Israel’s Corporate Pyramid Problem Threatens to Get Uglier

As the Knesset prepares to vote limits on tiered corporate structures, the two bidders for the troubled IDB group are proposing the biggest pyramids Israel has ever seen.

As the Knesset readies the final stages of legislation to limit the phenomenon of business pyramids, a Tel Aviv court is being asked to approve the country's biggest pyramid ever: Nochi Dankner’s IDB group.

Two groups remain in the battle to take control and rescue the financially troubled conglomerate, but the structures being proposed are problematic, particularly given that IDB is already the country’s largest corporate pyramid.

A corporate pyramid lets a holding company at the top control companies lower down via relatively small holdings and invested capital. In IDB’s case, the group controls some of the most important businesses in the country like supermarket chain Super-Sol and cellular service provider Cellcom.

As things look now, the debt-settlement agreement for IDB, which must be approved by the Tel Aviv District Court, will include a grand maneuver to bypass legislation pending in the Knesset designed to limit the number of tiers in corporate pyramids. Unless everyone comes to their senses soon, IDB, the biggest pyramid of them all, will evade the new law.

The two groups vying for control of IDB are offering to put significant amounts of new capital into the group, but both plan to do it by imposing another pyramid of publicly traded and closely held companies on top of the existing one. That raises the question of whether the new pyramid involves leveraged finance. Put another way, how much of the capital will come from the controlling shareholders and how much from the small-fry investor who holds shares in the companies involved?

One of the two groups bidding for control, which includes Dankner himself and Ukrainian Jewish businessman Alexander Granovsky, is probably the more problematic one. That’s because Dankner and Granovsky are establishing a privately held company to control IDB. Since Dankner doesn’t have any cash to put into the new company, it will have to come from Granovsky.

As far as is known, Granovsky will provide the money through a three-tiered pyramid of publicly traded companies, including cash from high-tech firm Emblaze, which Granovsky controls. That means another pyramid and additional leveraged funding.

The other group, led by Argentine-Jewish businessman Eduardo Elsztain and Moti Ben-Moshe and his Xtra Holding, includes a series of publicly traded companies stacked on top of one another pyramid-style, at least on Elsztain’s side.

Distorting in the extreme

To Elsztain’s credit, his bid is apparently not leveraged like the Dankner-Granovsky. Elsztain has holdings in each of the companies on every tier of his pyramid. The proposed Elsztain-Ben-Moshe structure is not a leveraged pyramid in the classical sense, but there’s no way of knowing what the future holds.

The court’s decision on which group gets the nod isn’t limited to which puts more in money for the benefit of the IDB group’s creditors. The court and the creditors also need to take into consideration potential control and management incentives for the new owners. And these incentives could be distorting in the extreme.

Corporate pyramids encourage controlling shareholders to take dangerous risks because they’re risking only a small portion of their capital. Minority shareholders and bondholders are exposed to most of the risk. The multiplicity of companies also encourages the channeling of minority shareholders’ funds to the controlling shareholders through various transactions.

And in pyramids where the controlling shareholders’ control is leveraged, there is also the incentive to pay excessive dividends, which in turn creates risks for bondholders and can weaken the balance sheets of the companies at the bottom. A government committee headed by the justice minister at the time, Yaakov Neeman, examined the compensation of top executives at publicly traded companies. It found that pyramid companies tend to pay excessive compensation that have no relation to their financial performance.

The bottom line is that if the court accepts either of the groups’ offers for IDB, it will be taking the country’s biggest pyramid and magnifying the distortions even further. Putting a pyramid on top of the troubled IDB group is like earthquake-proofing Tel Aviv’s Shalom Tower by putting the Empire State Building on top of it.

Corporate pyramids are such a problem that the Neeman panel recommended that they be limited to two tiers of publicly traded companies. That’s precisely what a bill nearing the end of the legislative process proposes. The bill is set to be voted on by the Knesset Finance Committee on Monday and then move to second and third readings by the full parliament for final approval.

Time is short

As it’s currently drafted, this so-called business concentration bill will only take effect a year after it passes. Companies structured as pyramids exceeding the two-tier limit would have three to five years to meet the new rules, either by selling off layers or consolidating them by acquiring companies in the lower tiers.

But that prompts the question of what happens after the law is passed but before it takes effect. Can new pyramids of more than two tiers be created? At a Finance Committee hearing in May, MK Merav Michaeli (Labor) demanded that no new pyramids of this kind be created. Deputy Attorney General Avi Licht replied that the bill would have to be amended to provide such a restriction, and the Justice Ministry would draft such an amendment.

Eyal Gabai, the expert appointed by Tel Aviv District Court Judge Eitan Orenstein in the IDB case, realizes that time is short. If the business concentration bill passes before the IDB case is completed, the two proposals could prove problematic. That’s reflected in Gabai’s comments in a report to the court this month in which he indicated a preference of sorts for the Dankner-Granovsky bid.

He wrote that the bid provided “the highest degree of certainty that it will be carried out,” and noted that the only obstacles were a possible lack of approval by the antitrust commissioner and the pending economic concentration bill “if and to the extent that its provisions and period in which it comes into force apply” to the IDB deal.

Gabai also understands that the settlement proposal runs counter to the pending legislation. So why pursue it? Gabai doesn’t hide the risks inherent in both proposals, and regarding the Dankner-Granovsky option, he acknowledges that the company would “continue to be managed as a leveraged pyramid, revenues from which would be based on a dividend stream and thereby present risks to creditors.”

Meanwhile, Gabai notes the leveraging in the Elsztain proposal, but said it’s not clear what the final leveraging will be. The Elsztain group’s proposal is liable to become a substitute pyramid and present its own risks, he added.

In any case, Judge Orenstein should move the case in a different direction. The pending legislation in the Knesset justifies such a switch.

Months ago in the IDB case, there was little certainty that the legislative process would proceed as it has on the economic concentration bill. But now, as the bill nears passage, the situation merits a rethink of the rescue plans for IDB.

What should the court do? It’s simple. It should start over and look for a buyer that won’t build a pyramid on top of the existing one.

AP