Credit Crunch / Your Big Fat Conflict of Interest

What do you do when you have a conflict of interest with yourself? That isn't a theoretical question. It's a practical one, even an urgent one, with serious implications for your pension savings.

The great global economic crisis, which is now celebrating its first birthday, has placed this question squarely on the map. That's because the crisis brought two of Israel's biggest companies, meaning, two companies listed on the TA-25 index of large-caps, to their knees. One is Israel Corporation, where the difficulty is indirect: its subsidiary Zim Integrated Shipping Services is having difficulty meeting its debts to bondholders. The other is the real estate giant Africa Israel.

Since Israel Corporation and Africa Israel are two of the most important companies in Israel, you naturally have invested some of your pension savings in them. If not directly, then through your provident fund, executive insurance policy or pension fund. Not only that, you're into both companies up to your neck. The people managing your savings bought shares and bonds of both companies on your behalf.

This is where your conflict of interest comes in. Regarding both companies, you're wearing two hats: creditor and shareholder. As creditor (you lent money when your pension fund bought Africa Israel or Israel Corporation bonds) you're demanding that the shareholders repay you. As shareholder, you don't want to pay the debt.

Don't expect Economics 101 to provide answers. There are none. The Israel Securities Authority issued exactly one directive, forbidding Bank Leumi, the biggest shareholder in Israel Corporation (and one of Zim's creditors) to vote at the shareholders' assembly addressing whether Israel Corporation should help Zim honor its debts.

The watchdog may mot have thought things through. Zim's bondholders are Israel's big institutional investors. They also own shares in the parent company Israel Corporation. By the same logic, none of them should have a say in Israel Corporation's help for Zim, which means nobody would be left to vote at the Israel Corporation shareholders assembly.

The institutional investors, bewildered by the Securities Authority's position, each resolved their knotty problem in a different way when the vote arrived. Some shrugged off the responsibility and handed the decision over to an independent third party.

Some voted based on their relative holdings in bonds or stock: The ones with more stock than bonds voted against helping Zim, and the ones with more bonds than stock voted in favor of assistance.

Some gave freedom to each of their provident funds. Psagot and Migdal, for instance, wound up with provident funds voting against each other. Kudos on fairness, but zero points for reaching an orderly decision.

When bonds collide

The case of Africa Israel, where no votes have been held yet, is even more complicated. That's because Africa Israel has 13 different series of bonds, and there are conflicts of interest between the different series, which are scattered among thousands upon thousands of holders.

How is an institutional investor to vote, if it owns shares in Africa Israel, long-term that the company admits it can't pay, and also short-term bonds (which it does have the money to honor)?

Capital market circles say the problem with Africa Israel is so complicated that it's basically impossible to reach a consensus arrangement. The courts will have to get involved, through a stay of proceedings, and will have to force a debt arrangement.

While the global economic crisis birthed problems worldwide, these seem to be unique to Israel. They have never arisen in this form before. There is no precedent. There is no global experience to draw on.

In the world, institutional investors do not generally suffer from internal conflicts of interest, because their diversification of holdings is tremendous. So if one particular fund found itself in a similar conflict, it simply wouldn't matter during votes on a debt arrangement. In Israel, there are exactly five big institutional investors, and all are now wracked with internal conflicts of interest.

The complexity of the issues makes one thing glaringly clear: the bond market completely mispriced risk.

The corporate bond market is far riskier than had been thought, and not because companies can collapse. They can, but the danger unforeseen is that after a company stumbles, no debt arrangement can be reached.

That risk, which is bureaucratic and legal in nature, does not increase the risk of bankruptcies, but it badly increases the risk that you won't get your money back after a company goes belly-up.