Court of Chancery Prohibits Implementation of Board Reduction Plan

In Pell v. Kill,[1] the Delaware Court of Chancery considered a challenge by a plaintiff-director and shareholder to actions taken by defendant-directors to reduce the size of publicly traded Cogentix Medical, Inc.’s (the “Company”) board of directors where the defendant-directors anticipated a proxy contest led by plaintiff.  Ultimately, Vice Chancellor Laster issued an injunction prohibiting the implementation of the board reduction plan.
Plaintiff held 7.1% of the Company’s stock and was also a director.  Displeased with the Company’s board, plaintiff publicly disclosed his desire to effectuate changes to Company’s board of directors and other management teams in an amendment to his Schedule 13D filing.  In the face of plaintiff’s public statements, the defendant-directors anticipated a proxy fight wherein plaintiff would likely try to place new Class I directors on the board that were less favorable to the incumbent management at the Company’s upcoming annual meeting.  As a result of that fear, the defendant-directors developed a plan to reduce the size of the Company’s board in order to minimize the number of Class I directors that could be elected at the upcoming annual meeting in order to prohibit plaintiff from effecting a change of control.
The Court of Chancery applied enhanced scrutiny analysis to the defendant-directors board reduction plan because the plan (i) affected an election of voters and (ii) touched on matters of corporate control pursuant to Mercier v. Inter–Tel Inc.[2]  Notably, the Court “assumed that the defendants’ actions were proper and not selfish[,]” thus satisfying the first prong of the enhanced scrutiny analysis.  Turning to the final two prongs of enhanced scrutiny, the court found that the reduction plan made it reasonably probable that a proxy contest would be unattainable, and that the defendant-directors presented no adequate justification for their actions.  Specifically, the Court held that the justifications offered by the defendant-directors were not sufficiently tailored to achieve a legitimate end.
Instead, the Vice Chancellor Laster explained that defendant-directors actions appeared to be predicated on the desire of the incumbent defendant-directors to maintain a majority on the board until after the annual meeting so that the defendant-directors could refashion the make-up of the board to their liking, and “without shareholder disruption.”
But because the defendant-directors board reduction plan was only implemented after plaintiff publicly disclosed his intention to effectuate change to the Company’s board of directors and not on a “clear day.”  As a result, the defendant-directors actions had to be “compelling” rather than merely “reasonable.” 
The Court noted that Delaware law precludes actions taken by a board of directors to preserve incumbents’ position on the board; even if the board’s honest belief is that incumbency is in the best interest of shareholders.  The Court further noted that such conduct “typically amounts to an unintentional violation of the duty of loyalty.”  The Court then reasoned that the defendant-directors “belief that they knew better than stockholders is not a legitimate justification when the question involves who should serve on the board of a Delaware corporation.”

Special thanks to Evan Hoey for preparing this summary.

[1] Pell v. Kill, et al, C.A. No. 12251-VCL (Del. Ch. May 19, 2016).
[2] Mercier v. Inter–Tel Inc., 929 A.2d 786, 797 (Del. Ch. 2007).