The Israeli Supreme Court ("Court") was asked to consider whether a holding company's shareholders are entitled to file a derivative action in the name of a second-tier subsidiary. In this case, a shareholder alleged that the holding company's CEO, who was also a director of a second-tier subsidiary, may have privately profited from a business transaction carried out by a second-tier subsidiary.
The Court held that where impropriety at the subsidiary level could harm its ultimate parent company, it is appropriate under certain circumstances to lift the corporate veil and provide a right of action to the parent company's shareholders. The Court noted that a broad interpretation of the Israeli Companies Law leads to the same conclusion: a company's subsidiaries are its property; harm to a subsidiary can decrease the parent company's value; therefore a shareholder in a parent company has an interest in filing a lawsuit regarding its subsidiary.
The Court further held that when considering the right to bring a derivative suit, a mathematical test of control between related companies based on share ownership should be replaced with a qualitative test, pursuant to which the entirety of the circumstances is considered.
In the case at hand, the parent company held eighty percent of the share capital of the first-tier subsidiary, which in turn held fifty percent of the share capital of the second-tier subsidiary. The remaining fifty-percent interest in the second-tier subsidiary was owned by a third party, which had entered into a management agreement with the first-tier subsidiary granting the first-tier subsidiary veto rights regarding decisions involving the second-tier subsidiary.
The Court held that based on the circumstances – the parent company's holdings and the management agreement – the parent company held qualitative control over the second-tier subsidiary. This conclusion was bolstered by the fact that the same individuals served as officers in various group companies, and that one such officer had privately exploited a business opportunity. Taking into consideration all of the relevant circumstances, the Court granted the holding company's shareholders the right to file a derivative action in the name of the second-tier subsidiary.
In obiter, the Court indicated that its judgment could be seen as a response to the Israeli reality of complex corporate group structures created to reduce exposure. Pyramid structures tend to separate ownership and control, which can negatively affect investors. The Court emphasized that permitting derivative actions in the name of a subsidiary may strengthen corporate governance in pyramid corporate structures.
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