When a Convenient Deal Becomes a Fundraising Obstacle
An Israeli technology company engaged a cloud services vendor owned by a relative of one of its directors. The arrangement was commercially reasonable, the pricing was competitive, and both sides acted in good faith. The problem surfaced only during due diligence ahead of a funding round: no one had documented disclosure of the relationship, no one had approved the transaction through the required mechanism, and the investor demanded clarifications that delayed closing.
This scenario is common. Related party transactions are not improper in themselves, but Israeli law requires that they be conducted transparently and approved through the correct channel. The failure here was not the transaction itself, but the missing process around it. This article explains what constitutes a related party transaction, what the disclosure duty entails, and which approval tracks are required under the Israeli Companies Law, 5759-1999.
Who Qualifies as an 'Interested Party' and What Counts as a 'Personal Interest'
The Israeli Companies Law, 5759-1999, defines several key terms in Section 1 that every company should understand. An 'interested party' is a shareholder holding a material percentage of the company's share capital or voting rights, including anyone with the right to appoint a director or CEO. A 'controlling shareholder' is anyone with the ability to direct the company's activities, including through a holding that confers de facto control even if it falls short of an absolute majority.
An officer's 'personal interest' includes an interest arising from being a party to the transaction, as well as an interest stemming from family ties, an additional role, or an economic stake in another entity that is party to the deal. This definition is deliberately broad: it applies even when the officer is not the formal party to the transaction, but rather a family member or an entity under the officer's control.
Common Examples
- A company controlled by a founder that contracts for services with another company owned by that same founder
- A director who receives additional consulting compensation beyond standard director fees
- A transaction with a vendor owned by a relative of a material shareholder
The Officer's Duty of Disclosure
Section 269 of the Companies Law requires an officer to disclose to the company, without delay, any personal interest and its nature in connection with any existing or proposed transaction of the company. Disclosure must be made at the board meeting where the transaction is discussed, and must be recorded in the minutes. This duty derives from the fiduciary duty set out in Section 254 of the Law, under which an officer must act in good faith solely for the benefit of the company.
Partial disclosure, late disclosure, or disclosure that is not properly documented does not satisfy the statutory requirement, even if all parties were in fact aware of the relationship. The law requires formal documentation because it is what enables the board or the general meeting to make an informed decision, and allows the process to be reviewed after the fact.
Beyond the legal obligation, orderly disclosure is also a protective tool: it reduces the officer's personal exposure and significantly eases due diligence in funding rounds and M&A transactions.
Approval Tracks: From the Board to the General Meeting
The Companies Law sets out different approval tracks depending on the type of company and the nature of the transaction. In a private company, Sections 255-256 of the Law permit board approval of a transaction in which an officer has a personal interest, provided the articles of association do not state otherwise and the transaction is not an 'extraordinary transaction.' An extraordinary transaction is one that falls outside the ordinary course of business, is not on market terms, or may materially affect the company's profitability or assets.
In a public company, the bar is substantially higher. The provisions of Part Six of the Companies Law, which govern transactions involving officers and interested parties in public companies, require, depending on the type of transaction, a three-tier approval process: the audit committee, the board of directors, and in certain cases the general meeting as well. Transactions between officers and the company, and terms of office and employment for directors and the CEO, generally require approval by the compensation committee, the board, and the general meeting, in accordance with the provisions of the Law.
It is important to distinguish a one-time transaction from a continuing one: an ongoing extraordinary transaction with an interested party requires periodic re-examination of the approval, and cannot rely solely on a historical sign-off.
Transactions with a Controlling Shareholder: The Special Majority Requirement
Transactions with a controlling shareholder in a public company, or transactions in which the controlling shareholder has a personal interest, are subject to a stricter mechanism under Sections 270 and 275 of the Companies Law. In addition to audit committee and board approval, the general meeting must approve the transaction by a special majority: a majority of votes cast that also includes a majority of the votes of shareholders who have no personal interest in the transaction's approval and who participated in the vote.
This mechanism is designed to prevent a situation in which a controlling shareholder effectively approves a transaction that benefits themselves at the expense of public shareholders. Even when a company is not publicly traded, it is advisable to adopt similar principles where institutional investors or significant minority shareholders are involved, since a transparent approval mechanism substantially reduces the risk of shareholder disputes.
Many private companies, particularly those that have completed funding rounds, find themselves subject in practice to similar requirements under shareholder agreements, which mandate special approval by independent directors or by a specified percentage of investor holdings for related party transactions.
What Happens When a Transaction Is Not Properly Approved
A related party transaction that was not approved in accordance with the Companies Law may be voidable by the company, and the officer involved may bear personal liability for breach of fiduciary duty. Depending on the circumstances, a court may order the officer to disgorge any profit derived from the transaction, even if the transaction was commercially fair on its own terms.
Failure to comply with approval requirements can also jeopardize coverage under a directors and officers (D&O) liability insurance policy, since some policies carve out exceptions for knowing breaches of fiduciary duty. In addition, in M&A transactions or funding rounds, related party transactions that were not properly documented and approved constitute a red flag in due diligence, and can delay a deal or lead to price adjustments.
It is worth remembering that retroactive ratification, meaning belated approval of a transaction that has already been executed, is sometimes possible but does not fully cure the defect, and is no substitute for a proper disclosure and approval process conducted in advance.
How to Build an Effective Conflict-of-Interest Management Framework
Companies that manage this issue systematically save themselves time, risk, and headaches down the road. Several practical principles are worth implementing early on:
- Adopt a written conflict-of-interest policy that defines what constitutes a personal interest and when it must be reported
- Include a personal interest disclosure form that every director and officer signs at the start of their term and updates periodically
- Document every disclosure of personal interest in the board minutes, including the officer's recusal from discussion and voting where required
- Assess in advance, before signing a transaction with a related party, whether it qualifies as an extraordinary transaction requiring enhanced approval
- Consolidate all relevant approvals and agreements in one place, so they are readily available for future due diligence
As a company grows, adds institutional investors, or moves toward an IPO, it is worth considering the appointment of independent directors or a voluntary internal audit committee, even if the law does not yet require it at that stage. A transparent and consistent approval mechanism is not merely a technical requirement; it is a governance tool that protects the company, its officers, and its shareholders alike.
The information contained in this article is general in nature and does not constitute legal advice. For advice tailored to the specific circumstances of your company, we invite you to contact our firm.
