First Time in Israel: Enhanced Scrutiny Standard Leads to Issuing of Interlocutory Injunctions
Much has been written about the Israeli Supreme Court’s landmark ruling in Civil Appeal 7735/14 Ilan Verednikov vs. Saul Elovitch, in which, for the first time, Delaware’s standards of judicial review of a company’s business decisions were expressly adopted.
The State of Delaware has developed three standards of judicial review of a company’s business decisions:
- the entire fairness rule;
- the enhanced scrutiny rule; and
- the business judgment rule.
The business judgment rule provides officers a kind of “full immunity” from judicial review and the imposition of liability in respect of a breach of duty of care. This defense is possible provided that the officers reached an informed business decision without any conflicts of interest and in good faith.
Officers who reach a business decision while fulfilling these criteria will benefit from a “presumption of propriety,” and the courts will not second-guess the business decision, but rather only the propriety of the decision-making process.
As stated, two additional rules apply to officers’ decisions under special circumstances. The entire fairness rule applies if a business decision was reached while officers were in a state of conflict of interest or had a direct personal interest. The enhanced scrutiny rule applies to officers if they have an indirect personal interest in a transaction, or the officers were not made an informed decision.
Israeli district courts have granted protection under the business judgment rule in a series of rulings handed down in this regard since the landmark ruling, but there are instances when courts also denied the the protection under the business judgment rule, and applied the stern enhanced scrutiny rule.
For example, our firm represented the petitioners in civil case 45220-01-19 Soiref et al v. Gal-On et al, which was deliberated recently by the honorable Judge Ruth Ronen in the Tel Aviv-Jaffa District Court (Economic Department). On March 28, 2019, a ruling was handed down on the petitioners’ applications for temporary relief.
This ruling constitutes a precedent in the way Judge Ronen applied the standards of judicial review and held that the business judgment rule should not be applied if business decisions are made by officers while in a state of conflict of interest.
To briefly outline the facts of the case: Ilan Bioculture Ltd., which engages in the development of medical cannabis plants, undertook an investment and convertible loan agreement in the inclusive sum of USD 4 million, under which preferred stock of the company was allotted to the investors and the investors appointed a director to the company.
After all the investment funds were invested, and shortly before the repayment date of the convertible loan, the company’s CEO sent a letter to the company’s lead investor informing it that the company was terminating the investment agreement signed with the investors and was cancelling the stock allotment. The company thus appeared to be acting ultra vires and in a state of conflict of interest.
Against the backdrop of the above, the company’s officers sought to promote a transaction to merge the company into a public company traded on the Tel Aviv Stock Exchange, whereby shares of the public company would be allotted to shareholders of the private company. The main beneficiaries of the proposed merger transaction were clearly the officers, who were also the majority shareholders of the company, that voted to terminate the investment agreement and cancel the stock allotment.
After hearings were held and witnesses on behalf of the parties were interrogated, the Tel Aviv-Jaffa District Court accepted the investors’ pleadings (the petitioners), rejected the position of the company and its officers, and essentially ruled that, under the above mentioned circumstances, the officers were clearly tainted by a conflict of interest, since their decision to terminate the investment agreement and the petitioners’ shares would increase their holding ratios of the company’s shares.
Thus, the court the court ruled that, in an instance of officers reaching a business decision while in a state of conflict of interest, the business judgment rule should not be applied.
Therefore, the court issued exceptional mandatory interlocutory injunctions, whereby the company and its officers were obligated to transfer the preferred stock owned by the lead investor to our firm as trustee in favor of the lead investor. Furthermore, the director on the investors’ behalf (which as of the letter mentioned above was considered by the company and its officers removed from his position) was to remain in office as a director of the company.