Situational and Structural Conflicts Inherent in Proxy Contests
The context in which a director acts can be outcome determinative in a subsequent breach of fiduciary duty action.
Reprinted with permission from the June 1, 2016 edition of the Delaware Business Court Insider. © 2016 ALM Media Properties, LLC. All rights reserved. Further duplication without permission is prohibited. (ALMReprints.com, 877.257.3382).
On May 19, in Pell v. Kill, C.A. No. 12251-VCL, the Delaware Court of Chancery preliminarily enjoined certain directors of Cogentix Medical Inc. from completing a board reduction plan, under which such directors sought to reduce the size of the board from eight to five members. The court enjoined the board reduction plan, which was proposed to stave off a threatened proxy contest, because it found that it inhibited stockholders' ability to vote at an annual election and precluded stockholders from being able to establish a new board majority.
Background
Cogentix was formed by way of a merger between Vision-Sciences Inc. (VSI) and Uroplasty Inc. As such, Cogentix's board was composed of three former directors of VSI, including plaintiff Lewis C. Pell (the VSI directors), and five former directors of Uroplasty, including defendant Robert C. Kill (the Uroplasty directors). Cogentix's board was divided into three classes with three directors in Class I, three directors in Class II, and two directors in Class III. Class I was composed of two VSI directors (including Pell), and one Uroplasty director. The issue raised in this litigation revolved around an election of Class I directors that was to take place at the Cogentix annual meeting scheduled for May 20.
Shortly after the merger between VSI and Uroplasty closed, disputes arose between the companies' former leaders, Pell and Kill. As a result of those disputes, on Feb. 16, Pell sent the board a publicly filed letter in which he expressed his desire to change the management team and signaled his willingness to run a proxy context. Two days after Pell sent the Feb. 16 letter, the board held a regularly scheduled meeting, during which Pell, again, indicated that he was prepared to change the board composition. According to the court, at that point, "everyone understood that Pell was threatening a proxy contest."
In the days following the meeting, Kill and two other Uroplasty directors developed the board reduction plan, which, in Kill's words, was intended to "avoid any proxy fight."
On March 28, Pell officially proposed a slate of Class I nominees for consideration at Cogentix's annual meeting. At a board meeting the next day, the Uroplasty directors, over the dissent of Pell and the VSI directors, voted to adopt the board reduction plan. As adopted, the plan immediately reduced the size of the board from eight to five members by reducing the number of Class I seats from three to one, and removing a Class II seat to eliminate a vacancy created by the resignation of a Uroplasty director.
Before the board reduction plan (but taking into account the resigning Uroplasty director), the Cogentix board was composed of four Uroplasty directors and three VSI directors. Without the board reduction plan, the company's stockholders had the opportunity to elect three Class I directors to the board and potentially establish a new 4-3 board majority in favor of the VSI directors. By enacting the board reduction plan, the Uroplasty directors ensured that no matter how the stockholders voted, the Uroplasty directors would retain a 3-2 majority.
Accordingly, Pell moved to preliminary enjoin the Uroplasty directors from reducing the number of board seats in advance of the May 20 annual meeting, which, for the reasons that follow, the court granted.
The Court's Analysis
To obtain a preliminary injunction, Pell needed to demonstrate a reasonable probability of success on the merits; a threat of irreparable injury; and that the balance of the equities favored the issuance of an injunction. In analyzing the first element, the court found that Pell demonstrated a reasonable likelihood of success on the merits by showing that the proposed board reduction plan triggered and was not likely to withstand enhanced scrutiny review.
Delaware has three tiers of review for evaluating director decision-making: the business judgment rule, enhanced scrutiny, and entire fairness. The court noted that the standards of review espoused by Unocal v. Mesa Petroleum, No. 152, 1985 (Del. June 10, 1985), Revlon v. MacAndrews & Forbes Holdings, Nos. 353, 354, 1985 (Del. Mar. 13, 1986), and Blasius Industries v. Atlas, C.A. No. 9720-CA (Del. Ch. July 25, 1988), are varying forms of enhanced scrutiny review and are designed to address situational and structural conflicts (i.e., situations in which "the realities of the decision-making context can subtly undermine the decisions of even independent and disinterested directors").
The court explained that "directors who face a proxy contest confront a structural and situational conflict because their own seats are at risk," and that, in such situations, "when there is director conduct affecting either an election of directors or a vote touching on matters of corporate control, the board must justify its action under the [Blasius] enhanced scrutiny test." Here, the court found that Blasius enhanced scrutiny review applied for two reasons. First, "the board reduction plan affected ... an election of directors" by reducing the number of directors the stockholders were entitled to elect in a contested election from three to one. Second, "the board reduction plan touched on matters of corporate control" because the board reduction plan eliminated the stockholders' ability to elect a new majority in favor of the VSI directors.
When tailored for reviewing director action that affects stockholder voting, enhanced scrutiny requires that the defendant directors prove that their motivations were proper and not selfish, that they did not preclude stockholders from exercising their right to vote or coerce them into voting a particular way, and that the directors' actions were not only reasonable, but also compelling, in relation to their legitimate objective. In this context, the shift from "reasonable" to "compelling" requires that the directors establish a closer fit between means and ends of the director action.
Although the court assumed that the defendants' motivations "were proper and not selfish," the court nevertheless found that the plaintiffs were reasonably likely to succeed on the merits under the latter prongs of Blasius enhanced scrutiny (i.e., that the defendants' actions were preclusive and not sufficiently tailored to achieve a legitimate end).
In short, the court found that the factual record demonstrated that the defendant directors approved the board reduction plan to avoid a proxy fight that they feared Pell would win. One of the key factors that the court relied upon in reaching this conclusion was that the defendant directors "acted in the face of an anticipated proxy contest." The court explained that the "defensive action by the [Uroplasty directors] compromised the essential role of corporate democracy in maintaining the proper allocation of power between the shareholders and the board, because that action was taken in the context of a contested election for successor directors." Notably, the court explained that the "outcome might have been different if the directors had acted on a clear day" before Pell sent a letter suggesting an imminent proxy contest. Because the directors' actions were taken in response to a threatened proxy fight, however, the court found that the plaintiff was reasonably likely to succeed in demonstrating that the board reduction plan was preclusive and not sufficiently tailored toward achieving a legitimate corporate objection, thereby proving that the defendant directors breached their fiduciary duty of loyalty.
The court also found that Pell sufficiently alleged a threat of irreparable harm and that the balance of equities favored issuing an injunction, and therefore granted Pell's motion to preliminary enjoin the Uroplasty directors from completing the board reduction plan.
Takeaways
One of the key takeaways from the court's decision in Pell for directors of Delaware corporations is that context is key. As indicated by the court, the context in which a director acts can be outcome determinative in a subsequent breach of fiduciary duty action. Director action that would otherwise constitute a valid exercise of business judgment may give rise to a fiduciary wrong in factual contexts that by their very nature present certain situational or structural conflicts of interest, such as proxy contests. In such contexts, Delaware courts will not merely defer to, but will instead more closely examine the reasonableness of director decision-making, including the motivation, justification and practical effect of such director action. Even well-intentioned decisions of directors, if preclusive in nature or not sufficiently tailored toward achieving a legitimate corporate objection, may amount to a breach of the directors' duty of loyalty in such contexts. Directors should accordingly be cognizant of the situational contexts in which they are operating and determine how that context affects the manner in which a Delaware court would analyze and view certain director action.