On May 19, 2016, the Delaware Chancery Court preliminarily enjoined the directors of Cogentix Medical from reducing the size of the company’s board because, under the facts presented, there was a reasonable probability that the board reduction plan was implemented to defeat insurgent candidates in a contested director election.  Pell v. Kill, C.A. No. 12251-VCL (Del. Ch. May 19, 2016).  The decision is a reminder that board actions that affect the shareholder vote—particularly decisions that make it more difficult for stockholders to elect directors not supported by management—will be subject to enhanced judicial scrutiny by Delaware courts on the lookout with a “gimlet eye” for conduct having a preclusive or coercive effect on the stockholder vote.

Background

In March 2015, VSI and Uroplasty combined to form Cogentix, a specialty medical device manufacturer.  After the merger, Uroplasty’s management team continued at the helm of the combined company.  Robert Kill, who was formerly the President, CEO and Chairman of Uroplasty, assumed those same roles at Cogentix.  The Cogentix board was comprised of eight legacy directors from the two companies, divided into three staggered classes: five Uroplasty directors and three VSI directors.  Among the legacy VSI directors was Lewis Pell, who also owned 7.1% of Cogentix’s shares and was the company’s second largest stockholder.  Pell was one of three Class I directors, whose terms expired in 2016.  The Class II and Class III directors’ terms expired in 2017 and 2018, respectively.

Disputes arose immediately after the merger, culminating in Pell’s threats in early 2016 to have Kill fired as CEO and to nominate candidates for the Class I board seats up for election that year.  In February 2016, the Cogentix board held a regularly scheduled meeting, during which they selected the date for the annual stockholder’s meeting and discussed the dispute between Pell and Kill.  At this point, the rift widened, with the legacy Uroplasty directors siding with Kill and the legacy VSI directors siding with Pell.  Kill and his closest allies—fellow legacy Uroplasty directors Kevin Roche and Kenneth Paulus—saw two possible paths for dealing with Pell’s threats: either (A) negotiate a consensual resolution; or (B) come up with a solution that would preempt Pell’s threat to seek to elect himself and two allies to fill the three Class I directorships at the annual meeting (which, in turn, would alter the board dynamics by giving Pell and his allies, now in the minority on the board, effective veto power by creating a four-four split on the board).

To combat Pell’s threat, Kill, Roche and Paulus devised a plan to reduce the size of the board by eliminating two of the three Class I director seats, which Kill described as “avoid[ing] any proxy fight.”  Then, after the annual meeting had passed, they intended to increase the size of the board back to eight and recommend candidates aligned with the legacy Uroplasty directors’ interests.  After negotiations to reach a consensual resolution failed, the board passed a resolution decreasing the number of Class I seats from three to one.

Pell then commenced litigation in the Chancery Court, challenging the board reduction plan as an unlawful interference with the stockholder franchise.  The Chancery Court granted Pell’s motion to preliminarily enjoin the board reduction plan pending a trial on the merits.

In setting the stage for his decision, Vice Chancellor Laster summarized the three standards of review employed by Delaware courts to assess director conduct—the business judgment rule, enhanced scrutiny and entire fairness review.  The Court explained that “[w]hen there is director conduct ‘affecting either an election of directors or a vote touching on matters of corporate control,’ the board must justify its action under the enhanced scrutiny test.”  That test, explained the Court, requires the board to prove that (i) “their motivations were proper and not selfish,” (2) they “did not preclude stockholders from exercising their right to vote or coerce them into voting a particular way,” and (iii) there was a reasonable and “compelling” justification for their actions in relation to a legitimate corporate objective.

Takeaways

• Enhanced scrutiny will apply to board decisions that impact the election of directors or touch upon matters of corporate control, regardless of whether that conduct has actually prevented shareholders from successfully electing one or more nominees in a contested election. Vice Chancellor Laster explained that, “[f]or enhanced scrutiny to apply, the board’s actions ‘need not actually prevent the shareholders from attaining any success in seating one or more nominees in a contested election for directors and the election contest need not involve a challenge for outright control’ . . .  When there is director conduct ‘affecting either an election of directors or a vote touching on matters of corporate control,’ the board must justify its action under the enhanced scrutiny test.”  Here, the Court found that enhanced scrutiny was required for two separate reasons: (i) the board reduction plan affected the election of Cogentix’s directors because, before the plan, stockholders could have voted on three Class I seats at the 2016 annual meeting, and after the plan, they could only vote for one Class I director; and (ii) the board reduction plan implicated issues of corporate control: before the plan, stockholders could alter majority control of the board by electing three dissident nominees as Class I directors; after the reduction plan, it no longer was possible to alter majority board control because stockholders could only vote for one Class I director.
• Directors must establish a justification that is not only “reasonable,” but “compelling” for decisions affecting shareholder voting rights, particularly where the decision is made after the board is aware that the election will be contested. Courts will scrutinize justifications for challenged decisions with a “gimlet eye” for inequitably motivated electoral manipulation or subjectively well-intentioned conduct that nonetheless is coercive or preclusive.  In explaining this standard of review, the Court stated that “the shift from reasonable to compelling requires that directors establish a closer fit between means and ends.”  It is not, however, a standard of review separate and apart from enhanced scrutiny.  Rather, the compelling justification concept articulated by Chancellor Allen in Blasius Industries, Inc. v. Atlas Corp., 564 A.2d 651 (Del. Ch. 1988) is applied within the enhanced scrutiny standard of judicial review.
• Subjectively well-intentioned board actions that impact the shareholder franchise and are undertaken in the midst of a proxy contest are unlikely to survive enhanced scrutiny. In reviewing the board’s claimed justification for implementing the board reduction plan, the Court assumed that the directors’ motives were proper and not selfish.  Nonetheless, Vice Chancellor Laster found that it was reasonably probable that Pell could establish that the reduction plan precluded the election of insurgent directors because: (i) it eliminated the possibility that insurgents could be elected to the two Class I seats that were eliminated; and (ii) it prevented stockholders from establishing a new majority on the board.  The Court added that contemporaneous emails sent by Kill to his allies, Roche and Paulus, demonstrated that they saw the plan as a way to “avoid[] any proxy fight” and prevent Pell from having any chance at “calling the shots.”  The Court dispatched with ease the defendants’ argument that it adopted the plan to save costs and make the board more efficient because, among other things, cost savings were never mentioned in Kill’s emails with his allies when discussing the plan and, in fact, cost savings were not a credible justification because the plan contemplated increasing the size of the board back to eight seats after the annual meeting.
• In the context of voting rights, directors cannot meet the “compelling justification” standard by arguing that, “without their intervention, the stockholders would vote erroneously out of ignorance or mistaken belief about what course of action is in their own interests.” Vice Chancellor Laster explained that “the belief that directors know better than stockholders is not a legitimate justification when the question involves who should serve on the board of a Delaware corporation.”  Indeed, according to the Court, “even a board’s belief that its incumbency protects and advances the best interests of the stockholders it not a compelling justification.  Instead, such action typically amounts to an unintentional violation of the duty of loyalty.”
• Board actions that may affect the shareholder franchise or touch upon matters of corporate control may fare better under enhanced scrutiny review if undertaken “on a clear day.” Vice Chancellor Laster explained that the board’s decision to implement the board reduction plan was particularly problematic in light of the fact that it was undertaken under the cloud of an imminent contested election.  The Court noted that “the outcome might have been different if the directors had acted on a clear day.  Under those circumstances, justifications like cost savings or the superior dynamics of a smaller board might well have been sufficient.”
• Courts are likely to attach relatively greater weight to evidence consisting of contemporaneous emails and other documents over after-the-fact testimony offered during the litigation. Virtually no weight will be accorded post-litigation, non-adversarial affidavits submitted as a means to offer testimony.  The Court made this point throughout its opinion, as it has in prior decisions.  See, e.g., Fox v. CDX Holdings Inc., C.A. No. 8031-VCL (Del Ch. July 28, 2015); In re El Paso Pipeline Partners, L.P. Derivative Litigation, C.A. No. 7141-VCL (Del. Ch. Apr. 20, 2015).  For instance, in discussing the board’s cost-savings justification for the board-reduction plan, the Court observed that “[g]iven the absence of meaningful contemporaneous evidence supporting the cost savings justification, it can be discounted as pre-textual.”  The Court added:

“As with many litigation constructs, the secondary justifications were built around grains of truth. The Defendant Directors testified that during 2015, discussion took place about the possibility of reducing the size of the Board from eight directors to six. The thought seems to have been that Zauberman and Stauner would leave, but the concept was not fleshed out in detail, and Stauner does not recall anyone discussing his departure with him.  When the idea of the Board Reduction Plan re-emerged in February 2016, however, the concept was not animated by a desire to reduce costs or make the Board more efficient. With one minor exception, the issue of costs did not appear at all in the internal communications among [the director defendants]. They instead focused on preserving control, and they discussed re-upsizing the Board after the Annual Meeting, showing that cost was not a material factor to them.”

In short, according to the Court, the defendants’ cost justifications “were embellished for purposes of litigation.”