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Supreme Court Rules Anti-Dilution Provisions are Limited

September 25, 2016

In HaAma Ltd. V. Orna Muller the Supreme Court recently ruled that an anti-dilution protection mechanism in a founder’s agreement was limited by nature.

The lawsuit deals with a founder’s agreement made between the shareholders (the Appellant and the Appellee) , and to which the newly founded company was not a party. In the founders agreement, an anti-dilution protection provision was included, that obligated Appelant (the majority holder) to provide the company with its ongoing capital needs (without dilution of the minority holder).

A few years later, the company’s directorate decided on an investment round to raise capital from investors of the company, in order to improve profitability and streamline its production of products. In return for investment of capital, the investors were to receive ordinary shares pro-rata to their investment an and independent company valuation. The Appellee sued claiming the decision forcing investment was contradictory to the anti-dilution provision in the founders agreement. The Appellant claimed that the anti-dilution provision was intended only to pertain to working capital, and is not relevant to investment in capital. The District Court found for the Appellee, ruling that had the parties wished to restrict the anti-dilution provision to specific conditions that should have been specified.

However, the Supreme Court, finding for the Appellant, overturned this decision.

In his decision, Justice Danziger outlines three models of anti-dilution protection: (1) the first model, described as the “high-road”, is incorporation of the anti-dilution provision in the Articles of Association. In most cases, this option would protect a shareholder in future rounds of investment; (2) the second model for anti-dilution protection is the insertion of an anti-dilution provision in a contract obligating the company and all shareholders; (3) the third model provides anti-dilution protection by is the ratification of an agreement by the company, effectively incorporating and ratifying the anti-dilution clause.

Justice Danziger points out that our case represents a fourth model, in which an agreement was made making provisions for anti-dilution, however, the company was not party to the agreement and it was not ratified retroactively by the company. Therefore, in this case, the company cannot be subjected to the founders’ agreement it was not party to, and that was not ratified later retroactively, despite the agreement being binding among its shareholders that are party to the agreement.

Justice Danziger made further ruling limiting the power of an anti-dilution provision, even in a case that the company itself was party to the agreement. Justice Danziger holds that protection afforded by an anti –dilution provision may be limited when such provision is conflict with the basics of corporate law or even with the good of the company.

In practical terms, this ruling indicates that in the context of anti-dilution protection, shareholders are actually obligated to act in good faith towards the company, which is the level of conduct that the law prescribes. Additionally, the majority shareholders are also required to act in good faith as well as act in the best interests of the company, even when their anti-dilution protection is at stake. Moreover, minority shareholders may also be obligated in these requirements, in special circumstances in which a shareholder is effectively the deal breaker-or-maker as a result of his anti-dilution protection. A shareholder attempting to use the protection afforded to him by an anti-dilution provision in order to sway the company, may be regarded as using an extortion strategy.

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