Prof. Nitzan Shilon’s Published an Op-Ed in Calcalist (a leading Israeli daily business and economics newspaper)

In 2017 the Israeli parliament enacted a law transitioning the Tel Aviv Stock Exchange (TASE) from a mutual association of exchange members operating on a not-for-profit basis to a limited liability, for-profit company accountable to shareholders. In the following two years most of TASE shares held by Israeli banks were sold to five groups of foreign investors. This is how Mainkay Partners (Manikay), an Australian-American investment fund, has become TASE largest shareholder. Simultaneously, TASE shares were listed and its top executives and directors received generous stock option and restricted stock grants as compensation. The theory was that TASE demutualization and incentivizing its managers to maximize its stock price would make it more efficient, which, in turn, would benefit Israel’s capital markets.

Seven years later, or last week, this theory was tested. The commonality of interests between Manikay, which was interested to realize its investment at a handsome profit of 175 million Shekel, and TASE management, that wanted to maximize its stock price, created a private deal, in which TASE repurchased almost 5% of its shares from Manikay. The rationale was to prevent Manikay from selling these shares on the stock exchange, which would have pressured the stock price down. The transaction triggered outrage from public shareholders, who brought the matter to court.

In this Op-Ed I do not intend to discuss the legality of the transaction. Instead, I argue that it demonstrates that the Israeli company and securities laws are dated and are not designed to challenge problematic transactions typical to modern capital markets.

First, the Israeli Company Law is based on the 1970s “agency theory”. According to this theory, in widely held companies there is a conflict of interest between managers and shareholders. Contrary to this theory, the problem with the transaction at stake stems from a commonality of interest between a major shareholder and management. The commonality of interests between TASE management and Manikay raises a concern for quid pro quo: allegedly, TASE management used its assets to allow Manikay to sell a significant portion of its investment at a high profit, and in return Manikay might approve generous compensation packages to the managers. The approval procedures of interested party transactions in Israel Company Law are not designed to deal with such conflicts.

Second, the transaction demonstrates that the significant amounts of stock and stock options that TASE managers received as compensation, in line with the traditional theory of “pay for performance”, might incentivize them to maximize the immediate stock price also when this is not in the best interest of the company and its shareholders. In this case, TASE mangers went out of their way to support the stock price by taking controversial measures: transferring 200 million Shekel to Manikay, treating shareholders unequally without asking for their approval, and initiating a deal without having liquid funds to finance it.

Third, the Manikay deal demonstrates potential adverse implications of the neo classical approach reflected in Israel securities laws, allowing stock buybacks without meaningful constraints. According to this approach, although firms intervene in the trading of their own stock in a stock repurchase, this should be allowed because market forces are strong enough to prevent any attempt by firms to manipulate their stock price. In the Manikay deal the market responded swiftly, with a 9% stock price decline within two days. But nothing in the market response helped public shareholders, that were excluded from the deal, to avoid their losses. For them, it was like shutting the stable door after the horse has bolted.

Finally, current corporate governance arrangements in Israel do not set up rules for private investment funds’ holdings in public firms. Investment funds have a built in “ticking time bomb”. When the time is up these funds must close their positions and return the money to their investors. When your largest shareholder is an investment fund, such as Manikay, you know that the liquidation of its position is just a matter of time, and when this happens it would create a significant pressure on the stock price. Instead of putting out fires TASE would have done better if it thought about this problem ahead of time. In this regard, firms should consider limiting the amount of shares that investment funds would be allowed to purchase.

Overall, the Makinkay deal highlights the need for renewed thinking about concepts that have been perceived almost axiomatic among legal and financial experts. I call on TASE, institutional investors, the Israeli Association of Publicly Traded Companies, the Israel Securities Authority, and the Department of Justice to adapt the rules of the game to the new reality.