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.  However, a poison pill designed either to oppress a minority shareholder, as in eBay v. Newmark,[1] or to minimize the impact of activist shareholders, as in Versata Enterprises, Inc. v. Selectica, Inc.,[2] seems to exceed the “maximum dosage” of the pill.  The “tax benefits preservation plan,” or net operating loss (NOL) poison pill, while facially plausible as a tool to protect tax assets from impairment caused by a Section 382 “ownership change,” may be a low-trigger anti-shareholder wolf tactic in Unocal sheep’s clothing.  Instead of warding off uninvited potential acquirers, the pill could ward off even low-level shareholder voice.  Though the original poison pills were blessed by the Delaware courts to ward off hostile bidders, now boards can use a hostile poison pill to ward off noisy shareholders.  A brief look at issuers that adopted NOL poison pills between 1998 and 2014 and an analysis of how Section 382 of the Internal Revenue Code works suggests that preserving NOLs may not be the chief concern of boards adopting tax benefits preservation plans.

With the threat of the 1980s-era hostile bidder behind us, a new threat to board authority has emerged:  the activist shareholder.  These types of investors, often activist hedge funds, agitate not for control of a corporation, but for access to the board to argue for changes in strategy.  Activist shareholders may eventually encourage a sale of a company, but are more likely to propose share repurchases, dividends or restructuring as ways to maximize shareholder value.  Defensive tools used against hostile bidders at first seem inapplicable to these types of nuisances; staggered boards and poison pills with typical 15-20% triggers seem irrelevant.  However, a pair of cases decided in Delaware may have given managers a new tool for coping with these aggressive blockholders.  One Delaware Chancery case, Air Products and Chemicals, Inc. v. Airgas, Inc.,[3] allowed a company’s board to keep a poison pill in place for over a year even though the bidder did not seem to pose much of a cognizable threat to the corporation.  By itself, Airgas does not seem to give much relief to a board dealing with a noisy 5% or 10% shareholder.  However, the Delaware Supreme Court the year earlier had blessed a poison pill that would be triggered if a shareholder increased its ownership to 4.99% of the corporation, the lowest ownership threshold to be brought before the court.  In Selectica, the Delaware court upheld the poison pill even though the board did not focus its argument on the threat of a takeover.  In this case, the “danger to corporate policy and effectiveness” that the board was responding to was the probability that an activist shareholder’s creeping purchases would constitute an “ownership change” under existing federal tax law and therefore lead to the loss of its NOLs.  Because the NOLs were a very large, if potentially unusable, asset to Selectica that would be severely limited under Section 382 if the ownership change occurred, the court held that the low-trigger rights plan was reasonable and proportionate against a legitimate threat.  Together, these cases seem to suggest a new weapon to be used against non-acquiring activist shareholders:  a poison pill with a very low trigger.

The Delaware courts took at face value Selectica’s argument that the creeping acquisition could involuntarily cause the target company to lose a large tax asset.  The Unocal test requires the board to articulate its rationale for implementing a defensive tactic, foreclosing the opportunity for pretextual arguments.  However, this analytical technique may not work in the NOL context where the presence of NOLs may give a board of directors cover for keeping blockholders away.  A deeper analysis of Section 382 refutes the arguments in Selectica that corporations are powerless in the hands of shareholders who, without notice, may intentionally or unintentionally cause the corporation to loss attractive NOL tax assets.  Selectica was a very specific case in which a microcap company on the brink of insolvency had NOLs approximately six times as large as its market capitalization and had had great turnover in its shares in the preceding years.  In addition, the activist shareholder was Selectica’s largest creditor and competitor.  Few companies will face a threat of tax asset losses under Section 382 from a shareholder, particularly if the shareholder is not attempting to bankrupt the company.  In addition, companies can and have adopted article of incorporation provisions that restrict transfers of shares for Section 382 purposes, allowing boards, with the blessing of the IRS, to void purchases that would create an ownership change.

Second, NOL poison pills do not work.  Traditional pills work:  the deterrence value of diluting a 15% or 20% shareholder keeps that shareholder at bay.  The deterrence value of diluting a 5% shareholder who wants to acquire the company eventually is very small.  That shareholder values the NOLs at zero because an acquisition will trigger Section 382 anyway, and that shareholder, particularly in the microcap space, will not find dilution a large loss.  And of course, an NOL pill does not deter either an accidental share purchase or a saboteur.  In fact, the only shareholder that the NOL poison pill effectively deters is the activist shareholder, suggesting that the use of the poison pill in these cases may be “hostile.”

Finally, looking at a dataset of 155 companies that adopted NOL poison pills, it appears that though microcap companies are the largest adopters of NOL poison pills, so are billion-dollar companies with little fear of either ownership changes or hostile bidders, such as Citigroup.  However, this second cohort of issuers do have legitimate fears of activist shareholders.  Whether future courts will routinely bless low-trigger NOL pills after Selectica (along with poison puts and other new entrants into the field) or scrutinize the value of that company’s NOLs together with the probability that the NOLs will be used or lost will flesh out this new era of the poison pill.

ENDNOTES

[1] 16 A.3d 1 (Del. Ch. 2010).

[2] 5 A.3d 586 (Del. 2010).

[3] 16 A.3d 48 (Del. Ch. 2011).

The preceding post comes to us from Christine Hurt, the Rex J. & Maureen E. Rawlinson Professor of Law at BYU Law. The post is based on her article, which is entitled “The Hostile Poison Pill” forthcoming in the UC Davis Law Review and available here.