Pell v. Kill, C.A. No. 12251-VCL (Del. Ch. May 19, 2016) (Laster, V.C.)

In this opinion, the Court of Chancery preliminarily enjoined the implementation of a plan to reduce the size of the Board of Cogentix Medical, Inc. (“Cogentix” or the “Company”) from eight seats to five seats before an annual stockholder meeting (the “Board Reduction Plan” or the “Plan”) because there was a reasonable probability that the Plan was adopted to neutralize the threat of a proxy contest by one of the Company’s directors. In so ruling, the Court emphasized that board action touching on either an election of directors or matters of corporate control will be subject to the enhanced scrutiny test.

In March 2015, Cogentix was formed through a stock-for-stock merger between Visions-Sciences, Inc. (“VSI”) and Uroplasty, Inc. (“Uroplasty”). As a result of the merger, Cogentix’s board was comprised of three former directors of VSI, including Lewis Pell, the Company’s largest shareholder, and five former directors of Uroplasty, including Robert Kill, the Company’s CEO.  The board had three classes of directors.  Class I directors, whose terms were set to expire at the Company’s 2016 stockholder meeting, consisted of Pell, another legacy-Uroplasty board member, and a legacy-VSI board member.  

Shortly after the merger was completed, disputes arose between Pell and Kill, and on February 16, 2016, Pell sent a letter to the board to complain about the Company’s performance. In the letter, which Pell filed publicly as an amendment to his Schedule 13D, Pell also made clear his desire for a change in leadership.  Two days later, the board members discussed the letter at a regularly scheduled board meeting and aligned according to previous company ties.

In an attempt to avoid a proxy fight, Kill and his supporters devised the Board Reduction Plan which would reduce the number of Class I directors from three to one, with Pell as the remaining Class I director, and reduce the number of Class II directors from three to two (after the resignation of a legacy-Uroplasty director). As a result of the Plan, the legacy-Uroplasty directors would control of four of the six remaining board seats.  Following Pell’s formal nomination of three Class I directors, the board adopted the Plan with the three legacy-VSI directors voting against it.

Shortly thereafter, Pell filed suit in the Court of Chancery alleging that the legacy-Uroplasty directors breached their fiduciary duties in adopting the Board Reduction Plan and sought a preliminary injunction to block its implementation. In assessing the reasonable probability of success on the merits of that claim, the Court held that the Board Reduction Plan triggered the enhanced scrutiny standard of review.  This standard of review applies when the challenged director conduct affects either an election of directors or a vote touching on matter of corporate control.  Here, the Court held that the Plan implicated both elements since it would reduce the number of the Company’s board seats and eliminate the stockholders’ ability to elect a new majority as the stockholders would have the ability to vote on only one director rather than three.

Since enhanced scrutiny applied, the legacy-Uroplasty directors had the burden of proving that (1) that their motivations were proper and not selfish, (2) that they did not preclude stockholders from exercising their right to vote or coerce them into voting a particular way, and (3) that their actions were reasonable in relation to their legitimate outcome. Although the Court assumed, for purposes of its preliminary injunction analysis, that the directors’ motivations were proper and not selfish, the Court held that the defendants would likely not be able to satisfy the second or third elements.  As to the second element, a measure is preclusive if it renders success in a proxy contest realistically unattainable.  Here, the Board Reduction Plan was preclusive because it not only made it impossible for stockholders to establish a new majority but it also eliminated the possibility of Pell successfully attaining two board seats.  As to the third element, the Court held that the Board Reduction Plan was not sufficiently tailored to achieve a legitimate end since it was adopted in anticipation of a proxy contest that could have shifted control at the board level – a decision reserved for the stockholders.

On the last two elements for a preliminary injunction – irreparable harm and balancing of the equities – the Court held that (i) the Company’s stockholders would suffer irreparable harm if the Plan were implemented because they would be prohibited from exercising their voting rights and (ii) the balancing of the equities favored a preliminary injunction given the threatened harm to the corporate electoral process and the lack of any harm to the defendants if the Plan’s implementation was delayed.

While the Court granted the preliminary injunction, it did note that the outcome may have been different if the directors acted not in response to an anticipated proxy context but on a “clear day” with otherwise legitimate objectives like cost savings or the superior dynamics of a smaller board.

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