Institutional investors in Israel are starting to realise they have a problem. In truth, they are not just now becoming aware of it; the problem has existed for as long as the Israeli Companies Law has defined procedure for appointing board members at domestic public companies — in particular, those companies with a “control nucleus” of 25-90% ownership, which includes most of the Tel Aviv 125.
The problem is that investors may have put too much faith in the statutory independent, or “external”, directors who are appointed by law to all public company boards to act as gatekeepers of minority shareholder interests.
The flaws in the current system will be under the spotlight at a special meeting on August 15th for shareholders of Bezeq, the Israeli Telecommunication Corporation. The meeting, to elect one external director, comes at a time of crisis for the company, as it tries to manage a sweeping investigation that may confirm the worst fears held by institutional shareholders invested in tightly-held Israeli companies.
The Status Quo
The law dictates that public companies have a minimum of two external directors. In many cases, companies won’t feel themselves obliged to increase independence levels beyond this minimum. Upon appointment, such directors must be independent of the Company’s controlling shareholders for the last two years, or in the absence of a controlling shareholder, may not have a business relationship with the Company’s chair, CEO, significant shareholder, or senior financial officers.
Their appointment must be approved by a majority of voting shareholders, including within that a majority of disinterested (non-controlling) shareholders. Sounds good so far, right? This rigor appears to make the position of external director a powerful gatekeeper against wanton related party transactions, and a reliable representative of minority shareholder interests.
Nonetheless, there is skepticism about the efficacy of the external director appointment procedure, stemming from the following principal concerns: (i) although minority shareholders must approve the election of an external director, the candidate’s identity is invariably proposed by the company, and thus tends to be “acceptable” to the controlling shareholder; also, companies have generally proposed candidates without engagement with smaller shareholders; (ii) regarding candidates nominated for a first term, two separate vote counts occur, one for all shareholder votes, and one of minority shareholders; the voting power of the controlling shareholder thus acts as a veto in itself.
Viewed from this perspective, “external directors” don’t seem so verifiably “external” after all — they owe their appointment to the support of the controlling shareholder, potentially raising the question of whether their appointment hinges upon being “comfortable” yes-men in the boardroom?
The once trusting attitude of institutional investors has for some time been undergoing erosion, and related party transactions are frequently viewed with suspicion on the part of minority shareholders, even though such transactions must be approved by committees containing all external directors, who are expected to lead an independent negotiation process opposite the controlling party in the interests of all shareholders.
The Bezeq affair does nothing to increase their confidence in that regard.
What is happening at Bezeq?
On June 20, 2017, it was announced by the Israel Securities Authority (“ISA”) that an investigation had been opened into Bezeq and certain of its controlling shareholders, directors and officers. The investigation concerns suspected violations of the Securities Law and criminal law in connection with related party transactions involving Shaul Elovitch controlled-Eurocom, the Company’s controlling shareholder, with the initial investigation centering on the transaction under which Eurocom’s stake in DBS Satellite Services (1998) Ltd. (“YES”) was purchased by Bezeq.
This transaction was approved by shareholders on March 23, 2015, and included a consideration for the acquisition of Eurocom’s stake in YES of NIS 1,050.0 million in cash, NIS 370 million of which was to be deferred and contingent on utilization of the tax benefits arising from YES’ accumulated losses.
Concerns have been raised that Bezeq overpaid in a transaction which primarily benefited the indirect controlling shareholder, who was under more pressure to sell than Bezeq was under to buy. Note also that Elovitch’s actual economic stake in Bezeq hovers somewhere around the 10% mark, given that he holds his “controlling” stake in Bezeq (of 26%) through a series of two other public companies in a pyramid chain.
That investigation has since been expanded to another recent interested party transaction, regarding the provision of satellite communications services between YES and Spacecom Communications Ltd (“Spacecom”), a sister company of Bezeq controlled (64%) by Elovitch’s Eurocom. Shareholders of Bezeq and of Spacecom approved this transaction on March 26, 2017.
The ISA suspect that YES may have bought satellite services from Spacecom at an inflated price and without exploring alternatives. Under the approved agreement, YES will pay Spacecom a total of $263 million until December 31, 2028 to lease satellite segments in Spacecom satellites.
On July 14, 2017, the Tel Aviv Magistrate Court ruled that several suspects, including Messrs. Shaul Elovitch, Or Elovitch, and Ms. Stella Handler, Bezeq’s CEO, would be subject to house arrest for a week, under certain limitations, including limitations not to be in contact with other Eurocom and Bezeq officers and employees. The aforementioned have since been released under restrictive conditions.
The probes into Bezeq’s conduct have expanded significantly to include investigations into the highest echelons of Israeli public service, entangling a director general of the Ministry of Communications, and may even have the potential to involve the Israeli Prime Minister, who is a friend of Shaul Elovitch. The director general, Shlomo Filber, was questioned and placed under house arrest, under suspicion of fraud and breach of trust, corruption, offenses against the Securities Law, and of having improperly disclosed information to Elovitch. (See Globes and Haaretz. July 13, 2017).
The outcome of investigations could have serious implications regarding such transactions that have been approved at Bezeq and other Elovitch vehicles. The outcome is also likely to shed light on the performance of affiliated and non-affiliated directors alike within the group, and their role in the approval process of interested party transactions. Indeed, it has already been reported that the board is reexamining the existing payments, currently approximately NIS 6.4 million per year, that the company makes directly to Eurocom under a services agreement in effect until 2020.
The case for minority shareholder candidates: a positive development for Israeli corporate governance?
The ongoing proceedings at Bezeq may have the effect of improving governance at that company and at Israeli public companies with a control nucleus more generally. The past two years have seen an uptick in frequency of institutional investors attempting to reach agreements with companies to propose mutually agreeable candidates and, in some cases where their ownership exceeds 1% of company shares, to exercise their right to nominate alternative external director candidates. In the past year, external directors nominated by institutions have been appointed to the boards of Zvi Sarfati & Sons, Willy-Food Investments, and Orian, and earlier this year Delek Energy, with a US$10 billion market cap, became the largest Israeli company to see an externally nominated external director on the ballot.
This rising trend received some authoritative backing when in December 2016 the Israeli Supreme Court, acting in its function as civil court of appeals, posed a challenge to Israeli regulators and legislators to engage with this inherent discrepancy, whereby an external director owes the fact of their initial nomination, and continued re-nomination, to the stance of the controlling shareholder.
That 2016 ruling, ironically, also concerned Bezeq, and dealt with derivative action proceedings brought against Bezeq and Elovitch regarding the latter’s leveraged acquisition of the control stake in Bezeq, and the aggressive dividend policy and capital reduction program he set in motion after acquiring control. The judges dismissed the claims and came down on the side of Bezeq and Elovitch, resting on the “reasonable business discretion” to be allowed a board and management in the absence of a clear conflict of interests among decision makers.
Nevertheless, the judge who wrote the main text of the ruling, Itzhak Amit, queried whether an alternative method of appointing external directors should be found, such as multiple candidates and selection from a bona fide list of suitably qualified external directors, in order to more conclusively remove the potential for any affiliation to a company’s controlling shareholder:
“Is it appropriate that the controlling shareholder be the one who proposes the name of a candidate for external director, by virtue of a former acquaintance with such candidate? Or should the election of an external director be carried out in some other way, for example from a list of external directors, similarly to the “League of Directors” in use for state-owned companies?”
That these past interested party transactions are being placed under the spotlight, including the role of affiliated and non-affiliated, statutory external directors, may present a long-term benefit to the corporate governance standards in place at public companies in Israel more broadly.
August 15th: Israeli institutional investors expected to take a stand against Elovitch
In the build up to the August 15th special meeting, two of Bezeq’s institutional shareholders, Clal and Psagot, acting independently, informed the company of their intention to oppose the reelection of external director Haggai Herman to a second three-year term. These two institutions both proposed separate candidates, who will compete with Mr. Herman for the single position available at the special meeting.
Mr. Herman was involved in all the insider transactions for which the ISA is now investigating Elovitch, including serving on the audit committee prior to the YES transaction and on a special committee examining the agreement with SpaceCom. In neither case did he oppose the terms of the agreement. This fact alone may be enough to incur the wrath of Israeli institutions, the majority of whom voted against the acquisition of YES in 2015. That transaction was approved with the votes in favor from Bezeq’s international shareholders.
The outcome of the August 15th special meeting, and the developments of the proceedings currently being waged against senior Bezeq figures, may mark a significant watershed moment in two central features of Israeli corporate governance that the law was ostensibly intended to safeguard: approval of related party transactions, and election of independent directors.
Such improvement will be seen in the amount of legitimacy granted to board decisions and transactions that today are often viewed with some suspicion. Shareholders might be more inclined to support compensation packages and other transactions that have been reviewed by a verifiably independent director.
The spate of external director proposals by institutional shareholders is surprising in a positive sense. Some have even praised institutional entities for acting on their own to correct a market failure without the need for legislation. The outcome of the Bezeq special meeting will no doubt shed some light on which direction Israeli governance practices, as well as institutional shareholder involvement therein, are heading.