Securities Regulation Daily Wrap Up, DIRECTORS AND OFFICERS—Del. Ch.: Court enjoins directors' end-run around proxy fight, (May 20, 2016)

By Anne Sherry, J.D.

The Delaware Chancery Court enjoined a board's action to reduce the number of director decisions to avoid a proxy contest. Even assuming that the directors acted selflessly, incumbents are not entitled to determine the outcome of an electoral contest for stockholders. The plaintiff seeking to overhaul the board was likely to succeed on the merits of a claim that the directors breached their fiduciary duties (Pell v. Kill, May 19, 2016, Laster, J.).

Proxy fight. Following a merger, Cogentix Medical, Inc., had a staggered eight-member board; each member was aligned to varying degrees with either the plaintiff (a director and the company's largest stockholder) or the defendant (the CEO, president, and board chairman). The plaintiff disclosed on a Schedule 13D his intention to seek changes in the board composition and management team. It was understood that this meant terminating the defendant and ejecting his two closest allies from the board. If the plaintiff were successful, a majority of the board would be in his favor.

Reduction in board size. To avoid a proxy contest, the defendant and two allies developed a strategy to reduce the size of the board to five seats. Instead of three seats up for grabs at the May 20 annual meeting, there would only be one. The board approved the plan, eliminating one vacant seat effective immediately and the other two seats effective at the annual meeting. The plaintiff then sued for an injunction to stop the reduction from taking effect.

Likelihood of success on the merits. The chancery court applied enhanced scrutiny because the board reduction plan affected an election of directors and touched on matters of corporate control. In the voting context, enhanced scrutiny places the burden on the defendant fiduciaries to prove that their motivations were proper and not selfish, that they did not preclude stockholders from exercising their voting rights or coerce them, and that the actions were reasonable in relation to their legitimate objective.

The court assumed that the directors' motives were proper and not selfish. But it was reasonably probably that they would not be able to establish at trial that the board reduction plan was not preclusive. First, the plan eliminated the possibility of a successful proxy contest for two seats. Second, it prevented the stockholders from establishing a new majority. The court mentioned that it may have decided differently if the plaintiff had not notified the board of an imminent proxy contest, but in the circumstances, there was a reasonable likelihood of success on the merits as to preclusion.

As far as the board's justification, the directors offered one illegitimate justification and two that were insufficiently convincing to justify foreclosing a proxy contest. The principal justification was that the choice of replacement directors "will take a careful, thoughtful process that cannot and should not be hurried." The belief that directors know better than stockholders is not a legitimate justification when the question involves who should serve on the board. The other offered justifications—cost savings and efficiencies from a smaller board—"were embellished for purposes of litigation," the court found.

The case is No. 12251-VCL.

Attorneys: Kelly A. Terribile (Greenberg Traurig, LLP) for Lewis C. Pell. Sharon Oras Morgan (Fox Rothschild LLP) for Robert C. Kill.

Companies: Cogentix Medical, Inc.; Vision-Sciences, Inc.; Uroplasty, Inc.

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