Israeli regulators have opened a public consultation to discuss the perceived need to adapt corporate governance standards applying to non-controlled companies in the context of a visibly changing capital market.
For Israeli companies a nucleus of control or “control block”, defined under Israeli law as a shareholder representing at least 25% of share capital, is the norm. As of December 2018, non-controlled companies traded on the Tel Aviv Stock Exchange (TASE) made up about 12% of the total number of issuers, representing 28% of the index’s total market capitalization. In a review of Glass Lewis coverage, we found that 73% were considered to have a control block in calendar year 2018. However, according to the Ministry of Justice (MoJ), which issued the request for comments in tandem with the Israel Securities Authority (ISA), in recent years a growing number of Israeli companies do not have a control block.
Israel’s corporate governance regime and supporting legislation reflect the historic dominance of controlled companies within the market. With a hastening trickle of mid- to large-cap companies shedding their dominant shareholders, the MoJ believes the time is ripe to question whether Israel should legislate a parallel set of governance standards for non-controlled companies, on the assumption that the shareholder representation and agency problems at such companies may manifest themselves in different ways from the problems that can arise at controlled firms. They are not alone – according to the MoJ statement, non-controlled companies have recently raised concerns that the Companies Law does not provide a clear legal pathway for dealing with certain governance matters that affect them more acutely than controlled companies.
Some of the issues that have been raised include (translated from the Hebrew):
- The quantitative test for defining “control”.
- The composition of the board of directors, and the question of the need for anchoring a minimum proportion of independent directors in companies without a controlling stake.
- Appointment procedures and nomination of candidates as directors (independent and non-independent) in companies without a controlling interest, including the authority to nominate candidates to the Board of Directors, the ability of shareholders and officers to participate in the election of the directors and the manner of approval of the appointment, including the need to establish a nominating committee.
- Board committees that should be required in companies without a controlling holder and their composition, including terms of eligibility for service therein.
- Term of directors (independent and non-independent) and the authority to remove them at non-controlled companies.
- Separation of the positions of Chairman of the Board of Directors and CEO of non-controlled companies.
- Means of approving the Company’s transactions with dominant shareholders – including the definition of a shareholder whose transactions require special approval in companies without a controlling interest.
- How to approve transactions with directors and other officers and how to approve their remuneration terms in non-controlling interest companies.
- The possibility of adopting hostile takeover protection mechanisms.
(We note that above does not constitute a complete list, and that the public is also invited to offer suggestions)
The Israeli Companies Law has historically laid out governance mechanisms designed for controlled companies and the agency problem that derives from the tension between the interests of a controlling shareholder and those of minority shareholders (a “horizontal” agency problem). In particular, Amendments 16 and 20 empowered minority shareholder rights in approving independent external director elections and compensation policies—reflecting the potential for the controlling shareholder to exploit its dominant position at the expense of minority shareholders.
By contrast, companies with dispersed ownership tend to face a “vertical” agency problem between the diverse and dispersed shareholder population and management. The theoretical governance concern that accompanies this structure (nothing new to those familiar with North American capital markets but relatively novel for Israeli observers) is that members of senior management may (theoretically) work to promote their own personal benefit at the expense of the company’s interests and those of shareholders as a whole. Israeli shareholders, rightly or wrongly, are well accustomed to being paranoid that the largest shareholder is taking them for a ride; they’re not so used to fearing the senior officers too.
Since dispersed shareholders face considerable gaps in information compared to managers, have diverging interests and are less likely to cooperate, the fear is that they will not have an incentive (and at times may not be able) to effectively supervise management through the rights granted to them by law.
Israeli law is already regarded as providing one of the most robust legal frameworks in the world for protecting minority shareholders’ rights. There is a well-established process for minority shareholders to include their own proposals or additional director nominees on the ballot for general meetings, and board requirements ensure verifiably independent representation and key committee composition.
The legal requirements are backed up by softer “recommendations”, currently tacked on to the Companies Law in the form of an addendum. Some of these are already specifically addressed at non-controlled firms, such as maintaining a majority independent board. However, compared to a broader governance code, for example the “comply or explain” model used to detail best practices in the UK, the existing regime includes significant gaps in areas like the director nomination process, where nominating committees are still extremely rare.
It will be interesting to see which areas stakeholders, and ultimately the MoJ under the next Israeli government, choose to focus on—and whether they pursue a wholesale revamp of the existing regime, or a cautious approach that builds on the structure already in place. Members of the public are invited to submit comments to NCScompanies@justice.gov.il through November 10, 2019.
Oren is an analyst covering the Israeli market.