Newsletter 61- February 15, 2017

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We are pleased to present another edition of our periodic newsletter. In this edition we provide a brief synopsis of recent developments in Israeli corporate law affecting both private and public companies, , including the Israeli Supreme Court’s adoption of a modified form of Delaware’s Business Judgment Rule, the enforceability of contractual percentage interest anti-dilution provisions, director personal liability in the event of prohibited dividend distributions, and founder rights to start-up company intellectual property.

Our newsletter is intended to create awareness of important practical developments in Israeli corporate and commercial law, and the principles of law upon which these issues are based. We hope that you will find our newsletter informative and helpful, and your comments or suggestions are appreciated.

If you would like further information or have any questions concerning the issues discussed in this newsletter, please feel free to approach your contact person at our office or contact Yoram Shiv at 972-3-607-4777 or at, or Alex Berman at 972-3-607-4777 or at

You can view previous editions of our newsletter on our website at

Sharir, Shiv & Co., Law Offices


Supreme Court / Business Judgment Rule

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.


Supreme Court / Percentage Interest Anti-Dilution Protection in a Founders Agreement not Approved by a Company

The Israeli Supreme Court has ruled that anti-dilution protection contained in a shareholders agreement (“Agreement”) to which the company (“Company”) was not a party and had not adopted, and which provided for the maintenance of the percentage of shares held by a shareholder in the event of a future share issuance (as opposed to anti-dilution provisions with respect to future share issuances at a lower value than a fixed threshold), was unenforceable. .

The case before the Court involved a founders agreement that provided that a specific founder was not required to make additional investments in the Company. The Israeli District Court (“Lower Court”) had held that the above arrangement implies that the shareholder would also maintain his present percentage ownership in the Company without any dilution and the Lower Court found that the Agreement was enforceable. The Israeli Supreme Court (“Court”) overruled the Lower Court decision.

In its ruling, the Court noted that there are four types of documents in which shareholder anti-dilution protection can appear: Articles of Association, agreements to which a company is a party, agreements approved by a company post facto, and agreements to which a company is neither a party nor has approved.

Articles of Association are treated as agreements between a company and its shareholders and between the shareholders amongst themselves. Anti-dilution provisions included in Articles of Association are enforceable against the company.

Companies can also be bound by anti-dilution provisions included in an agreement to which the company is party, even where the company’s Articles of Association do not contain parallel protections.

Anti-dilution provisions can also be enforceable against a company when included in a founders agreement entered into prior to the company’s incorporation, provided that the company subsequently approves the agreement following its incorporation.

Provisions relating to anti-dilution protection are sometimes also included in agreements to which a company is not a party, such as founders agreements preceding incorporation, or agreements providing anti-dilution protection to investors that are concluded after incorporation. As a general rule, contractual anti-dilution protection will not bind a company to the extent that the company is not a party to the respective agreement and has not approved it post facto.

The Court ruled that in any event, the right to anti-dilution protection is limited and cannot be used to undermine principles contained in corporate law, such as the obligation of shareholders to act in good faith, and with respect to the controlling shareholder, also fairly, towards the company. The Court indicated that the greater the power of a shareholder to influence a company, the greater the shareholder’s responsibility to use its power to advance the company’s interests.

The Court observed that anti-dilution protection not enforceable against a company may still be enforceable against other shareholders who are party to a shareholders agreement. However, it is not reasonable that such obligations will be for an indefinite period.

On account of the foregoing, the Court held that the Company in the present case was not obligated to honor the anti-dilution protections that were contained in a founders agreement which the Company had not approved, and that the other founders were also not bound by such agreement because the Court found their obligations to have expired with the passage of time.

District Court of Tel Aviv / Director Liability to Repay Prohibited Distributions

The District Court of Tel Aviv (“Court”) was recently asked to find that certain dividend distributions (“Distributions”) that were approved by the directors of a public company (“Company”) were prohibited, had led to the Company’s collapse, and that the directors were personally liable for repaying the amount of the Distributions and the value of the Company’s outstanding debts.

In coming to its decision, the Court discussed the two-fold test that must be passed prior to the approval of a distribution of dividends: the earnings test, which is technical and accounting-based, and the solvency test, which considers whether a distribution will likely affect a company’s ability to satisfy its creditors. Passing the solvency test requires more than a simple predominance of assets over liabilities according to the company’s balance sheet; rather, it demands that a board of directors establish, based on information available to them at the time, that the company can meet its ongoing financial obligations. Should reasonable doubt exist, the distribution is prohibited.

When reviewing a board decision, the court will analyze the information available to the directors at the time of the decision and not hold the directors responsible for additional information available only with the benefit of hindsight.

In the event that a board of directors authorizes a prohibited distribution, directors may be found personally liable under either or both the laws of torts (arising from a breach of duty of care) or contract (arising from a breach of fiduciary duty). Direct damages would consist of the amount of the prohibited distribution. If there is a causal link between the prohibited distribution and future events such as the company’s collapse, consequential damages could include the sum of all company debts.

As a general rule, a director that has violated the duty of care by failing to demand and receive adequate information prior to making a decision carries the burden of proof with regard to establishing that the decision was reasonable and did not cause the company damage.

In the present case, the Court held that the board of directors had violated its duty of care in that it had considered neither the earnings test nor the solvency test in its approval of the Distributions, nor had the Board properly discussed the matter. Therefore, the burden of proof lay with the Board to demonstrate that the Distributions were reasonable under the circumstances and did not cause the Company damage.

With respect to one of the Distributions, the Court held that notwithstanding the Board’s failure to apply the two-fold solvency test and earnings test, as information available at the time of such Distribution did not constitute reasonable cause to believe that the Company would be unable to repay its debts once they became due, the directors were not obliged to repay the amount of such Distribution.

However, with respect to the other Distributions, as the information available at the time of the Distributions did raise reasonable doubt regarding the Company’s solvency, the Distributions were prohibited. The directors were therefore ordered to repay the amount of such Distributions, an amount of approximately NIS 20 million.

The Court rejected the plaintiff’s request that the directors also be ordered to pay the full amount of the Company’s debts, as no causal link was found between the prohibited Distributions and the Company’s collapse

The Court noted that in a public company, in which a controlling shareholder is also director and chief executive officer, directors serve as “gatekeepers” and are charged with avoiding decisions whose primary intent is to serve the interests of the controlling shareholders at the company’s expense, and in such role the directors are subject to the principle of Enhanced Scrutiny. _______________________________________________________________________________________________________________

District Court of Tel Aviv (Economic Division) / Founder Rights to Intellectual Property

Within the framework of a founder’s claim to certain shares and intellectual property of a private company (“Company”), the District Court of Tel Aviv (Economic Division) (“Court”) reviewed principles of intellectual property ownership in the event of a founder’s separation from a venture

In the case at hand, a group of founders executed a founders agreement providing that the intellectual property developed by any of the founders would be owned by all of the founders (“Agreement”). Subsequently, one of the founders left the project prior to the Company’s incorporation.

The Court noted that a start-up company’s intellectual property is its only asset and sole basis for securing investments. Without exclusive ownership of intellectual property, a start-up would not have any value and would not be successful in raising capital.

The Court observed that even though the Agreement did not explicitly address ownership of intellectual property upon founder separation, it did address share ownership in the event of founder separation prior to incorporation. As the value of shares of a start-up company is tied to ownership of its intellectual property, the Court found it reasonable to interpret the Agreement as also governing the ownership of the intellectual property developed by the founders in the event of founder separation prior to incorporation.

As the Agreement did not specify what would happen to the intellectual property upon founder separation, the Court held that the parties’ intentions were to be determined through principles of contract interpretation, such as understanding the intent of the parties, assuming fair and reasonable parties, and through completing the missing details of the contract in accordance with mechanisms provided for under Israeli contracts law. Using these techniques, the Court ruled that the intent of the parties directed that even upon separation of a founder, ownership of the intellectual property developed by such founder would remain with the Company and that the contractual provision as to joint ownership by the founders applied only to the pre-incorporation period.

This newsletter provides general information and should not be used or taken as legal advice for specific situations, which depends on the evaluation of precise factual circumstances.