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By Liat Yaron, Adv.
Introduction
The Class Action procedure was introduced into the Israeli legal system in 1988, when the legislature amended the Securities Law-1978 by enabling securities holders to file class actions.
In 1999, when the new Israeli Companies Law - 1999 was enacted, the provisions of the law concerning Securities Class Actions were incorporated into the Companies Law.
On 1st March 2006 a new Class Action Law was enacted. The new law handled all matters in which class actions may be filed including securities, and set principles and requirements which apply thereto.
Despite the time which has elapsed since he Securities Class Action procedure was introduced into the Israeli Law, only recently, for the first time, in C.A. 345/03 Dan Reichart v. Moshe Shemesh and Others the Supreme Court handed down a judgement in which it imposed liability on a class action defendant.
In addition, for the first time, the Supreme Court addressed the issues of calculation of damages in a class action claim and the distribution of the compensation between the class members. All previous class action claims were either denied by the Court in a preliminary stage or, if approved, were concluded through settlement agreements.
Factual Background
Reichart Industries Ltd. was a company engaged in the manufacture and marketing of cement products for underground use (hereinafter: the Company or Reichart).
On 3rd August 1993 a prospectus was published by the Company offering the Company's securities to the public. The prospectus and financial reports which were presented to the public indicated an optimistic future for the Company and as a result a sum of NIS28.5 million (approximately $7 million) was raised from the public.
Approximately one year after the public offering, a chain of dramatic events took place which influenced the Company's business and led to its collapse. Mr. Ezra Reichart, the Company's chairman of the Board of Directors and its CEO and Mr. Menashe Cohen (hereinafter: Menashe), the deputy CFO, and the Company's Comptroller were detained due to suspicions of tax evasion. Shortly after, the Company issued an immediate report indicating the errors which were discovered in the Company's financial reports.
As a result of the above mentioned events, the Company's share price dropped by approximately 71%. On 30th April 2005 trading in the Company's securities was ceased.
In July 1995 the District Court issued a liquidation order against the Company. The Company's securities were erased from the Tel Aviv Stock Exchange.
The Class Action
On 16th July 1995 Mr. Moshe Shemesh (hereinafter: the Plaintiff), who had purchased the Company's securities for an amount of NIS 60,000 (approximately $15,000) in 1994, filed a claim for its losses, together with a motion to approve it as a class action.
The claim was filed against Mr. Ezra Reichart and his family members who held 88% of the Company's shares, the public directors of the Company, the Company's comptrollers before and after the offering, Menashe and Discount Underwriting and Business Enterprise Ltd., which signed the Company's prospectus (all will be jointly referred to as: the Defendants).
On 1st December 1996, the District Court accepted the motion to approve the claim as a class action and defined the class members as the group of individuals who held the Company's shares and/or warranties on 3 rd April 1995.
Following the District Court's said decision, most of the defendants settled the claim against them.
Mr. Dan Reichart who was Mr. Ezra Reichart's brother (hereinafter: Dan) and Menashe, were not parties to the settlement and they filed a motion for leave to appeal to the Supreme Court concerning the decision to approve the claim against them as a class action. The motion was denied and the proceedings against Dan and Menashe in the District Court were continued.
On 27th November 2002 the District Court handed down its judgement in which it determined that Menashe took part in deceptive actions which were made in the Company before and after the public offering.
The Court determined that due to the deceptive actions, the Company's financial situation was misrepresented.
Menashe's liability for the damages caused to the public was based on his breach of duty of trust and his breach of his duty of care as set in the Tort Ordinance [New Version].
As for Dan, his liability for the damages caused to the investors was based on the fact that he was a controlling shareholder of the Company. The Court determined that Dan breached his duty of care towards the Company and its shareholders by failing to apply appropriate supervision on the Company's officers.
The Court also based its decision on Section 52(k) of the Securities Law which imposes liability on a controlling shareholder of an offering company towards its securities holders for damages caused to them as a result of the issuer's breach of the Securities Law.
The District Court decided to base its calculation of the compensation for class members on a general estimation. Accordingly, it ruled that Menashe is to pay the group NIS 3 million (approximately $750,000) and Dan is to pay the amount of NIS400,000 (approximately $100,000) plus interest and linkage differentials.
The Court determined that the compensation amount is to be apportioned among the members of the group according to the relative proportion of their holdings of the Company's securities.
The Supreme Court Judgement
Menashe, Dan and Plaintiff filed appeals to the Supreme Court which has now handed down its judgement.
Dan Reichart's liability - the Liability of a Controlling Shareholder
As mentioned above, Section 52 to the Securities Act imposes liability on a controlling shareholder of a company in the event that the issuer breached the Securities Act, inter alia, by including misleading details in a prospectus.
The Supreme Court has first addressed the question whether Dan is considered to be a controlling shareholder of the Company. In this respect, the Securities Act presumes that a person is a controlling shareholder of a Company if he or she holds 50% or more of the controlling shares (right to vote in the general assembly, right to appoint directors or CEO of a company). The presumption also refers to a joint holding of 50% or more of the shares, together with others.
The Supreme Court determined that although Dan held 8.75% of the Company's shares, Dan falls within the definition of controlling shareholder as he is a member of the Reichart family. The Reichart family had a voting agreement which presented a united front as a group of shareholders which held 87.5% of the Company's voting rights. The entire group, including Dan, undertook to vote as the dominant shareholder (Ezra Reichart) voted and thus is considered as a controlling shareholder.
Dan argued that he could not have controlled his family members behavior, and could not have prevented their violation of the Securities Law, and therefore he should not be considered as a controlling shareholder. The Court rejected this allegation, stating that Dan had not tried to prevent the publication of the prospectus.
Sections 52(m)(1) and (2) of the Securities Act set two defences which may be available to a controlling shareholder. According to these sections, Section 52(k) shall not apply in respect of -
- Whoever proved to have taken all appropriate measures to prevent the violation;
- Whoever proved that he or she was not aware of the violation and should not have been aware thereof.
The Supreme Court determined that these defences do not apply in Dan's case. Indeed, it appears that Dan was unaware of the deceptive actions which took place in the Company. However, he was aware of Menashe's deceptive character and thus of the real possibility that Menashe will steal money from the Company.
Methods of Calculation of Loss - individual damage or global damage?
The Supreme Court stated that there are two methods of calculating the loss sustained by class members:
- Individual Calculation - according to this method the calculation should be based on an individual basis as to the amount of recovery to which each of the class members is entitled.
The proof of damage suffered by each class member can be substantiated by affidavits which will be filed by each individual. Another possibility is to develop and provide common guidelines or a formula that would determine the measures of recovery for each individual.
- Global Calculation - pursuant to this method the Court will calculate the global damage sustained by the entire group without calculating the individual damage to each member of the group. This method is useful in certain situations - for instance when the calculation of an individual damage is difficult to prove in view of a lack of relevant details such as receipts, or in cases where the personal damage is very low, and does not justify the effort of proving the claim.
Even in cases where global damage is awarded to the group, it is possible to divide it between the members of the group according to their respective loss.
Preferable Method of Calculation of Loss in Securities Claims
The difficulties involved in determining the individual damage for each of the members of the group usually do not characterize securities class actions. In these claims it is usually easy to identify the class members and the price of the security. Since the damage sustained in securities claims is not usually low, it is justified to examine and prove each of the individual's damages and therefore when referring to this type of class action, the appropriate calculation of the damage is usually the individual calculation.
Only in cases where it is difficult or impossible to identify the class members, the compensation can be calculated separately. In such cases the Court will consider the damage arising from each of the company's shares, taking into account the date it was purchased and its market value in comparison with the true value multiplied by the number of shares purchased at the time.
In our case - the group was specifically defined and therefore the calculation should be made individually.
The Calculation of Damage Caused to Each Individual
The Supreme Court referred to several measures which may be used to calculate the damage caused to each individual.
The first measure of calculation is referred to as the "out of pocket measure". This measure determines the recovery based on the difference between the purchase price of the securities and their actual value on the purchase date.
The second measure is the "recessionary damage measure". According to this measure, the securities holder will be entitled to the full difference between the securities' purchase price and the securities price shortly after the wrongdoing was discovered.
The Court stated that the first measure is based on the principles of the Tort Law which is intended to place the injured party in the position he would have been had the tort not taken place. On the other hand, the recessionary measure is based on the Contracts Law pursuant to which when a party entered into a contract based on a mistake or deceit, he may be entitled to compensation which will restore him in the pre-contractual position.
The Court stated that the nature of securities fraud claims is mainly tortuous. The Court therefore determined that usually the appropriate method of calculation for individual damage will be the "out of pocket" method which bases the damage on the difference between the price which was actually paid for the securities and the "true value" of the securities when they were purchased.
The recessionary measure should be used cautiously only when there is a contractual relationship between plaintiff and defendant such as the relationship between plaintiff and the issuer (as opposed to controlling shareholders).
Since the calculation of damage according to the "out of pocket" method requires additional details, the Supreme Court decided to refer the case back to the District Court to which the parties will present additional evidence regarding the damage.
Dan and Menashe's Share in the Damage - separate liability or "jointly and severally"?
The final question which the Court addressed was what share of the damage should be borne by Dan and Menashe.
As a rule, when a claim is based on Section 52 (k) of the Securities Act, the liability of each of the Defendants towards the plaintiff is "jointly and severally". However, in certain securities class actions, the said rule should not be followed. The Court ruled that when some of the class action defendants reached a settlement with plaintiff, then the remaining defendants will not necessary bear all remaining damages, but rather their exposure will be limited to their share in the liability.
The Court stated that the class action procedure involves certain risks that may lead to deprivation of rights of plaintiffs, Defendants or both, and therefore several legal principles were developed in order to limit the said risks.
The new Class Action Act determines that the Court should take into account, when ruling compensation, the interests of the Defendants and the public in general.
The Court stated that the "joint and several" rule may expose an individual defendant to the danger of non-payment by the rest of the responsible parties. Since compensation awards in class actions are extremely high, the defendant's exposure in such cases is enormous.
Finally, the Court concluded that the compensation regime should derive from the specific circumstances of each case. In our case the Court determined that although Dan was liable towards plaintiffs, his share in the compensation should be limited to his relative extent of liability. Dan was not a director or officer of the Company, he was not an authorized signatory, nor did he sign the Company's prospectus.
In view of the above, the Supreme Court decided that it is appropriate to limit Dan's liability, and his exact share in the compensation was left to the discretion of the District Court.
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