Liability of an Israeli Parent Company for the Debts of its Subsidiary
Moshe Kahn*
A company often tries to separate its spheres of activity by establishing subsidiaries to avoid exposing successful operations to risks stemming from operations that are not so successful. In many cases,
a subsidiary will be established for that purpose and it will be dedicated to specific business activities.
The purpose of this article is to describe briefly the principles of Israeli corporate law with regard to the exposure of the parent company to the debts of the subsidiary, and to recommend several steps that can be taken to reduce the exposure to the risks entailed in the subsidiary's operations.
It is best to note right at the beginning that the usual rule is that, in the absence of express consent, the parent company has no liability whatsoever for the debts of a subsidiary vis-?-vis third parties, because the law recognizes the fact that in the normal course of events, these are two different entities with separate legal identities.
There are exceptions to the above rule, and these will be discussed below.
Article 6 (a) of the Companies Law, 5759-1999, states that the court is entitled to ascribe a company debt to the shareholders (piercing the corporate veil), if it finds that it is correct and justified to do so in the circumstances, in cases in which the shareholders' use of the legal entity which is separate from the company is implemented:
in a manner that could defraud a person or discriminate against a creditor;
in a manner that harms the company's purposes, and while undertaking an unreasonable risk regarding its ability to pay its debts.
The court may order the piercing of the corporate veil by virtue of Article 6 of the Companies Law, and charge the company shareholders with its obligations, as a response to the exploitation of the corporate veil by those shareholders in the company owned thereby. For example, the court will pierce the corporate veil in the following cases:
a) Fraud
b) Intermingling of the assets of the corporation with the assets of the shareholders
c) Extreme undercapitalization on the part of the shareholders, which led to the collapse of the company
d) A particularly large leveraging ratio
e) Transferring assets from the company without suitable consideration
It should be noted that until 2005, the wording of the aforementioned Article 6 gave the court broader discretion than it has today. In 2005, Article 6 was amended to reduce the court's possibility of piercing the veil, with the aim of "not leaving the business community in a state of uncertainty and unexpected risks" (in the words of the bill).
The exceptional cases enumerated above generally relate to a situation in which, by law, the corporate veil between the company and the shareholders, who are flesh and blood people, can be pierced. When the shareholder is a company, i.e., when it involves a relationship between a parent company and a subsidiary, there is actually no significant difference in the law regarding piercing the veil, i.e., the veil will be pierced in exceptional cases.
In practice, in borderline cases, it seems that it would be easier for the court to pierce the corporate veil between a parent company and a subsidiary than between a company and a private individual. This is because the liability in the first case is that of a corporation and not an individual, and because there is a certain approach whereby, in effect, creditors of the subsidiary also rely, in their engagement with the subsidiary, on the assets of the parent company as the source of payment of the debts.
As mentioned, the court's decision about whether to pierce the corporate veil between a parent company and
a subsidiary is generally made according to the regular of veil piercing criteria and the parent company will be charged with the debts of the subsidiary in the exceptional cases mentioned above, or in similar cases and in cases in which it is proved that the parent company prevented the subsidiary from acting as an independent profit center.
In view of the aforementioned, it is best to ensure that the operations of the subsidiary, when it is established, are conducted separately from the operations of the parent company, and that it is managed as an independent profit center.
It is also advisable to ensure that a separate management to be appointed for the subsidiary, and that
a board of directors be appointed for it which is composed of directors who are not serving as members of the parent company's board of directors. In this manner, each director will be able to consider only the good of the company on whose board of directors he is serving, and a conflict of interest in the activities of the directors will be avoided.
It is further advisable to insist that the contracts entered into by the subsidiary in the course of its operations be signed only by the subsidiary. As far as possible, efforts should also be made to physically separate the places of operations of the two companies.
* Moshe Kahn is an Israeli lawyer specializing in Business Law. He is licensed to practice law both in Israel and in the U.S., and serves as the vice chairman of the High-Tech Committee and as a member of the Corporations and Capital Market Committee of the Israel Bar Association.
www.kahn.co.il