A Second Thought on Minority Veto Rights.
At the beginning of this decade, three significant and important reforms transformed the Israeli capital market which led us to our current reality. And as you may all know, Prof. Zohar Goshen was a primary initiator of all three reforms.
The reforms are as follows: The establishment of an economic department in the Tel Aviv District Court; The amendment to the Securities Law, adding administrative enforcement capabilities to the Israeli Securities Authority; and finally Amendment no. 16 to the Companies Law, which was partially based on the recommendations of the Goshen Committee on Corporate Governance.
Establishing the economic department in the district court was designed to create judicial specialization and to accelerate decision making on matters related to corporate and securities laws.
Administrative enforcement was designed to diversify the enforcement tools available to the ISA and allow it to bring offenders to justice quickly and efficiently when offenses do not warrant criminal prosecution.
Amendment no. 16 to the Companies Law significantly increased the power of minority shareholders by determining that the adoption of certain types of decisions required approval of a higher majority of minority shareholders.
The most significant issue affected by this majority requirement was the approval of transactions in which the controlling shareholder had a personal interest. This requirement was extended in the latter years, and also to executive remuneration policies.
This special minority approval mechanism is designed to prevent the potential abuse of power by a controlling shareholder. As a whole, there is nothing negative about having a controlling shareholder in a public company. We are all aware of the fact, that there are very positive controlling shareholders who make significant contributions to their companies. The same applies to transactions involving controlling shareholders – some can benefit the company and in such cases the minority shareholders may gain by approving them. Still, the transactions themselves are "under suspicion" because the controlling shareholder has a personal interest in them.
The current situation in Israel is that several types of actions require approval of a majority of the minority shareholders. This requirement applies to potentially "suspicious" activities such as related party transactions that reflect a potential conflict of interest between the company and its controlling shareholder, as I just mentioned. But it also applies to actions that do not have a proven conflict of interests, such as approval of the CEO's remuneration or approval of the unified role of the CEO as the Chairman of the Board.
Consequently, the Israeli law gives shareholders the power to prevent transactions that do not entail a clear conflict of interest between the company and its controlling shareholder. As a result, minority shareholders have broad veto powers. Such power exists even in the case of an excellent controlling shareholder, whose actions can benefit the company, as well as actions in which his/her interests are identical or similar to the interests of the minority shareholders.
Let's have a look at comparative law. In the USA and Europe, there are also mechanisms that determine that related party transactions must be approved by a majority of minority shareholders at a general meeting. The mechanisms differ both with respect to the types of transactions that require such approval and also with respect to the extent of required implementation of this mechanism. In Delaware, for example, this mechanism provides protection from a broad judicial review but is not a condition for the execution of the transaction.
The big distinction I see is that the Israeli market undertook three major reforms within a relatively short period, of about a year. And in addition there was another significant reform about three years later, related to executive remunerations, which is exceptional in global standards. Executive remuneration approval (that isn't linked to the controlling shareholder), now requires a special majority instead of a "say on pay" mechanism as the global standards. The CEO remuneration now requires a special majority instead of BOD approval. And a mandatory cap on executive remuneration in the financial sector was also adopted around this time as well.
We may distinguish between two different systems of reforms: the reforms that were designed to create state corporate governance mechanisms, which are the economic department in the District Court and administrative enforcement tools, and the reforms that were designed to provide market corporate governance mechanisms, which are the minority veto right, and active behavior by institutional investors enabled by the corporate law.
The market mechanisms were, in fact, devised in response to the continual increasing holdings of institutional investors. This was a significant development in capital markets worldwide that also affected Israel (the share of institutional investors on the Tel Aviv Stock Exchange doubled within a decade from 23% to 47%). This was also accompanied by institutional investors' increased activism with their ability to influence public companies.
In this context it is worth noting that certain rights granted to Israeli institutional investors are effectively exercised only with respect to Israeli companies that are listed only in Israel and not with Israeli companies that are traded only abroad. Furthermore, the Israeli Companies Law clearly does not apply to institutional investors' holdings in non-Israeli companies that are listed abroad. Such differences have an adverse effect on the local market and potentially diminish its appeal for potential issuers.
What was the result of these reforms? From an optimistic perspective, we can talk about the positive effects. Establishing the economic department in the district court facilitated the rapid resolution of civil legal disputes as well as criminal cases. The new administrative enforcement tools made it possible to handle a larger number of offenses. The amendments to the Companies Law increased minority shareholders' power and reduced the controlling premium over time.
But what are the negative implications of those reforms? Aren't we seeing a surge in litigation and legal proceedings in the capital market in response to the establishment of the economic department? Have the new administrative enforcement tools created over-deterrence of executives? Have the amendments to the Companies Law created an excessive burden on companies operating in the capital market?
The answers to these questions remain to be determined. We are all familiar with the argument that the decline in the number of public companies and reduced desire of new companies to go public is the result of overbearing regulation. This decline actually stems from a series of causes rather than a single factor. It is however, undeniable that regulation can also lead to delisting, especially when several significant reforms are undertaken concurrently in a relatively short period.
We have no way of knowing whether the delisted companies generated more value to their shareholders after they became private, or what would have happened had they remained public companies, but the fact that they delisted indicates that the step was economically viable for their controlling shareholder (assuming she acted rationally). Otherwise they would not have invested efforts and money to do so. That is to say, from the controlling shareholder's perspective, the delisting transaction reflected a higher company value on the eve of that transaction.
When the reforms I mentioned earlier were undertaken, they were adopted on the basis of the specific merits of each reform, rather than an examination of their potential effects in total. And while each of these reforms made sense, was their combined adoption justified? Are these reforms to some extent substitutional? Is there a need for powerful regulatory tools when effective market mechanisms are in place? After all, a balance between the mechanisms is required if the goal is to attain a high, yet not excessive, standard of corporate governance.
Were that not enough, the three major reforms were joined by additional legislative amendments that added to the costs of companies' maintenance on the market. The first of these amendments was Amendment No. 20 to the Companies Law, adopted in 2014, which extended the minority shareholders' veto power to companies' remuneration policies and CEO employment terms. From an international perspective, this was an exceptional amendment.
The second amendment, adopted in 2016, limited the salaries of executives in the financial sector as well as investment managers in the institutional bodies. I believe that it is reasonable to assume that this amendment also affected voting policies of institutional investors on executive remuneration of non-financial firms, that were not intended to be affected by this amendment.
As Goshen and Hamdani's recent research, released this month (titled: Corporate Control and the Limits of Judicial Review), elaborates, it is too often difficult to quantify or estimate in advance of the difference between the agency costs created by a controlling shareholder— that is, the cost of private benefits of control — and the added value that the controlling shareholder generates for all shareholders through her management.
Therefore, in some cases, a controlling owner's added value to the firm may exceed the value of agency costs that she imposes, yet the minority shareholders may nonetheless decide to exercise their veto power, due to a miscalculation or simply a negligence.
The possible outcome of such cases could be the abandonment of those executives and owners who provide a positive value to their companies, and will represent a de facto blow to the firm's value and to its minority shareholders as well.
The question that I would like to pose is whether the far-reaching experiment conducted in the Israeli capital market in the past decade has truly yielded positive results, and if so, in what aspects of the market do they manifest? Another question that is warranted is whether the broad veto power granted to minority shareholders in Israel could ultimately have a detrimental impact on the market values of existing public companies?
All this brings me to the in-depth study made by Oded Cohen and Dr. Roey Stein from the Bank of Israel. This impressive study that will be published in the next few months, sheds some light on this issue. In this study, the researchers developed an index of corporate governance quality, based on 27-31 firm-level control factors. These factors cover almost all dimensions of firm operations that have significance for corporate governance: dividends, profit management, debt settlements, remuneration, related party transactions, probability of insolvency, to name a few. The study covers the period from 2007 to 2014, a period that coincides with the major reforms described earlier. The sample includes 127 firms.
Among other things, the researchers used their corporate governance quality index to investigate the connection between firm-level and state-level indices of corporate governance quality.
State-level corporate governance quality is typically unaffected by internal firm mechanisms. Corporate governance quality affects all firms equally through non-voluntary practices.
The question is, what is the relationship between firm-level corporate governance and state-level corporate governance? It is an exchangeable relationship — because the government forces low-quality corporate governance firms to meet a high standard of investor protection; and it is supplementary — because good firms can prove that their mechanisms are more reliable.
These researchers found that the reforms adopted in 2011 established a high level of minimum standard of investor protection, independently of the firms' internal mechanisms. More specifically, the reforms compensated for the low standard of corporate governance in certain firms by setting standards of investor protection. That is to say, the reforms created a compensatory effect between the protective mechanisms that the firm provided and the mechanisms that the state provided.
In terms of effects on firm value, the reforms reduced the potential for controlling private benefits, and we know about recent studies that show that control premiums in Israel are on the decline. Cohen and Stein demonstrated that private benefits of control motivated controlling shareholders to remain in the market. After the adoption of the reforms in 2011, this situation was reversed, and firms with a dominant controlling shareholder showed a greater tendency to delist. Therefore, according to this study, it appears that the market's response to Amendment no. 16 was positive, and the market considered controlling owners who used their powers to gain private benefits as having a detrimental impact on their firm's value.
But this is only a single study, on a single issue (Amendment no. 16). I hope that other researchers will face the challenge and conduct similar studies on the overall implications of these legislations.
I would also like to remind us, the regulators, to always look at the bigger picture and view the regulatory map as a puzzle in which all the pieces must fit correctly in order to create a holistic picture. Sometimes you may have a piece that is pleasing in itself, but does not fit into the puzzle, or you may have a puzzle with similar pieces. It's not easy. And, it's especially not easy to assess in advance the outcomes of each step or the combined impact of a number of steps, but it is our duty to do so.