The Tel Aviv-Yafo District Court (Economic Dept.) recently issued a ruling establishing a number of important Israeli corporate and contract law precedents. In the case of Haim Bukai vs. MCE SYS Ltd. (the “Company“) (civil case no. 7413-08-17), the Court assessed whether the plaintiff is entitled to 5% of Company’s outstanding shares as a finder’s fee after the investment agreement was mutually revised, and a substantial part of the investment was returned to the investor.
The Court ruled in favor of the plaintiff. Several important precedents were established in the ruling:
- The Court established criteria for unfair dilution that constitutes a deprivation of minority
- Absent of an explicit reference in the finder’s agreement to a scenario in which an investment is returned post-investment, it is likely that the company may not be released from its payment obligation for the finder’s services.
- Immoral conduct or tax evasion would not release parties from their contractual obligations.
Background
In 2006, the plaintiff introduced the Company’s founders to an investor. According to the investor and the Company, the two initially agreed that the investor would invest $500,000 in the Company in return for 20% of its issued and outstanding shares. Following negotiations, the investor and the Company signed an investment agreement on November 19, 2006 under which the investor would receive 15% of the Company’s outstanding shares in consideration for a $500,000 investment in the Company.
On November 26, 2006, the Company and the plaintiff entered into an employment agreement pursuant to which the Company hired the plaintiff as the Company’s new chief marketing officer. As part of the employment agreement, the parties agreed that upon completion of the investment, the plaintiff would receive options to purchase 10,442 of the Company’s shares which constituted 5% of the Company’s then issued and outstanding equity on a fully diluted basis (the “Options“).
The plaintiff’s employment was terminated by the Company after working for the minimum term established in his employment agreement.
After a while, following full payment of the investment amount and issuance of the shares to the investor and following negotiations between the parties, the Company agreed to cancel the investment agreement and returned $375,000 of the investment to the investor in consideration for the return of 75% of the original shares issued.
In 2013, the plaintiff learned that the Company did not issue him any Options, and in 2017, the plaintiff brought a claim against the Company, primarily to demand the Company to issue him 90,060 of the Company’s shares which at the time constituted 5% of the Company’s then issued and outstanding equity on a fully diluted basis.
The Company’s main argument was that the plaintiff and his brother, who served as the CFO of the investor at such time, breached their fiduciary duties during the negotiations and as a result of the revelation of the plaintiff’s actions, the investment agreement was cancelled and 75% of the investment was refunded to the investor.
The Company further claimed that the equity had been duly and validly issued to the Company’s existing shareholders after the investment transaction, as the agreement with the plaintiff did not include any anti-dilution provisions.
The Court ruled in favor of the plaintiff while establishing several important precedents in its ruling:
Employment (or Finder’s) agreement
The Court accepted the plaintiff’s position that given that (i) the employment agreement provided for a proportional amount of the options based on the actual investment paid by the investor and (ii) under the circumstances, given that the investment was fully paid to the Company (and only later partially returned to the investor), the finder is entitled to the full consideration.
Dilution
The plaintiff claimed that, starting from the execution of the investment agreement, the Company had issued shares at prices below their fair value and as such deprived him of his legitimate rights and expectations.
The Court referred to a ruling of the Israeli Supreme Court according to which an unequal allocation of resources by a company may constitute deprivation of a minority shareholder’s rights. The plaintiff showed that there was an approximate 850% increase in the number of the Company’s outstanding shares and options while the founding shareholders preserved their own fractional percentage in the outstanding share capital of the Company. The Court determined that this evidence established reasonable grounds for a claim of deprivation of rights which transfers the burden of proof to the founding shareholders of the Company to show that the issuance of the new shares by the officers and the controlling shareholders of the Company was consistent with the fiduciary duties of the shareholders of the Company to the founding shareholders under Israeli law.
The Court further stated that issuance by the Company of additional equity to its existing shareholders, and in particular to its controlling shareholders, for no appropriate consideration paid by them, must be made in an informed and professional manner which relies, inter alia, on an opinion or a valuation of the Company and its equity in order to ensure that the consideration paid is sufficient.
Tax treatment
Section 102 of the Israeli Tax Ordinance (“Section 102“) provides for favorable tax treatment to Israeli residents for compensation in form of equity awards to company employees, directors and officers (with certain exceptions). Such tax treatment is not available to service providers of the company who don’t serve as company officers.
The Court found that the Company’s actions evidence its commitment to issue the Options to the plaintiff in consideration for the finder services he provided. As a result of the Company’s undertaking under the employment agreement to issue the Options to the plaintiff under Section 102 whether during or after his employment, the Court ruled that even if the plaintiff’s options were not to qualify for favorable tax treatment under Section 102, the Company would not be released from its obligations under the agreement to grant option with the favorable tax treatment, and it therefore will be required to indemnify or compensate the plaintiff if he will be subject to a higher tax as a result of such non-qualification.
As a result of this recent ruling, we advise our clients and friends to take the abovementioned criteria into account when issuing additional equity to existing shareholders and in particular, to its controlling shareholders, to have explicit language in finder agreements regarding return of investment events, and consider tax implications that may arise with respect to contractual arrangements with finders and other service providers.
For more information and in case of any doubt, contact your Gross&Co. attorney or Adv. Shay Yanovsky Shayy@gkh-law.com or Adv. Tamar Shamir tamarsh@gkh-law.com.
