The duty to act in good faith dominates all branches of the law, including the corporate system. Thus, the duty of good faith applies to all of a company's shareholders, and its executives (more extensively than the shareholders). In view of the special status of the controlling shareholder in the company, and his ability to influence the company's decision-making process, on the one hand the law imposes on the controlling shareholder the duty of acting fairly towards the company, but on the other hand does not specify to what extent it is to be applied.
The status of the controlling shareholder in the company is two-fold – on the one hand, the controlling shareholder is a shareholder, and as such he is entitled to do with his shares as he wishes, similarly to the company's other shareholders. On the other hand, the controlling shareholder has the power to influence not only his own assets, but also those of others, and in this sense, he is similar to an executive.
So, the question is what is the level of liability that emanates from the controlling shareholder's duty to act fairly in general, and, in particular, at the time of selling his control to another private entity.
The Feuchtunger judgment and its implications
The nature, and the scope, of a controlling shareholder's liability, and also the scope of the judicial review which will be activated upon a breach of this duty, were at the very foundation of the judgement in Civil Appeal 7657/17 Chen Berdichev C.A., in his capacity as trustee of the Feuchtunger Industries Ltd. creditors' composition v. Azriel Feuchtunger et al. (henceforth: “the Feuchtunger Judgement”).
The facts of the case in brief – Feuchtunger Industries Ltd. was a public company that dealt in the fields of electricity and control for industry, infrastructure and public buildings. Mr. Azriel Feuchtunger served as chairman of the board of directors, and he was the company's controlling shareholder. In time, Feuchtunger entered into an agreement to sale his control of the company, to a group of investors, for the sum of approximately two hundred million New Israel Shekels (NIS 200,000,000). According to the purchase agreement, the purchasing companies intended to continue with the company's activity in the same fields, and to integrate the activity of the purchasing companies in a process that would bring about the creation of a large and elaborate entity in the building trade.
A short time after the purchase, and as a result of economic difficulties in the purchasing companies, some parties in the purchasing companies decided to make use of the company's cash for their personal use. This embezzlement of the company's money brought about the company's collapse and insolvency proceedings.
The trustee, appointed to the company, submitted a claim against Feuchtunger and others, on the grounds that he must be made personally liable, as controlling shareholder, for the sale of the company to purchasers who led to its collapse.
The majority opinion rejected the appeal and determined that, under the circumstances, Feauchtunger cannot be held liable, in view of the facts determined in the judgement given in the case, below.
Up to the Feuchtunger judgement and prior to the enactment of the Companies Law in 1999, the determining ruling was given in Civil Appeal 817/79 Cossoy v. Y. L. Feuchtunger Bank Ltd., Judgement 38(3)253 (1984) (henceforth: “the Cossoy Ruling”) in which the controlling shareholder in a company owes loyalty to the company and the sale of the company to a purchaser who will bring about the collapse of the company (an injurious sale) in circumstances known to the controlling shareholder, constitutes a breach of that duty. The Cossoy judgement was interpreted as applying exclusively in cases in which the purchaser acted with malicious intentions to ruin the company.
The Feuchtunger judgement extended the scope of the controlling shareholder's liability, in the case of an injurious sale (a sale to a purchaser which leads to the collapse of the company).
As stated above, on the one hand, it was the controlling shareholder who purchased the control of the company and invested his private capital in it, and so he is the owner of the proprietary right who is entitled to do with his property as he wishes. On the other hand, the controlling shareholder has the power to influence the company's activity and other people's assets.
In view of the above, and in view of the special status of a company's controlling shareholder, a delicate balance must be achieved when we come to impose liability on a controlling shareholder and on the actions that he takes. On the one hand, the imposition of too broad a liability might damage the efficiency of the market and the controlling shareholder's proprietary rights. On the other hand, the removal of that duty from the controlling shareholder, when he sells the control might lead to failures, in which the control of companies is transferred to doubtful entities in a manner that cause real harm to many, and, at the end of the day, also to the entire market.
In the light of all the considerations examined, Her Honour Judge Vilner determined the rule for the imposition of liability on a controlling shareholder, as follows: “The liability for a breach of the duty to act fairly will be imposed on a controlling shareholder for an injurious sale, if he knew (or turned a blind eye to knowing) of circumstances which a reasonable person, who knew of their existence, would have expected, with a high level of certainty, that the outcome of the sale would have been the collapse of the company. And in other words, the proposed rule of liability examines, first of all, the controlling shareholder's subjective state of awareness (of what circumstances was he aware), and secondly, thereafter, in view of what he actually knew, it examines whether the controlling shareholder deviated from a reasonable standard of behaviour”.
Her Honour Judge Dafna Barak Erez concurred with Her Honour Judge Vilner, but in her opinion the rule should be extended in two situations: first, in a situation in which the selling controlling shareholder will claim “that he did not know anything about the purchaser prior to the sale, even a basic check would have been likely to help him to obtain information about the purchaser and to spread light on the consequent damage that might have been caused to the company”; secondly, “Even in the normal situation, where grounds for a claim for injurious sale would have only been permitted when the company became insolvent, one cannot reject out of hand the possibility of a claim even in an instance of fatal damage to the company which did not reach the state of insolvency”.
His Honour Judge Elron wanted to reduce the imposition of the rule of liability and determined that, according to his approach, liability should not be imposed on a controlling shareholder in instances where the purchaser stole the company's assets, unless the purchaser intended to steal the company's assets at the time that the transaction was made.
In the Feuchtunger judgement it was rulled that in the event of an injurious sale, the liability of a controlling shareholder should be examined, mainly, from the point of view of the duty to act fairly. In practice, the Feuchtunger judgement granted the interpretation to the Companies' Law and to the duty, imposed by virtue of that law, on the controlling shareholder, to act fairly.
Thus, the Feuchtunger judgement determined that the rule of liability, according to which a controlling shareholder bears the liability for an injurious sale, if he knew, or turned a blind eye to knowing, of circumstances that would have brought a reasonable person to expect, with a high level of certainty, that the sale would cause the collapse of the company. Despite the ruling of the extension of the liability that should be imposed on a controlling shareholder in the case of an injurious sale, and in accordance with the rule of liability determined by Her Honour Judge Vilner, the three judges rejected the appeal and ruled that under the circumstances of the case, no liability should be imposed on Feuchtunger, in view of the facts determined in the District Court.
Originally Published March 2021
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