EL AL ISRAEL AIRLINES LTD.

Transcription

1 EL AL ISRAEL AIRLINES LTD ANNUAL REPORT CHAPTER A - OVERVIEW OF THE ENTITY'S BUSINESS CHAPTER B - DIRECTORS' REPORT CHAPTER C FINANCIAL STATEMENTS

2 2011 ANNUAL REPORT CHAPTER A OVERVIEW OF THE ENTITY'S BUSINESS

3 El Al Israel Airlines Ltd 2011 Periodic Report Chapter A Description of the Corporation s Business

4 Table of Contents Chapter 1: General 4 Chapter 2: Description Of The General Development Of The Corporation s Business 7 1. THE CORPORATION S ACTIVITY AND DESCRIPTION OF THE DEVELOPMENT OF ITS BUSINESS General Holdings Chart Year and Form of Incorporation Changes in the Corporation s Business FIELDS OF ACTIVITY INVESTMENTS IN THE CORPORATION S CAPITAL General Options Shares Held by Company Employees Changes in Holdings of Interested Parties Table Summarizing Data on Interested Party Holdings and Capital DISTRIBUTIONS OF DIVIDENDS FINANCIAL INFORMATION REGARDING THE CORPORATION S AREAS OF ACTIVITY Nature of the Adjustments Explanation of Developments Occurring in the Areas of Activity GENERAL ENVIRONMENT AND IMPACT OF EXTERNAL FACTORS ON THE COMPANY Traffic in the International Aviation Industry Movement in the Israeli Aviation Industry Fluctuations in Jet Fuel Prices Foreign Currency Rate Fluctuations Interest Rate Fluctuations Chapter 3: Description Of The Corporation s Business By Area Of Activity PASSENGER AIRCRAFT ACTIVITY General Information on the Area of Activity Services in the Area of Activity Analysis of Revenues and Profitability from Services New Services Customers Marketing and Distribution Accumulated Orders Competition Seasonal Factors Manufacturing Capabilities a - 2

5 7.11 Aircraft Fleet CARGO AIRCRAFT FIELD General Information on the Area of Activity Services in the Area of Activity Analysis of Revenues and Profitability from Services New Services Customers, Marketing and Distribution Accumulated Orders Competition Seasonal Factors Manufacturing Capabilities Aircraft Fleet Raw Materials and Suppliers INFORMATION ON BOTH FIELDS OF ACTIVITY Fixed Assets and Installations Insurance Intangible Assets Human Capital Raw Materials and Suppliers Working Capital Investments Finance Taxation Environmental Issues and Corporate Responsibility Restrictions and Supervision of the Corporation s Business Material Agreements Cooperation Agreements Legal Proceedings Goals and Business Strategy Projected Developments in the Coming Year Financial Data on Segment-Based Reporting Discussion of Risk Factors a - 3

6 CHAPTER 1: GENERAL El Al Israel Airlines Ltd. is pleased to present a description of the Corporation s business for the fiscal year ending December 31, 2011, surveying the Corporation in general and the development of its business, as they occurred during The report was prepared in accordance with the Securities Regulations (Periodic and Immediate Reports), The financial data included in the report is in U.S. dollars, unless stated otherwise. The financial data relating to monetary claims are in Israeli shekels ( NIS ) as of the date that the claim was filed, unless stated otherwise. The percentages of ownership are presented in numbers rounded out to the nearest whole percent, unless stated otherwise. Data appearing in this report are correct as of the reported date, unless stated otherwise. Data appearing in this report as correct as of a date close to the approval of the report, have been updated to March 12, 2012, unless stated otherwise. The importance of the data included in this Periodic Report, including the description of material transactions, has been assessed from the Company s point of view, while in some cases, additional descriptive information is given in order to provide a comprehensive review of the matter being described. This chapter, which deals with a description of the Group, its development, businesses and fields of activity, also includes forward-looking information, as defined in the Securities Law, forwardlooking information is information that is uncertain as to the future, based principally on existing Company information on the reporting date and includes estimates, assumptions or intentions of the Company, as of the report date, as well as estimates and forecasts of third parties, which might not be realized or only partially realized. Therefore, actual results, in full or in part, could be significantly different, positively or negatively, from the results estimated, derived or implied from this information. In certain cases, segments featuring forward-looking information may be identified by the presence of words such as we estimate, we mean, we believe, we predict and so on, but this information may also appear with different wording. Glossary For the sake of convenience, in this periodic report, the following abbreviations shall be assigned the meaning listed alongside them: Report of the Board of Directors - USD/Dollar - The Report of the Board of Directors on the State of Corporate Affairs for the Year Ending December U.S. dollar. a - 4

7 The Stock Exchange - The Financial Statements - The State - The Group - The Authority - The Corporation or the Company or El Al - Fifth Freedom - Sixth Freedom - The Tel Aviv Stock Exchange Ltd. The Company s Consolidated Financial Statements for the year ending December , unless noted otherwise. The State of Israel. The Company and its subsidiaries The Securities Authority. El Al Israel Airlines Ltd. Transporting passengers or cargo between two foreign countries by a third country carrier. For instance, El Al transports cargo between Liege and New York. Transporting passengers or cargo between two foreign countries with a stopover in the airborne carrier s country. For instance, a flight by a European airline from Israel to the U.S. through an airport located in that airline s European country. The Companies Law - The Companies Law, The Government Companies Law - The Government Companies Law, The Securities Law - The Securities Law, IATA - The International Air Transport Association The Report Date - December K nafaim - Date immediately prior to the approval of the report - Sun D Or - K nafaim Holdings Ltd. March , unless noted otherwise. Sun D Or International Airlines Ltd. Income Tax Order - The Income Tax Ordinance (New Version), NIS- New Israeli Shekel a - 5

8 The Reported Year Prospectus - The prospectus published May , as revised on June and June The Shelf Prospectus - ASK - ATK - RPK - RTK - FTK- PLF - The shelf prospectus published by the Company on May , which expired May Available Seat Kilometer number of seats offered for sale multiplied by the distance flown. Available Ton Kilometer - the available capacity for transport of passengers (translated into tonnage) and cargo multiplied by the distance flown. Revenue Ton Kilometer - the number of paying passengers multiplied by the distance flown. Revenue Passenger Kilometer - the weight of passengers and cargo multiplied by the distance flown. Freight Ton Kilometer the weight in tons of paid cargo (including mail) multiplied by the distance flown Passenger Load Factor the occupancy rate in passenger flights (percentage of seats used). a - 6

9 CHAPTER 2: DESCRIPTION OF THE GENERAL DEVELOPMENT OF THE CORPORATION S BUSINESS 1. The Corporation s Activity and Description of the Development of its Business 1.1 General The Group is engaged primarily in the air transport of passengers and cargo (including baggage and mail) in Israel and abroad, by means of passenger aircraft and cargo aircraft. The Company's passenger aircraft perform scheduled flights as well as charter flights. The Company serves as the designated air carrier of the State of Israel on most of the international routes operating to and from Israel. See Section 7.1.1, 7.1.2, and below for more on this subject and on the meaning of the term Designated Carrier, and on the Government's decision regarding "Open Skies". The Group is engaged in activities auxiliary to its air transport activity, such as sale of duty-free products, production and supply of food primarily to its aircraft, and in the leasing of aircraft, providing security services, regular maintenance and overhaul services to aircraft of other airlines at Ben-Gurion Airport ( BGN ) and management of travel agencies abroad. The business environment in which the Company operates is the international and domestic civil aviation sector and tourism to and from Israel, which are characterized by seasonal fluctuations and a high level of competition, which becomes more severe during periods of excess capacity. In the area of passenger transport, in 2011 the Company competed with two Israeli airlines (Arkia and Israir), 60 foreign airlines operating scheduled flights, and over 50 foreign charter companies, 34 of which operated regular flights. The airlines compete in various areas, principally: fares, frequency and flight times, operational punctuality, equipment type, airplane configuration, passenger service, etc. The competition is with airlines that maintain scheduled flights between different destinations, charter flights between those destinations and/or Sixth Freedom Flights (regular flights via stopover destinations in the mother country of those companies). In the field of cargo transport, in 2011 the Company competed with six airlines operating cargo planes in flights to and from BGN, in addition to C.A.L. Cargo Airlines Ltd. Additionally, the Group competes with most of the scheduled airlines that operate passenger airplanes and transport cargo in their holds. See Sections 7.8 and 8.7 below for more on competition. a - 7

10 1.2 Holdings Chart The reported year saw a change in the structure of the Company s holdings in light of an increase in the purchase of holdings in Maman Cargo Terminals and Handling Ltd. (for details see 9.12 below). The following is a chart of the structure of the Company s holdings in investees active as of the date immediately prior to the approval of the report (the percentages listed in the chart show the Company s holdings in the investee companies): El Al Israel Airlines Ltd. Sun Dor 100% TAMAM 100% Katit 100% Superstar Holidays (Britain) 100% Bornstein Caterers USA 100% 50% ACI Tour Air Airtour 50% Kavei Chufsha 20% Maman Cargo Terminals and Handeling Ltd. 15% a - 8

11 1.3 Year and Form of Incorporation El Al Israel Airlines Ltd was incorporated as a limited liability company on November 15, 1948 under the name of El-Al Israel Airlines Ltd., changing its name to its present name on May 16, Changes in the Corporation s Business Until June 6, 2004, the Company was a Government Corporation in a process of privatization (as these terms are defined in the Government Corporations Law). See Section 9.11 below, restrictions and regulation of the corporation s business, for additional details. In the context of the procedures for the privatization of the Company, on May 30, 2003, the Company and the State published the 2003 Prospectus, by means of which Company shares and options exercisable into Company shares were issued and sold. Within the framework of the 2003 Prospectus, the State also offered to sell shares and options to purchase shares from two series call options (Series A) and call options (Series B). On the prospectus issue date, the State of Israel held approximately 97.25% of the Company s issued capital. Immediately after issuing the securities pursuant to the prospectus, the State's holdings in the Company dropped to 85% of the Company's issued share capital (undiluted). On June 6, 2004, following the exercise of options by K'nafaim and others, the State s holdings in the Company decreased to below 50%. Therefore, the Company was converted from a Government Corporation to a Mixed Company, as the meaning of this term is defined in the Government Corporations Law. Following the exercise of further options on December 23, 2004, the holdings of K nafaim rose to approximately 40% of the Company s issued share capital. On January 6, 2005, the majority of the members of the Board of Directors were replaced when the meeting of the Company s shareholders, convened at the request of K nafaim, decided to appoint new board members. At the same time, the State announced the end of the term of all directors who were not public directors, who had been serving as of that date on the Company s Board of Directors. Close to the date of approval of the report, there are 14 members serving on the Company's Board of Directors (including two public directors). a - 9

12 As K nafaim holds Company shares at a rate exceeding that held by the State, the special provisions detailed in Section 108 of the Company s Articles of Association ceased to apply. See Section (k) below for additional details. To the best of the Company's knowledge, the State holds 1.1% of the Company s issued share capital, and therefore, the Company still has a "mixed company status. Likewise, the State holds a Special State Share (for information on the Special State Share and its related rights, see Section below). 2. Fields of Activity The Group s headquarters functions on an integrated basis in the fields of activity listed below, including financial management, procurement, human resources, legal counseling, IT, security, maintenance and engineering, sales, customer service, marketing and advertising, aerial and ground operations and construction. The Group has two reported operating segments. See Note 37 to the December Financial Statements for further details. a. Air Transport in Passenger Aircraft In this area, the Group transports passengers as well as cargo (including mail and baggage) in the holds of passenger aircraft, as well as providing auxiliary services, such as sale of duty free products and passenger aircraft leasing. Revenues from this area of activity constituted 89.6% of all of the Group s revenues in b. Air Transport in Cargo Aircraft In this area, the Group transports cargo in a designated cargo transport plane as well as providing auxiliary services, such as leasing cargo aircraft. Revenues from this area of activity constituted 4.9% of all of the Group s revenues in Starting June 2011 the Company operates a single leased Boeing cargo airplane. Other than the fields of activity detailed above, the Group conducts additional activities that are not included in these fields, which are not material to the Group s operations 1 and with total revenues from them constituting 5.5% of total Group revenues for The production and supply of meals for flight passengers, provision of security services, regular maintenance services and overhaul services to aircraft of other companies at BGN and management of travel agencies abroad. a - 10

13 3. Investments in the Corporation s capital 3.1 General In January 2011 an additional batch of 3.75% of the shares of Maman Cargo Terminals and Handling Ltd. (hereinafter: Maman ) were received, for no compensation, by virtue of the framework agreement between the Company and Maman. In January 2012 an additional batch of 3.75% of the shares of Maman were received, for no compensation, by virtue of the framework agreement in question, and on a date immediately prior to the approval of this report the Company holds 15% of Mamman's stock capital, in addition to options. For details see 8.2 below. 3.2 Options On February 26, 2006, the Company's Board of Directors resolved to adopt the 2006 Option Plan for Company employees and executives (hereinafter: the 2006 Options Plan ), in which 17,092,129 options were allocated to 50 recipients, 10 of whom were senior Company executives and 40 other Company managers. On May 23, 2006, the Company's Board of Directors decided to add 3,000,000 options to the pool of options for issuance pursuant to the 2006 Options Plan. In addition, the Board of Directors appointed the Human Resources and Appointments Committee of the Company's Board of Directors ( the Remuneration Committee ) as the administrator of the 2006 Options Program and authorized the Remuneration Committee to grant options to Company executives in accordance with the guidelines stipulated by the Board of Directors and subject to the law. In addition, the Board of Directors approved the publication of an outline that was published on May 29, Following that, on December 27, 2006, the Remunerations Committee decided to grant 3,072,536 options to nine Company executives (two of whom are officers), which were granted in practice on December 31, On November 20, 2007, the Company's Board of Directors resolved to publish an outline (which was published on November 21, 2007) for the issue of options, which returned to the pool of options that can be allotted pursuant to the terms of the 2006 Options Program, from the original quantity detailed in the outline from February 26, 2006 and as amended on March 15, 2006 and/or from the additional quantity detailed in the outline from May 29, 2006, totaling 3,382,843 options (hereafter: the 2007 Options Plan"). Likewise, the Board of Directors approved the allotment of 2,195,852 options to 6 offerees (including one officer), subject to the obtainment of the requisite approvals. The allocation in question took place on December a - 11

14 As of March , the total amount of options issued under the 2006 and 2007 Options Plans (as described above) after deducting the options returned to the pool for any reason, in accordance with the terms of the plan, including following the expiry of options following their failure to be exercised in time, equals 3,552,478 options. On April , the Company s Audit Committee and Board of Directors approved a private allocation of 4,650,000 options to the Chairman of the Board of Directors, Mr. Amikam Cohen. The option allocation and the terms of the employment of the Chairman of the Board were approved in the general meeting of the Company s shareholders, on June On January the Company s Audit Committee and Board of Directors approved a private allocation of 9,914,382 options to the Company's CEO, Mr. Eliezer Shekedi. For details regarding the terms of the options to the Company s Board of Directors and CEO, see Note 30.g.3 and 30.g.4 to the December Financial Statements. In 2011, the Company listed a benefit value of $290,000 for these option plans in question, as salary expenses listed against capital reserves, based on benefit value calculations carried out using economic models. 3.3 Shares Held by Company Employees Pursuant to the 2003 Prospectus, the State granted Eligible Employees (as defined in the 2003 Prospectus) the right to purchase 34,685,642 Company shares owned by the State (hereinafter: the Employees Shares ). The Employees Shares were offered to the Eligible Employees at 0.91 NIS per share. The Eligible Employees purchased 0.5% of the issued share capital of the Company in the framework of the tender offer (approximately 0.4% fully diluted). The State has also committed to sell to an employees' association, or to employees as individuals, the remaining Employees Shares not purchased by Eligible Employees ( the Remaining State Shares ), at the lower of two prices: 30% of the average closing price of the Company s shares on the stock exchange during the 90 trading days preceding the exercise date or 30% of a total of 1.30 NIS per share. On February 23, 2005, the employees association (Holdings in Trust for El-Al Employees Ltd.) acquired all of the remaining State shares (32,527,216 ordinary shares), at 0.39 NIS per share. As of December , the employees' association held 29,453,119 ordinary shares, representing 5.94% of the Company's issued share capital (5.711% fully diluted). As of March , the employees' association held 29,453,119 ordinary shares, representing a - 12

15 5.94% of the Company's issued share capital (5.73% fully diluted). Various restrictions apply to the sale of the shares that are held by the employees association Changes in Holdings of Interested Parties As of December 31, 2011, K nafaim held approximately 39.33% of the Company's issued capital and 37.78% of the Company s issued capital on a fully diluted basis. As of March 12, 2012, K nafaim held approximately 39.33% of the Company's issued capital, and 37.94% of the Company s issued capital on a fully diluted basis. The assumptions for the calculation of the percentages of ownership of capital and voting rights on a fully-diluted basis (above and hereafter: Full Dilution ) are the exercise of all the executives' options under the 2006 and 2007 Options Plans, including the options granted the Chairman of the Board of Directors, Mr. Amikam Cohen and the Company CEO, Mr. Eliezer Shekedi, as detailed in 3.2 above. Presented below are details of transactions with respect to interested party holdings that were executed over the past 2 years: On April Levim Assets Ltd. (hereinafter: Levim Assets ), a company owned and controlled by Yehuda (Yudi) Levi (Deputy Chairman of the Company s Board of Directors and controlling shareholder) and his wife, announced that it had become a Company interested party, by virtue of its holdings, as a result of the purchase of 500,000 shares on the stock exchange. On June Levim Assets Ltd. ceased being an interested party in the Company by virtue of its holdings, as a result of the sale of the entirety of its shares to A.L. Aviation Assets Ltd. ( Aviation Assets ), which is an interested party in the Company. Aviation Assets Ltd. is held in equal portions by Levim Assets and by Miella Venture Partners, a company fully owned by a foreign trust, the beneficiaries of which are members of 2 The following restrictions apply to the shares held by the employees association (in addition to the provisions of the tax code): (a) No transaction or proceeding will be made in the shares and no power of attorney or transfer document will be conferred for a period of 24 months from the date the purchase was completed; (b) At the end of the aforementioned blockage period, the remaining shares will not be marketable and/or realizable, pledged and/or used as collateral in any manner, except by the employees association within the context of the bylaws of the employees association and/or after their release to the employee, as specified in the bylaws of the employees association. (c) In accordance with the bylaws of the employees association, the employees of the Company and the subsidiaries have the right to sell the Company shares held for them by the association at the end of the blockage period, should any of the following occur: (1) with their retirement from work and the termination of the employee-employer relationship between them by their employer, in accordance with the bylaws of the employees association; (2) under other circumstances that are itemized in the bylaws of the employees association, such as a sale between Company employees, or upon the occurrence of exceptional personal circumstances; (3) in each year, starting from the end of five years, the beginning of which is after the period of blockage within the framework of the prospectus has concluded, up to 20% of the shares held for him by the employees Company, in a manner so that by the end of the tenth year, they may sell all of their shares. a - 13

16 the Effi Arzi family. As of December 31, 2011, Aviation Assets held 2.11% of the issued capital of the Company, and 2.03% of the Company s issued capital on a fully diluted basis. As of March , Aviation Assets held 10,481,769 shares, which constitute 2.11% of the Company's issued and paid-up capital and 2.04% of the Company's issued capital on a fully diluted basis. In July 2009 Phoenix Holdings Ltd. (hereinafter: "Phoenix Holdings") informed the Company that it had become a Company interested party due to accumulating holdings of Phoenix Group companies (hereinafter: "the Phoenix Group"), including the Delek Group Ltd. (hereinafter: "the Delek Group") and Excellence Investments Ltd. (hereinafter: Excellence Investments ) 3. As of December Phoenix Holdings held 4.34% of the Company's issued capital and 4.17% of the Company's fully diluted issued capital. As of March Phoenix Holdings held 23,260,877 shares constituting 4.69% of the Company s issued capital and 4.53% of the Company's fully diluted issued capital. Phoenix Holdings holds Company shares through a nostro account, participating in insurance as well as provident funds and provident fund management companies. As of December the Delek Group held 3.60% of the Company s issued capital and 3.46% of the Company's fully diluted issued capital. As of March the Delek Group held 17,868,380 shares, constituting 3.60% of the Company's undiluted issued capital and 3.48% of the Company's fully diluted issued capital. As of December Excellence Investments held 0.71% of the Company's issued capital and 0.68% of the Company's fully diluted issued capital. As of March Excellence Investments held 2,661,276 shares constituting 0.54% of the Company's undiluted issued capital and 0.52% of the Company's fully diluted issued capital. Excellence Investments holds Company shares through a nostro account as well as through joint trust investment funds. On March the Delek Group received the approval of the Special State Share, as required by the Company's bylaws, to hold, directly and through corporations under its control, Company shares at over 5% (but under 15%) of the Company's issued stock capital. 3 Note that according to the immediate report issued by Phoenix on July , it became a Company interested party in December 2007 but due to technical difficulties in locating the aggregate holdings rate that made the Phoenix Group a Company interested party, said notice was not provided the Company. a - 14

17 Over the course of 2011, the Ginsburg Group 4 conducted several purchase and delivery actions as reported by the Company. As of December , the Ginsburg Group held 8.94% of the Company's issued capital and 8.59% of the Company s fully diluted issued capital. As of March the Delek Group held 44,307,512 shares, constituting 8.94% of the Company's undiluted issued capital and 8.62% of the Company's fully diluted issued capital. Over the course of 2011, Ms. Tamar Moses-Borovitz (Deputy Chairperson of the Company's Board of Directors and Company controlling shareholder) conducted several stock purchase actions. As of December , Ms. Tamar Moses- Borovitz held 0.37% of the Company's issued capital and 0.36% of the Company's fully diluted issued capital. As of March Ms. Tamar Moses-Borovitz held 1,844,951 shares constituting 0.37% of the Company s issued capital and 0.36% of the Company's fully diluted issued capital. Over the course of 2011, the El Al Employees Trust Company Ltd. (hereinafter: the Employee Corporation ) conducted several sales actions, as reported by the Company. As of December the Employee Corporation held 5.94% of the Company's issued capital and 5.71% fully diluted. As of March the Employee Corporation held 29,453,119 shares constituting 5.94% of the Company's undiluted issued shares and 5.73% of the Company's capital fully diluted issued capital. 4 "The Ginsburg Group" refers to I. Hillel & Co. Ltd., a company fully owned by Mr. Pinchas Ginsburg, a Company director, along with individuals of the Ginsburg family. a - 15

18 3.5 Table Summarizing Data on Interested Party Holdings and Capital The following is a table summarizing a number of facts regarding the Company s securities and the holdings of the principal interested parties 5 : March December December Holdings of interested parties Rate of State holdings in issued 6 capital (undiluted) Special State Share Special State Share Special State Share Rate of K nafaim holdings in issued capital (undiluted) 39.33% 39.33% 39.33% Rate of Employee Corporation holdings in issued capital (undiluted) 5.94% 5.94% 6.09% Rate of Ginsburg Group holdings in issued capital (undiluted) 8.94% 8.94% 8.74% Rate of Ms. Tamar Moses- Borovitz s holdings in issued capital (undiluted) Rate of A.L. Aviation Assets holdings in issued capital (undiluted) 0.37% 2.11% 0.37% 2.11% 0.41% 2.24% Rate of Phoenix Holdings Ltd. holdings in issued capital (undiluted) 4.69% 4.34% 2.75% Rate of Delek Fuel investments and Assets Ltd. holdings in issued capital (undiluted) Rate of Excellence Investments Ltd. holdings in issued capital (undiluted) 3.60% 0.54% 3.60% 0.71% 3.60% 1.03% Company Equity Listed share capital in NIS (not including the Special State Share). 550,000, ,000, ,000,000 Issued share capital in NIS (not including the Special State Share). 495,719, ,719, ,719,135 Convertible Securities Options to the Chairman of the Company's Board of Directors, Mr. Amikam Cohen. Options to the Company CEO, Mr. Eliezer Shekedi Options to executives as per the 2006 and 2007 Option Plans 7 4,650,000 9,914,382 3,552,478 4,650,000 9,914,382 5,726,651 4,650,000 9,914,382 8,935,793 5 See Section below regarding the up to date provisions of the Special State Share. 6 To the best of the Company s knowledge the State holds 1.1% of the Company s issued capital. See 1.4 above for details. 7 Less options that have expired and returned to the option reserve for allocation in accordance with the terms of the plan. a - 16

19 Breakdown of holdings in Company shares as of December : K'nafaim, 39.30% Public, 34.70% Ginsburg Group, 8.90% Employee Asossiation, 5.90% Others, 2.50% Delek Group, 8.70% Breakdown of holdings in Company shares as of March : K'nafaim, 39.30% Public, 34.60% Ginsburg Group, 8.90% Delek Group, 8.80% Employee Asossiation, 5.90% Others, 2.50% a - 17

20 4. Distributions of Dividends On November 20, 2007, the Company's Board of Directors resolved to update its dividend distribution policy. Within the scope of the new dividend policy, the Company will periodically distribute dividends, at the discretion of the Board of Directors and subject to the Company's needs. The Company did not distribute dividends in the reported year and in the preceding year. On a related note, on March 28, 2005, K nafaim, the controlling owner of the Company, sent a letter to Bank Leumi stating that considering the present outstanding debt status of El Al with Bank Leumi, and considering the fact that the Board of Directors of El Al is likely from time to time to formulate policies for the distribution of the Company's profits, we state that as long as the balance of the existing principal outstanding debt of El Al to Bank Leumi is no less than $50 million, we will not support a resolution to distribute earnings at a rate that exceeds 60% of the balance of retained earnings of El Al available for distribution as they will exist from time to time, other than after consultation with the Bank regarding the percentage in excess of 60% as stated. Concurrent with this letter, El Al received a letter from Bank Leumi on March 28, 2005, according to which the bank will not consider the conversion of K nafaim into the controlling shareholder of El Al as an event that entitles the bank to immediate payment of El Al's debt to the bank, conditional upon the terms as detailed in the letter of the bank to the Company, all as detailed in Section c. below. 5. Financial Information Regarding the Corporation s Areas of Activity Changes in International Standards (IFRS) For details regarding new financial reporting standards and interpretations published and the impact of their application to the Group's Financial Statements, see Note 3 to the December Financial Statements. The Company's reported business segments in the Financial Statements are detailed based on aircraft fleets air transport by means of passenger aircraft and air transport by means of cargo aircraft. The breakdown into business segments selected by the Company as above is in accordance with IFRS-8, according to which the reporting is according to their reporting to the corporation's chief business manager. A revenue-producing unit is the aircraft or the family of aircraft bearing similar flight characteristics and not the type of cargo they carry. a - 18

21 A passenger aircraft is comparable to a car capable of carrying a certain amount of cargo, but primarily intended for carrying passengers, while a cargo aircraft is comparable to a container, capable of transporting cargo only. Everything located in an aircraft is equally affected by the cost generators (pilots, fuel, capital, air passage fees, parking fees etc.). These factors are a function of the airplane and not of what it carries. In addition, the majority of the operating costs of aircraft carrying cargo in their holds are shared by passengers and cargo fuel, depreciation, flight crews, air passage fees, communications, landing and parking fees, tarmac and transportation services, security etc. Therefore, the proper business approach is that of the passenger aircraft sector (the holds of which contain a certain amount of space available for cargo) and the cargo aircraft sector. As stated, cargo transport in the holds of passenger aircraft represents part of the operations of passenger aircraft. This activity is auxiliary and a derivative of the activity of transporting passengers in the passenger aircraft and is dependent upon these operations. Thus, for example, the destinations of freight transport in the holds of passenger aircraft are determined by the flight destinations of the passengers in the passenger aircraft. Additionally, the current operations of the Company s activities as carried out by Company management, including the decision as to the feasibility of the operation of a route and the actual departure of a flight, are carried out based on the above operating segments. Nonetheless, it must be noted that one must look at the profitability of the cargo transport field in a broader context derived from the cargo transport activity using the holds of passenger aircraft as well, since the cargo transport field carries out commercial and marketing activities complementing the activities of the cargo transport activities in the passenger aircraft. Allocation of costs not directly assigned to one of the areas is conducted according to economic models currently existing at the Company. In the future, these costs may be allocated according to other economic models employed by the Company at the time. For details regarding the Company s reported operating segments see Section a.5 of the Board of Directors Report. The cargo fleet is an independent fleet the economic viability of which is studied separately. For further details see 8.10 below. In the first half of the reported year, a was used for this activity. The concluded its service at the Company in May Starting from this date, the Company has operated a single leased cargo plane. For more regarding changes in the Company's cargo fleet, see below. a - 19

22 For an analysis of revenues and results by operating segments for 2011, 2010 and 2009 and a presentation of revenues by geographic destinations see Note 37b to the 2011 Financial Statements. 5.1 Nature of the Adjustments The adjustments of the revenues and costs result from additional activities that are not attributable to the principal areas of activity, primarily maintenance services to other airlines. 5.2 Explanation of Developments Occurring in the Areas of Activity See the clarifications in Section a.3 of the Board of Directors Report regarding the explanation of developments in the Company s operating results during the reported year compared to last year. 6. General Environment and Impact of External Factors on the Company 6.1 Traffic in the International Aviation Industry The international aviation industry is affected by the economic and security situation and by unusual events, such as the outbreak of epidemics and natural disasters in the world in general, and in specific areas in particular. Taking the weakness of the western economies (the euro crisis) into account, passenger traffic listed an impressive increase, but in general 2011 was a year of contrasts: fine growth in passenger traffic, mainly in the first half of the year, compared to a decrease in cargo traffic. Optimism in the Chinese market compared to uncertainty in Europe. While the weakening of the euro contributed to the increase in business traffic, the increase in European tax rates and a restricting approach to aviation policy, led to European airlines showing the lowest profits of all of the main regions. According to IATA data, total passenger traffic (both international and domestic) increased by 5.9% in 2011 compared to 2010, with international traffic alone increasing by 6.9%. This data matches expectations regarding increased growth in traffic in the long term. At the same time, cargo traffic dropped by 0.6%. The increase in traffic was lower than the rate of growth (6.3%) in seat offerings and the rate of growth (4.1%) in available ton kilometers, which led to a drop in load factors, with the average load factor in passenger flights being 78.1% compared to 78.3% in 2010, and the average cargo load factor was just 45.9% compared to 48.1% in See Sections and below for further details. a - 20

23 6.2 Movement in the Israeli Aviation Industry Despite the riots breaking out in January 2011 in Egypt, which continued in February 2011, and in spite of the continuing political instability in regional countries, according to data presented by the Central Bureau of Statistics, 2011 was a record year in terms of Israeli departures and tourist arrivals by air million inbound tourist and visitor entries via air were listed (including day visits) in 2011, a 2.5% increase over An increase was also noted in the number of Israelis travelling abroad million departures of Israelis via air were listed in 2011, a 7% increase over For further details see below. According to data provided by the Israeli Airports Authority, total international passenger traffic through BGN increased 6.5% in 2011 compared to saw a 2% decrease in cargo traffic to and from Israel in comparison to See Sections and below for further details. 6.3 Fluctuations in Jet Fuel Prices Jet fuel is a significant component of the Company s expenses. Jet fuel prices are characterized by extensive and severe fluctuations. The following data refers to the weighted average of jet fuel market prices (before marketing margins and other tolls) in the various markets in which the Company purchases fuel, as quoted by Platts8. Jet fuel prices (the markets basket the weighted price in accordance with markets in which the Company purchases jet fuel) increased by 41% relative to 2010 over the course of See Sections and below for further details. See Sections a.3 and b.1.(3) of the Board of Directors' Report for additional details on the financial effect of jet fuel prices, including due to hedging activity. 6.4 Foreign Currency Rate Fluctuations The Group s results are affected by a number of currencies, particularly the U.S. dollar. Fluctuations in the exchange rate of the dollar vis-à-vis other currencies are likely to improve or erode the Group s profitability. As of December , the exchange rate of the NIS vs. the U.S. dollar was revaluated by 7.7% relative to December To the best of the Company's knowledge, Platts is a company from the McGraw-Hill Group that has provided information on the energy industry for over 75 years. The company provides updated information and analyses, among other matters regarding prices and international occurrences in the petroleum, petrochemical, natural gas, electric and nuclear power markets a - 21

24 As of December , the exchange rate of the U.S. dollar vs. the euro was revaluated by 3.3% relative to December See Section below for details. 6.5 Interest Rate Fluctuations The Company took significant at variable interest rates based upon LIBOR interest in order to finance the acquisition of aircraft. A change in the LIBOR interest rate could materially affect the Company s financing expenses. In 2011, the average LIBOR 3-month interest rate decreased by 1%, compared to its average rate in During 2010, there was a decrease of about 49% relative to its average rate in See Section for details. a - 22

25 CHAPTER 3: DESCRIPTION OF THE CORPORATION S BUSINESS BY AREA OF ACTIVITY The following is a description of the Group's business in each of the areas of activity separately, with the exception of matters applying to the overall operations of the Group, which are described collectively in the framework of Section 9 below. 7. Passenger Aircraft Activity 7.1 General Information on the Area of Activity The principal activity of the Group in this area is the transport of passengers on scheduled and charter flights. In addition, the Company carries cargo in the holds of its passenger aircraft, an activity auxiliary to the activity of transport of passengers. Additional auxiliary services are associated with the service in this area, including sale of duty free products to passengers. Accordingly, in the context of describing this field of activity, the Company has focused on a description of transport of passengers. Certain matters that pertain to the transport of cargo in the holds of passenger aircraft are similar to transporting cargo in cargo aircraft, which are described in Section 8. The following is a description of trends, events and developments in the macroeconomic environment of the Group, which have or are expected to have a material effect on operating results or on the developments in the field of activity, in the following areas: Structure of the Field of Activity and Changes Occurring Thereof As mentioned, the Company's main field of activity is air transport in passenger aircraft in scheduled flights to and from Israel. By employing passenger aircraft, the Company carries both passengers and cargo in the holds of the passenger aircraft. The aviation rights under which the State permits one or more Designated Carriers to carry passengers on international routes are stipulated in international agreements. Each nation determines one or more air carriers as a Designated Carrier on its behalf to operate the flights and utilize the flight rights. The Company serves as the designated air carrier of the State of Israel on most of the international routes operating to and from Israel. See Section for details on the Company's status as a "Designated Carrier" and government resolutions on this issue. a - 23

26 7.1.2 Legislative Restrictions, Regulations and Special Obligations that Apply to the Field of operations a. General The field of activity of carrying passengers and cargo in passenger aircraft is distinguished by international and local regulatory restrictions in various areas. Among other things, authorization is required for operating a flight from one country to another country. In accordance with international agreements, each nation is permitted to grant authorization for the operation of scheduled flights (appointment as a Designated Carrier ) to one airline or to a limited number of airlines, as stipulated in the agreement, except for the aviation agreement between Israel and the United States, in which there is no limitation on the number of Designated Carriers that each country may appoint. The number of Designated Carriers that have been appointed between two destinations is likely to have a material effect on competition between those destinations. For details regarding Open Skies with the EU see Section (b) below. The frequency of the flights and the volume of traffic also depend on obtaining consent from the aviation authorities in both countries. Additionally, each flight needs a takeoff or landing slot at the airports to or from which it operates. A commercial and operational license is required in order to operate flights, in accordance with Israeli aviation laws. For further information on Israeli aviation laws see below. In the context of these licenses, the State sets various restrictions on the holder of the license. In the framework of international treaties and agreements and local legislation, arrangements have been made pertaining to operation of the area of activity, which include rules concerning the responsibility of the air carrier for damages caused during the course of international air transport and the responsibility of the air carrier for delays and flight cancellations. Additionally, the Group is committed to operate according to special instructions regarding flight security, which impose additional costs on the Group. In addition, the Group is obligated to maintain a minimal fleet of aircraft, in accordance with the Special State Share (see also Section for details). In addition to scheduled flights, the Company is also engaged in performing charter flights by leasing aircraft capacity to organizers of charter flights at prices agreed on in advance and the sale of blocks of seats to agents. For further details see (c) below. a - 24

27 b. Government Resolution no. 535 on Aviation Policy from 2003 Shortly before publication of the 2003 Prospectus, the Ministerial Committee for Social and Economic Matters decided (decision no. SE/14 dated May 19, 2003) that: (a) The Company would continue to serve as the Designated Carrier on all of the routes on which it served as Designated Carrier immediately prior to publication of the 2003 Prospectus, subject to the following conditions: (1) The Company shall at all times comply with the directives and obligations stipulated for it and which it had assumed vis-à-vis the State of Israel. (2) The Minister of Transportation will consider revoking El Al's status as the Designated Carrier for a specific route if the number of passengers that fly with the Company on that route are 20% or less than the number of passengers that fly on the same route on scheduled flights, or if the number of El Al scheduled flights on that same route are 20% or less than the number of scheduled flights operated by the Designated Carrier of the destination country, during the period of one calendar year. B. The Ministerial Committee for Social and Economic Matters also stipulated that the Minister of Transportation will consider whether to grant rights to an additional Designated Carrier for scheduled flights on routes, should the number of passengers flying on the Company's scheduled flights on a specified route be 30% less than the total number of passengers of the scheduled flights on that same route for a period of one calendar year It was also stipulated that, without detracting from the legal authority of the Minister of Transportation, this policy would be considered if and when the 9 The position of the Deputy Attorney General (Economic-Fiscal) and of the Legal Counsel of the Ministry of Transportation is that Section 2 of the decision is a clear case in which the Minister of Transportation must use his judgment, and according to the fundamental rules of administrative statutes, it does not contain, anything to restrict his judgment or to prevent him from invoking his authority under any law, including in the matter of a Designated Carrier on a scheduled air route, also under other appropriate circumstances. 10 On May 28, 2003, the Director of the Policy Division in the Ministry of Transportation made it clear that the determination of the percentages of the Company's operation, both in Section 1 and in Section 2 of that decision, means self-operation by El Al at the rates stipulated and that the aforesaid in no way eliminates the possibility of operating the route by means of a code-share agreement, but then also, the necessary operation is only that carried out by the Company. a - 25

28 volume of outgoing and incoming air passengers to Israel exceeds 10.7 million passengers per year. c. Government Resolution 3024 from January 2008 On January the Government passed Resolution 3024, as follows: a. (1) To determine the rate of the State's participation in the burden of security expenses of Israeli airlines at the level of 80% of total direct expenses of their operation of existing and future international routes, oriented towards enabling these companies to contend, to the degree possible, in fair and equal competition, opposite foreign airlines and in view of the great importance in the liberalization of the civil aviation field, while recognizing the need for the existence of strong Israeli aviation industry. (2) To revoke Government Resolution No from July b. To determine that the rate of participation mentioned in a. above is a continuation to the resolution of the relevant institutions in "El Al" Israel Airlines Ltd. ("El Al"), which recognizes, to the Company's favor, the importance of raising the percentage of the State's participation in the burden of security expenses of Israeli airlines, and accordingly, to change the Government's aviation policy on the scheduled routes, as provided in Section c. below. c. To revise Government Resolution 353(KM/14) dated June regarding the aviation policy of the State of Israel on scheduled routes as follows: (1) Instead of Section 1(b) of the Resolution, the following shall appear: (b) "The Minister of Transportation and Road Safety, within the scope of his jurisdiction regarding aviation policy, as authorized by law, will consider whether to grant rights to an additional Designated Carrier on scheduled air routes, and will consider whether to revoke El Al's status as a Designated Carrier on a specific route". (2) Sections 2-3 of the resolution shall be revoked. a - 26

29 d. To impose on the Minister of Transportation and Road Safety to form an inter-ministerial team with the participation of representatives of the Ministries of Transport and Road Safety, Finance and the General Security Service, to assess ways to implement the security instructions for Israeli civil aviation. Date of implementation as specified in the Resolution." d. Implementation of Government Resolution 3024 Government Resolution 3024 as denoted above (hereinafter in this subparagraph: "Resolution 3024" or "the Government Resolution") regarding the increase in Government participation in the security expenses of Israeli airlines while amending the 2003 government resolution regarding El Al's status as Designated Carrier mainly consists of two interrelated parts: (a) establishing the State's share of the airlines' security burden at 80%; (b) amending the aviation policy of the State of Israel for regular routes, as determined in the May 2003 Government resolution, by revoking various threshold demands, which require that the Minister of Transportation and Road Safety ("the Minister of Transportation") consider whether the Company's status as Designated Carrier on a regular route be revoked or a Designated Carrier be added to a certain route in addition to the Company. In practice, Resolution 3024 was only partially implemented, in such a manner that a. above was not implemented while b. was, as detailed in below. As a result of the failure to implement both parts of the decision concurrently, in a manner contrary, according to the Company's arguments, to the letter and spirit of the Government Resolution, and as the Company's queries to the Ministry of Transportation and the Ministry of Finance on the matter of the implementation of both portions of the Government Resolution received no response, the Company filed a petition against the Government of Israel, the Minister of Finance, the Minister of Transportation and other respondents ("the Petition") before the Supreme Court, sitting as the High Court of Justice, on May As part of the Petition the Company requested, inter alia, that a temporary injunction be issued against the respondents instructing them to give cause as to why Resolution 3024 has not been implemented immediately and in full. The Company also requested that a injunction be issued preventing the respondents from implementing and/or from continuing to implement Resolution 3024 in a partial manner only, meaning to avoid implementing only that portion of the a - 27

30 Resolution dealing in the appointment of additional Designated Carriers, this until the Petition is resolved. e. Government Resolution 4032 from August 2008 On August 24, 2008, Government Resolution no was passed, on the subject of the state's participation in Israeli airline security expenses, as follows: 1 To revoke Government Resolution no dated January (hereinafter "the Resolution") starting January or on the date on which the scope of passengers entering and exiting Israel by air is greater than 10.7 million passengers per year, whichever is later. 2. Section A of the Resolution shall be implemented until its cancellation as stated in Section 1 of this decision, only on flight routes for which an additional listed Israeli carrier has been actively appointed, which has started to operate on the flight route. 3. To authorize the Ministries of Finance and Transportation and Road Safety to increase the state's participation rate in security costs for Israeli airlines, pursuant to the signing of a global aviation agreement with the EU in accordance with Government Resolution no. 441 dated September The budgetary expense of Government Resolution 3024, until its cancellation as denoted in Section 1, shall be financed from the Ministry of Transportation's existing budget." f. Government Resolution 4462 from February 2009 On February the Israeli Government passed a revised resolution regarding participation in the security expenses of Israeli airlines (following the resolutions dated January and August ), as follows: a. To increase the participation rate in security expenses in Israeli airlines to 60% from 2009 onward. Implementation of the resolution shall take place immediately following the Knesset's approval of the 2009 budget. b. To instruct the Ministers of Finance and Transportation and Road Safety to increase the State's participation in Israeli airline security costs to 75%, immediately after the signing of a global aviation agreement with the European Union ("Open Skies") in accordance with Government Resolution 441 dated September a - 28

31 c. To instruct the Minister of Transport and Road Safety to report to the Government, six months subsequent to this resolution, on the progress of negotiations with the European Union regarding the global aviation agreement ("Open Skies"). d. Prior to the approval of the 2009 budget, the Budget Controller at the Ministry of Finance will act to submit a budget addition deriving from this resolution for the Government's approval, for funding for an increase in the State's participation in civil aviation security costs. e. The airlines will act to conduct "exchange purchases" in Israel, as much as is possible at rates agreed upon with the Industrial Cooperation Authority." On July the Court approved the Company s request to dismiss the petition with no expenses order, after the Company announced that talks were being held with the State on the matter of Israeli airline security. g. Government Resolution 4026 from December 2011 On August the Company signed an understanding with the State of Israel, which was designed to arrange the activity of the Israeli aviation security array ( the Understanding ). The Understanding mainly refers to a gradual increase in the State s participation in the security expense burden of Israeli airlines, from 60% (the current rate) to rates of 65% (in 2001), 70% (in 2012), 75% (upon the signing of the Open Skies agreement with the European Union) and 80% upon the implementation of the Open Skies agreement (as agreed upon in the understanding). Whether or not the understanding came into effect was dependent on the passing of a Government resolution by no later than the end of The submittal of the understanding to the Government for a resolution, as noted, was subject to signing an additional agreement between the Company and the Foreign Ministry. The additional agreement between the Company and the Foreign Ministry was signed on November and was approved by the Ministry of Finance. On December the Government passed Resolution 4056 ratifying the understandings with the Government ministries, mainly pertaining to the continued provision of aviation security services by the Company to Israeli airlines and a gradual increase in the State s participation in the security expense burden of Israeli airlines including the Company, as detailed in the following resolution: Following Government Resolution 3024 dated January , no dated August and 4462 dated February , regarding the State s a - 29

32 participation in the security expenses of Israeli airlines in international flights, and taking into account the understanding signed between El Al Airlines Ltd. (hereinafter El Al) and the State on August , and the complementary agreement from December (hereinafter the El Al Understanding), including El Al s commitment to continue to provide security services to Israeli airlines in accordance with General Security Services instructions and guidelines: 1. To revise the State s participation rate in the aviation security budget of Israeli airlines, providing aviation security services in accordance with General Security Services instructions, as detailed below: a. 65% participation starting January and ending December b. 70% participation starting January c. In spite of (a) and (b) above 1. 75% participation after signing a global aviation agreement with the European Union, in accordance with Government Resolution 441 dated September (hereinafter the Open Skies Agreement) % participation rate from the start date of at least two scheduled airlines that were not operating prior to the signing of the Open Skies Agreement or the expansion of the activity of four existing scheduled airlines, or the start of the activity of at least one scheduled airline that was not operating prior to the signing of the Open Skies Agreement and the expansion of the activity of two existing scheduled airlines, all in accordance with the Open Skies Agreement and whether the agreement allowed them to start or expand their activity. 2. As a result of the aviation security services provided by El Al to other Israeli airlines in accordance with General Security Services instructions, to increase the yearly overhead budget framework for El Al included within the framework of the aviation security budget, by US$ 250,000, starting 2011, so that it will amount to US$ 2.25 million The scope of the State's participation within the framework of the yearly overhead budget for El Al shall be prepared in accordance with the participation grades detailed above, as the case may be, and subject to the implementation of this sum. Increasing the overhead budget as stated in this item depends on the expansion in practice of El Al's insurance coverage war and terror risk from US$ 1 billion to US$ 1.5 billion U.S., and proof that these expenses have paid. a - 30

33 3. To revise the State s participation in the aviation security budget of an Israeli airline not covered by Section 1 of the resolution, in accordance with the outline featured in that section, under the following conditions: a. The airlines will include as part of the insurance policies and coverage expansions of the aircraft in their possession a waiver of the subrogation right against El Al for damages deriving from war and terror risks. b. The airlines will add El Al as an additional policy holder in the insurance policy and the coverage expansions of the insurance for their liability pertaining to bodily and property harm to passengers and third parties, to the issue of damage and harm caused them as a result of war and terrorism risks, as well as a waiver of the subrogation right against El Al. 4. To compel the General Accountant of the Ministry of Finance to prepare, within four months, a letter of indemnity in accordance with the principles detailed in the El Al Understanding due to harm caused El Al due to the events insured by the insurance policy and the coverage expansions of Israeli airlines. 5. Security instructions received after the approval of the aviation security budget that was not taken into account in the aviation security budget, the cost of the implementation of which exceeds $300,000 per year, or alternately, new instructions the cumulative cost of the implementation of which exceeds $900,000 U.S. per year (hereinafter Guidelines), shall be discussed by a joint forum featuring the Deputy Budget Commissioner in the Ministry of Finance, a representative of the General Security Services and a representative of the company providing the security services (hereinafter the Forum), before they apply to the airlines. The forum shall reach a decision regarding the sources of the financing for implementing the guidelines. Furthermore, the forum shall convene at El Al s request in the event of material changes in the cost of implementing the guidelines. In the event that the forum fails to reach an agreement, the issue shall be decided by the Deputy Budget Commissioner at the Ministry of Finance. After determining the source of financing, El Al shall carry out the guidelines, and shall bear the expenses involved in their implementation in accordance with this agreement, and subject to the decisions of the forum. 6. If the Interministerial Committee for Salary and Benefits Abroad decides that the salaries of the employees or their benefits must be revised retroactively, the aviation security budget (the Company's share and that of the State) will be revised and the salary price list will be changed accordingly, within 30 days of contacting El Al. a - 31

34 7. To establish a forum headed by the Ministry of Transportation and Road Safety and with the participation of El Al and the airlines for coordination, raise disputes and resolve them. In the event of discussions of disputes on the matter of costs or the State's participation in aviation security expenses, the representatives of the Budget Commissioner in the Ministry of Finance shall take part in the discussion. 8. For the purpose of examining aviation security costs, an interministerial economic team shall be established with the participation of the representatives of the Budget Commissioner, the Ministry of Transportation and Road Safety, the Foreign Ministry the Antitrust Authority and the General Security Services. 9. In the event that the Government decides to establish a government or other body for the purpose of carrying out the service, in whole or in part, the implementation of the services in question shall not be passed on to them, including the scope of the Government s participation in the companies; aviation security budget, unless the companies providing security services and the other airlines are provided with advance written notice at least 90 days before the transfer date in question. In the event that the Government decides that some of the service will be carried out by the government body in question, this resolution shall apply to the balance of aviation security services not transferred to the body in question. 10. This resolution shall remain in effect until December , and Sections 1, 2, 4-6 of the resolution shall not apply to El Al if it does not meet its obligations in the matter of the El Al Understanding, and Sections 1 and 3 of this resolution will not apply to airlines that do not uphold the conditions featured within. Upon passing the Government resolution in question and after an agreement was signed with the Foreign Ministry, in which, among other things, the employment of aviation security workers was arranged, the conditions for the implementation of the understanding in question were completed. The influence of the implementation of the understanding in question on the Company s 2011 Financial Statements was a $5.8 million reduction in expenses. For details regarding the talks for the signing of the Open Skies agreement with the EU see Section (b) below. The implementation in full of the Government Resolutions and their potential impact on the Company's activities and operating results constitute forward-looking information as defined in the Securities Law. The manner and degree to which the Government Resolutions are actually implemented, the receipt of security expenses funding at the updated rate and the appointment of additional Israeli airlines as a - 32

35 Designated Carriers for regular flights and the operating of said flights by additional Israeli airlines as well as the signing and implementation of the Open Skies agreement with the EU may be carried out other than as estimated, among other things due to regulatory limitations, economic limitations resulting from the need to purchase equipment required to operate additional airlines, contractual limitations involved in the alteration of bilateral agreements or other aviation agreements as well as changes in the national security, economic and geopolitical information and their impact on competition as well as changes in Government resolutions Changes in the Volume of Activity and Profitability of the Area a. International Developments According to IATA estimates, passenger traffic (both international and domestic) increased by 5.9% in 2011 and international cargo traffic (including in the holds of passenger aircraft) decreased by 0.6%. International traffic (not including domestic traffic) listed a yearly growth of 6.9%, but a slowdown has been evident in the last six months of the year. An 8.2% increase was listed in seat offerings in international flights, which led to a drop in the load factor in international flights to 77.4%. In December 2011 IATA published a new profit assessment, in which it revised its 2012 profits projection downward. At the same time the organization did not lower the profit projections for the current year and these still amount to $6.9 billion, constituting 1.2% of its total turnover. International Traffic 11 Regional cross-section 2011 vs. 2010: Passengers Cargo RPK ASK PLF FTK AFTK Area Annual Annual Annual Annual change change change change Africa 2.3% 4.4% % 3.1% Asia 4.1% 6.4% % 0.6% Europe 9.5% 10.2% % 6.4% South America 10.2% 9.2% % 5.6% Middle East 8.9% 9.7% % 13.9% North America 4.0% 6.0% % 6.8% Total 6.9% 8.2% % 5.2% 11 The data in the table refers to traffic in international flights only, not including domestic flights. a - 33

36 European airlines passenger traffic by European airlines increased by 9.5% and their seat offerings increased by 10.2%. The impressive performance by European airlines is surprising in light of the euro crisis, and in any event, European airlines made significant profits from the strong business traffic between Europe and the long-distance markets, partially connected to the increase in exports from northern European states. North American airlines noted the highest load factor 80.7%. This number indicates close supervision of the proposed seat capacity, and the increase rate in seat capacity was still higher (6%) than the growth rate in passenger traffic. (4%) South American airlines led the increase in passenger traffic in 2011, with a 10.2% increase vs This was also the only area in which demand exceeded supply (the capacity growth rate was 9.2%). Middle Eastern airlines listed an 8.9% increase in passenger traffic compared to a 9.7% increase in seat capacity, which led to a decrease in their load factor to 75.4%, which was the lowest of all areas, with the exception of Africa. Airlines in this region may have slowed down their expansion rate, but the competitive prices they offered and their geographical location, which allows them to operate their home airports as international hubs, increase the share of airlines in the region in traffic to long-range destinations. African airlines listed the lowest growth rate (2.3%) in passenger traffic in 2011; this result was partially caused by tension and instability in certain North African states. At the same time, comfortable economic conditions in the region have led to an increase in traffic, although, African airlines have failed to benefit from this, and their low growth rate represents the loss of their market share. The average load factor of airlines in the region was 67.2%, lower than the industry average. IATA projects that in 2012 global airlines will earn $3.5 billion (just 0.6% of the airlines revenues). This sum is lower than the sum published in September 2011, which projected profits of $4.9 billion. The reason for the drop in profits is the economic crisis in the Euro Zone that threatens to lead to a banking crisis and a new recession. The following are the key points of IATA s 2012 projections: According to IATA s estimates, even if government intervention in Europe prevents a banking crisis, the European countries will undergo a short recession. The business and consumer confidence indices are dropping and the projected a - 34

37 growth for 2012 was downgraded and is currently 2.1%. Historically, airlines lose money whenever the global economic growth (in GDP) drops below 2%. Demand passenger traffic is expected to grow by 4% (compared to expected growth of 4.6% in the previous projection) while cargo traffic is expected to remain unchanged (unlike the previous projection which predicted a 4.2% increase in passenger traffic). Yields no change is expected in yield per passenger and yield per ton of cargo in While the projection regarding the yield per ton of cargo remained unchanged compared to the previous projection, the projection regarding the yield per passenger was downgraded, as IATA had previously projected a 1.7% increase in yield per passenger. Fuel airline fuel costs remained almost unchanged compared to previous projections and will reach US$ 198 billion [based on an average price of $99 per barrel (compared to an average price of $100 per barrel from the previous projection)]. Income and expenses the airlines revenues are expected to grow by 3.7% and reach $618 billion. At the same time, the airlines expenses are expected to increase at a greater rate of 4.5% and reach $609 billion. All regions are expected to display a drop in profits compared to 211, but the gaps between the regions will expand. Based on the OECD projections that predict that the Euro Zone crisis may lead to a deep recession and a new banking crisis, the IATA prepared an additional scenario for According to OECD projections a new banking crisis may lead to the global growth rates amounting to just 0.8%. In such a situation, IATA estimates that airline losses may reach a sum of $8.3 billion. All regions will show losses: in Europe the losses will be highest and reach $4.4 billion, in North America losses will amount to $1.8 billion, in Asia losses of $1.1 billion are expected, in the Middle East and South America losses of $400 million are expected in either of the regions and in Africa losses are expected to reach $200 million. The following table shows the activity of the international aviation industry (regular flights) over the past four years as well as the industry's revenues and earnings throughout the period. a - 35

38 International operations of the aviation industry and its profitability from the passenger aircraft area 12 (scheduled flights) of airlines belonging to IATA: Year RPK 15 (in Millions) Annual Change in RPK Output RTK 14 (in Millions) Annual Change in RTK Operational Revenues 13 (Billions of Dollars) Operating Profit (Loss) (Billions of Dollars) Before Interest Expenses 6.9 After Interest Expenses ,578, % 319, % ,373, % 289, % ,436, % 295, % ,365, % 292,247 6% b. Developments in the Israeli market International passenger traffic to/from BGN totaled, according to Airports Authority data, 12.2 million passengers during 2011, which represents an increase of about 6.5% compared to Passenger Traffic to and from Israel (from/to BGN) 17 Year Passenger Traffic through BGN Millions of Passenger Legs Yearly Change 6.5% 9% - 5% 10% 15% 12 The source of the data regarding : IATA publications (World Air Transport Statistics) ( th edition). 13 Including cargo aircraft revenues. 14 Revenue Ton Kilometer weight of paid flown passengers and cargo in tons multiplied by distance flown. 15 Revenue Passenger Kilometer number of paying passengers multiplied by distance flown. 16 IATA data, estimates, assessments and projections referring to 2011 are preliminary. Final 2011 data is expected to be published by the IATA in June 2012 within the framework of World Air Traffic Statistics. 17 Source: Civil Aviation Authority (including non-paying passengers). In addition to the traffic to BGN, tourists on scheduled and charter flights arrive in Israel through the Eilat airport in minimal amounts as compared to the traffic at BGN. The term leg means a flight section from destination to destination. a - 36

39 The table and the graph below reflect the trends of incoming tourist traffic to Israel and the departing residents in recent years via air 18 Year Incoming Tourists (Foreign Passports) (In Thousands of Passengers) 2,506 2,385 2,049 2,190 1,790 Rate of change 5.1% 16.4% ( 6.4)% 22.0% 14.2% Departing Residents (In Thousands of Passengers) 3,857 3,588 3,397 3,552 3,433 Rate of change 7.5% 5.6% ( 4.4)% 3.5% 9.2% According to Company estimates, tourist traffic to Israel is influenced by international passenger traffic trends, by the economic situation and mainly by geopolitical processes in Israel or the region, which have affected the security felt by tourists to the region. In spite of the riots in Egypt that began in January 2011 and the continuing political instability in the regional states, 2011 saw an increase (+5%) in visitors entering Israel via air and an increase (+7.4%) of the number of Israeli departures via air as well. On the other hand, a significant decrease was listed in the number of land entries to Israel (-22%) and Israeli departures through the land border passages. In light of the euro crisis that is threatening to expand to a new global recession, the increase in fuel and input prices and global industry changes, 2012 is characterized by uncertainty and many countries have began adopting streamlining and belt tightening policies. The Bank of Israel s growth projection for 2012 was 3.2% in September 2011, but was revised to 2.8% in December, similar to the OECD projection (2.9%). Indications of the slowdown in growth can also be seen in the decrease of airborne cargo shipping to and from Israel, as mentioned in 6.2 above. The tourism and aviation industries are sensitive to domestic and foreign economic changes and a new recession, if in fact this occurs, may have negative implications on companies operating in these areas as well as on the Company. These influences will be expressed whether by cutting business travel, in the luxury classes in particular, cancelling and/or shortening vacations as well as changing the passengers; destination map to cheaper destinations. The forecasts and estimates of IATA regarding the volume of passenger traffic to and from Israel as above represent forward-looking information, as defined in the Securities Law. This information is supported, inter alia, by the Company s 18 Data from the Central Bureau of Statistics. a - 37

40 assessments in light of the trends of change in tourism during recent years and expected developments, and in view of the economic, security and geopolitical situation in Israel. Accordingly, the actual change in the anticipated volume of incoming tourists to Israel and the outgoing tourism from Israel may be materially different from that forecast above, if the Company's assessments are not realized, and because of a large number of factors, including a change in economic, security and geopolitical conditions in Israel Developments in the markets of the field of activity or changes in the characteristics of its customers: In recent years, competition has intensified considerably in the passenger aircraft transport field between dozens of international scheduled and charter airlines. The airlines compete in various areas, principally: fares, frequency and flight times, ontime performance, equipment type, airplane configuration, passenger service. Fare competition is reflected primarily by offering reduced rates to passengers. The competition is present both with relation to direct scheduled flights between various destinations and with charter flights to the same destinations. In addition, in this context, there has been an increase in the activities of the foreign airlines in Israel in the framework of Sixth Freedom. Additionally, during recent years, airlines known as low cost airlines have entered the mart 19, these being airlines that maintain low expenses and generally offer very competitive prices. For details see (d) below. The increase in the number of foreign airlines operating out of BGN, in the number of scheduled flights and in the seat capacity of the foreign airlines, has led to a further increase in the level of competition on routes to and from Israel, and the Group s market share in passenger traffic through BGN was 33.9% compared to 37.1% in See Sections and below for further details. For details regarding the implementation of the Ministry of Transportation's liberalization policy and the appointment of Israeli airlines as Designated Carriers see Section above Technological Changes that May have a Material Impact on the Area of Activity CRM system: the Company chose to realize additional components of the CRM approach on the Microsoft CRM infrastructure. The project has shifted to the 19 "Low cost" airlines are relatively new airlines with a structure of low expenses deriving mainly from direct marketing over the Internet and not through distribution systems and travel agents. Features include use of secondary airports, minimal service profile during the flight and operations on short range flights, with no code sharing agreements with other companies and high utilization of aircraft. a - 38

41 characterization stage, and its products will be expressed gradually over the course of RMS + Pricing systems: the complex competitive arena in which the Company exists has reinforced the need to implement up-to-date decision-supporting systems at the Company. In light of this, the Company has decided to implement an innovative revenue management system (RMS) as well as a system for the automated management and distribution of Company prices compared to market prices Pricing & Fare Management System which updates the Company's fares automatically in all of the distribution systems, according to strategies and rules dictated by the Company. The systems operate in conjunction with changes in market demand, and respond automatically with up-to-date availability and price based on the level of demand. The application will be added on an integrative package of functions dealing with the new conditions created in the market using more innovative methods. The contracts for implementing the pricing and the RMS systems were signed between the Company and Lufthansa Systems AG, whose proposals to implement the systems were selected from a number of proposals submitted to the Company following a request for proposals (RFP) it published. The pricing system is expected to go online over the course of the second quarter of The RMS system is expected to go online in mid Updating the registration classes: following the hierarchal reorganization of the classes in the inventory management of El Al flights and the changing of the bonus class, the discount system was changed in order to simplify the sales process, as practiced at other airlines, and to allow agents and/or business bodies to see the official prices as they are displayed in the global distribution systems. Duty free system: implementation of a new system for the management of duty free activity at El Al was completed. The system includes a module for managing the duty free item warehouse, a module for managing the operation of airborne sales and an accounting module for managing intra- and inter-organizational financial accounting. This system replaces an outdated system that has completed its life cycle. Following the Company's 2010 periodic reports, it was decided to freeze the plan for a comprehensive realization of an ERP plan and focus on replacing existing financial systems with SAP-based systems. SAP-based alternatives are being tested for the Maintenance and Engineering Division, alongside designated solutions for the maintenance software in the maintenance repair & overhaul (MRO) field. a - 39

42 An agreement was signed with Ness Technologies in late December 2011 to implement a project to replace the following financial systems: the Company s books GL, the Israeli and global payment system AP and the collection system AR. The system is planned to become operational in January Over the course of October 2011 the Company signed an agreement with the IATA to join an SIS project that deals with uniform monetary accounting processes between airlines, moving from paper documents to e-invoicing. An SIS system is required in accordance with IATA rules. Implementing the system will lead to changes and the automation of existing work processes. The project is in advanced development stages and the system is planned to be integrated at the Company over the course of Q As part of the development and establishment of the Company's direct distribution and marketing channels, growth in the direct online marketing of flight tickets continued to increase in such a manner that the Company's total online sales amounted to $120 million in 2011 (a 20% increase over online sales in 2010). The Company's new website was launched in early March 2011, and improvements were made to the Company s website over the course of the reported period, such as: improving the ordering process while improving the payment stage to a more convenient and user-friendly format, presenting luggage data in the ordering system and in addition, various technological and design improvements were applied. Furthermore, the Company improved its express check-in system and a new, modernlooking boarding pass was designed. The new homepage for the frequent flyer website was launched within the framework of the improvements to the new site. The new homepage s chief characteristics are: use of the graphic language employed by the Company s homepage, a personal members area for presenting important information regarding the state of their account, news and updates and an offering of customer-specific deals. The improvements were designed to create a familiar site, to improve the user experience and provide members with easy, simple and friendly orientation. The Company is acting to significantly expand its online trading capabilities, including by translating its website to additional languages (over the course of the reported period, two new languages were added to the home page: French and Russian), expanding its overseas clearing and sales options and developing sales options through additional channels besides credit cards. In the social networks, the Company has presented a new, highly-designed international page serving as an umbrella arena for all pages used by the Company's a - 40

43 representatives and serving as a platform for traffic arriving in Israel through content and communications in English. This channel joins the social media activity the Company engages in and helps increase user involvement in the El Al brand, encourage conversation and promote El Al in online search engines as well as increase sales on the site. In addition, online collaboration was expanded, including travel insurance sales options as part of the reservation site and collaborations with leading sites. In April 2011 the global Apple Store began offering a new application for frequent flyer club members, allowing them to check their points and membership status, view their latest actions in their account and detail any action, as well as provide a point conversion calculator for all credit card companies. In July 2011 a new website was launched for the duty free array and the site management system was upgraded, allowing it to display a broader variety of products. The site provides an internet experience that encourages shopping. Products may be ordered in advance and received on the plane, with an option of making purchases with the combination of money and frequent flyer points, and sky gifts can be purchased, to be given to El Al passengers for whom the gift was purchased during their flight. A computer for printing out boarding passes for passengers performing express checkins who had not printed out their tickets prior to arrival at the airport was recently installed in BGN Terminal 3. This service was designed to save time and allow passengers traveling without baggage, and businesspeople, to go directly to their gates. The Company is currently studying possible and applicable alternatives for accessorizing Company aircraft, in whole or in part, with communications systems (internet and/or cellular). As part of the process, cellular and internet trends in the world in general and the aviation industry in particular are studied, with the aim of putting together a business and operative plan for the project, taking into account the variety of considerations and possibilities in the field of aviation communications. The Company is currently undergoing PCI:DSS certification according to a budgeted work plan, and is acting to adapt its system to the standards requirements, including in the Company s overseas branches. An agreement was signed between the Company and DYNASEC (later purchased by Checkpoint) in 2011 for the purchase of an automated system for managing the ISOX process, and a timetable was set for implementation and training activities. a - 41

44 The information on the implementation and characterization of the above systems, including project completion dates and their impacts constitute forward-looking information, as defined in the Securities Law. The actual implementation of these projects, their dates, their scopes and their impact on the Company's could be materially different from that forecast, due to various reasons, including technological, commercial and service-related reasons and as a result of the Company's ability to accept the system and the resources allocated for this purpose. In recent years, the aviation market has geared up to deal with terror events by expanding the use of advanced technological and other means, on land and in the air. Within the scope of these preparations, the Company is working in accordance with the instructions of the General Security Service, inter alia, for evaluating and installing protective measures. For further details on security arrangements see Section below Critical Success Factors in the Area of Activity and Changes Occurring Thereof A number of factors can be pointed to in the operations of the passenger and cargo transport area via passenger aircraft that affect the competitive position in the field: the economic and security situation in Israel, which influences passenger traffic to and from Israel; the branding of the Company in the eyes of the customers, including matters of safety and quality of service; the ability to offer flights to popular destinations at competitive prices and development of a network of routes independently and in cooperation with other airlines; preservation of aviation rights; the ability to offer flights at the frequency and the capacity demanded; a distribution system; risk management by implementing appropriate risk hedging policies Changes in the Supplier Network and the Raw Materials for the Field of Operations The primary raw material consumed by airlines is jet fuel and it represents one of an airline's major expense components. See Section below for details relating to fuel Main Entry and Exit Barriers of the Field of Operations and Changes Therein One of the most significant entry barriers in the area of the international scheduled flights is obtaining the authorization to carry out scheduled flights from one country to another. In accordance with international agreements, each country is permitted to grant such authorization (appointment as Designated Carrier ) to carry out flights from that country to other countries to one airlines or to a limited number of airlines, as stipulated by agreement. The more liberal the aviation agreement between the countries is, the lower the entry barriers are. For Government resolutions on Designated Carriers and developments deriving from this decision, see above. a - 42

45 In addition to obtaining authorization from the airline's parent country, consent is generally required from the countries to which the airlines wishes to fly with relation to the number of flights and to the capacity of the flight. In addition, each flight is required to have a slot for takeoffs or landings at the airports to or from which it operates. See Section and Section below for details. Another Significant entry barrier is the initial relatively large investment that is necessary in order to establish and operate an airline, including aircraft acquisition or leasing. Under the international aviation agreements, obtaining the appointment as Designated Carrier is conditional upon the substantial ownership and effective control of the air carrier being in the hands of the state or citizens of the country that has established it as a Designated Carrier. This requirement represents an entry barrier for obtaining the appointment as Designated Carrier by companies the majority ownership and control of which is held by foreign citizens. However, within the framework of the liberalization of the aviation industry, over the course of the past few years, bilateral agreements between the State of Israel and other nations have been revised in such a manner so as to allow the appointment of a Designated Carrier the principle place of business of which is located in the territory of the side appointing the carrier and that the carrier holds an air operator's certificate issued by the appointing side (as in the agreements with the U.K., France and others). As part of the "horizontal" agreement signed between Israel and the EU in December 2008, it was agreed to grant authorizations to European airlines to fly to Israel from any country in the EU, even if it is not the airline's parent country, with the only limitation being that the number of the flights from the third country be no greater than the sum of the flights allowed from that country in accordance with the aviation agreement between it and Israel. With this, the ownership and control limitation was in effect removed as a condition for receiving the Designated Carrier status. For details regarding the "Open Skies" agreement with the EU see Section b.(3) below. With regards to the operation of passenger aircraft in international charter flights, each Israeli carrier must obtain a license to operate charter flights to and from Israel, subject to various demands, mainly: economic stability and ownership or leasing of at least two aircraft. Additionally, each Israeli carrier and foreign carrier must obtain authorizations for charter flights from the Civil Aviation Authority. At present, a more liberal policy of granting authorizations in the area of charter flights is in place, both with relation to Israeli charter airlines as well as with relation to foreign charter companies. Therefore, in the Company s estimation, there are no material entry barriers in the field of charter a - 43

46 flights. In addition to the above, various licenses and permits are required to conduct activity. For further details see Section 9.11 above. The restrictions placed on the Company by the holder of the Special State Share in the matter of the reduction of the Company's aircraft fleet, constitutes an exit barrier. See Section below for further details Substitutes for Services of the Field of Operations and Changes that have Occurred Therein The alternatives to transportation via passenger aircraft are transportation by other means (maritime and surface vehicles and cargo aircraft for cargo in the holds of passenger aircraft). Note that Israel has no significant alternative to air transport for passengers. In addition, the Group has competitors that offer alternative transport in passenger aircraft via scheduled flights, charter flights and low cost flights. There were no substantial changes during 2011 in alternatives to transport by means of passenger aircraft. In the Company's estimation, the major considerations in preferring flight to sea and/or land transport are purpose of travel, the travelers' schedules, the distance and the nature of the route Structure of Competition in the Area of Activity and Changes that have Occurred Therein a. General Severe competition exists in the passenger aircraft transport field between dozens of international scheduled and charter airlines. The airlines compete in various areas, principally: fares, frequency and flight times, on-time performance, equipment type, airplane configuration, passenger service, bonuses to frequent travelers, commissions and special incentives to travel agents and supply of computerized reservation and distribution systems to travel agents. Fare competition is reflected mainly in offerings of cheaper fares to passengers or special rates to cargo shippers. The competition is not only with the Designated Carrier of the country that is located on the other end of the route and with charter airlines that operate on the same route, but also with other airlines, including those not operating flights to Israel (offline airlines), this as the result of the travelers' diverse alternatives in arranging their own flight schedule, in which a number of airlines participate, and the strengthening of code sharing agreements between airlines (Star, Sky Team, One World). a - 44

47 Additionally, most of the scheduled airlines operating flights to and from Israel also carry passengers on Sixth Freedom Flights. Because the flight from the home airport (Europe) to the United States is carried out without any connection in flights from Israel to Europe, this situation sometimes allows foreign companies to lower the total price for the flight from Israel to the United States (through Europe) without reducing the price for which the airline ticket from Europe to the United States is sold. As a matter of fact, sometimes foreign airlines offer airline tickets from Israel to the final destination (the United States, for example) at a price lower than the price which they offer for the flight from the stopover destination (Europe, for example) to the final destination. On the other hand, the Company does not presently enjoy the similar ability to transport passengers between different countries via Israel, primarily because of the current geopolitical situation. A significant portion of the aviation agreements between Israel and other countries state that the offered capacity must be based on the scope of traffic between Israel and the other country with which the agreement was signed. In recent years, the Ministry of Transportation has begun implementing a policy of increased liberalization in the aviation industry, with the aim of encouraging and increasing tourist traffic to Israel by increasing competition between airlines. As an implementation of the liberalization in its aviation policy, the Civil Aviation Authority approved requests by foreign companies to increase frequencies or capacities, even when these were not required by existing bilateral aviation agreements. Likewise, over recent years, aviation discussions were held with the civil aviation authorities of several countries and new agreements were signed, in which the liberalization policy in the air transport field was expressed in such a manner that the agreements established multiple Designated Carriers, enabling an increase in the number of airlines that can operate scheduled flights on the routes to and from Israel as well as increasing their frequency (see below for details on the agreements and resulting developments). b. Open Skies Policy The Public Commission for Examining the "Open Skies" Issue The key points of the report and recommendations of the public commission for evaluating the "Open Skies" issue were published on April 16, According to the commission's report, the State of Israel is striving to adopt an aviation policy that will serve as a springboard for economic growth and for a - 45

48 increasing tourism to and from Israel, based on the importance of a national aviation industry that will take part in equal and fair competition in accordance with global environmental conditions, transforming the State of Israel, from an aviation standpoint, to a more attractive destination than its competitors, in terms of price and in terms of capacity of airlines over time. The report further states that the opening of the skies will bring with it the entry of new operators, a decrease in fares and an increase in the State of Israel's exposure as a competitive destination and consequently, an increase in the number of tourists arriving via air. At the same time, the report states that the policy will also apply to Israeli passengers, who will benefit from reduced prices and a more diverse range of services and destinations. Implementation of the Open Skies Policy The following is a description of the main changes deriving from the Ministry of Transportation's Open Skies policy in 2011: Colombia a new aviation agreement was signed between Israel and Colombia in April According to the agreement, each party may operate direct flights between the two countries, with no restrictions on the number of carriers, frequencies and types of aircraft. The new aviation agreement includes the operation of passenger and cargo flights and allows passengers and cargo to board and alight at stopovers ( Fifth Freedom ) between countries. The agreement also allows Israeli and Colombian airlines to sign code sharing agreements, including code sharing agreements with carriers from a third country. Jordan in March 2011 Israir received the approval of the Minister of Transportation to act as designated carrier, in addition to Arkia, on the Tel Aviv- Amman route. The date on which flights will begin has not yet been published. Ukraine in June 2011 Israel and Ukraine signed a memorandum of understandings allowing additional Israeli and Ukrainian airlines to operate direct flights between the countries. According to the new agreement, each country will be allowed to operate via two scheduled airlines (instead of one today), on routes between Israel and Ukraine, with the exception of Tel Aviv-Kiev, in which each country is allowed to operate flights via three scheduled airlines, and the number of frequencies on this route was increased to 24 weekly flights, instead of 21 flights as of today. On each of the other routes between Israel and Ukraine, each side will be allowed to operate seven weekly flights. In addition, it was agreed that the quota of flights intended for the transportation of religious tourism from Israel to Ukraine a - 46

49 over the course of the Rosh Hashanah period will be increased by 20% to 22,000 seats (11 seats on each side), with the special flights operated by three Israeli airlines, El Al, Arkia and Israir as well as by Ukrainian airlines. Note in this regard that in December 2011 the Minister of Transportation issued his approval that Arkia operate scheduled flights between BGN and Kharkov. Hungary in June 2011 Israel and Hungary signed a new aviation agreement allowing additional Israeli and Hungarian airlines to operate direct weekly flights between the countries, totaling up to 30 weekly flights on the Tel Aviv-Budapest route (15 flights on each side). In this regard note that the Company currently operates an average of 5 weekly flights on the Tel Aviv-Budapest route while the Hungarians operate 11 weekly flights on this route, until February 2012 when Hungarian airline Malev announced that it would be discontinuing its activity due to economic difficulties. Additionally, the new agreement allows Israeli airlines to operate scheduled passenger flights to additional Hungarian destinations. It was also agreed that the both countries airlines will be able to operate code sharing flights, as well as with airlines from other countries. Czech Republic a new aviation agreement was signed between Israel and the Czech Republic in September According to the new agreement, Israeli and Czech airlines can operate up to 36 scheduled weekly flights, instead of 12 flights as things currently stand. Furthermore, Israeli and Czech companies can operate 7 weekly charter flights to any additional Czech destinations. The agreement allows the operation, for the first time, of flights using code sharing between Israeli and Czech airlines and with airlines from third countries, which can market seats on flights between the Czech Republic and Israel. According to the new agreement, each country will be entitled to appoint additional airlines that will operate flights on the Tel Aviv-Prague route, alongside El Al and CSA. The agreement allows the continued operations of Czech airline CSA, which had lost its concession for flights to Israel in favor of Smart Wings, which operates low cost flights and was originally selected to replace CSA. Starting October , Smart Wings began operating 4 weekly scheduled flights on the Prague-Tel Aviv route, alongside continued activity by CSA on the Prague-Tel Aviv route. In this regard, note that Smart Wings had until now operated charter flights on the Tel Aviv-Prague route. Over the past five years new aviation agreements have been signed between Israel and a large number of countries (Spain, Italy, France, the UK, Belgium, Russia, Ukraine, Slovakia, Thailand, South Korea, Germany, Switzerland, Brazil, Turkey, the U.S., Greece, Rumania, Georgia, Jordan, Hungary, the Czech Republic and a - 47

50 Colombia). All of these new aviation agreements were expression of the liberalization of air transportation, via agreements for multiple Designated Carriers for each side as well as a significant increase in frequency allocations for scheduled flights. These agreements allowed an increase in the number of companies operating scheduled passenger flights and the introduction of low cost flights to Israel. Furthermore, cancellation of the section of the 2003 government resolution limiting the appointment of Israeli carriers on routes operated by El Al, allowed Ministers of Transportation to appoint Israeli airlines as additional designated carriers on a series of international routes. The prominent routes in 2011 on which the appointment to regular flights was exercised by Aria and Israir over the course of the year are the routes to Paris, Barcelona and Larnaca, which are operated by Arkia, and routes to Moscow, Rome and Berlin operated by Israir. Overall, in 2011 the capacity of other scheduled airlines (including scheduled Arkia and Israir flights) increased by 10% and passengers increased by 11% compared to The airlines that increased their frequency and/or capacity in 2011 to a significant degree were KLM, Air France, Iberia, Air Berlin, EasyJet, Jetair Fly, Aerosvit, Aeroflot and Ukraine International Airlines. The increase in capacity allowed these companies, which operated international hubs at their home airports, to increase the number of passengers flown between Israel and a large number of destinations via indirect flights, taking advantage of their route networks (Sixth Freedom traffic) and that of their partners in global aviation alliances and code sharing agreements. The Company made no material changes to its seat capacity (1%) and its passenger numbers remained essentially unchanged (1%). In this regard note that activity of subsidiary Sun D Or dropped significantly (-21%), after its operational licenses was revoked, and in total the Group listed a slight 1% drop in its seat capacity and a 3% drop in the number of passengers compared to A 6.5% increase was listed in passenger volume at BGN in 2011, with a 6% increase occurring in scheduled passenger travel (including the Company) and an 8% increased in charter flights compared to last year. Overall, charter traffic (including Sun D'Or flights) through BGN constituted 15% of all traffic, akin to its share in Passenger traffic through BGN in 2011 was broken down as follows: the Group 33.9%; other scheduled airlines 53.3%; charter airlines (not including Sun D'Or) 12.8%. a - 48

51 Competition is expected to continue growing fiercer in 2012 as well as a result of the entry of additional foreign airlines such as Austrian airline Niki, which operates, starting from February 2012, three direct and scheduled weekly flights from Vienna to Tel Aviv. The re-entry of Greek airline Olympic Airways, which announced that it would be renewing its flights on the Tel Aviv-Athens route starting March 2012 (alongside the activity of Aegean Airlines on this route), and Belle Air, which will begin operating a scheduled route between Tirana in Albania and Israel in June Furthermore, competition is expected to escalate as a result of increased capacity and/or frequency and destination expansion by existing airlines as well as the operation of scheduled flights to new destinations by other Israeli airlines. The prominent examples of this are: German airline Lufthansa, which announced its intention to operated direct flights on the Tel Aviv-Berlin route for the first time starting from June 2012, subject to the approval of the German and Israeli governments. These flights will be added to the 19 weekly flights operated by Lufthansa on routes between Frankfurt and Munich and Tel Aviv. Air France announced that it would be starting a new direct route between Tel Aviv and the city of Nice on the French Riviera starting April Air France is expected to operate 3 weekly flights on this route. Russian airline Aeroflot will begin marketing flights to Saint Petersburg under its code in March 2012, pursuant to a code sharing agreement it made with Russia Airlines, which it recently purchased, and which operates flights between Tel Aviv and Saint Petersburg. Ukraine International Airlines announced that starting April 2012 it would add 3 weekly frequencies on its route to Kiev and will operate a total of 10 weekly frequencies instead of 7. Polish airline Lot increased its flight frequency on the Warsaw-Tel Aviv route from 5 to 6 in February Belgian airline Brussels Airlines announced that it would be adding an additional day flight, the eighth per week, on the Tel Aviv-Brussels route on the springsummer flight schedule, starting April Conversely, Spanish airline Spanair and Hungarian airline Malev, which had operated flights on routes to Israel, discontinued their activity in early 2012 in light of economic difficulties. a - 49

52 The Company's estimates regarding increased competition in 2012 and its possible impact on the Company constitute forward-looking information as defined in the Securities Law based on the influence of the Open Skies policy, including the increase in the number of foreign airlines operating at BGN, and the increase in the capacity of foreign airlines operating today. The actual level of the increase and its impact on the Company are influenced, inter alia, by economic, security and geopolitical factors and by trends in the airline industry. For further details see above. For regulatory changes that may alter the structure of competition in the field of activity see Section below. The Open Skies Agreement with the European Union In accordance with the aforementioned commission recommendations, talks began in November 2007 between Israel and the European Union, the objective of which is to eliminate the need for separate agreements with each European country, and the execution of one general agreement with the Union's executive, in order to foster aviation liberalization that will increase competition and freedom of movement between the airlines. In February 2008, Israel and the European Union Commission signed a preliminary memorandum of understanding, toward the signing of a uniform global aviation agreement between European countries and Israel. In December 2008, a new aviation agreement (the "Horizontal Agreement") was signed between Israel and the EU. The Horizontal Agreement updates the sections of the bilateral aviation agreements between Israel and the EU members referring to the ownership and control of Designated Carriers (without changing the aviation rights established in the bilateral agreements) and allows airlines controlled and owned in one of the EU members to operate scheduled flights from any other country in the EU, subject to the bilateral agreement. The Horizontal Agreement does not influence the aviation rights set as part of the bilateral agreements. These rights include, inter alia, the right to operate regular flights on agreed-upon routes, the number of companies on each side entitled to operate flights on these routes (Designated Carriers) and the weekly frequency quota granted Designated Carriers. At the same time, the Horizontal Agreement may in the future allow the realization of aviation rights not realized to date on the lines between Israel and the EU and pave the way for a global aviation agreement with the EU. a - 50

53 The first round of talks between Israel and the EU regarding the global agreement ("the Vertical Agreement"), which is designed to replace all of Israel's bilateral agreements with EU members and to gradually cancel the limitations on the number of carriers, frequencies, capacity and type of aircraft, were held in December Additional rounds of meetings between the parties were held over the course of 2009 through 2011 and negotiations on a global aviation agreement between Israel and the EU continued. The latest round of talks with the European Union took place in January The gaps and disagreements between the parties have been reduced, and a revised draft agreement is coming together to serve as a basis for discussion in an additional round of talks planned for late March The Company is operating, in conjunction with the other Israeli airlines and the Israeli Pilot s Association, in order to regulate within the framework of the agreement a number of subjects that to the best of the Company s understanding are not material and vital to safeguarding the interests of Israeli airlines and of fair competition, including the gradual nature of the agreement s implementation, in such a manner that will allow adequate preparations by the Israeli airlines for the implementation of the agreement, the mutuality of aviation rights and the regulation of the subject of slots in Europe, as well as to prevent the implementation of the agreement before the required preliminary conditions are resolved, including the return to Category 1 (see (h) below in this regard), the removal of restrictions in the Antitrust Law for the signing of cooperation agreements between airlines (see (i) below) and more. In late February 2012 the Minister of Transportation instructed that the signing of the Open Skies agreement be postponed in order to reexamine the agreement and test its influence on the fortitude of Israeli airlines after hearing the positions of the Israeli airlines, including the Company, who object to the agreement in its current format. Signing the agreement may have a negative impact on Israeli airlines, including the Company, following an additional worsening of the state of competition, the multiple carriers and enlarged capacity the agreement will bring about and the inability of Israeli airlines to realize the aviation rights resulting from the agreement in an equal manner. The Company's estimates regarding the progress of the negotiations and possible signing of an Open Skies agreement with the EU over the course of 2012 and its possible impact on the Company constitute forward-looking information as a - 51

54 defined in the Securities Law, and is based on estimates that as a result of the agreement an increase will be noted in the number of foreign airlines operating at BGN, and an increase in the capacity of foreign airlines operating today. The degree at which competition will increase in practice and the expected implications on the Company s activity are influenced, among other things, by the possibility of a fair and mutual implementation of the agreement, the receipt of takeoff and landing rights at European destinations, the degree of gradualism in implementing the agreement and the scope of the change in the capacity and the frequency of foreign airlines operating to Israel. c. Charter Airlines Charter traffic to and from Israel increased by 8% in Charter flights to Turkish vacation destination saw a slight 2% decrease compared to 2010, in light of the continued tension in relations between Israel and Turkey. See also Sections 6.2 above and 7.2 below for further details. After deducting the traffic to Turkey, charter traffic to other destinations through BGN increased by 10%. The share of charter airlines (Israeli and foreign) of total passenger traffic through BGN amounted to 15% in 2011, similar to 2010, as detailed in the following table: Year Share of Charter Airlines of Total Passenger Traffic through BGN 15% 15% 17% 22% 22% d. Low Cost Companies Airlines referred to as low cost airlines have become active in recent years. These airlines maintain low costs and generally offer very competitive prices, while providing a low level of service and using alternate, less desirable airports. These airlines have succeeded in growing enormously in the United States, in Canada and in Europe. A stirring in this field has also been felt recently in Asia. The entry of low cost airlines into certain markets forces the airlines competing in these markets, which do not have a low cost structure like the low cost airlines, to a - 52

55 become more efficient in order to reduce costs. Until recently, the low cost airlines have performed short flights, and have not performed flights to and from Israel. Starting 2006, several airlines have begun operating as Designated Carriers on routes from various European countries to Israel. The following airlines provided low cost flights to and from Israel in 2011: EasyJet, which operate flights between Luton, Geneva and Basel and Tel Aviv; Jet 2, which operates flights on the Manchester-Tel Aviv route; Air Berlin, which operates flights on routes from Berlin, Cologne, Munich and Dusseldorf; German Wings, which operates flights on the Cologne-Tel Aviv route; Jetair Fly, which operates flights on the Liege-Tel Aviv routes; Spanish airline Vueling, which operates flights on the Barcelona-Tel Aviv route during summer months; Cimber Sterling, which operates flights on he Copenhagen-Tel Aviv rout; Norwegian Air Shuttle, which operates flights on the Stockholm-Tel Aviv route; Air Mediterranee, which began operating flights on the Paris-Tel Aviv route; Smart Wings, which operates flights on the Prague-Tel Aviv route. In total, the foreign low-cost airlines transported 5% of the passenger traffic from BGN. In February 2012 Austrian low-cost airline Niki began operating flights on the Vienna-Tel Aviv route. In addition to the above, Israeli airline Arkia began operating low-cost flights on the Tel Aviv-Paris and Amsterdam-Tel Aviv routes starting November The entry of these and other airlines into the Israeli market could have a negative effect on the Company's business results, due to the increased capacity offered by these airlines at reduced prices. The Company's estimates regarding the entrance of these companies may be different or incorrect and in such a case the scope of the activity of these companies may differ from the Company's estimates. The Company's estimates regarding the scopes of activity of the low cost companies and the future development of this activity in Israel constitutes forward-looking information as defined in the Securities Law. This estimate is based on the fact that this activity involves operating difficulties that might arise such as a shortage in a critical amount of passengers, which this activity requires, difficulty in quick flight turnaround (ground time of no more than an hour) and more. a - 53

56 e. Domestic Flights On February , the Minister of Transportation accepted, in principle, the CAA recommendation to allow the Company to operate regular flights between BGN and Eilat, alongside Arkia and Israir, and decided the following: 1. To allow El Al Airlines to operate the scheduled Ben Gurion Airport-Eilat- Ben Gurion airport route in the following manner: 1.1 El Al shall be required to operate at least one flight per day in each direction, on five out of seven days a week. El Al shall offer a capacity of at least 100 seats in each direction on each of the frequencies noted in this section. 1.2 El Al shall not be entitled to operate more than three frequencies a day in each direction. In addition, El Al may not offer more than 430 seats a day in each direction. So as to remove all doubt this restriction applies to seats and not to actual passengers. 2. The frequent flyer programs operated by the Company must separate international and domestic services as follows: 2.1 In sales of tickets for the BGN-Eilat-BGN route, El Al shall not be permitted to accept as payment Frequent Flyer points accumulated by its passengers as a result of purchasing flight tickets on international routes operated by the Company. In addition, El Al shall not be entitled to grant frequent flyer points for the purchase of tickets for the BGN-Eilat-BGN route usable on international routes operated by the Company. 2.2 El Al may grant frequent flyer points for the purchase of tickets for the BGN-Eilat-BGN route for use on the BGN-Eilat-BGN route only. From the sale of tickets for the BGN-Eilat-BGN route, El Al may only accept as payments frequent flyer points accumulated by its customers as a result of purchasing tickets for the BGN-Eilat-BGN route. 3. To carry out the process required by law for the purpose of establishing a uniform maximum price for all airlines operating on the BGN-Eilat-BGN route and the Sdeh Dov-Eilat-Sdeh Dov route, equaling the following sums:... a - 54

57 These maximum prices are for one direction only. Maximum prices for the Haifa-Eilat-Haifa route shall remain unchanged. 4. To free Israir from its obligations towards the flight schedule and seat offerings to which it committed itself in the 1995 Ministry of Transportation tender, and allow it to establish its schedules for the Sdeh-Dov-Eilat-Sdeh Dov and BGN-Eilat-BGN routes as it sees fit. 5. The conditions denoted in this resolution shall remain in effect for a period of six months from the beginning of flights by El Al. At the conclusion of the six month period, the impact of El Al's entry into the BGN-Eilat-BGN route shall by studied based on the characteristics of the route at the time, and the alteration or even cancellation of the above conditions shall be considered. This condition shall be written explicitly in the terms of the license. 6. This resolution shall be not be applied prior to 30 days from today." In August 2010 the Company began operating 3 daily flights on the BGN-Eilat route, in accordance with the terms set in the decision made by the Minister of Transportation and Road Safety. In August-December 2011, the Company flew 222,600 passenger legs, and its share of domestic traffic to Eilat was in this period was 16% In August 2011, the Minister of Transportation announced his intention to approve an additional daily flight to Eilat for the Company, 4 daily flights in total, based on the recommendations of the Civil Aviation Authority. On January 2012 the following decision was received from the Minister of Transportation: (a) To allow El Al Airlines Ltd. (hereinafter: El Al ) to operate a single additional daily frequency in each direction, and to increase its daily seat capacity from 430 seats to 580 seats in each direction on the BGN-Eilat-BGN route (hereinafter: the Route ). So as to remove all doubt this restriction applies to seat capacity as expressed in the configuration of aircraft operated by El Al on the route, and not to actual passengers. (b) To establish that the restriction on granting benefits to El Al Frequent Flyer Club members will be revised in such a manner so as to forbid the distribution of flight tickets for free (or under preferred condition) on the Route, dependent on the a - 55

58 purchase of flight tickets on El Al international routes, whether or not the passengers are members of the El Al Frequent Flyer Club. (c) To reexamine the Route s data a year from the revision of the addition to the El Al commercial license, and to determine whether there is room for additional changes to the conditions, to cancel the conditions in question or to cancel the permit to operate flights on the route in general. The Company s commercial operation license was revised in accordance with the agreement in question. 7.2 Services in the Area of Activity a. General The main services provided by the Company in this field of operations are transportation of passengers and cargo by air to various destinations using passenger aircraft. As of a date close to the approval of this report, the Group operates flights using passenger aircraft to 33 destinations in 25 countries in Europe, North America, East and Central Asia and other destinations. Additionally, the Group operates flights from a number of locations in Europe to Eilat and as noted above, has begun operating domestic flights on the BGN-Eilat route. In 2011, the Company operated an average of 230 weekly flights in each direction. In addition to the flights it operates, the Company markets flights in the framework of interline agreements with other airlines, which make it possible for passengers on scheduled flights, subject to certain restrictions, to use airline tickets issued by another airline, for flights of the other airlines. The company whose flights are used by the passenger submits the bill for payment to the company that issued the flight ticket. Accounts are settled between the airlines on a monthly basis, generally through IATA's clearinghouse. The scheduled airlines also operate flights in the context of code sharing. The use of the code sharing permits the air carrier to market flights operated by another air carrier as if they were its own flights, so that the passenger orders the flight through one carrier, despite the fact that, in practice, his flight is with another carrier. The code sharing provides the participating carriers with the possibility of increasing the frequency of the flights offered to its customers, accessibility to additional destinations and also marketing advantages, including amplifying the attractiveness of joining the Group s frequent flyer club. The Company has also operated in this area in recent years. For information regarding regulation in the antitrust field and details of the Company's code sharing agreements, see 7.4 and (i) below. a - 56

59 In its scheduled flights, the Group operates four service sections that are distinct one from the other in type of seat, space between the seats, their food and beverage menu, the manner of serving, the assortment of convenience and leisure products and the number of flight attendants in relation to the number of passengers. The sections are first class, improved business class - platinum, business class and economy class. The charter flights operate a service profile suitable to charter operations. Not all classes are operated on each flight. Scheduled flights feature a system of programs of audio, films, screened magazine and printed magazine and services are provided for the sale of duty free products. In addition to its scheduled flights, the Group is engaged, through Sun D Or, in carrying out charter flights by leasing aircraft capacity to organizers of charter flights at prices agreed upon in advance, and the sale of blocks of seats to agents. For further details on Sun D Or see Section below. The Group s flights are supported by a system of ground services that administers the processes of boarding passengers and their baggage, their alighting at destination airport and unloading their baggage, and cargo handling. The ground services exist at BGN and at each of the destinations at which the Group s aircraft land. At the same time, the Company, as directed by government security authorities, operates a ground security array in each of the overseas airports at which Israeli airlines land and a system of air security, which operates during the flights of passengers of Israeli airlines (the ground security system at BGN is operated by the Airports Authority). b. Data Regarding the Destination Groups of the Group The following are data regarding the Group's market share separated into groups of key destinations, relative to all passenger traffic to or from BGN, broken down into these destination groups: a - 57

60 To/From BGN North America Europe East and Central Asia 22 Total Passenger Traffic Through BGN By Destination According to Direct Flights 21 Change in % in 2011 ( 2.9) (In Thousands of Passenger Legs) ,640 8, ,690 7, ,525 6, Company Estimates of Company Market Share (In %) Others ,674 1,593 1, Total ,194 11,450 10, c. Routes to North America (to the United States and Canada) During the height of the 2011 summer season, the Company operated 32 weekly flights to North America and during the winter season, it operated some 22 weekly flights (mostly to New York). Competition exists between Continental/United, Delta, Air Canada and U.S. Airways on routes to North America. In this regard note that following the Company s reports in its 2010 periodic report regarding the merging of United Airlines and Continental Airlines starting December 2011, Continental Airlines began flying to Israel under the United 20 This data has been broken down by the passenger s final flight destination (including the final destination in Sixth Freedom flights). The Company s estimate concerning the passenger s final destination is based upon data from global distribution systems. The Company cannot estimate the precision of the data received from the distribution systems, which include paying passengers only. Note that the Civil Aviation Authority publishes data that includes non-paying passengers and which is broken down by the airlines carrying out the flights. Thus, in cases of Sixth Freedom flights of European airlines between Israel and the U.S. through European airlines the flight shall be attributed to the parent company of the European airline. According to the Company's processing of the Civil Aviation Authority data and cross-sectioning of flights to the airlines parent companies, while ignoring Sixth Freedom flights, the Company s market shares were: in the North America route: 44.6% in 2011 compared to 44.5% in 2010; European routes: 32.9% in 2011 compared to 36.7% in 2010; in East and Central Asian routes: 86.8% in 2011 compared to 85.9% in 2010; in other destinations: 14.2% in 2011 compared to 17.6% in Civil Aviation Authority data refers to the airlines making the flights and not the flights destinations. Therefore, this data constitutes the group's estimates based on an analysis of Civil Aviation Authority data. This data has been broken down by direct flight destination and do not take into account passengers real destination in the case of foreign airline Sixth Freedom flights. 22 The Group is unable to assess the level of precision of its estimate of the market share which includes Sixth Freedom flights in the East and Central Asia market, Africa and regional destinations (such as Turkey, Greece and Cyprus), this in view of the lack of precision of the information in the Company s possession regarding the number of passengers of other airlines in these markets. 23 Others: passengers to regional destinations (Cyprus, Egypt, Greece, Jordan, Malta and Turkey) and Africa. Starting May 2009 and until November 2011 the Company operated direct flights to Brazil. Therefore, in , passengers on these flights have been included under Others" (regional destinations, Africa and Brazil). a - 58

61 Airlines code (UA). In addition, intensive activity by European airlines taking traffic to the United States and Canada via their home airport (Sixth Freedom) continues. Overall, in 2011 there was a 3% decrease in passenger traffic on North American routes compared to In September 2011 Delta Airlines discontinued its activity on the Tel Aviv-Atlanta route, in light of a strategic decision to streamline and reduce costs on a number of international routes, in response to an increase in fuel prices. As a result, its activity (both passengers and seats) on the Atlanta route decreased by 51% compared to the previous years. At the same time, Delta listed a significant increase (+23%) in its activity on the New York route. The capacity of other scheduled airlines on routes to the U.S. remained unchanged while noting a slight 1% decrease in passenger numbers; Air Canada slightly increased (+3%) its seat capacity, and its passenger traffic increased at a similar rate (+2%). The Company decreased its capacity on routes to the U.S. by 2%, and the Company's passenger traffic decreased by 3%. The Company increased its seat capacity on the Canada route by 3% but passenger traffic remained essentially unchanged (-1%). On the route in question all of the airlines (Israeli and American) have full freedom of action in the matter of rates, frequencies, types of aircraft, aircraft configuration and so on. The Company, as a Designated Carrier to the U.S., has the right to carry passengers, cargo and mail to/from New York and other points in the U.S., some as part of a code sharing agreement with American Airlines. This agreement allows the Company to offer its passengers dozens of central destinations in North America, relying on the Company's network of direct routes. At the moment, and in light of the lowering of Israel's flight safety rating to Category 2 by the FAA in December 2008, American Airlines has dropped its code from Company flights and at this stage the agreement is implemented unilaterally, with the Company allowed to sell tickets with the Company's code for American Airlines flights, but American Airlines not selling tickets with the American Airlines code in Company flights. Furthermore, the Company has collaboration agreements (on an interline basis) with American airline Jet Blue and with Canadian airline West Jet, which also allows the Company to expand the variety of its destinations. The Company's estimates regarding the changes in capacity and frequency of other airlines and the intensifying of competition constitutes forward-looking a - 59

62 information as defined in the Securities Law. This information is based, inter alia, on the Company's estimates in light of the current scope of the Group's activity and the level of market competition that may not be realized in whole or in part, or which may be realized in a significantly different manner. The actual situation may differ from projections, among other reasons due to the opening of the market to additional competition, regulatory changes, the manner in which the Company deals with competition and the risk factors listed in Section 9.18 below as well as economic, security and geopolitical changes. d. Routes to Europe As of this report, the Company has scheduled flights to 23 destinations in Europe, with the key destinations being London, Paris, Moscow, Frankfurt, Rome, Milan, Madrid and Zurich. The Company competes on the routes between Israel and Europe with the national Designated Carriers of the destination country, as well as with other scheduled airlines that take Sixth Freedom traffic to other countries via their home airport, and with foreign and Israeli charter airlines that operate charter flights to various destinations in Europe. In this regard, it should be pointed out that European scheduled airlines flying to Israel have an advantage over the Company, since they have the ability to offer continuing flights to destinations to which the Company does not fly. The Group, as a designated carrier, has the right to transport passengers, cargo and mail to/from various European destinations, some applied in effect pursuant to code sharing agreements only. In 2011, the liberalization of the Israeli aviation industry continued, with the signing of new aviation agreements with several European countries, the appointment of additional Designated Carriers on these routes and approvals granted by Israeli authorities to increase capacity for foreign airlines. On European routes, competition intensified with the entry of additional designated carriers, mainly airlines operating low cost flights on routes to Basel, Copenhagen, Stockholm, Paris and Prague (see Sections 7.1.1, 7.1.4, and for details), and as a result of increased capacity and/or frequencies on behalf of existing airlines. In addition as detailed above, over the course of 2011 Israir and Arkia were appointed Designated Carriers to additional destinations. For details regarding the appointments as Designated Carriers to other airlines see (d) and above. a - 60

63 Note that in spite of the above, Arkia and Israir still operate charter flights on some of the aforementioned routes. Western European routes saw a 6% increase in total passenger traffic, with the foreign scheduled airlines increasing their seat capacity and listing a similar increase in passenger traffic. The most prominent airlines to increase their activity on these routes in 2011 are: Air France, which added a third daily frequency during the peak summer period and in total increased its seat capacity by 16% and listed a 12% increase in passenger traffic; Spanish airline Iberia, which operated on average 16 weekly frequencies compared to 14 weekly frequencies in 2010 and listed a total increase of 18% in its seat capacity and an 11% increase in its passenger traffic; Dutch airline KLM, which increased its seat capacity and passenger traffic by 43% (by using a larger airplane for part of the period); low cost airline EasyJet, which expanded its activity and began operating 3 weekly flights from Basel in Switzerland and starting November 2011 added a fourth weekly flight on this route, in addition to flights it operated from Luton and Geneva; Air Berlin, which operated 9 weekly frequencies on routes to Germany compared to 8 in 2010 and in total increased its seat capacity by 16% and its passenger traffic by 14; and Jetair Fly, which added a third weekly frequency on the Liege route and increased its seat capacity and passenger traffic by 37%. The Company increased its seat capacity by 3% and its passenger traffic remained essentially unchanged (+1%), however, since subsidiary Sun D Or lost its operating license in April 2011, Sun D Or s activity on this route network decreased significantly (-23%), and therefore in total no material change was listed in the Group s seat capacity and passenger traffic (both El Al and Sun D Or), at 0% and -1%, respectively. On routes to Central and Eastern Europe passenger traffic increased by a total of 3% compared to The foreign scheduled airlines operating on these routes decreased their seat capacity by 3% and their passenger traffic decreased at a similar rate of 4%. In this regard, the Czech airline stands out, after reducing its weekly frequencies on the Tel Aviv-Prague route from 10 to 7, and listing a 31% decrease in passenger numbers. Note that starting November 2011, Smart Wings also began operating 4 weekly scheduled flights on the Tel Aviv-Prague route, as detailed in above. a - 61

64 A significant decrease was also noted in the activity of Israeli airlines Arkia and Israir (-23% and -82%, respectively), and a major increase (36%) was noted in the activity of foreign charter flights. No material change (-1%) was listed in the Company s activity on these routes, and in total the Group listed a 6% decrease in seat capacity and in passenger traffic, in light of the decrease in Sun D Or's activity (for details see 9.7.1a below). Routes to Russia and CIS states listed a significant increase in total passenger traffic (+28%) and in seat capacity (21%). The foreign scheduled airlines operating on these routes increased their seat capacity by 33% and their passenger traffic increased by 46%. Competition continued to increase on these routes in 2011 with the expansion of these airlines activity. Most of the increase in traffic was listed on routes between Russia and Israel (17%) and between Ukraine and Israel (+72%). In this regard note that starting February 2011, the visa requirement between Israel and Ukraine was revoked, and scheduled airlines operating on these routes significantly increased their seat capacity. Due to economic considerations and as part of the Company s streamlining and cost reduction processes and the optimization of its route network, the Company discontinued its activity on routes to Odessa and Dnepropetrovsk in Ukraine over the course of December The airlines that most prominently increased their seat capacity and passenger traffic are: Aerosvit, which operated 20 weekly frequencies on routes to Ukraine on average compared to 14 frequencies it operated in 2010 along with Donbassaero, which is controlled by the same owners. In total, Aerosvit increased its seat capacity by 55% and listed a 90% increase in passenger traffic; Ukraine International Airlines, which operated 7 weekly frequencies on the Kiev route in 2011 compared to 5 weekly frequencies on average in 2010 and in total increased its seat capacity by 163% and multiplied its passenger traffic fourfold; Aeroflot, which operated 7 weekly frequencies on the Tel Aviv-Moscow route compared to 5 frequencies in 2010; and TransAero, which increased its capacity by 6% and listed a 15% increase in passenger traffic. The Company slightly (-2%) decreased its seat capacity on these routes, while its passenger numbers remained unchanged (0%) compared to However, as a result of the reduced activity by Sun D Or (as mentioned above), a total decrease of a - 62

65 5% was listed in the Group s seat capacity and a slight drop of 3% was listed in the Group s passenger traffic. In total, passenger traffic to Europe (East, Central, CIS and West) increased by 9%, with the foreign scheduled airlines increasing their passenger traffic by 19%. The Group s passenger traffic to these destinations saw a slight 2% decrease. Aviation agreements signed over the past five years as well as other agreements including the global agreement between Israel and the EU members expected to be signed in the future and the Government resolution regarding the Open Skies policy are expected to lead to the operation of scheduled flights to and from Israel by additional airlines, and to an increase in the capacity and frequency and/or an expansion in destinations among the existing airlines. Therefore, in 2012, a further increase is expected in competition for traffic on these routes. The Company's estimation regarding the increased capacity and frequency among the other airlines and the intensifying competition constitutes forwardlooking information as defined in the Securities Law. This information relies, inter alia, on the Company's estimates in view of the volume of the Group's current activity and the degree of competition in the markets that may not be realized in full or part or be realized in a significantly different manner. The actual situation may differ from projections, among other reasons due to the opening of the market to additional competition, regulatory changes, the manner in which the Company deals with competition and the risk factors listed in Section 9.18 below as well as economic, security and geopolitical changes. e. Routes to East and Central Asia In September-October 2011, Korean Air added a fourth weekly frequency in response to peak holiday and autumn demand. After that, Korean Air returned to operating 3 weekly frequencies, but replaced its airplane for the Tel Aviv-Seoul route with a bigger aircraft. In total, Korean s seat capacity increased by 2% compared to 2010, but its passenger numbers decreased by 7%. Other than the Company, which operates on routes to India (Mumbai), Thailand (Bangkok), China (Beijing) and Hong Kong, and Korean Air which operates on the route to South Korea (Seoul), scheduled airlines that operate in Israel operate flights to these destinations in the context of Sixth Freedom traffic. In total, in 2011 the supply of seats in these routes increased by 8% compared to 2010 but the number of passengers on these routes remained essentially unchanged a - 63

66 (1%). Most of the increase in seat capacity derives from an increase in activity by the Company, which added a fifth weekly flight to Honk Kong and increased its seat capacity on the route to Bangkok by using a larger aircraft. In total, the Company increased its seat capacity on these routes by 9% and its passenger numbers increased by 2%. f. Other Routes The other routes that the Company operated during 2011 were Greece, South Africa, Egypt and Brazil (until November 2011). Since 2009, due to the continuing tension between Israel and Turkey, Israeli airlines avoided operating flights on routes to Turkey. In September 2011 the relations between the countries grew even worse, following which the Turkish charter airlines announced that in light of the lack of demand, they were discontinuing their activity, meaning that the vacation flights between Israel and Turkey no longer existed and that the flight activity continuing on the Tel Aviv-Antalya route was day flights for foreign tourists from CIS countries on vacation in Antalya who purchase single-day tours in Israel. In spite of the above, Turkish Airlines continues to maintain its scheduled flights on the Istanbul route without change, with many of the passengers on this flight being Sixth Freedom passengers, meaning passengers departing from Israel through Turkey to connecting flights. No change occurred in 2011 compared to 2010 in total travel to Turkey, which constituted 5% of all traffic through BGN. Note also that a sharp decrease was listed in traffic to Egypt (-62%), in light of the riots breaking out in Egypt in January 2011 and the continuing political instability in Egypt. The Company operated a limited number of flights on this route after the riots broke out and it is continuing to adapt its activity on the route in accordance with developments in the region. On the other hand, a significant increase (19%) occurred in passenger traffic to Greece and the Greek islands, which replaced the Turkish holiday destinations. Greek airline Aegean Airlines operated an average of 15 weekly flights (7 of which are scheduled flights to Athens) compared to 12 weekly flights on average in In total Aegean increased its seat capacity on these routes by 32% and listed a 45% increase in passenger traffic. A significant increase (125%) in the number of passengers to Greek destinations was also listed with the foreign airlines operating on these routes. a - 64

67 In all, passenger traffic on regional routes and on African routes decreased by 6% and the number of Group passengers on these routes decreased by 15% compared to As stated above, the Company began operating regular direct flights between Tel Aviv and Sao Paolo, Brazil from May 2009 until November 2011, when the Company decided to discontinue its activity on this route as part of streamlining measures, reducing expenses and optimizing the route network. The Group's market share of these destinations (Greece, South Africa, Egypt and Brazil) was 13% in In addition, from time to time the Group operates unique charter flights or short series of charter flights to various destinations. 7.3 Analysis of Revenues and Profitability from Services In 2011 the Group's revenues from this area of activity increased by 3.7% compared to 2010 revenues, with the rate of increase in passenger traffic through BGN in 2011 being 6.5% versus For details regarding the breakdown of the Company s revenues and profitability (consolidated) by reported operating segments in the area of passenger aircraft see Section a.5 of the Board of Directors Report. 7.4 New Services Updates to the passenger luggage policy as is common practice in many European and American airlines, it was decided to update the Company's policy on the matter of economy-class passenger luggage for the Company's destinations. Starting November , each passenger will be able to carry just one suitcase containing up to 23 kg of cargo. For a second suitcase, weighing up to 23 kg, an additional payment of $70 will be charged. This Company policy matches that of major international airlines. In September 2011 a memorandum of understanding was signed with Luxury Lounges Ltd. for the operation of a lounge for the Mauro corporation (the coffee manufacturer), in a space the Company will rent from the Port Authority at Newark Airport in New Jersey. The lounge will serve the Company s passengers and El Al passengers shall be given preference in it. The lounge is expected to open in late a - 65

68 In September 2011, an online sales site was launched on the Company s website, in conjunction with Best Buy, called Global Store. The store offers products complementary to the flight experience, both via direct sales and via tenders. In September 2011, the GlobaLY program was launched for frequent flyer club members residing abroad. As part of the program, the Company will contribute the equivalent of 5% of the total points accumulated by plan members up to a maximum of 500,000 points a year, for the following goals: flying Jewish youths from overseas to Israel to introduce them to the country and its people, in conjunction with the Birthright organization; flying soldiers with no family in Israel to visit their families abroad, in conjunction with AWIS; making wishes come true for children with life-threatening diseases, in conjunction with the Makea-Wish Foundation. The point contribution shall take place on a quarterly basis at the Company's expense only and plan members will be informed of the sum of points the Company contributed to the various organizations. In January 2011 the Company signed an agreement with the Flix Company (the Israeli YouTube) for the display of entertaining content on flights to Eilat. The El Al Ambassador initiative: in September 2011 the Company launched a new initiative, in conjunction with the Israeli Foreign Ministry and leading global publicity firms, intended to assist various Foreign Ministry delegations to promote a positive, non-political agenda that can present a different image of the State of Israel. As part of the initiative, a high-quality group of pilots, flight service managers and flight attendants were carefully selected, were provided with special training and will be voluntarily integrated into the official public relations array of the State of Israel during their tours of duty overseas. The Company began collaborating with the ICast website, in which the site provides the Company with a number of books on tape for the flight entertainment systems. Starting July 2011 the Company's planes have offered a number of books on tape from leading authors. The Company and K'nafaim Holdings Ltd. the Company's controlling shareholder ( K'nafaim ), are studying the establishment of a joint international venture in China for the provision of maintenance services for commercial aircraft operating in the Chinese and international market, in conjunction with a Chinese company ( the Venture ). Pursuant to the study of the Venture s feasibility, the Company, K'nafaim and the Chinese company ( the Parties ) signed a non-binding memorandum of understandings according to which the Parties shall study the a - 66

69 various options for establishing the Venture. An additional study of the feasibility of the venture was conducted and at this stage there is no certainty as to any of the parties entering any binding agreement. In order to improve the entertainment experience for passengers of luxury classes on Boeing 767 aircraft to long-range destinations, in February 2011 the Company began distributing ipad/pmp devices to business class passengers for their personal use during the flight. In January 2011 the Company began distributing destination booklets, in conjunction with tourist guide publishers Shichur, for passengers on Company flights. The destination booklets are divided by flight destination with their content being updated on a quarterly basis. The booklet includes a map of the city and additional maps as well as recommendations by subject. In addition, a destination guide in English is distributed to tourists arriving at Israel featuring maps and recommendations for activities in Jerusalem and Tel Aviv. In March 2011 a joint venture was launched between the Company and Steimatzky s Books Our Story, in which Company customers are invited, during their flights, to take part in an award-bearing short story competition on the subject of home. Some 1,400 stories were written, of which the 30 best reached the finals, with the best story awarding its writer with two flight tickets to Europe and a publishing contract for their first work. In addition, the 20 best stories were selected and collected in a book to be sold at Steimatzky shops. All revenues pursuant to this collaboration constitute were given as charitable donations. In August 2011 a joint venture was launched between the Company and Steimatzky Books titled Our Drawing, in which children flying on El Al flights were invited to take part in an award-bearing children s drawing competition. In December 2011 the Company launched a special deal to convert points from all of the Israeli credit card companies to the Company s frequent flyer club points. As part of the deal, credit card company customers converting points won bonus tickets at particularly attractive prices. In December 2011 the Company launched a new service El Al Plus, allowing Company passengers who had purchased economy class tickets on some of the Company s flights to submit a request to update the flight tickets to business class through a designated upgrade system available at the EL Al site or through their travel agents. The size of the upgrade proposal as set by the passengers, in accordance with the price range offered to them, which changes according to the a - 67

70 destination of the flight. Passengers whose upgrade requests have been accepted will be upgraded to business class and enjoy the class s full service, including Shalom check-in and entrance to the King David lounge. Notice regarding the upgrade is sent to passengers 30 hours before the flight on regular days and 48 hours before the flight on Saturdays and holidays. Over the course of 2012 the Company s 767 aircraft are also expected to undergo an upgrade, in which these planes will undergo a redesign. The redesign will include the sitting environment, the entertainment system, the seats, the storage compartments and the galleys. The 767 airplanes are used by the Company for its flights to Beijing, Bombay, Bangkok, Johannesburg, Toronto and London. In order to usher in a new age in terms of customer experience, the Company is currently working on an advanced review of the customer service chain. The guiding concept is the creation of a single central system for surveys, feedbacks and customer experience management, allowing information to flow from the field to management and vice versa, to close the real-time customer treatment circle and structured debriefing and organizational learning in order to constantly improve customer service. The pilot was started in August 2011, and the plan is to adopt the system as a regular control tool over the course of In March 2011 the Company launched the El Al legacy site. The site features stories, images and films documenting the Company's 63 years of history. From time to time, the Group assesses the possibility of increasing its frequencies to existing destinations and the possibility of operating flights to new destinations, in accordance with market demand, inter alia, through code sharing agreements and other agreements with other airlines (for details regarding regulatory approvals necessary for such agreements see (i) below). The following are updates regarding the Company s code sharing and cooperation agreements for 2011: Following the Company s reports in the 2010 periodic report regarding the code sharing agreement signed in November 2010 with Russian airline Siberia Airlines, note that in May 2011, the agreement was expanded to nine additional destinations throughout Russia (besides Novosibirsk): Omsk, Rostov, Chelyabinsk, Nizhny Novgorod, Perm, Kazan, Samara, Sochi, Krasnoyarsk. The expanded agreement came into effect over the course of May a - 68

71 Following the Company's reports in its 2010 periodic report regarding the code sharing agreement signed December 2010 with Ukrainian airline Aerosvit, the agreement was approved by the Minister of Transportation and Road Safety and the Antitrust Director General and has been applied starting November Following the Company's reports in its 2010 periodic report regarding the code sharing agreement signed December 2010 with Armenian airline Armavia Airlines (hereinafter: Armavia ), the agreement came into effect in late March In December 2011 Armavia informed the Company that as no understandings were achieved between the parties regarding the revision of the prices of seats allocated to the Company on Armavia flights according to the agreement, the agreement was brought to a conclusion in late The code sharing agreement with American Airlines was expanded, and starting December code sharing destinations were added throughout the United States, both from New York (JFK) and from Los Angeles. The Company signed a cooperation agreement (on an interline basis) with regional Canadian airline West Jet. This agreement came into effect in September 2011 and it allows the Company to offer its passengers a variety of follow-up destinations throughout Canada, South America and the Caribbean. Following the update reported in the report for the fourth quarter of 2011 regarding the code sharing agreement between the Company and South African Airways, the Company decided to alter the agreement s format and is currently negotiating in preparation for the signing of an alternative code sharing agreement in a free sale format, for flights on the Tel Aviv-Johannesburg route. Later on, the option to expand the agreement to domestic South African flights will be considered. Insomuch as the agreement is reached, it shall require the approval of the Director General of the Antitrust Authority and the Minister of Transportation and Road Safety. Following the Company's reports in its 2010 periodic report regarding the code sharing agreement signed December 2010 with Bulgarian airline Bulgarian Air, the Company decided not to activate the agreement at this stage. 7.5 Customers The Group renders its services to passengers who are both members of households and of the business sector. The majority of the airline tickets of the Group are sold by means of travel agents and marketers of tourism packages, and directly by the Company to a - 69

72 institutions and individuals. See Section 7.6 for additional details. For information on the frequent flyer program, see Section below. The Group does not have a single customer in the passenger aircraft field whose revenues account for 10% or more of total Group revenues. The Group estimates that it is not dependent on any single agent in the passenger aircraft transport field. See Section 8.5 below for details relating to customers of cargo transport services. 7.6 Marketing and Distribution Travel Agents and Marketers of Tourist Packages Most travel agents are IATA members and sell flight tickets for a number of airlines. Upon making their sale, the agents are entitled to commissions from the airlines at rates determined by them and in accordance with IATA directives 24. Agents may occasionally be entitled to additional commissions, including sales incentives, as decided by the airlines. The vast majority of the marketing of airline tickets to passengers is carried out by means of travel agents and marketers of tourism packages. In addition, airline tickets are sold by the sales offices of the Group and by direct sale over the telephone and the Internet. As of the writing of this report, the Group has 4 sales offices in the country (Tel Aviv, Jerusalem, Beersheba and Eilat; the Haifa branch closed on August ) and 30 sales offices in 21 branches abroad (the Dnepropetrovsk and Odessa branches in Ukraine closed in December 2011 (see 7.2.(d) above); starting February the Company s Denmark branch has closed, and sales and marketing activity there will be carried out by a general sales agent). In addition, the Group sells airline tickets through 37 overseas general sales agents (GSAs). On November 2011 the Company discontinued its activity on the Sao Paolo route (for details see 7.2.(f) above), following which the station was closed and just the sales office remains. Airtour Israel Ltd. (hereinafter- Airtour ), a company jointly-owned by the Group and by travel agents, is an important marketing channel for the Group in the Israeli market, as a distribution arm to all agents in Israel with respect to sales campaigns and packages to all agents in Israel. 24 For details regarding IATA directives see a - 70

73 In the passenger aircraft transport field, the Group does not have an agent through which sales volume amounts to 10% or more of total Group revenues. The Group estimates that it is not dependent on any single agent in the passenger aircraft transport field. The Group provides support to travel agents and package marketers, inter alia, through the Group s sales offices. The Company grants commissions and special incentives to travel agents, primarily based on the sales volume of airline tickets. In principle, the compensation given to Israeli agents is divided in two: a fixed component (a basic 7% IATA commission) and a variable commission component, as an incentive. There are various methods in use around the world regarding this matter, in accordance with market needs. In recent years, a trend has developed in the aviation world of transition to a reduced commission system, reaching a net fare system (fares without commissions) in such a manner that the agents' base commissions are cancelled and service fees collected by the agents are added. The foreign scheduled airlines operating in Israel have instituted a similar policy to that of the Company, although starting January 2009 a number of airlines operating in Israel cancelled the base commission. Note that in December 2011 the Petach Tikva District Court ruled that Lufthansa and Swissair acted illegally by unilaterally cancelling the base commission in violation of the IATA contract, which states that travel agents are entitled to compensation for their work. Furthermore, legal proceedings are underway against additional airlines operating in Israel regarding changes in base commissions Commissions to agents abroad vary from country to country, according to market conditions. See Section 8.5 below for details with respect to commissions in the area of cargo transport Computerized Reservations System Until 2008, flight reservations were made by means of the Carmel computerized booking system, which also served both as a pricing and as a ticketing system, to which all of the Company's sales offices in Israel and abroad, most travel agents in Israel, general agents of the Company and a number of large agents abroad were linked. A computerized reservation system displays the up-to-date flight schedule of the Company and of foreign airlines, and enables the users to book reservations and ticket on those companies flights. The Group also has agreements with certain international distribution systems that allow sale and direct access to the Carmel system by the users of such systems in order to book reservations for Company flights. a - 71

74 In 2010 the Company completed its transition to the Amadeus ordering system, including transferring the Company's check-in system (DCS activity Departure Control System) to the Amadeus system. The check-in system is the third module in a system containing and constituting an integral part of the inventory management and reservation module. The application was installed in a gradual fashion at El Al stations in Israel and abroad. These technological changes included, among other things, adjustments and development of applications and interfaces for Company systems, creation of communication for active airports in which the Company operates "online", installation of applications at all stations, including the ACM (Amadeus Customer Management) system and the AFM (Amadeus Flight Management) system, establishing procedures and entering rules into the system, testing applications and preparing instruction formats. In addition, as part of the adaptation of activity to the new system, more efficient use was made of loading capabilities by calculating weight and balance using concentrated calculated data as well as more efficient supervision of customer treatment procedure. Upon the completion of the transition to the Amadeus system, activity with the Carmel system was discontinued. Furthermore, in order to expand to the Company s distribution network in offline destinations, an agreement was signed in February 2011 with German company Aviareps regarding the Company s connection to the IBCS system in a number of destinations around the world. This is with the goal of penetrating these markets through the distribution systems, with clearance carried out by the IATA IBCS according to the BSP model Marketing and Sales to Passengers The Group takes action in order to advertise its services to passengers in the Israeli market and in other large markets. The Group also initiates marketing events, sponsorships and joint efforts saw a continuation of the trend of global growth in e-ticketing, meaning the direct marketing of flight tickets over the Internet. These trends are intended to reduce airlines' marketing and distribution costs. The Company continues to adapt its operations to these trends, by developing means that enable self-service for customers, such as online ticket purchasing, check-in and seat selection, check-in and seat selection at counters in the terminal, etc. The Group sells directly to passengers through the Group's reservations department and website. The Group also operates a business desk to promote sales to business entities, mainly in Israel. a - 72

75 Over the course of December 2011 changes were made to the price list for the business department in the Israeli branch. The change is expressed in a transition from a discount method to a special rate filing method. In order to increase the attractiveness of the Group's flights for passengers interested not only in transport services to and from Israel, but also in tourism services, the Group markets a variety of ground services for tourists (hotels, tours, car rental) to individual passengers, directly and through agents. For this purpose, the Group markets packages through Airtour. See Section (g) below for details. This activity is marketed abroad through Superstar Holdings (England) at the Company s branches abroad by independent direct marketing or through travel agents. See Section 9.7.1(e) for details. The Group also holds shares in the marketers of packages operating in Israel: Kavei Chufsha Ltd. (see Section 9.7.2(h) below for details). See Section 8.5 below for details on the marketing and distribution of freight transport in the holds of passenger aircraft Frequent Flyer Program As part of its marketing efforts, and in order to fortify the loyalty of Group passengers, the Group offers special benefits to passengers belonging to its frequent flyer club, which is based upon a recorded database. The passengers receive points for their flights on all of the international routes carried out by the Group. These points award passengers with various benefits, including airline tickets at a discount or for free (with the exception of a cash surcharge for port taxes and various extra charges, including a fuel surcharge), upgrades to better classes and access to the Company s lounges throughout the world. Staring January the Company issues reports regarding program liabilities in its Financial Statements according to the IFRIC-13 international accounting regulations. This clarification states that flight ticket sales agreements in which the Company grants its customers frequent flyer points exercisable in the future as flight tickets will be treated as multi-component transactions, and the payment received from the customers will be allocated between its various components based on the fair value of the bonus credits. The proceeds attributed to the award shall be recognized as revenue when the credit awards are cashed and the Company s obligation to supply the awards is upheld. In recent years, the Group has entered into agreements that allow the accrual and redemption of points in other airlines and/or conversion of points/stars from credit cards and other businesses to the frequent flyers club as well as collaborative agreements a - 73

76 allowing the accrual of points and/or the receipt of other benefits as a result of purchases made from various businesses (compensation is generally paid the Company by the business) and agreements for the use of points at various businesses. In addition, agreements have been made with various non-profit organizations working for social, ethical and humanitarian causes, for the contribution of points to said organizations by club members. The frequent flyers club has hundreds of thousands of members and is composed of a number of ranks according to the activity level of their members: Regular Frequent Flyer", Silver, Gold, Platinum and "Top-Platinum". Concurrent with commercial changes made in recent years in the club's terms, various technological improvements were also made, including upgrading the information system by allowing club members to execute transactions in their accounts through the website, improving the call routing system at the service center, improving the customer account statement format, and more. Frequent flyer club member traffic accounted for 32% of the Company's total passenger traffic during 2011 compared to 30% in The Company's program for cultivating and retaining prestigious customers continued in Accumulated Orders The Company has no financial data as to the volume of projected revenues from reservations for future flights. Furthermore, a portion of these tickets may also be redeemed by the customer over an extended period that does not exceed two years. The Company has unearned revenues deriving from the receipt of advance payments for flights yet to take place as well as from points accumulated by frequent flyer club members as noted above. 7.8 Competition General a. The cargo aircraft transport field is characterized by fierce competition between the airlines that supply transport services between the same destinations or alternative destinations. b. The Company serves as the Designated Carrier of the State of Israel to most of the destinations from which it operates regular flights to and from Ben Gurion Airport. a - 74

77 c. The Group estimates that, over the course of 2011, competition on flights to and from Israel was with approximately 120 airlines, including Israeli airlines Arkia and Israir (operating both charter flights and scheduled flights to certain destinations), 60 foreign airlines operating scheduled flights to 80 destinations in 45 countries and over 50 airlines operating charter flights (of which 34 operated throughout the year and the balance operated individual flights). The competition for cargo transport in the holds of passenger aircraft, which is included in this field, is against airlines transporting cargo in cargo aircraft and in the holds of passenger aircraft. See Section for additional details. See Section above for details on the competitive structure of this area of activity The Group s Market Share in the Service Categories According to the Company's estimates, in 2011 the Group's share of all traffic to and from BGN amounted to 33.9%, compared to 37.1% in For the Company's market share of service groups see Section 7.2.(b) above Significant Competitors in the Field of Passenger Aircraft Transport To the best of the Group's knowledge, the Group's major competitors in the passenger aircraft transport field, in terms of market share, are Continental/United (U.S.), Delta (U.S.), U.S. Airways (U.S.), Lufthansa (Germany), British Airways (UK), Alitalia (Italy), Air France KLM (France and the Netherlands), Swissair (Switzerland), TransAero (Russia), and Aerosvit (Ukraine). See Section above for details regarding the intensification of competition in the field in Key Methods for Coping with Competition The Group acts in a number of venues in order to raise profitability, while preserving and increasing its market share and increasing its load factor: a. Adapting its schedule, as much as possible, to the seasonality of traffic and to international events. b. Increasing the frequency of flights to popular destinations and increasing the number of flight destinations, including by cooperating with other airlines. c. Striving to constantly improve service to passengers, including improving seat comfort, food quality and variety, flight entertainment, etc. focusing on business class. d. Providing benefits to frequent flyers club members and to businesses belonging to the Group s business desk. a - 75

78 e. Operating through all relevant marketing channels. f. Addressing the traveling public through advertising campaigns in Israel and abroad. The positive factors that affect, or are likely to affect the Group s competitive position include the following: a broad and varied flight structure; a distribution system dispersed widely throughout Israel; the existence of an attractive frequent flyers club; a formidable brand in the local market; high level of safety and security; schedule stability and on-time performance; adapting services to market needs and code sharing agreements with other airlines. The negative factors that affect, or are likely to affect, the Group's competitive position include the following: a geopolitical situation that significantly reduces the Group's opportunities to carry out Sixth Freedom Flights (indirect flights via BGN) as opposed to the expansion of Sixth Freedom Flights by foreign airlines; the possibility of appointing additional competitors as Designated Carriers in Israel to destinations to which the Group flies or to nearby destinations, especially in view of the Government's aforementioned decisions; the declaration made by the U.S. FAA to lower the State of Israel's flight safety rating to Category 2; the entry of low cost airlines; membership of foreign airlines in global aviation alliances (STAR, One World, SKY); regulatory changes and legislative restrictions applicable to the area of activity (for details see (i)); excess capacity of competitors; the Group's reliance on distribution by means of agents as opposed to the growing trend of direct marketing via the internet; the absence of Company passenger flights on the Sabbath or Jewish holidays and the possible deterioration of the economic, security and political situation in Israel. 7.9 Seasonal Factors The Group's activity is seasonal and focuses on peak periods. Heavy traffic of Israeli residents traveling abroad occurs primarily during the summer months and during holidays, while heavy incoming tourist traffic occurs during the summer months and during Jewish or Christian holidays or vacation periods in their countries of origin. The Group's peak operations are in the third quarter, when passenger volume in 2011 and 2010 was approximately 31% of total yearly passenger traffic. a - 76

79 The following is data on the Group s quarterly revenues from passenger planes 25 : Year 2011 % of Area of Activity Quarter (In Millions of Dollars) April- July- June September % 29.6% January- March % October- December % Yearly (In Millions of Dollars) January-December 1, % 7.10 Manufacturing Capabilities The accepted indices of output in the world of aviation as regards passenger aircraft are load factor 26 and ASK 27. At peak demand (August), the Group s productive capacity approaches its full potential output. In August 2011 the Company s ASK was 2,283 million RPK and the Company load factor for August 2011 was 84.1%. The following graph describes the monthly ASK average and the Company's average load factor over the past five years: In accordance with the 1982 government resolution, the Company ceased operating scheduled flights on the Sabbath and Jewish holidays, and, accordingly, does not fully utilize its productive capacity. With the conversion of the Company to a Mixed 25 The Jewish holiday period, according to the Gregorian calendar, varies from year to year; this may have an effect on comparing quarterly operations between one year and another. 26 Passenger Load Factor calculated by passenger- flown KM (RPK- number of paying passengers multiplied by distance flown) as a percentage of seat- KM availability (ASK -ASK number of seats offered for sale multiplied by distance flown). 27 Available Seat Kilometer - number of seats offered for sale multiplied by distance. a - 77

80 Company on June 6, 2004, this prohibition was removed. Pursuant to an agreement reached in January 2007 between representatives of the Rabbinic Committee for Sabbath Observance and Company representatives, the parties agreed that the Company would continue to maintain the status quo which had existed up to then, according to which the Company does not perform EL Al passenger flights on the Sabbath and on Jewish holidays, pursuant to the 1982 government resolution. In light of the need that arises from time to time for flights to be carried out on the Sabbath, it was agreed that, prior to such flights, the Company would communicate with the Chief Rabbi, Shlomo Amar, to clarify the position of Jewish doctrine. Additionally, the parties formulated understandings concerning the refund of cancellation fees for portions of kosher meals, in the event that, as the result of the breach of this understanding, ultra-orthodox customers would be forced to cancel their flights. See Section below for further details Aircraft Fleet As of a date near the approval of the report, the Company employs 37 passenger aircraft, of which 12 are planes leased by the Group and 25 are planes owned by the Group. The number of planes owned includes a (EAD), which discontinued its activities in October 2011, and does not include a plane (EAC), which discontinued its activity over the course of September 2011 and was sold in parts over the course of January 2012 as well as a (EBT), which was discontinued on January and was sold in February The Group's fleet of passenger aircraft was manufactured entirely by Boeing. As a result, El Al is dependent upon the aircraft manufacturer Boeing for all matters related to the supply of aircraft parts, in the event of failures and findings occurring during regular maintenance (as a result of it being the aircraft s manufacturer) and engineering consulting. a - 78

81 The following table details the fleet of passenger aircraft owned by the Group, as of December 31, 2011: Type of Aircraft Total Average Age (in Years) Average No. of Seats Maximum Flight Range (Nautical Miles)29 Cargo Capacity , ER , , , ER(CD) , ER (EF) , ER , Total Reports on aircraft purchase transactions: Boeing aircraft (ELH) Following the agreement signed with R.B. Leasing Company Limited for the purchase of a aircraft, the airplane was received at the Company in early March Renovation and adaptation works were performed on the aircraft, including configuration adjustment, and were concluded in July The plane s configuration includes 455 seats. In May 2011 the Company signed a loan agreement with a local bank to finance the purchase of the aircraft to the amount of $14.5 million. The loan is in USD and bears variable LIBOR interest plus a margin. Principal and interest payments are quarterly payments. The financing is for a period of 4 years. For the purpose of this loan the airplane was pledged to the local bank. One third of the sum of the loan was deposited at the local bank and is used as a means of lowering credit costs. In November 2011 the financing 28 Cargo capacity of a aircraft full of passengers for a range where the required amount of fuel does not come at the expenses of effective cargo. 29 The range is for a plane full of passengers without cargo. 30 Including the EBT plane that discontinued its activity on January and which was sold in February Including the EAC plane that discontinued its activity in late September 2011 and was sold in parts over the course of January 2012 as well as the EAD plane that discontinued activity in October 2011 and is currently for sale, and the Company is currently considering the possibility of selling it and its engines to companies dealing in engine restoration and parts sales. 32 Three of the 777s were purchased using ExImEXIMExIm guarantees and therefore the legal formula states that the aircraft were first leased by the Company, with the Company retaining the option to purchase the aircraft at the end of the period in return for $1. a - 79

82 sum was raised by 39.5 million NIS. The loan is in NIS and bears Prime interest plus a margin. Principal and interest payments are quarterly payments. The financing is for a period of 4 years Boeing ER aircraft On February an agreement was signed with aircraft manufacturer Boeing (hereinafter: the New Agreement ) for the purchase of 4 new Boeing ER aircraft and two additional aircraft of the same model convertible to purchase options. In addition, the Company was granted the option to purchase two additional aircraft of this model (hereinafter: the Option ). In the New Agreement the Company was granted conversion rights for other models as well as associated rights. The comprehensive value of the agreement is estimated at between $220 million and $325 million (respectively for four to six aircraft, as purchased in practice, without the option), and reflects an average market value of aircraft of this model and similar production year, in accordance with generally accepted industry aircraft prices list and subject to adjustments and investments (including the purchase of an additional reserve engine for the fleet) in accordance with the version agreed upon by the parties, including linkage of aircraft prices, using an agreed-upon linkage formula According to the New Agreement, the aircrafts are expected to join the Company s aircraft fleet between late 2013 and The aircraft are expected to serve the Company in short and medium ranges (Europe and other destinations) and shall replace narrow-bodied aircraft as per Company strategy. The aircraft shall be operated in a seat configuration, divided into two services classes. Note that these are aircraft of a new and advanced model, with modern engines and advanced internal configurations The payments for each plane will be made two years before each plane is delivered to the Company, or according to other payment options from which the Company may choose. Furthermore, the parties agreed upon terms for the use of some of the advance payment, including use of advance payments paid in the cancelled ER airplane purchase, as detailed in Note 16.e.1 to the 2011 Financial Statements. Note that the as of the signing date, the Company has made advance payments for six aircraft to the amount of 1% of the purchase price and paid, upon the signing of the New Agreement, an additional advance payment for the aforementioned option. a - 80

83 As of the publication of this report, $9.3 million were paid for the first aircraft and $9.3 million were paid for the second aircraft Following the new agreement, in March 2012 the Company signed a loan agreement with a foreign bank to finance the advance payments for the purchase of the first two aircraft, for a total of up to $46 million. For further details see below Thrust upgrade purchase following the agreement signed with airplane manufacturer Boeing for the purchase of ER aircraft, in May 2011 an agreement was signed with engine manufacturer CFM International, S.A. for the purchase of a thrust upgrade for engines provided with the airplanes Reports on aircraft sales transactions: Boeing (EAC) aircraft the plane discontinued its flights on September Its parts were sold to Turbo Resources in a consignment agreement. The contract was signed in January 2012 and the disassembly of the aircraft and the transfer of its parts to sale are expected to be completed by July Boeing (EBT) aircraft in February 2012 an agreement was signed with TES Parts Limited (connected to DVB Bank) for the sale of EBT for disassembly into parts. The aircraft was delivered to the buyers in the United States on February 23,2012. a - 81

84 The following table details the fleet of aircraft leased by the Company, as of December 31, 2011: Type of Aircraft Total Average Age End of Lease Date Average no. of Seats Additional Details * 7.4 EKO November 2012 (op./ Nov. 13) EKP October 2014 EKI October 2015 EKS August 2016 EKF December 2016 EKT November 2012 (op. Nov. 16) 143 * 2 new aircraft are expected to enter service over the course of May/June 2012 EKM, EKR * - EBM December 2011 EBS August 2011 * EBM and EBS left El-Al service over the course of ER EAP November 2014 (op. Oct. 13) EAR November 2016 (op. Nov. 2014) EAJ November EAL November 2017 (op. Nov. 15) EAM December 2017 (op. Feb. 16 and onward with the exception of December, January, June, July and August). EAK November Total Leasing fees for the Company s aircraft in this area of activity amount to $59 million in 2011 compared to $58 million in 2010 and $53 million in Reports on aircraft leasing transactions: Boeing (EAL) aircraft in February 2011 the Company signed an agreement to lease a ER aircraft from A. I. AWMS, Delaware Statutory Trust, with whom a memorandum of understanding was signed in November 2010 regarding the aircraft in question. The aircraft is leased for a period of 78 months, with an early departure option granted each of the parties after 54 months. In April 2011 the aircraft joined the Company s a - 82

85 aircraft fleet. The aircraft was manufactured in 2000 and operates in the Company s service in a 223-seat configuration Boeing aircraft (EAM) the Company signed a leasing agreement with ILFC in July The aircraft is leased for a period of 72 months, with an early departure option granted the Company after 48 months. The airplane was received by the Company on December 30, 2011 and joined the Company s aircraft fleet in January The aircraft was manufactured in 1998 and is operated in the Company s service in a 237-seat configuration aircraft (EKR, EKM) in November 2011 a memorandum of understanding was signed with BBAM for the lease of two aircraft which will be operated in a charter configuration (activity carried out in the past by Sun D Or) The aircraft are planned to be received at the Company over the course of May 2012 and begin operations over the course of June The lease agreements are expected to be signed over the course of March Reports on aircraft lease extension transactions: In January 2011 the Company signed an extension and revision to the agreement to lease a ER aircraft (EAR), manufactured in 1995, from ILFC, for an additional 60 months with the option to end the additional leasing period early after 36 months In January 2011 the Company signed an extension and revision to the agreement to lease a ER aircraft (EAP), manufactured in 1991, from CIT Aerospace International for an additional period until October , and the Company was given the option to extend the additional leasing period to November In October 2011 the Company signed an agreement to amend and extend the lease of a ER aircraft (EAJ), manufactured in 1991, from Celestial Aviation Trading 36 Limited, owned by GE Capital Aviation Services ( GECAS), for an additional period of 32 months. a - 83

86 Aircraft return report: Boeing aircraft (EBS) returned to its owners (M.K. AVIATION, S.A.) in September Boeing aircraft (EBM) returned to its owners (M.K. AVIATION, S.A.) in December Reports on sale and lease-back transactions: Agreement to Sell and Lease Back Rolls Royce Trent 895 Engine The agreements to sell and lease back the engine was signed with an international company, which mostly deals with the leasing of engines (hereinafter the Buyer or the Lessor ), and pursuant to the agreements the rights to the engine were transferred to the buyer. The following are the key points of the transaction: The total proceeds for the engines were USD$13 million (hereinafter: the Proceeds ). The Proceeds were set according to market prices accepted in the industry for engines of an identical model and age and according to its maintenance condition upon delivery and was paid upon delivery. The lease period is for 9 years (hereinafter: the Lease Period ) The Company was granted an option to extend the Lease Period by two additional extension periods of three years, or restoration near the extension date and two years, respectively, in accordance with market conditions on the extension date. The Company listed capital gains of $3 million in its 2011 Financial Statements for the transaction in the last quarter of Agreement to Sell and Lease Two CFM 56-7B engines Following the immediate report published by the Company on February , an agreement was signed to sell two CFM 56-7B engines manufactured in 1998 and 2000 (hereinafter: the Engines ) owned by the Company and to lease them back to the Company. The agreements to sell and lease back the engines was signed with an international company that mostly deals in the leasing of engines (hereinafter the Buyer or the Lessor ), and pursuant to the agreements a - 84

87 the rights to the engines were transferred to the buyer. The following are the key points of the transaction: The total proceeds for the engines are USD $13-$14 million (hereinafter: the Proceeds ). The Proceeds were set according to market prices accepted in the industry for engines of an identical model and age and according to its maintenance condition upon delivery and was paid upon delivery. The lease period is for 7 years (hereinafter: the Lease Period ) The monthly payments to the lessor include the monthly leasing fees including the deposit of reserves for repairs for the engines activities in the leasing period, as required in accordance with the leasing period, which together constitute 0.75%-1.2% of the proceeds. The Company was granted an option to extend the leasing period by two additional extension periods, of three and two years, respectively, in accordance with market conditions on the extension date. The Company is expected to list capital gains of $9 million in its Q Financial Statements for the transaction. At the same time, the Company is expected to list an expense of a similar scale in 2012 as a result of the implementation of actions involving the removal of old aviation equipment, parts and equipment surpluses. As of that date, the precise sum of the expense is unknown, among other things as a result of the fact that the transactions are still under consideration and have yet to be formulated in a binding manner. These transactions were carried out as part of the Company s policy to rationalize its aircraft fleet and aviation equipment inventory in its possession in such a manner so as to guarantee the date of their removal from service in the future and which was intended to improve the Company's cash flow at the current time, following management s activities described in Note 1(d) to the Company s Financial Statements for the year ending December Reports on engine purchase transactions: In March 2011 the Company signed an agreement with engine manufacturer CFM International S.A. for the purchase of a spare engine for its 737 aircraft fleet. The engine entered service in the 737 fleet in July The engine's price is approximately $8 million. A loan was received from a foreign bank to finance the engine to the amount of $3.9 million U.S., for a period of 7 years with quarterly interest and principal payments, a - 85

88 bearing fixed interest. For the purposes of this loan, a lien was placed on the engine and a guarantee was received from the U.S. Export and Import Bank ExIm Adding winglets to aircraft: As part of its attempt to reduce the impact of rising fuel prices on its flight expenses, the Company has decided to add winglets to the aircrafts in its possession. A winglet is a vertical upward extension or backward pull of the end of the wings of fixed wing aircraft. Adding winglets is expected to save fuel costs. At this stage, winglets have been added to a single aircraft, and over the course of the first half of 2012, winglets installation is planned for two additional aircraft Maintenance General The Company is following Boeing s recommendation to perform alterations on the fuel tanks of Company planes. The total cost of purchasing fittings for applicable Company aircraft is $9.3 million. At this stage there is a delay in the fittings supply dates and in the planned timetable. To date, the Company has purchased fittings for three aircraft at a cost of $1.1 million. The Company is preparing to upgrade its aircrafts communications equipment over the course of 2012 through 2015 at an investment of $5.5 million. In May 2011, a technical problem occurred in a Company Boeing 777 in flight from Ben- Gurion Airport to Newark. After takeoff, a display appeared in the cockpit indicating that the landing gear had not risen and locked properly. In accordance with standard operating procedure for such a case, the captain decided to lower the landing gear and return to land in Israel. The plane landed safely. After landing, a crack was discovered in the main axle of the left landing gear, which was in all likelihood the reason for the incident. The landing gear was replaced and the plane returned to service after two weeks of maintenance works, and the issue was accounted for with the aircraft s manufacturer. The incident is being investigated by the Chief Investigator at the Ministry of Transportation and the summary report has yet to be published. 8. Cargo Aircraft Field 8.1 General Information on the Area of Activity The following is a description of trends, events and developments in the Group's macroeconomic environment, which have, or are likely to have, a material effect on the operating results or on the developments in the entire Group or in the cargo aircraft area of activity, regarding the following matters: a - 86

89 8.1.1 Structure of the Field of Activity and Changes Occurring Thereof There are four types of competitors in the cargo air transport market: airlines that carry cargo solely in cargo aircraft; airlines that carry cargo solely in the holds of passenger aircraft; companies, like El Al, that carry cargo both in cargo aircraft and in the holds of passenger aircraft; courier airlines which, in addition to cargo related to courier services, also carry other cargo in their aircraft. In recent years, a trend has increased among airlines studying the possibility of converting passenger craft to cargo craft primarily for economic reasons. The Boeing cargo craft are of a relatively advanced age, and various limitations have been placed on their activity, which have a negative impact on the economic feasibility of their operation. In addition, there is a relatively low global supply of designated cargo craft, and therefore the aviation market has come up with the solution of converting passenger planes to cargo craft. This trend is reflected, inter alia, in the transition to passenger aircraft with greater cargo carrying capacity. Continuation of this trend could transfer cargo transport operations from the cargo aircraft field to the passenger transport field. According to the Company's estimates, the Group's portion of the cargo shipping market in 2011, 2010 and 2009 has been assessed at 33.3%, 34.2% and 33% respectively, out of all cargo transported to and from Israel (including cargo shipped in the holds of cargo craft. Not including Sixth Freedom and including mail activity) Legislative Restrictions, Regulations and Special Obligations that Apply to the Field of operations In July 2009 the Company submitted a request to the Government Companies Authority for the consent of the holder of the Special State Share, as required by the Company's articles, to remove two cargo aircraft from Company service. In June 2011 the consent of the holder of the Special State Share was received for the sale or removal from service of one cargo plane (AXK) and for the leasing of a F cargo plane. The regulatory restrictions for cargo transportation in cargo aircraft are similar to those applicable to passenger transport in passenger aircraft. For details see above. Regulatory arrangements have also been made for the cargo field pertaining to a number of operational aspects, such as permissible flight capacity, responsibility of the air carrier for damages, flight safety standards, security and noise. See Sections 9.11 and below for details. Nevertheless, the policies of the global aviation authorities in granting permits for cargo aircraft have tended to be more lenient than in the passenger aircraft a - 87

90 field. The situation especially affects the huge opportunity to carry out flights of cargo aircraft using Fifth Freedom and Sixth Freedom Changes in the Volume of Activity and Profitability of the Field a. Extent of Global Cargo Transport According to IATA data, there has been a growth in the cargo shipping field over the past 20 years. According to IATA data, starting from the third quarter of 2009, the process of emerging from the economic crisis and economic recovery has begun, mainly in developing Asian markets, which has accelerated the airborne cargo shipping sector. In the second half of 2010 the airborne cargo shipping sector returned to the level of activity it had reached prior to the crisis, thus pushing forward projections that predicted a recovery within two years, and 2010 saw a 20.2% increase in the scope of global shipping of airborne cargo (including in the holds of passenger aircraft). According to IATA estimates, in 2011 global airborne cargo transport (including in the holds of passenger aircraft) decreased by 0.6%. In December 2011 IATA published its estimates according to which by 2015 an average annual growth ( ) of approximately 4.5% is anticipated in global airborne cargo transport (including in the holds of passenger aircraft). 33. IATA estimated that 2012 will see a growth at a rate of 0.3%. The following table describes the development of airborne cargo shipping activity between 2007 and 2011, based on IATA data 34 : Year Output RTK 35 (in Millions) Yearly Change in RTK (%) No data. No data. 152, , , ,990 ( 11.2) ( 2.6) The IATA projection for up to 2015 refers to increases in the weight of cargo shipped in tons times the distance flown revenue ton kilometer (RTK) data has not yet been published. 35 Revenue Ton Kilometer weight of paid tons of cargo in cargo craft, times the distance flown. a - 88

91 b. Volume of Cargo Transported on Aircraft to and from Israel The following is data on cargo traffic to and from Ben Gurion Airport over the past five years (The data includes cargo carried in cargo aircraft and in the holds of passenger aircraft) 36 : Exports Imports Total Cargo Traffic through BGN (Thousands of Tons) for the Year Ending December Change from 2010 ( 5%) 2% ( 2%) Change from % 15% 10% Change from 2008 ( 15%) ( 16%) ( 16%) Change from 2007 ( 9%) 1% ( 5% ) Aircraft traffic through BGN listed a 1.9% decrease in 2011 compared to In addition to Israeli cargo company CAL, the cargo capacity of foreign airlines included cargo capacity of passenger flights and capacity in cargo flights by six airlines: FedEx (U.S.), MNG and Turkish Airlines (Turkey), EAT (Belgium), Korean Air (Korea) and Royal Jordanian (Jordan). Likewise, unscheduled cargo flights were flown through foreign companies, on an ad hoc basis. 50% of the total cargo traffic through BGN was flown on cargo aircraft and the remainder (50%) was flown in the holds of passenger aircraft (primarily wide-body planes). This data does not include cargo that the Group flew via BGN in the context of Sixth Freedom (flight from one foreign country to another via BGN) at negligible amounts 38 in 2011 as well as 1,000 tons, 500 tons and 2,000 tons in 2010, 2009 and 2008, respectively Developments in the Area of Activity's Markets, or Changes in its Customers Characteristics The Israeli market in the area of activity of cargo shipping using cargo aircraft is characterized by high seasonal fluctuations, due to the relatively high volume of agricultural exports (carried out primarily in the winter months), out of total exports. See Section 8.5 below for information on the Company's customers in the field of cargo aircraft shipping. 36 Source: the Civil Aviation Authority and the Company s estimate, which includes the deduction of Sixth Freedom activity by El Al through BGN and the addition of El Al mail activity. 37 Without deducting the Company's Sixth Freedom activity through BGN, the rate of decrease in traffic in 2011 was about 2.1% compared to Data includes cargo that was carried in cargo aircraft as well as cargo carried in the holds of passenger aircraft. a - 89

92 8.1.5 Technological Changes that May have a Material Impact on the Area of Activity The Company is working to expand and develop advanced IT solutions in the field of airborne cargo, in the field of online trade and in self-service abilities with the goal of improving service and reducing the Company's costs. A new system for the management of cargo transactions entered service in the second quarter of 2009, and use of the online ordering system was expanded. The system is intended to lead to improvements in commercial processes including in the areas of pricing, reduction of the amount of transactions, simplification of the transaction approval process, greater precision in attaching transactions to bills of lading, greater precision in customer billing and improvements in service. In addition, completion of the project was expected to bring about a work process with a centralized operation system, improvement in the quality of information and improvement in the transparency of information on the network. The expectations were partially realized, due to the interface with the accounting system. In light of this, in November 2010 the Company issued an RFP for an off-the-shelf product supporting the commercial, operational and accounting processes (from the sales stage to accounting). As of this report the Company has decided to freeze the replacement of the systems until the unification of work methods between the operational divisions and the financial divisions. The Company successfully completed the development of an interface between the cargo system and Israeli customs, which was followed by a pilot that will continue over the coming months. Over the course of Q additional European destinations began receiving automatic messages from the cargo system, in response to the requirements of European customs authorities. The information regarding possible implications of the completion of the automation of the accounting system and the improvement expected as a result to the Company's commercial processes constitutes forward-looking information, as defined in the Israeli Securities Law. The information is based in its entirety on the Company's estimates as of this report, derived largely from the system s capabilities and purpose, as presented to the Company. Therefore, the actual implications may be materially different from those forecasted, as the result of many factors, including technological factors, the Company's ability to implement the new system and its actual implementation as well as changes in cargo aircraft activity levels a - 90

93 8.1.6 Critical Success Factors ion the Area of Activity and Changes Occurring Thereof A number of factors can be pointed to in the operations of the cargo transport sector via passenger aircraft that affect the field's competitive status: the ability to offer to transport cargo to popular destinations at competitive prices; development of a network of routes on an independent basis, including the possibility of carrying out Fifth Freedom Flights and Sixth Freedom Flights, both as operations supporting transport to and from Israel; cooperation with other airlines; offering transport at the frequency and quality demanded while meeting time schedules; risk management and risk hedging Changes in the Supplier Network and the Raw Materials for the Field of Operations The primary raw material used by airlines is jet fuel and it represents airline carriers main expense components. See Section below for additional details relating to fuel. Likewise, as the Company's entire passenger plane fleet was manufactured by the Boeing Corporation, the Company is dependent upon this manufacturer for all matters pertaining to the regular maintenance of its aircraft, as regards parts and repairs Main Entry and Exit Barriers of the Field of Operations and Changes that have Occurred Thereof The regulatory entry barriers (the need for appointment as Designated Carrier and the permits as to flight frequency, capacity, etc.) for regular flights in cargo aircraft are similar in essence to the regulatory entry barriers for scheduled flights in passenger aircraft. See Section above and Section 9.11 below for details. The Company estimates that some countries have a more liberal policy of granting permits in the field of cargo transports. Therefore, in the Company s assessment, this entry barrier may be less significant for some countries in the cargo field. Another important entry barrier in the industry is the initial, relatively large investment required in order to establish and operate an airline, including acquisition of aircraft and other substantial current investments, including aircraft leasing. According to international aviation agreements, obtaining appointment as a Designated Carrier is conditional upon substantial ownership and effective control of the air carrier being held by the government or citizens of the country that has specified that it be a Designated Carrier. This requirement represents an entry barrier for obtaining appointment as Designated Carrier by foreigners. See Section above for details on changes in this condition under the terms of the State of Israel's aviation agreements. a - 91

94 The limitations of the holder of the Special State Share in the matter of the reduction of the Company's cargo fleet constitute an exit barrier. See Section below for further details Substitutes for Services of the Field of Operations and Changes that have Occurred Therein The principal alternatives to air transport in cargo aircraft are transport in the holds of passenger aircraft, maritime shipping or a combination of maritime shipping to the nearest destination port and from there, shipment overland. The Company estimates that the major considerations in selecting air transport over ocean and/or land transport are the nature of the product, the requisite shipping conditions, the necessary delivery period and the transport costs. In 2011, no material changes occurred in the alternatives to cargo aircraft shipping Structure of Competition in the Field of Operations and Changes that have Occurred Therein There has been a structural change in the industry in the Israeli market in recent years, due to increased sources available to customers with the entry of new airlines with cargo aircraft, inter alia, by means of the Fifth and Sixth Freedoms, upgrade of the passenger aircraft of the foreign airlines to broad-body planes capable of carrying more cargo in their holds and also by the entry of an additional Israeli cargo carrier- C.A.L. Cargo Airlines Ltd. (above and below: CAL ). See Section 8.7 below for further details. 8.2 Services in the Area of Activity In this area of activity, the Group offers cargo transport services in cargo aircraft from Israel to destinations to and from Israel; cargo transported from one foreign country to another foreign country (Fifth Freedom), for example from Liège to New York; or cargo transported in the context of Sixth Freedom (indirect flights via stopovers in the home country of the airlines), for example from Asia to Europe or the U.S. with a stopover in Israel. The Company transported negligible amounts of cargo in its cargo aircraft using Sixth Freedom rights (in ) The Group differentiates between three main destination groups: (1) North America; (2) Europe; (3) East and Central Asia. During the reported year, the services offered by the Group in this area of activity were cargo transport services to one destination in Europe, one destination in North America and one destination in East Asia (over the course of the first quarter). Moreover, the Company offers cargo services to many additional destinations by means of the Group s a - 92

95 passenger aircraft or by means of cooperative arrangements with other airlines and also by means of land transportation from the airport. The Company has decided to discontinue its weekly cargo flight to Hong Kong starting April In November 2011 an agreement was signed between the Company and the airport at Liege, Belgium, regarding the operation of cargo flights at Liege Airport and regarding the continued concentration of cargo aircraft activity at Liege Airport for a period of 3 years. The total financial scope of the agreement (expenses and revenues) is 3.9 million. Starting April 2010 the Company entered into an agreement with JDR J.A.M. de Rijk BV (hereinafter: "JDR") for ground transport services of cargo in Europe. JDR was selected as the chief transporter for ground shipping of Company cargo to various European destinations, in addition to managing the Company's transportation desk at Liege. The following is a breakdown of the volume of cargo traffic in the Group s cargo aircraft, by principal destination category, in 2008 to 2011: Cargo Traffic in Group's Cargo Aircraft, by Region (Tons), for the Year Ending December 31 Israel to/from Europe Israel to/from the U.S. Israel to/from the East and Central Asia Total ,336 8,073 1,384 42, ,068 8,310 1,418 45, ,796 6, , ,281 13,364 3,451 58,096 This data does not include cargo the Group flew other than via BGN in the context of Fifth Freedom rights and cargo that the Group carried via BGN in the context of Sixth Freedom rights. The Group flew cargo using cargo planes according to Fifth Freedom rights to the amount of 10,000 tons, 5,000 tons, 3,000 tons and 7,000 tons in 2011, 2010, 2009 and 2008, respectively. The Company transported negligible amounts of cargo using Sixth Freedom rights. The chief markets for cargo shipping services are for importers, industrial enterprises and the agricultural sector. For the purpose of cargo distribution from its cargo depots the Company operates in Europe, through sub-contractors, a system of truck based shipment. Following the framework agreement signed by the Company in February 2010 with Maman Cargo Terminals and Handling Ltd. ( Maman ), which operates a cargo terminal at Ben Gurion Airport, for all matters pertaining to the receipt of terminal services from a - 93

96 Maman, the agreement was extended by an additional period and the Company currently holds 15% of Maman's shares, and the Company has options to purchase Maman shares at a rate constituting 10% of Mamman's issued capital, exercisable within six years of issue at an exercise price of million NIS (in the event of exercise within first three years after granting) or alternately million NIS (in the event of subsequent exercise). 8.3 Analysis of Revenues and Profitability from Services In 2011 the Group's revenues from this area of activity increased by 13.6% vs. revenues in 2010, compared to a 1.9% decrease in cargo traffic through BGN in For information regarding the breakdown of the Company s revenues and profitability (consolidated) by the Company's reported operating segments in the area of cargo aircraft shipping see Section 5.a. of the Board of Directors report regarding the status of the Company. 8.4 New Services From time to time, the Group studies the prospects of operating flights to new destinations and increasing the frequency of its flights to existing destinations, in accordance with market demands. In August 2011 the Company entered into an agreement with Global GSA Group ( 3G ) to appoint it as general cargo agent in various European countries as well as to create a venture for business collaboration on flights originating from the same European counties in which 3G serves as a general cargo agent. 8.5 Customers, Marketing and Distribution Most of the Group's sales in the cargo aircraft shipping field are made through cargo agents (87.1% in 2011). The remaining sales are made directly to customers. In the field of transport using cargo planes, the Company does not have any customer from which the Group s revenues amount to 10% or more of total Group revenues. In addition, the Israeli cargo consolidation company (ACI), part of the shares of which are held by the Company (without the right to receive dividends), is engaged in consolidation of air cargo at BGN and its transfer abroad, mainly through the Company. ACI, like other airlines that operate in this field, consolidates the cargo of individual dispatchers into one shipment and, as a dispatcher, transfers it to El Al for shipment. In this way, it avoids interaction with a large number of dispatchers and cargo recipients, leading to cheaper air transport costs of consolidated shipments. The Group is evaluating a - 94

97 the possibility of changing its holdings in ACI, with everything this implies. This issue has yet to be resolved. Following a court ruling, in October 2011 Agrexco Agricultural Exports (hereinafter: Agrexco ) was sold to a new owner (the Bickel company), after encountering financial difficulties. 8.6 Accumulated Orders In general, air transport of cargo in cargo aircraft is carried out near the execution of the service reservation. Therefore, the Group does not have a significant reservations backlog. 8.7 Competition Competitive Conditions in the Field of Activity a. The cargo aircraft transport field is characterized by strong competition between the airlines that supply transport services between the same destinations or alternative destinations. The airlines compete in different areas, mainly: transport rates, schedule of flights and frequency of flights. b. Until 1999, the Company was the sole Designated Carrier of the State of Israel to most of the destinations to which it operates regular flights of cargo aircraft to and from Ben Gurion Airport. In recent years, other foreign airlines operating cargo aircraft have entered the field of operations in Israel. Starting in 1999, CAL was given a full commercial operating license and, over time, was appointed as Designated Carrier to a number of destinations. CAL operates two cargo aircraft, which it owns, and leases additional aircraft as needed. As of the date of the report, CAL operates flights to various destinations in the United States and Europe. The issue of a full commercial operating license to CAL led to a reduction in the Group's cargo activities. Previously, CAL had requested appointment as Designated Carrier to more destinations to which El Al is the sole Designated Carrier, and to which, under current aviation agreements, no more than one Designated Carrier may be appointed. c. In 2011 the Group competed for cargo transport in cargo aircraft to and from Israel with six foreign airlines (in addition to CAL), which operated cargo aircraft on flights to and from Israel. d. In recent years, the Civil Aviation Authority has tended to approve requests of foreign scheduled airlines to increase the frequency of their flights to Israel. As a a - 95

98 result, an increase has been apparent in the capacity of cargo shipping in the holds of passenger aircraft of foreign airlines. This increase has led to intensifying competition in cargo shipping as well. e. The significant increase in the flight capacity of regular foreign airlines referring to the passenger aircraft field of activity also led to a significant increase in cargo shipping capacity in the holds of passenger aircraft operated by regular foreign airlines to and from Israel. In light of this, competition is expected to escalate in 2012 as well as a result of the entry of new foreign airlines, as a result of additional increased capacity and/or frequencies and destination expansion by existing airlines as well as the operation of scheduled flights to new destinations by Israeli and foreign airlines. In light of the above, competition in the industry has continued to intensify. f. In April 2011 British Airways and Iberia signed a merger agreement that in effect created the third largest airline in the world. A new merger agreement was signed in late 2011 between United Airlines and Continental. The agreement came into effect in early December The Group competes with most of the scheduled airlines that operate passenger aircraft and carry cargo in their holds 39. According to Civil Aviation Authority statistics, 50% of the air transport of cargo to and from Israel during 2011 was carried out in the holds of passenger aircraft (primarily wide-body aircraft) on scheduled flights, while the remaining cargo (50%) was flown to and from Israel in cargo aircraft Major Competitors in the Field of Cargo Aircraft Transport To the best of the Group's knowledge, its most significant competitor in the field of shipping using cargo aircraft, from the standpoint of market share, is CAL Key Methods for Coping with Competition The Group acts on a number of levels in order to raise its profitability, while retaining and increasing its market share and also increasing the volume of the cargo it transports, including: a. Adapting the timetable, as much as is possible, to the seasonality of traffic and maintaining the timetable's stability. 39 In recent years, there has been an intensification of a trend of transporting cargo in the holds of cargo aircraft. This trend is expressed, inter alia, in the transition to passenger aircraft with larger cargo carrying capacity. a - 96

99 b. Increasing the frequency of flights to popular destinations and increasing the number of flight destinations by cooperating with other companies. c. Offering competitive prices. d. Adding to the frequency of the Company s cargo flights between foreign countries. Positive factors that affect, or are likely to affect, the Group s competitive position include: leasing a designated cargo plane; a strong brand name in the local market; a high standard of service, high safety levels; timetable stability and punctuality. Negative factors that affect, or are likely to affect, the competitive position of the Group include: the possibility of appointing in Israel additional competitors as Designated Carrier or to additional destinations; regulatory changes that restrict the option of entering into agreements with other airlines or prevent the utilization of flight rights; the entry of new, foreign competitors; increases in flight capacity of foreign airlines (including Fifth and Sixth Freedoms); downturn in the economic, security and political situation in Israel. 8.8 Seasonal Factors The field of operations is characterized by high seasonal fluctuations due to the relatively strong influence of agricultural exports out of total exports by means of cargo aircraft. The following is data on the breakdown of the Group s quarterly revenues from cargo aircraft: Year 2011 % of Area of Activity January- March % Quarter (In Millions of Dollars) April- July- June September % % October- December % Yearly (In Millions of Dollars) January-December % 8.9 Manufacturing Capabilities The generally accepted output indices for airborne cargo shipping using cargo aircraft are load factor 40 and ATK 41. During peak demand (in 2011 March), the Group's productive capacity approaches its full potential output. In December 2011 the Group s ATK was 335,962,000 ATK with a load factor of 75.9%. Note that the load factor indicator is 40 Calculated by RTK (the weight in tons of the paid cargo times the flight distance) as a percentage of ATK (the available cargo shipping capacity times the distance flown). 41 The available cargo shipping capacity times the distance flown (availableavailable Ton Kilometeravailable ton kilometer). a - 97

100 calculated based on the weight of the cargo only and does not take the volume of the cargo into account. The following graph describes the Group s average load factor and ATK index per quarter in 2011: 8.10 Aircraft Fleet As of immediately prior to the approval of the report, the Company employs one leased Boeing Starting June 2011 the Company completed its discontinuation of operations of its cargo plane (AXL) due to the need for heavy maintenance works required for its continued activity. The Company approached the State for its consent to remove the plane from service. Concurrent with and subject to the approval of the State, alternatives are being studied to the airplane s sale. a - 98

101 a. The following table details the fleet of cargo aircraft owned by the Group, as of December : Type of Aircraft Total Age (in Years) Maximum Carrying Capacity F tons b. The following table details the fleet of cargo aircraft leased by the Group, as of December : Type of Aircraft Total Age (in Years) Maximum Carrying Capacity F tons F (ELD) cargo aircraft in March 2010 the Company signed an agreement for the leasing of a Boeing aircraft, manufactured in 1994, with Bank of America Leasing Ireland Co. Limited ("BALI"). According to the agreement, the leasing period is from the date of the aircraft's receipt (April 2010) until June with the option (held by the Company) to extend the lease for a maximum of an additional 36 month period. In addition, pursuant to the agreement, the Company was granted the right of first refusal and options to purchase the aircraft, in accordance with the agreements between the parties. In January 2012 the Company announced that it intended to correct and extend the lease by an additional 12 months, with the end of the lease set near the date of the heavy maintenance inspection. The extension in question was approved by BALI in February In addition, the Company leases cargo aircraft via wet leases (aircraft leased with its crew) as needed. As described above, the Company is acting to replace its entire fleet due to reasons of economic feasibility in operating the fleet in light of the advanced age of the aircraft and the problem of complying with the maximum permissible engine noise 42 The aircraft has not been in use since June 2011 due to the need for major maintenance works. a - 99

102 restrictions in various airports worldwide (see Section below for details of noise restrictions), and no such aircraft are operated by it as of thus report. Total leasing costs borne by the Company in this area of activity amounted to $12.8 million in 2011, compared to $5.9 million in Raw Materials and Suppliers The principal raw material employed by the Company is fuel; see Section for further details. In the cargo aircraft field, the Group, in its various stations throughout the world, engages suppliers engaged in unloading and loading aircraft, in cargo storage in warehouses and in land transport of the cargo from the customer to the airport and vice versa. The rate of expenses related to commitments with these suppliers in 2011 accounted for some 14% of the operating sector s expenses. The Group was not dependent on any single supplier in Information on Both Fields of Activity 9.1 Fixed Assets and Installations Real Estate: a. The Group owns an area of 1,560 square meters in the El Al Building on 32 Ben Yehuda St. in Tel-Aviv, which serves as the offices of the Company's Israeli branch. The Group also owns offices in Spain (Madrid) and Argentina (Buenos Aires) with a total area of 269 square meters. b. The yearly rental cost for space in Israel is $8,200,000 for built-up property 88,000 square meters in size (80,000 square meters of which is in the El Al campus). The following are details of material real estate properties rented by the Group in Israel: a - 100

103 The Property Parties to the Agreement Consideration Contract Period and Option to Extend The El Al BGN campus has a built-up area of 80,000 square meters on 29 hectares of land. See (c) below. Authorization agreement between the Airports Authority (authorizing) and El Al (recipient). 10,150,000 NIS for the ground and structure component for The agreement shall be in effect until December Furthermore, the option exists to extend it for an additional 25-year period. The Company announced its intent to exercise the above option in accordance with the agreement, and is currently negotiating with the IAA to extend the period by an additional term. The SLN warehouse at BGN with a built-up area of 2,600 square meters plus 1,750 square meters of operational grounds. Authorization agreement between the Airports Authority (authorizing) and El Al (recipient). Yearly usage fees to the amount of $650,000. The agreement was extended to December Areas in BGN Terminal 3 a. King David Lounge and other areas. See (d) below. b. Other operational areas in Terminal 3. Authorization agreement between the Airports Authority (authorizing) and El Al (recipient). Authorization agreement between the Airports Authority (authorizing) and El Al (recipient). Yearly usage rights: A total of 11,000,000 NIS per year until April and a total of 18,000,000 NIS per year starting May ,635,000 NIS per year This agreement was extended to November Agreements to grant a permit for the other areas were signed, covering a period of 10 years starting November 2, Areas in BGN for the Company s cargo shipping activity, which include the Maman Building compound, with a total area of 445 sq. meters. Agreement between El Al and Maman Cargo Terminals and Handling Ltd. Yearly usage fees to the amount of 760,000 NIS in a shekel contract. The agreement was extended to December El Al branches throughout the country with a total area of 600 square meters (not including 650 square meters of parking rented in various locations). Different owners in conjunction with the Company. Total yearly cost of $220,000. The agreements are for different periods. c. Land Usage Rights at Ben Gurion Airport (BGN) Ben-Gurion Airport (BGN) serves as the Group's home port and central base of operations. The Group s headquarters, hangars, aircraft parking areas, workshops, warehouses and other offices and installations are located at BGN. Most of the offices, hangars and other buildings used at BGN were constructed on land to which the Group has long-term usage rights. a - 101

104 By virtue of the agreement dated June 1992 with the Airports Authority (IAA), as amended in February 1995, the Company has the usage right (permit) to 29 hectares of land at BGN through December 31, This period may be extended for an additional 25-year period under the terms of the contract or under other terms as will be agreed upon with the AA. It appears that exercise of the option will be subject to the payment of Purchase Tax. The Company is currently negotiating with the Airports Authority regarding the extension in question. According to the aforementioned agreement, the AA permits the Company to use the property and the access roads to it and also allows the Company to operate airline services on and/or through the property. The agreement gives the AA the right to demand that the Company vacate space and/or a building it might need for the operations, safety, development or security of the airport. In 2005, the Company paid $960,000 in licensing fees for the aforementioned usage rights, and starting 2006 and subsequently, the licensing fees will rise by 7.4% per year until the end of the contract period, so long as the maximum payment does not exceed $4 million. In accordance with an October revision to the agreement, in addition to the payment for the land, the Company will pay yearly usage fees to the IAA for certain fully depreciated buildings and installations. Payment is at a gradually increasing rate (according and subject to the amount and type of structures finishing the depreciation period each year, according to a depreciation period of 40 years from the structure s construction). A sum of 10,150,000 NIS was paid in d. Terminal 3 Following talks held between the Company and the Airports Authority, the Airports Authority announced that it would be extending and amending the contract for the operation of the Company's passenger lounge in Terminal 3 to November , under the following conditions: Until April at a yearly cost of 11,000,000 NIS. The yearly cost is revised based on the CPI and in accordance with indices of El Al passenger traffic through BGN. Starting May at a yearly cost of 18,000,000 NIS. The yearly cost is revised based on the CPI only. a - 102

105 Agreements were also signed for a permit for the other areas in Terminal 3, covering a period of 10 years starting November in return for rental fees of $7,635,000 a year. In the context of the operations of Terminal 3, the Group considered whether to set up an aircraft maintenance center adjacent to Terminal 3. For this purpose and in preparation for the move to Terminal 3, in April 2000 the Company signed an agreement in principle with the IAA to lease an area of 2 hectares in order to construct a maintenance center, a hangar and supporting facilities near Terminal 3. The IAA Board of Directors has ratified the deal, but it is subject to the signing of a detailed agreement between the parties and the ratification by the Company's Board of Directors. As of these statements, no detailed agreement has yet been signed between the parties. The Company has received notice from the IAA, according to which the IAA apparently cannot uphold the agreement and allow the Company to construct a hanger for large aircraft at the location decided upon. In light of this notice, the sides have been holding talks to find an acceptable solution. e. Global Real Estate Rentals The following are details of material real estate properties rented by the Group around the world: Category Area in Square Meter Cost in Thousands of Dollars The middle east 2, Europe 7,250 3,400 Britain 1,650 1,100 North America 4,100 2,500 Overall Rent paid around the world 15,150 7,960 Note that starting January 2011, the Company s offices in Paris have moved to a new location, at an initial one-time investment of 250,000. Current rental costs are expected to reach 250,000 a year (compare to 450,000 in the previous offices). f. El Al Building in Tel Aviv: On September the Company filed a claim along with other property owners at the El Al Building (which as noted above, serves as the Company s Israeli branch offices), before the Tel Aviv Local Committee for Planning and Construction, for the decrease in the value of the El Al Building following the Tel Aviv preservation plan. The total compensation sought for the loss of the building's a - 103

106 value is 15,540,000 NIS, with the Company's share being 2,400,000 NIS (the Company owns 15.5% of the properties in the EL Al Building) Accessories, Spare Parts and Spare Engines The Company keeps accessories, spare parts and spare engines in its warehouses, with a total amortized cost of $102,448,000 as of December 31, In recent years, the Company has begun to purchase external logistic support services from designated suppliers abroad, to complement the spare parts purchased by the Company. See Note 16 to the Financial Statements for additional details of fixed assets. 9.2 Insurance The Company s insurance coverage is mainly related to two aspects: insurance of the different types of Company property and legal liability insurance for property and bodily injury. El Al s airline liability insurance is limited to a ceiling of $1,500 million per occurrence, with the insurance coverage for third party damages from terror and war actions amounting to $1,000 million. According to the Company's estimates, this coverage suffices to provide suitable insurance protection for its operations. The hull all-risk insurance of the aircraft owned by or in the service of the Company, or as regards loss or damage to aircraft for which the Company has agreed to be responsible for their insurance, is based on the agreed value of each aircraft and includes deductible levels acceptable in the aviation industry. Insurance of aircraft hulls against dangers of war and similar risks covers, inter alia, acts of war, terror actions, civil war, strikes, riots, malicious damages, hijackings and confiscation. It should be noted that the Company entered into an agreement with its controlling shareholder K'nafaim according to which joint application was made to the Company's insurers. As of the report date, the Company's insurance policies include a "contingent stratum" rider for the 23 aircraft owned by the K'nafaim Group leased to various airlines. The insurance is designed to insure the rights of the K'nafaim Company in the event that the lessors or their insurers fail to comply with their insurance obligations. The incremental premium for this rider amounted to $38,000 in 2011, and according to the agreement between the Company and K'nafaim, K'nafaim is responsible for this entire a - 104

107 incremental premium, and also pays the Company an additional 15% of the incremental premium. Additionally, K'nafaim undertook to be responsible for additional premiums that the Company may be required to pay, if and when such demand should be made. The Company is also covered by various insurance policies, which the Company assesses are sufficient to provide insurance coverage adequate for the primary risks to which the Company and its employees are exposed. These refer to policies to insure employers liability, insurance of buildings against fire, earthquakes and the like, health insurance personal accident insurance for company employees, etc. The policies are renewed on a yearly basis. Group directors and executives are insured by director and officers' liability insurance in the framework of the insurance coverage prepared by K'nafaim, in accordance with an agreement with K'nafaim. See Section 29a of Chapter D (further details on the Corporation's activities) for details. The overall cost to the Company for insurance premiums during 2011 was $9 million. 9.3 Intangible Assets The Group owns the El Al trademark, which constitutes the Group s anchor brand, the Company s name and logo design. A registered trademark is valid in Israel for limited periods fixed by law, and may be renewed at the end of each period. In addition, the Company owns the trademark for "El Al" (name and designed logo) in the U.S. and in other countries around the world. In the Group s assessment, the economic lifespan of the El Al trademark covers a multi-year period, being part of the Company s name, and due to the many years that this symbol has been used and its dominant market position. Various internet domain names have been listed in the Company s name in Israel and abroad, valid for variable periods of time, in accordance with registration rules in various countries, with an option to extend. See Section 9.11 below details as to licenses and flight rights given to the Group. For details regarding the Company s rights to the use of security equipment see Note 17b to the Financial Statements. a - 105

108 9.4 Human Capital Organizational Structure Determining the Company's general policies and supervising the activities of the CEO are the responsibility of the Company s Board of Directors. Day-to-day management of the Company s affairs has been assigned to the CEO, who is assisted in his duties by the management team, serving as the Company head office, and comprised of the CFO, the VP of Maintenance and Engineering, the VP of Commerce and Aviation Relations, the VP of Human Resources and Administration, the VP of Services, the VP of Operations, the VP of Information Technology, the VP of Global Sales, the VP of Cargo, the General Counsel and Corporate Secretary and the Company Internal Auditor. For details regarding the CEO's terms of employment see Section below. During 2011 and until the approval of this report, the following changes took place in the Company's head office: a. In January 2011 the Company CEO decided that the VP of Cargo should head the Cargo Division instead of a department manager, as the case had been in the past. b. As part of streamlining efforts at the Company, the positions of certain Company department heads were filled by lower-ranked executives, the position of Regional Manager for South America (filled by a Company VP) was cancelled and the position of Regional Manager for the United Kingdom was filled by a department manager (instead of a VP). c. In March 2012 the Acquisitions and Engagements Department was transferred to the Finance Division and placed under the auspices of the CFO (instead of HR). a - 106

109 The following chart describes the Group s organizational structure: Board of Directors President & CEO Chief Audit Officer General Counsel & Corporate Secretary Cargo Operations Customers &Service Global Sales HR & Admin. Finance Commerce & Maintenance Industry Affairs & Engineering I.T Planning & Organization Operations Control Ground Operations Customers Service & Sales Human Resources Accounts Revenue Management A/C Overhaul Information Systems Flight Operations Israel Station Israel Branch Administration Budget & Control Pax Marketing Workshops & Logistics IT Infrastructure & Comm. *Security In-Flight Services North & Central America Training & Organizational Development Procurement & Supply International Affairs A/C Maintenance * Safety & Quality Customer Relations North Europe * Security Officer Company Treasurer Commercial Planning & Distribution Sys Engineering Crew Assignment West Europe Schedule Planning Quality Control Central Europe & Africa East Europe Asia & Oceania Employees On December the Company employed 5,791 employees, 3,836 of whom on a regular basis [336 of which in the Company s overseas offices (including 25 Israelis posted abroad)] and 1,955 temporary employees (110 of them overseas). 43. The following are details of regular and temporary employees as of December and December : Position December December Regular employees Temporary employees Total employees 3,836 1,955 5,791 3,814 2,150 5,964 The fierce seasonality of the industry requires modulation of personnel, which is carried out, according to demand, through a variable number of temporary employees. Personnel 43 The distribution of temporary employees by areas of activity is as follows: flight attendants (841), ground and service operations (667), maintenance and engineering (159), marketing, sales and cargo (44), overseas (110) and the remainder (134) in other positions. a - 107

110 employed by the State also work as part of the Group s security system, and the Company pays part of their salaries (in accordance with the splitting of security costs between the Company and the State - see Section below for details). The following is a breakdown of the Company's permanent employees in Israel and abroad as of December and December , according to their fields of employment: Position December December Senior employees Marketing, sales and cargo Pilots and flight engineers Flight attendants Ground, security, control, operations and service operators Maintenance, renovations, engineering and inspection 1,167 1,171 Auxiliary services Total regular employees 45 3,836 3, Material Dependence on a Specific Employee. The Company has no material dependence on any specific employee and/or executive Investment in Training and Instruction The Company s training center has been certified as a Qualification Institute according to the Aviation Regulations (Inspection Institute, Qualification Institute and Self- Maintenance), The center trains workers and holds training courses for most of the professions needed by the Group: pilots, aircraft technicians, flight attendants, traffic officers, ground attendants, reservations and ticketing personnel, marketing and sales managers, middle management, etc. In addition, the Company holds courses and study programs for travel agents and cargo agents in Israel and abroad. 44 Since the discontinuation of aircraft at the Company, this profession no longer exists at the Company. Note that some of the professionals were transferred to the Company's maintenance and operations arrays and some retired. 45 Includes 1st Generation and 2nd Generation (next generation) employees. a - 108

111 Other than its activities in the training center, the Company assists its employees in acquiring technological schooling and higher education. The Company also sends employees to study programs and professional and management courses abroad and in Israel as well as academic studies. The Company invested $9 million in employee instruction and training in Employee Compensation Plans See Section 3.3 above for details of the rights of the employees and of the Company to purchase shares from the State. For details regarding option plans for Company employees and executives, including the Chairman of the Board of Directors and the Company CEO see 3.2 above and Note 30g to the December Financial Statements Exemption from the Budget Fundamentals Law The Company s request for an exemption from Section 29 of the Budget Fundamentals Law was approved by the Minister of Finance, and was ratified by the Knesset s Finance Committee on March 17, Special Collective Agreements In addition to labor legislation and extension orders, the terms of employment of Company personnel employed in Israel, with the exception of executives and other personnel employed under personal contracts, are organized in special collective agreements signed from time to time between the Company and the New General Workers Histadrut (above and hereinafter- the General Histadrut ) and also by procedures that are published from time to time by management. On February notice was received at the Company s offices from the New General Worker s Histadrut the Transportation Workers Union, on a work dispute ( the Notice ). The Notice stated that the national central managing institute of the New General Workers Histadrut had authorized a strike starting March According to the notice, the disputed issues are the demands by the worker s representatives to hold collective negotiations in light of the implications of the signing of the Open Skies agreement on the employees. To the best of the Company's knowledge, work disputes on the same basis have also been declared at Arkia Airlines and Israir Airlines. For details regarding the "Open Skies" agreement with the EU see below. 46 These costs include the direct training budget, payments for simulator practice, including related expenses, and also the salaries of employees during their training period. a - 109

112 The following is a concise description of the main collective agreements applicable to the Company and its employees. a. Special Collective Agreement for Permanent Company Employees ( 1st Generation Agreement or the Collective Agreement ) The special collective agreement applies to all of the Company s permanent employees in Israel, including air crews. The agreement does not apply to senior employees (executives and others), who have personal employment agreements, nor to temporary employees who have their own special collective agreement. The agreement regulates all of the terms of employment of the permanent employees, and stipulates, inter alia, work procedures, basic rights and obligations, productivity incentives 47, appointments and stationing abroad, internal tenders, insurance, pension arrangements, dismissal procedures, responses to disciplinary violations, rights to free and discounted airline tickets and a conflict resolution apparatus. The agreement forbids strikes and sanctions, unless the strike has been declared by the Histadrut in compliance with the Law for Settling Labor Disputes, 1957, and subject to the Histadrut constitution, including a vote via secret ballot by all employees. According to the agreement, all permanent employees of the Company are ranked based on an enterprise wage ranking, which has no connection to national rankings. There are a number of rankings: ground worker ranking; veteran air crew personnel ranking; a separate ranking at lower wages for new air crew personnel; veteran flight attendant crew personnel ranking and a separate ranking at lower wages for new flight attendant crew personnel. On November , the collective employment agreement was signed by the Company, the employees' representatives and the Histadrut ("the Agreement"), after the Company's Board of Directors ratified the agreement on October The key points of the Agreement are as follows: The Agreement shall remain in effect until December Industrial peace and discipline - a commitment exists to uphold industrial peace for the duration of the agreement, while focusing on competition and growth challenges. The Company, the Histadrut and the employees' 47 See Note 23.b.(2) to the Financial Statements. a - 110

113 representatives shall conduct joint activities to promote and maintain order and discipline in the Company. The Company's authority as regards the termination of employees guilty of severe disciplinary violations shall be expanded. Bonuses and pay raises when the Company becomes profitable, a general pay raise shall be granted equal to 3% of their pension salaries. In the event of profits greater than $10 million, employee shall receive a one-time bonus equal to between 18% and 24% of their base pay. In addition, in the following year, if the Company earns over $10 million, a further raise equal to 1% of pension salaries shall be granted. If the Company earns over $35 million, an additional 0.5% shall be added to salaries. In the following year, if the Company earns over $10 million, an additional 1% shall be added to pension salaries. If the Company earns over $35 million an additional 0.5% shall be added. By virtue of the agreement and in accordance with the Company s profits in 2010, a 3% addition was granted to pension salaries in January 2011, along with bonuses at a rate exceeding that set in the agreement. Horizon promotion bonus when the Company becomes profitable, an annual budget for the financing of a horizon promotion bonus for nonpromoted ground personnel as well as for flight crews and flight attendants with similar status. Non-promoted employees are workers who have spent many years at the top step of their existing standard pay scale and are not designated for promotion. Work cessation initiated retirement and/or work cessation of 30 employees via a process including work cessation pathways using an increased compensation format, early pension or a choice between the above (in accordance with the retiring worker's age). Shifts and rest periods shifts in Israel station and maintenance shall be adjusted and reinforced according to activity levels. Rest periods for pilots and regular and temporary flight attendants in North America shall be shortened. Special tracks and promotion temporary employees with more than 3 years seniority may participate in bids for entry-level managerial positions. The Company shall be permitted to employ up to 40 employees via personal a - 111

114 contracts. Employees in the flight technical field shall receive tenure after their fourth year instead of their second. b. Special Collective Agreement for the Employment of Temporary Personnel ( the Temp Agreement ) The terms of employment of the temporary employees have been arranged in a special collective agreement that, on May 20, 2004 was extended to December 31, The agreement stipulates the maximum length of employment of temporary employees, in accordance with the type of work and the department in which the worker is employed. The agreement regulates all of the terms of employment of temporary employees, including wages, bonuses, provisions for comprehensive pensions, insurance, sick leave, rights to airline tickets, etc. The agreement was extended as part of the Special Collective Agreement on November to December A special collective agreement pertaining to temporary flight attendants and temporary employees in the administrative sector was signed in February According to the agreement, a special reserve of 150 employees from each sector shall be established, who shall remain employed for an additional period of up to ten years as temporary employees. The working conditions of these employees shall be equivalent to full-time second generation workers, with the exception of the education fund. These employees shall adhere to the second generation employee disciplinary code. Dismissal of such employees due to incompatibility shall be via a consensual on par committee or following arbitration. The agreement shall remain in effect for three years with the option of extending it by an additional two. Note that most of the Company s service personnel are employed as temporary workers and this agreement constitutes a significant milestone in aspects of service quality and is expected to reduce personnel turnover, increase profitability with the aim of achieving service excellence, as a material element of the Company s approach. c. Special Collective Agreement for the Permanent Next Generation The agreement was signed on May 20, 2004 with regard to the administrative, commercial and operational professions, including supervisory and management, flight attendant and academic positions in administrative professions. This agreement regulates the terms of employment of the personnel, which are different than those applying to the 1 st Generation employees, with savings in future costs a - 112

115 and achievement of managerial flexibility, including the dismissal of employees due to lack of professional or operational suitability. The agreement was extended as part of the Special Collective Agreement on November to December d. Special Collective Agreement (Ground Crew- Permanent Intermediate Generation ). The agreement was signed on May 20, It pertains to employees who began working prior to January 1, 1999 and is intended to apply different terms to them than those stipulated in the agreement for the 1 st Generation and than those stipulated for the Next Generation. The agreement was extended as part of the Special Collective Agreement on November to December e. Special Collective Agreement (Air Steward Crew Personnel - Permanent Intermediate Generation ). The agreement was signed May 20, 2004, and pertains to flight attendants who began their employment prior to September 1, 1996 and flight attendants who began their employment between January 1, 1996 and December 31, 1997, and is intended to apply different terms to them than those stipulated in the agreement for Generation A and for those stipulated for the Next Generation. The agreement was extended on November as part of the Special Collective Agreement to December f. Special Collective Agreement (Securities) The agreement was signed on May 20, It obligates the Company to act to create balance among all personnel whose employment is organized by special collective agreements (Generation A, Interim Generation, Next Generation), in order to avoid the preference of one field over another and also regards granting future wage increments to different fields. The agreement stipulates, inter alia, that the number of permanent employees in certain professions may not be less on various dates than those stipulated in the agreement. The agreement was extended as part of the Special Collective Agreement on November to December g. Special Collective Agreements for Ground Crews and Air Steward Crews (Shortening Stay Over) In July 2006 and in July 2007, a number of special collective agreements were signed between the Company and the New General Workers Histadrut - the a - 113

116 Division for Professional Unions and the employees' representatives, relating to ground crews and flight attendant crews for improving the Company's operational flexibility by removing existing restrictions on direct flights without any intermediate stopovers and shortening the stay of the crews in North America. The agreement was extended as part of the Special Collective Agreement on November to December h. Special Collective Agreement for Finding Agreed-Upon Solutions for the Company s Streamlining in All Segments The agreement was signed on May and allows changes in the terms of employment of technicians, in that technicians who are not signing technicians will be certified as signing technicians for Israel only, for Boeing and Airbus planes only, and will as a result carry out tasks detailed in the agreement, beyond that defined in their duties prior to signing the agreement, in return for salary increases, for a restricted period. The agreement shall be in effect until December i. Special Collective Agreement for 1 st Generation Employees for the Deposit of Severance Pay in a Fund in the Employee s Name The agreement was signed on December , in light of a legislative arrangement that came into effect on January , and which no longer allows the deposit of severance pay in the main compensation fund. In accordance with this agreement, 1st Generation employees for whom severance pay was deposited in the main fund as of December , shall have money deposited starting January in the compensation component ion the provident fund in the employee s name Pension Arrangements The Pension Agreement Beginning September 1992, the social rights of part of the Company s employees have been regulated within the context of a pension agreement. Pursuant to this agreement, an employee joining the comprehensive pension must insure a portion of his salary in the pension plan, and the balance can be directed to executive insurance or to the provident fund of the Company's employees. After the agreement was signed, new employees must be insured by the comprehensive pension. The agreement stipulates that the Company's payments to the pension fund and an approved fund (executive insurance or provident fund) for an employee joining the pension plan, will come in lieu of its severance pay obligation to that employee, pursuant a - 114

117 to Section 14 of the Severance Pay Law, 1963, for that part of the salary and for that period as to which the payments were made. Up to the joining date, employees are entitled to severance pay based on their last salary. During 2005, amendments were made to the Income Tax Regulations (Rules for Approving and Managing Provident Funds), which change the rules for deposits and withdrawals of monies in pension insurance plans, inter alia, with regard to the reduction of the maximum amount which may be insured in capital insurance. In June 2005, the Company, the New Workers Histadrut Professional Union Department and the Employees' Association of El Al Employees signed a special collective agreement that enables the adjustment of the provisions to the new rules, as selected by the employees. Executive Insurance Agreement The agreement between the Company and the Phoenix Israeli Insurance Company Ltd., which became effective December 1, 1990, was extended until the end of the effective period of the executive insurance policies that were issued under its auspices to employees. According to the stipulations of the pension agreement, redirecting part of the pension salary to executive insurance is conditional upon joining comprehensive pension. Executive insurance may be considered solely a savings plan or a savings plan with specified insurance (insurance against work disability and/or life insurance). The provisions for insurance are at the rate of 18 1/3% of the insured salary, of which 8 1/3% is for severance pay and 5% for a provident fund on the Company s account and 5% for a provident fund on the employee s account. The Severance Pay Deficit and the Manner in which it was Covered Until the pension agreement was signed, Company personnel employed in Israel who were covered by the collective agreement had no pension insurance. According to the provisions of the collective agreement, since January 1983, the Company makes deposits (for employees who did not join the pension) of 8 1/3% of the current wages of the employees in a provident fund for severance pay in Israeli banks. The deposits are in the Company s name. Since the Company did not deposit monies for severance pay in a severance pay provident fund until January 1983, and since January 1983, severance pay was paid to retired employees from the money accrued in the provident funds for severance pay, a a - 115

118 substantial shortfall was created in the provident fund for severance pay, which was filled in by deposits from the Company s and the State s option money by virtue of the stock issue (in this regard, see Note 23.3.(3).b to the Financial Statements). In addition, the Company s books include an actuary liability in accordance with International Accounting Standard 19 for a bonus for unutilized sick days. The bonus is paid according to the provisions of the collective agreement upon retirement from the Company due to disability or age, or subsequent to a period of service, on the condition that the employee is entitled to severance pay. The liability is in accordance with the eligibility accumulated by the employees and subject to the maximum ceiling for redemption of sick leave, as detailed in Note 23.c.(4) to the Financial Statements. In addition, an actuary liability for accumulated vacation days is listed in the Company's books. The following lists the Group s liabilities in connection with employee benefits, net (consolidated data in thousands of dollars)*: Net post-employment benefits for retirement and termination compensation, pension funds, sick day redemption and retiree benefits Long-term benefits due to seniority bonuses Net benefits due to consensual retirement plans Less current maturities Short-term benefits due to vacations and others Total December ,512 4,341 10,121 (1,183) 53,514 80,305 December ,725 2,691 2,946 ( 390) 52,687 70,659 * The data featured in the above table does not include wages and associated (current). For further details on employee benefit liabilities see Note 23 to the December Financial Statements. In June 2003, an agreement was signed between the State, the Company and the employees association, according to which the State and the Company agreed to act to cover the deficit between the provisions for severance pay recorded in the Company s accounts ( Provision ) and the monies actually deposited into the severance pay provident fund ( Fund ) and which is connected to the eligibility of employees who had been employed by the Company at the date that the Company entered receivership in 1982 and who continued to be employed in June 2003 ("the Eligible Employees"). On the date of the agreement, the deficit amounted to at 516,240,000 NIS and it is CPI-linked and bears annual interest of 5.05%, starting June 1, Under this agreement, the State a - 116

119 and the Company transferred the immediate proceeds they received from the sale of securities pursuant to the 2003 Prospectus ( the initial offering ), less expenses, to the severance pay fund for the eligible employees (the balance of the severance pay funds includes the above proceeds). The State and the Company also undertook to transfer to the severance pay fund of the eligible employees, any amount that was raised from the conversion of convertible securities that were issued in the initial offering or from the sale of securities in other offerings which would be executed through the date of the end of the last exercise date (June 5, 2007). From January through December 31, 2007, deposits were made to the severance pay funds of eligible employees: state deposits totaling 104,624,444 NIS, Company deposits of 100,862,605 NIS and in total deposits were made to the severance pay fund of eligible employees to the amount of 205,487,049 NIS. After making the above State and Company deposits, the deficit in the fund for eligible employees, as defined in the agreement between the Company and the State signed on the eve of the Company's privatization, was covered. After making the above deposits and fully covering the deficit in the severance pay fund, as required by the agreement, the Company deposited 31.3 million NIS (including interest accrued as of the reporting date), representing the balance of the offering proceeds, in a separate account (included in short-term deposits as of December 31, 2011 see Note 6 to the Financial Statements). As part of the restatement of the Financial Statements on December , the capital reserve from transactions with a former controlling party was reduced in return for a liability listed to the State of Israel. The Company is assessing whether limitations exist on its ability to use the balance of proceeds in question, pursuant to the agreement between it and the State, and in this context, it has requested a response from the General Comptroller of the Ministry of Finance. As of this report, negotiations are taking place with the General Comptroller s Office at the Ministry of Finance in order to examine entitlement to issue surpluses Legislative Amendments Pertaining to Retirement Age and Retirement Arrangements Provident Deposits According to the Comprehensive Pension Insurance Expansion Ordinance and Deposits in the Central Compensation Fund Starting January 2011, the rate of provident deposits increased in accordance with the Comprehensive Pension Insurance Expansion Ordinance, reaching 3.33% employee deposits, 3.33% employer deposits to provident funds and 3.34% employer deposits to severance pay. a - 117

120 Furthermore, starting 2011 no option shall exist to deposit in a central compensation fund, meaning that compensation deposits may only be deposited in personal compensation funds, which are compensation funds that do not pay a stipend. General Collective Agreement to Increase the Minimum Wage in the Israeli Economy On February a collective agreement was signed between the Coordination Office of the Economic Organizations and the Histadrut, according to which the minimum wage would be revised in two pulses starting July the minimum wage will amount to 4,100 NIS and starting October the minimum wage will amount to 4,300 NIS. The agreement was stipulated on the according amendment to the Minimum Wage Law or on the issue of an expansion order to this agreement. On June the Minimum Wage Law (Raising Minimum Wage Sums Temporary Ordinance), 2011 was amended. Raising Sick Pay Rate Amendment On March the Knesset passed Amendment 4 to the Sick Pay Law, 2011 (hereinafter: the Amendment ), which sets revised conditions for the rates of sick pay given employees. The revision came into effect on April , and applies to sick pay owned for periods of illness starting April , even if the period began before April Pension Provisions A collective agreement was recently signed between the Coordination Bureau of the Economic Organizations 48 and the Histadrut, according to which employer provisions shall increase, starting January onward, to 12% half for pension payments and half for compensation, and employee provisions shall increase from 5% to 5.5%, meaning each employee shall receive a full pension plan at a cost of 17.5%. This collective agreement has yet to be expanded to the entire Israeli economy, but apparently as of the date it becomes relevant, the agreement will be expanded via expansion order, and will apply to all employees not receiving a preferred pension arrangement. Amendment to the Worker Employment by Personnel Contractors Law Added to the law was an ordinance forbidding the receipt of personnel services from personnel contractors, or service from a service contractor, and forbidding engagement 48 In this agreement the Bureau represents the Manufacturer s Association, the Contractors and Builders Association, the Farmers Association, the Diamond Manufacturer s Association, the Hotels Association, the National Association of Security Works, the National Association of Maintenance and Cleaning Works, the Craft and Industry Association, the National Association of Trade, the Film Industry Association, the Merchants Association, the Professional Organizations Bureau, the Manpower Supply Companies Organization. a - 118

121 for the receipt of personnel services, unless the personnel contractor or the service contractor, as the case may be, is licensed in accordance with the law ( service contractor, as of today, is defined in law as a security services contractor or a cleaning services contractor). In accordance with the amendment, engagement with a personnel contractor or a service contractor without a license as required by law, constitutes a criminal offence punished by fine, while receiving service from a contractor lacking a license is an offence punished by a fine for each employee employed within this framework. This amendment enters into effect on January Amendment to the Women s Labor Law The provisions of the Women's Labor Law were expanded, so that a significant number of them apply to adoptive parents, to designated parents (parents receiving children from surrogate mothers) and parents of foster families. The amendment makes adjustments that correspond the protections set in law for biological parents to those of parents of the types noted above. Female Retirement Age On December the Retirement Age Law (Amendment no. 3), 2011 was revised, and the extension of the retirement age for women past the age of 62 was postponed by five years. In light of the above, this is the state of affairs for the next five years: * Mandatory retirement age for male and female employees, meaning the age on which they may be compelled to retire, remains 67. * The employee retirement age, meaning the first age at which employees may retire from work and begin to receive the full pension they had accumulated to date in their pension fund remains 67. * The retirement age for female employees who were born by December 1954, meaning the earliest age at which female employees may retire from work and begin to receive the full pension they had accumulated to date in their pension fund 62 (with a concurrent adjustment of the Social Security Law). The retirement age for employees born starting January 1955 will began to rise gradually in January a - 119

122 Labor Law Enforcement Law The Labor Law Enforcement Law, 2011 was published on December This law does not create new rights beyond those rights currently anchored by existing labor laws, and its sole purpose and goal is to increase the enforcement of existing legislation. Two new innovations were anchored in the law: The first innovation is the establishment of a mechanism for placing economic sanctions on employees for violating labor laws. This mechanism will be operated by senior labor supervisors who will be appointed for this purpose by the Minister of Industry and Employment, and should be more effective and offer more deterrence than currently existing judicial mechanisms. The second innovation was the placement of direct responsibility on those ordering services from contractors, to uphold the obligations set in labor laws toward contractor workers, which (currently) covers the following areas: security, catering (intended for workers of the party ordering the service) and cleaning Eligibility for Flight Tickets According to IATA regulations, Company employees are entitled to service-vacation flight tickets (free or at a discount), the great majority of which are on an available seat basis for themselves and for their families, including retired employees. This right is anchored in the labor agreements (and in the personal employment agreements of the senior executives), in the personal retirement agreements, in Company procedures and in the professional instructions of the human resources division. The quota of free or discounted flight tickets is limited by the provisions of the labor agreement, of personal agreements or retirement agreements and by Company procedures. For details regarding the agreement with Income Tax and Social Security regarding deductions due to employee flight tickets, see Section below as well as Note 28f to the Financial Statements Employees Voluntary Early Retirement Plans Within the framework of its efficiency and cost-cutting measures, the Company has created voluntary early retirement plans. During 2010, 2009, 2008, 2007, and 2006, 11 employees, 8 employees, 31 employees, 52 employees and 95 employees, respectively, retired in the context of the retirement plans. During the period between 2006 and the date of the report, a total of 197 employees have retired in the context of early retirement plans. For further details see Note 23e and 32.e.2 to the Financial Statements. a - 120

123 In order to carry out the retirement plans, agreements were reached between the employees and the Company, between the employees and financial institutions, and between the Company and financial institutions. In the framework of these agreements, the financial institutions serve as the payer, making the pension payments to the retirees. As security for the Company s obligations to the retirees, the Company provided guarantees, according to which, inter alia, the Company will make periodic deposits (mostly, for one year in advance) to the financial institutions or will pledge a deposit in a commercial bank, a sum identical to the total sums that the Company must pay as pension to its retirees for the coming year, and the Company s payments to the retirees will be made from these monies. From time to time, the financial institutions estimate the anticipated costs of the retirement plan, and the Company updates its estimates to the extent necessary, according to actual costs and the experience gained on the subject. As of December 31, 2011, to secure the voluntary retirement plan for employees, the Company furnished guarantees to third parties totaling $558, Local Employees at Company Branches Abroad Most of the Company personnel overseas, other than Israeli employees posted overseas, are employed according to collective labor agreements between the Company and the local union in that country, or according to agreements with the employees association, or according to agreements between the employers' organization (foreign airlines) and the umbrella organization of airline employees, or according to other agreements. The terms of employment of Company employees in the remaining countries are not covered by any collective agreement, but are established by the Company, in accordance with accepted practice in the aviation industry or in the national airlines in those countries. In some branches, the employees are engaged through personal contracts or through a contractor. Some of the branches have undertaken to pay severance pay in accordance with law or contract; some of the branches have a pension insurance obligation or a right to pension by agreement. The Company makes regular payments for pension insurance and includes a full provision in its accounts for the liability for severance pay. An extension was signed to the agreement with the U.S. trade union on February for the period between January and December Israeli Employees Posted Abroad The Company employs abroad, among others, permanent workers, consisting of Israeli residents dispatched to fill managerial positions abroad ( posted ). As of December 31 a - 121

124 2011, 25 employees out of all of the Company's overseas employees (336) were Israelis posted abroad. Similar to State emissaries abroad, the salaries of those posted during their service abroad (hereinafter Salary Abroad ) are also different from Israeli salaries, considering the standard of living and taxation abroad, and also the fact that the salary is subject to income tax and social taxation, both abroad and in Israel. The salary abroad, including participation in car maintenance, is paid to the posted employee based on net salary (taxes, including social taxation and the grossing-up abroad, are paid by the Company). If the salary abroad or special payments in excess of the tax-exempt ceiling are subject to tax in Israel, the Company assumes the Israeli tax. In addition to the salary abroad, the Company also bears the rental costs of those posted as well as tuition expenses for their children. These payments (up to a certain ceiling) are exempt from taxes in Israel, but are liable for tax according to the laws of the various countries. The Israeli salary of the posted employee (salary according to rank and position, had they been employed in Israel) serves as the determining salary by the Company for the purpose of making provisions for severance pay, for compensation (pensions and/or executive insurance) and to an advanced education fund, as stipulated in the posting letter. On December an agreement was signed between the Company and Harel Insurance Ltd. (hereinafter in this section: Harel ) to provide medical insurance services to employees of El Al and/or the State of Israel employed in various countries around the world, as well as their families. The agreement, which concentrates all of the insurance policies of policy holders posted abroad under a single supplier, was taken to streamline and lower total insurance costs, while adapting the standards in the insurance agreements to National Health Insurance requirements. The agreement will remain in effect until May , when the Company has the option to extend it by two additional periods of one year each. The Company is entitled to terminate the agreement, for any reason, at its sole discretion, with 60 days notice. The insurance policy for policy holders who are employees of the State of Israel and their families (95% of all policy holders) comes at the expense of the aviation security budget Welfare Services and Payments In addition to salary, part of the Company s permanent employees also receive welfare services and payments, which include: subsidized meals for employees and grossing up of related taxes, medical examinations for employees, participation in medical and health care insurance and dental insurance for employees, clothing, uniforms, and partial a - 122

125 participation in higher education. Some of these benefits are also given to temporary employees. Employees may, under certain conditions, receive guarantees for loans for various purposes. The loans are for periods of up to 60 months and are provided by the Company and Bank Yahav on terms that have been approved by the Ministry of Finance. See Note 13 to the Financial Statements for details Restrictions on Leasing Aircraft via "Wet Lease" According to a letter dated December 1999 from the Company s CEO to the Chairman of the Division for Professional Unions of the Histadrut, the Company is to restrict itself in the future to leasing up to 4 aircraft from Israeli airlines, so that the flight hours that will be executed by the Israeli airlines for the Company will not exceed 10% of the Company's total flight hours (including flight hours that will be carried out in wet leases by the Israeli airlines, but not including leased aircraft from foreign companies), and they will operate in specified aircraft models on routes from/to Israel to destinations to which the flight range from Israel does not exceed 2,400 nautical miles. The Company will continue to plan the employment of its air crews at a volume of 83 monthly flight hours on an annual average, as it has done until now, and in the event of a significant change in external circumstances that will create the necessity to change this policy, the CEO will discuss the matter with the Chairman of the Division for Professional Unions of the Histadrut, before deciding on the matter Executives and Senior Management The members of the Company s Board of Directors are not Company employees. The Chairman of the Board of Directors On January the Company's Board of Directors decided to appoint Mr. Amikam Cohen as Chairman of the Company's Board of Directors (hereinafter: the Chairman ), starting February On April the Audit Committee and the Company's Board of Directors approved a service agreement with the Chairman (hereinafter "the Service Agreement"). On June the General Meeting of the Company's shareholders ratified the Service Agreement. According to the Service Agreement, the Chairman shall provide the Company with active Chairman services as expected in publicly-owned companies in the Company's area of activity and that of its subsidiaries, as they exists on the date the service agreement was made and as may be from time to time (hereinafter "the Services"). a - 123

126 In return for the services, the Chairman shall be entitled to the following: (a) a monthly salary of 90,000 NIS plus VAT linked to the CPI (hereinafter "the Remuneration"); (b) 4,650,000 non-tradable options exercisable as 4,650,000 regular 1.00 NIS NV Company shares; (c) benefits pertaining to the receipt of flight tickets; and (d) reasonable expense reimbursements for travel, hosting and mobile telephone expenses made by the Chairman in the context and for the purpose of providing the services subject to the law and in accordance with Company procedure. The remuneration and the remaining benefits and payments detailed above constitute full remuneration to the Chairman for the provision of services, including for his services as Company director, and with the exception of these he shall be entitled to no additional benefit and/or wage and/or remuneration from the Company of any form, including directors' salary (participation remuneration and yearly remuneration) as a Company director. In the event that the Chairman ceases serving as Chairman or the Board and continues serving as a director at the Company, he shall be entitled only to a Director's salary (participation remuneration and yearly remuneration) in accordance with the remuneration paid to Company directors at the time as well as flight ticket entitlements awarded to Company directors. The aforementioned options, exercisable as 4,650,000 ordinary 1 NIS NV Company shares, constituted as of the signing of the Agreement 0.95% of the Company's issued and paid-up share capital. The options were granted as part of the Company's 2006 option plan and were issued to the Trustee for the Chairman in accordance with Section 102 of the Income Tax Ordinances (New Version), 1961, in the capital gains track and may be exercised as Company shares, subject to adjustments and as detailed below: The exercise price of each option shall be NIS, the closing price of a Company share on February , which is when the Chairman of the Board began his term in office. The right to exercise the options shall vest in three equal yearly portions (one third each year) throughout the Chairman s first three years. In the event of the discontinuation of the Chairman's service past the end of the first year from the issue date, the options shall vest on a quarterly basis. The number of options and/or the vesting price, as the case may be, shall be subject to adjustments as detailed in the Service Agreement, including adjustments due to dividends, due to mergers/acquisitions or acceleration due to changes in control. In accordance with the value assessment provided by an independent outside value assessor, and in accordance with the calculation made by the value assessor in accordance with the Black & Scholes model (as well as reference to Binomial options pricing model for comparison), the value of the options, based on the following parameters, for the date a - 124

127 on which the option plan was approved by the Company's General Meeting on June was 1,310 thousand NIS. The parameters used by the assessor to determine the value assessment were, among other things, the value of the Company's stock on June (0.879 NIS), the exercise price set at NIS, the options' average lifespan, the fact that the options are granted in three portions and the fluctuations of the Company's shares throughout the vesting period. The parties' entry into the Service Agreement was retroactive starting February until the date the Chairman ends his service as Chairman of the Company's Board of Directors for any reason. In spite of the above, the Service Agreement can be revoked by either of the parties for any reason with advance written notice of 90 (ninety) days. In light of the streamlining and costs savings measures taken by the Company, on November the Chairman of the Company s Board of Directors announced that he would be unilaterally waiving 20% of the (gross) monthly salary to which he is entitled. The aforementioned waiver is for a period beginning December and ending December Directors As of this report, there are 14 members on the Company s Board of Directors, this after the Company s General Meeting ratified the extension of the tenures of the directors serving on the Company's Board of Directors (who are not external directors) on January as follows: Amikam Cohen, Tamar Moses Borovitz, Yehuda (Yudi) Levi, Amnon Lipkin-Shahak, Amiaz Saggis, Nadav Palti, Eran Ilan, Pinchas Ginsburg, Shlomo Hannael, Sophia Kimmerling, Yael Andoren as well as the appointment of Mr. Avraham Bigger as member of the Company's Board of Directors, until the conclusion of next annual General Meeting. In addition, Mr. Yair Rabinowitz and Professor Yehoshua (Shuki) Shemer serve as external directors, this after on November the Company's general meeting approved the extension of the tenure of Professor Yehoshua (Shuki) Shemer as external director with accounting and financial capabilities for an additional 3 year term, starting November In light of the streamlining and savings measures taken by the Company, the members of the Company s Board of Directors (with the exception of the external directors) announced that they would be unilaterally waiving 20% of the (gross) yearly remuneration and the per-meeting remuneration to which they are entitled. The aforementioned waiver is for a period beginning December and ending December The Company s Audit Committee and Board of Directors explained their a - 125

128 decision by stating that this was a unilateral waiver on behalf of the Chairman and the other members of the Board of salary and remuneration owed them by the Company, in return for no other compensation on behalf of the Company, and therefore the engagement in question is purely beneficial to the Company. For details regarding executive and director liability insurance and letters of indemnity see Regulation 29a of Part D Additional Corporate Details For details regarding the Securities Authority s audit report regarding the terms of the employment of senior Company executives, including the Company's outgoing CEO, including decisions made following the audit report in question, see Section C.11 of the Company s December Board of Directors Report. The Company CEO On October , the Company's Board of Directors decided to appoint Mr. Eliezer Shekedi as the Company's CEO (hereinafter "the CEO"). On January the Company s Audit Committee and Board of Directors approved the engagement with the CEO via the employment contract (hereinafter: the Employment Contract ) which came into effect retroactively starting November , the key points of which being the following: The CEO shall be subordinate to the Company s Board of Directors. The CEO's gross monthly salary shall be 115,000 NIS, linked to the Consumer Price Index on the basis of the known index, with the basis index being the CPI published December The CEO shall be entitled to a bonus comprised of the following three components: a. "Profit bonus" - a sum equal 2.0% of the Company's yearly pre-tax profit as it appears in the Company's consolidated and audited yearly Financial Statements ( the Yearly Statements") for each calendar year during the CEO's tenure as Company CEO ("the Tenure"), starting 2010, when such a profit was achieved and for any portion of such a calendar year; as well as: b. "One-time bonus" a one-time bonus to the amount of two million NIS for the first calendar year over the course of the tenure in which the Company achieved a pre-tax yearly profit, this in accordance with the yearly statements for the year in question ("the base year") and an additional (and final) one-time sum of 1 million NIS for an additional calendar year over the course of the tenure, in which the Company achieved a pre-tax yearly profit, this in accordance with the yearly statements for the year in question; as well as a - 126

129 c. "A result improvement bonus" - a sum of 2.0% of the aggregate improvement in the Company's yearly pre-tax profit, starting from the base year until the end of the tenure, according to the yearly statements. This bonus shall be paid the CEO for the base year and for each subsequent calendar year in which an improvement occurred (if any) in the yearly profit in question compared to the previous peak year in the tenure, with "previous peak year" in this regard being a previous calendar year, starting from the base year, in which the Company's highest pre-tax profit was achieved to date for which the bonus in question is paid. Eligibility for this bonus shall apply only if (a) a pre-tax yearly profit was achieved for the calendar years during the tenure in accordance with the relevant yearly reports; as well as (b) under the condition that the profit in question is larger than the pre-tax profit achieved in the previous peak year, and (c) due to the difference (delta) only between the two profit sums in question (with the exception of the base year in which the bonus in question is calculated for the entire pre-tax yearly profit for that year). In addition, the Company granted the CEO 9,914,382 options exercisable as 9,914,382 ordinary 1.00 NIS NV Company shares, which constituted, as of the signing of the option agreement (approved pursuant to the approval of the Employment Contract) ( the Options Agreement ), 2% of the Company's issued and paid-off stock capital, and 1.90% fully diluted. The options were granted on February in accordance with the Company's 2006 option plan and in accordance with the Options Agreement with the CEO. The options were placed in trust for the CEO in accordance with Section 102 of the Income Tax Ordinance, on a capital gains track, and are exercisable as Company shares, subject to adjustments and as detailed below: Vesting The right to exercise the option shall vest in three equal yearly portions (one third each year) throughout the CEO's first three years. In the event of the discontinuation of the CEO's employment after the end of the first work year the options shall vest on a quarterly basis. In the event of the discontinuation of the CEO's employment within six months after a change of control event (as defined in the Options Agreement), all options allocated to the CEO the vesting date of which has yet to be reached shall vest immediately, and they shall be exercisable within 12 months from the date on which the CEO stopped working in practice. Exercise Price The exercise price of each option shall be NIS, the closing price of a Company share on November , which is when the CEO began his tenure. a - 127

130 Exercise Period Any portion of options vested may be exercised up to six months from the vesting date of that portion, or at the end of twelve months from the actual end of the CEO's employment, whichever comes first. Adjustments the amount of options and/or the exercise price, as the case may be, shall be subject to adjustments as detailed in the Options Agreement including adjustments due to dividends and due to merger/sales agreements. The economic value of the options in accordance with the value assessment provided to the Company by an independent outside value assessor, and in accordance with the calculation made by the value assessor in accordance with the Black & Scholes model (referring to Binomial options pricing model for comparison), the value of the options as of January is 3,847,000 NIS (on the date of the approval of the commitment the value of the options was 3,293,000 NIS). The parameters used by the assessor to determine the value assessment were, among other things, the value of the Company's stock on January (0.879 NIS), the exercise price set at 0965 NIS, the options' average lifespan, the fact that the options are granted in three portions and the fluctuations of the Company's shares throughout the vesting period. The CEO shall be entitled to social benefits such as executive insurance provisions or pension funds, loss of work ability and education fund, as are commonly granted to Company senior executives. In addition, the CEO shall be entitled to 30 paid sick days per year (which may be accumulated to up to 120 days, but not redeemed), 16 recovery days per year, as well as 25 vacation days per year (which may be accumulated, unlimited in amount and redeemable). In addition, the CEO shall be entitled to reasonable personal and hospitality expenses, spent as part of his duties and in return for appropriate receipts/ invoices. The employment contract was set for an unlimited term and established that each party may discontinue the agreement subject to providing advance notice as follows: (a) during the first year of work if the Company has discontinued the agreement or if the discontinuation was with both parties consent, the advance notice period shall be 3 months from the end of work in practice or by December , whichever is later, and if the agreement is discontinued by the CEO the period shall be 3 months in length; (b) if advance notice on the agreements discontinuation is delivered during the second year of work if the Company has discontinued the agreement or if the discontinuation was with both parties consent, the advance notice period shall be 12 months from the end of work in practice, and if the agreement is discontinued by the CEO the period shall be 6 months in length; (c) if the advance notice regarding the discontinuation of the agreement is delivered after the completion of the second year of work, the advance notice period shall a - 128

131 be 12 months from the end of work in practice, whether it was discontinued by the Company, by the CEO or with their mutual consent. In this regard, the end of work in practice means the date set by the Board of Directors (or a Board committee) as the date on which the CEO s work at the Company ended in practice. Upon the discontinuation of the CEO's employment, for any reason, with the exception of criminal circumstances, the CEO shall be entitled to, in addition to the payments specified above, a retirement bonus to the amount of a single monthly salary multiplied by the amount of years he worked at the company (not including the advance notice period), including for a portion of a work year, this according to the CEO's last pay slip. This agreement includes confidentiality and non-compete clauses, according to generally accepted practices, for a 12 month period from the actual discontinuation of work. The Company shall provide the CEO with a mobile phone, a telephone line and home fax machine and shall bear full maintenance and usage costs as well as payments for calls. The Company shall provide the CEO and his household with a Licensing Group 6 vehicle. The Company shall bear all costs involved in the use and maintenance of the vehicle, according to Company practice and its procedures as revised from time to time. The Company shall pay the tax payments borne by the CEO for the vehicle and telephone at his disposal. The CEO shall be entitled to flight tickets for himself and for his family according to Company practice regarding any person serving as CEO, this according to existing Company procedures, revised from time to time. In light of the streamlining and savings measures employed by the Company, on November the Company CEO announced that he would be unilaterally waiving 20% of the (gross) monthly salary to which he is entitled. The aforementioned waiver is for a period beginning December and ending December Excelling Employees Fund As part of the terms of the Company CEO s employment and at the CEO's request, the Board of Directors approved the establishment of a CEO fund for the remuneration of excelling employees, to the amount of 2 million NIS. This fund was established after the Company's financial results in 2010 showed an improvement of over 50% over In addition, on March the Company CEO informed the Company Board of Directors, at his own initiative, that he had decided to transfer to the Excellence and People fund, established in 2011, a sum equal to 50% of the yearly bonus owed him for a - 129

132 2010, in accordance with the term of his employment, meaning a total of 5.7 million NIS (gross). It was established that use of this fund shall be at the CEO's discretion, to provide incentives to excelling Company employees who are not Management members, aimed at developing, encouraging and promoting the subject of excellence at the Company and personal excellence. The purpose of the fund was to create a challenging environment that encourages excellence, to systematically and continuously encourage the fulfillment of personal and team capabilities and the accomplishment of exceptional achievements, to encourage personal and group investigation that will lead to progress in thought and action and to advance individual creative and progressive thought. The fund is intended for advancing and realizing three main areas: The person/team behind the excellence 10 El Al CEO prizes for excellence for employees/teams each year for the next three years who will prove a final result in one of the following indices: increasing profitability, improving service, reducing expenses, increasing revenues, improving products, increasing customer numbers, improving availability, improving precision, improving processes, streamlining and safety improvement suggestions. Supportive environment creation of a positive dynamic at the Company for encouraging excellence by remunerating the group from which the excellence arose in the nearby work circle. Excelling in all of the Company s profession 55 of the Company's workers were selected and granted monetary awards in order to encourage long-term excellence. High-value education reinforcing affiliation of Company members to history, heritage and Jewish values. The goal is that all Company members tour Jerusalem through the fund and visit Yad Vashem over the next few years. The Company established a committee to study the proposals made by the Company s employees including their compliance with criteria set for the purpose of winning prizes and in October 2011 the Company CEO, in a special ceremony, awarded the CEO s prizes for excellence for 2010 for the finest proposals. a - 130

133 The fund s activity is expected to continue in the future and the budget earmarked for the fund is designated for this purpose and is not dependent on the Company's business results. Senior Executives On November , all of the Company s VPs waived 10% of the monthly (gross) salaries to which each of them was entitled and the heads of the Company s departments waived between 7.5% and 10% of the (gross) monthly salaries to which each was entitled (in accordance with their pay grade) for the period beginning December and ending December In March 2012, holders of personal contracts with the Company waived between 3% and 7.5% of the (gross) monthly salary to which each was entitled (according to their pay grade) for the period ending December The above waiver on behalf of executives and employees as noted above is for the salary and remuneration to which they are entitled, as the case may be, and will not impact all of the other associated benefits to which the executives and workers in question are entitled, including social provisions. In addition to the CEO, other senior personnel are employed under personal employment contracts. The salary of the senior personnel under personal contracts is updated, so that the overall salary is linked to the CPI and updated each year, in the month of January, after deducting the cost-of-living increments paid. In cases where the personal contract is silent as to eligibility to augmented severance pay, the Company customarily approves incremental severance pay at the rate of one month per year of work. See also Section above for a description of the options plan. The following details the number of employees in the Group executive and senior management personnel category during 2011 and 2010: Number of Employees 49 CEO Senior management Expanded management and additional senior employees 50 December December Pursuant to the organizational structure (as opposed to salary levels). 50 Not including CEO and senior management. a - 131

134 Internal Enforcement Plan In December 2011 the Company s Board of Directors approved, after receiving the recommendations of the Corporate Governance Committee, the key points of the internal enforcement plan in the field of securities and corporate law (hereinafter: the Internal Enforcement Plan ). The internal enforcement plan was formulated by a work team consisting of Professor Assaf Hamdani, the law firm of Matari, Meiti & Co., the Company s legal counsel and secretary and the manager of the Company s and Board s administrative offices, and was approved by Company management. The internal enforcement plan expresses the Company s recognition of the importance of compliance with the law on behalf of Company employees, executives, Board members and relevant service providers and concentrates the Company's policy on the subject of preventing and treating violations, including its policy for the evaluation of the damages of violations and preventing their recurrence. The goal of the internal enforcement plan is to assimilate and enforce norms in matters of observing the law, ethical rules and other codes of behavior by the Company, its executives and its employees and therefore to confirm compliance by the Company and by individuals working at it with securities law. The enforcement plan includes means for the internal identification of potential violations and failures, the purpose of which among other things is to locate and correct failures, improve reporting processes, identify and treat cases of conflict of interest, prevent the loss of internal information out of the Company and to prevent prohibited influence on trade in Company shares. To be clear, the internal enforcement plan may constitute a tool employed by the CEO and the Board of Director pursuant to the observance of their oversight obligation and may be held in the Company s favor in the event of any violation of securities law. The internal enforcement plan adopted by the Company includes an outline for the activities of the Company s internal enforcement array and key procedures including: the Board of Directors work procedure; the procedure for defining the positions and authorities of the Audit Committee; the procedure for transactions with related parties; the Board of Directors conflict of interest procedure; the executive remuneration procedure; the reporting (non-financial) procedure; internal information procedure; as well as the delivery of information to the media and to the capital markets. a - 132

135 The Company's Board of Directors approved and adopted the internal enforcement plan and its central procedures and also, at the recommendation of the CEO, appointed the Company s legal counsel and secretary, Omer Shalev, as the Company s internal enforcement supervisor. The Company is acting to implement and assimilate the internal enforcement plan among its workers as well as to establish mechanisms for the appropriate assimilation of the plan at the Company. 9.5 Raw Materials and Suppliers Fuel a. The principal raw material employed by the Company is jet fuel. Jet fuel is one of the Company's main expense components, as it is for every airline. In 2011, the Company s jet fuel expenses represented some 39% of the Group s operating expenses (compared to 37% in 2010). b. The price of jet fuel has a material effect on the Company s profitability. The Company estimates that at the operating level as of the date of the report, every change of 1 cent in the price of a gallon of jet fuel over the course of the year increases the Company's fuel expenses by $2.3 million. c. Starting 2001, the Group has taken actions to hedge part of the forecasted jet fuel consumption. A special committee of the Board of Directors for the management of market risks sets the Company s policies on the hedging of jet fuel prices, the hedge period and the proportion of the hedge out of total jet fuel consumption for that period. The Company requests proposals for framework arrangements from several financial institutions and fuel companies with which the Company has contacts, carries out commercial negotiations with them and executes the hedging transactions with them. The accounting between the parties is done once each period, and if the average price for the above period in the market is higher than the hedged price, the Company receives a refund in the amount of the price difference multiplied by the quantity for that period; where the average monthly market price is lower than the hedged price, the Company pays the difference multiplied by the quantity for that period. In 2011 the Company paid $69.6 million for a hedging transaction conducted in the past, while the fair value of these transactions dropped by $17.6 million. d. On March the Company reported that it had conducted sales and purchase transactions of certain financial instruments pursuant to its jet fuel hedging portfolio for the period between September 2011 and March 2012, consisting mainly of a - 133

136 replacing some of the financial instruments used to hedge jet fuel in the period in question with other financial instruments, while making an early realization of hedging revenues to the amount of $31 million and purchasing other financial instruments worth $6 million in such a manner that the total result of the actions in question derived a cash bonus of $25 million that entered the Company's accounts immediately prior to the transaction. Hedging revenues to the amount of $31 million were recognized in the Company s Statements of Operations based on the original repayment dates of the transactions for the period in question, of which $22 million were recognized in the second half of 2011, and the balance to the amount of $9 million shall be recognized in the first quarter of The sales transactions have no impact on the Company s jet fuel hedging for other periods beyond that described above. For details regarding the Company s hedging policy see Section b.1.(2) of the Board of Directors Report and Note 31c to the Financial Statements. e. In 2011, the average market price of jet fuel rose by 41% in comparison with 2010 before hedging activity. The effect of this price increase on the Company's operating results is substantial. Following the increase in jet fuel prices, from time to time the Company updates the fuel surcharge paid by passengers as part of their flight tickets. f. The Group purchases fuel in Israel and abroad. In 2011, the Company purchased fuel from three suppliers who were chosen via tender process, with some 70% of its fuel purchases in Israel from one supplier (the Paz Company). For details regarding the Company s engagements in fuel purchasing agreements in 2012 see 9.12 below. g. The Group purchases jet fuel abroad from a number of suppliers, including fuel companies that supply jet fuel to a large number of airports. The foreign contracts are for periods of two years, except for cases in which engagements of just one year were allowed. Most of the contracts are signed with suppliers after a tender process and after commercial negotiations the Company conducts with the suppliers, except for those stations where there is only a single supplier. As of this report, the Group has agreements for the overseas purchase of jet fuel that will be in effect through June 30, h. From time to time, the Company reviews the feasibility of importing jet fuel independently as opposed to purchasing it from local suppliers, and carries out these activities based upon market conditions. There were no jet fuel imports in a - 134

137 i. The Company purchased 37% of its total fuel purchases (in Israel and abroad) during 2011 for that year from one supplier (Paz). The Company has seven additional fuel suppliers from which it purchased more than 5% of its total fuel purchases in that year. The Company believes that the scope of purchases from the central supplier in Israel may create a dependence on this supplier in so much as there are no suitable and immediate alternatives for the supply of jet fuel at BGN. j. In 2003 the Company initiated a policy of maintaining an inventory of jet fuel, which was purchased from local suppliers. As of December 31, 2011, the Company held an inventory of jet fuel purchased from suppliers in Israel and abroad to the amount of $16.4 million. k. In addition to fuel suppliers, the Group receives fueling services in Israel from other suppliers. l. In May 2011 the Airports Authority informed the Company that jet fuel refueling at Ben Gurion Airport would be halted, after an unidentified contaminant was found in the BGN refueling tanks, causing disruptions to Company flights as a result. The Company is considering taking legal action for the damages caused to he Company as a result of the fuel contamination in question. For details regarding a request to approve a class action filed against the Company in relation to this incident, see below Aircraft a. All of the aircraft operated by the Company were manufactured by the Boeing Corporation. The Company has a material dependence on Boeing both with respect to spare parts as well as with respect to engineering support. At the same time, the Company estimates that the likelihood that engineering support will be discontinued is low. b. For details regarding agreements for the purchase and sale of aircraft and engines see Note 16e to the Financial Statements. a - 135

138 9.6 Working Capital Inventories The Company has an inventory of raw materials that include jet fuel for consumption, duty-free products to be sold in flight, and expendable inventory (chemicals, food, and supplies.) for the use of passengers during flight. The following is a calculation of average inventory days: Jet fuel inventory 10 5 Inventory of food and supplies for passengers Duty Free Inventory Purchasing Policy The Company purchases 80% of its duty-free products from the DFASS Company, with the remaining products being Israeli products purchased directly from local suppliers (20%). Products are selected by a committee consisting of Company employees including representatives of the purchasing, marketing and customer units, in accordance with market survey considerations (consumer preferences, foreign companies, BGN duty free), potential product profitability, package size and more. Regarding DFASS products, after the selection of products by the Company, orders are made for a period of 2-3 months in advance. Supply of products to the duty free warehouse is carried out in a single occasion. Alcoholic beverages and cigarettes are provided directly to the duty free warehouse, on a quarterly basis, with the remaining products provided to El Al stations, and the Company shipping them on the basis of available space in Israel. The Company is entitled to return any product (not food, tobacco or logo products) so long as the product is in its original packaging. The Company is responsible for sending the products including shipping and insurance costs to their point of supply (cigarettes and alcoholic beverages from the duty free warehouse, other products to the Company's overseas station). Product returns also include products classified as hazardous materials (such as perfumes). Regarding the purchase of Israeli products, after receiving the approval of the committee mentioned above for the product offered for sale on the plane, an agreement is signed with the product's supplier along with an initial offer (the minimum amount is 250 units). a - 136

139 Supply of products to the Company is under export conditions and the warehouse in which the products are stored is a bonded warehouse. The Company reserves the right to discontinue sales of a certain product at its sole discretion. In such a case, the Company is entitled to return the entire remaining inventory (in whole or in part, as it chooses), but shall make a reasonable commercial effort to reduce the amount of products returned to the supplier. The supplier shall be responsible for any taxes needed to pay customs agents to free the returned products from the bonded warehouse. The Company provides some of the Israeli suppliers with "framework orders for each supplier, for a 3-4 month period and the duty free warehouse withdraws the required amount from time to time. No amount may be withdrawn past the amounts open in the framework orders. Storing Products in the SLN Warehouse All purchased products are stored in the duty free warehouse (a separate unit within the SLN warehouse, with restricted access). Products requiring special storage conditions (such as chocolate), are stored in refrigerated conditions. The value of inventory in the warehouse at any given moment averages one and a half million dollars. Orders are made on a periodic basis, including multi-seasonal products (sold throughout the year) in order to maintain a low inventory level. Inventory is kept by the Purchasing buyer, along with a representative of the Duty Free Unit and a representative of the Duty Free warehouse, to keep up to date on planned sales, expiring products in inventory and so on. For details regarding the extent of the inventory see Note 11 to the Financial Statements Reservation Cancellation Policies In general, Company policy is that customers are permitted to cancel their reservation, without payment, until the date that the ticket is issued to the customer ( ticketing ). The customer may cancel certain tickets even after ticketing, at times without the payment of cancellation fees and at times with payment of a cancellation fee. Tickets also exist that the customer may not cancel at all, including after ticketing. Generally, the higher the ticket price, the greater the willingness to allow cancellation of the ticket without a cancellation fee or with a low cancellation fee. The above is subject to the fact that legal requirements do not demand otherwise. In this regard note that as regards certain transactions the Consumer Protection Law, 1981 and the Consumer Protection Regulations (Canceling Transactions), 2010 provide special instructions regarding the possibility of cancelled transactions see Section (j) a - 137

140 below on this regard. In addition, a new DOT law that came into effect in January 2012 allows a reservation to be held for 24 hours with no charge, or alternately, allows a reservation to be cancelled within 24 hours with no cancellation fees, for reservations made up to 7 days before the flight see (n) below Policies for Providing Assurance for Services The Group s responsibility for damages (bodily damages and property damages) caused over the course of international air transport are stipulated in international conventions adopted in the Air Transport Law, 1980 and resulting directives. The Group also operates in accordance with IATA directives on various matters connected to responsibility for passengers and their luggage. The Group s liability for denial of passenger boarding due to overbooking is established in the Aviation Services Licensing Regulations, In addition, in all matters pertaining to bumping passengers from flights, flight delays and flight cancellations to and from countries belonging to the European Union, Regulation 261/04 of the European Union applies. In March 2012 the Knesset Economic Committee held a number of discussions in order to prepare the second and third reading before the Knesset of the Aviation Services Bill (Compensation and Assistance due to Flight Cancellation or Changes in Flight Conditions), 2012, which seeks to adopt the principles denoted in EU regulation 261/2004. For further details on the bill Section (n) below Credit Policy a. Credit to customers: Travel or cargo agents approved by IATA enjoy special payment arrangements in accordance with IATA regulations (a non-iata agent is obliged to provide guarantees or pay in cash). The Group grants credit to agents in Israel for periods of between 15 to 45 days. As a rule, direct sales of air transport to customers are made in cash, other than credit sales to Government ministries and certain commercial customers. b. Suppliers credit: The Group receives credit from its suppliers in Israel for periods between 30 to 90 days, in accordance with the type of supplier and the arrangement with him. a - 138

141 c. The following are the average credit volume and average credit periods for Group customers and suppliers in 2010 and 2011: Customers Average Credit in Millions of Dollars 162 Average Days of Credit 28 Average Credit in Millions of Dollars 153 Average Days of Credit 27 Suppliers d. Note that the gap between the customer credit policy and its supplier credit policy derives, inter alia, from the fact that the supplier credit policy is set by the Company, taking into account market conditions, liquidity and generally accepted policy. On the other hand, the customer credit policy is largely set according to generally accepted practices in the aviation industry and in accordance with ordinances and procedures accepted by the IATA and travel and cargo agents Working Capital Deficit As of December 31, 2011, the Group had a working capital deficit of $393 million, compared to $316 million at the end of the previous year. The Company s current ratio as of the end of 2011 is 45% compared to 57% at the end of the previous year. See Section a.1 of the Board of Directors' Report for details of the factors leading to the decrease in the working capital deficit. The working capital deficit consists of three material elements included under the Company s current liabilities items and characterized by current business cycles: unearned revenues from the sale of flight tickets including port taxes, unearned revenues from frequent flyer clubs, and employee vacation obligations. Therefore, a material part of the capital deficit is not cash-flow based in the short term. 9.7 Investments See Note 15 to the Financial Statements for details of all of the investees of the Company A Concise Description of the Businesses of Principal Subsidiaries: a. Sun D Or International Airlines Ltd. ( Sun D Or ) The Group's charter activities, described above and below, are carried out through Sun D Or (a fully owned El Al subsidiary). Sun D Or acts as a tourism organizer in the charter flights it markets, while selling seats to tourism wholesalers. In addition, the marketed seats are combined by tourism wholesalers as parts of a - 139

142 tourism packages. Sun D Or has a commercial operating license that provides, inter alia, that the flights will be carried out on aircraft leased from EL Al to Sun D Or and that BGN will be Sun D Or s home base. On March the CAA informed Sun D Or that it would be revoking Sun D Or s operator s license starting April This announcement by the CAA followed talks between the CAA and Sun D Or and the CAA s requirements regarding Sun D Or s licensing and its operational performance and following a proceeding held before the European Commission on March , to which CAA and Sun D OR representatives were invited in order to provide explanations regarding the structure of Sun D Or and its operational functioning, in order for the European Commission to decide whether to place operational restrictions on Sun D Or s flights to Europe. Following the revocation of Sun D Or s operator s license, and following Sun D Or s appointment as designated carrier to various destinations by the Ministry of Transportation these appointments were transferred to the Company, with the exception of the Eilat-Moscow route. Furthermore, On April the Company ceased leasing to Sun D Or, via dry lease, three aircraft from its Boeing fleet and the aircraft returned to the Company's service. Note that following the revocation of its operator s license, Sun D Or continues to serve as a tourism organizer, as detailed above, while maintaining the Sun D Or label for charter flights it markets and which are carried out by the Company (on weekdays) and by other airlines (on weekend and holiday flights). As a result of this change in Sun D Or s activity, a significant 21% drop occurred in Sun D Or s total activity (on routes to Western, Central and Eastern Europe and the regional network). Sun D Or recently submitted an official request to the CAA to receive a new license. The outline of the activities and timetables allowing Sun D Or to return to operational activity has yet to be established. Sun D'Or's revenues amounted to $75,893,000 in 2011 compared to $88,638,000 in 2010 and $75,785,000 in As of December , Sun D'Or employed 32 employees. For further details see Note 15.a.(4) to the Financial Statement. b. Tamam Aircraft Food Industries (BGN) Ltd. ("Tamam") Tamam (a fully owned El Al subsidiary) is primarily engaged in the production and supply of prepared kosher airline meals. Tamam is located in Israel and its offices a - 140

143 are located outside Ben Gurion Airport. El Al is Tamam's principal customer. In 2011, some 85% of its sales were to El Al, with the remainder to other airlines and to other customers. Tamam s revenues in 2011 totaled $28.3 million compared to $25.1 million n 2010 and $22 million in As of December 31, 2011, Taman employed 345 workers. Note that in March 2011 Mr. Amit Schwartzman was appointed Tamam CEO. Note also that in January 2012 the CEO of Tamam announced that he would be applying streamlining measures and cancelling the position of Head of Human Resources and Administration at Tamam. For further information on Tamam see Note 15.a.(1) to the Financial Statements. c. Katit Ltd. ("Katit") Katit (a fully owned El Al subsidiary), deals mainly in the manufacture and supply of meals to Company employees. Katit is based in Israel and its offices are at Ben Gurion Airport. In % of its sales were to El Al. Katit's revenues in 2011 were $3,787,000 compared to $3,546,000 in 2010 and $3,248,000 in As of December , Katit employed 106 workers. For further details see Note 15.a.(5) to the Financial Statements d. Bornstein Caterers Inc. (USA) ( Bornstein ) Bornstein (a fully-owned El Al subsidiary), incorporated in the United States and operating out of New York s JFK airport, deals mostly in the production and delivery of prepared meals for airlines and other institutions. El Al is Bornstein's primary customer (some 53% of its sales for 2011). Bornstein s revenues amounted to $11,592,000 in 2011 compared to $10,713,000 in 2010 and $9,715,000 in As of December , Bornstein employed 85 workers. See Note 15.a.(2) to the Financial Statements for further details. e. Superstar Holidays Ltd. (Britain) - ( Superstar ) Superstar (a fully-owned El Al subsidiary), is a tourism wholesaler marketing tour packages to travel agents and individual travelers, and selling airline tickets on El Al routes at reduced prices. In recent years, Superstar has become one of the largest tour operators in Great Britain for tourism to Israel. The Company has operations in several other countries. Superstar's revenues were $15,141,000 in 2011 compared to $15,774, in 2010 and $16,449,000 in As of December , Superstar employed 4 workers. See Note 15.a.(3) to the Financial Statements for further details. 51 The sum in thousands of dollars has been translated from pounds Sterling at the December rate of exchange. a - 141

144 9.7.2 The following is a concise description of the businesses of the principal investees that are not subsidiaries: a. Cargo Consolidation: Air Consolidators Israel Ltd. ("ACI") ACI (a company in which the Company holds all of its Type B shares, granting the Company the right to appoint one half of the number of directors as well as participate and vote in general meetings) is primarily engaged in the consolidation of air cargo at BGN in order to reduce the price of airborne shipments. Air transport is carried out by the Company, at special prices, as well as by foreign companies. The shares do not provide El Al with the right to receive dividends or any other benefit to be distributed by ACI, other than earnings and dividends distributed from capital gains. In 2011, the Company paid commissions to ACI to the amount of $872,000. The Group is evaluating the possibility of changing its holdings in ACI, with everything this implies. The subject has yet to be decided on. For further details see Note 15.b.(2) to the Financial Statements. ACI's revenues were $30,456,000 in 2011 compared to $35,226,000 in 2010 and $25,903,000 in As of December 31, 2011, ACI employed 18 workers. b. Flight Marketing: Air Tour (Israel) Ltd. ("Airtour" or "Tour Air") Air Tour (a company 50%-owned by El Al) markets El Al flights and special promotions to all El Al destinations. The Air Tour shares held by the Group grant it the right to participate and vote in shareholders meetings and to appoint half of its directors, but do not grant the Group the right to receive dividends or earnings, other than earnings derived from Air Tour share capital investments. For further details see Note 15.b.(1) to the Financial Statements The Company pays Air Tour handling fees for certain actions carried out by Air Tour for the Company and in addition participates in one half of its operating expenses. It is Air Tour's policy to transfer the lion s share of the incentives it receives to the travel agents, based on their sales revenues at Air Tour, and to distribute the earnings as dividends to its ordinary shareholders (the travel agents) through dividends. Airtour's revenues were $4,016,000 in 2011 compared to $3,697,000 in As of December , Air Tour employed 63 workers. 52 The sums in thousands of dollars have been translated from NIS at the rates of exchange existing as of December and December , respectively. a - 142

145 c. Touring and Hotels: Kavei Chufsha Ltd. ("Kavei Chufsha") Kavei Chufsha (a company in which El Al has a 20% stake 53 ) deals in the marketing and sale of tourism services, including as a wholesaler and as an organizer of charter flights to and from Israel. The Company s investment in Kavei Chufsha was made in order to enlarge its marketing channels in the charter flights sector and to expand the Group's hold on the marketing of tourism traffic. Kavei Chufsha performs its marketing via travel agents and by the distribution of seats and touring packages to the end consumer. d. Maman Cargo Terminals and Handling Ltd. ("Maman") Maman is a public company the shares of which are traded on the Tel Aviv Stock Exchange. The Company holds 15% of Maman's stock capital and also holds options for 10% more exercisable Maman shares. Maman's chief activity is the management and operation of the cargo terminal authorized to handle all import and export cargo at Ben Gurion International Airport, as authorized by the Airports Authority. In addition, Maman is also active in the field of logistical services, real estate property rental and provides aviation services. Mamman's activity takes place in Israel, the Czech Republic and India. Mamman's revenues in 2011 were 453,584,000 NIS, compared to 436,677,000 in As of December 31, 2011, Maman employed 453 workers. 9.8 Finance Loans Not for Exclusive Use The Group does not have any loans (whether from banking or non-banking sources) which are not for designated use, excluding a credit framework, as mentioned in Section below. For details regarding the Company's long-term bank loans see Note 22 to the Financial Statements Credit Limitations on the Corporation a. Observance of Collateral Ratio In accordance with the stipulations of each agreement, the Company has committed to some of its long-term credit issuers to maintain a proper collateral ratio between unpaid credit and collateral pledged to the bank. In general, the agreements for 53 To the best of the Company's knowledge, the remaining shares are held by A. Arnon Aviation and Tourism Ltd. (44%), Cohen Kana Investments Ltd.(35.2%) and Arnon Englander (0.8%). a - 143

146 credit taken by the Company stipulate that the market value of the aircraft pledged should exceed the bank debt balance by at least 25% and that this should be verified once a year (in some of the agreements twice a year), on the basis of agreed-upon international professional publications. Whenever the value of the collateral falls below that specified in the agreement, the Company is obligated to provide additional collateral to the lender, so that the ratio, as stipulated in the agreement, is maintained. As of the date of the approval and publication of the report, the Company complies with the restrictions and the financial covenants that were prescribed with the banks. For further details see Note 22h to the December Financial Statements. b. Single Borrower and Group of Borrowers Limitation The directives of the Supervisor of Banks in Israel include restrictions according to which the debt of a single borrower and of a group of borrowers to a bank in Israel shall not exceed a given percentage of that bank s shareholders equity. From time to time, these directives may affect the ability of some of the banks in Israel to grant additional credit to the Company. Due to the change in the holdings in the Company, whereby K nafaim is the controlling shareholder and holds more than 25% of the Company s issued share capital, the Group is considered a part of the K nafaim group with respect to the borrower-group restriction placed on the granting of bank credit. In addition, in light of the weight of the Company s longterm liabilities to banks in Israel, the Company may encounter difficulties raising additional credit at significant sums from Israeli banks. c. Limitations on Transferring Control The Company has made commitments to banks, according to which, should there be a transfer or change of control of the Company in any manner without the consent of the lenders, the lenders may demand immediate repayment of the loan balances. d. Demand for Immediate Repayment by the Bank The loan agreements made by the Company include the bank's right to demand immediate repayment of the balance of the loans owed to that bank, as a result of a violation event such as: (a) if, in the bank's opinion, based on reasonable criteria, a change had occurred that adversely affects the Company s financial position or its operations or its business or its financial ratios, in a manner endangering or potentially endangering its ability to repay the bank loans; (b) insolvency; (c) failure to make timely payments; (d) a situation in which the aircraft for which the a - 144

147 loan was granted is uninsured; (e) a cessation of the Company's business and failure to renew them within 45 days from that cessation; and (f) a merger or transfer of control without the advance written consent of the bank. For details see Note 22g to the Financial Statements. For details on the matter of financial limitations and covenants involving the Company's long term loans, see Note 22h to the Financial Statements. As of December and immediately prior to the approval of this report, the Company has upheld these financial covenants and obligations Credit Frameworks As of December the Company's credit frameworks amounted to $35 million, similar to the credit frameworks at the Company's disposal on December Immediately prior to the approval of this report the Company's credit frameworks amounted to $35 million. Use of these facilities is intended for any purpose Guarantees for Collaterals The Company has unguaranteed frameworks to the amount of 43 million from the hedging institutions ($29 million on December ). As of December 3, 2011 the Company was not required to provide any collateral for its hedging transactions Loans Not for Exclusive Use The Company has taken loans for the purchase of aircraft, the principal terms of which are listed in Note 16 to the Financial Statements. The balance of the bank loans as of December amounted to $660.3 million. Interest on loans in 2011 ranged between 0.43% and 6.75%, and the effective interest on the loans in 2011 ranged between 0.69% and 6.02%. Details of New Loans In May the Company signed a loan agreement to finance the purchase of a Boeing (ELH) aircraft to the amount of $14.5 million; the loans bear interest of LIBOR plus a margin. Principal and interest payments are quarterly payments. The financing is for a period of 4 years. For the purpose of this loan the airplane was pledged to the local bank. One third of the sum of the loan was deposited at the local bank and is used as a source for lowering credit costs. a - 145

148 On November the Company signed an agreement with a banking institution in the matter of an additional loan for the difference between the airplane s value estimate and its purchase price, to the amount of 39.5 million NIS. The loan is at an interest rate of prime plus a margin and will be paid in 16 equal quarterly payments of principal and interest. In June 2011 the Company signed a loan agreement to finance the purchase of a CFM 56-7B24/3 spare engine for the 737 fleet to the amount of $3.9 million, for a periods of 7 years with quarterly principal and interest payments bearing fixed interest. For the purposes of this loan, a lien was placed on the engine and a guarantee was received from the ExIm U.S. export and import bank. In October 2011 the Company s Board of Directors ratified a loan agreement with a local credit card company according to which the Company will receive a 15 million NIS loan against the early sale of frequent flyer club points. The loan was granted for a period of two years in monthly principal and interest payments at an interest rate of Prime plus a margin. In March 2012 the Company signed a loan agreement with a foreign bank to finance the advance payments for the purchase of the first two ER aircraft, which were purchased in February 2011 from aircraft manufacturer Boeing, in return for a total of up to $46 million. The loan is in USD and bears variable LIBOR interest plus a margin. Principal and interest payments are quarterly payments. The financing period is up to the date set in the new agreement for the arrival of the two aircraft at the Company. To guarantee the loan s repayment, the Company shall assign its rights to the two airplanes in accordance with the new agreement to the foreign bank. The loan agreement includes a commitment by the parties to finance the purchase agreement for the two airplanes (under the condition that ExIm s guarantee for the purchase agreement is received, no later than October ), unless the Company decides to finance it through some other factor, in accordance with the terms set between the Company and the foreign bank. Rescheduling of Loans from Banking Corporations The repayment date of a loan from a banking organization to the amount of $76 million fell on January On March the Company entered into an agreement with the banking institution to correct the existing agreement, according to which the balance of the loan, including principal payments remaining until the original repayment date, shall be spread out across a period of a - 146

149 6 years from the signing date. At the end of this period a $32 million balloon balance shall remain. The loan is in USD and bears variable LIBOR interest plus a margin. Principal and interest payments are quarterly payments. According to the revision, the interest rate borne by the uncleared balance of the loan shall be updated to the LIBOR rate plus a margin, as accepted under current market conditions. Changing the above terms had no impact on the December Financial Statements. In July 2011 the Company signed an agreement with a banking institution for a $14 million loan. According to the agreement, the credit was extended for an additional year until April 2012, during which a principal sum of $2.5 million was repaid in October 2011 and an additional principal sum of $2.5 million will be repaid in April The Company is negotiating with a banking institution regarding the rescheduling terms of the uncleared balance remaining as of April Furthermore, the interest rate borne by the uncleared balance of the loan was updated to the LIBOR rate plus a margin, as accepted under current market conditions. Changing the above terms had no impact on the December Financial Statements. On August the Company s board of Directors approved a revision to the terms of a loan taken by the Company from a banking corporation in 2001, the balance of which upon the revision amounted to $157 million, and the original redemption date of which is in July A total of $37 million from the balance of the loan will be redeemed by July According to the revision, a total of $72 million U.S. from the balance of the uncleared loan will be repaid in equal quarterly payments starting July 2013 until July 2017 (hereinafter: the New Repayment Date ), and the balance to the amount of US$48 million will be repaid on the new repayment date. In addition, according to the revision, the interest rate borne by the uncleared balance of the loan will be updated to the LIBOR rate plus a margin, as accepted under current market conditions. Except for these changes, no material changes were made to the terms of the loan. Changing the above terms had no impact on the Company s December Financial Statements. The repayment date of a loan from a banking organization to the amount of $60 million fell on August On August the Company signed an agreement with the banking institution according to which a follow-up loan would be provided in lieu of the existing $50 million US loan. The loan was spread out across a 6-year period, and shall be paid in semiannual principal and a - 147

150 interest refunds and shall bear interest of LIBOR plus a margin. Furthermore, according to the agreement the interest rate borne by the uncleared balance of the loan was updated to the LIBOR rate plus a margin, as accepted under current market conditions. Changing the above terms had no impact on the December Financial Statements. Liens and Collateral In May 2011 the Company signed agreements to place specific liens in favor of a banking institution on the Company's right to receive money from the sale of flight tickets from a limited number of agents. In addition, the Company placed a lien on its property on 32 Ben Yehuda St. in favor of this banking institution. Financing the Company s Investment Plan In light of the price of jet fuel as of this report and based on the future curve as published daily by international commodities institutions, which on the report date was significantly higher than its date at the end of the reported period, and according to the Company's estimates, added funds may be needed to be raised, from time to time, to finance the Company s investment plan, as defined in the 2012 work plan. The Company's estimates regarding the need to raise additional funds to conduct the Company s business constitutes forward-looking information, as defined in the Securities Law, which is based upon the price of jet fuel on the date of the report and on the Company s assessments based mainly on past experience and its experience to date. Therefore, the need to procure additional sources of finance for the Company s operations may be materially different from the results estimated or implied from this data, as the result of a large number of factors, including changes in jet fuel prices, liquidity considerations, outfitting, unexpected expenses borne by the Company, unexpected events that may have a negative impact on the Company s activities and changes in interest rates. 9.9 Taxation Tax Laws Applying to the Corporation According to the Income Tax Regulations (Rules Concerning the Maintenance of Accounting Records of Airlines with Foreign Investments and of Certain Partnerships and the Determination of their Taxable Income), 1986, the results of the Company and some of its subsidiaries are measured for tax purposes on a dollar basis. Some of the subsidiaries are assessed jointly with the Company. a - 148

151 Pursuant to the Income Tax Regulations (Depreciation), 1941, the Company is entitled to depreciate aircraft it owns at a yearly rate of 30% of cost and spare engines that it owns at an annual rate of 40%. In accordance with the Value Added Tax Law, 1975, transactions for the sale of flight tickets to and from Israel, or from one destination abroad to another, as well as cargo transport by air to and from Israel, have been defined as transactions regarding which the VAT rate is zero. The recommendations of the Commission for Economic and Social Change headed by Professor Manuel Trajtenberg were published on September Subsequently, the Tax Burden Alteration Law (Legislative Changes), based on the recommendations of the taxation chapter of the Trajtenberg Commission Report, was published on December , after passing its third vote in the Israeli Knesset. The key changes in the new law in the field of corporate taxation were the cancellation of reductions planned for the coming few years in income tax and corporate tax starting from 2012, an increase in income tax and corporate tax starting 2012, an increase in corporate tax to 25% starting 2012 and an increase in capital gains taxes and betterment tax Status of the Corporation s Tax Assessments The Company and its subsidiaries have received final tax assessments (including self assessments that are regarded as final) for the period through the tax year: Tax year The Company Main direct subsidiaries Tax Laws Applicable to Significant Affiliated Companies Incorporated Abroad Overseas subsidiaries are subject to the tax laws applicable in the countries of residence. Most of the countries in which the Company operates representative offices are signatories to treaties for the prevention of double taxation or mutual arrangements between the nations, which exempt the Company from the payment of income taxes on its operations in those countries Reasons for Material Differences Between Effective Tax Rate and Statutory Tax Rate See Note 28d to the Financial Statements Accumulated Losses for Tax Purposes The balance of income tax losses as of the end of the 2011 tax year (based on an estimated tax return for 2011) amounted to a total of $723 million. a - 149

152 The Company recognized deferred tax assets for losses accumulated for tax purposes to the amount of $184 million and for deductable timing differences of $27 million. See Note 28 to the Financial Statements. Tax assets were listed after offsetting taxable timing differences deriving from accelerated aircraft depreciation for tax purposes Income Tax Withholding: The Company received withholding assessments for 1998 to 2005 in the matter of the benefit value of flight tickets granted employees flight tickets on the basis of available seats free of charge or flight tickets with a 50% discount. On February the Company signed a settlement with the Income Tax Authorities (Ramla Assessment Clerk). This settlement came as a result of a dispute between the Company and Income Tax in which the Company received assessments followed by orders for 1998 through the 2005 tax year. The sum of the assessments issued was estimated by the Company at a total sum of 186 million NIS ($52 million) including interest and linkage differentials up to December The key points of the dispute between the Company and the tax authorities was the value of flight tickets, on the basis of available seats and on the basis of reserved seats, granted employees as discounts, as follows: a. For flight tickets granted on an available seat basis, the Company s position was that the value of the ticket shall be calculated at a rate of 22.5% of the flight ticket price established as a basic price for the issue of employee economy class tickets, according to an arrangement conducted in the past with Income Tax which was revoked in The assessor determined, in assessments issued for the Company for , the value of the flight ticket at variable rates from the average price of economy class tickets, which are higher than the rate set by the Company above (up to 75% of the price of an average ticket), this based on the average load factor for the month in which the flight took place. b. For flight tickets on the basis of reserved seats, the Company allows its employees to purchase in return for a payment of 50% of the cost of a flight ticket set by the Company as an average economy class price, the Company paid fixed tax levels, but in assessments issued for the Company for 2001 to 2005, Income Tax determined that the value of the flight ticket is 214% of the price of an average economy class ticket. a - 150

153 c. In addition, the assessments issued for 1998 through 2002 included tax debits for employees stationed abroad for periods of over 4 years as well as for a tax offset paid by Company employees in the U.S. The Company has appealed these assessments before the District Court based, among other things, on economic opinions materially different from those of the Income Tax assessments. The parties held talks to resolve the disputes in question and on February , after the ratification of the Company s Board of Directors, a settlement was signed between the Company and the Ramla Assessment Clerk, the key points of which are as follows: a. The Company shall pay Income Tax up to and including 2010 a final and absolute sum of 65 million NIS ($18 million) including payment for the assessments for which the orders were issued for tax years and the full deduction debts for employee flight tickets and other surplus expenses for 2006 through Upon the signing of the agreement and its approval by the court, the legal proceedings between the Company and Income Tax regarding the deduction assessments issued for the Company will be concluded. b. An agreement regarding the value of flight tickets for Company employees in the purchase of flight tickets on the basis of an available seat and on the basis of a reserved seat, for 2011 through The settlement received the force of a court ruling on February The payment mentioned above was paid by the Company on March Furthermore, in accordance with an agreement with the Social Security Institute, Social Security assessments were received on February totaling 12.3 million NIS up to and including In light of the financial provisions made by the Company in its Financial Statements, the Company cancelled part of the sum of the settlement listed in its books and recognized other revenues before adjustments and tax influence pursuant to the Company s operational profit in its 2011 Financial Statements to the amount of $5 million. For details see Note 27e and Note 28f to the Company s December Financial Statements. a - 151

154 9.10 Environmental Issues and Corporate Responsibility Significant Implications of Rules Pertaining to Environmental Matters Many countries, including Israel, have adopted conventional international standards regarding engine noise of aircraft and have prescribed additional directives for environmental conservation. Restrictions exist in various airports in the world as to the times of takeoff or landing of aircraft. The schedules of airlines, including those of the Group, are determined in accordance with these restrictions. The Company attributes a great deal of importance to the subject of the environment and invests resources and time to this issue (inter alia through the Company's Safety and Environmental Branch, which is responsible for these activities). The Company's representatives take part in professional conferences and make sure to remain at the global professional forefront of environmental issues and the field of the relationship between aviation and the environment. Group representatives are also members of the Interdepartmental Committee for the Improvement of Noise Climate at BGN, and the Company has put a great deal of effort into this field. Thus, for instance, the Company has mapped all of its areas of interest and assigned each area to a company executive, with each executive responsible for problems in their area of responsibility. The Environmental Supervisor at the Safety and Quality Department conducts regular and continuous inspections throughout the Company to locate environmental hazards. Each Company management forum, which convenes once per week, receives reports of the results of these inspections (including photographs) and conducts follow-ups on the correction of these flaws. The Company is undergoing ISO environmental certification. The Company has launched an internal campaign to increase environmental awareness, with each area of the Company having a person assigned as responsible for the environment, pollution prevention and careful use of resources. The Company is acting to complete its writing of work procedures on the matter of environmental protection, training and increasing awareness among Company employees, implementing work processes and increasing enforcement. In this regard, in 2009 a survey was conducted in order to achieve initial identification and analysis of environmental, health and safety issues at Company facilities, and significant improvement was observed in the Company's treatment of environmental issues compared to previous years, this as a basis for establishing environmental indices and goals. The Company has set preserving the environment as one of its goals, and shall act a - 152

155 to develop and implement management systems that recognize and take into account environmental implications and risks evident in Company activities, inserting environmental awareness into the business planning and business activity, establishing and constantly testing environmental targets and goals, promoting processes and work procedures involved in the reduction of environmental damage, reducing waste, continuing with recycling efforts (in-flight and on the ground), and increasing awareness among Company employees. In the field of waste reduction paper and cardboard from the Company s flights and offices is sent to recycling Restrictions on Night Takeoffs at BGN According to a Government resolution (PS/15 of July 15, 1997), BGN has halted takeoffs between the hours of 02:00 and 05:30 AM, starting October 30, In the summer of 2002, the Minister of Transportation decided to expand the prohibition on night takeoffs and to set it between 01:30 until 06:00 AM. Some of the foreign airlines in Israel petitioned the High Court of Justice. The case was resolved by a compromise under which the petitioners were permitted to start engines and to carry out arrangements that would allow the aircraft to leave at 05:50 AM. In May 2010 the municipality of Holon the head of the BGN Surrounding Authorities Forum ( the Petitioner ) filed a petition to the Supreme Court, against, inter alia, the Minister of Transportation, the Civil Aviation Authority and the Airports Authority. The Company was not listed as a respondent in the petition. The petitioner petitioned, among other things, to reverse the decision of the Minister of Transportation from April to allow the Airports Authority to open BGN for takeoffs between 1:40 and 5:50 AM ( the Restricted Hours ) on the basis of the claim that these flights would disturb the residents of municipalities in the BGN region. On June the Court issued an injunction prohibiting the respondents from allowing takeoffs during the restricted hours, in the event of flights resulting from airline operational needs and not due to the load on the airport only. Following this injunction, no changes were made to the Company s flight schedule or to the takeoff permissions granted it. On November the Court issued a ruling clarifying and amending the injunction in question, in which arrangements were set for the winter season, as follows: when a request is received to allow a takeoff outside the restricted hours which cannot be complied with due to the volume of traffic at BGN - the airline shall be offered a takeoff a - 153

156 time outside the restricted hours. If the airline refuses to take off on the hour offered, it shall be offered a takeoff during the restricted hours as near as possible to their beginning or end; in exceptional cases, takeoffs can be approved between 02:00 and 05:00 AM, this following a detailed and reasoned decision by the head of the Civil Aviation Authority, with a copy produced to the Court and to the petitioner. Following the ruling in question, the Airports Authority announced that it would no longer permit El Al flights on the nights between Thursday and Friday and before holiday eves. In light of this, on November the Company filed a request to join the petition as a respondent and to clarify or revise the injunctions in such a manner so that they no longer apply to takeoffs taking place during the night between Thursday and Friday and the night before Jewish holidays. On November , the Court accepted the Company s request and ruled that the injunction regarding flights during the restricted hours would not apply to the special permission given the Company for specific takeoffs during the nights between Thursday and Friday and during the nights before holiday eves. On November an additional petition was filed before the High Court of Justice by the City of Holon Head of the Forum of Authorities Surrounding Ben Gurion Airport against the Minister of Transportation and Road Safety, the Minister of the Environment, the Airports Authority, the Civil Aviation Authority and the Company, for the issue of an injunction regarding the permit received by the Company in 1998 to perform takeoffs between Thursday and Friday or before holiday eves, during certain hours of the night. On March a ruling was issued in which the Supreme Court rejected the petition against the Company and the other respondents. Over the course of 2011 the Company continued its process of removing older aircraft from the Company's operational fleet. See 7.11 above for details. In July 2008 the Company received a letter of warning prior to the filing of a criminal complaint (according to Section 11.e of the Hazard Prevention Law 1961) from the Israeli Public Committee for the Prevention of Noise and Air Pollution (hereinafter: "MALRAZ"). In its letter to the Company and its executives, MALRAZ claims that in accordance with the noise monitoring reports from 2003 to 2008, a violation has occurred, it claims, of Section 2 of the Hazard Prevention Law. The Company held talks with MALRAZ with the aim reaching understandings for cooperation. The Company s estimates regarding the implementation of a decision restricting the activity of certain aircraft or activity at certain hours, or a judicial decision which hinders the Company's flight schedule, constitutes forward-looking information, as defined in the Securities Law, which is based on the proposed resolutions, estimates, a - 154

157 experience and knowledge possessed by the Company as of the date of the report. Accordingly, the results in practice may be materially different from the results assessed or implied by this data, as the result of a large number of factors, including changes in the final wording of the regulatory directives to be enacted, the results of legal proceedings, legal or operational provisions in the destination airports or foreign airports, equipment purchases, environmental implications and more Noise Restrictions in the Operation of Aircraft at Airports The noise levels are defined by the International Civil Aviation Organization (ICAO) in Appendix 16 to the Chicago Convention and are catalogued into four levels from Chapter 1 to Chapter 4, the latter being the most severe level. The most prevalent restriction in most airports in the world is that comparable to Chapter 3. At central airports, such as London, Amsterdam, Brussels, Toronto, New York, Paris and BGN, more severe restrictions than Chapter 3 have been set. All Group aircraft meet Chapter 3 restrictions, and most even comply with Chapter 4. In addition, according to the decision of the European Union Parliament and Joint Commission of March 2002, the Union's member nations are required to implement policies intended to restrict the operations of aircraft defined as borderline from the standpoint of noise level. This policy is meant to be implemented in the following stages: (a) each EU nation will pass the legislation necessary to permit the decommissioning of such aircraft; (b) the performance of an environmental survey at the airports of EU nations, which includes a cost-benefit analysis regarding the continuation of the operation of borderline aircraft at the airports. The survey is to be performed in consultation with the parties affected by its conclusions; (c) in the event that the results of stage (b) lead to the conclusion that restricting the continued operation of borderline aircraft in any of the airports is justified, the aviation authorities will have the authority to instruct the airlines to freeze the number of flights on which these borderline aircraft will be operated at the subject airport, to an extent not to exceed the number of flights during the 6 months preceding the freeze notice; (d) starting with a date to be determined by the aviation authorities of each nation, and after giving advance notice of 12 months, the activities of the borderline aircraft will be reduced by up to 20% per year in comparison with the maximum volume of activity decided upon. To the best of the Company s knowledge, as of the date close to the approval of the report, consultation with the airlines has not yet begun in any European country and in some of the countries the relevant laws have not even been passed. On the matter of flight restrictions related to noise levels created by planes taking off see Section above. a - 155

158 After the passing of the new Aviation Law, the law in question contained several provisions regarding the subject of aircraft noise, according to which economic sanctions may be placed on the Company in the event of deviation from noise restrictions, as set in law. The information regarding the passing of a government resolution featuring various restrictions as noted above or the initiation of legal measures and the imposition of financial sanctions on the Company or individuals acting on its behalf constitutes forward-looking information, as defined in the Securities Law, which is supported by the Company's assessments based on data in the Company s possession regarding the progress of legislative proceedings and their application. Therefore, the effective date of the restrictions on the operation of aircraft and the scope of the restrictions and financial sanctions, insomuch as they are placed, may be materially different from that predicted, as a result of a large number of factors including the decisions of the authorities in various European nations and the Company s equipping process as well as the enforcement actions taken by regulatory bodies Waste Treatment The Company s waste is treated at a modern central facility within the confines of BGN, approved by the Ministry of the Environment and operated by the Airports Authority. Furthermore, the Company has been operating a facility at a cost of $600,000 since June The Company facility, constructed on the Group s land, serves as an emergency reservoir in the event of problems with the quality of the Company s waste. The Group pays usage fees to the Airports Authority for the use of the main facility to the amount of $75,000 per year over 22 years (from 2008). At the same time, the toxic waste created by the Company is transported to the Environmental Services Company at Ramat Hovav Fuel Tanks All of the Company s fuel tanks were examined during the second half of 2002 by an outside consultant who found that all of the tanks were suitably sealed. In addition, an examination was conducted by an authorized laboratory in December 2003, and all of the tanks were found to be in order. The Sonol fuel company also installed viscometers (devices that prevent the seepage of fuel from tanks into the ground) in some of its fuel tanks during the final quarter of 2004, pursuant to the regulations of the Ministry for Environmental Matters. The Group regularly carries out specific treatment of toxic soil waste, if such exist. a - 156

159 Over the course of the fourth quarter of 2010 the Company conducted tests of the integrity of its underground fuel tanks and tests for contamination of the surrounding ground. The fuel tanks have passed pressure tests and have been found to be in order. Over the course of 2011 the Company initiated ground contamination tests in various areas of the Company s compound in which contaminated ground was located at the main refueling station site, the ground equipment site and the transportation garage. The test did not detect any signs of leakage form the fuel reservoirs, and the source of the contamination is apparently the accumulation of fuel spillage at these areas over multiple years of activity. The Company intends to examine the report findings and study the measures needed to clean the ground according to the results Material Environmental Costs and Investments for the Reported Year and Those Anticipated Subsequently The Company carries out a great number of activities and invests financial expenses in improving environmental elements, including the establishment of a waste removal facility that will collect the Company's wastes in the event of deviation from waste quality (in accordance with its agreement with the Airports Authority), separating oil in the Company's yards and performing local separations between the drainage and sewage systems. Material Costs Material Investments Total 2010 $75,000 a year Some $350,000 a year Some $425,000 a year 2011 $75,000 a year Some $250,000 a year Some $325,000 a year 2012 (Projected) $120,000 a year Some $250,000 a year Some $370,000 a year Information concerning the material anticipated environmental costs and investments constitutes forward-looking information as defined in the Securities Law. The information is based upon the requirements of the environmental laws presently in effect and on current market prices of the goods and services that the Group must purchase in the framework of the environmental investments. Therefore, the actual costs and investments may vary materially from those forecast above, as the result of a large number of factors, including legislative changes, requirements by the authorities and changes in the prices of the goods and services that the Group will be required to buy within the framework of the environmental investments. a - 157

160 Restrictions on the Level of Engine Emissions Following growing world awareness of the subject of global warming, governments have become interested in monitoring and restricting the level of air pollution produced by engines. During coming years, laws are expected to be enacted on the matter in different countries all over the world. On January an EU regulation came into effect, establishing conditions for the supervision, reporting and confirmation of gas emissions in incoming and outgoing EU flights, this following the inclusion of aviation under emission policies in place for other industries, as established in the EU decision dated June In addition, an economic remuneration mechanism was established, according to which each Company shall receive an emissions cap based on past emission data. Exceeding this cap will require the purchase of an additional cap and reduction will allow the sale of the cap. Over the course of 2009 airlines were required to submit supervision programs on the subject of emissions. Such plans were submitted on behalf of the Company and were approved. In accordance with the EU decision, the Netherlands were appointed supervisor of the Company's activities. The reporting obligation, reporting procedures the manner of reporting have been fully established and binding directives on this subject have been published The supervising element has inspected the reporting and confirmed in writing that the Company has successfully passed the inspection Starting January 2011, the Company has been operating a CO2 emission monitoring and tracking system on Company aircraft. The system, employing advanced technology, collects data from various sources (messages and files both from the ground and from Company aircraft), concentrating it into a single database, and features control and analyzing tools. The purpose of the system is to create a database for the purpose of processing the data and producing statistical reports. These reports serve as a decision support system for the fuel control system and allow the location of potential fuel savings. In early 2011 the EU approved the reports issued by the Company on the subject of tracking air pollution from Company aircraft as a result of the EU s new emission regulations. The EU inspector commended the Company for the level of precision and quality of data collected using the system described above. The system is an intraorganizational system and is not exposed. Statistical data is encoded to prevent linkage. System authorizations are granted at the level of organizational user groups, with the Company being responsible. In addition, in order to reduce greenhouse gas emissions, winglets have been installed on some of the Company s airplanes, so as to improve the aerodynamics of the aircraft and thus also reduce fuel consumption (see above); in addition, aircraft engines are a - 158

161 washed to improve their efficiency the aircraft bodies are washed on the outside to lower air resistance. Starting 2012 the Company will be receiving the free allocation of pollution certificates in accordance with EU rules. This allocation is calculated in advance as a partial allocation on the basis of the airlines' performance in practice in In accordance with the planned flight plan, the Company is expected to exceed these quotas on a yearly basis, and thus will be required to purchase appropriate certificates on the free market, according to their cost on the date of purchase. The expected yearly expense for the purchase of these certificates as of this report amounts to an estimated sum of $2 to $3 million a year. The Company has been attached, along with other airlines operating out of Sao Paolo Airport, Brazil, to a Brazilian legal proceeding, on the matter of compelling the airlines operating at Sao Paolo Airport to carry out environmental actions or pay sums of money for CO2 emissions and the hazards created as a result of aviation activity, as claimed by the public prosecutor. The suit against the Company was dismissed by the first court and an appeal has been filed by the prosecutor, which has yet to receive a hearing. No provision was made for these proceedings in the Financial Statements. The degree of the influence of the implementation of legislation or the results of legal proceedings in this regarding on the Company's activity may constitute forwardlooking information, as defined in the Securities Law, based on Company assumptions and forecasts. Therefore, the actual results of the passing of these legislative changes or legal proceedings as noted above or their impact on the Company's activities may differ materially from the results estimated or implied by this information Fly Green The Company is active in the Fly Green Forum of IATA, and carries out activities with the objective of positioning the Company at the forefront of environmental air protection, inter alia, by using clean fuels (purchasing fuel only from suppliers that comply with the standard's conditions), significantly reducing the use of fuel and reducing the emission of pollutants from the Company's planes, by frequently washing aircraft engines, adopting more efficient operating procedures, etc. The Company convenes a panel headed by the VP of Operations once a month to deal with this subject. a - 159

162 Corporate Responsibility General The Company sees itself as committed to the community in which it operates and to the environment, and attributes a great deal of importance to working to promote and nourish them. As a result of the national carrier approach, the Company places the security and safety of its passengers at the top of its priorities, and conducts extensive activity in order to ensure their existence. Furthermore, the Company sees its workers as the source of its strength, and acts to foster an attentive, considerate, safe and fair environment. This arises from an understanding of the affiliation between high-quality businessstrategic management and the commitment to act and promote corporate responsibility The Company is a fellow in the Ma alah Organization an umbrella organization of businesses committed to managing the field of corporate responsibility, which acts to implement social, environmental and ethical considerations in regular corporate activity, and to promote the development and implementation of corporate responsibility strategies as a business approach. In the 2011 Ma alah rankings the Company received the Gold grade Ethical Code In 2011 the Company completed a process of formulating and writing an ethical code with the cooperation of employees and executives from the Company and its subsidiaries, and with the assistance of outside consulting firms specializing in the subject. The code features values, norms, enforcement and assimilation policies and communication channels for reporting violations of the code and of ethical rules, intended to direct the activity of the Group and of all of its workers over the course of their work, and to dictate criteria for their behavior. With the completion of the wording of the ethical code, a process has begun of formulating an assimilation and training plan, in order to ensure the familiarization of all of the group s employees in Israel and around the world with the code s values and to guide their actions in accordance with it. The code will be translated to English and distributed to all of the Group s representatives around the world Community Involvement and Support The Company attributes a great deal of importance to its responsibility to the community, out of a true and special affinity to the State of Israel. The Company has formulated a community responsibility policy, in which it conducts community contribution and a - 160

163 employee volunteering activity, which establishing long-term partnerships with community partners. Included among the groups supported by the Company are IDF soldiers, needy students who are active for the community, children with medical difficulties or disabilities and special needs children and families requiring assistance. As part of its activities, the Company contributed a total of $150,000 in cash and cash equivalents in Restrictions and Supervision of the Corporation s Business General Most aspects related to the operations of the Company as an air carrier are subject to a system of regulatory arrangements - Israeli and international - which pertain, among other things, to flight rights, setting of tariffs, capacity and flight safety standards, security and noise, and are stipulated on a commercial operating certificate and an operational operating certificate. See Section below regarding the regulatory arrangements. As to business and operational licenses see Sections to below. The Company s activity, in addition to the operating licenses, is contingent on it being an Israeli air carrier (principal ownership and real control held by the state or its citizens), on its appointment as Designated Carrier and on the permits issued by foreign companies to make use of the aviation rights granted it as Designated Carrier. See Sections to below for information on aviation agreements and Israel s civil and international aviation agreements. In addition, additional restrictions exist on the Company's activity by virtue of the Special State Share. See Section below for further details Regulatory Arrangements The following are principal regulatory arrangements, Israeli and international, pertaining to the Company's operation as an air carrier. (For security arrangements see below, for emergency operations see below). a. The Aviation Law, 2011 (hereinafter: the Aviation Law ) This law replaced the old 1927 law and constitutes a key element of the State of Israel's return to FAA Safety Category 1. The purpose of the law is to create a comprehensive legal infrastructure for the regulation of all fields and aspects of civil aviation in Israel while establishing a basis for the adoption of relevant arrangements in secondary legislation, granting a - 161

164 requisite professional authorities to the Civil Aviation Authority Manager and providing effective enforcement tools to the Civil Aviation Authority. The law regulates the activities of all factors active in the field of civil aviation personal licensing of aviation employees (air crews, air traffic controllers, maintenance personnel, trainers and instructors) as well as licensing organizations (aircraft manufacturers, airlines, flight schools and maintenance technical certification institutions, airports and airfields and air traffic control units). The Aviation Law covers a great deal of subjects in the field of aviation, including those dealing in aviation matters and their obligations, aircraft, the aviation supervision sector, gliders, supervision rights, safety incident investigations, and establishes directives regarding penalties and financial sanctions due to the violation of the law. Over the course of 2011 the Civil Aviation Authority published the Aviation Regulations Bill (Maintenance Facilities), 2012, which removes from the Aviation Regulations (Maintenance Facilities, Certification Facilities and Self- Maintenance), 1971, the provisions regarding maintenance facilities, and places them in new, designated maintenance facility regulations. On February the Knesset Economic Committee began discussing the Regulations bill. The amount of time until the issue is resolves is not known. At the same time, and in order to facilitate Israel s return to Category 1, an agreement was reached between the Company and the CAA to officially begin the relicensing process of the Company s maintenance facilities, on the basis of the draft Aviation Regulations in question b. Aviation Services Licensing Law, 1963 (hereafter - the Licensing Law ) 54 This law, which regulates the principles of aviation licensing, was amended in and the key elements of the law (following the amendment) are as follows: (1) The law prohibits the operation of aircraft in a commercial flight, except under license from the Minister of Transportation Road Safety and in accordance with the terms of the license (Section 2 of the law). 54 A commercial operating license and an operational license were granted to El Al under the authority of the law see Sections below 55 The law was amended in the framework of the State Economy Arrangements Law (Law Amendments in Order to Achieve Budget Goals and the Economic Policies for the Fiscal Year 2006). The amendment came into effect on July a - 162

165 (2) The law grants the Minister of Transportation, after consultation with the Minister of Tourism and after obtaining the opinion of the professional committee, 56 the following authority: (a) (b) (c) When issuing or renewing the license (Section 3 of the law), to stipulate conditions regarding the operation of aircraft, the proposed services, the training and experience of those engaged in operating and inspecting the aircraft, aviation routes to be operated by the license holder and operational standards by which he should operate, frequency of the services, rates and insurance. To refuse to grant a license if, among other reasons, it might damage the regulation in the aviation market, or its planning or the security of the State or contrary to its interests or the matter does not comply with an agreement between Israel and a foreign country or if the flight might cause damage to public safety or could lead to unfair competition in the civil aviation industry due to prices set below a fair price (Section 5 of the law). To make a license conditional or to revoke it if one of the following is discovered: (a) one of the license's conditions or a directive under any law that applies to operation of aircraft has not been fulfilled; (b) the aircraft is not operated safely, efficiently, in a capable manner or with proper consideration of public needs; (c) one of the grounds according to which the Minister of Transportation is permitted to refuse to grant a license in accordance with this law exists. The significance of the amendment to the law is the involvement of the Ministry of Tourism (and, to a certain extent, the Ministry of Finance and the Office of the Prime Minister, as well) in the decisions of the Minister of Transportation in the context of his authorities under the law. See Sections , above and below as regards the effect of the changes in competition have on the Company. Note that the Aviation Bill included indirect amendments to the Aviation Services Licensing Law for the purpose of adapting the Licensing Law to the provisions of the Aviation Law 56 A committee composed of the managing directors of the Ministries of Transport, Tourism, Prime Minister and Finance and the Civil Aviation Authority, the function of which is to render an opinion to the Minister of Transportation on any matter relating to licenses, for which an opinion is necessary. a - 163

166 c. Licensing Regulations The regulations issued under the auspices of the Licensing Law regulate, inter alia, aircraft operation and flight rules, operation of flight schools for flight instruction, transfer and endorsement of transport documents on scheduled flights, flying time restrictions for aviation services, overbooking, licenses for operating and leasing aircraft and operations of charter flights. d. The Air Transport Law, 1980 This law and the orders and the notices issued as a result adopt a number of international conventions that stipulate various rules relating to international air transport, particularly regarding the air carrier s liability for damages (bodily damage and property damage), caused during international air transport, and the damages imposed on the air carrier for this liability. This law applies the treaty for the purpose of consolidating certain rules pertaining to international airborne shipping (the Warsaw Treaty), and their revisions. In May 1999 a new treaty was prepared in Montreal establishing rules for international civil airborne transportation (hereinafter: "the Montreal Treaty") the purpose of which is to formulate, update and modernize the existing set of rules, including raising the limits of liability for damage caused a passenger's person or property, adding judicial powers and requiring air carriers to take out insurance. In December 2009 the Airborne Shipping Law (2nd Amendment), 2009 was passed, the purpose of which was to create clarity and uniformity in the areas of responsibilities, compensation and authorities in the area of airborne transport while adopting the updated and uniform Montreal Treaty. On January the Consul General of the State of Israel in Montreal submitted to the Manager of the Legal Department of the International Civil Aviation Organization (ICAO) a letter by which the State of Israel joined the Montreal Treaty. As a result, the Montreal Treaty came into effect in Israel starting March e. Equal Rights for Persons with Disabilities In the third chapter of the Equal Rights Regulations for Persons with Disabilities (Accessibility Arrangements to Public Transport Services), 2003, provisions were prescribed regarding the obligation to integrate assistance for persons with disabilities in aviation transport, which imposes various obligations on air carriers as a condition for operating aircraft. In July 2007, Regulation 1107/2006 of the European Union came into effect, imposing various obligations on the air carrier and the travel agent in all that relates a - 164

167 to booking reservations and flight check-in, in order to provide special protection for people with disabilities. The Regulation's provisions apply to every flight by a European airline to and from the European Union states, as well as to non- European airlines (such as the Company), in flights departing from EU states. In July 2008, the regulation dealing with the obligation to provide disabled passengers various means of assistance at airports (for whom the airlines will bear the cost) and which requires airlines to provide their employees with instruction on the subject came into effect. In December 2010 a discussion was held at the Ministry of Transportation and Road Safety regarding a proposed revision to the Equal Rights for Persons with Disabilities Regulations (Arranging Access to Public Transportation Services), 2003, as proposed by the Commission for Equal Rights for Persons with Disabilities. The proposed revision is based on the U.S. Non Discrimination on the Basis of Disability in Air Travel Regulation. In February 2011 the Company provided its response to the proposed revision. In December 2011 the Ministry of Transportation and Road Safety announced that as part of the negotiations in preparation for signing the Open Skies agreement with the EU (see above), it seeks to implement the standards set in the European regulation in question in Israeli legislation, while taking into account the Israeli airlines point of view on the matter. f. The Airports Authority Law 1977 This law, the regulations and rules issued under its auspices, regulate, inter alia, the following issues: aviation fees, transport by import couriers, entry into restricted territories, licensing fees and the unloading and loading of aircraft. The amendment to the Airports Authority Regulations (Fees), 1991 came into effect on January , the key point of which being the increase of exit tariffs from $13 U.S. to $21.70 U.S. as well as integrating a linking mechanism for payment of fees and raising the remainder of fees and services by a rate of 10% across a two-year period (5% from January and an additional 5% from January ). In June 2010 the Airports Authority announced that it would be closing Runway 26 for renovations for a period estimated at 20 months. Closing the runway in question requires that the Company carry out adjustments to its regular operations, which cause it to bear additional expenses and/or financial losses, including due to added fuel required to operate its flights due to: changes in arriving flight planning a - 165

168 definitions; a 15 minute increase in loitering time during busy periods at the airport; the extension of the flight route due to changes in takeoff directions, restrictions to takeoff weight due to the use of a shorter runway during the renovation period and a reduction of the possible amount of cargo carried by aircraft in flights to distant destinations, performing takeoffs on a shorter, eastward-facing runway leads to increased engine wear and increases repair costs; furthermore, unavoidable use of greater engine force during takeoffs from a shorter runway may lead to failure to comply with permitted BGN noise thresholds set by aviation authorities, and may lead to fines imposed on the Company. g. The Civil Aviation Authority Law 2005 This law designates the functions of the Civil Aviation Authority. Among the functions of the Authority are: to determine and assure the existence of internal and international flight regulations according to aviation laws; to grant civil aviation licenses, permits and approvals, according to aviation laws; to supervise the civil aviation sector, including maintaining a proper level of flight safety for Israeli aircraft and for aircraft present in Israeli airspace. Lowering of the State of Israel's Safety Rating to Category 2 On December the U.S. Federal Aviation Agency (the FAA) announced that it would be lowering the flight safety rating of the State of Israel to Category 2. This announcement refers to the level of supervision of civil aviation safety in the State of Israel by Israeli aviation authorities including the Civil Aviation Authority at the Ministry of Transportation. Although the FAA s announcement was not issued against the Israeli airlines and that the inspection or safety rating do not derive from the abilities or safety status of Israeli airlines, the meaning of the announcement is that active limitations are placed on airlines flying from Israel to the U.S., including the Company, pertaining to, inter alia, restrictions on increased activity, inspecting Israeli airlines in the U.S. as well as restrictions on code sharing agreements with U.S. airlines. The effects of the rating decrease may harm the Company, including by freezing bilateral agreements and the inability to alter existing agreements; freezing commercial agreements without the possibility of submitting requests for added frequencies, adding flight times, changing destinations or receiving new flight destinations; freezing airlines' operational operator's licenses and the inability to add or integrate new aircraft on these routes; damaging code sharing agreements; careful examination of planes arriving from Israel to the U.S., which may lead to a - 166

169 significant delays in planned flight times. Note that in March 2009 the Company addressed a letter to the Minister of Transportation and Road Safety in which it stated that the State was responsible for the decreased flight safety rating and the damages caused the Company as a result. In a letter dated June , the Civil Aviation Authority (CAA) informed the Company that pursuant to the actions taken in preparation for a return to Category 1, the CAA must undergo and document the recertification of the Company s operational activity. The State of Israel s safety rating remained unchanged in 2011 and as of the reported date and it has yet to be raised back to Category 1 by the FAA. The Company has no knowledge as to when the Category 1 rating will be restored. The Company's assessment with regard to the implications of the FAA announcement regarding the safety rating of the State of Israel and the date on which the State of Israel s rating will be restored constitutes forward-looking information, as defined in the Securities Law. Therefore, the actual outcome of this announcement or restrictions pertaining to safety or the extent of their impact, whatever they may be, on the Company's activity may be significantly different from the outcome expected or implied by this information. h. The Antitrust Law, 1988 Amendment no. 10 to the Antitrust Law, which cancelled the statutory exemption currently granted to arrangements between air carriers regarding international shipping, came into effect January As an accompanying step to the statutory exemption, a block exemption was installed by the Antitrust General Director (hereinafter: "the Block Exemption" and "the General Director", respectively) which exempts various types of arrangements between air carriers, with the goal of preventing sweeping and unwanted incidences of the binding arrangement chapter on the thousands of arrangements which serve as the basis of aviation activity to and from Israel and which pose no risk to competition. The Block Exemption deals with a broad range of arrangements and provides an exemption from licensing requirements to various operational arrangements, interline and cargo arrangements which do not include an assurance of a minimal amount of flight tickets or cargo capacity and frequent flyer agreements. The Block Exemption also includes "dry" lease arrangements (leasing the plane alone, without the crew) and non-long term "wet" leasing (leasing the plane, crew included), but sets special restrictions on leasing agreements carried out with Israeli air carriers. a - 167

170 The Block Exemption also applies to code sharing agreements, subject to material limitations and restrictions set in it. In this reported period, the Company was a party to a number of code sharing agreements, for which an exemption was given from a binding arrangement approval from the General Director, as detailed above. Code sharing agreements between the Company and American Airlines, Swiss, Iberia, Czech Airlines, and Thai Airways. These agreements were exempted from a binding arrangement approval by the General Director on September , for a three-year period, so the exemption will expire on September ; A code sharing agreement with Air China. The exemption from a binding arrangement approval for this agreement will expire on December ; A code sharing agreement with Turkish airline Atlas Jet. The exemption from a binding arrangement approval for this agreement, which has not yet come into effect, will expire on January ; A code sharing agreement with Armenian airline Armavia; The exemption from a binding arrangement approval for this agreement (which was concluded in late 2011 see 7.4 above) will expire on January ; An agreement with Ukrainian airline Aerosvit. The exemption from a binding arrangement approval for this agreement will expire on August When the exemptions in question expire, the Company will study the need to submit renewed exemption requests for these agreements. For details regarding new code sharing agreements coming into effect over the course of 2011 and the status of their approval, see 7.4 above. The Company's assessment with regard to the impact on the Company's activity as a result of the implementation of such legislation may constitute forwardlooking information, as defined in the Securities Act, based on Company assumptions and forecasts. Therefore, the actual outcome of this legislative change on the Company's activity or on its ability to enter into agreements, as stated above, may be significantly different from the outcome expected or implied by this information. See also Section below regarding this matter. a - 168

171 Decisions and Proceedings on the Subject of Monopolies On October 27, 2005, the Company received notification from the Antitrust General Director concerning his designation of the Company as the holder of a monopoly in transporting time sensitive and price sensitive passengers in the civil aviation market to Johannesburg, Hong Kong, Bangkok and Mumbai (hereinafter: "the General Director's Decision"). The following are the key points of the General Director's Decision, as received at the Company's offices: a. The General Director classified and characterized consumers in the passenger aviation sector into two categories: time sensitive passengers and price sensitive passengers. b. The General Director determined that, as a rule, for the aviation sector in Israel, the geographic market should be defined based on the departure points and the destination points of the flight route (city pairs). c. The General Director determined that as to substitutability between charter flights and scheduled flights, since charter flights had not been operated to the destinations included in the pronouncement as of 2004, or had existed marginally, there is no need for him to reach a decision on this matter; however, he did stipulate that, in principle, charter flights are not a viable alternative for business travelers. d. Regarding the interchangeability of scheduled flights, the General Director has determined that, for vacation passengers, an indirect flight shall constitute, in certain cases, an alternative to direct flights. However, this will apply mainly to long flights when the overall flight time is not extended by much longer than the direct flight. Regarding business passengers, the General Director determined that, as a rule, an indirect flight cannot replace a direct flight, except if it is specifically more advantageous for them than the direct flight, such as being more frequent than the direct flight. e. The General Director stated that for markets denoted in the announcement, El Al is the sole airline operating direct scheduled flights. He also stated that the Authority approached all of the foreign airlines that were thought to be relevant, and an examination of the market shares in the destinations covered by the pronouncement disclosed that El Al holds (as of the date of the examination) the following market shares: a - 169

172 Tel-Aviv Johannesburg route - a market share in excess of 90%, for both business and leisure travelers. Tel-Aviv Bombay route a market share in excess of 80% for business travelers and 80% for leisure travelers. Tel-Aviv Bangkok route a market share in excess of 80% for business travelers and in excess of 70% for leisure travelers. The Tel-Aviv Hong Kong route a market share in excess of 90%, both for business travelers and for leisure travelers. The General Director also declared that the examinations performed had indicated that, even if indirect flights to other destinations in the same countries were included in the analysis of El Al's market share, this would not alter his conclusion. On March 30, 2006, the Company filed an appeal with the Antitrust Tribunal regarding the General Director's decision. In this appeal, the Court was asked to revoke the declaration regarding markets the subject of the decision, in whole or in part. Among the main arguments at the basis of the appeal: the argument that the General Director's market definition is incorrect and ignores competition characteristics of flights from Israel to long-range destinations in East Asia; the claim that the General Director s analysis regarding the interchangeability of demand only is a lacking and incorrect analysis that ignores the interchangeability existing from the supply side, despite it being immediate and lacking sunken costs; the claim that the judgment applied by the General Director, in deciding to impose his authority to declare a monopoly, was essentially mistaken the General Director erred in the manner in which he applied his judgment and in the cumulative results of his declaration; the claim that even according to the market definitions adopted by the General Director, the Company does not transport over 50% of the passengers travelling between Israel and India. In November 2007 the General Director filed a motion to dismiss the appeal, which was rejected by the Antitrust Tribunal. The Company stands by its claims in its petition, and believes that its declaration as a monopoly holder for the routes denoted in the declaration is erroneous, but in light of the far-reaching changes occurring in the aviation market with the advancement of the "Open Skies" policy by the State of Israel, opening routes to Israel for additional carriers, the appointment of other Israeli carriers as Designated Carriers, the activities of new airlines on routes to Israel, including low cost companies, and the trend of mergers and alliances between foreign airlines around a - 170

173 the world, as well as the commercial changes that have been made and which are undergoing at the Company, the Company believes that from a commercial point of view the need to discuss the appeal has become superfluous. Under these circumstances, the Company filed a motion to withdraw the appeal, and this motion was accepted in September 2009 by the Antitrust Tribunal without an expenses order. For further details see below. For information regarding the announcement of the Antitrust General Director, according to which he was considering declaring the Company a monopoly in the supply of aviation security services outside of the country, see below. i. The Consumer Protection Law, On October an amendment was published to the Consumer Protection Regulations (Cancelling Transactions), 2010, according to which a cancellation right exists in frontal agreements for the purchase of tourism, vacation and flight services, within 14 days of the date of purchase, so long as the cancellation takes place 18 work days prior to the beginning of the service. In the event that the transaction is cancelled, the business may charge a cancellation fee of 5% of the value of the transaction or 100 NIS whichever is lower, in addition to credit clearance costs, if any. Not covered by the above are transactions involving services conducted entirely outside of Israel, including connecting flights to flights departing Israel and provided through another airline and vacation packages outside of Israel, with the exception of flights included in packages that are flights from Israel and not connecting flights. This is under the condition that the business had informed the consumer of the cancellation terms for the service abroad prior to the engagement. On July the Consumer Protection and Fair Trade Authority Commissioner published a directive according to which the Consumer Protection Law and resulting regulations pertaining to the cancellation of transactions in the field of tourism and aviation shall apply to airlines even when the transaction is conducted between consumers and their travel agent and not directly with the airline. On August an amendment was published to the Consumer Protection Regulations (Size of Type in Uniform Contracts), 1995, which will come into effect on January , establishing various obligations pertaining to the terms included in information intended for consumers within the frameworks of various publications produced by commercial entities. The amendment establishes, among a - 171

174 other things, requirements pertaining to the size of the letters in a publication, their shape, their color, typesetting and more. The Company's estimates regarding the effect of legislative changes in the field of consumer protection constitute forward-looking information as defined in the Securities Law. Therefore, the actual outcome of legislative changes and the manner in which they are realized may be materially different from the outcome estimated or implied from this information as a result of a large number of factors, including changes in the wording of the legislation, the incidence date and scope of legislative amendments and more. j. Legislative Provisions Applicable to the Company as a Mixed Company (1) Until June 6, 2004, the Company was a Government Corporation in the process of undergoing privatization as these terms are defined in the Government Corporations Law. Starting from June 6, 2004, the Company is a Mixed Company, as defined in the Government Corporations Law. In other words, a company no longer a Government Corporation, for which half or fewer of the voting rights at its general meetings, or the right to appoint half or less than its directors, are held by the State. As a practical matter, as long as the State owns shares that provide it with voting rights in El Al, the Company will remain a Mixed Company. In June 2007, the State ceased being an "interested party" by virtue of its holdings in the Company, although as of a date immediately prior to the report date, the Company continues to hold 1.1% of the Company's share capital (in addition to the Special State Share in the Company). As a Mixed Company, the Company is subject to part of the provisions of the Government Corporations Law (as provided in Section 58 of the law, which applies various provisions of Government Corporations Law on a Mixed Company). (2) Chapter H2 of the Government Corporations Law authorizes the Prime Minister and Minister of Finance, with the consent of the Ministerial Committee for Privatization, in consultation with the minister responsible for the company s affairs, to prescribe instructions by order designed to protect the vital interests of the State in connection with a company undergoing privatization. These provisions will apply to a specified period, or in general, they might also apply after the company s privatization, as stipulated in the order. The definition of vital interests includes various interests, which in a - 172

175 part are similar to those which, in order to protect them, led to the issuance of a Special State Share, and also the avoidance of concentration in the economy, damage to the foreign interests of the State, etc. The position of the Government Corporations Authority is that Chapter 2H to the Government Corporations Law also applies to a Mixed Company. On November 17, 2004, the Government Corporations Order (Declaration of Vital Interest to the State as to El Al Israel Airlines Ltd.), 2004 (hereafter in this paragraph: the Order ) was published under the aforementioned Chapter H2. The Order stipulates that the State has a vital interest with regards the Company, in order to make effective use of vital assets during times of emergency or for security purposes, to assure the continuation of activities which are vital to the security of the State. The Order also prescribes that the Company is required to employ, at all times, Israeli air crew members, and Israeli ground crews in Israel, properly qualified and licensed in order to operate the vital assets (minimal fleet of aircraft; see Special State Share ), at sufficient numbers for the continuous and simultaneous operation of all of the vital assets during times of emergency or for security purposes. The Order adds that it does not intend to make the Company subject to Section 59i of the Government Corporations Law (which deals with restrictions on the transfer of control), and that the Order does not intend to detract from the provisions of the Special State Share. See Section for details of additional restrictions to which the Company is subject under the auspices of the Special State Share. k. Class Action Law, 2006 On March 12, 2006, the Class Action Law was published, which, inter alia, enables a motion to be filed for recognition of a suit against a dealer in connection with a matter between the dealer and a customer as a class action, whether or not they have engaged in a transaction. This provision significantly broadens the grounds for filing class actions. The provision will also be applicable as of the publication of the law to motions for class action recognition that were filed before the publication of the law which have not been decided. According to the law, claimants in pending class actions may request to amend the claim and approve it as a class action (or the statement of appeal if the claim is in the stage of appeal) and add additional grounds or extend the existing causes, inter alia, as regards the deceit and abuse in the course of the contractual relations. See 9.14 below for details on class actions to which the company is a party. a - 173

176 l. Communications Law (Telecommunications and Broadcasts) (40th Amendment), 2008 The amendment to the Communications Law, known as the Spam Law, was passed June The amendment came into effect December The law applies to "advertising" (defined as a message disseminated commercially, the purpose of which is to encourage the purchase of a product or service or encourage the use of money in some other fashion) distributed via fax, , short text message and autodial, and establishes the obligation for explicit advance consent from the recipient, in writing, including via electronic announcement or recorded conversation, including mailing by the aforementioned methods. In addition, the Amendment sets details that need to be included in the advertisement and other operational instructions. Violation of this law constitutes a criminal offense as well as grounds for a civil suit leading to the possibility of damages being awarded without proof of harm caused. m. Protection of Passenger Rights in U.S. Domestic Flights and International Flights to and from the United States. On April the U.S. Department of Transportation (DOT) published a new passenger rights protection law for domestic U.S. flights and flights to and from the United States, which includes new requirements regarding the current situation as well as changes to existing legal requirements. Some of the legal requirements came into effect on August and other requirements, which require greater preparations by the airlines, came into effect on January Among the new requirements included in the law: providing reports to the DOT on flight delays after passengers have boarded the flight of 3 hours and longer, the option of disembarking the aircraft after 4 hours, adopting plans of action in the event of such extended delays and preserving documentation, announcements to passengers regarding delays, cancellations and flight diversions, known in advance, adoption of service plans that include various mandatory requirements, the ability to save a reservation for 24 hours free of charge or alternately, cancel a reservation within 24 hours with no cancellation fee for reservations made up to 7 days before the flight, establishing minimum standards for handling passenger problems and responses to passenger complaints, the requirement to present a full price, full disclosure of luggage costs and other costs related to the flight and new rules regarding overbooking flights and treatment of unwillingly postponed passengers. n. Aviation Services Bill (Compensation and Assistance due to Flight Cancellation or Changes in Conditions), 2012 a - 174

177 In March 2012 the Knesset Economic Committee completed its preparations for the second and third reading before the Knesset of the Aviation Services Bill (Compensation and Assistance due to Flight Cancellation or Changes in Flight Conditions), 2012, sponsored by MK Ahmad Tibi. The bill adopts, with certain adjustments and alterations, the principles of EU Regulation 261/2004, which came into effect in February 2005 and establishes conditions for denied boarding ("overbooking") of passengers from flights, flight delays and flight cancellations. This EU regulation applies to scheduled and chartered flights that leave from countries belonging to the European Union (including flights to Israel), and stipulates, inter alia, compensation to passengers denied a flight and to passengers whose flight has been cancelled with no advance notice within the times specified in the regulation. Additionally, such passengers are entitled to a substitute flight or to a refund of the payment for the flight ticket, at their choice. The regulation also stipulates the right of passengers booked for a flight that sustained an extended delay in their takeoff time, to a refund of the sum paid for the flight ticket. The proposed law is supposed to apply to all of the flights (scheduled and charter) departing from Israel, as well as flights arriving in Israel if their passengers had not received the remedies owed them in accordance with the laws of their countries of origin. In accordance with the bill, in cases of flight cancellations, flight delays, the refusal to allow a passenger on board a flight or downgrading a ticket to a lower seating class, under the terms and circumstances set in the law, passengers shall be entitled to benefits such as free assistance, reimbursements, alternate tickets or even financial compensation. Passage of the bill could significantly increase the scope of the financial damages to passengers by airlines, among them the Group, due to flight delays, flight cancellations, changes in seating classes and passenger bumping. The Company's assessment of the scope of the damages if this legislation takes effect could constitutes forward-looking information as defined in the Securities Law, which is based upon assumptions and forecasts of the Company. The actual outcome of the change in legislation, as stated above, or the extent of the effect of the change in legislation, if passed, on the Company's operations, may be materially different from the outcome estimated or which might be deduced from this information Business Licenses, Building Permits and Employment Permits Some of the Company's activities require the receipt of licenses under the Business Licenses Law, 1968 or the receipt of permits from various regulatory bodies. As of 2003, a - 175

178 the Company has filed requests for business licenses for activities requiring licenses. Within the framework of the arrangement of business licenses, the Company acts to regularize all of the buildings within its properties, including old buildings, for which the Company does not have building permits from the period that the Company was a government company. The Company acts in coordination with representatives of the Ministry of Interior, and hires consultants to assist in the process. In this framework, the Company acts according to an orderly Outline Plan to complete the process of obtaining the building permits and adapting them to the existing buildings, and to arrange the licenses for conducting the Company's business. In 2008 the Company received temporary business licenses for all businesses in its fields of activity. The Company is acting to complete the building permit receipt processes and thus permit the receipt of permanent business licenses. As of March 2012, 18 permanent business licenses and 6 temporary licenses were received. In addition, two requests were submitted to renew expired temporary licenses. The Company reached agreements with the regional committee regarding the manner in which the terms of the disputed building permits would be upheld and the Company is acting to receive over the course of 2012 building permits for all structures listed in the request, in such a manner so as to allow them to receive permanent business licenses for the remainder of the Company's businesses for which temporary business licenses only were granted. In addition, the Company is acting in conjunction with the Regional Committee to arrange the licensing of several building constructed prior to the application of the Planning and Construction Law. Note that agreement has not yet been reached with the Regional Committee regarding the manner in which business licenses are received for activity requiring such a license inside such structures, insomuch as such licensing is required. A legal opinion on this matter has been conveyed to the Committee, which has yet to issue its response. Regarding the subsidiary Tamam part of the Tamam factory has an expired business license, and the Licensing Committee is currently considering a new application filed by Tamam for a business licenses for the entire Tamam factory. A building permit has been issued for most of the factory s area. At the same time, there are several areas of the factory for which no building permit has been issued. The position of the Licensing Committee at this stage is that a business license for the Tamam factory will only be issued after the subject of building permits for the entire area of the factory is resolved. In accordance with an agreement in principle with the factory, inasmuch as the building permits can be arranged, a temporary license will be issued in the first stage before the a - 176

179 building permit is even received. As a result, a renewed request for a building permit was issued in order to legalize the entire area of the factory, including the submittal of a legal opinion for certain areas, in accordance with the committee s requests. A discussion was recently held on the subject at the Local Council, and the Council's decision has yet to be received. Note that as regards the material issues, those relevant in terms of health and safety, Tamam is in compliance with the required conditions and holds approvals both from the Ministry of Health and the approval of the Fire Department. For details regarding Tamam see Section above. Failure to receive permits and licenses as noted may place restrictions on the Company's activities pertaining to the buildings covered by the permits and licenses in question, affect the Company's activity and even cause sanctions to be placed on the Company. In August 2011 the Company received permission from the Ministry of Industry, Trade and Employment to employ workers during the weekly rest period, in accordance with its request, in effect to December Non-receipt of the licenses and permits or failure to meet the terms set in the permits and the resultant implications constitute forward-looking information as defined in the Securities Law, which includes Company estimates or projections as of the reported date. Therefore, the actual outcome of failure to receive business licenses and building permits or failure to receive the proper permits may be materially different from the estimated outcome or the outcome that might be deduced from this information as a result of a large number of factors, including among other things the actions of the licensing agencies, changes in legislative provisions and the results of legal proceedings Commercial Operating License The Company has a commercial operating license (No. 1/88 dated August 2, 1988) granted by the Minister of Transportation under the Licensing Law. The key points of the license are as follows- (1) The license holder may not operate aircraft, except under an air operation license granted by the head of the Civil Aviation Authority (hereafter - the CAA ) (see below as to the operational certificate). (2) The license holder will meticulously follow the provisions of every law that applies to the operation of aircraft and all directives that have been or will be prescribed by the CAA. a - 177

180 (3) The license holder shall not operate the aircraft in a manner that might jeopardize national security, public safety and health and flight safety or in a manner that could pose danger to the public in any other way. (4) The license holder will notify the Minister of Transportation of any demand from a foreign country to submit a commercial document or commercial information that is found outside of the territorial authority of that nation and will not submit or provide such documents or information without obtaining the Minister s consent. (5) The license holder will ensure that at least 51% of the share capital of the license holder is owned by Israeli citizens and permanent Israeli residents and that at least two-thirds of its directors (board members), including the Chairman of the Board of Directors and the CEO, are Israeli citizens and permanent Israeli residents 57. (6) The license holder will submit to the CAA, upon demand, reports, data or information on the matter of aircraft operation. (7) The holder of an operations license will not operate aircraft in operational activities, unless insurance coverage has been purchased as provided in the license. (8) The license holder will submit for the approval of the CAA, at least 30 days before it becomes effective, a seasonal flight schedule with detail of aviation routes and frequency of flights on them. A change of a permanent nature in the timetable requires The CAA's prior approval. (9) In its scheduled flights under this license, the license holder will transport passengers and goods, to the extent possible, in accordance with the fares and travel and transport conditions prescribed by IATA, or pursuant to other rates, all approved in advance by the CAA. (10) The license holder will transport passengers and goods for free or at reduced rates if requested to do so by the CAA and according to the terms of the request. (11) The services that the license holder is permitted to offer and perform are stated in the addendum to the license. The appendix represents an integral part of the license, and the CAA is permitted to change or revoke it. The following are the key points of the appendix: 57 On May 26, 2003, Section 8 of the commercial operating license was amended that the percentage of holdings by Israeli citizens was reduced from 76% to 51%, so that foreign ownership could reach 49%. Pursuant to the Special State Share, as long as no other decision has been reached by the holder of the Special State Share or the Company s Board of Directors, the restriction which will apply to the percentage of foreign holdings of the Company s shares will conform to the Company's commercial operating license, as it will be at all times. The decision as above on changing the restriction applicable to foreign shareholdings will be reported in an Immediate Report. a - 178

181 (a) Transporting passengers and goods on scheduled flights between Israel and points in foreign countries, and between the points themselves. It should be noted that some of the points are not utilized by the Company due to lack of economic feasibility. (b) Transporting passengers and goods on international charter flights in accordance with official licensing regulations. (c) Special assignments subject to the CAA s consent. The Minister of Transportation is authorized to revoke the selection of the Company for a point(s) that are not utilized by the Company or under-utilized, and to authorize another Israeli carrier in its stead. See Section below for details. (12) The license is valid as long as it has not been revoked or suspended by the Minister of Transportation or the CAA Operational Operator's License The Company has an operational license (no. 1/88) (hereinafter: License ) which is reissued from time to time. A new license came into effect January , issued by the CAA in accordance with ICAO standards. The license stipulates, inter alia, that the operator (El Al) is permitted to act as a Designated Air Carrier of large airplanes (under Section 13 of the Flight Regulations - Operation of Aircraft and Flight Rules), and to operate international flights to regions defined in the operating specifications and continuing domestic commercial flights, conditional upon the operational restrictions and the conditions listed in the operational specifications that constitute part of the license. The aircraft recorded in the license have Israeli registration or foreign registration approved by the CAA, are fully owned by the license holder, or have been placed at the disposal of the license holder, with the consent of the Civil Aviation Authority and the Minister of Transportation. The operator has an obligation to report any change in the list of aircraft that appears in the operational specifications, such as sale, purchase, lease to another operator and/or lease from any Israeli operator or foreign operator. The report will be submitted to the operational division and the air capability department at the CAA. For details regarding the amendment of the Company's operating license in relation to the domestic BGN-Eilat route see (e) above. a - 179

182 International Regulatory Arrangements The principle of universality, whereby every country is sovereign over its own air space, guides civil aviation and therefore, each commercial flight to or over any country requires that country's permission. The permission may be in the form of a bilateral agreement (as is customary for scheduled flights) or for specific flight(s) on an ad-hoc basis. The international civil aviation industry operates in the context of a system of regulatory arrangements that affect most of the operational aspects of the airlines and, in particular, the subjects of flight rights, permissible capacity, fare setting, air carrier s responsibility for damages (physical and property damage) and flight safety standards, security and noise. This system of arrangements is composed of international conventions, laws, regulations and administrative directives, and bilateral agreements. The existing basis for the international regulatory arrangement for international civil aviation is the Chicago Convention of The International Civil Aviation Organization (ICAO), a United Nations agency, was established in wake of the Convention. In the framework and under the auspices of ICAO, recommended standards and procedures were prescribed for various areas of aviation activity. Rights to transport passengers and cargo between countries for compensation, permissible capacity and rate setting are organized via air transport agreements or aviation agreements (bilateral), which are based on reciprocity and provide fair and equal opportunities to airlines from both countries Air Transport Agreements and the Civil and Aviation Policy of the State of Israel Aviation Agreements- General Most of the aviation rights by which the State of Israel permits a company to transport passengers and cargo on international routes are anchored in aviation agreements between Israel and foreign countries, and a minority (due to the absence of aviation agreements) in agreements between aviation authorities or commercial agreements between the Company and the air carrier of the other country, which require the approval of both countries. The principal elements of air transport agreements include, inter alia, the aviation rights granted, appointment of the Designated Carrier and permitted capacity. Until recently, in most aviation agreements between countries, each government appointed an air carrier as a Designated Carrier on its behalf to operate the flights and utilize the traffic rights under the agreement. For details regarding changes in aviation agreements see (b). After the Designated Carrier is selected, it must obtain a permit from the aviation authority of the other country. In order to obtain a permit, the carrier a - 180

183 must prove that the substantial ownership and effective control of the air carrier is held by the government of the country or by citizens of the country which selected it as Designated Carrier, and that the carrier meets all international flight safety standards. A new aviation agreement was signed between Israel and the European Union in 2008, which removed the control and limitation restriction from Designated Carriers, as specified in Sections above and below Most of the aviation agreements to which Israel is a party may be terminated or cancelled with one year's prior notice. After such notice, negotiations are generally held between the two governments in order to set an interim arrangement or new conditions before the expiration of the agreement. Several aviation agreements between Israel and a number of countries came into effect over the course of The various agreements allow the entry of additional Designated Carriers to existing and new destinations, as well as an increase in frequencies allowed the sides' airlines. See above for further details Designated Carrier In aviation agreements, each government grants its counterpart the right to appoint one or more of its air carriers as Designated Carrier. The Designated Carrier is granted the right to carry passengers and cargo between the two countries. At times, the Designated Carrier also receives the right to operate scheduled flights from the second country to a third country (subject to an agreement with the third country). Until the second half of the 1990 s, the Company was the sole Israeli Designated Carrier for scheduled flights for the transportation of passengers and cargo to and from Israel, with the exception of Sharm-a-Sheikh. The change in the Company's aforementioned exclusive status occurred after licenses were given additional Israeli carriers as Designated Carriers to several destinations, some in the Company s place. As of immediately prior to the approval of this report, the other Israeli companies (Arkia and Israir) were appointed Designated Carriers to 31 international destinations from Tel Aviv, 5 international destinations from Eilat and 2 international destinations from Haifa. Sun D'Or was appointed Designated Carrier to 11 destinations; however, after its operational license was revoked on April , its appointments were transferred to the Company, with the exception of the Eilat-Moscow route. For further details regarding Sun D Or s activity, see also Section above. a - 181

184 The following are the destinations to which Israeli airlines Arkia, Israir and Sun D Or were appointed Designated Carriers: Arkia on routes between Tel Aviv and Sharm-a-Sheikh, Copenhagen, Stockholm, Amman, Dublin, Tbilisi, Larnaca, Paris, Barcelona, Madrid, Kiev, Krasnodar, Yekaterinburg, Dusseldorf, Munich, Baku, Kharkov as well on routes between Eilat and Moscow, St. Petersburg, Kiev and Paris and Haifa-Amman and Haifa-Sharm-a-Sheikh; Israir - Izmir, Ankara, Riga, Lisbon, Ljubljana, Nice, New York 58, London, Rome, Milan, Berlin, Stuttgart, Geneva, Zurich, Basel, Kiev, Amman as well as the Eilat- Moscow route; Sun D'Or (transferred to the Company in 2011) Antalya, Zagreb, Bratislava, Rostov, Sochi, Frankfurt, Dusseldorf, Minsk, Riga, Lisbon and Almaty (see (a) above). Regarding the implementation of the Open Skies policy, see above Air Carrier Ownership and Control There is no uniform international arrangement regarding the percentage of the practical ownership and control over an air carrier that must be held by a state or its citizens. The bilateral air transport agreements to which Israel is a party include a provision according to which each of the contracting states maintains the right to suspend or to cancel the permit it gave the airline of the other state, if the substantial ownership and effective control are not held by the contracting state or the citizens of the contracting state. The agreements do not include the definitions of substantial ownership and effective control. The practice in the countries of the Western world is to receive the appointment of an airline as Designated Carrier as if it included an affidavit that the required demand for substantial ownership and effective control is complied with in full, and if it is found that the requirement no longer exists, the state will demand that the situation be rectified. As part of the liberalization policy being instituted by the Ministry of Transportation and implementation of the "Open Skies" policy, a new aviation agreement was signed between Israel and the European Union in December 2008 ( Horizontal Agreement ). The new agreement updates the sections of the bilateral aviation agreements between Israel and EU members referring to the ownership and control of Designated Carriers. 58 The 2006 appointment of Israir as Designated Carrier (in addition to the Company) to New York for the operation of scheduled flights was for a period of 24 months. The petition filed by the Company before the High Court of Justice against the appointment (as well as the additional petitions filed by the representatives of the Company's employees, including the employee corporation holding Company stock, and the K'nafaim company) were dismissed February Note that in September 2008 Israir announced that it would be discontinuing its flights to New York. a - 182

185 The agreement will allow airlines the ownership and control of which is in one of the EU member states to operate scheduled flights from any other EU member, subject to the bilateral agreement; thus, for instance, Sky Europe, which is owned by Austrian citizens, may operate regular flights between Slovakia and Israel, subject to the aviation agreement between Israel and Slovakia. The commercial operating certificate given El Al specifies that at least 51% of the Company s share capital must be held by Israeli residents and permanent residents of Israel, and that at least two thirds of the directors (Board members), including the Chairman of the Board of Directors and the CEO, are Israeli citizens and permanent Israeli residents (see Section above the Commercial Operating License). In addition, the Special State Share, which is anchored in the Company's articles, includes instructions regarding maintaining the status of the Company as an Israeli company and restrictions on the ownership of shares by foreigners (see Section above) Capacity Most of the aviation agreements to which Israel is a party (excluding the agreement between Israel and the United States and Great Britain) feature limitations to the maximum permissible capacity or frequency that each airline may offer on the agreed routes in order to assure equal opportunities to the air carriers of the two countries that are parties to the agreement. Additionally, a substantial part of the aviation transport agreements between Israel and other states also stipulate that the capacity must be based on the volume of the traffic between Israel and the other state with which the agreement was signed. Accordingly, the policies of the Ministry of Transportation in the past had been to restrict the flight capacity of the foreign airlines to and from Israel. At the beginning of 2006, and pursuant to the "Open Skies" policies led by the Israeli Ministries of Transport and Tourism, authorizations were granted to the foreign airlines that operate on the routes to and from Israel to add capacity and frequency. This trend of liberalization and "Open Skies" continued in the following years, and is expected to become more significant with the implementation of the Government's decision on "Open Skies" and the continued negotiations in preparation of signing of uniform global agreement between Israel and the EU member states. See above for further details Approval of the Minister of Transportation and Road Safety Government Resolution No. 161 states that commercial agreements between Designated Carriers involving the restriction of competition require pre-approval by the Minister of Transport. In 2011 the Minister of Transportation approved several code sharing agreements made by the Company as well as further agreements, as required by law. a - 183

186 Regarding legislative changes pertaining to commercial agreements between airborne carriers and the type exemption orders in the area of business restriction as regards these agreements see Section (i) Flight Rates The rates for flights on international routes are published within the framework of the IATA, the international association of scheduled airlines. These fares allow passengers to purchase a flight ticket from one company and to utilize it in a flight or flights for other companies (within the framework of interline agreements). In addition to the fares within the framework of IATA, which are supervised by aviation authorities, El Al is permitted to set special rates on a unilateral basis. The Israeli Ministry of Transportation does not generally intervene in setting rates published by the Group unilaterally, provided that the level of these rates is not higher than IATA fares. The IATA evaluates the airlines' fares, and accordingly, publishing flex fares that serve as interline fares. Under the aviation agreement between Israel and the United States, the carriers are free to set fares, and only if the two governments oppose a proposed rate (a method known as double disapproval ) due to its being abnormal (exaggerated or within the boundaries of "dumping ), the new rate will not be approved and it may not be offered to the public. Despite the flex fares set by the IATA, most flight tickets and cargo capacity are sold at prices below those that were agreed upon and approved or at conditions different from those prescribed for the various fares. The Company behaves in accordance with general industry practices, while adapting its policies to market conditions and to the actions of its competitors. A substantial part of the Company s revenues is derived from sales under these conditions. In recent years, a broader variety of flight ticket fares has been created. In all of the aircraft service classes (first, business and economy), there are different types of reservation classes (or price classes). Varied demand and different conditions exist for each reservation class during different periods of the year. Charter flight fares are set in a different manner than those for scheduled flights. Every organizer commits to pay the air carrier for the capacity (number of seats) they have chartered and, on the other hand, they themselves set the price per seat, generally a package price that includes seats and ground arrangements. Organizers requesting authorization to operate a flight or series of charter flights must state the price offered the public and obtain approval to carry out the flights and their prices from the aviation a - 184

187 authorities/administrations of the relevant countries. Airlines, including the Company, collect fuel surcharges, which are updated from time to time in accordance with increases and decreases in jet fuel prices. In addition, the airlines charge a security surcharge as part of the flight ticket price Israel s International Civil Aviation Policy Over the years, the Government of Israel and ministerial committees (privatization or social and economic) have approved a series of decisions pertaining to Israel s international civil aviation policies. Resolution 323 HC/14 of the Ministerial Committee for Social and Economic Matters in the matter of "Aviation Policies of the State of Israel on Scheduled Routes" was passed in May 2003, as detailed in (b) above. A resolution, "Encouragement of Competition in Civil Aviation to and from Israel", was passed in August 2005, following which the Aviation Services Law was amended (see B above), and Resolution 441 on the matter of encouragement of competition in civil aviation to and from Israel was passed September 2006, and the decision made by the Minister of Transportation to establish a public committee to examine the "Open Skies" policy (see Section above). In recent years, the Ministry of Transportation has begun implementing a policy of increased liberalization in the aviation industry, the "Open Skies" policy, with the objective of encouraging and increasing tourist traffic to Israel by increasing competition between airlines. As provided above, on January 27, 2008, Government Resolution No was adopted, on the matter of the State's participation in the security expenses of Israeli airlines, including an amendment of Government Resolution No. 353 (HC/14) on the matter of the State of Israel's policy on scheduled routes. On August Government Resolution 4032 was passed, on February Government Resolution 4462 was passed and on February Government Resolution 4026 was passed, all three of which are also relevant to the issue. For further details on Government resolutions and the Open Skies policy see Sections and above The Special State Share Immediately prior to the publication of the 2003 Prospectus, the Company issued a Special State Share to the State. The rights granted to the holder of the Special Share are listed in the Company s Articles of Association, which also detail the vital interests of the State in the Company, which must be protected by means of the Special State Share. These vital interests are: a - 185

188 Preserving the Company as an Israeli company so that it will remain subject to Israeli law, including legislation that allows equipment to be mobilized for security purposes and legislation for times of crisis, and so that the conditions needed to maintain its operating license and traffic rights should be maintained. Safeguarding the possibility of ensuring that the operating capability and ability to fly passengers and cargo by the Company will not fall below the capacity specified in the Company s Articles of Association, in order to provide the State with effective use of vital assets in times of emergency or for security purposes, as will be determined from time to time by those authorized to do so, all as detailed in the Company s Articles of Association. Preventing parties hostile to the State of Israel or persons who could cause damage to the vital interests of the State or to the foreign or security interests of the State or to the aviation ties of Israel with foreign nations, or persons that are found in and/or likely to be found in substantial conflict of interest which could cause damage in one of the areas detailed above, from being an interested party in the Company or from influencing its management in any other way. Fulfilling the security directives and arrangements that apply, or that will apply as a result of Government resolutions or under any law, to the area of security of flights, passengers, baggage, cargo and mail, in Israel and abroad, including in relation to the Company s activities abroad and to the cooperation needed from local authorities abroad in these areas; in the area of security classification of employees and suppliers of services to the Company; and in the area of security over classified data and protection of security information The holder of the Special State Share is the State of Israel through a minister or ministers, and in order to protect these vital interests, instructions were prescribed for the Special State Share as to the following matters: Instructions for the purpose of preserving the Company as an Israeli company, including restrictions as to the citizenship and security clearance of Company executives; Instructions on the matter of compliance with security rules and arrangements; Instructions on the matter of rights to security information and classified information in the Company; Instructions on the matter of the Company s discussions of security issues; Instructions on the matter of Company discussions on security matters; a - 186

189 Instructions on the matter of observing minimal flight capacity59 - the Company is not permitted to carry out certain transactions relating to its aircraft without the 59 (a) Transfer of vital assets will be invalid as regards the Company, shareholders, and any third party without the prior written consent of the holder of the Special State Share if, as a result, the usable, fit, and fleet of aircraft ready for immediate operation will be reduced (including due to any legal provisions) or the operational capability and flight ability of the Company will be reduced (including due to any legal provisions) below the level detailed in one of the following subsections: (1) At least 4 cargo aircraft providing a minimal cargo transport capability from the United States to Israel of 320 tons per day ; (2) At least 3 wide-bodied passenger aircraft providing an overall minimal passenger transport capability from the United States to Israel of 1,000 passengers per day; (3) At least 6 medium and small aircraft providing an overall minimal passenger transport capability from Europe to Israel of 2,000 passengers per day. (b) Should there be a significant change in the relevant circumstances, the holder of the Special State Share will be permitted, with the Government s authorization, to decide to increase the number of vital assets and/or to change their quantity and/or the composition of the assets on a permanent basis or for a specific matter, all for up to one half of the number of aircraft owned by the Company at that time. This decision will not be made before the Company is given a fair opportunity to express its position to the Government - the total of the vital assets after increasing the number of vital assets according to this paragraph is limited to up to half of the number of aircraft owned by the Company at the time of the decision. A change in the composition of the vital assets will be made in the framework of the composition of the current fleet of aircraft owned by the Company at the time of the decision. The Company will not be required to acquire new aircraft under this sub-paragraph (b); (c) In spite of sub-paragraph (a) above: (1) An aircraft leased by the Company from an Israeli corporation, which is lawfully incorporated and registered in Israel, will be deemed owned by the Company, as long as that aircraft is owned by such corporation and Israeli law specifically applies to the lease agreement regarding the terms of lease and the aircraft. (2) The holder of the Special State Share will be permitted, at the Company s request, to approve the lease of an aircraft by the Company from a non-israeli entity, as long as the State's vital interests are protected and the agreement contains the proper provision which grants the State the authority to use the aircraft, including mobilizing it at any time under Israeli law, all to the satisfaction of the holder of the Special State Share. (d) In the event that the provisions of sub-paragraph (a) above are not complied with, the Company will not purchase and/or own shares or means of control, at a rate providing it with control, in corporations that own, directly or indirectly, including by subsidiaries, aircraft or auxiliary equipment, other than with the consent of the holder of the Special State Share. (e) Without detracting from the above, should a vital asset be transferred in contravention of this section, and the sale cannot be revoked and/or the situation cannot be restored to what it was within a reasonable period of time, the Company will be obliged to immediately purchase an alternate vital asset and to cover the expenses incurred by the State due to the temporary absence of the vital asset. (f) In the event that the holder of the Special State Share refuses the Company s request to transfer a vital asset, an arrangement will apply to indemnify the Company for the damages it incurred, principally, that the State will indemnify the Company in monthly payments to the extent of the leasing fees which the Company would have received, had it leased the vital asset when the monthly indemnification began, in the open market to a willing lessee, the transfer of which was refused, as will ultimately be determined by the appraiser(s) appointed jointly by the State and the Company. (g) Should the period in which the holder of the Special State Share refuses the Company s request to transfer the vital asset exceeds 6 months, or in the State's judgment, at an earlier date, the State will purchase the hindered asset at the price which the Company would have received had it sold the hindered asset to a willing purchaser at the time of the purchase, as will ultimately be determined by the appraiser(s) jointly appointed by the State and the Company. (h) Without detracting from the above, should the holder of a specific fixed lien on an aircraft or auxiliary equipment, including the loading equipment necessary to protect flight operation capability, wish to realize it (subject to the approval of the lien under the terms which were stipulated), the Company and the lien holder will so notify the holder of the Special State Share at least 45 days in advance, and the State will be entitled, at its sole discretion, and after giving prior a - 187

190 consent of the holder of the Special State Share if, as the result of such transactions, it might reduce the Company's flight capacity below the level that was set by the Special State Share; for details regarding the consent of the holder of the Special State Share see above. The acquisition of influence or status in the Company requires the State's consent in accordance with the Company's Articles of Association, transactions involving the Company s shares at a certain scope will not grant any right that is derived from holding and/or from purchasing shares in the Company without the prior written consent of the holder of the Special State Share (the State through the ministers designated by the Government) 60. The Articles of Association stipulate a detailed arrangement on the subject of the manner of submitting the request for obtaining the consent to own shares in the Company, in the event such consent is necessary as above. Instructions on the matter of obtaining approval to vote at the General Meeting the right to vote at the General Meeting requires the Company s approval. Approval to vote at the General Meeting will not be given when circumstances exist that require the consent of the holder of the Special State Share, and such has not been granted. The articles of association also prescribe special instructions in cases when there is reasonable concern that the ownership of the Company s shares by foreigners might cause damage to the Company's flight notice of one week of its intention to the Company and the holder of the lien, to sustain the charge against which the asset had been pledged as collateral. If the State sustains the charge in accordance with the contents of this section, it will be permitted, if the holder of the lien had the right to return to the Company and receive payment from it, including expenses that were connected with sustaining the charge, and the lien will serve it to secure this right. The contents of this section will be included, as an obligation of the parties to the State, in every agreement for the lien on an aircraft or auxiliary equipment, including the loading equipment that is necessary to protect flight operation capability, which will be entered into after the Special State Share was issued, as a condition of the lien agreement with the Company, its shareholders and any third party. 60 (a) Holdings of 5% or more of the issued share capital of the Company; (b) holdings of 15% of more of the Company's issued share capital (also if agreement had been received in the past for an holding percentage below 15%); (c) holdings of 25% or more of the Company's issued share capital (also if agreement had been received in the past for a holdings percentage below 25%); (d) holdings of 40% or more of the Company's issued share capital (also if agreement had been received in the past for a holdings percentage below 40%); (e) holdings that grant control of the Company even if agreement had been received in the past as to the holdings percentage (though not agreement as to control ). For this purpose, control is defined in accordance with the Securities Law. In addition, the largest shareholder, at any time, will be deemed the controlling interest; (f) holdings or acquisition as a result of which foreigners will own 24% of the Company's issued share capital, or a higher proportion, which might, in the opinion of the State or in the opinion of the Company s Board of Directors, cause damage to the Company s aviation rights and/or to its operating license, which will be and/or has been given by the State, in its sole judgment (the commercial operating license given to the Company stipulates that at least 51% of the Company s share capital must be held by Israeli citizens and permanent Israeli residents). In any event, the holdings by foreigners of the Company's shares exceeding 49% of the Company s issued share capital is a proportion which might damage the Company s flight rights; (g) every security and/or pledge transaction of the Company s shares, which, following its realization or invoking of underlying rights, the security holder or the pledge holder is likely to own shares out of the Company s share capital in the proportions mentioned in sub paragraphs (a) to (f). a - 188

191 rights or to its operating license Any change, including an amendment or cancellation, in the Company s memorandum or bylaws pertaining to the rights granted to and/or ascribed to the Special State Share and to its holder, will not apply as regards the Company, its shareholders and any third party, without the prior written consent of the holder of the Special State Share Regulation The Company is preparing for the implementation of the Safety Management System plan SMS. The plan s implementation constitutes an advanced perception of the Company s safety management, in a manner compatible with ICAO guidelines. The essence of the plan is the integration of safety issues as an inseparable part of management as a whole. The existence of the SMS plan and its implementation shall be inspected in the IOSA inspection planned for The Company's maintenance system has been certified by the Israeli Standards Institute at ISO 9001 standards. In addition, the Company's maintenance system has been certified as an maintenance institute, approved by the Civil Aviation Authority in Israel, the U.S. Federal Aviation Agency (FAA) and the EU aviation safety agency (EASA). To be clear, the EASA certification is for the Company's line maintenance array. Over the course of 2010 the Company underwent an IOSA (IATA Operational Safety Audit) inspection. The Company has complied with all requirements for the receipt of an extension to the Standards Association stamp granted in January 2009, and in October 2010 the Company received IOSA certification for an additional two years. This is an international standard in the area of airline operations, safety and QA. Likewise, starting 2008 the standard constitutes a condition for IATA membership. The receipt of this certification places the Company in the forefront of world airlines as far as flight safety is concerned Quality Control El Al's maintenance system is monitored by an internal quality control system that operates in accordance with the manufacturer s specifications and a maintenance program approved by the Civil Aviation Authority Security Arrangements The civil aviation industry, particularly on routes to and from Israel, could be targeted by various parties, particularly terror organizations. The Company takes extraordinary security measures, under the guidance of the governmental body responsible for this area. a - 189

192 The State s Participation in Aviation Security Expenses Until the early 1980s, the State had covered all of the Company's direct and indirect security costs. Over the years, the State has instituted a policy of reducing the rate of its participation in security expenses. In accordance with a decision by the Government of Israel, the Company participates in security expenses at a rate of 50%, since January During 2002, the rate of participation was between 30% and 34.14%, while in 2001, it was between 25% and 30%. As detailed above, on January 27, 2008, the Government passed Resolution No. 3024, which prescribes the rate of the State's participation in the security expenses of Israeli airlines at 80% of the total direct expenses for the operation of existing and future international routes, in an attempt to enable these companies to content, to the extent possible, with fair and equal competition opposite foreign airlines, keeping in mind the importance of liberalizing the civil aviation industry, while recognizing the need for the existence of a strong Israeli aviation industry. The decision revokes Government Resolution No dated July (which set a participation rate of 50%). Furthermore, on August Government Resolution 4032 was passed, on February Government Resolution 4462 was passed and on December Government Resolution 4026 was passed. For details regarding the Government resolutions and legal proceedings see Section above. The following details the direct costs of security of the passengers, aircraft and employees of the Group (El Al and Sun D'Or), divided between the portion financed by the Group and the portion financed by the State: State Financing (In Thousands of Dollars) 77,719 66,390 69,430 The Group s Share (In Thousands of Dollars) 40,036 41,068 38,398 Total (In Thousands of Dollars) 117, , ,828 Note that in accordance with the Government Resolution regarding the existence of regular aviation relations with neighboring countries (Egypt and Jordan), higher participation rates for the State of Israel were set for these rights, in order to maintain flights on these routes. The Company also has indirect security costs caused, inter alia, by flying security personnel in seats of paying passengers. Furthermore, beginning October 2001, the a - 190

193 Company has been allowed to collect an insurance and security surcharge of $8 per flight leg. Aircraft Protection Systems In January 2009 the Israeli Government approved a project for the installation of electrooptic protection systems in passenger aircraft. The meaning of the government resolution is that the Israeli airlines, including the Company, will be required to participate in the project in question (including installation in Group aircraft). On September the Ministerial Committee for National Defense decided that the State would participate in the Company s full expenses in financing the costs involved in operating the system and all its derivatives, maintenance and installation. The Company is negotiating with the State to regulate issues of indemnification, insurance and the State s participation in the Company's expenses in relation to the project in question as well as with Elbit Systems Ltd. regarding the Company's commitment to serve as subcontractor for installing and maintaining the system. Security Services for Israeli Airlines In addition, the Company provides security services to Israeli airlines, in return for a refund of the Company's aforementioned costs. Accounting for these services was arranged by use of a "payroll price list" (dated 1999) published by the Ministry of Finance and revised from time to time. In November 2010 the Minister of Transportation and Road Safety announced his intention to establish a government security authority to handle the subject of aviation security. Following this announcement, in November 2010 the Company announced its intention to cease providing security services to other Israeli airlines and shall provide security services for itself and for Su D Or until the establishment of a national security authority, starting March In March 2011 the Company responded to the Minister of Transportation and Road Safety and announced that it would continue providing security services to Arkia and Israir after April For details regarding a summary on the subject of security and updated government decisions as of December regarding the continuation of aviation security services by the Company and increasing the rate of the State s participation in the security expenses of Israeli airlines see (g) above. a - 191

194 Monopoly in the Supply of Aviation Security Services On April the Company received a notice from the Antitrust Authority, according to which the Antitrust General Director was considering using his authority to declare the Company a monopoly in the supply of aviation security services abroad, according to professional guidelines provided airlines by a certified officer in accordance with the Arrangement of Security in Public Bodies Law, 1998 regarding passengers and cargo on passenger flights. The Company presented the Antitrust Authority with its arguments as to why it should not be declared a monopoly in the provision of the service in question. The Company believes, among other things, that aviation security is the State s obligation as sovereign and that it is not a commercial service for which it can be declared a monopoly. The Company intends to ask the Antitrust Authority to complete its arguments in this regard in light of developments in the field in the past year, including in light of the agreement achieved with the Ministry of Finance to increase the State s share of responsibility for security costs. Agreement for the Receipt of Security Services at BGN In October 2011 the Company signed an agreement with QAS Israel Ltd., 50% of the shares of which are held by the Company s controlling shareholders, K'nafaim Holdings Ltd. According to the agreement, QAS shall provide the Company with certain security services at Ben Gurion Airport that are not provided by the Airports Authority, in accordance with U.S. TSA (Transportation Security Administration) requirements, in return for a non-material payment reflecting in the Company s opinion the market price for similar services. The agreement is for a period of one year and the Company may terminate it with 30 days notice. This agreement was approved by the Company Board of Directors after the Company s Audit Committee determined that it was a non-exceptional transaction. The essence of the Board s arguments for approval were that QAS, which specializes in ground services, currently provides similar security services based on TSA requirements for other foreign airlines flying to the U.S. that are subject to these requirements and has experience and expertise in these sort of services. Furthermore, in the opinion of the Board of Directors, after studying the alternatives presented, the engagement with QAS is the best offer the Company has received in economic and operational terms out of all of the alternatives presented. a - 192

195 The information provided above regarding the manner in which security services are provided, the extent of the State's participation in the Company's security expenses and the actual financing of existing and new expenses and the possibility that the Company will be declared a monopoly in the field of aviation security services outside of Israel constitutes forward-looking information, as defined in the Securities Law. This information is supported, inter alia, by the Company's assessments and is based on the realization of existing decisions. The actual change in the Company's performance could be significantly different from the forecasts, due to many factors, including regulatory changes and the enforcement of legislative regulation by the State authorities Operations during Times of Emergency and for Vital Purposes Under existing law, during times of emergency, the Israeli airlines, including the Company, may be activated for purposes of national defense or public security or maintaining supplies or vital services. In addition, arrangements exist with the Company as to flights for the security of the State, or at times of emergency, as well as flights for other extraordinary purposes, including the consideration to be paid for them on a commercial basis. The Law for the Registration and Mobilization of Equipment for the Israel Defense Forces, 1987, empowers the Minister of Defense, if he is convinced that the defense of the State so requires, to declare by decree the need to mobilize equipment (including aircraft). The law relates to equipment owned by the Company during times of emergency. The law obligates the State to pay usage fees for the equipment that was mobilized, and, if the equipment was damaged during the period of emergency - compensation for the damages. The Law for Work Services during Times of Crisis, 1967, empowers the Minister of Labor to certify an enterprise as a vital enterprise, and after such certification, to mobilize all of its workers for vital work service. The Company has been certified a vital enterprise. The approval is renewed from time to time at the Company s request. The current certification is effective through December 31, The Law for Supervision of Goods and Services, 1957, grants the minister so empowered by the Government, the authority to issue a personal decree or a general decree for the performance, inter alia, of a vital action for the defense of the State, for the security of the public, to maintain regular supplies or services. This action includes, among other things, the obligation to operate an enterprise or to perform any regulated service. a - 193

196 9.12 Material Agreements In October 2011 the Company published a Request for Proposals ( RFP ) for fuel companies and for companies performing refueling services for the supply and refueling of jet fuel in Israel for the period beginning January Following negotiations with the companies in the matter of the RFP, on January the Company's Board of Directors approved engagements with fuel supply companies Paz, Sonol and Dor Alon, to provide 70% : 15% : 15% (respectively) of the Company's yearly fuel consumption for 2012, as well as the Company's engagements with companies performing refueling services (Airports Authority concession holders) Paz Aviation Services and Mercury, according to which each would provide 50% of the refueling services for the Company ay BGN in The accumulated yearly scope of these agreements (providing jet fuel and refueling services) amounts to $400 million (according to jet fuel prices in February 2012). Over the course of 2011 agreements were signed with fuel companies providing jet fuel abroad to an accumulated yearly extent of $400 million. In June 2011 an extension and correction agreement was signed with United Technologies International Inc. which operates through engine manufacturer Pratt & Whitney, for the maintenance of PW4000 engines. The agreement grants the Company various credits in light of the transfer of the manufacturer s plant to Singapore. In March 2011 an extension and correction agreement was signed with SR Technics Switzerland Ltd. for the maintenance of CFM 56-7B engines to the total amount of $24 million for the extended period, to February The agreement includes maintenance of eighteen engines owned by the Company as well as additional engines as determined by the Company. In January 2011 the Company signed agreements with the Jewish Agency to fly in new immigrants and transport messengers. The agreement shall remain in effect for two years, with an option to extend it with the consent of the parties up to a maximum of two additional years and the right to revoke it at any time with 90 days advance notice. In December 2011 an agreement was signed with the March of Life organization to fly 1,500 young people from around the world to Poland, and from there to Israel and back to their home countries, over the course of April 20112, both on special flights and on scheduled El Al flights. a - 194

197 The Company is about to sign an agreement with the Taglit organization to fly Jewish youths from around the world (mainly from North America) for heritage and Zionism visits in Israel, over the course of summer Following the Company s reports regarding the exercise of an option to extend the engagement period in relation to a framework agreement with Maman Cargo Terminals and handling Ltd. ( Maman ), which operates a cargo terminal at Ben Gurion Airport, on September 5, 2011, the Company informed Maman that it was exercising its option to extend the commitment period as per the agreement to December For further details see 8.2 above. For details regarding the aircraft purchase agreement with Boeing see 7.11 above. For details regarding agreements to implement RMS and Pricing systems see above. For details regarding an agreement with NESS in a project for the replacement of financial systems see above. For details regarding an agreement to provide medical insurance services for employees posted abroad see above. In addition, the Company is party to agreements with regard to employees and their rights (see 9.4 above), agreements for the lease of real estate (see above), agreements for the lease and financing of aircraft (see 7.11 and 8.10 above), loan agreements for a designated purpose (see above), various agreements with airlines (see 7.2, 7.14, above and 9.13 below), and insurance agreements (see 9.2 above). The Company also has an obligation to indemnify Company executives. For further details see Section 29a of Chapter D (Further Details on the Corporation's Business) Cooperation Agreements The Company is party to agreements with other airlines (interline agreements) that permit passengers on scheduled flights, subject to certain restrictions, to use flight tickets issued by one airline for the services of another airline. In addition, the Company is party to code sharing agreements, which permit an air carrier to market flights on another air carrier, as if they were its own flights. See 7.2 and 7.4 above for details. For legislative changes that could have a material effect on the Company's ability to enter into "codeshare" agreements see Section (i). Additionally, the Company has various operational agreements with various airlines, which include, inter alia, technical operations arrangements, leasing arrangements, a - 195

198 aircraft maintenance and spare part agreements, mutual assistance in emergencies, the supply of aviation equipment and more. The Company also has arrangements with airlines on lounges, on frequent flyer collaborations, accounting for connecting flights, on matters of reservations and transportation agreements (passengers or cargo) Legal Proceedings As of December , $145 million in legal claims have been filed against the Company, for which the Company has listed a $22.2 million provision in its Financial Statements, based on the advice of the Company's legal counsel. In addition to the above, a motion was filed to recognize a claim as a class action against the Company and other bodies to the amount of 100 billion NIS; see below. Legal claims not quantified in monetary sums have also been filed against the Company. The sum of the provision in the Financial Statements includes provisions for nonquantified claims, as estimated by Company management. The following are the most significant pending claims in which the Company and/or its subsidiaries are involved: In October 2005, a claim was filed in the Supreme Court of Ontario, Canada against the Company and additional defendants by a former employee of the Company for alleged sexual harassment and sexual assault. The sum of the claim is $2.2 million Canadian ($2.2 million U.S.). According to International Financial Reporting Standards (IFRS) implemented by the Company since January , the Company has made a provision for this claim in the Financial Statements based on the advice of its legal counsel In June 2006, a suit was filed against the Company and against the State of Israel Ministry of Finance in the Tel Aviv District Labor Court by 94 claimants who were employed by the Company and who took early retirement between 2001 and The claimants in their suit have appealed for declaratory relief/order of performance to amend their retirement agreements in a manner in which the retiree will receive the early pension stipend, including fringe benefits, until the legal retirement age, instead of until the age of 65. Alternately, the claimants appealed to revoke the retirement agreements. The claimants quantified the claim at 18 million NIS ($4.8 million). In January 2009 the court ordered that this claim be consolidated with two additional claims. In addition, similar claims were filed by 5 additional claimants. The total sum of the additional claims is 1.6 million NIS (some $0.4 million as of the balance sheet date). On January it ruled that the claimants submit their position regarding the a - 196

199 limitation of the causes of the claim. In October 2010 a partial ruling was issued, stating that early retirement agreements must be reinterpreted, so that instead of 65 years of age they shall be considered valid until 67. The partial ruling also stated that within 60 days of the ruling, basic agreed-upon calculation principles shall be submitted to calculate the sums. Subsequently, the Company filed a request to appeal the partial ruling before the National Labor Court, which was rejected in January The Company made a provision for this claim in its Financial Statements On February , the Company received a statement of claim filed at the United States District Court for the Eastern District of New York in the matter of the rates for air cargo transport services. The Company, along with 38 other airlines, was included as a defendant in the statement of claim, which alleged that the defendants were partners in a conspiracy to fix prices for air cargo transport services, beginning in 2000, while violating competition laws and other laws in Europe and the United States. The claim was filed in the name of entities purchasing air transport services, directly and indirectly and it also included a motion for class action recognition. The claim includes a request for damages in an unspecified amount as well as additional remedies. The Company joined a mutual defense team with other airlines being sued. A settlement was signed between the Company and the claimants on December According to the key points of the settlement, the Company shall pay the claimants a total of $15.8 million U.S. in six payments: the first payment to the amount of $9.8 million U.S. was paid by the Company in January 2012 (30 days after signing the settlement). The balance of the sum to the amount of $6 million U.S. will be paid in five equal payments of $1.2 million each until December It was also agreed that the settlement would not be interpreted as the Company admitting to the claims made by the claimants or evidence of their veracity. In return for the Company upholding its obligations in accordance with the arrangement and subject to the approval of the arrangement, the claimants will retract their claim against the Company and undertake not to file any additional claim or make any additional demand from the Company regarding the direct purchase of air cargo transportation from the Company, inside the U.S., to and from the U.S., in the period prior to signing the settlement. The settlement is awaiting confirmation by a New York court and the process is expected to continue a number of months In January 2007, a suit was filed against the Company before the Jerusalem District Court, along with a motion to recognize a class action, to the amount of million NIS ($127 million). The plaintiffs allege that the collection of a security levy in the amount of $8 per flight leg from passengers on flights not carried out by the Company itself, but by other airlines, in the framework of code-sharing agreements with the a - 197

200 Company, represents consumer misrepresentation, breach of the agreement, absence of good faith, and unlawful enrichment, this as on these flights, the plaintiffs allege, security or protection services were not provided that were identical in level and quality to the security services provided by the Company. The plaintiffs requested that the Company be required to pay each of these passengers the sum of $8 as well as damages of 500 NIS for emotional distress and loss of benefit. As agreed upon by the parties and ratified by the Court, a revised motion was submitted to approve the suit as a class action. A response was filed by the Company and on August , the Court rejected the motion in question and ruled the petitioners liable for expenses to be paid the Company. An appeal was filed before the Supreme Court on October In the opinion of Company management, based upon the advice of its legal counsel, the Company is not expected to be found liable in this claim. No provision was made for this claim in the Financial Statements In March 2010 a civil suit was filed before the Jerusalem District Court by Mishpacha Newspaper Ltd. and Mishpacha Magazine (2005) Ltd. against a cargo agent and against the Company for a sum of 6.5 million NIS (of which a sum of $1 million is claimed against the Company), for claims regarding bills of lading issued for cargo shipments. The Company made a provision for this claim in its Financial Statements, based on the opinion of its legal counsel In March 2010 a lawsuit was filed against the Company as part of arbitration proceedings in the U.S. to the amount of $700,000 on behalf of a hotel that had provided hospitality services to the Company's air crews, which include arguments regarding accounts that required settlement between the parties. The parties have decided to engage in arbitration with the intent of resolving the dispute. The Company made a provision for this claim in its Financial Statements, based on the opinion of its legal counsel In October 2010 a suit was filed before the Rishon Lezion Magistrate s Court by the Airports Authority against the Company to the amount of 1.8 million NIS; in its suit, the IAA claimed that as part of a project for the construction of a new sewage treatment plant in BGN, the Company undertook to construct preliminary facilities and perform sewage treatment up to a specific date, so that the Company facilities may be connected to the new facility. The stated claim was that the Company had violated its obligations and as a result, the IAA was forced to continue operating old oxygenation ponds, causing it costs and damages. A statement of defense has been filed and the parties are undergoing mediation. The Company made a provision for this claim in its Financial Statements, based on the opinion of its legal counsel. a - 198

201 On May Company s main office received a motion to approve a claim as a class action (hereinafter: the Motion ), which was filed against the Company before the Tel Aviv District Court on May The motion was filed by a Company passenger, whose flight had been cancelled on May following the contamination found in the jet fuel. In the motion, the sum of the claimant's personal claim was set at a total of 5,000 NIS and the general damage estimated by the claimant for the entire Group including all of the purchasers of flight tickets from the Company whose flights had been cancelled under the circumstances in question (estimated by the claimant at 2,500 passengers) amounts to 12,500,000 NIS for the Group as a whole. In the opinion of Company management, based upon the advice of its legal counsel, the Company is not expected to be found liable in this claim. No provision has been made for this claim in the Financial Statements On May the Company s main offices received a motion to approve a claim as a class action, which was filed before the Haifa District Court. This motion was on the matter of plaintiff's argument according to which the Company is overcharging cancellation fees for off-site transactions at a rate exceeding the maximum rate permitted in accordance with the Consumer Protection Law. The motion did not note a precise sum for the class action, but the plaintiff noted that he estimated the sum of the claim at tens of millions of shekels at the least. An evidence hearing on the case was held in December 2011, and at its conclusion the parties were asked to submit their summations. The summations have been submitted and the Company is waiting for a ruling on the motion. In the opinion of Company management, based upon the advice of its legal counsel, the Company is not expected to be found liable in this claim. No provision was made for this claim in the Financial Statements On July the Company s main office received a motion to approve a claim as a class action, filed against the Airports Authority, the Company, Israir Aviation and Tourism Ltd., Arkia Israeli Airlines Ltd. and the General Security Services, at the Nazareth District Court. The subject of the motion is the plaintiff s claim that Israeli Arabs, while departing and/or arriving at Israel, are discriminated against due to the unique security screening they undergo. The personal sum of each plaintiff s claim amounts to 100,000 NIS. The number of potential plaintiffs is estimated by the plaintiffs at one million Arab citizens. In light of the Court s ruling that the plaintiffs must submit their motion for re-approval, while establishing a page limitation, the Company s response has yet to be filed and the chances of the claim cannot yet be estimated. a - 199

202 The following are material claims in which the Company and/or the subsidiaries were defendants, and which concluded during 2011 or by a date near to the approval of the report: On December 20, 2006 the Company received a letter from the European Competition Commission ("the Commission") at its head offices, containing a request for information in connection with an investigation being conducted by the Commission in connection with activities that, allegedly, cause damage to competition in the sector of air cargo transport services. The letter stated that the Commission has information regarding extensive contacts that took place between airlines and other entities with regard to various price increments and other matters such as cargo transport rates. In the context of the letter, the Company was requested to transmit data and documentation regarding the Company and its cargo activities, starting The Company has provided its response as requested by the Directorate's letter, while conducting an internal review of its cargo pricing practices. According to publications by the Directorate and by several foreign companies, in December 2007 the Directorate sent a "statement of objection" to several airlines with regard to the aforementioned inquiry, including claims of alleged breach of competitive statutes of the European Union (this is an administrative procedure in which the Directorate reserves the right to issue significant financial fines). The Company has not received the aforementioned letter of claims, and is not among the companies to which the letter of claims was addressed. On November the Commission published an announcement of its decision to fine 11 airlines for a total sum of 800 million for the operation of a global cartel influencing cargo services in the European Economic Area and in particular, for coordinating activities pertaining to fuel and security surcharges, in the period between December 1999 and February The Company was not a recipient of this announcement, and therefore was not found liable and was not fined for this violation On August , the South Korean Fair Trade Commission (hereinafter: "the Korean Commission") presented the Company with a request for information pertaining to an investigation the Korean Commission is holding regarding possible violations of Korean competition rules in the field of air cargo shipping for the period starting The Company received additional requests for complementary information from the Korean Commission and provided its responses to the requests in question. To the best of the Company's knowledge, the Korean Commission has conducted an investigation on a series of airlines. According to the publications of a number of foreign airlines, in October 2009, the Korean antitrust authority sent out an a - 200

203 "inspection report" to several airlines pertaining to the investigation in question containing claims on the matter of alleged violations of Korean antitrust laws. The Company has not received the inspection report in question and to the best of its knowledge is not numbered among the companies to which the inspection report was addressed. In May 2010 the Korean Fair Trade Commission published a press notice in which it announced its intention to fine 21 airlines in 16 different countries, for an accumulated sum of South Korean wons, based on findings regarding involvement in a cartel in the matter of a number of cargo routes to and from Korea. The Company was not a recipient of this announcement, and therefore was not found liable and was not fined for this violation On May , the Company received a copy of a motion to approve the filing of a derivative claim ( the Motion ) and the claim itself, which were filed before the Tel Aviv-Jaffa District Court (hereinafter: the District Court ). The claimant, who claims to hold 4,500 Company shares (constituting 0.001% of the Company's share capital) asked that the Court approve the claim as a derivative action against a number of executives serving in the Company in 2003 and who no longer serve in the Company ( the Claim ), on the basis of the argument that these executives allegedly violated their prudence obligation toward the Company by involving the Company in fixing one or more price component in the field of airborne cargo shipping to and from the United States in the relevant period and that, he claims, they caused damage to the Company estimated to be at least $15.7 million U.S., this on the basis of the plea bargain between the Company and the U.S. Department of Justice as reported by the Company. The claim was preceded by a motion to file a derivative claim, which was rejected by the Company after the Company's Board of Directors decided that it would not be in the Company's best interests to file such a claim against Former Company executives. The Company filed its response to the motion in September On August , the executives filed a motion to join the action (hereinafter the Motion to Join ). The Motion to Join was rejected by the District Court. After the attempt made by the executives to change the District Court s ruling by way of a motion to clarify their ruling was not successful, on December they filed a motion to appeal to the Supreme Court in Jerusalem. In its February ruling, the Supreme Court accepted the executives appeal and ruled that the Motion to Join was to be ruled upon by the District Court. A date for a hearing on the Motion to Join is to be determined. a - 201

204 Over the course of these proceedings and prior to the discussion on the request, the claimant passed away. On January , the claimant s representative announced that his heirs have stated their intent to take his place and continue with the proceedings. On November the Company received the Court's ruling that it was dismissing the claim due to lack of activity. In February 2011 the Company was provided with a copy of a motion to approve the filing of a claim as a derivative claim ( the Motion ) as well as a copy of the derivative claim. The motion was before to the Economic Department of the Tel Aviv District Court by a holder of 5,000 Company shares (constituting 0.001%). Note that the shareholder had submitted two demands to the Company, which had been rejected by the Company s Board of Directors. According to the motion, the court was asked to approve a derivative claim to the amount of 22,800,000 NIS against Israel (Izzy) Borovitz, Tamar Moses Borovitz, Amiaz Saggis, Nadav Palti, Amnon Lipkin-Shahak, Yigal Arnon, Eyal Rosner, Shimon Katzanelson and Yehoshua Ne eman, who had served on the Company s Board of Directors in 2005 during the ratification of the employment contract of the former Company CEO, Mr. Chaim Romano. The motion claimed, inter alia, that the aforementioned board members had been negligent in determining and approving the yearly incentive bonus for Mr. Romano, who had served as Company CEO between 2005 and 2009, as well as regarding the Company s reports on the formula of the bonus in question. On April , the Company submitted a motion to grant the power of a verdict to a proposed settlement in the derivative claim, according to which the Company would be compensated to the total amount of 4,750,000 NIS ( the Compensation Sum ). According to the agreement, this sum shall constitute full, final and absolute compensation for all matters pertaining to the derivative claim. Pursuant to the above motion, the court was asked to: (a) revise the derivative claim in such a manner that the Company s outgoing CEO and other Company directors, past and present, not appearing originally as respondents in the claim motion, be added to the defendants; and (b) revise the grounds of the claim so that it also includes other issues pertaining to the approval of the terms of service and employment of the outgoing CEO and resulting reports, including those noted in the Securities Authority audit review dated March (published by the Company on the same date). Out of the sum of the compensation, a total of 1,000,000 NIS was paid the Company by the outgoing CEO in April 2011, as a retroactive reduction of the sums of the bonuses he received during his tenure. In addition, the Company signed a waiver for the Outgoing CEO according to which, upon the repayment of the sum in question, the Company shall have no complaints against him for any matter pertaining to the terms of his employment at the Company. In accordance with the court ruling dated April , notice of the request for the settlement in question and additional details was published in two daily a - 202

205 economic newspapers and a copy of the motion was provided to the Securities Authority. On May the court approved the motion (including requested changes, as detailed in the Company's May immediate report, ref: ). The Court reduced the fees paid to the claimant s attorney to a total of 150,000 NIS and the claimant s compensation to 75,000 NIS. Note that the claimant's counsel appealed to the Supreme Court regarding the reduction of the fee in question and in January 2012 the Supreme Court ruled that the fee sums be paid according to the settlement agreement Goals and Business Strategy On September 20, 2005, the Company's Board of Directors approved the Company's strategic program for the next five years and the principles for implementing it, entitled "El Al 2010", the ultimate goals of which were designed to improve business results by increasing sales and improving profitability. The goals of the program included: (a) significant improvement in customer service by enhancing the customer's experience in all of the Company's activities according to the needs of specific fields, focusing on the business customer and dealing with his special needs, emphasis on developing customer loyalty, improving the treatment of the incoming tourist and establishing an integrated service center; (b) cultivation of operational excellence, in the dealings with customers and other processes, as well as by striving to reduce the level of fixed assets relative to revenues and investment in systems and processes for optimal management of the organization's resources; (c) business innovation and initiative, including initiatives for developing traffic to and from Israel, development of additional revenue sources in the areas of maintenance, tourist services and ground services, development of BGN as a transit airport for continuing flights and conversion into a global company, advancement of cooperation with aviation wholesalers and development of the Internet as a distribution channel; (d) outfitting, including investment in modern equipment for long range routes, gradual rejuvenation of the aircraft fleet in accordance with financing terms, repayment ability and market development, and weighing continued outfitting based upon market developments; (e) improvements in the areas of cargo and maintenance, through continued growth in cargo activities while, at the same time, evaluating the operational structure, strengthening the ability to sell maintenance services and examining the development of maintenance as a profit center for the Company, and investigating cooperative arrangements with Israeli and international airlines for expansion of the ranges and areas of activities; (f) cultivation of human resources by means of updating labor agreements, developing and updating a - 203

206 training systems, employee compensation and incentives, and embedding the culture of a private entity in a competitive market. In 2011 the Company faced the various factors influencing the Company s activity, including the geopolitical situation and its impact on the aviation industry and on passenger traffic to and from Israel, changes in jet fuel prices and increased competition. Over the past few months, the Company has been working on the development of a medium and long-range business strategy, which is supposed to express the Company's goals and strategies for coming years, while adapting its current situation to developments in world markets and in international aviation. The Company has retained the services of Sheldor Ltd., which specializes in the management of strategy construction processes. In order to manage the process, Sheldor has employed the assistance of international external aviation experts and professionals from inside the Company. As of the reported date, the analysis stage has been concluded and alternatives have been formulated, along with Company management, for business models for the Company for the coming decade. The alternatives are currently being studied by the Company and the selection of the strategic plan is expected to take place over the coming months, following which a detailed work plan will be prepared that is expected to be carried out in the next few months subject to the approval of the relevant Company organs. The Company s key activities in 2011 were as follows: a. Adapting means of production to the demand environment and profitability of the various routes by adapting capacity in order to optimize the route network. In this regard the Company discontinued its flights to three destinations, including Sao Paolo (Brazil) in b. Continued improvement in customer service throughout the entire service chain, while providing an appropriate response to various populations, carrying out customer preservation actions and developing collaborations in favor of customer service including increasing direct sales, in particular over the internet, and developing CRM systems. c. Reducing the number of aircraft fleets operating in the Company's service and in particular shutting down the Boeing cargo plane fleet and the process of removing Boeing 757 and planes from service, while placing an emphasis on making the fleet younger and adapting its activity to operational and environmental restrictions. a - 204

207 d. Expanding the various services provided by the Company in Israel and abroad, including expanding the route network by signing code sharing agreements and interline agreements with other airlines and improving existing agreements (for details see 7.4 above). e. Continuing to provide a response to the extensive regulation applying to the Company in its various areas of activity, including aviation regulation unique to the Company s activity as an airline as well as various regulatory directives and in particular antitrust law specific to the Israeli aviation industry, the Open Skies agreement with the EU, which is approaching completion, and the legislation of the new Aviation Law, which is expected to influence the Company's activity. f. Continuation of equipping activity by purchasing aircraft, leasing aircraft and carrying out aircraft and engine sale and lease-back agreements (for details see 7.11 and 8.10 above). g. Continuing the development of sources of income in maintenance areas while providing services to airlines, aircraft manufacturer and other maintenance centers and developing growth engines in areas close to the Company s area of activity. h. The continued assimilation of technological systems, including entry into agreements to assimilate technological systems in the field of trade revenue management systems (RMS) and pricing systems, and the continued use of designated systems in various operational areas (for details see above). i. Continuing with the comprehensive approach on matters of safety and the environment, including air pollution and noise hazards, for which the Company received various approvals and opens itself to regular inspection. For further details see 9.10 above. j. Investment in the field of corporate responsibility and community relations, while preparing an ethical code and continuing extensive cooperation with various bodies in contributing to the community and the environment as well as in the continued nurture of the human resource and the excellence at the Company, including through the CEO s Excellence and People fund. k. Formulating and adopting an internal enforcement plan in the field of securities and corporate law, in order to assimilate and enforce norms in matters of legal compliance, ethical rules and other codes of behavior by the Company, its executives and its employees and to confirm compliance by the Company and by individuals working with securities law. a - 205

208 Implementation of the business strategy presented above by the Group constitutes forward-looking information as defined in the Securities Law, and is based upon the Group s assumptions, assessments and forecasts as to its business environment, which could change, in whole or in part, from time to time, thus affecting the achievement of the program's goals and its results. Accordingly, actual results, in whole or in part, may not be realized as above, be realized in part or to be materially different than the results estimated, derived or implied from this information, inter alia, for the reasons detailed below. Application of this strategy may be affected by regulatory changes that may require that actions be taken, inter alia, as regards the route network and the aircraft fleet or may influence the Company s profitability as a result of changes in government policy on the matter of security expenditure. In addition, implementation of the strategy is subject to the implications of global economic, political and/or security changes on environmental demands, on increased competition as a result of the State of Israel's aviation policy and the expansion of the activity of low cost airlines or aviation pacts in the Israeli market and the planned implementation of an aviation agreement ("Open Skies") with the EU. In addition, implementation of the strategy could be affected by fluctuations in jet fuel prices, which constitutes a substantial part of the Company's expenses Projected Developments in the Coming Year The Company predicts that in 2012, particularly at its beginning, it will be forced to deal with the significant challenges that led to losses in 2011 such as the increase in jet fuel prices, dealing with constant competition and the loss of the market share and the ability to maximize its price policy so as to allow the Company to deal with the heavy expenses it must bear. As part of this, the Group intends to continue regularly studying the adaptation of its activities to trends and developments occurring in the Group's business-economic activity environment and in the global aviation industry. The chief challenge of the aviation industry in 2012 is expected to be influenced by the euro crisis threatening to expand into a new global recession and the political instability in the Middle East, which influences jet fuel prices and which may also influence demand in the area. These trends and changes require a constant in-depth examination of the Group's activities, including the combination and profitability of the Group's route network in the fields of passengers and cargo. In addition, the Group's activity over the coming year is also expected to be influenced by changes in regulations affecting the activity including the "Open Skies" policy, as described in Section above. The goals of the strategic program will be a - 206

209 accomplished by taking to account, among other things, the manner in which the Company's outfitting plan is being realized, the Group's ability to cope with and prepare for toughening competition, and striving to improve the business results in 2012 by enhancing the mix of revenues, improving yields, implementing organizational efficiency measures and cutting expenses. See Note 1d to the December Financial Statements. The information concerning the projected developments during the coming year represents forward-looking information, as defined in the Securities Law; this information is supported, inter alia, by the Company s assessments, forecasts or intentions as of the report date. Therefore, the actual developments during the coming year may be, in whole or in part, materially different than the developments assessed, derived or implied from this information, as the result of a large number of factors, including those listed in Section 9.15 above and the risk factors described in Section 9.18 below Financial Data on Segment-Based Reporting For data on segment-based reporting see Note 37b to the Financial Statements. For explanations regarding developments in these segments, see Section a Discussion of Risk Factors Like other airlines, the Company's activities are affected by several external and internal factors that could lead to material changes in its profitability (positive or negative). The risk factors may be divided into macro risks, industry risks and risks that are unique to the Group. The major risk factors are: Macro Risks Political or Security Events or Terrorist Acts Political or security events or terrorist acts in the world or in the region have an immediate negative effect on the demand for passenger and cargo transport and influence the price of jet fuel and the Company s economic condition and the volume of its activity. The risk is that the impact on the Company's revenues will be caused as a result of security and geo-political events in Israel or in target destinations, among other things in light of geopolitical events in the Iranian arena Exposure to Currency Risks Most of the Company s revenues and expenses are denominated in or linked to foreign currency (mainly the US dollar). The Company is exposed to a rise in the value of the a - 207

210 shekel relative to the dollar with respect to current wage expenses and other liabilities denominated in shekels in the Company's balance sheet, principally with respect to termination of employee-employer relationships and vacation provisions. The revaluation of the shekel vis-à-vis the dollar increases the Company's current expenses and also increases, in dollar terms (without effecting cash flows), the Company's obligations related to termination of employee-employer relations. Furthermore, natural internal protection exists for other foreign currencies (pound sterling, euro, rand etc.) carried out by comparing payments and receipts in each currency. In years when the volume of the receipts is not significantly different from the volume of payments in European currencies, the mixture serves as internal protection against exposure to these currencies, whereas in years in which a material difference exists between the payments and receipts and exposure is created for the Company with those currencies (mainly the Euro), the Company considers the need to invest in financial derivatives to reduce the exposure created. For details regarding the actions taken by the Company for hedging the exposure to currency risks see Section b.1.(5) to the Board of Directors Report, as well as Note 31e to the Financial Statements Changes in Economic Status The aviation and tourism industries are sensitive to changes in economic activity affecting the demand for passenger and cargo transport. The expense structure of the aviation industry, which includes a high component of fixed expenses, makes it very difficult to implement procedures to adapt the Company's supply to changes in short-term demand. During periods of an economic slowdown, the demand for air transport is reduced for different reasons, and excess capacity and unutilized labor and flight equipment is created. Consequently, the Company s economic position is worsened, as reflected in its business results. The euro crisis that is threatening to develop into a new global recession may lead to a drop in demand for international passenger and cargo traffic (for further details see Sections 6.1, 6.2 and above) Outbreak of Epidemics and Natural Disasters Outsides factors such as natural disasters, fires and earthquakes, epidemics and so forth, may harm the Company's normal course of operations. Outbursts of epidemics (such as the "Swine Flu") and natural disasters (such as the Icelandic volcano and Japanese tsunami) have a negative effect on passenger traffic to the disaster areas and therefore may have a similar negative effect on the Company's business results. a - 208

211 Exposure to Variable Interest Rates The Company finances part of its investments using credit from banking institutions. The Company s loans and most of its deposits are in dollars. Most of the loans bear variable interest and, accordingly, any change in interest rates might materially affect the Company s financing expenses and cash flow. In order to reduce exposure to this risk factor the Company has entered into interest risk hedging agreements. See Section b.1.(4) to the Board of Directors Report for details with regard to the actions taken by the Company to hedge the exposure to variable interest rates. These hedging agreements may expose the Company to changes in the fair value of said hedging agreements. For further details see Notes 25 and 31f to the December Financial Statements. Industry Risks Jet Fuel Prices Jet fuel is a significant component of an air carrier's operating expenses. Jet fuel prices are subject to sharp fluctuations. Between 2004 and July 2008 the price of jet fuel rose at a substantial rate, while starting from the third quarter of 2008, sharp decreases were listed in jet fuel prices. Jet fuel prices rose again in 2010 and continued to rise even further in The Company's profitability may be significantly harmed by changes or severe fluctuations in jet fuel prices. The Company employs hedging activities for part of its projected jet fuel consumption. This policy could change according to circumstances. As a result of this policy, the Company faces an accounting risk due to fair value changes as well as the requirement for restricted deposits. Due to the great weight of jet fuel in the Company's operating expenses, any increase in jet fuel prices has a negative effect on its operating expenses and business results. For details regarding the actions taken by the Company for hedging its exposure to changes in jet fuel prices see Section b.1.(3) of the Board of Directors Report as well as Note 31g to the Financial Statements Changes in Competition The aviation industry is characterized by a high level of competition, which becomes more acute during periods of excess capacity. The entry of additional charter airlines into the market, including the entry of additional foreign scheduled carriers into the Israeli market or an increase in capacity of existing foreign carriers, the entry of additional Israeli carriers into the market and the appointment of additional Israeli carriers as Designated Carriers (in the fields of passengers and cargo), the entry of additional charter and low cost airlines, and the granting of operating licenses to additional Israeli airlines in a - 209

212 the passenger and cargo areas lead to increased competition in the Israeli aviation industry, a situation that creates excess capacity, lowers the level of passenger and cargo transport prices and may reduce the Company s share in activity in the industry and hurt the Company s business results. This trend of increased competition intensified over recent years, as it did in 2011 with the entry of new airlines and the increased capacities and frequencies of airlines operating in the Israeli market (see 7.1.2, and 7.8 above for details). Special emphasis must be placed on the activities of the foreign airlines in the three largest aviation alliances, which operate in the Israeli market while cooperating in their activities and trade, which are based on non-israeli regulation (including competition laws practiced in Europe) allowing them to carry out code sharing agreements, merges and acquisitions and material commercial collaborations. In addition, changes in international agreements, including the implementation of an aviation agreement (the Horizontal Agreement) between Israel and the EU, signed in December 2008, and the progress of talks on the matter of the global agreement with the European Union (Open Skies), which is undergoing advanced talks in preparation for its signing, and which is designed to replace all bilateral agreements between Israel and EU member states and remove restrictions on the number of carriers, frequencies, capacity and types of aircraft, may have a negative impact on the Company's activities as a result of intensifying competition and multiple carriers and capacity. It should be stated further, that the increase in flight capacity of foreign airlines in the passenger aircraft field also led to a substantial increase in the capacity of cargo flown in the holds of passenger aircraft of these companies to and from Israel, and exacerbated the competition also as relates to the activity of cargo aircraft. See , 7.8, and 8.7 above for further details Seasonal Influences The Company's activities are seasonal by nature and are focused during peak periods (see Section 7.9 above). Tourism traffic, mostly during the summer season and during holidays (Jewish and Christian), is higher than the annual average. The cargo transport field is also characterized by high seasonal fluctuations. As the component of the capital expenditures and fixed expenses out of the total Company expenses is significant, the impairment of activities during the peak season (due, for example, to political and security events) or the inability to obtain replacement aircraft, even if concentrated over a relatively short period, can have a substantial negative effect on that year's business results. a - 210

213 Government Resolutions on Aviation and Licensing the Company as an Air Carrier a. A change in the Government s policy with respect to the Company s status as a Designated Carrier for all or part of the routes on which the Company serves as Designated Carrier could materially affect the Company s financial results, in general and according to the type of route. Additionally, Government resolutions could change the Company's position and have a negative effect on its financial results (see Sections and above for details on the Government resolutions on the subject of state participation in security expenses and the Israeli aviation policy in the matter of appointing Designated Carriers and related legal proceedings). b. The Company s operating licenses as an air carrier and its rights as such are conditional upon practical ownership and the effective control remaining in Israeli hands. The Company's ability to always know the extent of foreign ownership of its shares is limited to the records it administers, and, accordingly, a situation may exist in which the foreign owners of shares did not report their holdings to the Company (purchase or sale) and were not recorded in the shareholders' registry, so foreign ownership will exceed the permissible percentage or will be less than the percentage recorded in the shareholders registry, without the Company being aware of it. If the Company becomes aware that foreign ownership exceeds the permissible percentage, it will be able to act in conjunction with the Special State Share to reduce the percentage of foreign ownership. Should it be unable to do so and the foreign holdings in the Company s shares exceed the permissible percentage, the Company could lose its status as a Designated Carrier. However, whenever the holder of the Special State Share and/or the Minister of Transportation believe that the actual control and the ability to direct the Company s operations remains in the hands of the Board of Directors, of which two thirds of its members, including the Chairman, the CEO and Company officers, are Israeli citizens and permanent Israeli residents, the risk is minimal that the Company will lose its status as Designated Carrier just because of the rate of foreign ownership in the Company s shares. c. For details regarding the cancellation of the operational license of subsidiary Sun D Or see above Operations in an Industry with a High Fixed-Cost Structure The Company operates in the aviation industry, which has a structure of relatively high fixed costs and relatively low profit margins. Therefore, small changes in the level of revenues or expenses could have a direct effect on whether there will be earnings or losses. a - 211

214 Noise and Environmental Restrictions on Flight Operation Every change in restrictions on night operations at BGN or other airports from/to which the Group flies and each additional restriction or prohibition on the operation of aircraft due to air pollution, noise, etc. might have a material effect on the Company's business results. In this regard, note that the ETS plan, which is expected to come into effect in European countries in 2012, may involve added financial expenses to the Company s activity in Europe (for details see above) Effect of the Operations of Low Cost Airlines on the Israeli Market Airlines with a low production cost structure (low cost carriers) have increased their market share substantially in recent years, principally in the United States and in Europe. This growth has negatively affected veteran airlines with higher production cost structures, and has caused a decrease in their market share and a drop in their yield due to fare reductions as the result of competition. Most low cost airlines specialize in short flight legs. Under the terms of new aviation agreements signed in recent years airlines have begun operating in Israel with a format similar to that of low cost airlines which have not operated on Israeli routes before along with low cost airlines such as EasyJet (for details see Section above). The entry of these and other airlines into the Israeli market could have a negative effect on the Company's business results, due to the increased capacity offered by these airlines at reduced prices. See Sections 7.1.1, and above for additional details Impairment of Flight Safety or Flight Security In order to maintain flight security, the Company upholds security arrangements in accordance with the instructions of the authorized governmental agency. In order to maintain flight safety, the Company carries out the instructions and provisions stipulated by the relevant entities, including the instructions of the manufacturer and the Civil Aviation Authority. Damage to the Company's flights and/or its customers and/or its installations and/or its employees, due to an event involving flight security and/or flight safety is liable to have a material negative effect on the Company's operations, inter alia as a result of harm done to reputation, loss of revenues and customers and the Company's exposure to legal action In addition, the Company has a crisis event array, assembled and practiced in accordance with guidelines set by the IATA, which examined and approved the array in three separate inspections in 2006, 2008 and An additional IATA inspection is planned for June The Company conducts crisis event training exercises at the a - 212

215 Company level once per period, with the last exercise conducted in late 2011, and updates its procedures according to global developments in the field (booklets, conferences and professional media) For details regarding regulation and licensing requirements applying to the Company's activity see and above Aviation Regulation The Company's activity and its ability to expand the scope and layout of its activity, is dependent, among other things, upon various regulatory approvals granted by authorities in Israel and around the world. The absence of proper licensing and the failure to uphold international or local regulations may lead to increases in the Company's costs, to competitive inferiority in comparison with the Company's competitors and may harm the Company's regular course of activity. The FAA's lowering of the flight safety rating for the State of Israel to Category 2, which occurred in December 2008, may have a negative impact on the Company's activity, among other things in light of the fact that although the declaration in question refers to the safety rating of the State of Israel, the implications of the declaration are harmful to the Company's operations to and from the U.S. as well as damaging to its reputation. For details concerning the declaration and its impact on the Company see Section (h) above. During the reported year, regulatory changes were made to aviation legislation applicable to the Company, the most prominent of which was the passing of the Aviation Law, 2012, and proposals were raised for changes to laws and regulations in the field of aviation regulation, for which the legislative process has yet to be completed. For details regarding aviation regulation see Section above. Risks Particular to the Company Costs of Maintaining Flight Security Since the Company is required to maintain security arrangements which are determined by a governmental body and it bears security expenses over which it has no control, most of which do not apply to foreign, competing airlines, this situation hurts its profitability, its competitive ability, and the development of a route network. The Government passed several resolutions starting 2008 altering the rate of the State's participation in Israeli airlines' direct security costs, with the latest decision received on December and setting a gradual increase in the State's participation rate. For details regarding the Government resolutions on this subject see above. The changes in the rate of the a - 213

216 State's participation in the Group's flight safety expenses, changes in the extent of safety measures the Company will be forced to take (due to security events or attempted attacks), as well as whether the Company will be forced to discontinue or limit its flights to additional destinations as a result of safety concerns, may have a material impact on the Company's operating results. For details regarding steps pertaining to flight security costs see above Restrictions on the Future Receipt of Credit and Failure to Meet Financial Criteria The Company has commitments vis-à-vis its long-term loan providers to maintain a proper collateral ratio between the unpaid loan balance and the collateral pledged to the bank, as stipulated by each agreement. In addition, the terms stipulated in certain agreements relating to loans taken by the Company include the bank's right to demand immediate repayment of the loan balances owed to that bank if, in its opinion, based on reasonable criteria, a change had occurred that adversely affects the Company s financial status or its operations or its business or its financial ratios, in a manner endangering or potentially endangering its ability to repay the bank loans. The failure of the Company to comply with financial covenants stipulated in the loan agreements, including with regard to the decrease in market value of the collateral, and/or the demand for immediate repayment of Company loans by the banks, might have a negative effect on the Company's business results. In addition, single borrower and group of borrower limitations may apply to the Company, as well as limitations on the transfer of control and on changes to its ownership structure, taking the extent of the credit and the identity of the Company's controlling party into account. For details regarding credit limitations see Section above Business Restrictions In light of legislative changes in the field of antitrust laws, the competitive ability of Israeli carriers, among them the Group, may be damaged, and this may lead to a negative impact on the Group's activities due to regulatory restrictions on the existence of international agreements in the Group's areas of activity or the non-approval of these agreements (existing or new) by the Antitrust Authority (for details see Section (i) above). The gaps between Israeli antitrust law (according to which advance approval is required for certain commitments and a risk exists that this approval will not be granted) and antitrust law elsewhere in the world may impact the competitiveness of Israeli airlines, in particular in light of the mergers, acquisitions and aviation pacts common in international aviation. a - 214

217 For additional details regarding the impact of antitrust laws on the Company s activity, including on the subject of monopolies, see (h) above The Municipal Status of BGN From time to time, the addition of BGN to the jurisdiction of the city of Lod is taken under consideration. If the transfer of BGN to the jurisdiction of any local authority should become a reality, the Company's expenses may rise (due to the payment of municipal taxes which have not been paid to date), and the matter will negatively affect its business results Labor Relations Every interruption of operations of an air carrier due to sanctions or a strike causes a nonrecoverable loss and damage to customer confidence. The situation in the industry and the increasing rate of competition necessitate continuing efforts to increase the Company's efficiency and to improve service to the customer public. These depend on stable labor relations in the Company, on the employees' identification with the Company, their readiness to cooperate and their understanding with management. Although the industrial calm in the Company has been maintained since 1983, excluding a small number of disruptions, the efficiency expressed in structural changes, in the reduction in the number of personnel (with the emphasis on permanent employees), and the reduction of labor costs, could cause a shake-up, even for a short period, in the delicate texture of labor relations in the Company. This could cause damage in the immediate term and hurt the Company s goodwill over the longer term, and it might have a negative effect on the business results of the Company for that year and thereafter. Additionally, there could be difficulty in utilizing business opportunities and dealing with changes due to limitations in the labor agreements. For details on the collective labor agreement signed November , the proceedings pertaining to separate representation for the pilot sector among employee representatives and the special collective agreement for temporary employees, see above Legal Proceedings The Company is a party to legal proceedings, including claims the court was asked to recognize as class actions in Israel that may cause it to be charged with material sums that cannot be estimated, and for which no provision has been made in the Company s Financial Statements. The results of these proceedings may have a material impact on the Company due to their results (see 9.14 above for further details regarding these proceedings). a - 215

218 Restrictions Due to Certain Provisions of the Special State Share The restrictions pertaining to maintaining minimal flight capacity, especially for cargo aircraft, and the prospect of the State demanding to increase the minimal flight capacity with which the Company must comply, diminish operational flexibility and impose burdensome obligations (assurance of fitness). The indemnification in these cases does not cover the Company s expenses. In addition, the Government Corporations Law gives the government the authority to issue instructions to the Company that are intended to protect the vital interests of the State with respect to the Company, in accordance with decrees resulting from Chapter 2H of the Government Corporations Law, that may restrict the Company's business judgment and, as a result, impact its financial results. See Section 8.10 above for information concerning the holder of the Special State Share Dependence on Aircraft Manufacturer The Boeing Corporation manufactured all of the aircraft in the Company's service. The discontinuation of Boeing's operations could cause temporary operational difficulties for the Company. The Company is materially dependent on Boeing, both with respect to spare parts and with respect to engineering support. At the same time, the Company estimates that the likelihood of the discontinuation of this support is low Dependence on Regular Operations at the Home Airport (BGN) Most of the Company s activity is carried out at its home airport, BGN. Therefore, an interruption or breakdown in the normal operations of BGN and/or changes in the policies of granting takeoff and landing authorizations (slots) at the central airports in which the Company operates might have a material negative effect on the Company s activity. Restoration works began on a BGN in 2010, a process expected to last 4 years, during which BGN will feature just one functional runway. In addition, a proposal exists that Ben Gurion Airport be opened for departures throughout the night. Changing the operating hours and changing the activities to accommodate a single runway may have a material impact on the Company's operational abilities and financial results Flights on the Sabbath and Jewish Holy Days The Company continues to operate pursuant to a 1982 Government resolution and does not operate passenger flights on the Sabbath and on Jewish holidays. For details regarding the agreement between the Company and the Committee of Rabbis for Sabbath Observance see Section 7.10 above. Non-fulfillment of the understandings regarding flights on the Sabbath and Jewish holidays, or a change of the Company's policies with a - 216

219 respect to this subject, could cause a dispute with this customer sector, which could affect the Company's results due to a consumer boycott Information Systems and Information Security The Company's current activities, its business activities and the services that it provides are based upon information systems and databases. Some of the Company s information systems have reached the end of their life cycles and their replacement is not included in the Company s work plan. The Company is currently in the advanced stages of establishing an IT backup facility, in order to deal with a comprehensive failure situation in the main computer room. Likewise, the Company is preparing a comprehensive plan on the subject of data security as a response to the increase in risk deriving from cyber attacks. Until the preparations in the fields detailed above are completed, risk exists of mishaps and failures in the operation of the Company's information systems, which may lead to the shutdown of crucial systems or the lack of sufficient support for certain periods of time. The following table presents the risk factors described above according to their nature (macro risks, industry risks and risks particular to the Group), which have been ranked, as estimated by the Group s management, according to their effect on the Group s business as a whole - major, moderate and minor effect. The Company s assessment as to the ranking of the risks was determined in consideration of the likelihood of the occurrence of the event and the measure of damage that might be caused to the Group, should the event take place. a - 217

220 Extent of Risk's Effect on the Company Minor Effect Macro Risks Political events, security events or terrorist V actions Exposure to currency risks Changes in the economic situation Natural disasters and epidemic outbreaks Exposure to variable interest risks Industry Risks Jet fuel prices V Changes in competition V Seasonal influence V Government resolutions on aviation issues and the Company's licensing as an V air carrier Operations in an industry with a high fixed-cost structure Noise restrictions and environmental matters Effect of the activity of low cost airlines on the market Impairment of flight safety or flight V security Aviation regulation V Risks Particular to the Company Moderate Effect V V V V V V Major Effect V Costs of maintaining flight security Restrictions on receipt of credit and failure to uphold financial criteria Business restrictions Municipal status of BGN Labor relations Legal proceedings Restrictions due to provisions of Special State Share Dependence on aircraft manufacturer Dependence on regular operations at home airport (BGN) Saturday and religious holiday flights Information systems and information security Minor Effect V V V V Moderate Effect V V V Major Effect V V V V a - 218

221 2011 ANNUAL REPORT CHAPTER B DIRECTORS' REPORT

222 El Al Israel Airlines Limited. Report of the Board of Directors on the State of the Corporation's Affairs for the Year Ending December 31, 2011 Table of Contents Chapter Page 1. General 1.1. Changes in International Financial Standards (IFRS)...b The Company and its Business Environment...b Holdings of Company Shareholders...b-7 a. Comments of the Board of Directors on the State of Corporate Affairs a.1. Financial Position (Consolidated Financial Statements)...b-8 a.2. Analysis of Business Activity Results a.2.1 Market Data...b-11 a.2.2 Operational Data...b-12 a.3. Statement of Operations Data For 2011 (Consolidated Financial Statements)...b-13 a.4. Influence of Changes in Exchange Rates on the Company s Employee Benefit Obligations...b-17 a.5. Segment Reporting a.5.a General...b-19 a.5.b. Analysis of Revenues and Results by Operating Segments...b-19 a.5.c Analysis of Revenues by Flight Destination...b-21 a.6. Seasonal Factors...b-22 a.7. Liquidity and Financing Sources...b-22 b. Exposure to Market Risk and Management Thereof b.1. Qualitative Reporting on Exposure to and Management of Market Risks...b-24 b.2. Linkage Basis Report...b-34 b- 1

223 c. Aspects of Corporate Governance c.1. Charitable Contributions and Community Work...b-36 c.2. Directors with Accounting and Financial Capabilities...b-36 c.3. Disclosure Regarding Independent Directors...b-37 c.4. Disclosure Regarding the Internal Auditor...b-37 c.5. Disclosure Regarding Independent Auditors' Fees...b-40 c.6. Financial Statement Approval Process...b-41 c.7. Use of Securities Proceeds...b-43 c.8. Disclosure Regarding Consent to Perform Peer Review...b-44 c.9. Negligible Transaction...b-44 c.10. Remuneration of Interested Parties and Senior Executives...b -45 c.11. Audit Report Securities Authority...b-48 c.12. Internal Enforcement Plan...b-48 c.13. Effectiveness of Internal Controls of Financial Reporting and Disclosure...b-48 d. Disclosure Provisions with Regard to Financial Reporting by the Corporation d.1. Events Subsequent to the Balance Sheet Date...b-50 d.2. Disclosure on Critical Accounting Estimates...b-50 d.3. Explanation of the Matter to which the Company's Independent Auditors Draw Attention in their Opinion Regarding the Financial Statements...b-50 e. Additional Information e.1. Dividend Distribution Policy...b-51 e.2. Disclosure Regarding Changes in the Economic Environment, the Implications of the Capital Market Crisis and Market Risks...b-51 Appendix A - Assessment of Total Value of the and Fleets...b-54 Appendix B - The Company s Material Loans and Credit Frameworks...b-63 b-2

224 El Al Israel Airlines Limited. Report of the Board of Directors on the State of the Corporation's Affairs For the Year Ending December 31, 2011 We hereby present the Report of the Board of Directors on the State of the Corporation's Affairs for the period ending December 31, was a year of contrasts in global aviation. According to International Air Transport Association (IATA) data, international passenger traffic increased by 6.9% compared to 2010, while cargo traffic decreased by 0.7%. The seats and cargo volume offered by the airlines increased past the increase in the number of passengers and amounts of cargo and therefore the load factor decreased both for passenger traffic and for cargo traffic saw a 6.5% increase in the number of passengers passing through BGN, which reached 12.2 million passengers compared to 11.4 million passengers in Incoming passenger traffic increased by 5.1% compared to 2010 and departing Israeli traffic increased by 7.5%. The amount of cargo shipped by air decreased from thousand tons in 2010 to thousand tons in 2011, a 1.9% decrease. In 2011 El Al listed a 0.4% increase in the number of passengers on scheduled and charter flights, reaching 4.2 million passengers (a 2.6% decrease in the number of passengers not including flights to Eilat) and a 0.3% decrease in tons of airborne cargo, which amounted to thousand tons in The Company s market share at BGN amounted to 33.9% compared to 37.1% in Its load factor was 80.3% (81.6% in 2010). Group revenues in 2011 amounted to $2,043.2 million, a 3.6% increase over Gross earnings amounted to $278.3 million compared to $387.7 million the previous year, a 28.2% decrease. The Company listed a loss of $49.4 million in the reported year compared to a net profit of $57.1 million in Production of cash from current activity in 2011 amounted to a total of $61.9 million compared to $203.3 million in The balance of the Group s cash, cash equivalents and short-term deposits as of December totaled $93.5 million compared to $174.6 million on December The Company's equity as of December amounted to $161.8 million, a $85.7 million decrease from December In 2011 the Company continued with its response to increasing competition at BGN, which included the entry of new foreign airlines to BGN, added frequencies and the use of aircrafts with larger capacities. A total of, the capacity of the other scheduled airlines at BGN increased by 9% in 2011, and their passenger numbers increased by 11% relative to Since 2005 the seat availability of foreign airlines at BGN has increased by 108%, with their passenger numbers increasing by 106% in the period. The increase in capacity allowed these companies operating an international hub at their home airports, to increase the number of passengers flown between Israel and a large number of destinations via indirect flights, taking advantage of their route networks and that of their partners in global aviation alliances and code sharing agreements. Over the course of 2011 the Company carried out a broad variety of actions in the field of trade, customers, service, IT, technology, financing, the aircraft fleet and the route network. In the field of its aircraft fleets, the Company purchased an additional used passenger aircraft. Additionally, two additional wide-bodied passenger aircrafts and a narrow-body aircraft b-3

225 were leased and entered service. Furthermore, the Company began its project of adding winglets to the aircraft fleet in its possession for fuel economy purposes. At the same time, as part of its activities aimed at lowering the age of its aircrafts fleet, the Company decommissioned a cargo plane (thus discontinuing this fleet), and two leased 757 airplanes were returned to their owners at the conclusion of their lease period. Two aircrafts were decommissioned after 27 years of service at the Company. Over the course of 2011 the Company signed an agreement with Boeing to purchase four new and advanced ER aircrafts as well as an option to purchase four additional aircrafts of this model. An information system for the management and tracking of air pollution (CO2 emissions) from Company aircraft was implemented over the course of the year. In order to expand the route network at its customers disposal, in 2011 the Company implemented a code sharing agreement with Ukrainian airline Aerosvit in A cooperation agreement with regional Canadian airline West Jet allowing the Company to offer its passengers a variety of follow-up destinations throughout Canada, South America and the Caribbean, also came into effect. A code sharing agreement with American Airlines was expanded to 22 code sharing destinations across the U.S., and the code sharing agreement with Russian airline Siberia Airlines was expanded to 9 additional destinations across Russia. Due to economic considerations and as part of the Company s streamlining and cost reduction processes and the optimization of its route network, the Company discontinued its activity on routes to Sao Paolo, Odessa and Dnepropetrovsk, as well as its cargo flights to Hong-Kong. On the other hand, a fifth passenger flight was added to the Hong Kong route saw a continuation of the trend of global growth in the direct marketing of flight tickets through the call center and over the Internet, with income from these sales increasing by 12% in 2011 relative to Over the course of 2011 the Company completed the implementation of a new system for the management of duty free activity at El Al. The duty free site was upgraded with the aim of promoting sales through preflight orders. The new homepage for the frequent flyer website was launched. 111 thousand new members joined the club over the course of the year. The global Apple Store offered a new app for frequent flyer flub members. The Company's website was re-launched in March 2011, with improved business processes as well as technological and design improvements. The Company presented a new, well-designed international homepage for social networks. Over the course of the year, the El Al sites on these networks received some 100,000 new friends. The CEO s monetary fund for Excellence and People was established in The sums in this fund are intended for the development, encouragement and promotion of excellence in the Company and personal excellence. In the field of finance, extensive activity took place in 2011 with Israeli banks to redeploy balloon loans the repayment date of which fell over the course of the year. After an in-depth examination of the hedging process, a new policy for jet fuel and interest rate hedging was established and applied. Furthermore, agreements were signed with banking institutions to finance the purchase of a aircraft and a spare engine for the 737 fleet. In December 2011 the government ratified an agreement arranging the financing of aviation security. The understanding mainly refers to a gradual increase in the State s participation in the security expense burden b-4

226 of Israeli airlines, from 60% (the participation rate for 2010) to rates of 65% (for 2011), 70% (for 2012), 75% (upon the signing of the open skies agreement with the European Union) and 80% upon the implementation of the open skies agreement (as defined in the understanding). In December 2011 the Company s Board of Directors approved the key points of the internal enforcement plan in the field of securities and corporate law. Over the course of 2011, the Group completed a process of formulating and writing an ethical code, including values, norms and enforcement and assimilation policies, intended to direct the activity of the group and of all of its executives throughout their work, and to dictate criteria for their behavior. The Company launched its El Al Ambassadors initiative in conjunction with the Israeli Foreign Ministry and leading global publicity firms, with the goal of helping to present a different image of the State of Israel. The Company recorded a loss of $49.4 million in the reported year. The main reason behind the financial results for 2011 was the increase in operating costs, deriving mainly from the increase in jet fuel costs past the increase occurring in the reported year in the Company s revenues, and as a result of the loss of a market segment following increasing and aggressive competition, mainly as a result of the implementation of the State of Israel s open skies policy. In light of the above and taking into account the global crisis, the increased competition in the aviation market and the political instability in regional countries, the Company failed over the course of 2011 to catch up with the increase in operating costs. In addition, the streamlining plan that the Company put together in the third quarter of 2011 has only been partially applied to date. The Company estimates that it will be forced to face the same challenges in 2012 as it did in 2011, both on the financing level and on the cash flow level. The continued sharp increase in jet fuel prices, as expressed in the first quarter of 2012, combined with the global economic crisis and the competitive environment that raises difficulties for the Company's revenue policy, are challenges the Company faces as 2012 begins and possibly as the year goes on. In light of this, Company management is, among other things, optimizing commercial actions alongside close and controlled management of the flight schedule and increasing revenues from activities, including activities not related to the sale of flight tickets, reduction of costs and other actions in the fields of finance. Company management estimates that carrying out these actions will allow the Company to meet its obligations in the foreseeable future. For details, see also Note 1d to the Financial Statements.. b-5

227 1. General 1.1 Changes in International Financial Standards (IFRS) For further details regarding the changes occurring in international standards and the impact of their application to the Group's Financial Statements, see Note 3 to the December Financial Statements. 1.2 The Company and its Business Environment The Company serves as the designated air carrier of the State of Israel on most of the international routes operating to and from Israel. The key activities of the Company and its subsidiaries are the transport of passengers and cargo by way of scheduled flights, and on the matter of the transport of passengers, also on charter flights between Israel and other countries and starting August 2010, on domestic flights as well. The Company is also engaged in providing security services and maintenance services, including for other airlines at Ben Gurion Airport, in the sale of duty-free products, in the leasing of aircraft, and through investees in ancillary activities, mainly the manufacture and supply of airline food and the management of several overseas travel agencies. The business environment in which the Company operates is the international and domestic civil aviation industry, and inbound and outbound tourism, which is characterized by a seasonal nature and strong competition, which grows stronger in periods of over-capacity, as well as high levels of sensitivity to the economic, political and security situation in Israel and around the world. The Group has two operating sectors reported as operating segments in the Company's consolidated Financial Statements: a) Passenger aircraft activity in this segment, the Group transports passengers, as well as cargo in the cargo of passenger aircraft, and provides ancillary services, such as the sale of duty-free products and the leasing of planes. In the field of passenger transport, the Company competes in its flights to and from Israel with 2 Israeli airlines (Arkia and Israir), 59 foreign airlines that operated scheduled flights and over 50 foreign charter airlines, 34 of which operated flights on a regular basis. Revenues from this area of activity constituted 89.6% of all of the Group s revenues in b) Cargo aircraft activity in this segment, the Group transports cargo in cargo aircraft (starting June 2011 the Company operates a single leased aircraft). In the field of cargo transport, the Company competes with one Israeli airline (CAL) and with 6 foreign airlines operating cargo aircraft on a continuous basis, and with most of the scheduled airlines that operate passenger planes that carry cargo in their holds. Revenues from this area of activity constituted 4.9% of all of the Group s revenues in The Group has additional revenues that are not attributed to its major areas of activity, accounting for 5.5% of total revenues. b-6

228 For further information on the Company's fields of activity, see Section a.5 of the Report of the Board of Directors below and Note 37 to the December Financial Statements. 1.3 Holdings of Company Shareholders As of December 31, 2011 shareholder holdings in the Company are: Knafaim Holdings Ltd. ("Knafaim") 39.3%, the Delek Group 8.7%, the Ginsburg Group 8.9%, a Company employee corporation called "Holdings in Trust of El Al Employees Ltd." ("Employees Corporation") 5.9%, others 2.5%, the public 34.7%. Ratio of Holdings in Company Shares as of December 31, 2011 (undiluted): Knafaim 39.3% Public 34.7% Ginsburg Group 8.9% Employees Trust Holdings 5.9% Others 2.5% Delek Group 8.7% b-7

229 Explanations of the Board of Directors for the State of the Corporation's Affairs a.1 Financial Position (Consolidated Financial Statements) change in thousands US dollars in thousands US dollars in thousands US dollars Current assets Cash and cash equivalents 85, ,002 (25,646) Designated cash 1,827-1,827 Short-term deposits 8,183 63,565 (55,382) Trade receivables 142, ,960 9,449 Other accounts receivables 27,748 20,880 6,868 Derivative financial instruments 2,096 42,190 (40,094) Prepaid expenses 28,043 26,995 1,048 Inventories 26,481 18,756 7,725 Total current assets 322, ,348 (94,205) Non-current assets Long-term bank deposits 1,473 1,869 (396) Investment in affiliated companies 13, ,491 Investments in other companies 1,264 11,552 (10,288) Derivative financial instruments - 4,291 (4,291) Fixed assets, net 1,192,413 1,231,687 (39,274) Intangible assets, net 7,995 7, Prepaid expenses 7,547 8,121 (574) Assets due to employee benefits 39,817 38,799 1,018 Total non-current assets 1,263,693 1,304,856 (41,163) Total Assets 1,585,836 1,721,204 (135,368) Current liabilities Borrowings and current maturities 105, ,587 (41,642) Trade payables 160, ,912 2,890 Other payables 67,415 49,625 17,790 Provisions 24,843 44,939 (20,096) Derivative financial instruments 21,176 2,329 18,847 Employee benefit obligations 98,502 98,712 (210) Unearned revenues 235, ,204 4,794 Total current liabilities 714, ,308 (17,627) Non-current liabilities Loans from financial institutions 555, ,084 (5,314) Employee benefit obligations 57,789 65,590 (7,801) Loan from others 1,869-1,869 Derivative financial instruments - 19,739 (19,739) Other payables 7,673 10,700 (3,027) Provisions 5,348-5,348 Deferred taxes 28,984 32,792 (3,808) Unearned revenues 51,946 51, Total non-current liabilities 709, ,372 (31,993) Shareholders equity 161, ,524 (85,748) Total liabilities and equity 1,585,836 1,721,204 (135,368) b-8

230 The main changes in asset, liability and equity items as of December 31, 2011 compared to December 31, 2010 are: Current assets: The Company s current assets decreased by $94.2 million in 2011 relative to December 31, The balance of cash and cash equivalents and short-term deposits decreased by $81.0 million, mainly as a result of net investments in fixed and other assets to the amount of $96.1 million and from the redemption of net short-term loans and credit to the amount of $74.1 million after offsetting positive cash flows from current activity to the amount of $61.9 million. The balance of designated cash is the CEO s fund intended to encourage excellence among Company workers. The fund was first established in the reported year. The increase in trade receivables, derives mainly from an increase in passenger sales. The increase in the balance of payables derives mainly from a debit balance of aircraft leasing companies for engine repairs, as well as due to the State's debt as a result of the December 2011 government resolution to increase its participation in security expenses. (See also Note 9 to the Financial Statements in this regard). The following changes occurred to the Company's derivative financial instruments (presented in the Financial Statements under current assets and current liabilities): The fair value of jet fuel, interest and foreign currency as of December was a negative sum of $19.1 million, a $43.5 million decrease compared to the fair value at the end of 2010, mainly as a result of transactions reaching redemption and from additional transactions occurring in the reported period. The decrease in the fair value of derivative financial instruments was expressed in a $35.6 million decrease (net after tax) in the capital reserve in respect of cash flow hedges recognized in equity, in an $11.5 million decrease in deferred tax liability, in a $16.8 million decrease in fuel and financing expenses in the Statement of Operations and in an $13.2 million net increase in cash balances as a result of the realization of jet fuel hedging transactions and from the purchase of jet fuel hedging options. For further details regarding hedging transactions conducted by the Company see b.1.(3), b.1.(4) and b.1.(5) below. The increase in inventories largely derived from the increase in jet fuel reserves. Non-current assets: The Company s non-current assets decreased by $41.2 million relative to December 31, The increased investment in affiliates derived mainly from the receipt of an additional portion of 3.75% from Maman s stock capital. Due to the first-time achievement of material influence in Maman, the investment listed in the December 31 Financial Statements under investment in other companies was classified in this report under investment in affiliated companies. For further details, see Note 39a to the Financial Statements. Fixed assets decreased by $39.3 million. The Group s investments in fixed assets amounted to $107.4 million in 2011 and included, among other things, some $20.2 million for the purchase of aircraft, 9.0 million for the purchase of a spare engine for the 737 fleet and a total of $18.2 million as b-9

231 advance payment for the purchase of aircraft (see Note 16.e.1.c. to the Financial Statements). In addition, the Company purchased spare parts, accessories and flight equipment to the amount of $45 million in the reported year. Depreciation expenses, disqualifications and spare part and accessory consumption in the reported period amounted to a total of $139.0 million. A net reduction was also listed in fixed assets to the amount of 7.7 million due to the sale of assets. Current liabilities: The Company s total current liabilities decreased by $17.6 million relative to December 31, Short-term credit balances and current maturities decreased mainly as a result of a decrease in current maturities of bank loans, mainly due to the restructuring of balloon loans (see Note 22j to the Financial Statements), offset by an increase in short-term bank credit. The balance of trade payables increased, mainly due to engine renovations. The balance of payables and credit balances increased mainly as a result of advance payments received on account of future flights, as well as from an increase in deposits received due to passenger groups. The balance of provisions decreased mainly due to a settlement agreement with the Income Tax Authorities pertaining to the income tax deduction assessments (see Note 28f. to the Financial Statements). On the other hand, an increase was listed in the provision for a civil suit in the U.S. on the subject of cargo (see Note 27.d.b to the Financial Statements). The increase in the balance of unearned revenue derived from an increase in deferred income as a result of the accumulation of membership points in the frequent flyer club. Non-current liabilities: The Company s non-current liabilities decreased by $32.0 million relative to December 31, A decrease occurred in the balance of loans from banking institutions, mainly as a result of the repayment of loans, offset as a result of the loan restructuring mentioned above. The employee benefit obligations item saw a decrease mainly as a result of current payments or an early retirement plan as well as as a result of the devaluation of the NIS relative to the USD. The accounts payable item decreased mainly as a result of payments made for a cargo claim in the restraint of business field. The provisions item increased as a result of a settlement for a civil suit in the United States on the matter or cargo (see Note 27.d.b to the Financial Statements). The decrease in the deferred taxes item derives mainly from deferred tax revenues listed as a result of the yearly losses and a decrease in the fair value of hedging agreements recognized as defensive agreements. Conversely, an increase occurred in tax expenses as a result of the increase in the corporate tax rate following the Trachtenberg Law (see note 28e to the Financial Statements). b-10

232 Equity The Group s equity decreased by $85.7 million relative to December 31, The decrease in shareholders' equity is primarily due to a loss in the reported period and a decrease in capital reserves due to cash flow hedging, as a result of a decrease in the fair value of hedging agreements recognized as defensive agreements. As of December , the Company has a working capital deficit of $392.5 million, compared to a deficit of $316.0 million on December The Company s current ratio as of December amounted to 41.5% compared to 56.9% as of December Among the main reasons for the increase in the working capital deficit, one might note the decrease in cash and short-term deposits as well as the decrease in the fair value of derivative financial instruments and the increase in the payables item. The increase in the working capital deficit was mainly offset as a result of the increase in the customers and inventory items and the decrease in the current maturity items of loans from banking institutions and provisions. The working capital deficit consists of three material elements included under the Company s current liabilities items and characterized by current business cycles: unearned revenues from the sale of flight tickets including port taxes, unearned revenues from frequent flyer clubs, and employee vacation obligations. Therefore, a material part of the capital deficit is not cash-flow based in the short term. 2. Analysis of Business Activity Results a.2.1 Market Data Passenger and cargo January - December January - December change traffic at BGA in thousands in thousands in thousands % Incoming tourists * 2,506 2, % Departing Israelis * 3,857 3, % Cargo import - tons ** % Cargo export - tons ** (8.7) (5%) * Source: Central Bureau of Statistics. ** Does not include cargo in transit. b-11

233 Incoming Tourist & Departing Israeli Traffic, by Year (In Thousands): 3,433 3,552 3,397 3,588 3,857 4,000 3, ,000 1, Incoming tourists Departing Israelis Imports & Exports of Cargo by Air to and from Israel, by Year (in Thousands of Tons): Export Import b-12

234 a.2.2 Company Operating Data* January - December January - December change Passenger leg (scheduled and chartered) - in thousands 4,199 4,184 0% RPK (scheduled) - in millions 17,245 17,400 (1%) ASK (scheduled) - in millions 21,477 21,336 1% Load factor (scheduled) 80.3% 81.6% (2%) The Company's market share (scheduled and chartered) 33.9% 37.1% (9%) Flown cargo, in thousand tons (0%) RTK - in millions % Weighted flying hours (including leased equipment) - in thousands (*) (0%) Average man-years (El AL only): Permanent 3,855 3,820 1% Temporary 2,201 2,091 5% Total 6,056 5,911 2% Aircraft in operation - end of period - number of units (2) Average age of owned fleet at the end of the period - in years (0.4) * Operating data refers both to international and domestic activity. ** Total employees (permanent and temporary) in job slots - as of Dec. 31, ,791 and as of Dec. 31, 2010: 5,964. Glossary: Passenger leg Flight coupon in one direction. RPK Revenue Passenger Kilometer number of paying passengers multiplied by distance flown. ASK Available Seat Kilometer number of seats offered for sale multiplied by distance flown. RTK Revenue Ton Kilometer weight of paid flown cargo in tons multiplied by distance flown. Passenger Load Factor (occupancy) flown passenger-km is expressed as % of available seat-km. *** Weighted flight hours in Boeing 767/757 terms. Weighted value of the planes: Boeing 767/757 = 1.0; Boeing 747 = 2.0; Boeing 777 = 1.6; Boeing 737 = 0.6. These weighted values were determined based on an estimate of the total expenses of each type of aircraft, and are used consistently to calculate weighted flight hours as an indicator of the volume of aviation activity. b-13

235 Operating Data, by Year (in Millions): 25,000 21,336 21,477 20,104 20,074 20,261 20,000 17,068 16,529 17,400 17,245 16,410 15, % 82.3% 10, % 81.6% 80.3% 100% 90% 80% 5, RPK ASK L. F. 70% a.3 Statement of Operations Data For 2011 (Consolidated Financial Statements): January - December 2011 in thousands US dollars % of operating revenues January - December 2010 in thousands US dollars % of operating revenues change in thousands US dollars % Operating revenues 2,043, % 1,972, % 70,935 4% Operating expenses (1,764,879) (86.4%) (1,584,557) (80.3%) (180,322) 11% Gross profit 278, % 387, % (109,387) (28%) Selling expenses (215,926) (10.6%) (214,755) (10.9%) (1,171) 1% General and administrative expenses (97,392) (4.8%) (96,153) (4.9%) (1,239) 1% Other operating revenues (expenses), net (8,293) (0.4%) 11, % (19,562) (174%) Operating profit (loss) before financing (43,316) (2.1%) 88, % (131,359) Financing expenses (20,197) (1.0%) (35,911) (1.8%) 15,714 (44%) Financing income 20, % 10, % 9,625 89% Company's share in earnings of affiliates, net 1, % % 1, % Profit (loss) before income taxes (41,598) (2.0%) 63, % (104,624) Tax expenses (7,797) (0.4%) (5,971) (0.3%) (1,826) 31% Profit (loss) for the period (49,395) (2.4%) 57, % (106,450) The key factors that influenced the business results in the year ending December 31, 2011 compared with last year: Operating revenues operating revenues increased in all components relative to Passenger revenues increased mainly as a result of the increase in yield per passenger kilometer and from changes in exchange rates. Conversely, these revenues decreased as a result of the reduction in the amount of passenger kilometers flown by the Company. Cargo shipping revenues increased, as a result of the increase in cargo traffic, the increase in yield per ton kilometer and changes in exchange rates. An increase was also listed in other Company revenues such as the sale of tax-exempt items, providing maintenance services and so on. Operating expenses 2011 saw an 11.4% increase in the Company's operating expenses compared to 2010, mainly as a result of the increase in jet fuel and salary expenses as detailed below, as well as from the revaluation of the average rate of the NIS and the EUR relative to the USD. The rate of operating expenses from the turnover increased from 80.3% in 2010 to 86.4% in Note that over the course of 2011 the b-14

236 Company listed a decrease in expenses in the airport fees and services item to the amount of $3.4 million for the receipt, free of charge, of an additional 3.75% portion of Maman s stock capital, compared to a $15.4 million reduction in expenses listed for this company in (See Note 39a to the Financial Statements). Operating salary expenses increased over the course of 2011 relative to 2010, with most of the increase deriving from the implementation of the salary agreement starting January 2011 and from the revaluation of the average rate of the NIS relative to the USD. Regarding the impact of the changes in the NIS/USD rate of exchange on the Company s employee benefit obligations, see a.4 below. The Company's jet fuel expenses increased mainly as a result of the increase in jet fuel prices in 2011 relative to the The jet fuel market prices (the markets basket the weighted price in accordance with markets in which the Company purchases jet fuel) increased by an average of 41% relative to Hedging actions carried out by the Company moderated this increase and in total, the Company's effective jet fuel price increased by 18.1% relative to In total the Company listed added expenses of $102.1 million in 2011 for the jet fuel, after offsetting $101.2 million relative to 2010 for the hedging activities. The rate of jet fuel expenses from turnover increased from 29.6% in 2010 to 33.6% in For further information on jet fuel price hedging see b.1.(3) below. Gross profits amounted to $278.3 million in 2011, 13.6% of turnover compared to $387.7 million, 19.7% of turnover in Breakdown of Operating Expenses in 2011: Jet fuel 39% Meals 3% Depreciation 6% lease expenses 4% security expenses 2% Air crew expenses 3% Wages and social benefits 18% Air navigation & communication 6% Airport fees & service 10% Other expenses 3% Maintenance of aircraft 6% Sales expenses sales expenses underwent a non-material increase (0.5%) compared to 2010, mainly as a result of the increase in salary expenses offset by a decrease in advertising expenses. The total rate of sales expenses from turnover amounted to 10.6% compared to 10.9% of turnover in General and administrative expenses general and administrative expenses increased by 1.3% relative to 2010, but at the same time their share of the Company's turnover reached 4.8% compared to 4.9% in Other income and expenses over the course of 2011 the Company listed other net expenses to the amount of $8.3 million, mainly from the increase of the provision for the civil cargo suit in the U.S. (see also Note 27.d.b to the Financial Statements) as well as from a provision for a law suit on the matter of early retirement pension payments. On the other hand, income was listed as a result of the revision of a provision b-15

237 following a settlement agreement with the Social Security Institute regarding the issue of free and discounted flight tickets to Company employees (see Note 28f to the Financial Statements) and a capital gain was listed from the sale and lease back of a spare engine. The Company listed other net revenues of $11.3 million in 2010, mainly due to the revision to the provision due to the settlement with Income Tax on the matter of the flight tickets in question. Operational profit for 2011 amounted to $43.3 million, 2.1% of turnover, compared to an operational profit of $88.0 million in 2010, 4.5% of turnover. Financing - financing expenses in 2011 were reduced relative to 2010, mainly as a result in the increase in fair value of interest hedging agreements. The Company's financing income increased mainly from an increase in receipts due to NIS/USD hedging agreements and from exchange rate differences. In total the group listed net financing income of $0.3 million in 2011 compared to net financing expenses of $25.1 million in Pre-tax loss for 2011 amounted to $41.6 million compared to a pre-tax income of $63.0 million in Income tax - in 2011 the Group listed a tax expense of $7.8 million, mainly as a result of changes in corporate tax rates as a result of the revision of the Trachtenberg Law from 18% to 25%. (See Note 28e to the Financial Statements). Loss for the year amounted to $49.4 million, 2.4% of turnover, compared to a net profit of $57.1 million, 2.9% of turnover in The key factors that influenced business results in the three month period ending December 31, 2011 compared to the same period last year are: October - December 2011 in thousands US dollars % of operating revenues October - December 2010 in thousands US dollars % of operating revenues change in thousands US dollars % Operating revenues 485, % 481, % 4,334 1% Operating expenses (402,384) (82.9%) (393,847) (81.9%) (8,537) 2% Gross profit 83, % 87, % (4,203) (5%) Selling expenses (55,263) (11.4%) (54,268) (11.3%) (995) 2% General and administrative expenses (24,457) (5.0%) (26,343) (5.5%) 1,886 (7%) Other operating revenues (expenses), net 4, % 15, % (10,621) (69%) Operating profit before financing 8, % 22, % (13,933) (63%) Financing expenses (5,635) (1.2%) (8,072) (1.7%) 2,437 (30%) Financing income 1, % 3, % (2,523) (64%) The Company's share of the profits of subsidiaries, net of tax % % % Profit before income taxes 4, % 18, % (13,822) (77%) Tax expenses (12,008) (2.5%) (1,771) (0.4%) (10,237) 578% Profit (loss) for the period (7,776) (1.6%) 16, % (24,059) Operating revenues operating revenues in Q increased by 0.9% compared to the same quarter last year and amounted to a total of $485.4 million. Net passenger revenues listed a 1.5% increase while cargo revenues decreased, mainly as a result of the transition to the operation of a single aircraft starting June Operating expenses increased by 2.2% in the reported quarter compared to the same quarter last year, mainly as a result of the increase in jet fuel expenses. Salary costs decreased relative to the same quarter last year. Note that in Q the Company listed a decrease in expenses in the airport fees and services item to the amount of $9.0 million for the receipt, free of charge, of Maman stock and options, compared to a $0.8 b-16

238 million reduction in expenses for this transaction in the reported quarter (see Note 39a to the Financial Statements ). The market price of jet fuel (market basket) increased by 27.8% compared to the same quarter last year. The Company's effective price after hedging activity increased by 19.6%. Jet fuel expenses in the reported quarter increased by 7.6% compared to Q and their share of turnover increased from 29.0% to 30.9%. Gross profits in the reported quarter amounted to $83.0 million, 17.1% of turnover compared to a gross profit of $87.2 million, 18.1% of turnover, in the same quarter last year. Sales expenses listed an increase of 1.8% compared to the same quarter last year, but their share of turnover remained essentially unchanged. General and administrative expenses dropped by 7.2%, mainly as a result of decreases in salary expenses. Their share of turnover decreased from 5.5% in to Q to 5.0% in the reported quarter. Other income, net - amounted to $4.9 million in Q4 2011, as a result of the revision to the provision following a settlement agreement with the Social Security Institute regarding the issue of free and discounted flight tickets to Company employees (see Note 28f to the Financial Statements) as well as the listing of a capital gain from the sale of fixed assets. On the other hand, this item listed an expense due to a provision for a claim in the matter of pension payments for early retirement. The Company listed other net incomes of $15.5 million in the fourth quarter of 2010, mainly due to the revision to the income tax deduction provision. The Company listed an operational profit before financing in Q to the amount of $8.2 million, 1.7% of turnover compared to a $22.1 million operational profit, 4.6% of turnover in the same quarter last year. Financing expenses no material changes occurred in the Company s net financing expenses in the reported quarter. Interest expenses due to loans increased mainly as a result of the increase in Libor interest rates, while on the other hand the Company received income from exchange rate differences compared to expenses from exchange rate differences in the same quarter last year. Tax Expenses amounted to $12.0 million during the quarter, compared to $1.8 million in the corresponding quarter last year, mainly as a result of changes in corporate tax rates as a result of the revision of the Trachtenberg Law from 18% to 25%. (See Note 28e to the Financial Statements). In total, in the fourth quarter of 2011 the Company listed a loss of $7.8 million compared to a profit of $16.3 million in the same quarter. a.4 Effect of Changes in the Exchange Rate on the Company's Accrued Severance Pay Liability In 2011 the exchange rate of the shekel depreciated against the dollar by 7.7%, vs. an appreciation in the exchange rate of the shekel against the dollar of 6.0% in In the three month period ending December the exchange rate of the shekel decreased against the dollar by 2.9%, vs. an increase in the exchange rate of the shekel against the dollar of 3.2% in the same quarter last year. b-17

239 US Dollar - NIS Exchange Rate: The Company has a net obligation to its employees for severance pay, retirement plans, sick pay, and vacation pay as of December to the amount of $71 million. Since most of these obligations are denominated in shekels, whereas the functional currency of the Company is the dollar, these obligations must be translated into dollars, which causes differences deriving from changes in the exchange rate of the shekel against the dollar. Exchange rate changes are not one-directional, and cause the listing of revenues or expenses in the Company's Financial Statements. These revenues or expenses do not impact cash flow or operating costs of the Company in the short run. In order to enable a comparison of the Company's business results for the long run, these revenues or expenses should be neutralized. Expenses for this element to the amount of $4.8 million were listed in 2011, compared to 2010, in which expenses for this element were listed to the amount of $4.5 million. The quarter ending December saw a decrease in expenses for this component to the amount of $1.7 million compared with the same quarter last year, in which the expenses for this component amounted to $2.0 million. Presented below are details of the business results, after neutralizing the effect of the exchange rate on the accrued severance pay element, as described above: b-18

240 Before After neutralizing the exchange-rate effect For year ended on the accrued severance pay 31 December: (in thousands US dollars) Operating expenses 1,764,879 1,584,557 1,768,636 1,581,678 Gross profit 278, , , ,561 Gross profit rate 13.6% 19.7% 13.4% 19.8% Selling, general and administrative expenses 313, , , ,518 Other operating expenses, net (8,293) 11,269 (8,833) 12,499 Operating profit (loss) before financing (43,316) 88,043 (48,118) 92,542 Operating profit (loss) rate before financing (2.1%) 4.5% (2.4%) 4.7% Profit (loss) for the year (49,395) 57,055 (54,197) 61,554 Profit (loss) rate for the period (2.4%) 2.9% (2.7%) 3.1% b-19

241 a.5 Segment Reporting Presented below is operational segment data on a consolidated basis: a. General: The Group has applied IFRS 8, "Operating Segments" (hereinafter "IFRS 8") starting January According to IFRS 8, operational segments are identified based on internal reports on the Group's components, which are reviewed on a regular basis by the Group's chief operating decision maker for the purpose of allocating resources and assessing the performance of the operational segments. The report array conveyed to the Group's chief operating decision maker, for the purpose of allocating resources and assessing the performance of the operational segments, is based on the distinction between revenues from passenger aircraft, cargo aircraft, charter flights and other revenues. In light of the above, the following are the Company's reported operating segments in accordance with IFRS 8: Segment A passenger aircraft activity. Segment B cargo aircraft activity. Starting June 2011 the Company employs a single leased cargo aircraft. In determining the results of the reported operating segments, a number of components not part of the direct costs involved in operating the flights, such as depreciation as a result of aviation equipment, fixed maintenance costs and fixed costs at overseas offices are also included. b. Analysis of revenues and results by operating segments: passenger aircraft For year ended: cargo aircraft others Adjustment Total consolidated in thousands US dollars operating revenues revenue from external customers 1,830,080 99,442 45,359 68,293 2,043,174 inter-segment revenues ,919 (65,919) - Total segment revenues 1,830,080 99, ,278 2,374 2,043,174 segment results 159,633 (678) 31, ,989 Unassigned expenses (233,305) Operating loss before financing (43,316) Financing expenses (20,197) Financing income 20,474 The Company's share of the profits of subsidiaries, net of tax 1,441 Loss before income taxes (41,598) Tax expenses (7,797) Loss for the period (49,395) b-20

242 passenger aircraft For year ended: cargo aircraft others Adjustment Total consolidated in thousands US dollars operating revenues revenue from external customers 1,765,282 87,508 38,790 80,659 1,972,239 inter-segment revenues ,573 (78,573) - Total segment revenues 1,765,282 87, ,363 2,086 1,972,239 segment results 251,825 (264) 28, ,134 Unassigned expenses (192,091) Operating profit before financing 88,043 Financing expenses (35,911) Financing income 10,849 The Company's share of the profits of subsidiaries, net of tax 45 Loss before income taxes 63,026 Tax expenses (5,971) Profit for the period 57, passenger aircraft For year ended: cargo aircraft others Adjustment Total consolidated in thousands US dollars operating revenues revenue from external customers 1,489,496 58,317 37,874 70,146 1,655,833 inter-segment revenues ,051 (68,051) - Total segment revenues 1,489,496 58, ,925 2,095 1,655,833 segment results 112,453 (27,457) 27, ,453 Unassigned expenses (187,421) Operating loss before financing (74,968) Financing expenses (30,297) Financing income 3,999 The Company's share of the profits of subsidiaries, net of tax 442 Loss before income taxes (100,824) Tax benefit 24,524 Loss for the year (76,300) The worsening in 2011 in the Company's operating results relative to 2010 as detailed in a.3 above, was expressed in the results of the Company s reporting operating segments saw a 3.7% increase in passenger aircraft sector revenues relative to 2010, and a 13.6% increase in the cargo aircraft sector. The increase in revenues derived mainly from an increase in yield per passenger kilometer and in yield per ton kilometer, as well as from changes in exchange rates in the reported year. On the other hand, the increase in operating costs and primarily in the price of jet fuel, whose market price increased by 41% and which added $100 million (after hedging actions) to the expenses of these sectors, decreased the sectors profits. The contribution from the passenger aircraft sector decreased from a rate of 14.3% of the sector s revenues in 2010 to 8.7% in The loss from the cargo aircraft sector increased from 0.3% in 2010 to 0.7% in the reported year. This more significant increase in cargo aircraft segment revenues led to the fact that the contribution from this segment underwent no material changes. b-21

243 Revenues not attributed to the passenger and cargo aircraft segment dropped in 2011 relative to 2010,, mainly as a result of the decrease in charter flight income (presented to the organization's chief operational decision maker as separate activity), however, the contribution from them increased from 24.3% in 2010 to 27.9% in In total, the contribution from the Company's reported segments decreased from $280.1 million in 2010 to $190.0 million this year. Expenses not attributed directly to operating segments increased in 2011, mainly as a result of one-time income as a result of an arrangement with Income Tax listed in 2010, as noted in a.3 (Other Income and Expenses) above, as well as $14.8 million provision for legal expenses in the reported year that are not attributed to operating segments. In total the Company listed an operational loss of $43.3 million in 2011 compared to an operational profit of $88.0 million in c. Analysis of revenues by flight destination: America Europe Central Asia Rest of Total & Far East the world in thousands US dollars Year 2011 Operating revenues 694, , ,415 60,298 1,992,447 Non-segment revenues 50,727 Total consolidated revenues 2,043,174 Year 2010 Operating revenues 673, , ,468 50,268 1,928,348 Non-segment revenues 43,891 Total consolidated revenues 1,972,239 Year 2009 Operating revenues 547, , ,468 38,334 1,613,768 Non-segment revenues 42,065 Total consolidated revenues 1,655, saw an increased in revenues from all destinations compared to The Europe destination, which in 2011 constituted 47.0% of all revenues attributed to geographical destinations, saw a 2.1% increase in revenues relative to The America destination, which in 2011 constituted 34.9% of total revenues, saw a 3.2% increase in revenues relative to 2010; flights to Central and East Asia, which in 2011 constituted 15.5% of revenues attributed to segments, increased by 4.7% relative to 2010 and on the remaining routes ( the rest of the world ), which constituted 2.6% of revenues in the reported year, a 20.0% increase was listed relative to As noted above, most of the increase in revenues derived mainly from the increase in cargo amounts and from the increase in yields per passenger kilometer and cargo ton kilometer. b-22

244 a.6 Seasonal Factors The Group's activity is seasonal and focuses on peak periods. Heavy traffic of Israeli residents traveling abroad occurs primarily during the summer months and during holidays, while heavy incoming tourist traffic occurs during the summer months and during Jewish or Christian holidays or vacation times in their countries of origin. The peak of the Group's activity is in the third quarter, when passenger traffic in 2011, 2010, and 2009 constituted 30%, 28%, and 30% respectively of total yearly revenues. Revenue breakdown by quarters and percentage of turnover in 2011 (in millions of dollars): % 26.0% 20.8% 23.8% Q1-11 Q2-011 Q3-11 Q4-11 revenues % of revenues 50% 40% 30% 20% 10% a.7 Liquidity and Financing Sources January - December January - December change in thousands US dollars in thousands US dollars in thousands US dollars Cash flows from operating activities 61, ,291 (141,411) Cash flows used for investing activities (40,444) (95,232) 54,788 Cash flows used for financing activities (47,082) (103,744) 56,662 Net increase in cash and cash equivalents (25,646) 4,315 (29,961) Operating Activities The decrease in cash flow from current activity in 2011 compared to the previous year derives mainly from the pre-tax loss in the reported period compared to pre-tax profit in 2010, as well as from changes in asset and liability items. Investment Activities In 2011 the Company used $107.4 million for investment in fixed assets and $1.7 million for investment in intangible assets. On the other hand the Company received $55.4 million from the realization of short-term deposits and $13.0 million from the realization of fixed assets. In total, the Company used $40.4 million for investment activity in In 2010 the Company used $46.5 million for investment in fixed assets and general engine repairs, and $55.6 million for investments in short-term deposits and $3.1 million for investments in intangible assets. On the b-23

245 other hand, the Company received $7.0 million from the realization of restricted deposits and $2.8 million from the realization of fixed assets. In total, the Company used $95.2 million for investment activity in Financing Activities In 2011 the Company repaid loans to the amount of $87.3 million. Conversely, in 2011 the Company received long-term loans to the amount of $33.2 million and net short-term bank credit to the amount of $7.0 million. In total, $47.1 million were used for financing activity in In 2010, the Company repaid loans to the amount of $79.4 million, as well as repaid short-term credit from banking institutions to the amount of $26.9 million. Conversely, in 2010 the Company received long-term loans to the amount of $2.6 million. In total, $103.7 million were used for financing activity in The Group s total cash and cash equivalents and short-term investments as of December 31, 2011 totaled $93.5 million, compared to $174.6 million as of December The average scope of Company bank loans over the course of 2011 amounted to $681 million ($752 million in 2010). The average scope of credit from supplier received by the Company during 2011 was $171 million ($148 million in 2010). The average scope of credit given by the Company to its customers during 2011 was $162 million ($153 million in 2010). The Company's material loans and credit frameworks: Following Legal Position of the Securities Authority dated October , regarding a reportable credit event, the Company has established that the threshold of materiality for the purpose of detailing material loans is 5% of the Company s balance sheet total. Regarding a table detailing the material loans based on the criteria established above, see Appendix B to the Board of Directors Report below. Note that the Company has additional loans as of December that are not material as defined above, as detailed in this report. In the matter of additional details pertaining to the Company s loans and compliance with financial restrictions and covenants, see Note 22h to the December 31 Financial Statements. b-24

246 b. Market risk exposure and management: b.1 Qualitative Reporting on Exposure to and Management of Market Risks b.1. (1) General Description of Market risks to which the Company is Exposed Presented below is a summary of the market risks to which the Company is exposed: Exposure to changes in prices of jet fuel changes in prices of jet fuel, which constitutes a significant element of the Company's operating expenses, have a material effect on the Company's profitability. In the Company's estimation, at its current level of activity, every change of $0.01 US in the price of a gallon of jet fuel during an entire year impacts the Company's fuel expenses by $2.3 million. The Company has applied hedging measures to reduce the exposure, as detailed in b.1.(3) below. In the event of a sharp and continuous drop in jet fuel prices, the Company may be required to provide collateral to jet fuel hedgers. Exposure to changes in interest rates most of the Company's long-term loans are at variable interest. Therefore, an increase in the Libor rate could impact the Company's profitability. At the present level of activity, every 1% increase in the Libor rate for a full year increases the Company's financing expenses by $5.7 million. The Company takes hedging measures to reduce the exposure, as detailed in b.1.(4) below. Currency exposure Most of the Company's revenues and expenses are in foreign currency (mainly the U.S. dollar), except for several shekel expenses, mainly salary expenses and payments to local suppliers in Israel. Accordingly, a change in the shekel/dollar exchange rate influences the Company's shekel expenses in dollar terms. In the Company's estimation, at present levels of activity, each 1% in appreciation of the exchange rate of the shekel relative to the dollar for an entire year increases the Company's annual expenses by $4.2 million. Likewise, a surplus of payments over receipts exists in euros, but at insignificant rates. The Company has adopted hedging measures to reduce the exposure, as provided in Section b.1.(5) below. Exposure in long-term loan frameworks according to the provisions of the loan agreements, the Company must maintain a minimal collateral ratio between the market value of the planes and the balance of the loans guaranteed by these aircraft. Likewise, the Company is required to comply with certain covenants, which, if not complied with, can be used to compel the Company to repay the loans immediately. The Company's exposure to market risks in this area derives from the changes that occur in the market value of planes around the world. For further details, see Note 16j and Note 22h to the December Financial Statements. b-25

247 b.1. (2) El Al Market Risk Management Policies, Officials Responsible for their Management and Means of Controlling and Executing Policy The Company s Board of Directors is responsible for approving a market risk management policy and supervises the implementation of the policy through Market Risk Management Committee headed by Mr. Nadav Palti. The Committee is responsible for defining and updating the policy, supervising the policy s implementation and issuing instructions/approvals for Company management to deviate from implementing the policy in accordance with various developments. The Company CEO is responsible for making decisions regarding the implementation of hedging agreements in practice in accordance with the Committee's policy and guidelines. The Company moderates the influence of these risks through the use of derivative financial instruments in order to hedge its exposure to risk. Use of the derivative financial instruments is in accordance with Group policy approved by its Board of Directors, which sets written principles regarding: currency risk management, interest rate risk, jet fuel price risk, the use of derivative financial instruments and nonderivative financial instruments and the investment of surplus liquidity. Compliance with policy and with permitted exposure levels is supervised by the Risk Management Committee on a regular and continuous basis. The Market Risk Management Committee allows Company Management from time to time to deviate from said policy for limited amounts of time, in accordance with market developments. Starting from the second half of 2010 the Company expanded and deepened its capabilities in the field of financial exposure management, while implementing advanced IT systems granting it better capabilities for measuring, analyzing and controlling changes in exposure and in its hedging portfolio. The Company's policy as regards jet fuel hedging in 2010 was: hedging jet fuel quantities for up to 24 months forward, so that for every period, a minimum and maximum rate was set for hedging out of total expected consumption, in a gradual and decreasing manner. Therefore, the maximum hedging rate at the beginning of the period was 80% and the minimum hedging rate at the end of the period was 20%. Starting 2011, the jet fuel hedging policy was altered as follows: hedging jet fuel quantities for up to 24 months forward, so that for every period, a minimum and maximum hedging rate would be set out of total expected consumption, in a gradual and decreasing manner. Hedging agreements shall be carried out on a monthly basis. The maximum hedging rate at the beginning of the period is 75% and the minimum hedging rate for the 12th month is 5%. Instruments and hedging levels shall be selected so that the Company limits its maximum exposure to cash securities. Over the course of the reported year the Company adapted the implementation of the jet fuel hedging policy to rapidly-fluctuating market conditions, so that from time to time a deviation is created from the policy s base lines, all of which involves regular reports to the Market Risk Management Committee and to the Board of Directors. The Company's policy with respect to interest hedging is to hedge half of its credit portfolio for a period of up to 5 years. As of this report, the Company is hedged according to its policy. The Company's policy with respect to NIS/USD exchange rates in 2010 was to hedge up to half of its shekel exposure for up to one year forward. Starting 2011 the NIS/USD exchange rate hedging policy was changed b-26

248 to hedge up to 75% of its cash flow exposure for a 1-year outlook as decided by management. As of this report, the Company is hedged according to its policy. For details on the policy adopted, see Sections b.1.(3), b.1.(4) and b.1.(5) below. For details regarding the influence of the changes in the economic environment subsequent to the balance sheet date, see Section e2 below. b1. (3)Hedging Jet Fuel Prices The Company executes financial transactions to hedge against changes in jet fuel prices, in accordance with its policy as described in Section b.1.(2) above. As of December 31, 2011, the Company had several agreements designed for hedging jet fuel prices, at a scope estimated at 13% of expected consumption for Some of these transactions are recognized as hedging agreements for accounting purposes and some are not. The net fair value of all jet fuel hedging instruments as of December 31, 2011 is a sum of $2.1 million, presented in the Financial Statements as part of current and non-current assets under "Derivative Financial Instruments". The Company listed a net income of $52.1 million for these hedging agreements over the course of For further details, see Note 31g to the Financial Statements. For details regarding changes occurring to jet fuel prices and additional hedging agreements carried out by the Company subsequent to the balance sheet date, see Section e.2.c. b.1. (4) Hedging Interest on Loans The Company executes hedges of the exposure in its long-term credit portfolio, due to changes in interest rates, in accordance with its policy as laid out in Section b.1.(2) above. As of the end of 2011 these transactions are not recognized as hedging agreements for accounting purposes. The fair value of these instruments as of December 31, 2011 is a negative sum of $9.2 million, which is presented in the Financial Statements in the framework of current liabilities under "Derivative Financial Instruments". After carrying out the hedging in question, as of December 31, 2011, 38.6% of the balance of variableinterest loans received by the Company are hedged for a 10-months horizon, 47.3% of the balance of the loans received by the Company are at variable and non-hedged interest rates and 14.1% of the balance of the loans are at fixed interest for a period of 10 years, so that as of the report date 52.7% of the Company's loans are at fixed interest. The Company listed net expenses of $1.4 million for hedging agreements over the course of b-27

249 For additional information on these transactions, see Note 31f to the Financial Statements as of December 31, For information on changes in interest rates occurring subsequent to the balance sheet date, see e.2.(d) below. b.1. (5) Exchange Rate Hedges The Company executes hedges to protect its currency exposure due to changes in the exchange rate of the NIS versus the USD, in accordance with its policy as laid out in Section b.1.(2) above. As of December 31, 2011 the Company has entered into several financial transactions, designed to protect the Company from drops in NIS/USD exchange rates until October These transactions are recognized as hedging agreements for accounting purposes. The net fair value of these instruments as of December 31, 2011 is a negative sum of $12.0 million, presented in the Financial Statements in the framework of current liabilities, under "Derivative Financial Instruments". Over the course of 2011 the Company listed income for exchange rate hedging agreements to the amount of $14.3 million. For information on changes occurring in the NIS-USD exchange rate and additional hedging agreements carried out by the Company subsequent to the balance sheet date, see e.2.(e) below. b.1. (6) Sensitivity Analysis Reporting The following is an analysis of the sensitivity of the fair value of the financial instruments sensitive to possible changes in the risk factors to which they are exposed. The sensitivity analyses were performed relative to the fair value of the financial instruments as of December 31, The following is a description of the models for examining the fair value sensitivity of the various financial instruments: 1. Interest hedge Interest hedges are executed by means of financial instruments opposite Israeli banks. The underlying asset for these transactions is the Libor (London Inter Bank Offered Rate) rate for various periods (3 months, 6 months, one year), according to which the interest return on the Company's variableinterest loans (plus a margin) is set. Interest hedges are executed "back to back", in order not to create additional exposure of timing differences between the expiration date of the transaction and actual payment against the existing loans, so that the settlement dates match the repayment dates of the loans. On the loan repayment dates, the settlement amount b-28

250 is calculated for the next period, according to the market interest that prevailed on the two prior business days, and based on the structure of the transactions as determined in advance. Interest hedge agreements in effect as of the end of 2011 include interest rate fixing transactions (IRS). These transactions are not recognized as hedging agreements for accounting purposes. The fair value of interest hedges is calculated according to the projected Libor rate. In interest hedges in which the interest rate is fixed, the fair value is determined based on the difference between the projected interest and the interest published periodically by the world's leading banks, for the interest stated in the transaction, multiplied by the size of the hedge in each period. In hedge transactions that include options, the fair value is determined based on mathematical formulas for pricing options in recognized models. 2. Exchange rate hedging exchange rate hedges carried out by the Company are executed using financial instruments in conjunction with banks in Israel and abroad. The underlying assets for these transactions are the representative rate of exchange for dollar/shekel currencies set by the Bank of Israel. Dollar/shekel exchange rate hedges are executed in order to hedge the cash flow exposure to the NIS as detailed in b.1.(5) above. The yearly exposure rate is 1,600 million NIS. The transactions for hedging this exposure according to the Company's policy are monthly, corresponding with the conversion dates of dollars to shekels for the purpose of paying salaries and suppliers in Israel. The Company s transactions as of the end of 2011 are forward transactions according to which the Company fixes the exchange rate to the date on which it is required to perform a currency conversion. These transactions are recognized as hedging agreements for accounting purposes. The fair value of these transactions is calculated based on mathematical formulas for pricing derivatives in recognized models. 3. Jet fuel hedges Jet fuel constitutes the most material component of Company's expenses. Jet fuel hedge transactions are executed by the Company using financial instruments in conjunction with the leading Israeli and global financial institutions and banks engaged in this market. The underlying asset in these transactions is jet fuel in the various markets that serve as the basis for determining the jet fuel prices that the Company actually pays, and mainly Jet Aviation FOB Med. In addition to this market, the Company purchases jet fuel according to its price in other markets, of which the key ones are Singapore, US Gulf Coast and North-West Europe Jet fuel is an essential raw material for the Company for its operations the Company is obligated to purchase the raw material in order to fly its aircrafts, and there is no substitute or ability to alternate between the costs of these raw materials and other raw materials. The price of jet fuel is very volatile. b-29

251 The following graph shows the fluctuations in jet fuel prices since the beginning of 2008: /01/ /03/ /05/ /07/ /09/ /11/ /01/ /03/ /05/ /07/ /09/ /11/ /01/ /03/ /05/ /07/ /09/ /11/ /01/ /03/ /05/ /07/ /09/ /11/2011 The market price of jet fuel is determined based on several parameters, including: Crude oil prices include market expectations and supply and demand. The pace of demand for oil and it products has risen in recent years, due to the global growth (especially the growth rate in China). The supply of oil and its products is limited by physical and infrastructure factors (oil reserves, production infrastructures, refining, storage, transport, etc.), and by geopolitical and cartel influences of the large oil producers (OPEC). The marginal cost for fuel production is different at various levels of production, increasing along with the required level of production (as an example, the cost of producing a barrel of oil via deep sea drilling is three or four times the cost of producing a barrel of oil from Arabian oil wells). The trend of increased oil prices continued in The price of a Brent barrel of oil was priced at $107.4 at the end of 2011 compared to $94.5 at the end of December Price fluctuations Due to the meeting of the limited supply and the surging demand in recent years, any change, or expectations for change, in one of these factors, causes strong price fluctuations (such a: levels of economic activity and global growth, wars and terrorism, shut-downs and problems at large oil refineries, international relations and more). Seasonal demand for various crude distillates, including jet fuel (In the winter there is high demand for heating oil; in the summer there is high demand for gasoline. Likewise, transport costs vary, conforming to seasonal risks in sea shipping). Production cost and infrastructure limitation Distillate prices vary according to various constraints of the oil refining industry, refining infrastructures, storage and transport of oil and its products are limited, cost of their development is very high and their expansion takes many years (construction of a refinery takes 5-7 years). Moreover, future prices for oil and its derivatives (including jet fuel) are also strongly affected by the financial demands of institutional investors and speculators, which include these products in their investment portfolios. In recent years, due to various reasons (including those mentioned above), the risk embedded in the markets and the price fluctuations are very high. b-30

252 In view of the behavior of the markets, investment houses and the world's leading analysts are having difficulty in precisely and consistently estimating the price-change trends. The forecasting ability of the various investment houses and analysts represent, at most, the immediate current estimate of the macroeconomic influences prevailing when the estimate was made. Furthermore, these estimates are calculated according to the different economic analyses of each analyst and investment house. Even the forward curve structures are non-predictive, and at most, they represent the expectation and risk level embedded in the markets. According to the structure of the Company's hedge transactions, on the settlement date vs. the financial entity with which the hedge was executed (settlement date of the trade), a calculation is made of the transaction's strike price vs. the average monthly price of the underlying asset (Asian options) (published by Platts, a division of McGraw-Hill companies, which is the authorized and leading international entity in the field of providing data services on the energy market) and constitutes an accepted point of reference with respect to the trading of oil and its derivatives. The payment or receipt for the transactions is based on the transaction's structure as designated in advance. The financial instruments traded by the Company (mainly options on jet fuel) are traded over the counter (OTC) between the Company and the financial entities in conjunction with which the trade is executed, and are not contracts traded directly on various exchanges. The future price of the jet fuel, as traded in these instruments, is comprised of three main elements: crude oil price, the Gasoil crack and the jet differential. Each of these three elements is actually traded separately (between financial institutions and brokers), and priced separately. The pricing of each of the elements is affected by various factors, including the current price, duration, price fluctuations, supply and demand, seasonal factors, storage costs, transport, etc., and has a different effect on the overall price change of jet fuel. This pricing is done differently by every financial entity, according to models and algorithms that they developed (based on models such as Black & Scholes, Monte Carlo, etc.), opposite the investment portfolio of that party. As is accepted in this field by global aviation companies, the companies obtain the fair value estimates from the investment houses opposite which they execute the trades. These investment houses use macroeconomic models that take into account the individual behavior of each element, the proportionate mix in the formula among the elements, the individual fluctuation of each element, the cross influence between prices and fluctuation and between supply and demand (supply and demand flexibility), future development of production, refining, storage and transport (tankers and pipes) capabilities, geopolitical forecasts in the world and the behavior of the cartels, macroeconomic models of global growth rates and demand for energy sources, forecasts for changes in interest and exchange rates, forecasted production of alternative energy sources for the materials being discussed, the behavior of the financial markets in connection with trade in the relevant securities and derivatives and other factors. All the above elements are processed according to economic models that were developed by the different investment houses that own them. These models are capable of generating estimates and forecasts, with the qualification that they are correct as of the moment they are generated. Some of the investment houses use the "Monte Carlo" simulation model on these estimates, in order to predict the future price/value expectancy. In this report, we rely on fair value calculations made by the various financial entities with which the transactions were executed and which were provided the Company. These value calculations are also validated by feasibility tests conducted by the Company using the models and systems in its possession. b-31

253 The following is a sensitivity analysis of the fair value of the financial instruments sensitive to changes possible in the risk factors to which they are exposed. The analyses pertain to the fair value of the financial instruments as of December 31, Presented below are sensitivity analysis tables for instruments sensitive to changes in market factors: a. Sensitivity to changes in the NIS/USD exchange rate in thousands of dollars: Gain (loss) from changes Increase 10% NIS/$ Increase 5% NIS/$ Fair value NIS/$ Gain (loss) from changes Decrease 5% NIS/$ Decrease 10% NIS/$ Cash and cash equivalents (2,156) (1,129) 23,719 1,248 2,635 Designated cash (166) (87) 1, Short-term deposits (744) (390) 8, Trade receivables (80) (42) Other receivables (827) (433) 9, ,011 Long-term bank deposits (134) (70) 1, Total financial Assets (4,107) (2,151) 45,175 2,378 5,019 Short term and current maturities (4,547) (239) (505) Trade payables 2,465 1,291 (27,115) (1,427) (3,013) Other payables - Current (4,362) (230) (485) Derivative financial instruments 1, (12,017) (632) (1,335) Loans from financial institutions (7,753) (408) (861) Loan from others (1,636) (86) (182) Other payables - Non Current (4,437) (234) (493) Total financial liabilities 5,624 2,946 (61,867) (3,256) (6,874) Exposure in linkage balance sheet due to surplus of financial liabilities over financial assets 1, (16,692) (878) (1,855) * Does not include exposure for the effect of the changes in the exchange rate on assets and liabilities due to employee benefits; see Section a4. b-32

254 b. Sensitivity to changes in the EUR/USD exchange rate - in thousands of dollars: Gain (loss) from changes Increase 10% Euro/$ Increase 5% Euro/$ Fair value Euro/$ Gain (loss) from changes Decrease 5% Euro/$ Decrease 10% Euro/$ Cash and cash equivalents (445) (233) 4, Trade receivables (1,497) (784) 16, ,830 Other receivables (149) (78) 1, Total financial Assets (2,091) (1,095) 23,001 1,211 2,556 Trade payables 2,071 1,085 (22,780) (1,199) (2,531) Other payables (1,332) (70) (148) Total financial liabilities 2,192 1,148 (24,112) (1,269) (2,679) Exposure in linkage balance sheet due to surplus of financial liabilities over financial assets (1,111) (59) (123) * Does not include exposure for the effect of the changes in the exchange rate on assets and liabilities due to employee benefits; see Section a4. c. Sensitivity to changes in jet fuel prices on inventory (dollar/gallon) in thousands of dollars: Gain from changes Type of instrument Increase 10% $/gallon Increase 5% $/gallon Fair value * $/gallon Loss from changes Decrease 5% $/gallon Decrease 10% $/gallon Jet fuel Inventory ,394 (820) (1,639) * Jet fuel prices according to weighted moving average as of December 31, d. Sensitivity of jet fuel hedging to changes in jet fuel prices - in thousands of dollars: According to the model's principles, jet fuel hedges that react in a similar manner to market factors were grouped together, since there was no loss of material information required to understand the Company's exposure to market risks as a result of the grouping. On January 5, 2009 jet fuel prices changed by 14%, and therefore the following sensitivity analysis includes a 15% change in jet fuel prices. Gain from changes Loss from changes Type of instrument Increase 15% Increase 10% Increase 5% Fair value* Decrease 5% Decrease 10% Decrease 15% $/gallon $/gallon $/gallon $/gallon $/gallon $/gallon $/gallon SWAP transactions - designed for hedging 8,191 5,461 2,730 1,770 (2,730) (5,461) (8,191) Options - not designed for hedging 1, (69) (47) (70) Total transactions - jet fuel hedge 9,303 5,987 2,907 2,089 (2,799) (5,508) (8,261) * The price of jet fuel in the Mediterranean Basin ($2.884/gallon) as of December 31, 2011, according to which the fair value of the Company's hedge transactions is computed. b-33

255 e. Sensitivity of interest hedging to changes in market interest rates in thousands of dollars: According to the principles of the model, the Group executed interest hedges that respond in a similar manner to market factors (IRS agreements not intended for hedging), since no loss of significant information is sustained that is required to understand the Company's exposure to the market risk, as a result of the grouping. On December 16, 2008 a 75% change occurred to the dollar monetary policy, and therefore the following sensitivity analysis led to a 75% change in interest rates. Type of instrument Increase 75% in interest rate Gain from changes Increase 10% in interest rate Increase 5% in interest rate Fair value * Decrease 5% in interest rate Loss from changes Decrease 10% in interest rate Decrease 75% in interest rate IRS transactions - not designed for hedging (9,152) (43) (82) (590) * Fair value was calculated according to the market Libor rate as of December 31, 2011, at the following rates: 3- month Libor: 0.58%, 6-month Libor: 0.81%, and 12-month Libor 1.12%, all as applicable and according to the relevant transaction. f. Sensitivity of NIS/USD exchange rate hedging to changes in market exchange rates in thousands of dollars: Loss from changes Type of instrument Increase 10% in exchange rate Increase 5% in exchange rate Gain from changes Decrease 5% Fair value NIS/$ * in exchange rate Decrease 10% in exchange rate FORWARD transactions - designed for hedging (32,742) (16,375) (12,017) 16,367 32,742 * The sensitivity analysis was carried out in shekel terms, and the profit or loss in the event of a 5% or 10% decrease or increase was translated according to an exchange rate of NIS per USD on December 31, b-34

256 b2. Linkage Basis Report The following is the consolidated linkage basis report for December 31, 2011: In, or linked to In Israeli In, or linked to In, or linked to Non-monetary Total the US dollar currency the euro the other items currencies (in thousands US dollars) Current assets Cash and cash equivalents 49,841 23,719 4,900 6,896-85,356 Designated cash - 1, ,827 Short-term deposits - 8, ,183 Trade receivables 112, ,466 12, ,409 Other receivables 15,649 9,098 1,635 1,366-27,748 Derivative financial instruments 2, ,096 Prepaid expenses ,043 28,043 Inventories ,481 26,481 Non-current assets Long-term bank deposits - 1, ,473 Investment in affiliated companies ,184 13,184 Investment in other company 1, ,264 Fixed assets, net ,192,413 1,192,413 Intangible assets, net ,995 7,995 Prepaid expenses ,547 7,547 Assets due to employee benefits , , ,603 84,084 23,001 20,485 1,275,663 1,585,836 Current liabilities Short- term and current maturities (101,398) (4,547) (105,945) Trade payables (102,235) (27,115) (22,780) (8,672) - (160,802) Other payables (58,017) (4,362) (1,332) (3,704) - (67,415) Provisions (11,465) (13,378) (24,843) Derivative financial instruments (9,159) (12,017) (21,176) Employee benefit obligations (3,001) (94,387) (542) (572) - (98,502) Unearned revenues (235,998) (235,998) Non-current liabilities Loans from financial institutions (548,017) (7,753) (555,770) Employee benefit obligations (9,421) (43,065) (626) (4,677) - (57,789) Loan from others (233) (1,636) (1,869) Other payables (3,236) (4,437) (7,673) Provisions (5,348) (5,348) Deferred taxes (28,984) (28,984) Unearned revenues (51,946) (51,946) Shareholders equity (161,776) (161,776) (851,530) (212,697) (25,280) (17,625) (478,704) (1,585,836) Monetary assets, net of monetary liabilities (monetary liabilities, net of monetary assets) (668,927) (128,613) (2,279) 2, ,959 - b-35

257 The following is the consolidated linkage basis report for December 31, 2010: In, or linked to In Israeli In, or linked to In, or linked to Non-monetary Total the US dollar currency the euro the other items currencies (in thousands US dollars) Current assets Cash and cash equivalents 81,807 13,260 4,667 11, ,002 Short-term deposits 55,000 8, ,565 Trade receivables 104,504 1,114 14,879 12, ,960 Other receivables 10,551 8, ,098-20,880 Derivative financial instruments 30,020 12, ,190 Prepaid expenses ,995 26,995 Inventory ,756 18,756 Non-current assets Long-term bank deposits - 1, ,869 Investment in affiliated companies Investments in other companies 1,228 10, ,552 Derivative financial instruments 4, ,291 Fixed assets, net ,231,687 1,231,687 Intangible assets, net ,844 7,844 Prepaid expenses ,121 8,121 Assets due to employee benefits , , ,544 94,675 20,060 24,829 1,294,096 1,721,204 Current liabilities Short-term and current maturities (146,826) (761) (147,587) Trade payables (88,098) (32,680) (25,194) (11,940) - (157,912) Other payables (40,717) (1,814) (3,555) (3,539) - (49,625) Provisions (9,192) (35,747) (44,939) Derivative financial instruments (2,329) (2,329) Employee benefit obligations (3,690) (93,536) (767) (719) - (98,712) Unearned revenues (231,204) (231,204) Non-current liabilities Loans from financial institutions (561,084) (561,084) Employee benefit obligations (7,813) (52,092) (675) (5,010) - (65,590) Derivative financial instruments (19,739) (19,739) Other payables (6,263) (4,437) (10,700) Deferred tax (32,792) (32,792) Unearned revenues (51,467) (51,467) Shareholders equity (247,524) (247,524) (885,751) (221,067) (30,191) (21,208) (562,987) (1,721,204) Monetary assets, net of monetary liabilities (monetary liabilities, net of monetary assets) (598,207) (126,392) (10,131) 3, ,109 - b-36

258 c. Aspects of Corporate Governance: c 1. Charitable Contributions and Community Work El Al assigns a great deal of importance to making charitable contributions and assisting the needy and the community. As part of its activities, the Company contributed in 2011 a sum of $150,000 in cash and cash equivalents. Over the course of 2011, El Al continued its long-standing tradition of giving back to the community. The activity continued to focus mainly on two channels: 1. Employee volunteer activities within the scope of the departmental steering committee for weaker populations, including holocaust survivors without relatives, at-risk children, special-needs children, people with disabilities and the infirm, as well as volunteer work by Company employees in education projects such as Together Teachers, El Al in Education and Young Entrepreneurs. 2. Support with money or money-equivalents, for the needy: a. By management within the framework of the Contributions Committee, the Company donates sums of money, and in addition contributes assistance in the form of money equivalents, such as dozens of hot meals a day, free flight tickets, transport of special cargo free of charge and distribution of food containers. Furthermore, the Company has assisted the town of Kfar Orde in northern Israel, which was harmed in the Carmel disaster. In addition, El Al has donated to organizations assisting the mentally disabled (AKIM, Etgarim, Pitchon Lev, Larger than Life, the Israeli Youth Diabetes Association), and El Al has adopted the soldiers of the IDF s 201st Battalion as part of the Adopt a Warrior program. Within the framework of the Friendly Club, El Al transfers points for the purchase of flight tickets to the Make-a-Wish Foundation to fulfill the wishes of young cancer patients, to the AWIS in order to assist single soldiers and to Taglit project in order to bring Israeli youths to Israel. El Al has donated scholarships for the Heseg Fund for single soldiers who have been discharged from the military and are going to school. b. By the employees themselves whether in money or money-equivalents (home electrical appliances, clothing, books, games, etc.) to preschools for special-needs children, at-risk children s homes and more. c 2. Directors with Accounting and Financial Capabilities a) Under the Companies Law, 1999, and the regulations enacted under its auspices regarding reporting on directors with accounting and finance skills, the Company's Board of Directors resolved that the minimum number of directors with accounting and finance skills in the Company would be one-third of the number of directors serving at any time. As of the Financial Statement approval date the Company features fourteen directors. In the opinion of the Board of Directors, considering the scope and complexity of the Company's operations, this number of directors with accounting and finance skills will enable the Company's Board of Directors to meet the obligations imposed on it, especially as relates to the examination of the Company's financial position, preparation of Financial Statements and their approval. As of the Financial Statement approval date the Company has six directors with accounting and financial capabilities. b-37

259 b) Presented below are the directors who have accounting and finance capabilities, stating the facts by virtue of which they should be seen as such directors: Mr. Nadav Palti Director of the Company since January Mr. Palti is an accountant by training and serves as Chairman of Mapal Communications Ltd. and as CEO and President of Dori Media Group Ltd. Formerly a partner in a large accounting firm. Mr. Yair Rabinowitz Outside director of the Company since February 2007 (his term in office was extended for an additional period starting March 2010). Mr. Rabinowitz has been a certified public accountant since Owns a firm specializing in taxation and finance and in the past served as the managing partner of a large CPA firm, and also served as Commissioner of Income Tax and Property Tax. Served in the past as a member of the Bank of Israel advisory committee on banking matters and as a member of the presidency of the Institute of Certified Public Accountants, and also served as a lecturer in institutes of higher education. Professor Jhoshua (Shuki) Shemer outside director at the Company since November 2008 (his term in office was extended for an additional period starting November 2011). Prof. Shemer is an expert on internal medicine and medical administration. Serves as Chairman of the Board of Assuta Medical Centers Ltd. since 2005 and has served as CEO of Maccabi Health Services. Mr. Pinchas Ginsburg a Company director since June Mr. Ginsburg has a degree in economics and accounting, manages tourism companies and serves on the boards of several companies. Mrs. Yael Andoren outside director at the Company since November Ms. Andoren has a certificate in business administration (specializing in finance and accounting) and a degree and economics and sociology from Hebrew university in Jerusalem and until 2011 served as the special manager of the Senior Pension Funds. Mr. Avraham Bigger director at the Company since December Mr. Bigger has a certificate in business administration and a degree in economics from Hebrew University in Jerusalem. Mr. Bigger served in the past as the Chairman of the Board of Machteshim-Agan Ltd. and the Chairman of the Board of Shufersal. c 3. Disclosure Regarding Independent Directors The Company has not adopted the ordinance regarding the number of independent directors in its bylaws, in accordance with Section 219 (a) of the Companies Law, At the same time, as of the approval of the statements, the number of independent directors, as defined by the Company, is 5 out of 14, meaning hat over one third of the directors are considered independent directors. c 4. Disclosure Regarding the Internal Auditor of the Corporation 1. Information Regarding the Internal Auditor and Compliance with Conditions Name of Auditor: Gil Ber Beginning of term in office: June 1, Qualifications: accountant, with a degree in accounting and business administration and certified in public administration and auditing (with honors). Holds CIA (Certified Internal Auditor U.S.) and CRISC certificates. Has 15 years experience in auditing, in financial statements and in risk management. Until his appointment, Mr. Ber was a partner in Cost, Forer, Gabai & Ksirrer, Ernst & Young responsible for auditing and risk management, and served as internal auditor for various companies and organizations. A b-38

260 regular lecturer at the Academic Track of the College of Management on budgeting and control subjects. The Internal Auditor meets all compliance requirements set in Section 3(a) of the Auditing Law. The Internal Auditor complies with Section 146(b) of the Companies Law and Section 8 of the Internal Auditing Law The Internal Auditor had no holdings in Company securities or holdings in any related body in the reported year Starting from the date of his appointment, the Internal Auditor has had no business connections of any sort with the audited corporation or with any related body, with the exception of serving as Internal Auditor of Group subsidiaries The Internal Auditor is employed by the Company as a full-time Company employee. 2. The Internal Auditor's Appointment 2.1. The appointment of the Internal Auditor was approved by the Audit Committee on its April 21, 2009 meeting and by the Company's Board of Directors on its April 30, 2009 meeting and after considering the Auditor's education, skills and experience in corporate auditing and risk management to material degrees The Auditor was given duties and authorities in accordance with the Company's auditing procedure, the directives of which are based on the laws of the State of Israel. Pursuant to this, the Internal Auditor was tasked with proposing a work plan, to be carried out in accordance with the Company s auditing plans and to distribute, in writing, reports containing findings, conclusions and recommendations. 3. The Internal Auditor's Supervisor 3.1. The Internal Auditor is subordinate to the Company s Chairman of the Board of Directors and CEO, in accordance with the Company's bylaws. 4. Work Plan 4.1. The Internal Auditor's work plan is on a yearly basis The Internal Auditor's work plan is determined based upon the following considerations: The risk embodied in an area of activity and profitability of the Company The existence of appropriate controls, applicability and efficiency in the audited area Proposals by VPs and branch managers Previous audit findings and pace at which the recommendations submitted were implemented The effect of the subject on Company profitability, passenger service, the safety and security of passengers, employees and aircrafts The need for follow-up in order to ensure a proper auditing process Establishment of the work plan involves the Chairman of the Company's Board of Directors, the members of the Audit Committee and the Company CEO The work plan proposal is received on a yearly basis by the Chairman of the Company's Board of Directors, the members of the Audit Committee and the Company CEO. All of them approve the proposal in accordance with Section 149 of the Companies Law The work plan allows the Internal Auditor to exercise his judgment in deviating from the plan The Internal Auditor is present at Board meetings in which material transactions are approved. b-39

261 5. Overseas Audits for Subsidiaries 5.1. The Internal Auditor also serves as the Internal Auditor for all active subsidiaries and therefore the Auditor's work plan takes these companies into account. The Auditor's work plan also includes reviews of the Company's overseas activities. 6. Treatment of Complaints Pertaining to Flaws in the Management of the Company s Business The Internal Auditor was assigned the task of concentrating and presenting to the Audit Committee the manner of treatment of complaints by Company workers regarding flaws in the manner in which it conducts its business. For this purpose, a regular mechanism has been established at the Company so that the subject would be examined and controlled on a regular basis. 7. Scope of Employment 7.1. The Internal Auditor is employed full time by the Company and subordinate to him are eight full time auditors The following work hours were invested in auditing the Company and its overseas subsidiaries in 2011: Work hours for the Work hours for the Work hours due to Total hours Company's activity in Israel Company's activity abroad* investee corporations** 11,200 1,600 1,100 13,900 * 70% of the Company's work hours for activities abroad were carried out in Israel. ** Audits were carried out for 3 subsidiaries. 8. Auditing Proceedings 8.1. The Company's Internal Auditor conducts his work in accordance with the Companies Law, 1999, the Internal Audit Law, 1992 and generally accepted professional standards The Chairman of the Board holds a monthly meeting with the Internal Auditor regarding his work and regarding the professional standards according to which the Auditor operates The Audit Committee holds meetings in which it discusses the Internal Auditor's work and the audit standards Prior to the approval of the yearly audit plan the Chairman of the Board meets with the Internal Auditor to discuss the standards according to which the work plan was formulated, following which the audit committee discussed the proposed yearly audit plan and the standards according to which the proposal was formulated and approves it. 9. Access to Information 9.1. The Internal Auditor has free, continuous and direct access to any document or information held by the Company or by any of its employees, as well as access to any ordinary or computerized information listings, to any database and to any automatic data processing system at the Company, including for financial data, as noted in Section 9 of the Internal Audit Law. b-40

262 10. Internal Auditor Reports The audit reports are submitted in writing The Internal Auditor prepared 34 audit reports in The audit reports were submitted to the Chairman of the Board, the members of the Audit Committee of the Board of Directors, and to the Company's CEO In 2011, the Audit Committee convened 11 times to discuss the internal audit reports. 11. The Board of Directors' Evaluation of the Internal Auditor's Activity In the opinion of the Board of Directors, the scope, nature and continuity of the internal auditing activities and work plan are reasonable under the circumstances, and they achieve the corporation's internal auditing objectives, as they relate to all of the Company s material and key activities. 12. Remuneration The internal auditor's compensation is based on the salary and associated benefits granted members of the senior management group and in accordance with Company policy In the opinion of the Company's Board of Directors, the compensation given to the Internal Auditor and its components do not impair his ability to use independent judgment in carrying out his assignments, inter alia, in view of the fact that the audit work is performed through several Internal Auditors. c 5. Disclosure Regarding Independent Auditors' Fees Below are the Company's fee expenses to the accounting firm of Brightman Almagor Zohar & Co. for auditing, tax services and other services: Auditing and tax services Additional services Hours Thousands of dollars Hours Thousands of dollars , , , The increase in auditing and tax service hours relative to 2010 derives from auditing hours for the 2010 internal audit, accumulated in January-March 2011, as well as work hours for auditing the books of the Company s overseas representations. The Company received no additional services from the auditing accountant in the reported year. Additional services were received in 2010 following the first-time application of Securities Authority regulations on the examination of the effectiveness of internal controls in the corporation (I-SOX). These fees were approved by the Company's Board of Directors and are reasonable and acceptable according to the nature of the Company and the extent of its activities. b-41

263 c 6. Financial Statement Approval Process The body charged with ultimate control in the Company regarding the approval of the Financial Statements is its Board of Directors. Starting from the approval of the 2010 yearly Financial Statements, the financial statement approval process has been covered by directives set in the Companies Regulations (Directives and Conditions for the Financial Statement Approval Process), 2010 (hereinafter the Regulations ). Within the framework of the Board of Directors, the Company operates several committees, including the Audit Committee, the Market Risks Management Committee, the Human Resources and Appointments Committee, the Finance and Budget Committee, the Balance Sheet Committee, the Security Committee, the Corporate Governance Committee and the Government Affairs and Regulations Committee. In the Board meeting held on September it was decided to split the Finance, Budget and Balance Sheet Committee to two committees: the Finance and Budget Committee which will discuss various financial issues, including the Company s budget, as well as a Balance Sheet Committee, which will serve as a Financial Statements examination committee. At the head of both committees is the external director Mr. Yair Rabinowitz. The Balance Sheet Committee (Financial Statement Examination Committee) currently consists of six members (most of whom are independent), as follows: 1) Mr. Yair Rabinowitz, Chair of the Committee, outside director. Possessing accounting and financial qualifications, holding an accounting certificate from the Hebrew University in Jerusalem. Owns a tax consulting firm and is fluent in accounting issues and financial statement preparation. Mr. Rabinowitz provided a statement (as defined in the regulations) prior to his appointment. 2) Professor Jhoshua Shemer, outside director. Possessing accounting and financial qualifications, with a degree in internal medicine and an expert in medical administration on behalf of the Ministry of Health. Professor Shemer serves as the Chairman of the Board of Directors of Assuta Medical Centers and formerly served as General Manager of Maccabi Health Services. Professor Shemer has extensive business activity, mainly in managing major corporations and is capable of and experienced in reading financial statements. Professor Shemer provided a statement (as defined in the regulations) prior to his appointment. 3) Mr. Pinchas Ginsburg, director, possessing accounting and financial qualifications, economics and accounting graduate from Tel Aviv University. Serves as CEO of Hillel & Co. Travel Agencies. Mr. Ginsburg is qualified and has extensive experience in understanding financial statements and has provided a statement (as defined in the Regulations) prior to his appointment. 4) Mr. Amnon Lipkin-Shahak, independent director, with professional qualifications. General History graduate from the Tel Aviv University and Chairman of Tahal s Board of Directors. Mr. Lipkin-Shahak has provided a statement (as defined in the regulations) prior to his appointment. 5) Ms. Yael Andoren, independent director, with accounting and financial capabilities, has certificate in business administration (specializing in finance and accounting) and a degree economics and sociology from the Hebrew university in Jerusalem and until 2011 served as the special manager of the Senior Pension Funds. Ms. Andoren provided a statement (as defined in the regulations) prior to her appointment. 6) Mr. Avraham Bigger, independent director, with accounting and financial capabilities, has a certificate in business administration and a degree in economics from the Hebrew University in Jerusalem. Mr. Bigger served as the Chairman of the Board of Machteshim-Agan Industries Ltd. until 2010 and has provided a statement (as defined in the regulations) prior to his appointment. b-42

264 The Balance Sheet Committee meets for extensive and thorough discussion of the draft Financial Statements, in the presence of the auditing accountant. The Chief Executive Officer and the Chief Financial Officer present the members of the committee with extensive details on the Financial Statements, including detailed financial analyses about the Company's performance during the reporting period. The Balance Sheet Committee studies the material issues in financial reporting and formulates a recommendation for the Company s Board of Directors pertaining to, among other things, the following issues: (a) estimates and evaluations made pursuant to the Financial Statements; (b) internal controls pertaining to financial reporting; (c) the wholeness and propriety of disclosure in the Financial Statements; (d) the accounting policy adopted and the accounting treatment applied to material Group issues; (e) value estimates, including underlying assumptions and estimates, on which the data in the Financial Statements was based. The Committee also reviews different aspects of control and risk management, both those reflected in the Financial Statements and those impacting the reliability of the Financial Statements. When complex or material issues are on the agenda, special discussions are held by the Balance Sheet Committee on the issues on the agenda with the participation of the independent auditor. The Company s Board of Directors is the organ responsible for discussing and approving the Financial Statements, after the members of the Board receive the draft Financial Statements along with the recommendations of the Financial Statements Examination Committee at least two business days prior to the meeting. Over the course of the Board meeting in which the Financial Statements are discussed and ratified, the Company CFO provides a detailed review of the key points of the Financial Statements and the Company s accounting policy. The CEO also reviews the Company's current activity and the influence of this activity on the Company s Financial Statements and emphasizes material issues. In addition, the Chairman of the Financial Statement Examination Committee reviews the key points of the Committee s recommendations. Invited and present at the Board meeting in which the Financial Statements are discussed and ratified are representatives of the Company s independent auditor, who provide remarks and clarifications to the Financial Statements and who are at the Board members disposal to answer questions and provide clarifications regarding the reports prior to their approval. The Balance Sheet Committee convened on March to formulate recommendations for the Board of Directors. Taking part in the meeting in question were the Committee members: Yair Rabinowitz, Professor Jhoshua Shemer, Mr. Pinchas Ginsburg, Ms. Yael Andoren and Mr. Avraham Bigger. Also taking part in the meetings in question were the Chairman of the Board of Directors, Mr. Amikam Cohen, the Company CEO, Mr. Eliezer Shekedi, the CFO, Mr. Nissim Malki, the Legal Counsel and Company Secretary, Mr. Omer Shalev, esq, the Company Auditor, Gil Ber, CPA and representatives of the independent auditor. The Balance Sheet Committee held a discussion about the Financial Statements presented to it, including directing questions to the members of management present and to the independent auditor. Likewise, the independent auditor is asked to present his comments, if any, to the committee members, including accounting policy applied and special events that arose during the review of the Financial Statements. The following are details of the processes taken prior to the approval of the December Financial Statements. a. The draft Financial Statements were provided to the members of the Board of Directors to study on March b. Committee members are welcome to contact the Company CFO at any time with any question or clarification they require, prior to the meeting. b-43

265 c. Over the course of the meeting, the Committee reviewed the Company s financial results and viewed comparisons between the reported period and corresponding periods and the work plan, presented by the CFO. d. Pursuant to its meeting the Committee studied the estimates and assessments carried out in relation to the 2011 Financial Statement, the wholeness and propriety of disclosure in the 2011 Financial Statements, the accounting policy adopted and accounting treatment implemented regarding the Company's material issues. e. The Committee discussed the effectiveness of internal controls over financial reporting and disclosure in the Company and examined, among other things, the manner of treatment of the material weakness reported by the Company in its 2011 Financial Statements. The Committee was presented with a review by Company management regarding actions taken by the Company to correct the material weakness including the preparation of an administrative enforcement plan, which was approved by the Company s Board of Directors on December In addition, the Committee was also presented with the actions taken by the Company to ensure that its reports had been prepared in accordance with the law. The Company took steps in 2011 to correct the material weakness, including by conducting a comprehensive review of executive remuneration approvals, ratifying the remuneration for the former CEO and ratifying bonuses to executives for 2005, as well as formulating an administrative enforcement plan approved by the Board of Directors on December f. At the conclusion of the discussion and after it has been clarified that the Financial Statements adequately reflect the state of Company affairs and its operating results, the Committee recommended that the Board of Directors approve the Financial Statements. g. The drafts for the Financial Statements were provided to the members of the Board of Directors to study on March h. The Committee s recommendations were provided to the members of the Board of Directors on March in writing along with the draft Financial Statements, meaning 3 business days before the discussion by the Board of Directors. The Company s Board of Directors is of the opinion that in light of the scope and complexity of the recommendations and the time deemed reasonable by the Board of Directors to transfer the recommendations as noted above, they were passed on to the directors for study a reasonable amount of time prior to the Board of Directors discussion. i. On March 2011, a discussion was held by the Company s Board of Directors regarding the recommendations of the Financial Statements Examination Committee. At the conclusion of the Board meeting, the December Financial Statements, prepared on the basis of IFRS rules, were approved unanimously. Present at the Board of Directors Meeting in which the Financial Statements were approved, were the following Board members: Amikam Cohen, Tamar Moses-Borovitz, Nadav Palti, Eran Ilan, Yael Andoren, Yair Rabinowitz, Professor Jhoshua Shemer, Shlomo Hannael, Pinchas Ginsburg, Sofia Kimmerling and Avraham Bigger. c 7. Use of Securities Proceeds Pursuant to the commitment given by the Company and by the State of Israel, as expressed in the 2003 prospectus, the proceeds of the State's and the Company's offerings in recognized severance funds are recognized for securing severance payments. After making these deposits and covering the full deficit in the severance fund as required by the agreement, the Company deposited a sum of 31.3 million NIS (including interest accrued to as of this report) constituting the balance of the offering proceeds, in a separate account (included in short-term deposits as of December ). The Company is evaluating the existence of limitations related to its ability to use the proceeds balance, pursuant to the aforementioned agreement, between it and the State and the employees' representatives, and in this connection, the Company communicated to the State. As of the date of the report, negotiations are taking place with the General Comptroller s Office at the Ministry of Finance to examine b-44

266 entitlement to issue surpluses. For further details see Notes 6.b and 23.c.(3).b to the December Financial Statements. c 8. Disclosure Regarding Consent to Perform Peer Review On July 28, 2005, the Securities Authority issued a guideline under Section 36a of the Securities Law, 1968 regarding disclosure of consent given to perform peer review, the objective of which, according to this guideline, is to spur the process of controlling the work of accounting firms and test the existence of requisite procedures during the audit work performed, which will contribute to the existence of an advanced capital market. On March , the Company Board of Directors provided the necessary consent to undertake the peer review. c 9. Negligible Transactions On November the Company Board of Directors decided to adopt rules and guidelines for the classification of a transaction made by the company or one of its affiliates with an interested party (hereinafter: "an Interested Party Transaction") as a negligible transaction as defined in Regulation 41(a)(6)(a) of the Securities Regulations (Yearly Financial Statements), The Company's Board of Directors has determined that in the absence of special qualitative considerations deriving from the circumstances of the issue, an Interested Party Transaction shall be considered a "negligible transaction" if: (a) The transaction is carried out over the normal course of Company business; and (b) The transaction is under market conditions and its terms are acceptable to the relevant market; and (c) The relevant criteria for the transaction, one or more, whether it is a single commitment or a series of commitments on the same issue over the course of the same year, are at an extant of no greater than 200,000 NIS in any interested party transaction the classification of which has been considered as a "negligible transaction" on the basis of the Company's latest audited consolidated yearly financial statements. Relevant criteria for examining a transactions are, for instance: (1) total sales that are the subject of the Interested Party Transaction; or - (2) the total cost of the sales the subject of the Interested Party Transaction; or (3) the extant of assets the subject of the Interested Party Transaction; or (4) the extant of liabilities the subject of the Interested Party Transaction; or (5) the extant of the expense or yield the subject of the Interested Party Transaction. In this regard in the event the Company does not have full rights to a certain transaction, the transaction shall be determined based on the Company's relative portion of the transaction. In cases in which, according to the Company's judgment, all of the aforementioned criteria are irrelevant for the determination of the negligibility of the Interested Party Transaction, the transaction shall be considered negligible, in accordance with a different relevant criterion, determined by the Company, so long as the relevant criterion used for this transaction shall be no greater than 200,000 NIS. Over its regular course of business, the Company carried out, during the reported year or as of the date the report was filed or which are still in effect as of the report date, transactions with controlling shareholders defined as negligible transactions, as noted in Note 38j to the Financial Statements, of the following types and with the following characteristics: catering services for passengers whose flight has been delayed; b-45

267 security screening services for VIP travelers in the Masada Lounge; undercover inspections on Company flights and during security screening for Company flights; as well as controls for the Company s website. c.10 Remuneration of Interested Parties and Senior Executives For details regarding the remunerations given senior Company executives in accordance with employment agreements with the Company, see Regulation 21 in Chapter D of this periodic report. Upon their approval, the considerations guiding the Company's Board of Directors in determining salary payments to Company executives, were made after examining their contribution to the development of the Company's business, taking into account the provision of services required for the Company particularly in light of the current need to develop its business, as well as taking into account the knowledge, experience and skills possessed by these executives in the Company s areas of activity, the state of its business and its financial results, as well as the payment given executives in corresponding positions in companies with characteristics similar to those of the Company. Pursuant to the 2011 periodic report approval process, an additional discussion was held at the Company s Board of Directors on the terms of employment and service of each executive, detailed in Regulation 21 of the Securities Regulations (Periodic and Immediate Reports) 1970 ( the Reporting Regulations ). The Board of Directors discussed, among other things, the relationship between the sum of remunerations given in 2011 to each of the executives and their contribution to the Company in the reported period. For the sake of the discussion, the Board of Directors was presented with relevant data regarding each of the Company s executives, as required in accordance with Regulation 21 of the Reporting Regulations and in accordance with Parts B and C of the Sixth Addendum to the Reporting Regulations as well as comparative data regarding payments given executives in similar positions after examining the Company's chief characteristics including the nature of its activities, its operating cycle and the number of employees in companies with a yearly income turnover of a scope similar to that of the Company. The Board of Directors determined that remuneration to each member of the Company's senior management is reasonable and fair in accordance with the following criteria: (a) the scope and areas of responsibility and complexity of the position they fulfill; (b) the executive's education, training and professional experience; (c) the key terms of employment, including conditions for ending the commitment; (d) components of the remuneration given the executive in the reported period; (e) the contribution of the executive to the Company's business, its operating results, its stability and its compliance with the work plan in the reported year; (f) the executive's contribution to projects and unique tasks give them pursuant to their duties in the reported period; (g) the Company s need to continue retaining the executive as possessor of unique capabilities, knowledge and expertise; (h) the executive s meeting the Company's expectations regarding the position in which they serve; (i) the executive's compliance with agreements made with them and (j) generally accepted terms of employment in the Israeli economy in the reported period, in positions similar to those filled by those executives (benchmarks). b-46

268 Summary of the Board of Directors Arguments Regarding the Remuneration of the Five Highest Recipients at the Company a. Company CEO Mr. Elyezer Shkedi The Board of Directors examined the actions and contribution of the Company CEO, Mr. Eliezer Shekedi, to the Company over the course of his service in The Board of Directors reviewed the CEO s chief actions and achievements, and among other things his continued activities in the field of equipping including aircraft sale and leasing transactions, managing commercial policy, fuel hedging transactions, completing an arrangement with the Ministry of Finance to increase the State's participation in the Company's security expenses, expanding collaborations with other airlines, dealing with regulation in areas of activity in which the Company is active, developing growth engines, formulating a strategic plan as well as the day-to-day management of the airline, while upholding safety and security standards. In the opinion of the Company's Board of Directors, taking the above into account, taking into consideration, among other things, the Company s operating results in 2011, the activities and scope of the contribution of Mr. Elyezer Shkedi and the comparative remuneration data presented to the Board of Directors, the Board of Directors decided that the remuneration paid Mr. Elyezer Shkedi in practice for 2011 is fair and reasonable. b. VP of Operations Mr. Benjamin Livneh The Board of Directors reviewed the actions and contributions of Mr. Benjamin Livneh to the Company in 2011, particularly the execution of the Company's complex flight schedule in a safe, secure and economic manner, the management and control of exceptional incidents, the concentration of staff work of the Company's operational array, his handling of and responsibility for the Company's security issues (including its security budget) and his handling of the Company's operational precision. Mr. Benjamin Livneh also acts as the acting CEO in the CEO s absence and serves as the Company s liaison with the Civil Aviation Authority and other external operational elements. The Board of Directors has determined that Mr. Benjamin Livneh has met the demands of his position in a professional, loyal and responsible manner. In the opinion of the Company's Board of Directors, taking the above into account, taking into consideration, among other things, the Company s activities and comparative remuneration data presented to the Board of Directors, the remuneration paid Mr. Benjamin Livneh for 2011 is fair and reasonable. c. Chief Financial Officer Mr. Nissim Malki The Board of Directors has studied the work and contribution made by Mr. Nissim Malki to the Company over the course of 2011, including in all matters pertaining to the management of the Company's financial array, preparation of the Company's Financial Statements, estimates and the Company's preparedness to implement the subject of the effectiveness of internal controls at the Company and its successful implementation, managing the jet fuel, exchange rate and interest risk hedging array, managing the Company's insurance array, managing the Company s investor relations, managing the Company's budget, pricing and business controls, managing the Company s cash flow and financing proceedings, managing the integration of the Company's equipping actions and activating safety teams at the Company to reduce its expenses. The Company's Board of Directors has determined that Mr. Nissim Malki has met the conditions requested from him and with the demands of his position in a professional, loyal and responsible manner. In the opinion of the Company's Board of Directors, taking the above into account, taking into consideration, b-47

269 among other things, the Company s activities and comparative remuneration data presented to the Board of Directors, the remuneration paid Mr. Nissim Malki for 2011 is fair and reasonable. d. VP of Human Resources Mr. Reuven Virovnik The Board of Directors examined the work and contribution of Mr. Reuven Virovnik to the Company in 2011, particularly in all matter pertaining to the management of the Company s human resources array in Israel and abroad, including as regards collective agreements, material actions in the field of acquisitions, managing the Company s construction and assets array in Israel and abroad, and comprehensive responsibility for the training array. The Company's Board of Directors has determined that Mr. Virovnik has met with the conditions requested from him and with the demands of his position in a professional, loyal and responsible manner. In the opinion of the Company's Board of Directors, taking the above into account, taking into consideration, among other things, the Company s activities and comparative remuneration data presented to the Board of Directors, the remuneration paid Mr. Reuven Virovnik for 2011 is fair and reasonable. e. VP of Maintenance and Engineering Mr. Shmuel Kuzi The Board of Directors reviewed the actions and contribution of Mr. Shmuel Kuzi to the Company in 2011, particularly the actions required for the regular maintenance of the Company s large fleet of aircraft, the purchase, lease and upgrading of aircraft for the company, providing maintenance services to other airlines and the contribution of the Maintenance Division under Mr. Kuzi s management to maintaining the highest level of operational precision while meeting safety goals. The Board of Directors has determined that Mr. Shmuel Kozzi has complied with the terms of the agreement signed with him and with the demands of his position in a professional, loyal and responsible manner. In the opinion of the Company's Board of Directors, taking the above into account, taking into consideration, among other things, the Company s activities and comparative remuneration data presented to the Board of Directors, the remuneration paid Mr. Shmuel Kozzi for 2011 in fair and reasonable. f. Chairman of the Board of Directors Mr. Amikam Cohen. The service agreement signed with the Chairman includes salary and options, as detailed in Note 38d and in Note 30.g.3 to the December Financial Statements. The Board of Directors examined the actions and contribution of Mr. Amikam Cohen to the Company in 2011, particularly the cooperation between him and the Company CEO and his leadership of the Company in 2011, in light of his extensive business experience and his leadership of the process of formulating the Company s strategic plan. In the opinion of the Company's Board of Directors, after reviewing the contribution and actions of the Chairman of the Board of Directors, taking the above into account, taking into consideration, among other things, the Company s activities and comparative remuneration data presented to the Board of Directors, the remuneration paid Mr. Amikam Cohen for 2011 was fair and reasonable. b-48

270 c.11 Audit Report Securities Authority On March , the Securities Authority provided the Company with an audit report regarding the terms of the employment of senior Company executives, including the Company's outgoing CEO, Mr. Chaim Romano. For details on this issue, including regarding decisions made following the audit report in question, see immediate reports published by the Company on March (reference numbers: and ) and on March (reference number: ), as well as a report dated May (reference number: ). c.12 Internal Enforcement Plan In December 2011 the Company s Board of Directors approved, after receiving the recommendations of the Corporate Governance Committee, the key points of the internal enforcement plan in the field of securities and corporate law (hereinafter: the Internal Enforcement Plan ). The internal enforcement plan was formulated by a work team consisting of Professor Assaf Hamdani, the law firm of Matry, Meiri & Co., the Company s General Counsel and Corporate Secretary and the Manager of the Corporate Secretariat and board of directors, and was approved by Company management. The internal enforcement plan expresses the Company s recognition of the importance of compliance with the Law by Company workers, executives, Board members and relevant service providers and concentrates the Company's policy on the matter of preventing and treating violations, including a policy for evaluating the damages of legal violations and preventing their repetition. The internal enforcement plan adopted by the Company includes an outline for the activities of the Company s internal enforcement array and key procedures including: the Board of Directors work procedure; the procedure for defining the positions and authorities of the Audit Committee; the procedure for transactions with related parties; the Board of Directors conflict of interest procedure; the executive remuneration procedure; the reporting (non-financial) procedure; internal information procedure; as well as the delivery of information to the media and to the capital markets. The Company's Board of Directors approved and adopted the internal enforcement plan and its central procedures and also, at the recommendation of the CEO, appointed the Company s legal counsel and secretary, Omer Shalev, as the Company s internal enforcement supervisor. The Company is acting to implement and assimilate the internal enforcement plan among its workers as well as to establish mechanisms for appropriate assimilation of the plan at the Company. c.13 Effectiveness of Internal Controls of Financial Reporting and Disclosure Management, under the supervision of the Board of Directors, has conducted an examination and evaluation of its internal controls over financial reporting and disclosure in the corporation and its effectiveness. The assessment of the effectiveness of internal controls over financial reporting and disclosure carried out by management under the Board of Directors supervision included: b-49

271 1. Updating the scoping document prepared by the Company in 2010 for 2011 in order to verify the material processes and site intended to be included in the current mapping. 2. Determining the processes and controls in the areas determined to be the most material in the Company s activity, as follows: (a) entity-level controls, including controls for the process of preparing and closing financial reporting and general controls of information systems; (b) controls for passenger revenues from the sale of flight tickets (with the exception of subsidiaries); (c) controls for the frequent flyer club; (d) controls for fixed assets aircraft, engines and spare parts; (e) controls for derivative financial instruments; (f) controls for agent commission expenses (Israeli branch); (g) controls for fuel expenses; (h) controls for salary expenses for employees in Israel (with the exception of senior and very senior employees); (i) controls for actuary calculations for Israeli employees (with the exception of senior and very senior employees). 3. The internal controls effectiveness assessment included a definition of key controls in the field of ITGC (information systems) as well as in the field of entity-level controls (ELC) at the Company s headquarters. Based on the this assessment, the Corporation s Board of Directors and management have reached the conclusion that the Corporation's internal controls over financial reporting and disclosure as of December 31, 2011 are effective. Regarding the manner in which the Company s handled the material weakness reported in 2010, see c.6.(e) above. b-50

272 d. Disclosure Provisions with Regard to Financial Reporting by the Corporation: d 1. Events Subsequent to the Balance Sheet Date Regarding events subsequent to the balance sheet date, see Note 42 to the December Financial Statements. d 2. Disclosure on Critical Accounting Estimates The implementation of accounting standards by the Company's management upon preparing financial statements occasionally involves various assumptions, assessments and estimates influencing levels of the assets and liabilities and the business results reported in the Financial Statements. Some of the assumptions, assessments and estimates are critical to the financial position or operating results reflected in the Group's Financial Statements, due to their materiality, complexity of the calculations or likelihood of realization of uncertain matters. For details on the material estimates included in the Financial Statements see Note 4 to the December Financial Statements. d 3. Explanation of the Subjects to which the Company's Independent Auditors Draw Attention in their Opinion on the Financial Statements The Company's independent auditors draw attention, in their opinion on the Financial Statements, to Note 1d to the Financial Statements on the matter of the challenges faced by Company management, its plans for meeting these challenges and the Company s estimates regarding the Company s ability to meet its obligations in the foreseeable future as well as to Note 27.d.a to the Financial Statements, regarding the exposure to the approval of class actions against the Company and the Company s exposure to these class actions. b-51

273 e. Additional information: e.1 Dividend Distribution Policy The Company's dividend policy was revised on November 20, Pursuant to the new dividend policy, the Company will distribute dividends from time to time at the discretion of the Board of Directors and subject to the Company's needs. e.2 Disclosure regarding Changes in the Economic Environment, the Implications of the Capital Market Crisis and Market Risks a. The international aviation industry is affected by the economic and security situation and by unusual events, such as the outbreak of epidemics and natural disasters in the world in general, and in specific areas in particular, as well as by the economic situation in Israel and around the world. In the period subsequent to the report date, the economic crisis in the euro zone has continued as detailed below, as has the political instability in the countries surrounding Israel, and the tension in the Persian Gulf area has increased, leading to an additional increase in oil prices. In spite of the increase in traffic to and from Israel in 2011, the economic data published in December 2011 are added to the picture arising from the data from the last two quarters regarding the continued slowdown in the growth rate of activity in the Israeli economy. This slowdown is in light of the global economic slowdown and the severe crisis Europe is undergoing, which has also led to a drop in demand is characterized by uncertainty and many countries have begun adopting streamlining and belt tightening policies. The Bank of Israel s growth projection for 2012 was 3.2% in September 2011, but was revised to 2.8% in December, similar to the OECD projection 2.9% Indications of the slowdown in growth can also be seen in the decrease of airborne cargo shipping to and from Israel. The tourism and aviation industries are sensitive to domestic and foreign economic changes and a new recession, if in fact this occurs, may have negative implications on companies operating in these areas as well as on the Company. These influences may be expressed whether by cutting business travel, in the luxury classes in particular, by cancelling and/or shortening vacations as well as by changing the passengers' destination map to cheaper destinations. b. The euro zone crisis 2012 poses a threat to financial stability and economic growth, as a result of the financial crisis in some of the euro zone countries. The past few months have seen a drop in the international credit ratings of key euro zone nations such as France, Spain, Italy, Ireland, Greece, Portugal, Belgium, Cyprus and Slovenia. The financial crisis and the need to make extensive budget cuts has also led to political crises in several of the countries, with prime ministers being replaced in Greece, Italy and Spain. Over the past few months the threat has shifted from relatively small countries (Greece, Portugal and Ireland) to larger countries (Italy and Spain). As a result of this crisis, concerns have been increasing that the European economy might enter a recession and the state of the euro zone might continue to deteriorate and reach as far as liquidation, despite the agreements reached some in recent months at the EU leaders summit regarding the imposition of a new fiscal treaty. The world's economic status has a significant impact on the airborne traffic of passengers and cargo. The Company sells flight tickets and bills of lading in EU countries. In 2011 some 8.6% of its passenger revenues and 18.1% of its cargo revenues originate from incoming tourism and cargo from these countries. In addition, the Company finances some of its flight equipment purchases through euro zone banking institutions. (as of December 31, 2010, 33% of the balance of the Company's loans has been received from b-52

274 banks in these countries). The euro crisis is threatening to develop into a new global recession that may lead to a sharp drop in demand for international passenger and cargo traffic. The Company has a natural defense against changes in the rate of the euro relative to the dollar, as there is no real difference between its revenues and expenses in the Euro. In putting together the Company s 2012 budget, parameters pertaining to the state of the euro zone were taken into account. The Company estimates that the euro zone crisis will have less of an impact on incoming traffic from Western European countries, as it is based on ethnic tourism (UK France) and on tourism from relatively prosperous countries (Germany). In the field of cargo to and from Europe, the budget assumes a slight decrease in the amounts of airborne cargo and stability in the price per ton of cargo. In accordance with the above assumptions, the Company s Board of Directors assumes that as of the publication of the 2011 Financial Statements, the influence of the euro zone financial crisis on the Company's 2012 operating results will not be material. Most of the Company s financing is dollar financing which mostly leans on financing backed by guarantees from the American Import & Export Bank (EXIM). As a result, the impact of the state of the euros zone banks on the Company is relatively low. Note that in March 2012 the Company signed an agreement to take a loan to the amount of $46 million to finance advance payments for the purchase of two new airplanes from a foreign bank in one of the euro zone countries. The following are changes occurring to jet fuel prices, interest rates and NIS exchange rates from the end of the year until immediately before the publication of the December Financial Statements: c) As of the reported date (December ), the market price of jet fuel (before fees and supplier margins) weighted according to the markets in which the Company purchases jet fuel, was 291 cents per gallon while as of a date immediately prior to the approval of the report this price is 328 cents per gallon, a 12.7% increase; note that jet fuel expenses constitute nearly 34% of the Company's revenue turnover, and therefore changes in price may have a material impact on its financial results. Since the beginning of 2012 jet fuel prices have continued to increase, and thee effective price the Company is expected to pay for jet fuel consumption (after hedging) in January and February 2012 is 15% higher than the average effective price it paid during the fourth quarter of At the same time, the fair value of jet hedging instruments shall be set in accordance with price changes that occurred since the end of the year and the completion of accounting for some of the transactions. In Q the Company will also list revenue of $9.2 million in its Financial Statements, in addition to other jet fuel hedging revenues, constituting the portion hedged for fuel consumption in this quarter and which was exercised in March Subsequent to the reported period the Company performed additional financial transactions to protect it from increased jet fuel prices, including forward transactions and options. Following these transactions the Company is hedged for the consumption of one third of its expected fuel consumption in The Company took several additional steps in 2012 to deal with the increase in jet fuel process, including updating the fuel surcharge on flight tickets as well as updating its policy on the matter of passenger baggage on Company destinations in economy class, as practiced by other airlines. d) The three-month LIBOR interest rate dropped by 19% from 0.58% as of the report date to 0.47% near the approval of the Statements; the impact of the change in LIBOR rates in the payment of interest on loans will be evident in the next repayment period of each loan. The interest payments on Company loans for the first quarter of 2012 shall be made according to interest rates in previous quarters. The Company possesses hedging agreements for Libor rates (see Section b.1.(4) above), the fair value of which is expected to drop as a result of the decrease in Libor interest rates. b-53

275 e) Subsequent to the balance sheet date a 1.4% decrease occurred in the exchange rate of the NIS vs. the USD. The Company has hedging agreements on the NIS/USD exchange rate (see b.1.(5) above), the fair value of which may change according to changes in exchange rates. Note that the impact of exchange rates on next quarter's operating results will be determined based on exchange rates in effect throughout the quarter and at its conclusion (March ). Subsequent to the balance sheet date the Company carried out a number of financial transactions for periods of up to March 2013 intended to protect the Company from drops in the exchange rate of the USD. The Board of Directors thanks the Company's management and employees for their devoted work and efforts for the development of the Company and promoting its businesses. Amikam Cohen Chairman of the Board Elyezer Shkedi Chief Executive Officer March 20, 2012 b-54

276 Appendix A to the Report of the Board of Directors on the State of the Corporation's Affairs for the Period Ending December Minimal Disclosure Required for Value Estimates and in their Regard, and Rules Pertaining to their Addition to Reports as per Securities Authority Guidelines in Accordance with Section 8b of the Securities Regulations (Periodic and Immediate Reports), a. Introduction Assessment of the Total Value of the Fleets International Accounting Standard 36 establishes rules regarding the accounting treatment, presentation and disclosure required in the event of the impairment of assets. The purpose of the standard is to establish procedures the corporation must implement in order to ensure that these assets are not presented in sums higher than their recoverable amount. An asset is presented in the Financial Statements at higher than its recoverable amount when its book value is higher than the sum received from the use or sale of the asset. In this case the asset has undergone depreciation and IAS 36 demands that the corporation recognize the loss from depreciation. The following document presents the key points of the value estimate performed by El Al Israel Airlines Ltd. (hereinafter "El Al" or "The Company") in order to determine whether the depreciation of its and fleets (hereinafter "the Fleets") was to be recognized according to IAS 36, in accordance with Securities Authority directives. This document was prepared in accordance with guidelines from the Securities Authority as per Section 8b of the Securities Regulations (Periodic and Immediate Reports), 1970, regarding minimal required disclosure for value assessments and in their regard and rules regarding their addition to reports. b-55

277 b. Specification and Identification of Asset Group The asset group for which the test was conducted includes the fleet which consists of 6 aircraft owned by the Company and the fleet which consists of 6 aircraft owned by the Company. c. Opinion Validity Date March d. Value Assessor The value assessment was performed by El Al management. e. Circumstances under which the IAS 36 Value Assessment was Conducted The book value of the aircraft fleet is higher than its market value as appearing in price lists published by AVAC the Aircraft Value Analysis Company and Airclaims - ASCEND World Wide. Note that use of the market value of the aircraft on the basis of AVAC and Airclaims price lists is common practice among airlines around the world as well as among financing banks and has been used by El Al in its various commitments with banks. IAS 36 states that a provision for impairment must be made when the book value of an asset exceeds its recoverable sum. A recoverable sum is calculated as asset's the fair value less costs to sell, or its value in use, whichever is higher. Fair value less costs to sell is the sum that may be received from the sale of the asset in a good faith agreement between a willing buyer and a willing seller. The value in use of an asset is the current value of estimated future cash flow expected to be derived from continuous use of the asset and its sale at the end of the period of use. The Company considers the market value of the assets as published by AVAC and Airclaims as representing the fair value less costs to sell of its assets. As of this value assessment, the Company has examined the value in use of the aircraft in its possession and in its service, the depreciated value of which in the Company's December Financial Statements exceeds their fair value less costs to sell. As of this value assessment, the fair value less costs to sell of the fleet amounts to a total of $445 million, compared to the depreciated retained cost in the b-56

278 books of those aircraft as of December , which amounts to a total of $495 million. The fair value less costs to sell of the fleet amounts to a total of $164 million, compared to the depreciated retained cost in the books of those aircraft as of December , which amounts to a total of $231 million. f. Assessment Method The value assessment was conducted according to the discounted cash flow method. According to this approach, assessed cash flows expected for the Company from the use of the aircraft fleet were discounted. The following are key assumptions used in calculating value: The expected contribution from the aircraft fleet is based on results listed in practice in 2011, and is projected forward unchanged across the economic life span of the entire aircraft fleet, unless expressly noted otherwise. Useful life: for the fleet - 12 years of activity (and sale of the aircraft at fair value less cost to sell at the end of the 12 year period), for the fleet - 7 years of activity (and sale of the aircraft at fair value less cost to sell at the end of the 7 year period). Cash flow expected from activity: management calculated that the projected cash flow from the operation of the aircraft fleet will amount to $83 million in 2011 ($62 million after tax), and the cash flow from the operation of the aircraft fleet will amount to $100 million ($75 million after tax). This cash flow was calculated based on revenues from the aircraft fleet less commissions and variable expenses that may be assigned to the fleet in question and less fixed cash flow expenses such as security and maintenance expenses that may be allocated relative to the cost of these aircrafts' operation. Scrap value at the end of useful life (meaning after 12 years for the fleet and 7 years for the fleet): calculated based on AVAC and Airclaims projections and totaling $180 million for the fleet and $74 million for the fleet (non-discounted values). Discount rate: for the purpose of capitalizing cash flows expected from the operation of the aircraft fleet and capitalizing their scrap values, use was made of the Weighted Average Cost of Capital (WACC) model. This model makes use of a capitalization rate that reflects the time value of the money and the specific risks embodied in the b-57

279 activity. The capitalization rate is estimated according to the weighted average of the capital price and debt price, using the following formula: WACC= Ke*(e%) + Kd*(d%)*(1-Tc) Equity Price = Ke Rate of equity out of total equity and debt = e% Debt price = Kd Rate of debt out of total equity and debt = d% The Company s long-term effective tax rate = Tc The average weighted capitalization interest rate after tax according to this calculation amounted to 5.5%. The price of equity (Ke) is determined using the Capital Asset Pricing Model (CAPM) according to the following formula: Ke=Rf +β * (Rm-Rf) + α when: Rf = rate of risk-free interest based on the average interest rate of dollar debentures over the course of the average period of expected cash flow, some 4%. B = the relative risk coefficient reflecting the relative risk involved in a certain investments and based on the level of correlation between the activity s yield and the yield of the capital market as a whole (Rm-Rf)= the average risk premium on the market 7.3% α = added risk specific to the Company 2%. The price of equity according to the formula is 9.3%. Debt price (Kd): use was made of a 6.6% debt price, constituting a worthwhile interest rate on long-term debt for the Company. Tax rate (Tc): use was made of the Israeli corporate tax rate 25%. The Company assumes that the aircraft in question will be used as passenger aircraft for the next 7-12 years. The Company did not assume the need to make any unexpected investments in these aircraft in order to permit their continued use. b-58

280 g. Value set using the Discounted Cash Flow Method for the fleet (in millions of dollars): Total discounted cash flow Total discounted Scrap Value (After 12 Years) Total Total value of the above aircraft feet based on the cash flow discounted method: $646 million. The following is a sensitivity analysis of the value of these aircraft to changes in discount price, changes in jet fuel prices and for changes in the contribution of cash which according to the Company constitute key elements that may alter value in use projections: Discount Rate 2.5% 3.5% 4.5% 5.5% 6.5% 7.5% 8.5% 9.5% Yearly Contribution After Tax In Millions of Dollars b-59

281 Fuel price sensitivity analysis, use of the asset across 12 years: Difference of NPV Vs. Reduced Value Reduced Value NPV Yearly Contribution Fuel Price (Cent per Gallon) In Millions of Dollars h. Value set using the Discounted Cash Flow Discounted Method for the fleet (in millions of dollars): Total Total discounted cash flow Total discounted scrap value (after 7 years) Total value of the above assets based on the cash flow discounted method: $489 million. b-60

282 The following is a sensitivity analysis of the value of these aircraft to changes in discount price, changes in jet fuel prices and for changes in the contribution of cash which according to the Company constitute key elements that may alter value in use projections: Discount Rate 2.5% 3.5% 4.5% 5.5% 6.5% 7.5% 8.5% 9.5% Yearly Contribution After Tax In Millions of Dollars Fuel price sensitivity analysis, use of the asset across 7 years: Difference of NPV Vs. Reduced Value Reduced Value NPV Yearly Contribution Fuel Price (Cent per Gallon) In Millions of Dollars b-61

283 i. Summary The following table presents the summarized value assessment as of December for the fleet: Recoverable Sum Calculation Fair Value Less Costs to Sell Value in Use for El Al In Millions of Dollars Recoverable Sum Whichever is Higher for El Al Should Impairment be Listed in the Books? The Aircrafts' Depreciated Retained Cost as of December The Recoverable Amount of the Same Aircraft to El Al, as of December In Millions of Dollars Should Impairment be Listed in the Books? No The following table presents the summarized value assessment as of December for the fleet: Recoverable Sum Calculation Fair Value Less Costs to Sell Value in Use for El Al In Millions of Dollars Recoverable Sum Whichever is Higher for El Al b-62

284 Should Impairment be Listed in the Books? The Aircrafts' Depreciated Retained Cost As of December The Recoverable Sum of the Same Aircraft to El Al, As of December In Millions of Dollars Should Impairment be Listed in the Books? No This value estimate is accurate as of the balance sheet date. The expected contribution from the aircraft fleet is based on results listed in practice in 2011, and is projected forward unchanged across the economic life span of the entire aircraft fleet, unless expressly noted otherwise. Changes in the projected assessments detailed above may alter the value assessment and the Company may subsequently be required to perform depreciation due to impairment. b-63

285 Appendix B to the Report of the Board of Directors on the State of the Corporation's Affairs for the Period Ending December 31, 2011 The Company s Material Loans and Credit Frameworks: - As of December 31, 2011* Loan Characteristics Local banking institution (**) Foreign banking institution with EXIM guarantee Aircraft Loan Scope of Loan (Thousands of Dollars) Unpaid Balance (Thousands of Dollars) Securities: 737, , , aircraft, aircraft, aircraft, aircraft , , aircraft EXIM (**) ,261 89, aircraft Interest Variable: Libor + margin 2.31%- 2.75%. Variable: Libor + margin (- 0.01%) to 0.8% Fixed 3.62%- 4.01% Principal and Interest Repayment Frequency Quarterly Quarterly Clearance Board Scope of Principal Repayment (Thousands of Dollars) As of January ,344 Starting April ,751 Between 2,376 and 4,466 Quarterly 2,360 Balloon Balance (Thousands of Dollars) Loan Start Date 77,800 January ,299 July April May June Final Repayment Date July July April May June Requirement to Attribute Value of Collateral to Uncleared Balance 125% Financial Covenants Ratio of Value of Collateral to Uncleared Balance as of December % Upholds financial covenants * The credit currency of all of the loans detailed above is the U.S. dollar. ** A cross default mechanism exists between the various loans of the same banking institution. b- 64

286 Appendix B to the Report of the Board of Directors on the State of the Corporation's Affairs for the Period Ending December 31, 2011 The Company s Material Loans and Credit Frameworks: - As of March 20, 2012* Clearance Board Financial Covenants Loan Characteristics Local banking institution (**) Foreign banking institution with EXIM guarantee Aircraft Loan, EXIM (**) Scope of Loan (Thousands of Dollars) Unpaid Balance (Thousand s of Dollars) Securities: 490, , aircraft, aircraft, aircraft, aircraft , , aircraft 113,261 88, aircraft Interest Variable: Libor + margin 2.31%- 2.75%. Variable: Libor + margin (- 0.01%) to 0.8% Fixed 3.62%- 4.01% Principal and Interest Repayment Frequency Quarterly Quarterly Scope of Principal Repayment (Thousands of Dollars) As of January ,344 Starting April ,751 Between 2,376 and 4,466 Quarterly 2,360 Balloon Balance (Thousands of Dollars) Loan Start Date Final Repayment Date 77,800 13/01/ /07/ ,299 23/07/ /07/ /04/ /04/ /05/ /05/ /06/ /06/2021 Requirement to Attribute Value of Collateral to Uncleared Balance 125% Ratio of Value of Collateral to Uncleared Balance as of December % Upholds financial covenants Ratio of Value of Collateral to Uncleared Balance as of March % Upholds financial covenants * The credit currency of all of the loans detailed above is the U.S. dollar. ** A cross default mechanism exists between the various loans of the same banking institution. b-65

287 2011 ANNUAL REPORT CHAPTER C 2011 FINANCIAL STATEMENTS

288 EL AL ISRAEL AIRLINES LIMITED 2011 Consolidated Financial Statements

289 EL AL ISRAEL AIRLINES LIMITED 2011 CONSOLIDATED FINANCIAL STATEMENTS Table of Contents Page Independent Auditors' Report C C - 1 Financial Statements Consolidated Balance Sheets C C - 3 Consolidated Statements of Income C - 5 Consolidated Statements of Comprehensive Income C - 6 Consolidated Reports on Changes in Equity C C - 7 Consolidated Cash Flow Reports C C - 9 Notes to the Consolidated Financial Statements C-11 - C-116

290 Independent Auditors' Report to Shareholders of El Al Israel Airlines Ltd. On the Matter of the Auditing of Components of Internal Controls of Financial Reporting In Accordance with Section 9.b.(c) of the Securities Regulations (Periodic and Immediate Reports), 1970 We have inspected components of the internal controls of the financial reporting of El Al Israel Airlines Ltd. and its subsidiaries (hereinafter the Company ) as of December These control components have been determined in the manner explained in the following paragraph. The Company's Board of Directors and management are responsible for maintaining effective internal controls over financial reporting, and for evaluating the effectiveness of the internal controls over financial reporting which is included in the periodic report for the date in question. Our responsibility is to express our opinion on the internal control elements of the Company s financial reporting, based on our audit. Components of internal control of financial reporting inspected by use were determined according to Audit Standard 104 of the Institute of Certified Public Accountants in Israel Inspection of Components of Internal Controls for Financial Reporting (hereinafter Audit Standard 104 ). These components are: (1) organization-level controls, including controls of the process of preparing and closing financial reporting and general controls of information systems; (2) controls of passenger revenues from the sale of flight tickets (with the exception of subsidiaries); (3) controls of frequent flyer club; (4) controls for fixed assets aircraft, engines and spare parts; (5) controls for derivative financial instruments; (6) controls for agent commission expenses (Israeli branch); (7) controls for fuel expenses; (8) controls for salary expenses for employees in Israel (with the exception of senior employees and executives); (9) controls for actuary calculations for Israeli employees (with the exception of senior employees and executives) (all of the above together are referred to as the Audited Control Components ). We have conducted our audit in accordance with Audit Standard 104. According to this standard, we were required to plan and carry out the audit with the aim of identifying the inspected control components and achieve a reasonable level of certainty as to whether these control components were upheld effectively in all material aspects. Our audit included achieving an understanding of the internal controls over financial reporting, evaluation of the risk of the presence of any material weakness in the inspected control components, as well as testing and evaluating those control components based on the evaluated risk. Our audit, regarding those control components, also included additional procedures that we believed to be necessary under the circumstances. Our audit referred solely to the audited control components, unlike an internal audit on all processes material to financial reporting, and therefore our opinion refers to the audited control components only. Furthermore, our audit did not refer to mutual influences between audited and unaudited control components and therefore, our opinion does not bring such negative impacts into account. We believe that our audit provides a sufficient basis for our opinion in the context described above. Due to their understandable limitations, internal controls over financial reporting in general, and components thereof in particular, may fail to prevent or discover a misrepresentation. Likewise, conclusions regarding the future on the basis of any present effectiveness assessment may be exposed to the risk that the controls become inappropriate due to changes in circumstances or that the application of the policy or the procedures changes to the worse. In our opinion, the Company has upheld in an effective manner, in all material aspects, its audited control components as of December We have also conducted an audit, in accordance with generally accepted Israeli auditing standards, of the Company s Consolidated Financial Statements for December and 2010 and for each of the three years of the period ending December and our report, published March , includes our unreserved opinion of those Financial Statements, as well as directing attention to the state of the Company s business and exposing the Company to class actions, based on our audit and on the reports of the other auditing accountants. Brightman Almagor Zohar & Co. Certified Public Accountants Tel Aviv, March 20, C 1 -

291 Independent Auditors' Report to Shareholders of El Al Israel Airlines Ltd. We have audited the consolidated balance sheets of El Al Israel Airlines Limited (hereinafter "the Company") as of December and 2010 and the Statements of Operations, Statement of Comprehensive Income, Report on Changes in Shareholders' Equity and Cash Flow Report for each of the three years in the period ending December 31, The Company's Board of Directors and management are responsible for these Financial Statements. Our responsibility is to express our opinion of these Financial Statements on the basis of our audit. We did not audit the financial statements of subsidiaries, whose assets included in consolidation constitute 1.5%, and 1.3% of total consolidated assets as of December 31, 2011 and 2010, respectively, and whose revenues included in the consolidation constitute 1.2%, 1.0% and 1.1% of total consolidated revenues for the years ended December 31, 2011, 2010 and 2009, respectively. Furthermore, we did not audit the financial statements of an associated company on a book value basis, the investment in which amounted to a total of $10,120,000 as of December , and the Company's share of its results for the year ending December amounted to a total of $1,336,000. The financial statements of those companies have been audited by other accountants whose reports have been provided us, and our opinion, to the extent that it relates to the sums included for these companies, is based on the reports of those other accountants. We conducted our audit in accordance with generally accepted Israeli auditing standards, including standards set in the Accountants Regulations (The Accountant s Method of Operation), Those Standards require that we plan and perform the audit with the aim of obtaining reasonable assurance that the Financial Statements are free of material misrepresentations. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. The audit also contains an examination of the accounting rules implemented and of the material estimates made by the Company s Board of Directors and Management, as well as an evaluation of the propriety of presentation on the Financial Statements as a whole. We believe that our audit and the reports of the other CPAs provide an adequate basis for our opinion. In our opinion, based on our audits and the reports of other accountants, the Financial Statements referred to above adequately reflect, in all material respects, the financial status of the Company and its subsidiaries as of December and 2010 and the results of their operations, changes to their equity and their cash flows for each of the three years in the period ending December 31, 2011, in accordance with International Financial Reporting Standards ("IFRS") and with the provisions of the Israeli Securities Regulations (Yearly Financial Statements), Without qualifying the above opinion, we direct your attention to Note 1.d of the Financial Statements regarding the challenges faced by Company management, its plans for facing these challenges and the Company s estimates regarding the Company s ability to meet its obligations in the foreseeable future. Furthermore, we direct your attention to Note 24.d.(a) of the Financial Statements regarding exposure to approval of lawsuits as class actions and the Company s exposure to these class actions. We have also audited, in accordance with Audit Standard 104 of the Institute of Certified Public Accountants in Israel Inspection of Components of Internal Controls for Financial Reporting, components of internal controls of the Company s financial reporting as of December , and our March report includes an unreserved opinion regarding the effective existence of those components. Brightman Almagor Zohar & Co. Certified Public Accountants Tel Aviv, March 20, C 2 -