculated by the value of
its outstanding stock multiplied by the long term
exempt rate

22. That begs the question:
 Then is the loss of NOL carryovers due to an
“ownership change” under 382 really a threat?
 They’ll be limited or gone altogether if an acquisition
occurs or someone crosses the 5% threshold.
 What are the value of these NOL’s to a company?
 To Selectica, they were worth $9 mil in the end.
 Author argues they’re really near zero.

23. Time for a discussion on
 The Hostile Acquirer Threat
 Does not deter
 Going to value NOL’s at zero anyway because it wants to
acquire corp
 A bidder that values the NOL’s here understands the dilution
and wouldn’t proceed with the aquisition
 The Bad Faith Saboteur Threat
 Rare
 May be a competitor in industry or by holdings
 Going to happen anyway
 The Accidental Bungler Threat
 Going to cross the 5% line without knowing
 Rules allow buy backs to get this guy back below the threshold

24. Strategic Use of Poison Pill
 Very lower trigger with very low threat
 Centered on thwarting nuisance factor of
activist shareholders
 Del Courts have essentially blessed two-tier
defense tactics while sending two-tier bids to
the dump bin of history

25. Who is using the NOL Poison Pill
 Largely microcap companies (<300 mil)
 Some nanocap companies (<50 mil)
 And some big firms (>1 bil)
 155 unique firms implement NOL pill from 1998-
2014
 Two-thirds adopted the poison pills after January
2008, and in 2009, forty-four firms adopted poison
pills, four times as many as in 2008
 45 firms are in the Finance, Insurance and Real
Estate Industries

26. Author’s recommendations about
NOL Poison Pill
 Under 1st prong of Unocal:
 Del Court should include determination of
whether companies are pretextually claiming
the NOL’s are valuable and worthy of protection
from threat
 Under 2nd prong of Unocal
 Del Court will still have to decide if 5% threshold
would be preclusive at a major corp because
the Plan B proxy fight would be near impossible
to attain.

27. Conclusion
 Whether one ascribes to the agency theory of
shareholder primacy or the contractarian
theory of director primacy, boards of directors
have great discretion in determining whether,
when and how to sell the corporation.
 Defensive tactics, like poison pills, can be
tools in wielding that discretion in the service
of creating shareholder value.

28. Conclusion
 However, a poison pill either to oppress a
minority shareholder or to minimize the impact
of activist shareholders, seems to exceed the
“maximum dosage” of the pill.
 The NOL poison pill, while facially plausible as
a tool to protect tax assets from impairment,
may be a stepping stone to a low-trigger anti-
shareholder pill.
 Instead of warding off uninvited potential
acquirers, the pill could ward off shareholder
voice.