Ben Reed Zakarin
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The Selectica Strategy: Reimagining Taxes in the Market for Corporate Control.
The intersections of corporate tax law, antitrust, and securities law are rarely a space
occupied by intrigue fit for the silver screen. It is likely the case that this analysis will not change
that fact. Yet, the story of Selectica, Inc. and its rivals may just offer a thrill to a reader wellversed enough in these areas to understand the tale’s wider implications. In Versata Enterprises,
Inc. v. Selectica, Inc. history was made—at Selectica’s expense—with the second known
deliberate “triggering” of an arcane defensive device from the 1980s known as a “poison pill”
that had been modified to handle corporate tax questions that the pill itself predated. At stake
were $160 million in losses Selectica already had sustained. After the dust settled, the question
remains: could this happen again? Can the tax code really be useful?
I. Most Valuable Losers
Under the Internal Revenue Code (“IRC”), a net operating loss (“NOL”) is defined as a
firm’s excess of business deductions over its gross income for a given taxable year. (Section
172(c)). Standing alone, the fact that companies may (and often do) incur losses greater than
their respective income in any given taxable year would appear to serve as, if nothing else,
validation of the market system’s ability to select winners and losers. The repeated inability of a
corporation to turn a profit, in theory, should portend its diminished influence in its industry until
it collapses under its own weight. The term “loss,” after all, tends to suggest a permanent
departure of assets.
Section 172, however, provides a potent accounting mechanism that enables companies
to preserve this “red ink” for a future, beneficial use. Under §172, NOLs may be “carried back”
for up to two years preceding the taxable “loss year,” allowing the company to retroactively
reduce its taxable income for that period. (Section 172(b)(1)(A)(i)). More significant, however, is
the potential prospective use of NOLs; under §172, these losses may be “carried over” or
“carried forward” for up to 20 years to reduce the firm’s taxable income. (Section
172(b)(1)(A)(ii)). The underlying purpose of these anomalous tax benefits has been characterized
by the Supreme Court as “designed to permit a taxpayer to set off its lean years against the lush
years, and to strike something like an average taxable income computed over a period longer
than one year” and to “stimulate enterprise and investment, particularly in new businesses or
risky ventures where early losses can be carried forward to future more prosperous years.” (U.S.
v. Foster Lumber Co., Inc. 429 U.S. 32, 42-3 (1976)). Understood this way, these carrybacks and
carryovers appear to be, at a minimum, justifiable tools for promoting economic growth.
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The Selectica Strategy: Reimagining Taxes in the Market for Corporate Control.
Indeed, it is arguably the characterization of a firm’s accrued NOLs, taken in conjunction
with principles of corporate law, that has given (and continues to give) rise to the potential for
significant manipulation of the tax code. Under 26 C.F.R. § 1.381(a)(1), a “successor
corporation” in a merger described under § 361 succeeds to a total of twenty-six tax attributes
defined in § 381(c). (26 C.F.R. 1.381(a)-1(a)). One of these carryover attributes is the target
company’s net operating losses. (Section 381(c)).
The unfettered transferability of accrued NOLs in a corporate acquisition, merger, or
reorganization would—and did—facilitate the practice of “loss trafficking.” (Davidow Jr.,
Limitations Imposed By the 1986 TRA on NOLs). This practice would allow a taxpayer,
“[t]hrough the acquisition of the stock of a corporation with a NOL carryover, or through a
merger with such corporation . . . the benefit of offsetting their profits with the NOL carryover.”
(Id.) Allowing these carryovers to be transferred in order to offset income otherwise unrelated to
the activity that generated the NOLs would both obviate the “legitimate averaging function”
underlying § 172 and would effectively require the Government to “reimburse a portion of all
corporate tax losses.” ( Staff of Joint Comm. on Tax'n: General Explanation of TRA of '86 at
294). In recognition of this potential issue, Congress has undertaken a series of prophylactic
amendments to the IRC over the last half-century. The most recent, substantive overhaul of the
relevant provisions took place in 1986; as such, any reference to the IRC, unless otherwise noted,
will be to the 1986 provisions.
II. Section 382- No Benefits Shall Pass (Through)
Congressional response to statutory gaps in its “anti-loss trafficking” regime through
acquisitive transactions of companies with substantial NOLs came in the form of an amended §
382. (Tax Reform Act of 1986). In the 1987 “General Explanation of the TRA,” the Staff of the
Joint Committee offered—by way of incorporation of an earlier report—three general
justifications for its amendments. (Staff of Joint Comm. on Tax'n: General Explanation of TRA
of '86 at 294). Put simply, these justifications were: 1) simplifying the statutory scheme; 2)
reducing the possibility of manipulating the statutory scheme; and 3) making the law “more
neutral, providing less influence over, and less interference with, general business dealings.”
(The Subchapter C Revision Act of 1985 at 38). By fixing gaps in the statutory scheme and
reducing opportunities to manipulate the pre-1986 conditions, Congress sought to “make NOL
carryovers a relatively neutral factor in acquisitions.” (Bittker & Lokken, Fed. Tax’n of Income,
Estates, & Gifts at ¶95.5.1 at *5).
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The Selectica Strategy: Reimagining Taxes in the Market for Corporate Control.
a.) Understanding § 382
Defining and understanding the precise operation of § 382 and its associated regulations is an
extremely complex exercise. What follows here, necessarily, is a concise overview of its
terminology and operation in acquisitive transactions or reorganizations.
i.) Terminology
Key Terms for Understanding §382 and Regulations Thereunder
[*unless otherwise indicated, statutory references are to Title 26 of U.S.C. and 26 of CFR]
Statute/ Reg.*
Term
Definition
382(k)
Loss
Corporation
A corporation that is either:


Entitled to use an NOL carryover; or
Incurs an NOL in the year of an “ownership change.”
Subject to regulation:

382(k)(7)
Person
1.382-3
Entity
Natural persons; public group(s); shareholders in either first or higher tier
entities; and entities.


1.3822T(j)(1)(iv)(C)
382(k)(7)
Direct Public
Group
5 Percent
Shareholder
382(g)
Ownership
Change
Owner Shift
382(g)(1),
382(g)(3)
Equity
Structure Shift
Any corporation, estate, trust, association, company, partnership or
similar organization; or
A group of persons with either a formal or informal understanding to
make a coordinated purchase of stock.
Public shareholders otherwise not associated with entities are aggregated and
considered to be a 5% shareholder. There may be several public groups.
Any person holding 5 percent or more of the stock of the loss corporation at
any time during the testing period.
Includes: constructive ownership; beneficial ownership.
Excludes: acquisitions by reason of death; divorce; gift; separation, etc.
Occurs if, after an owner shift involving a 5% shareholder(s):


382(g)(1)
Any corporation with a net unrealized built-in loss.
As between one or more 5% shareholders, the total proportionate
ownership of the company’s shares has increased by more than 50%
relative to their lowest proportionate holdings in the company during
the test period.
Ownership is measured by value of shares.
A transaction that increases or decreases the proportionate interest of a
5% shareholder, either before or after an ownership change.
Most tax-deferred reorganizations, excluding:


Divisive “D” reorganization qualified under IRC §355
Bankruptcy reorganization under IRC §368(a)(1)(G) subject to
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The Selectica Strategy: Reimagining Taxes in the Market for Corporate Control.
conditions.
An “F” reorganization.

382(i)
Testing Period
**Equity structure shifts affecting ownership interests of a 5% shareholder
may also constitute an owner shift.**
Generally: 3-year period ending on “testing date.”

382(j)
Testing Date
NOL/NCL carryforwards not extant for 3 year period: Testing Period
commences on first day of taxable year in which NOL/NCL
carryforwards arose.
Generally: the date on which Loss co. must determine if it has experienced an
“ownership change” under §382.
Testing dates are triggered by:



382(k)(6)
1.382-2T
“Stock” v.
“Not Stock”
viz.
Ownership
Change
An owner shift;
Equity structure shift; or
Issuance or transfer of qualifying options.
Deemed “Stock”
 All stock, unless excluded
 Non-“stock” ownership interests
Not Deemed “Stock”
 “Pure preferred stock”
 Exempted (de minimis) stock
b.) How § 382 Operates
Practically speaking, § 382 is comprised of a series of statutory “triggers,” i.e. conditions
giving rise to an ownership change, that, if satisfied, will result in a limitation on the taxable
income against which the NOL deduction may be used. (Davidow at 36). Provided below are a
few relevant, non-exhaustive, examples of events that may, either by themselves or in the
aggregate, cause an “ownership change” under § 382. These have been adapted from "A Primer
on Protecting Tax Losses from a Section 382 Ownership Change". The central point is that the
determination of an ownership change “is made by aggregating the increases in percentage
ownership for each 5% shareholder” whose ownership percentage has increased over the relevant
testing period—usually 3 years. Id.
i.) Acquisition- This is the “quintessential transaction that creates percentage point increases.”
Any acquisition which either 1) causes a person to become a 5% shareholder or 2) made by a
5% shareholder to increase their stake requires inclusion in the “ownership change”
calculation.
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The Selectica Strategy: Reimagining Taxes in the Market for Corporate Control.
Ex. Shareholder A owns 7% of Corporation’s stock. A sells the entire stake. The next
year, Shareholder A purchases 6% of Corporation’s stock. A is deemed to have
created a 6% increase for the purposes of determining an ownership change. Since
A’s lowest stake in Corporation during the testing period was 0% (after the sale) and
A owns 6% on the testing date, this is a 6% increase in ownership by a 5%
shareholder.
ii.) Redemptions- Under the segregation rules, a self-tender creates two groups for
measurement purposes: those that tender and those that do not (the “continuing public
group”). The ownership increase of the continuing public group treated as owning the
stock that is not acquired will increase.
Ex. Loss Co. is publicly traded and 100% of its stock is owned by one direct public
group. Following a self-tender in which Loss Co. successfully acquires 20% of its
outstanding stock, the direct public group is treated as segregated into 2 public groups
prior to the tender. The Continuing Public Group will be deemed to have owned 80%
of Loss Co.’s shares prior to the tender and 100% of Loss Co.’s stock after the tender.
For ownership change purposes, the Continuing Public Group will be treated as
creating a 20% increase.
iii.) Stock Offerings- Stock offerings which fall under § 1032 (an exchange of stock for
property or money) generally creates segregated groups of new shareholders and pre-offer
shareholders.
Ex. Company has 100,000 outstanding shares, all owned by one direct public group.
Company issues 50,000 new shares for a mix of cash and property. None of the new
shareholders is a 5% shareholder. The pre-offering group is segregated; the new acquiring
shareholders (“Offering Public Group”) are treated as a distinct public group. The Offering
Public Group is deemed to own 33.3% of Company’s shares, resulting in a countable 33.3%
increase in ownership.
Solely for Cash Exception- If the offering is solely for cash, “the general segregation rule
does not apply to stock issued in the offering in an amount equal to (as a percentage of
issued stock) 50% of the aggregated percentage ownership interest of the direct public
groups immediately before issuance. (see "Primer" at 8.)
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The Selectica Strategy: Reimagining Taxes in the Market for Corporate Control.
iv.) Tax-Deferred Mergers- Most acquisitive tax-deferred reorganizations (“A,” “C,” specific
“D” and specific “G”) reorganizations involving Loss Co. require segregation of public groups
existing before the merger and treating them as post-merger owners. Since this is outside the
context of using §382 as an offense to compel a merger, see "Primer" at 7.
d.) Limitations on Using NOL’s Following an Ownership Change.
If the statutory conditions give rise to an “ownership change” under § 382, the NOLs
themselves remain intact; rather, their use is limited to a specified amount of income. This
limitation, as a starting point, is equal to the “value of the loss corporation” multiplied by the
“long-term tax-exempt rate” for the month of the ownership change. (26 U.S.C. 382(b)(1)). The
value of the loss corporation is equal to the fair market value of the corporation’s stock
immediately before the ownership change. (26 U.S.C. 382(e)(1)). For publicly traded companies,
the IRS has determined that the company’s market capitalization immediately prior to the
ownership change. (TAM 200513027). The justification for limiting the use of NOLs in this
manner after an ownership change is to “allow preacquisition losses to be deducted against
postacquisition income only to the extent the income is allocable to capital invested in the loss
corporation immediately before the acquisition.” (Bittker & Lokken, Fed. Tax’n of Income,
Estates, & Gifts at ¶95.5.1 at *5).
Given these limitations, it might seem that Congress accomplished its goal of making
these tax attributes “neutral” in the calculus for an acquisition or reorganization. Limiting the
application of NOLs, however, does not eliminate the fact of their existence; nor does it allow a
potential bidder to merely “wave off” these book assets. The principles of financial reporting
dictate otherwise. In fact, ASC 740-10-25-2 (formerly FAS-109) instructs that companies shall
recognize NOLs in its financial statements as a tax-deferred asset—at least to the extent they
may be estimably utilized in the future to offset likely income. (ASC 740-10-25-2). The
reportable value of NOLs as deferred tax assets is calculated by calculating the firm’s gross
NOLs by their effective tax rate. (ASC 740-10-25-2).
In the context of the market for corporate control, this accounting mechanism may give
rise to significant differences of opinion between targets and bidders over a company’s value.
From this position, § 382 might be able to disproportionately assist a potential bidder by reconceptualizing these vulnerable NOLs as powerful negotiating leverage.
IIIa. The Potential Battle
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The Selectica Strategy: Reimagining Taxes in the Market for Corporate Control.
Companies with significant NOLs are, by definition, more likely than their peers to be
suffering through a period of financial distress as these tax assets accrue (here, such a company
will be generally deemed “Loss Co.”). Less fortuitous for their management, however, is the fact
that such floundering firms, in actively competitive markets, may present an attractive target for
more stable competitors. Under ASC 750-10-25 et seq, however, Loss Co.’s management may
be in the position to significantly inflate its book value based on a belief, however sincerely held,
that Loss Co.’s future prospects were bright enough to use, and thus record as an asset, a large
percentage of its NOLs to offset taxable income.
Loss Co.’s own, potentially self-inflated valuation based on future performance provides
a financial incentive for management to remain entrenched and attempt to stay “off the market.”
Yet under the byzantine, unforgiving rules of § 382, a loss corporation might be unaware that it
is in danger of experiencing an “ownership change” until it’s too late, thereby losing most, if not
all, of the leverage it had to resist a coercive offer—the expected value of its NOLs. In order to
discourage shareholders, and the market more broadly, from engaging in transactions that would
contribute to an “ownership change,” the corporate world recalibrated a familiar tool for a new
purpose: the poison pill.
IIIb. Picking Your Poison
Generally speaking, a poison pill is a plan implemented by a potential target’s board of
directors, which effectively makes a potential bidder negotiate with management instead of
initiating a tender offer. (Nicholas Walter, Antitrust and Corporate Law: Revisiting the Market
for Corporate Control, 15 U. PA. J. BUS. L. 755, 783 (2013)). A poison pill will be triggered by
the acquisition of a certain percentage of the company’s stock—usually 15-20% by any single
buyer—allowing the Board to consider implementing the “pill plan.” (Id.) Under the plan, the
prospective target makes a potential takeover prohibitively expensive by providing the
company’s other shareholders the opportunity to make discount purchases of newly-issued
shares in order to dilute the triggering entity’s stake in the company. It generally also provides
the shareholders to purchase discount shares in the bidder if the bidder achieves over 50%
control, making it even less attractive to attempt a hostile offer. (Id.) Since the board has
discretion as to whether or not it will implement the plan, it has adequate discretion to redeem
the plan in case of a sufficiently attractive offer.
The “NOL poison pill” operates on similar principles as the standard poison pill, but on
different terms. There are two critical distinctions to be made between an NOL poison pill and a
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The Selectica Strategy: Reimagining Taxes in the Market for Corporate Control.
“standard” pill. First, an NOL poison pill seeks to preserve what may be a loss corporation’s
most substantial asset—its NOLs—rather than protecting against a takeover attempt. (NOL
Poison Pills: Using Corporate Law for Tax Purposes, at 313.) Second, an NOL poison pill plan
is generally set to be triggered, thus allowing implementation, right before a purchaser achieves
a 5% ownership interest in the company; usually, this trigger is set at around 4.9%. (Id. at 315.)
Thus, before a purchaser reaches the threshold of being another “5% shareholder” in the
company that could contribute to the “change of ownership,” the board may choose to
implement the triggered plan in order to dilute the purchaser’s interest.
Lest this disappoint accountants and boards of directors across the country, there is an
intriguing consolation prize embedded in plain sight within § 382. Remember, the IRC
categorically applies to “ownership changes,” and these changes result in the significant
impairment or destruction of one of a struggling company’s largest assets. Could § 382 be used
by a bidder in order to impair its potential target—regardless of whether or not it has an NOL
poison pill in place? The answer to this question has not been addressed by any U.S. courts. But
it may already exist—in the 2010 Delaware Supreme Court decision of Versata v. Selectica.
(Versata Enterprises Inc. v. Selectica, Inc., 5 A.3d 586 (Del. 2010)).
IVa. The Selectica Case
Selectica was a Delaware corporation listed on the NASDAQ Global Market which
provided enterprise software solutions for contracts and sales management systems. (Id. at 590).
It went public in March 2000 at a price of $30 per share, and failed to achieve an annual profit
since its IPO; by March 2009, its price was under $1 per share and its market capitalization was
$23 million. (Id.). Its principle assets were its intellectual property rights, its remaining cash,
intangible business assets, and $160 million in NOLs. (Id.) Trilogy, another company
“compet[ing] in the relatively narrow market space of contract management and sales
configuration,” was also the parent corporation for its subsidiary Versata Enterprises, Inc. (Id.)
Trilogy and Selectica had a contentious relationship; mainly, Selectica had lost a patent
infringement case to a Trilogy affiliate in April 2004 for a judgment of $7.5 million (Id.)
Trilogy made its first offer to purchase Selectica in January 2005 for $4 per share cash;
the deal represented a 20% premium over Selectica’s trading price. Selectica’s board rejected the
offer; in the autumn of 2005, Trilogy made yet another offer that represented a 16%-23%
premium over Selectica’s price. Selectica rejected that offer. (Id.) After two more rounds of
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The Selectica Strategy: Reimagining Taxes in the Market for Corporate Control.
litigation in which Selectica lost to Trilogy and an affiliate—one lawsuit over options backdating
and another for patent infringement—Selectica and Trilogy settled in October 2007. (Id. at 591).
At the urging of its largest shareholder, the private equity fund Steel Partners, Selectica
conducted several analyses of its NOLs over the course of 2006 through 2007. Its final study,
ending in March 2008, found that Selectica had $165 million in NOLs. (Id. at 592). Steel
Partners’ apparent investment strategy was to partner with small companies with large NOLs to
try to reap tax benefits through arranged mergers. (Id.) In July 2008, Selectica received five
unsolicited acquisitions offers, prompting it to hire an investment banker, Needham.
Needham’s proposed options for Selectica were, inter alia, a merger with another
company, a reverse IPO or going private, the sale of assets to buy another company, share
repurchases, or special dividend issuances. (Id. at 593.) Trilogy re-entered the conversation with
two separate offers to acquire Selectica in July 2008; both involved the primary consideration of
cancellation of debt of $7.1 million Selectica owed, and one of which included a cash payment.
Selectica rejected both offers in October 2008; Trilogy made a more attractive offer of $10
million and cancellation of Selectica’s debt. Selectica’s board once again rejected the offer. (Id.)
What Selectica had failed to realize in October 2008 was that Trilogy began buying Selectica
stock on the open market.
On November 10, 2008, Trilogy’s President contacted Selectica’s Co-Chair of the Board
to inform her that Trilogy had already purchased over 5% of Selectica’s stock, filing a Schedule
13D three days later. On November 15, Selectica’s accountants had calculated that it had
undergone, for the purposes of IRC § 382, a 40% shift in ownership over the relevant testing
period. The next day, Selectica’s board met to discuss lowering its previous poison pill plan
trigger to 4.99% to protect its NOLs; at this meeting, it was informed that another 10% purchase
of shares by relevant 5% shareholders would permanently impair its NOLs under §382 due to a
change-in-control event. The analysis showed that it would be particularly vulnerable over the
next quarter to a change-in-control event. By November 17, Trilogy had purchased another 1%
of Selectica’s shares. (Id. at 594.) On the same day, Selectica announced its 4.99% NOL poison
pill; the pill grandfathered in Trilogy and gave it another 0.5% cushion in purchases.
After determining the amount of Selectica shares they would need to purchase to cause a
change-in-control to “ruin the tax attributes that Steel Partners is looking for,” Trilogy sent a
letter to Selectica insisting that it had breached the October 2007 settlement in a contract with
Sun Microsystems. (Id. at 595). After December 2008 meetings, Selectica asserted that Trilogy
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The Selectica Strategy: Reimagining Taxes in the Market for Corporate Control.
made clear its intent to “trigger the NOL Poison Pill deliberately unless Selectica agreed to
Trilogy’s renewed efforts to extract money from the Company.” (Id. at 596.) In the next two
days, Trilogy informed Selectica it would buy though the pill; indeed, it purchased 154,061
shares, bringing its share to 6.7% and triggering the pill. (Id.) Trilogy then “suggested” Selectica
repurchase its shares, accelerate its debt payments, terminate the contract with Sun
Microsystems, and pay Trilogy $5 million “to settle” the entire conflict. (Id.)
The Selectica pill gave its Board 10 days to decide whether it would exempt Trilogy or
whether it would instead allow its pill to implement; Trilogy refused a standstill agreement. (Id.
at 597.) Again, the Board met, heard that its ownership changes under § 382 were around 40%,
and were unlikely to decline anytime soon. The Board refused Trilogy’s demands, and following
Trilogy’s final rejection of a standstill agreement, Selectica implemented a 2:1 exchange on its
common stock for owners besides Trilogy and Versata. (Id. at 598). The decision to implement
the poison pill resulted in a freeze in trading of Selectica’s stock as the back office attempted to
sort out the exchange rights.
IVb. The Delaware Court Drinks the Poisoned Kool-Aid
Selectica sought a declaration of the validity of its pill in the Chancery Court. The
Chancery Court “concluded that the protection of company NOLs may be an appropriate
corporate policy that merits a defensive response when they are threatened.” (Id. at 599). The
Delaware Supreme Court (“Court”) upheld the Chancery Court’s application of the Unocal
standard, saying that an NOL poison pill “must also be analyzed under Unocal because of its
effect and its direct implications for hostile takeovers.” (Id.)
Applying the first Unocal prong, the Court agreed that the Selectica Board had
undertaken a reasonable investigation before determining its NOLs were “an asset worth
protecting.” (Id. at 600). The Chancery Court noted that “Trilogy, a competitor with a
contentious history, recognized that harm would befall its rival if it purchased sufficient shares of
Selectica stock, and Trilogy proceeded to act accordingly.” (Id. at 601).
The Supreme Court quoted approvingly from the Chancery Court, which continued to
note specifically that “the 4.99% threshold for the NOL Poison Pill was driven by our tax laws
and regulations; the threshold, low as it is, was measured by reference to an external standard,
one created neither by the Board nor the Court.” (Id.)
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The Selectica Strategy: Reimagining Taxes in the Market for Corporate Control.
Under the second Unocal prong, the Court upheld the Chancery’s findings that the plan
was not preclusive—even in conjunction with Selectica’s staggered Board. They cited
Selectica’s evidence that in prior instances where a company had an NOL poison pill set at
4.99%, there had been successful proxy fights by the insurgents (in fact, there had only been
one). (Id. at 602). Stating that the pill did not render “a successful proxy contest realistically
unattainable given the specific factual context,” the Court validated, for the first time, an NOL
poison pill’s use. The Court cautioned that this was not a per se validation, and it was a specific,
fact-driven analysis. (Id. at 605).
V. Considerations
By forcing Selectica with a set of choices that might have caused it to cause a change in
control on its own, including a redemption, going private, and a merger, Trilogy placed it in a
no-win position. Its biggest shareholder, Steel Partners, was insistent on preserving Selectica’s
NOLs. Trilogy intentionally bought through the pill, perhaps assuming it was invalid due to the
low trigger. Yet it came at a significant cost to Selectica—its trading was suspended for an entire
month as it tried to untangle the exchange in its back offices. Even if it did not bring the swift
end to Selectica it had attempted to administer, certainly Trilogy gained an advantage in the
marketplace by turning its competitor’s main asset on them and nearly destroying it at the same
time. This strategy may have not paid off precisely as Trilogy had wanted; but could it work
elsewhere? Would it be allowed to work elsewhere?
Selectica presented the Delaware Supreme Court with a specific question of state
corporate law on specific facts. As such, the Court did not—and could not—have reached any
conclusions of law addressing the propriety of Trilogy’s aggressive strategy under any
potentially relevant securities or antitrust regimes. In fact, there appears to be an entire dearth of
scholarly consideration on the question of whether Trilogy’s aggressive purchasing strategy to
impair Selectica could be more broadly undertaken. The following Part will examine, on a broad
level, whether this NOL-impairment strategy is viable under key federal antitrust and securities
laws. This analysis does not claim to be exhaustive or comprehensive; it only seeks to consider
the general viability of an NOL-impairment strategy pursued to aggressively undermine a
competing corporation.
a.) Securities Laws
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The Selectica Strategy: Reimagining Taxes in the Market for Corporate Control.
This section does not purport to examine every potentially relevant federal securities law
that might impact a company’s decision to pursue an NOL-impairment strategy. In this set of
hypotheticals, the main assumption is that the target company (“Loss Co.”) is a publicly traded
microcap with its outstanding, registered shares trading on a national, regulated exchange.. This
follows the facts in Selectica. The buyer will be labeled “Bid Co.” Since the entity whose
behavior is under examination is the purchaser of securities (Bid Co.), the most significant
statute under this analysis is the Securities Exchange Act of 1934 (“1934 Act”). (15 U.S.C. §78a
et seq.).
Under the broadest jurisdictional rule for manipulation of a security, Rule 10b-5, any
person—including corporate persons—may not “directly or indirectly” “employ any device,
scheme, or artifice to defraud…make any untrue statement [or omission] of a material fact
or…engage in any act, practice, or course of business which operates or would operate as a
fraud…in connection with the purchase or sale of a security.” (17 CFR 240.10b-5) Bid Co.’s
mere purchase of Loss Co. shares with knowledge of the Loss Co.’s poison pill plan and
potential § 382 limitations would not constitute the requisite “manipulation” of a securities price
that would give rise to a private cause of action. Even under the most permissive reading of 10b5, fraud is still a necessary element—an element missing in a small purchase of a competitor’s
shares. (17 CFR 240.10b-5(c)). Additionally, it seems unlikely that Bid Co. could, or would need
to, engage in conduct that would constitute deception—in Selectica, Trilogy stated its intent to
buy through Selectica’s pill. On the most basic level, the choice to implement a poison pill falls
to Loss Co.’s directors—there is likely insufficient connection between open-market purchases
on fair terms and any “act, practice, or course of business which operates or would operate as a
fraud or deceit upon any person.” (17 CFR 240.10b-5(c)).
More relevant to, though ultimately not necessarily preventative of, an aggressive NOLimpairment strategy is the Williams Act of 1968, incorporated into the 1934 Act as section 13.
(15 U.S.C. §§ 78m(d)-(e), 78n(d)-(f)). The Williams Act regulates the process of making a
tender offer and requires certain disclosures for share purchases. Since, under these facts, there
has been no tender offer made, the relevant portion of the 1934 Act (as amended) is §13(d). (§15
U.S.C. §78m(d)(1)). Under the authority of §13(d), the SEC promulgated Schedule 13D, which
“imposes certain disclosure requirements on persons within ten days of the date that they acquire
more than five percent of the beneficial ownership of a public company.” (Jonathan R. Macey,
Jeffrey M. Netter, Regulation 13D and the Regulatory Process, 65 WASH. U. L. Q. 131 (1987))
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(emphasis added). Among the required information is the purchaser’s plans for any specific
proposals or plans it has for the target and their reasons for purchasing the shares. (Id.)
Under IRC § 382, any “5% owner” of a loss corporation’s shares will be deemed to
contribute to an “ownership change,” based on the relative increase of their stake in the loss
corporation. (§382). This includes an entity that becomes a 5% owner in a loss corporation
during a relevant testing period. Thus, Bid Co. could, in theory, buy exactly, or just under 5% of
Loss Co.—depending on whether or not Loss Co. had in place an NOL poison pill—and not
disclose this purchase until it crossed over the 5% threshold. In Selectica, Trilogy bought up to,
but not over, the 5% threshold before making demands on Selectica’s board. (Selectica at 593-4).
This strategy is in clear compliance with the letter of the 1934 Act. The filing of a Schedule 13D
is often the first signal to the broader markets that a firm is “on the market;” this may often
trigger a rush of trading volume that could contribute further to an aggregate “change in
ownership.” It is worth noting, however, that once the 5% threshold has been exceeded and a
13D is required, the purchaser must indicate their future plans for the target. (Regulation 13D
and the Regulatory Process, 137). In fact, a dishonest 13D form is a violation of Rule 13d-1 that
may trigger injunctive relief to prevent further purchasing or corrective disclosure. (Id.) Thus,
Bid Co. may, under the 1934 Act, lawfully purchase shares approaching, or even equal to, but
not exceeding, 5% and make a demand on Loss Co.’s board (either through a demand for
repurchase, i.e. greenmailing, or coercion into a merger). At the 5% mark, Bid Co. has achieved
a position in Loss Co. that, even in the case of a successful greenmailing scheme by Bid Co.,
would contribute to Loss Co.’s “change in ownership” calculus under § 382.
b.) Antitrust Laws
Analysis of major antitrust statutes suggest that an NOL-impairing strategy to devalue a
competitor is a legal, if not viable, strategy to force a target into an unwanted merger or
acquisition. This is a more fact-driven analysis, however, and may be potentially upset by the
nature of the business the competing firms.
The Sherman Antitrust Act forbids “every contract, combination in the form of trust or
otherwise, or conspiracy, in restraint of trade or commerce . . .” occurring in interstate
commerce. (15 U.S.C. § 1). Section 1 of the Sherman Act requires, however, a contract or
combination…or conspiracy. (Id.) At first glance, the in-concert purchasing of Selectica shares
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by Trilogy, and its subsidiary, Versata, qualifies as, at minimum, a “conspiracy” that might
restrain trade. This has been expressly repudiated by the Supreme Court. In 1984, it held that
“the coordinated activity of a parent and its wholly owned subsidiary must be viewed as that of a
single enterprise for purposes of § 1 of the Sherman Act.” (Copperweld Corp. v. Indep. Tube
Corp., 467 U.S. 752 (1984)). Thus, at least in the context of examining a parent and subsidiary
engaging in open-market purchases of a competitor, such conduct would not be illegal.
Section 2 of the Sherman Act forbids single-firm, monopolization and attempts to
monopolize. (15 U.S.C. §2). Violation of § 2 either requires a firm to have monopoly power and
engage in exclusionary power, or, to attempt to monopolize. (Spencer Weber Waller, Corporate
Governance and Competition Policy, 18 GEO. MASON L. REV. 833, 840 (2011)). In order to
unlawfully attempt to monopolize, a firm must: 1) have specific intent; 2) engage in unlawful or
exclusionary act; and 3) have at least a “‘dangerous probability of achieving monopoly power.’”
(Id.) The line between “unlawful and exclusionary” and serious competition is not easy to locate;
some courts attempt to determine “whether there is a significant adverse effect on competition
and whether that effect is outweighed by efficiency considerations, business justifications, or
precompetitive justifications for the conduct at issue.” (Id. at 841).
The context in which a potential § 382 NOL-impairing strategy to force a merger dictates
that there would likely already be at least two firms competing in a market. This suggests that
Bid Co.’s NOL-impairing purchasing would be analyzed, if at all, under the latter half of § 2—
requiring an attempt to monopolize. Granting that Bid Co. might be found attempting to
monopolize—satisfying the first prong—it is not clear that simply buying shares past the 5%
owner threshold in § 382 would qualify as “unlawful and exclusionary.” The conjunction
requires the conduct meet both parts of the second prong; without more, purchasing shares may
be entirely permissible as long as Bid Co. complies with other legal requirements. Bid Co.’s
conduct, while perhaps reprehensible under the Sherman Act, does not imply illegality.
The final, and likely most consequential, antitrust laws that would be relevant to an
analysis of the legality of an NOL-impairing strategy are taken together: the Clayton Act and the
Hart-Scott-Rodino Antitrust Improvements Act of 1976 (“HSR”). Section 7 of the Clayton Act
prohibits anticompetitive conduct, not market manipulation, by forbidding partial acquisition or
the commencement of a merger where “the effect of such acquisition may be substantially to
lessen competition, or to tend to create a monopoly.” (15 U.S.C. §18). Ostensibly, if Bid Co. and
Loss Co. are deemed competitors such that their merger would “substantially lessen
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competition,” then it would be deemed illegal. (Id.) But under § 7, then, the partial purchase of a
competitor’s stock may subject a firm to sanction where the impact of the acquisition would be
to substantially lessen competition. (Id.) The critical analysis, then, is whether a specific
purchase of Loss Co.’s shares on the market—likely the one that pushes Bid Co. past the 5%
ownership threshold and puts it in a position of power over Loss Co.—would constitute an
acquisition that substantially lessens competition. This is a question for the courts to decide.
HSR is a procedural statute that enforces § 7 of the Clayton Act by requiring prenotification and preclearance of any mergers that meet a set of specific tests. (15 U.S.C. §18a).
Under HSR, if 1) “as a result of the transaction, the acquiring person will hold an aggregate
amount of voting securities” of the acquired entity in excess of $303.4 million; or 2) the
acquiring entity will hold between $75.9 million and $303.4 million of the acquired’s assets; and
a) one entity has sales or assets in excess of $151.7 million; and b) the other entity has sales or
assets in excess of $15.2 million, then the merger must be reported to the FTC and DOJ for
review. (15 U.S.C. §18a); (FTC Announces Increased HSR Thresholds). HSR carries significant
filing fees, but, for HSR to present a specific problem would mean that Bid Co. has likely
already achieved its goal—a merger—and this would be a built-in cost already projected by Bid
Co. It seems unlikely, then, that HSR would substantively prevent a merger that was pursued and
achieved under an aggressive, NOL-impairing strategy.
VI. Conclusion
The legacy of Selectica in corporate law is still yet to be determined. Though this analysis
focused on broad issues in tax law, securities law, and antitrust law, mergers and acquisitions—
and the people that execute them—have been essential to the development of each of these fields
in the modern American landscape. Though the facts of Selectica, and thus this analysis, are
limited, the importance of § 382 and NOLs to international banking and industrial giants cannot
be understated. Section 382 can carry harsh consequences; the Treasury Department recognized
this fact in late September 2008 with a surprising reminder. IRS Notice 2008-83 stated that for
the purposes of calculating Net Built in Losses, § 382(h) and the §382 limitation would not be
applicable to corporations “that is a bank” under IRC §581. (Notice 2008-83). The Notice was
issued “out of nowhere” as Citigroup mounted a $1-a-share bid for Wachovia, only to be outbid
by Wells Fargo for $7 per share. (Gretchen Morgenson, In Bank Crisis Report, a Whodunit With
Laughs and Tears, NY TIMES (January 29, 2011)). Wells Fargo saw the opportunity, with
Wachovia’s massive loss portfolio, to reduce its taxable income by $3 billion in its first year
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after buying Wachovia. As it turned out, Wells never had any taxable income to offset before the
notice was repealed by Congress, effective 2009. (Id.)