by Maital Ben-Baruch and Adv. Shemer Sendak
Benjamin Franklin put it well, saying that “in this world nothing can be said to be certain, except death and taxes”. In the volatile world of business, it is a widely accepted truth that profit goes hand-in-hand with risk. However, the question to be asked is who should be the bearer of this uncertainty and risk – the company or those who lead it? In this article, we will discuss the extent of office holders’ personal liability according to Israeli and US law.
According to the Israeli Company Law of 1999 (hereinafter: “The Law“), an office holder has two major duties to his company – a Fiduciary Duty and the Duty of Care. His fiduciary duties are to always act in good faith and for the benefit of the company. The Duty of Care states that a director must do his job well, making sure he receives all information needed in order to do so. Although these duties seem straight-forward when all is well, they are heatedly debated when something goes amiss. The laws regarding these duties and the court’s interpretation of them have evolved over the years to create a complex legal web we will now try to untangle.
Up until 1994, a director’s position was viewed in Israel as a largely ceremonial role that bestows honor and status. Office holders were virtually impervious to personal lawsuits, since they were seen as mere organs of the company. The reform began with The Supreme Court’s decision in Buchvinder vs. The Bank of North America’s Official Receiver, where the court ruled that in order to fulfill his role and duty of care, a director must act as “a reasonable director” would and exercise business judgment, i.e. genuinely supervise the executives, read internal reports and investigate, be involved and well versed in the affairs of the company, receive external guidance when needed, demand to receive full information and not act merely as a rubber stamp. Since this verdict, the court’s expectations have gradually escalated to demand more competence and involvement on behalf of the director, and the new Company Law of 1999 anchored these changes in legislation.
This revolution in legislation and case law combined with the risk-taking nature of the business world might discourage people from serving as office holders. In order to prevent this, The Law states the tools which office holders may use to protect themselves from liability if their duties were breached in good faith. Section 258 of The Law declares that a company may exempt an office holder from accountability in advance, and indemnify and insure his liability. These tools can be used only subject to the provisions of The Law, and must appear in the company’s articles of association. Any provision that exempts/indemnifies or insures an office holder’s fiduciary duty, or a breach of duty of care committed intentionally or recklessly is void. These are cogent laws that cannot be stipulated or contradicted in any contract.
The last two decades have seen a growing number of claims against company directors who have breached their duties. A company who wishes to claim damages instigated by an office holder’s breach of duty may decide to prosecute him. However, how can shareholders legally defend themselves against their own office holders’ infringement if the last still have control over the company’s decisions? This unique yet not uncommon set of circumstances has led to the creation of the Derivative Suit. This action is brought by a corporation shareholder against the directors, management and/or other shareholders of the corporation due to a failure by management. In effect, the suing shareholder claims to be acting on behalf of the corporation, because the directors and management are failing to exercise their authority for the benefit of the company and all of its shareholders. This type of suit often arises when there is fraud, mismanagement, self-dealing and/or dishonesty which are being ignored by officers and the Board of Directors of a corporation. A court of law will approve a derivative action if it is filed in good faith and in the interest of the company, and will usually examine the probability of success of the claim before it approves it.
An example of such a procedure has just been approved by the Supreme Court of Law in the noteworthy case of the public company Pacifica Holdings Ltd. Pacifica’s shareholders are suing their office holders for 63M NIS in damages caused by their negligence in a failed real-estate deal in Galatz, Romania. The company directors had transferred 5.25M Euro to the supposed property owners, without checking that they are indeed the owners of the property. As it turned out, they were not. Moreover, a major part of these funds were transferred prior to the board’s approval of this deal. This gross negligence had caused this public company great damage, however, when approached by the shareholders, the directorate was not willing to file suit against its directors. With no other alternative, the shareholders turned to the courts to approve their derivative suit.
The importance of this case stems from the question it faces – Can a company exempt its office holders from liability retrospectively? Pacifica had exempted, indemnified and insured its past and present officeholders for negligent actions that were made or will be made just days after the first negligent action occurred in the matter of Galatz. However, as we mentioned earlier, the Company Law allows companies to exempt officers in advance. Both the District and Supreme Courts decided to leave this theoretical question undecided and decide only on the matter at hand. It was ruled that if a company did indeed exempt its officeholders retrospectively, this exemption cannot be derived from section 258 of The Law but could be viewed as an approved engagement of the company derived from general legal principles. However, Pacifica’s exemption was so outstandingly sweeping in its phrasing that it falls under section 270 of The Law as an “extraordinary transaction of a public company”. The Law decrees that in order to be valid, such a transaction must be approved according to procedure, disclosed properly and be in the company’s best interest. In the case of Pacifica, the court ruled that this exemption did not meet all requirements, and is therefore void. The derivative action was approved.
When examining US law, one discovers it is more-or-less identical to the law in Israel. In fact, the Israeli legislators who phrased The 1999 Law, had used the Delaware General Corporation Law as their basis. Yet the US courts have a slightly different standpoint on their role in enforcing director’s liability and the Israeli court’s relative activism is contrasted by US courts’ more non intrusive stance. The key to understanding the US court’s approach to the matter is the Business Judgment Rule, a case law derived concept that shields a director from liability and presumes he acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the company. Similarly to section 258 of the Israeli Law, the rationale for the rule is the recognition by courts that in the inherently risky environment of business, directors need to be free to take risks without a constant fear of lawsuits affecting their judgment. The burden is on the plaintiff to rebut this presumption and is generally very difficult to overcome since US courts tend to disdain getting involved in business matters unless it is clear that the directors are guilty of fraud or misappropriation of corporate funds. As the Delaware Supreme Court said in Aronson v. Lewis, a court “will not substitute its own notions of what is or is not sound business judgment”.
There is much more to be said on the intricacy of case law in the US in general and Delaware in particular, however the complex doctrinal structure could be expected to continue to grow, adding rule upon statute upon regulation until it is refined over time. The Israeli doctrine seems to be easier to predict with its growing expectations from office holders and gradual escalation in their exposure to personal liability. The latest influx of collapsed business conglomerates in Israel will doubtlessly bring more lawsuits to the steps of the courts of law. One might hope that the stringency demonstrated in the latest Pacifica ruling will cause office holders to be more conscientious when performing their duties, and thus bring upon a more responsible business conduct and a stable Israeli market.