The Israeli Companies Law provides for two tests a company’s board of directors must perform to approve a resolution to distribute dividends. The first test is the “profit test” and the second is the “solvency test.”

The profit test is a retroactive technical test that examines a company’s accumulated profits (in the aggregate or over the last two years) based on the company’s most recent financial statements.  The profit test is a retroactive technical examination. It assesses a company’s accumulated profits (in the aggregate or over the last two years) based on the company’s most recent financial statements. The solvency test is an active forward-looking assessment that obliges the board of directors to determine whether there is a reasonable concern that a distribution might hinder the company’s ability to fulfill its current and future liabilities.

According to the Companies Law, in certain circumstances, a court may allow the distribution of dividends even if the company does not meet the profit test, provided it does meet the solvency test. There is no mechanism allowing the court to approve a distribution of dividends in the event a company does not meet the profit test.  

New Ruling – Brot v. Discount Investment

The Israeli Supreme Court recently issued a new ruling on the subject of profit tests in Brot v. Discount Investment Corporation Ltd. This ruling increases the board of directors’ certainty when performing the profit test, and clarifies the court’s ruling in the previous Lahav case.

The ruling in the Lahav case states that if developments occur in a company before its board passes a dividend distribution resolution, and these developments significantly change the company’s accounting position from the date of publication of the financial statements forming the basis of the distribution resolution, the board must consider the updated information during the profit test. This includes information from financial statements that have not been signed yet.

In the case at bar, Discount’s board of directors resolved to distribute profits to the company’s shareholders in January 2019. The aggregate amount was NIS 100 million. The distribution was based on the company’s financial statements published in the third quarter of 2018, which provided the company’s profits were sufficient to distribute the dividend.

Prior to said resolution, further information was made available to Discount’s board of directors, according to which the company was to expect losses in the fourth quarter, which would result in the company not being able to meet the profit test. In addition to the information provided with respect to fourth-quarter losses, the board also received information regarding the company’s expected profits in later quarters. Based on the latter information, the board resolved the company met the profit test and decided to distribute dividends.

Following the resolution approving the dividend distribution, Brot, a security holder in Discount, submitted a request for the certification of a derivative claim against Discount and its officers for the unlawful distribution of dividends. Brot claimed that Discount’s board had an obligation to act in accordance with the ruling in the Lahav case and to consider the expected losses in the fourth quarter, which would have prevented the distribution of dividends.

Distribution of dividends

The economic department at the District Court in Tel Aviv – Jaffa made a distinction between the circumstances in the Lahav case and the circumstances in the Discount case. It ruled the resolution to distribute dividends was lawful, since a future period in which the company may expect losses, in itself, does not constitute a material event, and the board does not need to consider it to determine if the company meets the profit test.

Brot appealed to the Supreme Court. The Supreme Court dismissed the appeal and, as part of its ruling, sought to clarify the proper interpretation of the profit test. Ultimately, the Supreme Court ruled not to expand the profit test as set forth in the Lahav case.

The Supreme Court clarified that the legislature included a precise and clear definition of the profit test in the Companies Law. Such test specifically details the calculation methods of the amounts available for distribution (aggregate profits or profits for the last two years), and the date that should form the basis for such calculation (i.e., an audited or reviewed financial statement for the period ending no earlier than six months prior to the board resolution approving the distribution).

The Profit Test

The Supreme Court further clarified that the profit test is a secondary test that is backward-looking, technical in nature, based on precise numerical figures as set forth in the company’s latest financial statement, and presumably easy to implement. The profit test does not require the board of directors to analyze information or exercise its discretion, and the Supreme Court has determined that deviating from this language is not possible.

The solvency test, on the other hand, is a forward-looking test that requires discretion, judgment, and analysis of information to foresee the company’s ability to pay its existing and expected liabilities. The Supreme Court emphasized that as part of a board of directors’ duty of care and fiduciary duty, it is required to examine material events that are likely to affect the company’s profitability, even if such events are not reflected in the published financial statements, within the framework of the solvency test.

Fiduciary Duty

To conclude, according to the Supreme Court’s ruling in the Discount case, the profit test is a technical one. The profit test should not include information contained in financial statements not yet signed or any information not reflected in the company’s latest financial statements. When determining if the company meets the profit test, the board of directors does not need to consider future developments that may affect the company, even if such developments are known. Material events not reflected in the company’s audited financial statements and that are expected to affect the company’s profitability should be examined within the framework of the solvency test, all in accordance with the board’s fiduciary duty and duty of care.

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