SOMMARIO:

1. Introduction - 2. A Note on Israel’s Legal System and Capital Market - 2.1. Legal System - 2.2. Capital Market - 3. Evolution of Israel’s Corporate Law - 4. Israel's Companies Law – General Structure and Main Features - 5. Legislative and Regulatory Developments - 5.1. Amendments to the Companies Law - 5.2. The Goshen Committee - 5.3. Board Composition - 5.4. Remuneration of Directors - 5.5. Accountability and Audit - 5.6. Institutional Investors - 5.7. Establishment of a Court Specializing in Companies and Securities Law - 6. Conclusion - NOTE

1. Introduction

This report portrays recent developments in the field of Israeli corporate law and corporate governance. It illustrates the key legislative and regulatory changes which took place over the last years and provides a general overview of reforms which are underway. As an emerging economy that strives to stimulate its growth by attracting foreign investment and facilitating corporate commercial activity, Israel had to reform its corporate laws to meet advanced international standards. The first step was to codify the various corporate statutes and case law, which was developed over the years by the judiciary, into a unified body of legislation. This task was achieved only in year 2000, when the new Companies Law entered into force. The following step, currently in progress, concerns further legislative improvements alongside the formation of an Israeli Corporate Governance Code, based on specific attributes and needs of the local market. The report continues as follows: First, a brief note on Israel’s legal system and capital market features shall be provided; Secondly, I shall sketch in general lines the evolution which led to the enactment of Israel’s Companies Law 5759-1999 (hereinafter – Companies Law) [2] and present its structure and main features. Subsequently, an overview of recent legislative and regulatory developments will be offered as well as an account of specific recommendations submitted in 2006 by a professional Committee for examination of corporate governance in Israel chaired by Professor Zohar Goshen (hereinafter – Goshen Committee) [3].

2. A Note on Israel’s Legal System and Capital Market

2.1. Legal System

Israel inherited parts of its legal culture from the two powers that ruled the country before the state was established in 1948, namely, the Ottomans and the British. In the absence of a written constitution, a constitutional status was given to Basic Laws enacted by Israel’s Parliament, The Knesset, and to the Declaration of Independence [4]. Upon attaining independence, it was decided that in order to prevent a legal vacum it would be sensible to maintain the prevailing laws for an unlimited transition period insofar as they comply with the principles embodied in the Declaration of Independence and are in line with new laws to be enacted by the Knesset. In sum, Israel’s legal system borrowed extensively from British Mandate laws, which incorporate a large body of English common law, as well as from Ottoman law and traditional Jewish law. By now, a vast body of independent Israeli statutory and case law has almost entirely replaced the Ottoman and British Mandate laws.

2.2. Capital Market

Israel’s market characteristics feature a highly concentrated economy with significant governmental involvement compared to developed countries [5]. The banking sector plays a major role in all aspects of the economy, much like in Germany [6]. Until recent reforms, both commercial banking and financial intermediation were almost entirely dominated by the main commercial banks (Poalim, Leumi and IDB) which controlled around three quarters of overall public deposits, as well as mutual funds and provident funds [7]. Poalim and Leumi, the two largest banks that maintain control over most of the capital market [8], are not facing substantial competition from abroad, partially due to Israel’s political situation and regional instability considerations that keep potential foreign competitors from entering the Israeli market [9].   In April 2004, Israel’s finance minister appointed an inter-ministerial professional committee to make recommendations with respect to the necessary actions required for establishing an efficient and competitive capital market. The Committee, chaired by Dr. Joseph Bachar (hereinafter- Bachar Committee) was instructed to submit to the government a reform plan and propose operative steps. Its report, published in September 2004, was overall accepted by the government, and later enacted as legislation by the Knesset [10]. Accordingly, the Israeli banking system is going through a restructuring process which goal is to reduce concentration and minimize conflicts of interest among the entities operating in the capital market. The reform includes gradual sale of the banks’ holdings in provident funds and mutual funds, restricting a single corporation’s rate of holding in entities engaged in long-term saving and in mutual fund activity, and determining rules for employment in financial consultancy and marketing, including regulations covering the payment of remuneration to entities engaged in such activities [11]. The reform also limits large banks’ possibility to engage in underwriting activities [12]. According to LLSV comparative study on corporate ownership, only five percent of Israel’s twenty largest listed companies had no controlling shareholders [13]. Few control groups hold large fractions of the Israeli stock market through holding companies with pyramidal structure. Many of these groups are either [continua ..]

3. Evolution of Israel’s Corporate Law

English law has left its mark on the Israeli legal system, in terms of its common law characteristics. When the State of Israel was established, the Mandatory Companies Ordinance, 1929, came into force [15]. Israel’s corporate law was previously based upon the English Act of 1929 from which the Companies Ordinance was derived. From time to time the law was changed by the Knesset through separate legislative amendments. Judicial precedents, inspired by the common law tradition, contributed to the shaping of Israeli corporate law by moulding the content of general standards such as good faith, fairness, duty of care and duty of loyalty into a corporate context. To this end, some of the landmarks in Israeli corporate case law include Panider v. Castro, where a duty to act in good faith towards third parties was imposed on organs acting on behalf of the company [16], Bernovic v. ISA, where the duty of fair disclosure by the corporation was defined by Justice Shamgar [17] and Kosoy v. Poichtwenger Bank LTD, where the nature of the duty of loyalty owed by corporate directors and offices to the company and its shareholders was discussed by Justice Barak [18]. Apart from updating the Companies Ordinance, the Knesset enacted a number of important laws which laid the cornerstone for the infant capital market and helped inducing corporate commercial activity. The Securities Law of 1968 [19] laid the regulatory foundations for the operation of the Tel Aviv Stock Exchange (TASE) and constituted Israel Securities Authority (ISA), the equivalent of the American SEC. ISA is in charge of enforcement as well as regulation of public companies according to the law and its related statutes [20]. In 1975 the Knesset enacted the Government Companies Law [21], which regulates the establishment and functioning of all government companies. Another important development was the enactment of the Non-Profit Associations Law 1980 [22], which replaced the ancient Ottoman Law of Association, of 1909. In 1983, a new version of the Companies Ordinance [23] was introduced, to consolidate the mandatory law with its amendments and other relevant statutes. However, it contained no legal arrangements to deal with agency problem and other corporate governance concerns. Although the basic notions of the English Companies Ordinance 1929 were absorbed by the 1983 legislation, a [continua ..]

4. Israel's Companies Law – General Structure and Main Features

Due to specific attributes of the Israeli market the Companies Law focuses more on agency problems between controlling stakeholders and minority shareholders than on agency problems between managers and owners [28]. In contrast to the US, the primary agency problem in Israel, like in Continental Europe, originates in the concentrated ownership structure and the existence of controlling shareholders which have the capacity to expropriate minority shareholders. Consequently, much of the Companies Law attention is directed to cope with protecting minority shareholders from expropriation by controlling blockholders [29]. Most of the Companies Law provisions are primarily dedicated to traded companies although the law applies also to private companies. Based on fundamental principles such as the separate legal entity doctrine and shareholders’ limited liability, the law is designed to regulate all the principal areas which concern the company during its life cycle, apart from corporate dissolution which remains outside the scope of the law. Accordingly, the Companies Law dictates the company’s incorporation, registration, actions, structure, governance, and the relationship among its constituencies. It is characterized by an extensive use of standards, such as good faith, accepted way and fairness, which have become an integral part of Israel’s common law tradition. The law is complemented by secondary legislation which consists of a set of statutes and ordinances, issued by the Minister of Justice and ISA, concerning various administrative and procedural aspects.   The main features of the ten parts of the Companies Law are summarized as follows: Part 1 defines various terms used by the law with cross-references to parallel terms and definitions used by the Securities Law 5728-1968 [30]. The law defines a public company as a company whose shares are listed for trading on a stock exchange, or have been offered to the public pursuant to a prospectus as defined in the Securities Law, and are held by the public; a private company is defined as any company which is not public [31]. Part 2 deals with the company’s incorporation process. The new law permits an incorporation of a one man company [32]. It defines the legal entity of the company [33] and sets its term of [continua ..]

5. Legislative and Regulatory Developments

Since its enactment in 2000, the Companies Law has been amended on several occasions [65]. Amendment No. 3, a result of public debates and interest group pressure, stands out because it introduces far reaching changes in several respects [66]. One of its main modifications concerns the necessary justifications for piercing the corporate veil. The amendment reduces the scope of the doctrine by adding further conditions to its implementation. First, it narrowed the list of cases in which courts may decide on piercing the corporate veil. Secondly, it abolished the possibility to pierce the corporate veil in order to reach corporate managers and directors. Finally, an awareness criterion (related to the shareholder) was added, meaning that it has to be proved in court that the shareholder was aware of her actions being fraudulent, unreasonably risky and could lead to expropriation of the company’s creditors [67]. According to the drafters of Amendment No. 3, changes to the original law were required because the business community was facing too much uncertainty and unexpected risks. The modifications came as a response to regulatory competition and their main objective was to induce local companies to incorporate in Israel rather than abroad [68]. Other examples for substantial alterations that promote this objective include the narrowing of the list of transactions which require special approvals by the general shareholders meeting; narrowing of the criteria for inapt independent directors; exclusion of certain situations from the definition of personal interest [69]; extension of the legal presumption regarding the type of duty breached in case of prohibited distribution to include also the duty of care which, in contrast to the duty of loyalty, is insurable.

5.1. Amendments to the Companies Law

Since its enactment in 2000, the Companies Law has been amended on several occasions [65]. Amendment No. 3, a result of public debates and interest group pressure, stands out because it introduces far reaching changes in several respects [66]. One of its main modifications concerns the necessary justifications for piercing the corporate veil. The amendment reduces the scope of the doctrine by adding further conditions to its implementation. First, it narrowed the list of cases in which courts may decide on piercing the corporate veil. Secondly, it abolished the possibility to pierce the corporate veil in order to reach corporate managers and directors. Finally, an awareness criterion (related to the shareholder) was added, meaning that it has to be proved in court that the shareholder was aware of her actions being fraudulent, unreasonably risky and could lead to expropriation of the company’s creditors [67]. According to the drafters of Amendment No. 3, changes to the original law were required because the business community was facing too much uncertainty and unexpected risks. The modifications came as a response to regulatory competition and their main objective was to induce local companies to incorporate in Israel rather than abroad [68]. Other examples for substantial alterations that promote this objective include the narrowing of the list of transactions which require special approvals by the general shareholders meeting; narrowing of the criteria for inapt independent directors; exclusion of certain situations from the definition of personal interest [69]; extension of the legal presumption regarding the type of duty breached in case of prohibited distribution to include also the duty of care which, in contrast to the duty of loyalty, is insurable.

5.2. The Goshen Committee

In August 2004, ISA appointed a professional Committee for the examination of corporate governance in Israel. The Committee, chaired by Professor Goshen (hereinafter – Goshen Committee), was assigned to structure an Israeli corporate governance code. Its report, submitted in January 2006, contains detailed recommendations pertaining best practice standards for corporate governance in Israel. It covers a broad spectrum of corporate governance issues, for instance, transactions with principal shareholders, as well as specific recommendations regarding institutions such as the board of directors, the auditing committee, institutional investors and a proposal to establish a specialized court for securities and corporate law. Following are the main findings and recommendations put forward by the Goshen Committee with respect to a number of selected topics [70].

5.3. Board Composition

The Companies Law stipulates that two external directors have to sit on the board of public companies, one of whom must be an expert in the fields of accounting and financing, while inside directors are required to have the necessary skills and professional capacity to fulfil their duties [71]. This arrangement might be unsuitable where the relative representation of the external directors is very small compared to the size of the board. Therefore, the Goshen Committee proposed to increase the minimum number of external directors (as defined under the Companies Law) from two to three. According to Amendment No. 3, all external directors in a public company must be qualified professionals [72]. Their term of office shall be three years, and they may be reappointed for one additional term of three years [73]. Amendment No. 3 further stipulates that appointment of an expert director shall not affect in any way the duty of care owed by the other directors to the company and its shareholders [74]. In order to enhance compliance, the Goshen Committee calls for the imposition of additional monetary sanctions on corporations that fail to comply with the regulatory requirements concerning composition of the board of directors [75], auditing committee [76] and internal auditor [77]. To facilitate the independence of the board of directors it is suggested that none of the directors shall hold an official position subordinated to the CEO. With the intention to underline the separation between the management and the board, the Goshen Committee recommends that the CEO shall not be allowed to act as chairman of the board and that the latter shall not hold another office in the corporation. The report draws attention to the importance of having a qualified board of directors, and contains a series of measures to assure that board members have the necessary professional qualifications to carry out their duties. It is recommended that board members will provide the chairman of the board with signed declarations in which each of them states that she has the time and the qualifications required to perform her obligations. This declaration does not derogate from external directors’ duty to demonstrate certain accounting and financial qualifications. Information regarding the competences of the directors shall be verified by the chairman of the board and brought to the attention of the shareholders.

5.4. Remuneration of Directors

According to the Companies Law, every agreement signed between a company and a director, regarding the terms of his tenure and employment, requires the approval of three bodies, namely the auditing committee, the board of directors and the general shareholders meeting [78]. Amendment No. 3 stipulates that in a private company, the board of directors shall, on the demand of one or more shareholders holding at least ten percent of the voting power in the company, be obliged to provide such person with a verified statement by the company’s auditor, containing full details of all payments (including obligations to pay and retirements schemes) made by the company to each of the directors. Where the board of directors finds that the demand is not made in good faith, it may turn it down and refuse to disclose information [79]. In order to enhance transparency, the Goshen Committee recommends that rules regarding greater disclosure pertaining fees paid to directors and other corporate officers shall be stipulated by the ISA. It is proposed that companies will be required to disclose in their annual reports the overall remuneration of the five highest paid corporate officers in the company, including all types of short and long term benefits. Where the highest paid officers are not acting as directors, it is proposed to disclose the overall remuneration of the five highest paid directors.

5.5. Accountability and Audit

The Companies Law stipulates that the auditing committee shall have at least three members (including all external directors). It is also stipulated that the auditing committee shall not include the chairman of the board, any director employed by a company or providing his services to the company on a permanent basis, as well as controlling shareholders or their relatives [80]. In order to assure its independence, The Goshen Committee recommends that the auditing committee will be chaired by an external director and that the majority of its members will be external directors. Members of the auditing committee shall not be allowed to actively participate in the compilation of company financial reports. The auditor of a company will have to be present in all the meetings in which company financial reports are discussed. It is further suggested that a majority presence of external directors, among the participants of the auditing committee, will constitute the quorum for meetings. Although the role of the auditing committee and its precise reporting duties are defined by the board of directors, it is stressed that the auditing committee has the responsibility to assist the board in examining all material issues contained in financial reports, including estimates and conclusions that have been reached during their preparation, as well as internal and other official reports.

5.6. Institutional Investors

The influence of institutional investors on capital markets has long been recognized both in Europe and in the United States. In order to encourage institutional investors to exercise their voting rights and monitor the companies in which they invest, the Goshen Committee proposes to amend existing regulations to impose the duties of institutional investors on additional bodies other than mutual funds and provident funds. It further recommends enhancing the disclosure requirements pertaining voting policy of public institutions and their actual voting.

5.7. Establishment of a Court Specializing in Companies and Securities Law

There are several specialized courts in Israel that adjudicate exclusively in certain fields of expertise, such as antitrust, family matters and juveniles. Inspired by the Delaware model, the Goshen Committee proposes to establish a court specializing in Securities and Companies Law litigation. The Court will be established within the framework of the Tel Aviv District Court and shall operate according to the procedures set by other specialized courts in Israel, such as the specialized court for family matters. It will have jurisdiction over all claims derived from Companies Law, Securities Law and pertaining regulations. The judges would be selected according to their expertise in Securities and Companies Law, knowledge of corporate financing and degree of court room experience in these fields. Their minimal term is proposed to be 10 years.

6. Conclusion

Israel’s corporate law has undergone a comprehensive reform over the last decade. A key milestone was the enactment of the new Companies Law. The codification and modernization process of Israeli corporate law serves as an important building block in the ongoing reform process. Some of the provisions included in the Companies Law were subsequently modified due to public debate and interest group pressure. Implementation of the Bachar Committee recommendations with regards to the banking sector, alongside the progress made by the Goshen Committee concerning the design of a corporate governance code, reflect Israel’s commitment to advance its corporate laws in order to enhance corporate commercial activity and induce economic growth. It will take more time until it would be possible to assess the actual contribution of the developments described in this report to Israel’s economic growth. Nevertheless, it is fair to say that thus far the reforms have yielded a significant impact on the shape and character of Israeli corporate law and succeeded to stimulate a much broader debate on corporate governance in Israel.

NOTE