Interested-Party Deals in a Private Israeli Company

A shareholder in New York owns forty percent of a small Israeli company. Her co-owner runs it from Petah Tikva and sits as its sole active director. One day she notices, in a line of the annual financial statements, that the company has been paying rent to a building her co-owner happens to own. Nobody asked her. Nobody, as far as she can tell, approved anything. Her first instinct is that this must be against the rules, and her second is that there is nothing she can do about it from four thousand miles away. She is right about the first and wrong about the second.

Related-party leases are the most common way value quietly leaves a small Israeli company, and Israeli law does not leave them to the goodwill of the people signing. Chapter Five of the Companies Law 5759-1999 sets out an approval track that binds a two-shareholder company exactly as it binds a listed one. Our answer on what Israeli law requires before a director leases his own building to the company states the rule in outline; this guide works through how a US shareholder identifies the problem and forces it into the open.

Section 270: The Gateway

Section 270(1) is where every one of these questions begins. It catches a transaction of the company with an office holder of the company, and a transaction of the company with another person in which an office holder has a personal interest. An office holder means a director or a senior manager. A personal interest reaches beyond the individual to a company he controls, so a lease from a building owned by the director's own holding company is caught just as directly as a lease in his own name.

The point of the section is not to ban these deals. Small companies rent premises from their founders, buy from businesses their directors own, and lend to related parties all the time, often for perfectly good commercial reasons. The point is that such a deal must be approved by someone other than the person on both sides of it. What that approval looks like depends on one question.

Ordinary or Extraordinary

The Law splits interested-party transactions into two kinds. An extraordinary transaction is one outside the ordinary course of business, or not on market terms, or likely to have a material effect on the company's profitability, its assets or its liabilities. Everything else is ordinary.

An ordinary, arm's length lease at a market rent is approved by the board under Section 271, unless the articles set some other method. An extraordinary one moves up to Section 272(a), which in a company that has an audit committee requires that committee's approval ahead of the board's. Here is the practical turn that surprises foreign shareholders: a private company that is not a bond company is not required to maintain an audit committee at all. So in most small Israeli companies the extra stage simply does not exist, and the approval lands on the board sitting properly. That is not a weakness in the protection. It is where the protection actually lives.

In Practice: Section 270(1) of the Companies Law 5759-1999 catches the transaction, Section 271 sends a non-extraordinary one to the board of directors, and Section 272(a) adds an audit committee stage only where such a committee exists. On a related-party lease at NIS 25,000 a month, three years at even a 30% premium over market is roughly NIS 270,000 drained from the company. The interested director is excluded from the vote under Section 278, and a defective approval can be undone; proceedings go to the Economic Department of the Tel Aviv District Court, where an application is typically heard within 6 to 12 months of filing.

Sections 278 and 280: The Teeth

Two sections give Chapter Five its bite. Section 278 provides that a director with a personal interest in the approval may not be present during the deliberations and may not take part in the vote. Read that carefully, because it contains two separate rules. His presence during the discussion is a defect in its own right, even if he abstains. These applications are often won on the protocol showing the interested director in the room, quite apart from how the vote was recorded.

Section 280 supplies the consequence. A transaction with an office holder that was not approved under Chapter Five, or where a substantial defect occurred in the approval process, has no effect as against the company or the office holder. The company can treat the lease as if it were never made. Sitting beside these provisions, Section 193 requires a controlling shareholder, or a shareholder whose vote decides a matter, to act with fairness towards the company, which gives a further line of attack where the numbers are lopsided.

The Non-Resident's Real Problem Is Discovery

For a shareholder in the United States the difficulty is rarely the rule. It is finding out. Israeli private companies file almost nothing useful with the Registrar of Companies, so a related-party arrangement usually surfaces months late, in a footnote to the financial statements or in a bank record showing a standing order to a half-familiar name. Waiting for the annual accounts is waiting too long.

Two steps come first, and both are done from a desk abroad. Ask in writing for the board protocols and the signed agreement; a shareholder is entitled to inspect them, and the request travels by email while the answer is a document rather than a meeting. Then check the protocol for one thing above all: was the interested director recorded as absent from the discussion and the vote. If the protocol is missing, or shows him present, you already have the core of a case. Our answer on what minority shareholders in an Israeli company can actually do sets out the oppression and derivative routes that follow.

Enforcing From Abroad

Where the approval is missing or the interested director voted, the remedy is not a demand letter but an application to the Economic Department of the Tel Aviv District Court. It can be run entirely by an Israeli lawyer under a notarised and apostilled power of attorney, so the shareholder never leaves the United States. The oppression remedy addresses unfair prejudice to a shareholder directly; a derivative claim, brought on the company's behalf, needs leave under Section 198 first, which typically takes 6 to 12 months to obtain. Court fees run at 2.5% of the amount claimed, with half on filing.

In Practice: Section 280 of the Companies Law 5759-1999 lets the company treat a defectively approved interested-party transaction as having no effect, and Section 193 requires a controlling shareholder to act with fairness towards it. A minority holder enforces both through the Economic Department of the Tel Aviv District Court, where an application for leave to bring a derivative claim under Section 198 carries a court fee of 2.5% of the sum claimed. Recovering NIS 270,000 of overpaid rent therefore costs roughly NIS 6,750 to launch, half of it on filing, with the leave application typically decided within 6 to 12 months.

The US side of the ledger is usually simpler than clients fear. A US person who owns ten percent or more of a foreign corporation already files IRS Form 5471 each year regardless of any dispute, and recovering value that was improperly taken from the company does not, by itself, create a new US tax event. What matters on the US side is standing, addressed below.

Common Mistake: A US shareholder who has known about a related-party lease for years, and let the company keep paying without objection, assumes the Section 280 argument is still there whenever she chooses to use it. Acquiescence is the standard defence, and the longer the silence after learning of the deal, the weaker the challenge becomes. Courts read years of untroubled payment as informal ratification, and a claim that would have succeeded early can fail on delay alone.

Practical Checklist

• Request the board protocols and the signed agreement in writing as soon as you suspect a related-party deal; you are entitled to inspect them.
• Check whether the interested director was recorded as absent from both the discussion and the vote under Section 278.
• Do not wait for the annual financial statements; act on the first concrete sign, because delay is the main defence.
• If you hold shares through a US LLC or trust, confirm how you appear on the register of shareholders before filing anything, as standing is tested against it.
• Instruct an Israeli lawyer under a notarised and apostilled power of attorney rather than sending correspondence yourself.
• Weigh the 2.5% court fee and the 6 to 12 month timeline for derivative leave against the value at stake before committing.

Speak With an Israeli Attorney

An interested-party deal that skipped the Chapter Five track can be unwound, but only if you move before acquiescence sets in. We obtain the board protocols and the underlying agreement, establish whether the approval was valid, and where it was not, bring the application in the Economic Department without you leaving the United States.

Contact us for a confidential initial consultation.