In Pell v. Kill, et al, C.A. No. 12251-VCL (Del. Ch. May 19, 2016), the Delaware Court of Chancery issued a preliminary injunction against a board’s plan to reduce the size of the board of directors in the face of an looming proxy battle.
The case involved Cogentix Medical, Inc., a NASDAQ-listed Delaware corporation. Plaintiff, who held 7.1% of the company’s stock and was a director, filed an amendment to his Schedule 13D wherein he publicly disclosed his intention to seek changes in the company’s board of directors and its management team. Expecting a proxy contest in which the plaintiff might foreseeably attempt to install Class I directors less favorable to management at the upcoming annual meeting, the three defendant directors developed a strategy to reduce the size of the board and, accordingly, the number of Class I directors to be elected at the annual meeting. In so doing, the defendant directors foreclosed the possibility of a change in control of the board at the annual meeting. The Court of Chancery issued a preliminary injunction against the board’s reduction plan.
The Court of Chancery assumed that the defendants’ actions were proper and not selfish. Rather, it appeared that the defendant directors intended to maintain a majority on the board until after the annual meeting so that the board could be rebuilt after the annual meeting by the incumbent directors “without shareholder disruption”.
Nonetheless, given that the adoption of the board size reduction plan was not coming on a “clear day” but rather after the plaintiff had publicly disclosed his intention to seek changes and that the decision both affected the election of directors and touched on matters of corporate control, the Court of Chancery applied an “enhanced scrutiny” standard. The result is that the decision to reduce the size of the board needed to be not only “reasonable” but “compelling” – a standard that was not met.
As the Court stated: “Unfortunately for the Defendant Directors, 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.” And, quoting precedent, “The notion that directors know better than the stockholders about who should be on the board is no justification at all… Even a board’s honest belief that its incumbency protects and advances the best interests of the stockholders is not a compelling justification. Instead, such action typically amounts to an unintentional violation of the duty of loyalty.”
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