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Pell v. Kill: Court of Chancery Enjoins Board Reduction Plan Adopted to Neutralize Proxy Contest Threat

January 12, 2017

In Pell v. Kill, 135 A.3d 764 (Del. Ch. 2016), the Court of Chancery granted a preliminary injunction enjoining the implementation of a plan to reduce the size of a classified board and to reduce the number of directors in the class of directors standing for election at the next annual meeting that was adopted to neutralize the threat of a proxy contest by one of the corporation’s directors.

In March 2015, Cogentix Medical, Inc. (“Cogentix”), a medical device manufacturer and developer, was formed through a stock-for-stock merger between Vision-Sciences, Inc. (“VSI”) and Uroplasty, Inc. (“Uroplasty”). Cogentix’s classified board consisted of eight members: five former Uroplasty directors and three former VSI directors. Robert C. Kill, the former Uroplasty chief executive officer, president, and chairman, continued in those roles at Cogentix; Lewis C. Pell, co-founder and former chairman of VSI, served as a director. The board was divided into three classes. Class I consisted of three directors, including Pell, former VSI director Howard I. Zauberman, and former Uroplasty director James P. Stauner. The Class I directors’ terms expired in 2016.

Shortly after the merger, disputes arose between Pell and Kill. In February 2016, Pell sent his fellow directors a letter in which he announced his desire to change Cogentix’s management and signaled his willingness to run a proxy contest. Pell was largely critical of Cogentix’s performance under Kill and expressed his belief that Kill had too much control over Cogentix and the board. Two days after the letter was sent, the board held a regularly scheduled meeting, at which it selected the date for its annual meeting and discussed Pell’s letter. After the meeting, the remaining directors chose sides between Pell and Kill, with the VSI-legacy directors siding with Pell and the Uroplasty-legacy directors siding with Kill.

Hoping to avoid a proxy contest, Kill and his strongest supporters—Uroplasty-legacy directors Kevin H. Roche and Kenneth H. Paulus—devised a plan whereby Roche and Paulus would lead the outside directors to identify director nominees who might be acceptable to both Pell and Kill. If a negotiated resolution failed, the three believed Pell would launch a proxy contest to elect himself, Zauberman, and a third Class I director who would be allied with Pell. If Pell succeeded, the board would move from a five-to-three majority in favor of the Uroplasty-legacy directors to a four-four split.

Kill, Roche, and Paulus came up with a “Plan B” to avoid a proxy fight—a board reduction plan that would reduce the size of the board from eight to five directors, with the number of Class I directors reduced from three to one and Class II directors reduced from three to two (after the resignation of a Class II Uroplasty-legacy director) (the “Board Reduction Plan”). Following Pell’s formal nomination of three Class I directors, the board passed the Board Reduction Plan, with the three VSI-legacy directors voting against it.

In April 2016, Pell filed suit in the Court of Chancery, seeking a preliminary injunction to prevent the Board Reduction Plan from taking effect. In determining whether Pell had established a reasonable probability of success on the merits, the Court explained that enhanced scrutiny would apply to the board’s adoption of the Board Reduction Plan. The Court stated that enhanced scrutiny applies “[w]hen there is director conduct ‘affecting either an election of directors or a vote touching on matters of corporate control.’” The Court explained that the Board Reduction Plan affected an election of directors because it reduced the number of seats that the stockholders could vote on from three to one. As such, the Board Reduction Plan had “a clear and obvious effect on the ability of the stockholders ‘to vote either contrary to the will of the incumbent board members generally or to replace the incumbent board members in a contested election.’” It also touched on matters of corporate control because, prior to the plan’s adoption, control over Cogentix “was in play” as the stockholders could have elected three directors that could have formed a new board majority. After the adoption of the Board Reduction Plan, however, the stockholders could only re-elect one incumbent director, without affecting the composition of the board or the direction of Cogentix.

Applying enhanced scrutiny in the context of reviewing director action affecting stockholder voting, the Court explained that enhanced scrutiny requires defendants to prove “(i) that their motivations were proper and not selfish, (ii) that they ‘did not preclude stockholders from exercising their right to vote or coerce them into voting in a particular way,’ and (iii) that the directors’ actions ‘were reasonable in relation to their legitimate objective.’” The Court went on to note that when a vote involves an election of directors or touches on matters of corporate control, the directors’ justification must not only be reasonable, but must be “compelling.” The Court noted that the burden of showing a “compelling” justification requires directors to establish a closer fit between means and ends and serves as a reminder that courts should approach such situations with a “gimlet eye.”

The Court, assuming that defendants’ motives were proper and not selfish, nevertheless found that Pell had established a reasonable probability of success on the merits due to the unlikelihood of defendants establishing that the Board Reduction Plan was not preclusive. The Court explained that “[f]or a measure to be preclusive, it must render a successful proxy contest realistically unattainable given the specific factual context.” The Court held that in the current context, the Board Reduction Plan made a successful proxy contest realistically unattainable by both eliminating the possibility of success for two board seats (due to the reduction from three seats to one seat) and preventing the stockholders from establishing a new board majority. The Court further noted that even if the Board Reduction Plan was not viewed as preclusive, defendants would likely not be able to show a compelling justification for the plan due the Court’s determination that the director defendants approved the plan because it “enabled them to avoid a proxy contest . . . that could shift control at the Board level.”

In its discussion of Pell’s likelihood of success on the merits, the Court observed that the results may have been different if the Board Reduction Plan had been approved on a “clear day”—that is, approved not in response to an anticipated proxy contest, but for otherwise legitimate objectives.

In granting the preliminary injunction, the Court further determined that there was a threat of irreparable harm to the stockholders if the injunction was not granted due to the fact that the Board Reduction Plan preordained the results of the annual meeting, thereby depriving the stockholders of their right to vote. Additionally, the Court found that granting the injunction would result in no hardship to the defendant directors. As a result of such determinations, the Court preliminarily enjoined defendants from completing the Board Reduction Plan by reducing the number of seats from seven to five and fixing the number of Class I seats at one until the Court rendered a final decision on the merits.