Be Careful What You Wish For: How Progress Engendered Regression in Related Party Transaction Regulation in Israel

Because of their pernicious tendency to serve as a vehicle for extracting value from firms corporate related party transactions (RPTs) have come to epitomize corporate governance ills.  Respectfully, the regulation of RPTs and private benefits of control more generally is a focal issue in corporate governance policy making.  In the legal and institutional arsenal for curbing inefficient RPTs specialized business courts feature prominently as a potent mechanism.  Such courts have mushroomed in the United States and around the world, but Delaware’s courts remain the undisputed leaders and the recipe for its success as the “corporate capital of the world” remains secret.

This paper recounts a rapid deterioration in Israeli company law with regard to corporate actions tainted by insiders’ interest.  This process took place largely after the establishment of a specialized business division in the Tel Aviv District Court, purportedly with a view to mimicking Delaware’s courts.  Within just a few years, Israeli law shifted from conditioning tainted corporate actions, including RPTs, on a fully-informed-consent mechanism to apparent tolerance of such actions, provided that they appear appropriate to the court upon review of their substantive business terms or rationale.  Crucially, this legal change happened notwithstanding prior case law that had adopted a strict “no further inquiry” approach to potentially conflicted transactions.  The establishment of a specialized business court thus engendered a converse effect than the corporate governance improvement anticipated from it.

To a non-Israeli lawyer seeking to understand and design optimal regulation for corporate RPTs, the Israeli experience is puzzling.  While certain individuals and interest groups could benefit from the erosion in RPT regulation, the cases provide no hint that the courts heeded to such interests.  To the contrary, the courts’ stated motivation is to buttress the protection of companies and public shareholders from powerful insiders.  To this end, they have looked uncritically to the Delaware appellation, while ignoring important Israeli and other comparative jurisprudence and providing no justification for this move.  That the result was quite the opposite is thus ironic.

In assessing corporate governance reforms commentators often focus on powerful forces that could thwart them such as wealthy families that have a grip over the economy and politics, or countries’ cultural and social institutional infrastructure.  This paper adds to the literature the modest insight that sometimes, weak forces, too, can exert a significant effect.  The Israeli experience provides a sobering reminder that such initiatives should be implemented with keen attention to the legal infrastructure in which business courts are to operate, and surely without any naïve expectations.