In a case involving a profitless company’s fight to preserve valuable net operating loss carryforwards, the board’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. While the value of net operating loss carryforwards is inherently unknowable before they are used, said the Delaware Chancery Court, a board may properly conclude that NOLs are worth protecting when it does so reasonably and in reliance on expert advice. Vice Chancellor Noble ruled that the board here relied on outside expert advice to conclude that the NOLs were an asset worth protecting and that their preservation was an important corporate objective. Selectica, Inc. v. Versata Enterprises, Inc., Del. Chan. Ct., Feb 26, 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, Internal Revenue Code Section 382 establishes limitations on the use of NOLs in periods following an ownership change. If Section 382 is triggered, the law places a restriction on the amount of prior NOLs that can be used in subsequent years to reduce the firm’s tax obligations. Of course, once NOLs are so impaired, a substantial portion of their value is lost.

The precise definition of an ownership change under Section 382 is rather complex. At its most basic, an ownership change occurs when more than 50 percent of a firm’s stock ownership changes over a three-year period. Specific provisions in Section 382 define the precise manner by which this determination is made. Most importantly for the purposes here, the only shareholders considered in the context of calculating an ownership change under Section 382 are those who hold, or have obtained during the testing period, a 5 percent or greater block of the corporation’s shares outstanding.

With Section 382 in mind, the board reduced the threshold trigger in the company’s poison pill from 15 percent to 4.99 percent to prevent additional 5 percent owners from emerging and potentially causing a change in control and devaluing the company’s NOLs. The court found that, under the business judgment rule, the board’s adoption of the low-threshold pill was reasonably designed in relation to the threat posed to protect assets of a speculative nature. The court noted that shareholder advisory firm RiskMetrics Group now supports poison pills with a trigger below 5 percent on a case-by-case basis if adopted for the purpose of preserving a company’s net operating losses.

Yes, the pill has a low trigger, the court acknowledged, but that did not make it preclusive and draconian. To find a measure preclusive, said the court, it must render a successful proxy contest a near impossibility or utterly moot, and this pill did not do that. Moreover, the adoption of the poison pill was a proportionate response to the threatened loss of the NOLs. The low trigger in the pill was driven by federal tax law and regulations, noted the court, an external standard not created by the board.