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Minority Interests in a Company

Writer: Tziki Woolfson, Attorney.

We are frequently faced with investment and business opportunities. Occasionally, we do not have all the money required for it, and we work with several people in order to execute the transaction, becoming partners with other parties. As a result, when decisions must be made we are not the only ones who decide. Sometimes our part of the venture – when considering the amount invested - is small compared to others.

Many times things go well, and the partners are satisfied over time.

Over time, there can be differences of opinion, which can be overcome through dialogue. Many parties succeed in doing so, and they have the greater likelihood to succeed with their venture in the best manner possible.

These disagreements can stem from a lack of mutual interests among the majority - all the more so when the majority is one person or a cohesive group with mutual interests - and the minority.

We will try to describe some of the tools in civil and commercial law available to those who believe they are being harmed by the "tyranny of majority rule" [1]. In this column, we will focus only on companies. Therefore, although one partner sometimes calls the other "my partner," we are talking about shareholders in the same company, and as such should be treated.

Think Before You Act

When entering into a transaction, it is possible and appropriate to create a separation mechanism for the time when one of the parties wishes to exit the transaction. There are several mechanisms available which are aimed at the exit of a shareholder, while determining the manner of a transfer of shares from one to another.

The Right of First Refusal

Sometimes, parties require each other to grant an initial right to acquire the shares held by a party leaving to be sold to a party remaining. This act is usually referred to as the "right of first refusal".

There are a number of technical possibilities for implementing this, such as comparing the offer of a shareholder wishing to purchase these shares, to an external offer of a person wishing to exit or sell his shares.

The "Buy Me Buy You" Option

Another option is the "Buy Me Buy You" option – in situations where parties cannot or do not want to continue, for such and such reasons. Therefore, the concept "you buy me, or I will buy you" results in one of the parties leaving the company.

Insofar as these mechanisms were determined at the "honeymoon" stage - in the Founders' Agreement or in the company's Articles of Association – their implementation during the separation process would be significantly easier.

Derivative Claim

A derivative claim is a process whereby one shareholder sues on behalf of the company, another of its officeholders [2]. This process is intended to be used in situations where the interests of the company have been impaired, but the company – primarily for reasons of control and lack of motivation or conflict of interest of the controlling shareholders or majority - is not interested in suing its internal forums or officers, with a claim that the company was harmed by their actions or they are responsible for impairing the interests of the company.

This process is a tool that can be used by a shareholder who feels that the majority – which, usually in small companies, are also the officeholders, are impairing the company.

This tool also constitutes a threat that prevents such behavior.

The claim is filed by the shareholder and on behalf of the company, after contacting the company and asking it to do so, and if the company was reluctant to do so. This process requires court approval but only a few applications are approved.

Furthermore, this option is not intended to resolve disputes between shareholders, but rather is an instrument for preserving the company's rights as such. Therefore, indirectly, the derivative claim option serves as a safeguard for the interest of the shareholder.

Minority Discrimination

Section 191 of Companies Law [3] provides that there is cause for action by virtue of "minority discrimination." The law provides to keep the majority shareholders in check and prevent any discrimination of the powerless minority, as well as to provide relief to the discriminated parties by means of a claim on the basis of said cause. Thus, for example, discrimination against the minority may also be expressed in certain cases by the non-distribution of a dividend when the company is profitable, the appointment of controlling shareholders to senior positions in the company with high salaries, approving preferential interest rates, and other actions.

Lifting The Corporate Veil"

Despite the fact that a company is a separate legal entity [4], in certain circumstances it is possible to go beyond the corporate veil and to reach directly - that is, to sue personally - its shareholders. This is a threat to the majority shareholders so that they will manage the company in a manner that maximizes the benefits to all and is not illegal in nature. It should be noted that this tool is not unique to shareholders and is available to anyone impaired by the company in such manner that the law allows for "lifting the corporate veil" [5].

Duty of Caution

Under Companies Law, an officer is required to act in accordance with the "duty of caution" [6]. As a result, an officer may be personally liable for damages to the company or to a third party. Sometimes, in certain circumstances, even without "lifting the corporate veil" of the company, it is possible to personally charge an officer for an action or oversight committed, when he caused third party damage.

The tests used by the court to examine whether the officer should be personally liable for the damage are based mainly on torts law, in combination with other legal principles, particularly those on which Companies Law is based.

This tool may also be used by a shareholder who believes that the officer did not take the required caution and impaired the company or him as a shareholder.

As stated, the remedy is given sparingly and proving it is not simple.

Duty of Loyalty

An officer must be loyal to the company and can be held liable for any breach [7]. The officer must attend to the company's good and not to his personal benefit or for the benefit of any shareholder who appointed him. As well, under Companies Law [8],, a shareholder must act to exercise his rights and fulfill his duties towards the company and towards the other shareholders in good faith and in an acceptable manner, and refrain from abuse of his power at the company. In addition, there is a duty of fairness on the part of the controlling shareholder, and sometimes also on the part of the other shareholders, towards the Company [9].

In Conclusion

A minority shareholder of a company has several mechanisms that enable it to preserve and uphold its rights while preventing the majority from exploiting its power for the worse. These mechanisms are those that must be exercised with each entry into a transaction,

We would like to conclude with some advice. In small to medium-sized companies, when shareholders start to quarrel, there is strong likelihood that the company will not succeed in these quarrels, and reach a non-simple commercial situation, and sometimes face economic collapse. Therefore, sometimes the best solution - even if sometimes not a just one - is to employ an exit mechanism from the company and to leave the shares "to your partners", the other shareholders.

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[1] It is understood that this column, which is not academic law, cannot refer to all legal tools and conclusions and that it is not a substitute for individual legal advice in any given case.

[2] As defined by Section 1 of Companies Law: "Officer" - Chief Executive Officer, Chief Business Officer, Deputy Chief Executive Officer, Assistant Chief Executive Officer, any person acting as said in the Company, even if his title is different, and a director or manager directly subordinate to the Chief Executive Officer.

[3] If the company’s business is run in a manner that constitutes discrimination against all or some of its shareholders, or in a manner that gives rise to real apprehension that the company’s business will be run in such a manner, , the court may, at the request of a shareholder, give such instructions at it sees fit to remove or prevent such discrimination, including instructions for running the company’s business in the future, or instructions to the shareholders of the company under which either they or the company itself is to purchase its shares, subject to provisions of Section 301

[4] Section 4 of Companies Law states:" The legal personality of the Company." "A company is a legitimate legal entity for every right, obligation, and action which conforms to its character and nature as an incorporated body.

[5] Lifting the Corporate Veil:

(A) Lifting of the corporate veil includes any of the following:

(1) Attribution of rights and obligations of a company to a shareholder therein;
(2) Attribution of the features, rights, and obligations of a shareholder to the company.

(B) Notwithstanding the provisions of Section 4, a court may lift the corporate veil if it meets the conditions prescribed by legislation or if under the circumstances, it is just and proper to do so, or if the conditions stipulated in subsection (c) are met.

(C) A court dealing with a process against a company may, in exceptional cases and for special reasons, lift corporate veil, if one of the following applies:

(1) The use of the separate legal personality of the company is intended to frustrate the intention of law, or to defraud or to deprive a person;
(2) Under the circumstances, it is just and proper to do so, taking into account that there were reasonable grounds to assume that the management of the company's business was not in the best interest of the company, and it also assumed an unreasonable risk as to its ability to repay its debts.

(D) Lifting the corporate veil for the purpose of attribution of the company's debts to a shareholder therein shall be made taking into consideration the company's ability to repay its debts.

(E) The provisions of this Section shall not prevent a court from granting other remedies, including suspending the right of a particular shareholder of the company to repay its debt until after the company has fully repaid all its other obligations.

[6] Section 252 of the Companies Law provides:

(A) An officer of a company must act in good faith, as per Sections 35 and 36 of Torts Law (New Version). (B) The provisions of Subsection (a) do not prevent the duty of care of an officer against another person. Even Sections 253 and 253 A refer to the duty of care vis-à-vis an officer

[7] Section 254 (a) (2) of Companies Law states: "An officer owes an obligation of trust to the company, shall act in good faith and in its favor, including - shall refrain from any action of competition with the company's business ."

[8] Section 192 (35) of Companies Law

[9] Pursuant to Section 193 of Companies Law.

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*This article is not meant to constitute legal advice for a particular client, for which consultation with a qualified attorney is required.