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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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