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Committee on Increasing Competitiveness in the Economy Principal Recommendations September 2011. 1. Disclaimer : The binding version is the Hebrew text only. Mandate of the Committee.

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Committee on Increasing Competitiveness in the Economy

Principal Recommendations

September 2011

1

Disclaimer : The binding version is the Hebrew text only.

mandate of the committee
Mandate of the Committee

The Committee was appointed in October 2010 by the Prime Minister, the Minister of Finance and the Governor of the Bank of Israel

Mandate of the Committee: Examining the effect of the existing structure of the economy on the level of competitiveness in its various sectors; on the economy’s financial stability and economic efficiency; and recommending advisable policy measures, particularly with respect to the following issues:

  • Actions required to reinforce corporate governance in public companies
  • The issue of the control of real companies over financial companies
  • The scope of the antitrust policy
  • The issue of control of a public company using a pyramid holding structure
  • Examining the imposition of stricter conditions on business groups with respect to the acquisition of government assets and the receipt of licenses and concessions

2

members of the committee
Members of the Committee
  • Chaim Shani, Director General of the Ministry of Finance, Chairman
  • Eyal Gabbay, outgoing Director General of the Prime Minister’s Office, Chairman
  • Prof. Eugene Kandel, Prime Minister’s Office, Head of the National Economic Council
  • Prof. Shmuel Hauser, Chairman of the Securities Authority
  • Prof. David Gilo, Antitrust Commissioner
  • Gal Hershkovitz, Ministry of Finance, Budget Director
  • Dr. Karnit Flug, Bank of Israel, Assistant Governor of the Bank of Israel
  • David Zaken, Bank of Israel, Supervisor of Banks
  • Prof. Oded Sarig, Ministry of Finance, Commissioner of Capital Markets, Insurance and Savings
  • Adv. Avi Licht, Ministry of Justice, Deputy Attorney General
  • Dr. Gitit Gur-Gershgoren, Economics Department Director, Securities Authority

3

work of the committee
Work of the Committee

Three work teams:

  • Team for the review of real and financial holdings

Headed by Prof. Eugene Kandel, Head of the National Economic Council

  • Team for the review of control using a pyramid holding structure

Headed by Prof. Shmuel Hauser, Chairman of the Securities Authority

  • Team for the review of the conditions for the allotment of public assets

Headed by Prof. David Gilo, Antitrust Commissioner

4

the committee s work procedures
The Committee’s Work Procedures
  • Called for the public’s position prior to the formulation of a draft
  • Examined Ministry papers on and studies of the Israeli economy
  • Held dozens of discussions in full session and numerous other discussions in smaller teams
  • Received 30 position papers from organizations and individuals
  • Heard close to 20 speakers, including experts and academics, NGO’s representatives and organizations and bodies that represent interested parties
  • Will hear the public’s positions on the draft recommendations
  • Received an opinion from Prof. Arye Bebchuk of Harvard University

5

real financial holding
Real financial holding?

Controlling shareholder

Controlling shareholder

Public funds

Pension fund

Bank

Real estate

Infrast-ructure

Bank

Provident fund

Food

Energy

Pension fund

Bank

Comm-erce

Commu-nications

Financial sector

Business sector

7

potential problems of real financial connection
Potential Problems of Real-Financial Connection

Ineffective allocation of resources

Conflict of interests – use of insider information

Competition blocks – withholding credit from competitors

Business relations between related companies

Systemic risk

Advantage – controlling shareholder with substantial capital (stability)

In an economy as small as the Israeli economy, it is preferable to maintain major borrowers and lenders detached

8

recommendations
Recommendations
  • Prohibition of control or holding in a significant financial institution by a significant real entity or by the controlling shareholder of a significant real entity.

Controlling shareholder

OR

  • Significant real operations:
  • NIS 8 billion in sales
    • OR
  • Balance in excess of NIS 20 billion

Significant financial operations:

NIS 50 billion

9

recommendations10
Recommendations
  • Restricting directors from serving concurrently in a financial entity and a real entity
  • A controlling shareholder in a significant financial entity that is a bank will be prohibited from controlling a significant financial entity that is not a bank (insurance – supplement to the Bachar Committee)
  • Advancement of the required supplemental legislation, as a prerequisite for the implementation of the recommendations

Significant financial entity

Significant real entity

OR

10

implementation mechanisms and exceptions
Implementation Mechanisms and Exceptions

Transitional provisions:

  • Entities will be required to execute the separation withinfour years
  • Separation of Boards of Directors – within four years

Encouragement of competition:

  • In order to encourage small entities to compete, they will be permitted to grow (without acquisitions) and exceed certain prescribed thresholds

11

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International comparison:The weight of the ten largest groups in the market value of public companies

Percentage of public companies’ market value

OECD countries

41%

Non-OECD countries

Sources of the data: Claessens, Djankov & Lang; Faccio & Lang. Processed by the Securities Authority’s Economics Department.

* According to Claessens et al., the rate in Sweden is close to 10%. According to Hogfeldt, in 2000 this rate exceeded 50%.

Source: the Securities Authority’s Economics Department

13

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The common denominator of the major groups in Israel is their incorporation under a pyramid structure with a controlling shareholder

15

decoupling phenomenon
Decoupling Phenomenon
  • Decoupling of the economic interest from the ability to control the company
  • The larger the wedge driven by the decoupling between the voting rights and the equity rights, the greater the potential prejudice of the minority shareholders and the holders of debentures
  • Decoupling and control may be achieved by a number of means, including the creation of a pyramid of control or a cross holding structure

16

who is affected by the committee s recommendations
Who is affected by the Committee’s recommendations?

Whenever the interests of the controlling shareholder differ from the interests of the public companies that he controls

Public

51%

Public

Wedge company:

A company in which the controlling shareholder does not have majority ownership and cannot be replaced

51%

Public

51%

17

potential advantages of business groups
Potential Advantages of Business Groups
  • Intercompany backup when necessary
  • Sharing of knowhow, business relations
  • Penetration of new areas
  • Substitution for missing institutions
  • Survivability

The pyramid structure is very common in emerging markets

18

potential problems of the pyramid structure
Potential Problems of the Pyramid Structure
  • Tunneling of resources
  • Ineffective allocation of resources
  • Excessive risk taking
  • Internal capital market (ineffective)
  • Double leverage
  • persistence

Public

51%

Public

51%

Public

51%

The interests of the controlling shareholder may differ from the interests of the companies that he controls

19

potential problems on the economy level
Potential Problems on the Economy Level
  • Detrimental to stability
  • Multi market contacts
  • Determent of foreign investors
  • Inflation of indexes

20

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The Wedge Between Investment and Control in Business Groups

NIS in billions

Value of equity holdings of all controlling shareholders

Market value of shares

Market value of debentures*

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24

* The market value of debentures includes corporate bonds, convertible debentures, debentures of private companies in the group and institutional trading. Additionally, it relates to direct and indirect holding in equity. The value of the issued and paid share capital was used as an estimate for debentures traded in the institutional trading system.

* Data in effect as of June 30, 2010.

21

The Securities Authority’s Economics Department

international comparison average control premium
International ComparisonAverage Control Premium

Source: Dyck and Zingales (2004)- Private Benefits Of Control: An International Comparison

22

international comparison number of layers
International Comparison – Number of Layers

Source: Masulis et al. 2011- Family Business Groups around the World: Financing Advantages, Control Motivations and Organizational Choices

23

the guiding principles for the committee s recommendations
The Guiding Principles for the Committee’s Recommendations
  • Strengthening the position of minority shareholders
  • Restricting the volumes of credit in the major groups
  • Reinforcing the authority of the Antitrust Commissioner

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principals of the recommendations
Principals of the Recommendations

Reinforcement of Regulation – Corporate Governance

  • Reinforcing the independence of the Board of Directors
  • Executive compensation
  • Transactions with interested parties
  • Strengthening the position of minority shareholders
  • Encouragement of individual enforcement by the shareholders
  • Encouragement of activism of institutional investors

25

principals of the recommendations cont
Principals of the Recommendations – cont.

Structural changes

  • Prohibition of the listing for trade of a duplicate activity
  • Restrictions on the creation of a new wedge company
  • Granting an “exit” right to shareholders in a company within a pyramid in the event that the controlling shareholder undermines an outside bid

Reducing leverage and the risks to the economy

  • Disallowing financing expenses (for tax purpose)
  • Restrictions on credit from institutional investors

Encouragement of competition

  • Broadening the authority of the Antitrust Commissioner

26

1 reinforcing the independence of the board of directors
1. Reinforcing the Independence of the Board of Directors

1.1 One third of the members of the Board of Directors will be outside directors

1.2 Outside directors will be approved by the minority shareholders rather than by the controlling shareholder

1.3 The appointment of a director in a subsidiary by the controlling shareholder will be subject to the approval of the Audit Committee

28

2 executive compensation
2. Executive Compensation

The Committee recommends the advancement of the amendment to the Companies Law concerning executive compensation, pursuant to the recommendations of the Neeman Committee, so that the granting of the compensation would be subject to the approval of the minority shareholders that are not related parties of the controlling shareholder

29

3 transactions with interested parties
3. Transactions with Interested Parties

3.1 Adopt or disclose with respect to the performance of a competitive procedure prior to the approval of a transaction with an interested party in the event of the sale of an asset, the receipt of operating services, the purchase of a shelf product or the receipt of a loan

3.2 Authorization and supervision by the Audit Committee of transactions that, although not “extraordinary”, are also not financially negligible

30

4 strengthening the position of the minority shareholders
4. Strengthening the Position of the Minority Shareholders

4.1 The following resolutions will require approval by the general meeting with a majority of the minority shareholders

  • Acquisition of a significant operation
  • Acquisition of a control core in another public company
  • Raising of capital or debt in a significant amount

4.2 Shareholders and debenture holders will be permitted to vote via the Internet

31

5 encouragement of individual enforcement by the shareholders
5. Encouragement of Individual Enforcement by the Shareholders

5.1 The Securities Authority will expand the financing of class actions and derivative claims

5.2 Arrangements will be determined with respect to the financing of class actions or derivative claims that are submitted by institutional investors

32

6 encouragement of activism of institutional investors
6. Encouragement of Activism of Institutional Investors

6.1 Institutional investors will be allowed to coordinate positions ahead of the general meeting

6.2 Institutional investors will be required to take into consideration the quality of the corporate governance when making an investment decision

6.3 The disclosure requirements that are applicable to the voting by institutional investors will be expanded

33

7 prohibition of the listing for trade of a duplicate activity
7. Prohibition of the Listing for Trade of a Duplicate Activity

7.1 Prohibition of the inclusion of a duplicate activity in the Stock Exchange indexes

7.2 Prohibition of the future issuance of a duplicate activity in a wedge company

When 70% of the operations come from B

A – holding company

B – operations company

34

8 restrictions on the creation of a new wedge company
Controlling shareholder8. Restrictions on the Creation of a New Wedge Company
  • Company D
  • Equity: 51%
  • Voting: 51%
  • Company C is interested in acquiring a controlcore in company D
  • As a result, company D becomes a wedgecompany
  • The acquiring company will be required tooffer to purchase all of the shares of theacquired company forthe price offered forthe control core

Bid

Public

51%

Public

51%

Public

51%

51%

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9 granting an exit right to shareholders
Bid9. Granting an “Exit” Right to Shareholders

Company C

  • Outside bid on company C for all the company’s shares at 10% over the market price
  • The controlling shareholder undermines the bid by refusing to accept it
  • Public shareholders in C are interested in the offer
  • The controlling shareholder would be required to accept the bid or tooffer to buy the minority sharesat the price of the bid

Public

51%

Public

51%

Public

51%

51%

10% premium

Exists at least 7 years

36

restricting the influence of the controlling shareholder over the general meeting
Controlling shareholderRestricting the influence of the controlling shareholder over the general meeting

Company A

Equity: 51%

Voting: 51%

Company B

Equity: 25%

Voting: 33% 51%

The Committee requests to receive the public’s comments on the proposal:

In a wedge company, each of the controlling shareholders will have effective voting rights at the general meeting that equal to:

The controlling shareholders’ equity interest

The controlling shareholders’ equity interest

+

Equity interests attributable to the other shareholders

51%

Public

51%

Public

Reduction of the controlling shareholders’ voting rights

37

slide39
10. Disallowing Financing Expenses

It is proposed that financing expenses will be initially allocated to dividend income (for tax purpose)

If the financing expenses exceed the dividend income – the difference will be added to the cost of shares for tax purposes

‘Controlling shareholders’

Debt + financing expenses

100%

Parent company

51%

Dividend

Subsidiary

39

11 restrictions on credit from institutional investors
11. Restrictions on Credit from institutional investors
  • The restrictions on the exposure of (financial) institutions to a single entity and a group of borrowers (similarly to the restrictions imposed by Banking Supervision) will be tightened
  • The team in charge of systemic risk, headed by the Bank of Israel, will allocate resources to the monitoring and handling of business groups based on the applicable indicators

40

12 broadening the authority of the antitrust commissioner
12. Broadening the Authority of the Antitrust Commissioner

12.1 The Antitrust Court will be authorized to enforce changes (structural remedies) in concentration groups

12.2 Imposition of administratively enforced sanctions

43

recommendations45
Recommendations

The functions that are in charge of the procedures for the allocation of State rights and assets (sale of assets to private entities, granting of concessions, licensing, BOT) will be required to also take into consideration the competition in the sector and the decentralization of control in essential infrastructures

Preventing the transfer of control in State infrastructure to the hands of few

45

assimilation of sector competition considerations
Assimilation of Sector Competition Considerations
  • A prerequisite for the allotment of rights will be to consult the Antitrust Commissioner whenever the value of the right or the asset is in excess of NIS 150 million or the economic value of the asset does not reflect its significance to the public

46

assimilation of concentration considerations in the control of essential infrastructures
Assimilation of Concentration Considerations in the Control of Essential Infrastructures
  • A prerequisite for the allotment of rights in essential infrastructures (as shall be defined by law) will be to consult an Advisory Committee whenever the value of the right or the asset is in excess of NIS 150 million or the economic value of the asset does not reflect its significance to the public
  • Members of the Advisory Committee: The Director General of the Ministry of Finance, the Antitrust Commissioner, the Assistant Attorney General (Economic-Fiscal), Head of the National Economic Council
  • Examples for areas of essential infrastructures: water, energy, communications, transportation, healthcare and natural resources

47

principal recommendations
Principal Recommendations
  • Separation of the holdings in a significant real operation and a significant financial operation
  • Separating the office of directors in real companies and in financial companies (significant)
  • Imposing stricter corporate governance and strengthening the position of the minority shareholders in pyramid-structured business groups
  • Changing the rules of the game of pyramidal expansion and of controlling existing companies
  • Reinforcement of the capacities of the Anti Trust Commissioner when treating concentration groups
  • Taking into account competition and centralization considerations in the allotment of rights by the State

48

significance of the overall recommendations of the committee
Significance of the Overall Recommendations of the Committee
  • More effective allocation of capital in the economy
  • Continued development of the Israeli capital market
  • Allotment of national resources with the overall economy in mind
  • Increasing competitiveness in the market
  • Reducing systemic risk

The full implementation of the recommendations will take place in stages and is expected to affect the economy in the medium and long term

49

timetable for implementation
Timetable for Implementation
  • Submission of a draft report for hearings and elaborate consulting with the public
    • The report will be submitted within three weeks
    • Hearings will be held over the course of the next two months
  • Submission of a final report for government approval
    • Within three months
  • Completion of legislation

50

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