In Pell v. Kill, et al, C.A. No. 12251-VCL (Del. Ch. May, 19, 2016), Vice Chancellor Laster preliminarily enjoined incumbent members of a board of directors from implementing a plan to reduce the number of board seats prior to a directors’ election at an annual meeting after a proxy challenge had been made.

In Pell v. Kill, et al. Cogentix Medical, Inc., a Delaware corporation (“Cogentix”), was the surviving company of the March, 2015 merger of Vision-Sciences, Inc. (“VSI”) and Uroplasty, Inc. (“Uroplasty”). The plaintiff Lewis Pell (“Pell”), was VSI’s former chairman and co-founder. As a result of the merger, Pell was the second largest Cogentix stockholder and also held $28.5 million of Cogentix debt, and Pell, and two other members of the VSI’s board became directors of the Cogentix board.

Five members of Uroplasty’s board joined and held a majority of seats on the eight member Cogentix board. These former Uroplasty board members also chaired and held a majority on all Cogentix board committees. Robert Kill (“Kill”), one of the defendants, was a Uroplasty director and was CEO, President and Chairman of Uroplasty. Kill held these same positions with Cogentix after the merger.

Cogentix board elections were staggered with three classes of board members. The three Class I seats were set for election in 2016 and consisted of Pell, one other VSI director and a single Uroplasty member.

On February 16, 2016, the plaintiff Pell declared his desire for a change in leadership and willingness to conduct a proxy battle in an open letter to the board. Pell filed the letter as an amendment to his Schedule 13D. He took issue with Kill holding the roles of chairman, President and CEO concurrently and with the compensation Kill was paid for those roles. Pell also asserted that the Uroplasty directors’ stock ownership in Cogentix was not sufficient to align their interests with the stockholders’ interests and that these directors’ actions were influenced by their loyalty to Kill.

Two days later, the board members met and appointed one member each from the Uroplasty and VSI directors to conduct negotiations to attempt to reach a resolution of Pell’s proxy challenge. Negotiations included offers by several of the Uroplasty directors to resign if the parties all agreed on neutral directors to appoint in their stead. Because only the Class I directors were up for election, board members other than Pell considered that Pell’s challenge could potentially result in a deadlock if four Uroplasty directors were to cast votes opposing four VSI directors.

In parallel with these negotiations, Kill and other board members prepared a proposal for a Board Reduction Plan that would preserve Uroplasty directors’ control of the board. The Board Reduction Plan was formulated to reduce the number of Class I seats from three to one, with Pell as the sole remaining Class I director. As a result, the board would have six members composed of four Uroplasty directors and two VSI directors.

Throughout the negotiations and the process of preparing the Board Reduction Plan, emails were exchanged among the Uroplasty directors regarding their views on the need to prevent disruption resulting from a proxy contest and for the board to take time after the stockholders’ meeting to search for and appoint new board members.

After the board was unable to resolve Pell’s concerns through negotiations, the Nominating Committee voted not to recommend the Class I VSI director for reelection, voted to recommend re-election of Pell to the stockholders and recommended that the board approve the Board Reduction Plan. Three days later, a Uroplasty director from Class II resigned. The Nominating Committee then approved eliminating the vacant Class II seat. The Nominating Committee’s report to the board explained that the reductions in the number of board seats would avoid hurry and insure the directors could “rebuild a Board that has the skills to effectively oversee the company’s business.” The recommendations of the committee were approved by the board with a vote of four to three, split along Uroplasty directors and VSI directors lines. As a result of the board approval, the vacant seat was removed immediately with the two Class I seats removed under the Board Reduction Plan to remain in place until the annual stockholders’ meeting.

The plaintiff Pell filed suit seeking declaratory and injunctive relief to invalidate the defendant directors’ actions, to vindicate Pell’s rights as a stockholder and a board member, to protect the stockholder franchise, and to negate the defendant directors’ efforts to maintain board control and suppress opposition.

To receive a preliminary injunction the plaintiff must show (1) a reasonable probability to succeed on the merits, (2) a threat of irreparable injury, and (3) that the equitable circumstances favor the injunction. The court applied the enhanced scrutiny standard and determined that directors facing a proxy fight confront a “structural or situational conflict,” and as such, the board bore the burden of defending their actions in light of the circumstances. The opinion indicates the court’s determination that the Board Reduction Plan affected a board election which as a result of Pell’s proxy challenge could have altered the incumbent directors’ control of the board and that therefore the board’s actions were subject to the enhanced scrutiny standard of review.

Relying on the settled test laid out by the Delaware Supreme Court, the court stated that a board must show: (i) “‘their motivations were proper and not selfish,’” (ii) stockholders were not precluded from exercising their vote or coerced into one outcome, and (iii) that the directors’ actions were reasonable in the context. The court assumed proper motivations existed and did not discuss the first factor.

Turning to the second prong, the court found the Board Reduction Plan was clearly preclusive. The Board Reduction Plan prevented stockholders from electing directors to the eliminated seats. Furthermore, the board destroyed the ability to wage a proxy fight to change control of the board. The directors adopted the Board Reduction Plan after they were under stress from a threatened proxy fight and their communications made clear that their goal was to avoid the fight and allow the board to add seats and restructure after the stockholders vote. The court noted that these activities may be looked at differently if no proxy challenge had been issued and the board was not in conflict.

Kill and the other defendant directors put forth three arguments as to why their actions had adequate justification under the third prong of the test: (i) the board required time to identify and appoint independent directors whose appointment to the board would create value for the shareholders and result in a board which was not mired in personal conflicts; (ii) the reduction in directors was a cost saving mechanism; and (iii) the efficiency of smaller boards. The court rejected these arguments.

In concluding its analysis on the injunction, the court stated that irreparable harm arises when stockholders are denied their votes on corporate governance matters. Failing to issue the injunction would prevent the stockholders’ ability to vote for the two Class I directors at the annual meeting. While the interest of corporate democracy is high, the directors faced no hardship by allowing the vote. The possibility of not being re-elected is not an equitable factor the court recognizes in this context.

In short, in its application of enhanced scrutiny of the directors’ approval of the Board Reduction Plan, the court reiterated the longstanding prohibition against director interference with stockholders’ rights to elect the directors, and through those votes to dictate major strategies and policies of the company. The court made clear that even earnest belief that preserving incumbent directors’ control is in the best interest of the company is not recognized as a justification for that interference.