Nothing Lasts Forever – New Israeli Supreme Court Ruling Expected to Reduce Legal Protection Granted to Managers and Board Members in Israel
After a lawsuit filed by liquidators of a company that collapsed against the company’s former officers, directors, and independent auditors was dismissed in limine, a new Israeli Supreme Court ruling overturned that decision and allowed the liquidators to move forward with the lawsuit, alleging that lack of oversight was what led to the company’s collapse. The significance of this new ruling is that the “business judgment rule” will no longer be interpreted as providing automatic protection to executives, and they may now be compelled to participate in lengthy legal proceedings to prove their entitlement to legal protection.
It is rare for the Supreme Court to reverse a ruling of one of its judges. It is rare for the Supreme Court to “resuscitate” a lawsuit totaling hundreds of millions of shekels, after a dismissal in limine. And it is rare for the Supreme Court to issue a ruling that may influence the way corporations make decisions and the agendas of managers and boards of directors. This is one of those rare occasions: the ruling in the Better Place case.
In its latest ruling, the Supreme Court determined it was warranted to hold a substantive hearing of an allegation that managers and independent auditors of a company that collapsed failed to exercise independent judgment prior to the collapse and were derelict in their duties. The outcome of this ruling is that the business judgment rule will no longer be used to dismiss lawsuits in limine and will no longer provide automatic protection to managers. The managers, for their part, may be compelled to engage in lengthy legal proceedings to prove their entitlement to legal protection.
The Collapse of Better Place Group
The Better Place Group formed as an ambitious venture that sought to change the face of transportation and replace gasoline-powered vehicles with electric vehicles. However, this pioneering venture proved ahead of its time. In 2013, about six years after its founding and after about USD 850 million were invested in it, the companies in the group collapsed and became insolvent. Liquidators were appointed to the group and, in 2016, filed a lawsuit totaling ILS 200 million against those who had served as directors, officers, and independent auditors of the group until it collapsed.
In short, the liquidators allege the defendants’ negligence is what resulted in the group’s collapse. In addition, the liquidators allege the officers of the group’s subsidiaries failed to exercise independent judgment and followed the instructions of the parent company’s board of directors. The liquidators further allege that the parent company’s board of directors failed to hold discussions of numerous material matters, that control and budget-building processes were not implemented in the group, and that decisions were reached without alternatives being presented and without any in-depth deliberations. The liquidators also allege that all of the defendants, including the independent auditors, disregarded “financial warning signs,” added a “going concern caveat” in the financial statements too late, and continued to take on liabilities when it was evident the group was incapable of paying them.
A few months after the liquidators of the Better Place Group filed their lawsuit, the Israeli Supreme Court issued its ruling on a lawsuit concerning the acquisition of control over Bezeq (the Verdnikov vs. Elovitch case). This ruling scrutinized the issue of the application of the “business judgment rule” in Israeli corporate law. As is well known, this rule affords officers a form of “immunity” from judicial review of the content of business decisions reached, provided the decisions were reached in good faith, in an informed manner, and without any conflict of interest.
The District Court’s Ruling in 2018
Against the backdrop of the Bezeq ruling, in 2018, the Lod District Court (Judge Prof. O. Grosskopf) took an unusual measure in the Better Place case and dismissed the liquidators’ lawsuit in limine, even before the defendants filed their statement of defense.
At that time, the District Court ruled that the statement of claim relates to typical business decisions that are at the core of the managers’ business judgment and that, even if the plaintiffs could prove all of the facts, they do not suffice to indicate the officers acted recklessly or made uninformed decisions. The court stated that when deliberating a business activity, which is risky by nature and involves risk-taking, it must avoid the “wisdom of hindsight” and refrain from imposing additional risks on officers in a way that could detract from the Israeli market’s attractiveness. It determined that since the entire lawsuit constitutes a retrospective assault on business logic that did not work out well, the lawsuit should be dismissed in limine already at the preliminary stage and before any comprehensive substantive clarification.
Since the handing down of the ruling in the Better Place case, Judge Grosskopf received a promotion and appointment as a Supreme Court justice. Concurrently, additional district court judges have followed his lead and ruled that the business judgment rule should be interpreted broadly, so that it will be used in appropriate instances to dismiss (even in limine) lawsuits against managers alleging it was their negligence that resulted in a company’s collapse. (See, for example, Judge Kabub’s ruling in the Habas case.)
However, as stated, the Supreme Court’s current ruling has determined otherwise. It reversed the District Court ruling in the Better Place case and is allowing the lawsuit against the managers and independent auditors who held office prior to the group’s collapse to move forward on its merits.
The Supreme Court’s Ruling
The Supreme Court ruled that, in principle, although it is possible to dismiss a lawsuit in limine by virtue of the business judgment rule, the courts should be sparing in their use of this possibility and should prefer to order the amendment of the statement of claim over simply dismissing the lawsuit. The Supreme Court further stated that the court should have allowed the liquidators to amend their claim, to elucidate their allegations against the managers and against the independent auditors, and to clarify exactly how the board of directors failed to exercise independent judgment. In relation to the independent auditors, the Supreme Court stated that the business judgment rule does not apply to them at all. Therefore, it held, the liquidator’s cause of action against the independent auditors in respect of their negligence should not be ruled out a priori.
The bottom line is that the Supreme Court is allowing the lawsuit to move forward, thereby adding a tailwind to a popular practice in Israel that has already led to a deluge of lawsuits against officers in respect of business decisions. Managers no longer have automatic protection and must now conduct proceedings to prove their entitlement to protection.
It is worth examining these matters through the prism of the coronavirus crisis period, which is forcing managers to adopt highly risky business plans on a daily basis, including coronavirus crisis exit strategies, and to make adjustments to a company’s activities. In such a reality, management’s concerns about personal lawsuits, if a business activity results in losses or even in the company’s collapse, are liable to completely paralyze the company’s business activities and to kill any managerial appetite for taking risks.
Within this context, we note the new Insolvency Law that came into effect about a year ago. For the first time, section 288 of the Insolvency Law imposes personal liability on a company’s directors and CEO who knew or should have known the company was approaching insolvency and failed to take reasonable measures to reduce the volume of insolvency. This provision of the law is very broad (its scope has not yet been discussed in case law), and it imposes numerous risks on managers and potential personal exposure if the company collapses. Section 288 of the Insolvency Law does not apply to the Better Place case, and the courts have not yet hammered out a binding interpretation of the obligation prescribed therein. Time will tell if the Supreme Court’s ruling in the Better Place case will serve as a compass for those engaging in this issue.