In a significant judgment, the Israeli Supreme Court has held that a modified form of Delaware's Business Judgment Rule, which limits judicial intervention in corporate management decisions, is now part of Israeli corporate law.
The present case was an appeal of a ruling of the District Court of Tel Aviv (Economic Division) ("Lower Court"), in which the Lower Court rejected a request for approval of a derivative action against the officers and controlling shareholder of a public company ("Company") in connection with the distribution of dividends ("Distributions"). The Distributions occurred following the leveraged acquisition of a controlling interest in the Company and were based upon the Company's cash profits, accounting profits, and a court-approved capital reduction. The Company incurred loans to fund the payment of the full amount of the Distributions. The petitioners alleged that the Distributions benefitted the controlling shareholder at the expense of the Company, for the controlling shareholder was relying on the Distributions to repay loans that the controlling shareholder incurred in its acquisition of the Company.
In its decision, the Israeli Supreme Court ("Court") rejected the allegation that the Distributions were an exceptional transaction with a controlling party, as defined in the Israeli Companies Law ("Companies Law") requiring consent from each of the Company's Audit Committee, board of directors, and a majority of Company shareholders with no personal interest in the matter. Rather, the Court held that the Distributions affected all Company shareholders, not merely the controlling shareholder, and therefore were not an exceptional transaction in which a controlling party has a personal interest. The Court further noted that it is unclear whether the Distribution would even amount to a "transaction" as defined in the Companies Law, for as dividend distributions are fundamental to share ownership, distributions and receipt of dividends are merely the implementation of existing rights.
The Court also affirmed existing Israeli case-law that provides that the duty of fairness imposed on controlling shareholders is more rigorous than the duty of good faith to which other shareholders must comply. The Court then compared the duties of care and loyalty existing in Israeli law with the law in Delaware, especially with respect to the Business Judgment Rule, the principle of Entire Fairness, and the principle of Enhanced Scrutiny:
- Business Judgment Rule. The Business Judgment Rule provides that a decision is presumed to be correct and immune from judicial review when it is informed, does not involve a conflict of interest, and has been made in subjective good faith. The Court ruled that Israeli corporate law now includes the Business Judgment Rule and its derivative arrangements, subject to the following qualifications:
- Entire Fairness. In Delaware, the principle of Entire Fairness applies where conditions required for satisfaction of the Business Judgment Rule do not exist, especially in cases involving conflicts of interest. In such situations, corporate transactions will be upheld if they meet the Entire Fairness standard. Entire Fairness requires that the overall fairness of a transaction be evidenced both procedurally (such as through establishing a disinterested and independent board committee to review a transaction) and substantively (a determination that a transaction was fair to the company), taking into consideration details of the specific transaction. The Court held that the Delaware principle of Entire Fairness does not replace provisions in the Companies Law, such as those providing that transactions with conflicts of interest require prior approval, and that a material condition of receiving prior approval is that the transaction is in the best interests of the company. The Court held that so long as a company complies with those procedures that are required by the Companies Law to neutralize effects of a conflict of interest, there is no need to also employ the principle of Entire Fairness.
- Enhanced Security. The principle of Enhanced
Scrutiny was designed to deal with exceptional circumstances where
there are potential conflicts of interest. In these situations, the
application of the Business Judgment Rule might conflict with the
requirements of the duty of loyalty and the principle of no
conflict of interest with respect to corporate officers. In this
context, the burden of proof is on the board of directors to show
that its motivations were proper and that its actions were
reasonable in relation to a legitimate objective. Generally, a
change in a company's capital structure, including the
distribution or non-distribution of dividends, is a type of
transaction that is subject to the Business Judgment Rule. However,
in a scenario of a leveraged purchase of control followed by a
significant change in capital structure, an Enhanced Scrutiny level
of review is more appropriate due to the concern that company
decision makers may have acted for the benefit of the controlling
shareholder rather than the good of the company.
In the present case, the Court rejected the appeal for a number of reasons. The petitioners did not prove that the controlling shareholder had liquidity difficulties which led to the Distributions. Furthermore, the Court noted that it is acceptable for controlling shareholders to rely on dividend distributions in order to repay loans. The Distributions were discussed exhaustively by the Board. There was no evidence of material damage to the Company. The vast majority of shareholders had approved the Distribution. Therefore, there was no basis for holding that the best interests of the Company had not been considered.
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