Pell v. Kill: Board-Seat Reduction Plan Adopted Under Threat of Proxy Contest Fails Enhanced Scrutiny

Practical Law Legal Update w-002-5575 (Approx. 7 pages)

Pell v. Kill: Board-Seat Reduction Plan Adopted Under Threat of Proxy Contest Fails Enhanced Scrutiny

by Practical Law Corporate & Securities

Background

The company at the heart of the dispute, Cogentix Medical, Inc., was formed in March 2015 through a stock-for-stock merger between Vision-Sciences, Inc. (VSI) and Uroplasty, Inc. Under the certificate of incorporation of VSI, which remained in effect after the merger, the board of directors of the company was staggered into three classes, with one class of directors coming up for election every year. The post-merger board of directors consisted of eight members, with five of the directors coming from the Uroplasty legacy board and three of the directors coming from the VSI legacy board. One of the three VSI-legacy directors was plaintiff Lewis Pell, owner of 7.1% of the company's outstanding shares. The four defendant directors all came from the Uroplasty-legacy board; one of them, Robert Kill, had been the CEO and Chairman of the Board of VSI and assumed those roles at Cogentix. The Class I slate of directors, whose terms are to end at the company's 2016 stockholder meeting, was comprised of Pell (a VSI-legacy board member), defendant James Stauner (a Uroplasty-legacy board member), and non-party Howard Zauberman (a VSI-legacy board member).

Disputes between Pell and Kill arose immediately after the merger closed and began to come to a head in February 2016. In a letter to the board dated February 16, Pell described his complaints about the company's performance and Kill's compensation and warned that he intended to take action to "make fundamental changes" at the board and management levels. While he had made similar threats internally before, Pell took the additional step of filing this letter in an amendment to his Schedule 13D. At a regularly scheduled board meeting two days later, Pell indicated that he had the support of 40% of the company's stockholders and implied that he was prepared to change the composition of the board. The other members of the board understood Pell to be threatening to launch a proxy contest, in which he would nominate himself, Zauberman, and another ally to the Class I slate. Were this slate to win, the board would be divided 4-4 between Pell and Kill allies, instead of maintaining a 5-3 majority in favor of the Uroplasty-legacy board members.

After attempting to broker a compromise, the Uroplasty-legacy board members implemented a plan to prevent their loss of board control. The plan consisted of reducing the size of Class I to one director for purposes of the upcoming stockholder meeting (the nominee for which would be Pell) and then increasing the size of the board back to eight seats afterwards. In so doing, the Uroplasty-legacy board members would retain their majority of the board at all relevant times. The authority for the board to add and remove seats is granted in the company's charter, which provides that as long as there is a minimum of three directors, the board can fix the exact number of directors by resolution. Various emails between Kill and his allies made clear that the purpose of the plan was specifically to avoid what they called "shareholder disruption," which is to say, a proxy contest. The court's decision does not cast doubt on the motives of the Uroplasty-legacy board members and assumes they sincerely believed that Pell would use any increased influence on the board to the detriment of the company.

On April 5, 2016, the company filed its preliminary proxy statement in connection with the annual stockholder meetings. Two days later, Pell filed his competing preliminary proxy statement. On April 25, 2016, Pell filed suit seeking an injunction to bar the company from implementing the board-reduction plan pending a trial on the merits. Pell argued that the injunction was necessary to protect the stockholder franchise, as the board-reduction plan, if allowed to proceed, would thwart the exercise of the stockholders' voting rights.

Outcome

The Chancery Court granted Pell's motion for an injunction and barred the defendant directors from implementing the plan, pending final disposition of the case. The court held that although adopted with sincere intentions, there was a reasonable probability that the board-reduction plan constituted an impermissible interference with the stockholder franchise for which there was no compelling justification under Delaware law.

Enhanced Scrutiny Standard of Review Applies

The court began its analysis by locating the familiar Blasius standard, in which a board must demonstrate a compelling justification for interfering with the stockholders' voting rights, within the broader enhanced-scrutiny standard of review (Blasius Indus., Inc. v. Atlas Corp., 564 A.2d 651 (Del. Ch. 1988)). As the court explained, though Blasius when first issued had been thought to constitute a separate category of review, subsequent case law clarified that the Blasius standard is a form of enhanced scrutiny in which the compelling-justification concept applies within the enhanced standard of review first articulated in Unocal (see MM Cos., Inc. v. Liquid Audio, Inc., 813 A.2d 1118, 1129-31 (Del. 2003); Mercier v. Inter-Tel (Del.), Inc., 929 A.2d 786, 797, 805-813 (Del. Ch. 2007)).

Understood in this light, the court addressed whether adoption of the board-reduction plan triggered enhanced scrutiny. In the most common circumstances, enhanced scrutiny applies when a board adopts a defense against a hostile takeover (which implicates Unocal) or when a change of corporate control becomes inevitable (implicating Revlon). However, enhanced scrutiny is not limited to those situations; it can apply whenever the context surrounding the board may undermine the decision-making of even independent and disinterested directors. This is understood to happen in a live proxy contest because the directors' seats are then at risk. But enhanced scrutiny is not only triggered when the entire board faces the threat of replacement. Rather, whenever there is director conduct that affects either an election of directors or a vote touching on matters of corporate control, the standard of enhanced scrutiny must be satisfied (Mercier, 929 A.2d at 811).

In the case at hand, the court held that the board-reduction plan implicated both prongs outlined in Mercier:

The plan affected the election of directors because the stockholders would elect one director instead of three.
The plan touched on matters of corporate control because it would prevent a change on the board in which the Uroplasty-legacy directors would lose their majority.

Enhanced Scrutiny as Applied in Voting Context

The enhanced-scrutiny standard plays out differently depending on the facts that triggered it. In a negotiated sale, for example, Revlon requires that the board focus its efforts on obtaining the highest price reasonably attainable for the stockholders.

When enhanced scrutiny is triggered due to director action that affects stockholder voting, enhanced scrutiny requires the board to prove that:

Its motivations were proper and not selfish.
It did not preclude the stockholders from voting or coerce them into voting a certain way.
Its actions were reasonable in relation to its legitimate objective.

(Mercier, 929 A.2d at 810-811.)

A measure taken by the board is considered preclusive if it renders a successful proxy contest realistically unattainable given the specific factual context (Versata Enters., Inc. v. Selectica, Inc., 5 A.3d 586, 603 (Del. 2010)).

The third prong changes if the vote at issue involves an election of directors or touches on matters of corporate control. In those situations, the board's justification for its action must be more than reasonable, but "compelling" (Liquid Audio, 813 A.2d at 1129-30). A compelling justification requires a closer fit between the means and ends (Mercier, 929 A.2d at 819). Importantly, a contention on the part of the board that the stockholders would vote erroneously or against their own interests without the board's intervention does not qualify as a compelling justification.

The Board-Reduction Plan Failed Enhanced Scrutiny

The court reiterated that it assumed for purposes of ruling on the motion that the board's motives had been proper and unselfish. Nevertheless, the court ruled that it was reasonably probable that the adoption of the board-reduction plan would fail the second and third prongs of the enhanced-scrutiny analysis.

The court held that the board-reduction plan made success in a proxy contest realistically unattainable (thereby making it preclusive) in two ways:

It eliminated the possibility of success for two board seats.
It prevented the stockholders led by Pell from establishing a new majority on the board.

Notably, a board-reduction plan is not impermissibly preclusive per se. The court suggested that the outcome might have been different had the board acted to reduce the size of the board before Pell had sent his February 16 letter. On a "clear day" when no proxy contest is imminent, the deferential business judgment rule has been held to apply to similar board-reduction plans (see Openwave Sys., Inc. v. Harbinger Capital P'rs Master Fund I, Ltd., 924 A.2d 228, 242-44 (Del. Ch. 2007)).

Though this finding was enough for it to grant the injunction, the court added that there was a reasonable likelihood that the board would not be able to demonstrate a compelling justification for the plan. The defendant directors approved the plan so that they, rather than the stockholders, could determine who would serve on the board. Under Delaware law, the notion that directors know better than the stockholders about who should serve on the board does not qualify as justification, let alone a compelling one (Mercier, 929 A.2d at 811; Blasius, 564 A.2d at 663).

Here as well, the court allowed that the plan, if passed on a clear day, could have been justified on the basis of cost savings or creating a smoother dynamic with a smaller board. But the court did not credit these justifications in this case, assessing that they were not the genuine motivations for the board-reduction plan.

Having found that the plan failed enhanced scrutiny, the court granted the motion to enjoin its implementation, holding that absent the injunction, the stockholders would suffer an irreparable harm by being prevented from exercising their voting rights.

Practical Implications

The decision in Pell v. Kill is a useful primer on the application of the compelling-justification standard, which does not tend to arise as frequently in Delaware litigation as other types of disputes. As the court pointed out, the compelling-justification standard is sometimes thought of as existing outside the traditional set of three standards of review. The decision clarifies that compelling justification is a subset of enhanced scrutiny.

Beyond this doctrinal interest, several practical takeaways are noteworthy:

A board-reduction plan is not impermissible in and of itself. If a company's certificate of incorporation authorizes the board of directors to add or remove board seats, the board may do so, subject to whatever limitations are contained in the charter itself. However, this can only be stated without qualification on a clear day, when there is no threat of a proxy contest.
In that respect, even when a board of directors is authorized as a legal matter to take a given action, equitable considerations can weigh against taking that action. In a proxy contest situation, the board may not be able to take action that a reading of the company's charter and by-laws alone would have otherwise allowed it to take.
When enhanced scrutiny applies, a sincere belief on the part of the board that it must remove a choice from the stockholders for their own best interests does not pass muster as a compelling justification for that action. The right of stockholders to vote for directors is "sacrosanct" and the board cannot interfere with it lightly (EMAK Worldwide, Inc. v. Kurz, 50 A.3d 429, 433 (Del. 2012)).
Enhanced scrutiny applies once a board decision impacts the election of directors or touches upon matters of corporate control, even if the full board is not threatened in a proxy contest and even if the board's action has not actually prevented stockholders from successfully electing one or more nominees in a contested election. Here, enhanced scrutiny was triggered simply because the stockholders' opportunity to elect three directors changed to an election for one director, which would have had the effect, at most, of changing the dynamic on the board from a 5-3 majority to a 4-4 tie.

Comparison to Application of Business Judgment Rule

A recent decision from a federal court in Texas highlights the significance of the application of enhanced scrutiny to board decisions that affect stockholder voting rights in proxy contest situations. In Ashford Hospitality Prime, Inc. v. Sessa Capital (Master), LP, a hedge fund stockholder attempted to nominate a slate of five directors to a company's seven-member board (C.A. No. 3:16-cv-0527-N; C.A. No. 3:16-cv-0723-N (N.D. Tex. May 20, 2016) (ORDER)). The company's by-laws required that potential nominees fill out a questionnaire with all information that would be required to be disclosed to the stockholders in a proxy contest. The hedge fund completed the questionnaires, but left out any answer to the question of whether the nominees had any plans or proposals that would result in a sale or material change to corporate structure. The fund insisted that it had no such plans, though subsequent discovery revealed internal discussion about amending the company's by-laws, stopping acquisitions, and details of a "gameplan" for selling the company after the stockholder vote. Regardless, the board of the company excluded the candidates on the basis of the blank answers to the question of plans for the company, insisting that a sophisticated hedge fund would not engage in expensive litigation and a difficult proxy contest without any plans for the company after it seized control.

At first glance, the factual circumstances, if analyzed under Delaware law, would apparently trigger enhanced scrutiny: the board took action that directly implicated stockholder voting rights pertaining to the election of directors and corporate control. However, the company is incorporated in Maryland, not Delaware, and the Texas court applied Maryland law. In so doing, the court noted that the Maryland statute specifically states that board action relating to or affecting a change of corporate control is not subject to a higher duty or greater scrutiny than is applied to any other act of a director (MD. CODE ANN., CORPS. & ASS'NS § 2-405.1). The court also cited a Maryland Court of Appeals decision that explained that this statute was passed specifically for the purpose of rejecting Unocal in hostile takeover situations. Consequently, the Texas court applied the business judgment rule to the decision of the board. Given the deferential nature of the business judgment rule, the court held that the board was justified in believing that the hedge fund must have had ulterior motives for the proxy contest.

Comparing Ashford Hospitality Prime to Pell illustrates how doctrine matters.

Pell v. Kill: Board-Seat Reduction Plan Adopted Under Threat of Proxy Contest Fails Enhanced Scrutiny | Practical Law