Dangerous Shoals Ahead

Prof. Lucien Bebchuk doesn't mince his words: In contrast to the tycoons' spin, Israel has a grave problem with economic concentration that constitutes a real danger to economic stability.

The members of the Committee on Enhancing Competitiveness had no choice; and neither do the prime minister, the finance minister and the members of various Knesset committees. They must, willy-nilly, crack down. They must find ways to reduce economic concentration - the domination of the economy by a handful of powerful business entities.

The committee's draft report, which the Finance Ministry published right before Rosh Hashanah, seems divided into two parts. The first part lists the findings, which are grave and extreme. It discusses the feebleness of competition, the peril to the public's savings, the danger to financial stability in Israel. This part was written by economists working at the Finance Ministry, the Bank of Israel, the Justice Ministry, the Antitrust Authority and the Israel Securities Authority.

Their position papers shatter the myth forged by tycoons who benefit from the status quo. Abetted by tame academics, regulators and journalists, they have argued that competition is alive and well, that Israel has no problem of economic concentration, that pyramidal corporate structures are perfectly legitimate, and that the big business groups make a contribution to the Israeli economy.

Yet in that first part of the concentration committee draft report, the economists reach other conclusions entirely. They conclude that Israel has the worst concentration in the OECD; they conclude that allowing tycoons to own both finance companies and non-finance companies (such as industry and retail ) is dangerous; and they conclude that the pyramids constitute a danger to Israel's financial stability, to investors and to competition.

They conclude that economic concentration in Israel has been developing at a frightening speed, that the big business groups are gobbling an ever-growing share of profit in Israel, and that they are causing wage gaps to widen.

They conclude that the "market mechanism" doesn't work.

The second part of the report contains recommendations on how to reverse the process and defang economic concentration. This part was written by the committee members themselves. The recommendations seem limp and pussy-footing. The crushing pressure exerted on the committee members by the "concentration club" is palpable in this feeble chapter.

It is hard to bridge - not that one needs to - between the gravity of the findings on economic concentration in Israel and its dangers, between the need to protect the public's pension savings and democracy, and the caution characterizing the recommendations.

Yet the lie has been exposed. The state of competition in the Israeli economy is bad. The public will not accept and should not accept tentative, diffident economic policy.

We have a historic opportunity to tear down the capital market, and the business sector, and to rebuild them to serve the economy, the people and the savers - and not a clique of perhaps 1,000 people.

Especially gripping was the opinion by Lucien Arye Bebchuk, professor of economics and law at Harvard University, who advised the committee. Bebchuk, an expert of international renown on corporate governance, wrote a draft opinion two weeks ago in which he related to most of the burning issues of the day.

His language is clear and cutting. Unlike the political mealy-mouthed evasions we usually hear, he submitted a historic paper that could ignite the revolution.

Bebchuk doesn't need the perks that tycoons can lavish on those they hold precious. In his "Interim Expert Report", he wrote things as he sees them. He painted the ugly face of economic concentration in Israel as it is. Here are some of the things he wrote:

• "The Israeli economy is characterized by the significant presence of large business groups and a high degree of concentration in the economy. The pyramidal structure of some of these groups enables their controllers to control assets to a much greater extent than the controller's own capital would otherwise allow, thereby facilitating the existence of large business groups."

• "The use of a pyramidal structure enables an individual or a family to maintain control of an entity while owning only a minority, and sometimes a small minority, of the equity capital. The combination of a lock on control and ownership of a small fraction of cash flow rights can be expected to produce significant distortions in the controller's decision-making, producing 'agency costs' that adversely affect the interests of public investors in the group." [By 'agency costs,' Bebchuk means inflated salaries, insider transactions that do the company no good but the controlling shareholders plenty of good, that sort of thing ).

• "A controller that owns a small percentage of cash flow rights can expect to bear only a small fraction of the effects of decisions on the group's equity capital. Consequently, the controller may favor a course of action that would serve the controller's private interests even if such course of action would adversely affect the value of the equity capital of the group."

• "Pyramidal groups therefore raise serious concerns about agency problems, even from a 'static' perspective - that is, taking as given and fixed the scale of assets under the pyramid's control. However, as I stressed to the Committee, it is also important to pay close attention to the effects of 'dynamic' distortions in choices made over time [by the tycoons] with respect to the size and scope of pyramidal groups."

• "When the set of assets under the control of a pyramidal group expands, the [tycoon] will benefit from a larger level of private benefits of control, but will bear only a fraction of the effects of the expansion on the value of cash flow rights."

• "As a result, the controllers of corporate pyramids have an excessive incentive to expand (for instance, by adding additional layers lower in the pyramid ladder ) or to avoid contracting the pyramid's scope (for instance, by spinning off or selling one of the group's firms and distributing the firm's value to its shareholders )."

• "This distortion can be expected to be especially severe when the controller's fraction of cash flow rights is small."

Negative shock

• "In addition to the significant presence of pyramidal structures, the Israeli economy is also characterized by links among financial and nonfinancial firms. The control of financial firms by major non-financial groups raises concerns that capital may flow to major business groups in excessive amounts or on excessively favorable terms."

• "In addition to analyzing the adverse effects that existing structures in the Israeli economy have on the efficient operation of pyramidal non-financial groups and financial firms controlled by non-financial groups, [Bebchuk's] Final Expert Report will also consider the adverse effects of such structures on the broader Israeli economy."

• "The significant presence of pyramidal groups, and the links between financial and non-financial firms, can be expected to have adverse effects on the allocation of capital in the economy, as well as on the level of competition in various economic markets."

• "The significant presence of large pyramidal groups in the Israeli economy creates significant systemic risks. Some of the pyramidal groups are highly leveraged, and both the ratings and market pricing of their bonds reflect a significant perceived likelihood of financial distress or even insolvency."

Magnified distress

• "While the choice of the appropriate level of debt in private firms is generally best left to private choices in the marketplace, the substantial level of debt in Israel's large business groups deserves the attention of policymakers."

• "While the insolvency or financial distress of a small firm largely affects only the shareholders and creditors of that firm, the insolvency or financial distress of one of Israel's large business groups can be expected to have significant spill-over effects across the economy."

• "Because of investment by pension funds, provident and mutual funds and insurance companies in securities issued by the big business groups," explains the professor. "The economy-wide effects of financial distress in one or more of Israel's pyramidal groups can be expected to be substantially magnified. Because of these investment practices, financial distress or insolvency in one or more of Israel's large groups would also result in a significant negative shock in the value of the population's retirement savings."

• "In my opinion, Israeli policymakers should be concerned about the likelihood of persistence of corporate pyramids that results from the excessive incentives of the controllers of corporate pyramids against allowing the enterprises under their control to contract in size, even when doing so would be value-enhancing."

Bebchuk goes on to propose a number of legislative amendments, some radical, that would strengthen the management boards of pyramidal companies, strengthen their audit committees, change mechanisms for approving executive pay, constrain the empire-building aspirations of the tycoons, allow hostile takeovers of companies inside pyramid groups, and restrict the degree to which tycoons control companies lower down in the pyramid, to the extent of their actual holdings.

Among other things, Bebchuk proposes that when a tycoon wants to expand, he must obtain a majority vote from the minority shareholders, since there is a danger that his expansionary dreams will destroy value.

Bebchuk's opinions and the far-reaching analyses by the research departments of the Bank of Israel and Finance Ministry are appended to the draft recommendations of the economic concentration committee, which appears on the Finance Ministry website (Hebrew, for the most part ). His opinions are a stinging slap on the cheek for the not-small club of people denying the existence of economic concentration in Israel. They also constitute a platform for the economic concentration committee to expand its handling of its own findings.

If the economic concentration committee itself cannot expand and strengthen its recommendations before filing the final report, the political echelon - and then the various operational authorities, including the Bank of Israel, the Finance Ministry, the Antitrust Authority and the Israel Securities Authority - will have to do the job themselves.