Newsletter 64- November 15, 2017

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THE LEGAL NEWSLETTER

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 standing in derivative suits and impact of improper shareholder conduct on shareholder debt claims.

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 yoram@sask.co.il, or Alex Berman at 972-3-607-4777 or at alex@sask.co.il.

You can view previous editions of our newsletter on our website at www.sask.co.il.

Sharir, Shiv & Co., Law Offices

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Supreme Court / Independent Standing for a Company in a Shareholder Derivative Suit

The Israeli Supreme Court (“Supreme Court“) held that a company may have independent standing in a shareholder derivative suit, but only in the event that the derivative claimant’s actions have a high probability of causing severe irreversible damage to such company.

The derivative suit procedure allows a claimant who is not the company (usually a shareholder) to file a lawsuit on behalf of the company where the authorized organs of the company have failed to file a claim or take other action to enforce the company’s rights vis-à-vis a third party (generally an office holder or controlling shareholder of the company). The derivative claim process can be divided into two parts: (a) the certification stage of the derivative claim in which the company has independent standing to respond to the claims of the derivative claimant and may attempt to convince the court that it is unjustified to grant the plaintiff the right to sue on behalf of the company; and (b) the derivative proceeding, which occurs only if the claim certification request is accepted by the court. During this second stage, the derivative claimant steps into the shoes of the company and acts on the company’s behalf without the company being actively involved in the management and administration of the claim.

In the matter at hand, the Supreme Court discussed whether at the stage of conducting the derivative proceeding, the company (the “Company“) could have standing in certain situations to represent its position, or whether at this stage the Company is always represented solely by the derivative claimant.

The Supreme Court ruled that the Company could have limited independent standing at the second stage of a derivative procedure. In so far as a question relates to the management of the derivative claim, exclusive authority is vested in the derivative claimant. However, in so far as a question relates to the Company’s ongoing activities, the Company’s organs continue to represent the Company’s interests.

The Supreme Court noted that the Company is not a typical third party with respect to a derivative claim but is generally a party interested in the claim’s failure. The Supreme Court recognized that the concern that the Company might attempt to thwart a justified derivative claim but determined that this concern should not be addressed by an absolute denial of the Company’s independent standing, but rather should be addressed by imposing a high threshold for the Company to meet in order to challenge the manner in which a claim is being managed by the derivative claimant. The Supreme Court explained that the focus of the derivative claimant is not usually the Company’s current activity, but rather the success of his or her claim and that the derivative claimant often does not consider the damage that can be caused to the Company.

The Supreme Court ruled that at the stage of the derivative proceeding, the Company may not argue that the derivative claim per se will cause damage to the Company, but can question the impact of the manner in which the claim is managed by the derivative claimant. The Supreme Court emphasized that the Company is not granted an independent and permanent standing, but one limited to situations where the management of the claim may harm the interests of the Company. For example, where the disclosure of a document that is essential to proving the derivative claim may cause damage to the Company that exceeds the benefit that will be derived from the document’s disclosure (such as where disclosure would subvert an important transaction).

Alongside the determination that the Company has independent standing at the stage of the derivative proceeding, the Supreme Court determined that for the Company to appeal the manner in which the derivative claimant is conducting the suit it must pass a high threshold. Not every concern or damage will justify judicial intervention and the Company must establish that a particular action taken by the derivative claimant will reasonably cause the Company serious and irreversible damage.

It was further determined that the Company is obligated to cooperate with the derivative claimant and that the claimant is not required to convince the Company that his or her actions are essential or relevant to the suit. The derivative claimant has exclusive discretion in this regard, and the ability of the Company to apply to the Court is limited only to when the action taken may cause harm to the Company, as aforesaid.

Finally the Supreme court ruled that it is for the Company to determine what person or organ (such as a special purpose committee) will act on its behalf in its dealings with the derivative claimant.

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District Court / Shareholder’s Conduct Against the Interest of the Company and Impact on Such Shareholder’s Debt Claim

This ruling pertains to a number of appeals against the decision of the trustees of New Central Bus Station Company (the “NCBS“), a company in liquidation that owned assets in the building of the New Central Bus Station in Tel Aviv, related to the debt claim submitted by Nitsba Holdings 1995 Ltd. (“Nitsba“). The ruling dealt with the status of NCBS’s debts to Nitsba, who was the controlling shareholder of NCBS and asserted that it was NCBS’s secured creditor. Nitsba effected several actions that caused the District Court (the “Court“) to suspect that Nitsba’s hidden purpose was to cause NCBS’s collapse and to then re-acquire NCBS at a reduced price during an insolvency procedure.

Nitsba claimed that it acted in good faith belief of its ability to rehabilitate NCBS and in NCBS’s ability to fulfill all of NCBS’s obligations, including NCBS’s obligations to its shareholders. The Court concluded that Nitsba had acted in bad faith. Nitsba had not believed in NCBS’s ability to rehabilitate itself or, alternatively, was not interested in such rehabilitation. Nitsba’s coverall plan was to implement certain transactions that established its control and its position as a debtor and which enabled it to initiate insolvency proceedings against NCBS at the time of Nitsba’s choosing. NCBS’s subsequent insolvency allowed Nitsba to submit an offer to purchase NCBS or its assets at a reduced price.

The Court held that due to the exceptional circumstances in this case, it would subordinate some of the components of the debt owed to Nitsba (i.e., rule that the Nitsba debt has a lower preference than other debts of NCBS, such that these Nitsba debts will be prior in repayment only to the shareholders).

Firstly, the Court noted that Nitsba thinly capitalized NCBS by providing loans to NCBS rather than equity investments, leaving NCBS with insufficient capital. Although Nitsba claimed that the real estate assets of NCBS provided sufficient capital to meet the terms of the “thin capitalization” tests, the Court ruled that such test must be primarily on a cash flow basis and that NCSB’s real estate assets were not sufficiently liquid to be taken into account. The thin capitalization discussion in this case was limited to the issue of debt subordination and was not expanded to include piercing the corporate veil between Nitsba and NCBS (even though piercing the corporate veil is a possibility in severe cases of thin capitalization). Piercing the corporate veil would have resulted in more serious consequences for Nitsba, as it would leave Nitsba responsible for NCBS’s debts.

Secondly, despite the precarious economic situation of NCBS, Nitsba decided to purchase NCBS’s secured debt and not invest in NCBS’s capital. This created a “market distortion” in that NCBS had a conflict of interest by wearing “two hats” – as a controlling shareholder and as a secured creditor. This failure to make an equity investment is one of the reasons the Court “re-characterized” the shareholders’ loans as a capital investment in the Company.

The Court adopted the position that it is necessary to not recognize the validity of a pledge accompanying a shareholder’s loan due to the resulting market distortion which places the controlling shareholder in a position of absolute priority over the other creditors and shareholders. The Court held that a shareholder’s loan can place the shareholder, at most, in a position of an unsecured creditor.

In addition, it was determined that Nitsba had violated its duty of trust towards NCBS as a de facto office holder and as its agent. The Court examined Nitsba’s substantial involvement in NCBS’s decision-making process and determined that Nitsba had a significant influence on NCBS’s business. Similarly, it was found that NCBS gave Nitsba broad authority to conduct NCBS’s affairs, which created a principal-agent relationship between the companies.

The Court ruling indicated that Nitsba sidelined the board of directors of NCBS from involvement in material business activity, presented false representations and violated its obligations of disclosure and good faith. It was determined that, in practice, Nitsba acted on its own behalf in reaching an agreement for the purchase of the outstanding debt of NCBS at a reduced price (less than 75% of the full value of the original debts).

Out of the Nitsba’s seven debt claims, the court accepted two, three were subordinated and two were completely dismissed.

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