When a company distributes dividends to its shareholders, the sum of the distribution is deducted from the company’s accumulated profits and the company’s value decreases by the sum distributed. Therefore, a dividend distribution could expose the company to legal and economic risks if it results in the company not having sufficient resources to pay back its creditors. Since a company’s creditors take precedence over the shareholders in the repayment hierarchy, a distribution that fails to take the company’s financial stability into account could adversely affect the allocation arrangements on which the corporate market is based.
To strike a balance between shareholders’ right to profits and creditor protection, the Israeli Companies Law stipulates that companies must pass two cumulative tests to prove the existence of distributable profits prior to the distribution: the profit test and the solvency test. Failure to do so could not only result in shareholders being obligated to return their dividends but also in personal liability being imposed on the directors who approved the distribution in violation of the law.
Sections 302 and 303 of the Companies Law regulate these two interdependent tests:
- Profit test – a technical retrospective accounting test based on the most recent financial statements, designed to ensure the existence of sufficient distributable profits.
- Solvency test – a prospective test requiring analysis and judgment, designed to ensure the distribution will not jeopardize the company’s ability to pay its existing and future liabilities.
Section 303 also allows a company that passes the solvency test but fails to pass the profit test to distribute a dividend, subject to court approval.
Israeli Supreme Court Rulings Interpreting the Scope of the Profit Test
The profit test permits a distribution solely from profits recorded in the company’s most recent adjusted audited or reviewed financial statements, provided they were published no earlier than six months prior to the dividend distribution date.
The law prescribes two alternatives: (1) the balance of the company’s accumulated surpluses, or (2) the surpluses accumulated over the past two years, whichever is higher.
The correct interpretation of the scope and nature of the profit test has been a bone of contention in Israel for years: is it merely a retrospective accounting test, or is the board of directors also obligated to consider prospective information having material implications?
The Supreme Court has issued rulings over the years that took fundamentally different approaches to this question, from Lahav v. IDB Development Company Ltd. et al. (which expanded the interpretation to include material prospective information), to CA 1734/21 Amir Brot v. Discount Investment Corporation (2023), which essentially clarifies its earlier ruling in the Lahav case and provides directors with more certainty.
According to the Lahav ruling’s expansive interpretation, the board of directors must not disregard current material information indicating an adverse change in the company’s situation, even if this information has not yet been reported in the financial statements used for the purposes of the profit test.
According to this interpretation, in a scenario whereby the financial statements show surplus profits, but the board of directors is already aware of a material development that will adversely impact the company’s ability to pay its current and future liabilities, the directors have a fiduciary duty not to blindly rely on the profit test. Therefore, the court ruled that, in exceptional circumstances, the profit test should not be limited to a technical retrospective test and must consider the latest information having prospective negative implications.
This approach essentially expanded the judicial interpretation of the profit test and obfuscated the legislature’s differentiation between the two tests. The criticism was not long in coming, inter alia, because the interpretation in the Lahav case created uncertainties with regard to the scope of directors’ fiduciary duties.
The Supreme Court eliminated these uncertainties in its ruling in the Brot case. In that case, Discount Investment’s board of directors resolved to distribute a dividend based on the latest financial statements, despite the fact the board of directors already knew that a loss was expected in the following quarter. The court ruled that the profit test is solely a technical, retrospective test that does not take into account future losses that have not yet been reported in the financial statements. However, the board of directors does have a fiduciary duty to consider prospective information within the scope of the solvency test.
Solvency Test: A Critical, Forward-Looking Test
Case law has defined the solvency test as the “real test” for dividend distributions, while the profit test solely provides an indication. Unlike the profit test, the solvency test obligates the board of directors not only to examine the retrospective balance sheet data and the information reported in the financial statements, but also to analyze the company’s business situation going forward, including future cash flows and future liabilities, based on the latest facts and expected developments (including business risks, market risks, anticipated changes in the market), and to exercise business judgment with regard to the company’s actual ability to fulfill its obligations subsequent to the proposed dividend distribution.
In short, pursuant to the Companies Law, even if a company passes the profit test, it is prohibited from distributing a dividend if it has reasonable concerns the distribution will result in the company becoming incapable of paying its liabilities. The board of directors’ fiduciary duties and professional responsibilities towards the company and its creditors are examined in light of its actions in this regard.
Board of Director Responsibilities
Sections 252-254 of the Companies Law impose a duty of care and fiduciary duties on boards of directors. Section 311 prescribes that if a company executes a prohibited distribution, all incumbent directors at the time of the distribution shall be presumed to have breached their fiduciary duties to the company, unless they prove:
- They objected to the prohibited distribution and exerted all reasonable preventive measures.
- They had, in good faith, reasonably relied on information that, had it not been misleading, showed that at issue was a permitted distribution.
- They did not have and were not expected to have knowledge about the execution of the distribution.
The burden of proof is imposed on the directors, who must prove they took active and informed measures. Passive reliance on management or on consultants is not enough. Furthermore, Section 259(b) of the Companies Law negates any possibility of releasing directors in advance from liability in respect of a prohibited distribution.
The case law emphasizes that boards of directors must examine all economic data, including cash flow forecasts, future liabilities, and business risks. A resolution to distribute a dividend notwithstanding failure to pass the statutory tests could result in personal liability being imposed on the directors toward the company and even toward its creditors, particularly in instances of insolvency.
Best Practices When Passing Resolutions to Distribute Dividends
Boards of directors must pass resolutions to distribute dividends only after analyzing all information and ensuring they have been fully informed, with bona fides and while exercising professional prudence. Otherwise, they could bear personal liability. Israeli law is clear: a distribution is permitted only if it is well-founded, responsible, and poses no risk to creditors.
Responsible boards of directors take measures to minimize legal exposures to the extent possible according to the following best practices:
- Examine the latest financial statements that present the current situation.
- Examine the latest cash flow reports, including future forecasts and scenarios.
- Obtain and analyze professional opinions (legal, economic, and accounting advice).
- Record detailed minutes of the board discussions, including the rationale behind passing the resolution.
- Re-examine market changes, risks, and cash flows after approving the distribution in principle and before passing the final resolution.
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Adv. Omri Oren is a partner in the firm’s Capital Markets Department.
Barnea Jaffa Lande’s Capital Markets Department provides comprehensive legal counsel to public and dual-listed companies, underwriters, and boards of directors on all aspects of corporate law, securities law, and corporate governance. Thanks to our proven international track record, we represent Israeli companies listed on foreign stock exchanges and international investors. Our team specializes in IPOs and in providing ongoing counsel to public companies, including in relation to controlling shareholder transactions, mergers and acquisitions, private issues, remuneration policies, internal enforcement programs, proxy fights, etc.