In corporate law, it is customary to identify three organs through which a business company operates: the shareholders, the company’s management, and the board of directors. While the duties and rules by which shareholders and company managements should act are pretty clear (albeit completely different from one another), when it comes to board members, the situation is far more complex.
Shareholders are perceived primarily as a passive organ called to act only at particular points in time or under particular circumstances, mainly by voting during a shareholders’ meeting. That being the case, it is rare for shareholders to even have to consider what actions they must take in order to be deemed as having fulfilled their duties.
On the other hand, a company’s management and especially its CEO are perceived as a highly active organ that in-effect manages the company and is directly and immediately responsible for the company’s actions. That being the case, a company’s management is obligated to fulfill its duties toward the company on a daily basis. The management is actively involved on an ongoing basis and, consequently, is held accountable for its actions and omissions.
The Unique Role of the Board of Directors
The board of directors’ role falls somewhere in between. On the one hand, it is a relatively passive organ that does not actually manage the company, is not involved in the company’s routine activities, and keeps abreast almost entirely from the information fed to it by the management. On the other hand, the board is an organ convened to take action (and sometimes to be proactive) by supervising the company’s management, formulating company policy, and passing resolutions with operative implications of the highest order. Board members therefore must contend with this precarious position. On the one hand, the law imposes obligations on the board of directors, and case law in recent years has expanded the applicability of these obligations and raises the standards of conduct expected of a reasonable director. On the other hand, board members are not involved in the company’s day-to-day management, visit the company’s offices infrequently, and their familiarity with the company, its activities, and its situation derives almost exclusively from the data and representations communicated to them by the company’s management. So what is expected from directors?
When Has a Company’s Board of Directors Fulfilled Its Duties as Required?
This question arises, for example, in the instance of a business failure or a transaction that is more beneficial to one party at the expense of another. In such instance, the board of directors may find itself sued by a shareholder or even by a creditor of the company. Moreover, if the company is a public company or an entity subject to regulatory supervision, the board may face scrutiny from the Israel Securities Authority or the relevant regulatory authority. In recent years, the courts and the regulatory authorities have imposed higher accountability on boards of directors, which brings the question of the appropriate and desirable standards of conduct into high focus.
What is the the Business Judgement Rule
The Business Judgement Rule (also known as “BJR”) is a doctrine developed in United States case law, primarily by the Delaware Court of Chancery. According to this doctrine, so long as an officer’s actions fall within the parameters of three criteria, the officer will be granted immunity from liability if a plaintiff sues on the grounds the officer breached the duty of care. More specifically, courts deliberating lawsuits against officers in respect of decisions they made in their capacity as officers will rule that those officers acted properly and will refrain from intervening in their decisions if they fulfilled three criteria.
The Three Criteria
- The decision was reached without any conflict of interest.
- The decision was reached in subjective good faith.
- The decision was reached in an informed manner, after reviewing the data and taking all relevant considerations into account.
In other words, if the board of directors appoints a forum with no personal interest or conflicting interest for the purposes of decision-making (for example, members of an audit committee or a board committee comprised exclusively of independent directors) and that forum holds an in-depth discussion on all aspects of the transaction or the resolution at hand in good faith, after consulting independent experts, then the resolution passed at the end of this process will benefit from a presumption of propriety and the court will focus on the decision-making process, while refraining from intervening in the substantive resolution or in the business action that was the subject of discussion.
To complete the picture, you should know that another rule, the “entire fairness” rule, is also in play. According to this doctrine, when company officers make decisions while in a state of conflict of interest (for example, when the company’s controlling shareholder is a party to both sides of the transaction under consideration), the defendants must prove they have fulfilled two criteria – the procedural fairness and the substantive fairness of the transaction – to convince the court to dismiss the suit.
The Doctrine in Israel
In Israel, directors who fail to fulfill their fiduciary duties and duties of care may find themselves sued in civil proceedings and, in some instances, even criminal proceedings. A concrete example of this is the Peled-Givony Group case. Uncovered during an investigation conducted by the Israel Securities Authority that began in the summer of 2002, this scandal ended with a Supreme Court ruling in 2016.
A Legal Imbroglio that Dragged on for 14 Years
In this case, the former police commissioner, Rafi Peled, who engaged in a business venture with several partners, was convicted of fraud and corporate breach of trust and of reporting offenses with the intent to mislead. Peled’s accomplices were sentenced to prison terms, and Peled himself was sentenced to community service and fined ILS 200,000. In Peled’s case, the district court ruled as follows:
“Although Rafi Peled did not steal money from public companies and did not embezzle these funds, he colossally failed to fulfill his duties as chairman of the board of directors, as a controlling shareholder, and as a member of the control group. He failed to exercise his own judgment and conceded to others; he allowed Jaegerman (a financial advisor to the company, Z.G.) to do as he pleased with these companies; he knew about Jaegerman’s actions and tactics, but did nothing to oppose them; and he heard warnings from Shenhav, Istrik, and others and chose to ignore them or perhaps hoped they were resolvable problems. In so doing, Peled committed a breach of trust of the public companies he headed and also of the public of investors.”
Basically, Peled’s sin was that he did not properly supervise the actions of others. It is even possible Peled acted in subjective good faith. However, he was in a state of conflict of interest by virtue of his being the chairman of the board and a member of the control group, and he definitely failed to scrutinize, consider, or criticize in an “informed” manner the actions ultimately cited in the indictment. Had Peled been diligent about adhering to the three criteria of the BJR, he could have spared himself 14 years of legal imbroglio.
Elovitch and the Leveraged Acquisition
Another example of the importance of adhering to the business judgment rule is the 2016 Supreme Court ruling in the Vardnikov v. Elovitch case. In that case, the plaintiff attacked the resolutions of Bezeq’s board of directors to distribute dividends, raise debt capital, and reduce capital in a way that enabled Shaul Elovitch to finance the leveraged acquisition of the company’s control core. The Supreme Court explicitly applied the Business Judgment Rule and determined the board of directors had fulfilled the three requisite criteria: it was not in a state of conflict of interest, it acted in good faith, and it passed an informed professional resolution after weighing all relevant considerations. In that case, the court also added an interim test and left ample room (too much room, in my humble opinion) for judicial discretion and intervention in the board’s resolution. However, as stated, the court defended the resolution by Bezeq’s board of directors, notwithstanding Elovitch’s clear interest in the capital reduction that would enable a dividend distribution.
Better Place
The Supreme Court again addressed the question of applying the Business Judgment Rule in its February 2022 ruling in the Better Place Israel v. Shai Agassi case. In that case, the plaintiffs alleged, inter alia, that the board of directors was negligent in managing the company and argued that the BJR does not apply when a company is in an “insolvency environment” or when the directors failed to exercise independent judgment, because the board of directors of a parent company passed the resolution. Interestingly, the General Attorney submitted his position on the issue at hand. He argued, inter alia, based on a Delaware court ruling, that the fact a company is facing insolvency does not affect the obligations imposed on officers and does not place them in an inherent state of conflict of interest, which would deny them any ability to rely on the BJR in the first place. The Supreme Court cited its ruling in the Bezeq case with regard to the interim test, ruled that it must be careful not to make automatic analogies between the issue at hand and the issue that was presented before the court in Bezeq, and decided to remand the case to the district court for adjudication. That being said, what is important for our purposes is that the Supreme Court has, in fact, strengthened the application of the Business Judgment Rule in Israeli law. Moreover, it has also opined that the rule can substantiate a motion to dismiss of a claim against an officer already at the preliminary stage of the proceeding.
The Director’s Best Friend
This shows how important it is for every director to know the Business Judgment Rule. Different companies operate in different industries, develop unique expertise, and are motivated by different people under dynamic circumstances. Consequently, it is very difficult to compare the decisions of one board of directors against the decisions of another board of directors. Nevertheless, a board of directors must act according to particular standards of conduct, and deviating from those standards may be deemed a breach of fiduciary duties and the duties of care imposed on directors. In light of this diversity, it is clear that judges cannot re-evaluate every board decision submitted to them. For this reason, the Business Judgment Rule was developed. It essentially focuses on the decision-making process and releases the court from having to scrutinize the minutiae of each decision. This insight is of critical importance to directors, because the BJR is straightforward: implement an orderly, fair, informed, and prudent process, and you will likely be protected. For this reason, it is clear why the Business Judgment Rule is a director’s best friend.
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Barnea Jaffa Lande’s Capital Markets department is at your service regarding corporate governance, public companies and board of directors related questions.
Dr. Zvi Gabbay heads the firm’s Capital Markets Department.