Selectica, Inc. v. Versata Enterprises, Inc., C.A. No. 4241-VCN (Del. Ch. 2/26/2010)

• Decision Date: 26 February 2010
• Docket Number: C.A. No. 4241-VCN.
• Parties: SELECTICA, INC., Plaintiff, v. VERSATA ENTERPRISES, INC., and TRILOGY, INC., Defendants. and VERSATA ENTERPRISES, INC. and TRILOGY, INC., Counterclaim Plaintiffs, v. SELECTICA, INC., JAMES ARNOLD, ALAN B. HOWE, LLOYD SEMS, JIM THANOS, and BRENDA ZAWATSKI, Counterclaim Defendants.
• Court: Court of Chancery of Delaware

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SELECTICA, INC., Plaintiff, v. VERSATA ENTERPRISES, INC., and TRILOGY, INC., Defendants. and VERSATA ENTERPRISES, INC. and TRILOGY, INC., Counterclaim Plaintiffs, v. SELECTICA, INC., JAMES ARNOLD, ALAN B. HOWE, LLOYD SEMS, JIM THANOS, and BRENDA ZAWATSKI, Counterclaim Defendants.

C.A. No. 4241-VCN.

Court of Chancery of Delaware.

Submitted: October 2, 2009.

Decided: February 26, 2010.

Gregory V. Varallo, Esquire, Lisa A. Schmidt, Esquire, John D. Hendershot, Esquire, Ethan A. Shaner, Esquire, Scott W. Perkins, Esquire, and Jillian G. Remming, Esquire of Richards, Layton & Finger, P.A., Wilmington, Delaware, and Jonathan S. Kitchen, Esquire and Christian H. Cebrian, Esquire of Cox, Castle & Nicholson LLP, San Francisco, California, Attorneys for Plaintiffs and Counterclaim Defendants Selectica, Inc., James Arnold, Alan B. Howe, Lloyd Sems, James Thanos, and Brenda Zawatski.

Martin P. Tully, Esquire, Megan Ward Cascio, Esquire, Leslie A. Polizoti, Esquire, and Ryan D. Stottmann, Esquire of Morris, Nichols, Arsht & Tunnell LLP, Wilmington, Delaware, and Noel M. Hensley, Esquire, and Nicholas Even, Esquire of Haynes and Boone LLP, Dallas, Texas, Attorneys for Defendants and Counterclaim Plaintiffs Versata Enterprises, Inc. and Trilogy, Inc.

MEMORANDUM OPINION

NOBLE, Vice Chancellor.

I. INTRODUCTION

This is an action for declaratory judgment with respect to the validity of (1) the implementation of a rights agreement adopted by the plaintiff company in attempt to preserve certain net operating loss carryforwards perceived to be at risk as a result of share purchases by the defendants; (2) certain subsequent actions taken by plaintiff's board of directors in response to defendants' purposeful trigger of the rights agreement; and (3) the amended and restated rights agreement established in the wake of the rights agreement's triggering. The defendants who triggered the rights agreement have countersued seeking to have the rights agreement and other actions by plaintiff's board of directors declared invalid, void, and unenforceable, as well as the entry of an order enjoining or rescinding them. The defendants also seek damages for alleged breaches of fiduciary duty by the plaintiff's board.

II. BACKGROUND

A. A Brief Explanation of NOLs

At its core, this case is about the value of net operating loss carryforwards ("NOLs") to a currently profitless corporation, and the extent to which such a corporation may fight to preserve them. For convenience, the Court provides a brief overview—although perhaps a simplistic and certainly incomplete one—of the concepts surrounding NOLs, their calculation, and possible impairment.

NOLs are tax losses realized and accumulated by a corporation that can be used to shelter future (or immediate past) income from taxation.¹ If taxable profit has been realized, the NOLs operate to provide a refund of prior taxes paid or to reduce the amount of future income tax owed. Thus, NOLs can be a valuable asset, as a means of lowering tax payments and producing positive cash flow. However, NOLs are considered a contingent asset; their value is contingent upon the firm's reporting a future profit (or having an immediate past profit). Should the firm fail to realize a profit during the lifetime of the NOL (20 years), the NOL expires worthless. The precise value of a given NOL is impossible to determine since its ultimate use is subject to the timing and amount of recognized profit at the firm. If the firm never realizes taxable income, at dissolution, its NOLs, regardless of their size, would have zero value.

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.² 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% 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 Court's purposes, 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% or greater block of the corporation's shares outstanding.³ Calculating the likelihood of a Section 382 ownership change at a given company at a particular time is extraordinarily difficult and requires making a number of factual assumptions, subject to varied interpretations of the correct application of Section 382, upon which reasonable experts may disagree.⁴

With this general background in place, the Court now turns to the facts of this case.⁵

B. The Parties

Plaintiff and Counterclaim-Defendant Selectica, Inc. ("Selectica" or the "Company") is a Delaware corporation, headquartered in California and listed on the NASDAQ Global Market. It provides enterprise software solutions for contract management and sales configuration systems. Selectica is a micro-cap company with a concentrated shareholder base: the Company's seven largest investors own a majority of the stock, while fewer than twenty-five investors hold nearly two-thirds of the stock.⁶

Defendant and Counterclaim-Plaintiff Trilogy, Inc. ("Trilogy") is a Delaware corporation also specializing in enterprise software solutions. Trilogy stock is not publicly traded, and its founder, Joseph Liemandt, holds over 85% of the stock. Defendant and Counterclaim-Plaintiff Versata Enterprises, Inc. ("Versata") is a Delaware corporation and subsidiary of Trilogy; it provides technology powered business services to clients. Before the events giving rise to this action, Versata and Trilogy beneficially owned 6.1% of Selectica's common stock.⁷ Following their intentional triggering of Selectica's shareholder rights agreement through the purchase of additional shares, the joint beneficial ownership of Versata and Trilogy was diluted from 6.7% to approximately 3.3%.⁸

Counterclaim-Defendants James Arnold, Alan B. Howe, Lloyd Sems, Jim Thanos, and Brenda Zawatski are members of the Selectica Board of Directors (the "Board").⁹ Zawatski and Thanos also served as Co-Chairs of the Board during the events at issue in the case.¹⁰ In this role, they handled the day-to-day operations of the Company, as Selectica has been without a Chief Executive Officer since June 30, 2008.

C. Selectica's Historical Operating Difficulties and Relationship with Trilogy

Selectica, since it became a public company in March 2000, has lost a substantial amount of money and failed to turn an annual profit, despite routinely projecting near-term profitability. Its IPO price of $30 per share has steadily fallen and now languishes below one dollar per share, placing Selectica's market capitalization at roughly $23 million at the end of March 2009.¹¹ By its own admission, its value today "consists primarily in its cash reserves, its intellectual property portfolio, its customer and revenue base, and its accumulated NOLs."¹² By consistently failing to achieve positive net income, Selectica has generated an estimated $160 million in NOLs for federal tax purposes over the past several years.¹³

Selectica has had a complicated and often adversarial relationship with Trilogy, stretching back at least five years. Both compete in the relatively narrow market space of contract management and sales configuration. In April 2004, a Trilogy affiliate sued Selectica for patent infringement and secured a judgment that required Selectica, among other things, to pay Trilogy $7.5 million. While the suit was pending, in January 2005, Trilogy made an offer to buy Selectica for $4 per share in cash—a 20% premium from the then-trading price—which the Board rejected. Nevertheless, during March and April of that year, a Trilogy affiliate acquired nearly 7% of Selectica's common stock through open market trades. In early fall 2005, Trilogy made than another offer for Selectica's shares at a 16%-23% premium, which was also rejected. In September 2006, a Trilogy-affiliated holder of Selectica stock sent a letter to the Board questioning whether certain stock option grants had been backdated.¹⁴ The following month, Trilogy filed another patent lawsuit against Selectica, which was settled in October 2007, when Selectica agreed to a one-time payment of $10 million, plus an additional amount of not more than $7.5 million in subsequent payments to be made quarterly. In late fall 2006, Trilogy sold down its holdings in Selectica.¹⁵

D. The Role of Steel Partners

Steel Partners is a private equity fund that has been a Selectica shareholder since at least October 2006 and is its largest shareholder. One of the apparent investment strategies of Steel Partners is to invest in small companies with large NOLs with the intent to help pair the failing company with a profitable business in order to reap the tax benefits of the NOLs.¹⁶ Steel Partners has actively worked with Selectica to calculate and monitor the Company's NOLs since the time of its original investment.

By early 2008, Steel Partners was advocating a quick sale of Selectica's assets, leaving an NOL shell that could be merged with a profitable operating company in order to shelter the profits of the operating company.¹⁷

In October 2008, Steel Partners informed members of the Board that it planned to increase its ownership position to 14.9%, just below the 15% trigger of the 2003 Pill, which it later did. Jack Howard, President of Steel Partners, lobbied for a Board seat twice in 2008, citing his experience dealing with NOLs, but was rebuffed.¹⁸

E. Selectica Investigates...