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Revival of the Grandfather Rule?

In a surprising opinion, the General Counsel of the Securities and Exchange Commission held that the grandfather rule should be used in determining

the nationality of a corporation engaged in a partly nationalized activity instead of the traditionally used control test.

As stated in SEC-OGC Opinion No. 10-31 (December 9, 2010), Medusa Mining Ltd (MML) is an investor in a joint venture that is the holder of a mineral

production sharing agreement. It is in partnership with PHILSAGA Mining Corp. (PHILSAGA), apparently a Filipino corporation. MML, a 100% foreign

corporation, owns 40 % of the joint venture, while PHILSAGA owns the remaining 60% equity. Answering the question of MML on whether it has violated

the Constitution and other pertinent laws regarding foreign participation in mining activities, the OGC said that:

We opine that we must look into the citizenship of the individual stockholders, i.e. natural persons, of that investor-corporation in order to determine if the Constitutional and statutory restrictions are complied with. If the shares of stock of the immediate investor corporation is in turn held and controlled by another corporation, then we must look into the citizenship of the individual stockholders of the latter corporation. In other words, if there are layers of intervening corporations investing in a mining joint venture, we must delve into the citizenship of the individual stockholders of each corporation. This is the strict application of the grandfather rule, which the Commission has been consistently applying prior to the 1990s.

This opinion, as admitted by then General Counsel Vernette G. Umali-Pacio, is in contravention of the SEC’s prevailing policy of applying the “control

test”. Under this latter test, a legal fiction is created where if 60% of the shares of an investing corporation are owned by Philippine citizens then all of the

shares of the 100% of that corporation’s share are considered Filipino owned for purposes of determining the extent of foreign equity in an investee

corporation engaging in an activity restricted to Philippine citizens. The opinion defended its stand in this way:

Control test must not be applied in determining if a corporation satisfies the Constitution’s citizenship requirements in certain areas of activities…Philippine citizenship is being unduly attributed to foreign individuals who own the rest of the shares in a 60% Filipino equity corporation investing in another corporation. Thus, applying the control test effectively circumvents the Constitutional mandate that corporations engaging in certain activities must be 60% owned by Filipino citizens. The words of the Constitution clearly provide that we must look at the citizenship of the individual/natural person who ultimately owns and controls the shares of stocks of the corporation engaging in the nationalized/partly-nationalized activity. In fact, the Mining Act strictly adheres to the text of the Constitution and does not provide for the application of the control test.

Disini & Disini Law Office. (2013). Disini and Disini Law Office. Retrieved February 1 2013, 2013, from www.disini.ph: http://www.disini.ph/bespin/index.php?option=com_content&view=article&id=61:revival-of-the-grandfather-rule&catid=38:news&Itemid=59

How to determine the nationality of a corporation

The Constitution and various laws reserve certain areas of activities to Philippine citizens or to corporations that have a minimum

percentage of Filipino ownership. For example, with respect to corporations, ownership of land is limited to corporations “at least sixty

per centum of whose capital is owned” by Philippine citizens. If 60% of the capital of a Philippine corporation is owned by individuals

who are Philippine citizens, then there would be no issue on whether the Philippine corporation is a Philippine national qualified to own

land. On the other hand, an issue would arise if 60% of the capital of the Philippine corporation is owned, in turn, by another Philippine

corporation that has foreign stockholders.

If a Philippine corporation has corporate stockholders, how does one determine whether such Philippine corporation is a Philippine

national? Two tests have been employed in the Philippines: (a) the grandfather rule; and (b) the control test.

To illustrate how these tests are applied, let’s take a Philippine corporation (called “Corporation X”) with the following ownership

structure:

(a) non-Philippine citizens own 40% of the capital stock outstanding and entitled to vote of Corporation X;

(b) another Philippine corporation (called “Corporation Y”) owns 60% of the capital stock outstanding and entitled to vote of Corporation

X.

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On other hand, Corporation Y has the following ownership structure:

(a) non-Philippine citizens own 40% of the capital stock outstanding and entitled to vote of Corporation Y;

(b) Philippine citizens own 60% of the capital stock outstanding and entitled to vote of Corporation Y.

Let’s also assume that Philippine citizens constitute at least 60% of the members of the board of directors of each of Corporation X and

Corporation Y.

If the grandfather rule is applied, Corporation X will not be deemed a Philippine national because the grandfather rule takes into

account the direct and indirect foreign equity of foreigners in Corporation X (see SEC Opinion re: Silahis International Hotel, May 4,

1987). Applying the grandfather rule, the direct and indirect foreign equity in Corporation X would be 64%, calculated at follows:

Direct foreign-owned equity in Corporation X – 40%

Indirect foreign owned equity in Corporation X – 24%

Under the above scenario, the foreigners are deemed to have a 24% indirect foreign equity in Corporation X because foreigners own

40% of Corporation Y, which in turn owns 60% of Corporation X (i.e., 40% multiplied by 60% equals 24%). Thus, under the grandfather

rule, Corporation X is not qualified to own land.

On the other hand, if the control test is applied, Corporation X is deemed to be a Philippine national qualified to own land. Under the

control test, Corporation X is considered a Philippine national since at least 60% of its capital stock outstanding and entitled to vote is

held by Corporation Y, which is also considered a Philippine national since at least 60% of its capital stock outstanding and entitled to

vote is held by Philippine citizens.

The July 26 post describes two tests for the determining the nationality of a corporation: the control test and the grandfather rule. Which

one applies? As discussed below, the control test is the primary test for determining the nationality of a corporation; however, a recent

decision of the SEC raises the question of whether the SEC is now abandoning the control test in favor of the grandfather rule.

The control test as the primary test

As a rule, the control test applies. The primacy of the control test over the grandfather rule can be traced to DOJ Opinion No. 19, s.

1989 (the “1989 DOJ Ruling”), which states:

. . . the “Grandfather Rule”, which was evolved and applied by the SEC in several cases, will not apply in cases where the 60-40 Filipino-alien equity

ownership in a particular natural resource corporation is not in doubt. (underscoring supplied)

In other words, according to the Department of Justice, the control test generally applies, with the grandfather rule applicable only when

the 60-40 Filipino-alien equity ownership is in doubt.

On the basis of the 1989 DOJ Ruling, the SEC issued several opinions doing away with the grandfather rule. For example, in a May

30, 1990 opinion, the SEC stated:

. . . the Commission En Banc, on the basis of the Opinion of the Department of Justice No. 18., S. 1989 dated January 19, 9189 voted and decided to

do away with the strict application/computation of the so called “grandfather rule”. . . and instead applied the so-called “control test” method for

determining corporate nationality. (underscoring supplied)(see also SEC Opinion dated August 6, 1991; SEC Opinion dated October 14, 1991)

Around two years after the issuance of the 1989 DOJ Ruling, Congress enacted the Foreign Investments Act of 1991 (“FIA”), which

expressly embodied the control test. Section 3(a) of the FIA (as amended by Republic Act No. 8179) provides:

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. . . the term Philippine national shall mean a citizen of the Philippines; or a domestic partnership or association wholly owned by citizens of the

Philippines; or a corporation organized under the laws of the Philippines of which at least sixty percent (60%) of the capital stock outstanding and

entitled to vote is owned and held by citizens of the Philippines; or a corporation organized abroad and registered as doing business in the Philippines

under the Corporation Code of which one hundred percent (100%) of the capital stock outstanding and entitled to vote is wholly owned by Filipinos

or a trustee of funds for pension or other employee retirement or separation benefits, where the trustee is a Philippine national and at least sixty

percent (60%) of the fund will accrue to the benefit of Philippine nationals: Provided, That where a corporation and its non-Filipino stockholders own

stocks in a Securities and Exchange Commission (SEC) registered enterprise, at least sixty percent (60%) of the capital stock outstanding and entitled

to vote of each of both corporations must be owned and held by citizens of the Philippines and at least sixty percent (60%) of the members of the

Board of Directors, in order that the corporation shall be considered a Philippine national.” (underscoring supplied)

Similarly, Section 1(a) of the rules and regulations implementing the FIA expressly provides for the application of the control test:

Philippine national shall mean a citizen of the Philippines or a domestic partnership or association wholly owned by the citizens of the Philippines;

or a corporation organized under the laws of the Philippines of which at least sixty percent (60%) of the capital stock outstanding and entitled to vote

is owned and held by citizens of the Philippines; or a corporation organized abroad and registered as doing business in the Philippines under the

Corporation Code of which 100% of the capital stock outstanding and entitled to vote is wholly owned by Filipinos or a trustee of funds for pension

or other employee retirement or separation benefits, where the trustee is a Philippine national and at least sixty percent (60%) of the fund will accrue

to the benefits of the Philippine nationals; Provided, that where a corporation and its non-Filipino stockholders own stocks in Securities and

Exchange Commission (SEC) registered enterprise, at least sixty percent (60%) of the capital stock outstanding and entitled to vote of each of both

corporations must be owned and held by citizens of the Philippines and at least sixty percent (60%) of the members of the Board of Directors of each

of both corporation must be citizens of the Philippines, in order that the corporation shall be considered a Philippine national. The control test shall be

applied for this purpose. (underscoring supplied)

While the control test was enshrined in the FIA and its implementing rules, the SEC continues to apply the grandfather rule when the

Filipino equity ownership is “in doubt” (as provided in the 1989 DOJ Ruling). For example, in SEC-OGC Opinion No. 22-07

dated December 7, 2007, the SEC stated:

. . . when there is doubt as to the actual extent of Filipino equity in the investee corporation, the Commission is not precluded from using the

Grandfather Rule.

My former professor at the UP College of Law, Prof. Raul Palabrica, makes a great summary of the SEC position in his Philippine Daily

Inquirer column:

. . . this should not be taken to mean that the grandfather rule is already history. In an inverse way, the SEC pointed out that the “grandfather rule

will not apply in cases where the 60-40 Filipino equity ownership … is not in doubt.”

The rule therefore is: While the control test shall be used as standard to determine the nationality of corporations, the grandfather rule will be applied

if there are questions about compliance with Filipino ownership requirements. (see Raul Palabrica, Nationality Ownership Rule, Philippine Daily

Inquirer, October 19, 2007)

Based on the FIA and its implementing rules and regulations (which embody the control test), my personal view is that the control test

should be the test used in determining the nationality of a corporation. While the 1989 DOJ opinion made reference to the application

of the grandfather rule when the 60-40 equity ownership interest is in doubt, the 1989 DOJ opinion was issued prior to the enactment of

the FIA. Also, I believe that if there is doubt as to the 60-40 Filipino-alien equity ownership interest in the investing corporation that has

a 60% equity in a corporation engaged in a partly nationalized activity, what should be applied is the Anti-Dummy Law (in conjunction

with the control test), not the grandfather rule. Thus, if 60% of the shares of the investing corporation is held by Filipinos as dummies

for foreigners, that 60% equity in the investing corporation will not be deemed held by Philippine nationals. Applying the control test,

the investee corporation will not also be a Philippine national.

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A return to the grandfather rule?

It is noteworthy that a recent SEC case raises the issue of whether the SEC is now going back to the grandfather rule as the primary

test for determining the nationality of a corporation. In Redmont Consolidated Mines Corporation vs. McArthur Mining Corporation, SEC En

Banc Case No. 09-09-177 dated March 25, 2010, the SEC applied the grandfather rule because the foreign investor provided

“practically all the funds” of the Philippine mining companies; as such, the SEC concluded that the 60-40 Filipino alien equity ownership

was in doubt and therefore the grandfather rule should be applied. However, the SEC did not stop there – the SEC made statements

that seem to indicate a return to the grandfather rule. The SEC said:

The avowed purpose of the Constitution is to place in the hands of Filipinos the exploitation of our natural resources. Necessarily, therefore, the Rule

interpreting the constitutional provision should not diminish that right through the legal fiction of corporate ownership and control. But the

constitutional provision, as interpreted and practiced via the 1967 SEC Rules, has favored foreigners contrary to the command of the Constitution.

Hence, the Grandfather Rule must be applied to accurately determine the actual participation, both direct and indirect, of foreigners in a corporation

engaged in a nationalized activity or business.

Compliance with the constitutional limitation(s) on engaging in nationalized activities must be determined by ascertaining if 60% of the investing

corporation’s outstanding capital stock is owned by “Filipino citizens”, or as interpreted, by natural or individual Filipino citizens. If such investing

corporation is in turn owned to some extent by another investing corporation, the same process must be observed. One must not stop until the

citizenships of the individual or natural stockholders of layer after layer of investing corporations have been established, the very essence of the

Grandfather Rule.

Lastly, it was the intent of the framers of the 1987 Constitution to adopt the Grandfather Rule.

While the constitutional deliberations certainly made reference to the grandfather rule, there is nothing in the Constitution that ultimately

embodied the grandfather rule. In the absence of any provision in the Constitution embodying the grandfather rule, I believe that

Congress can adopt a law (in this case the FIA) embodying the control test.

Hopefully, the statements made by the SEC in Redmont do not signal a return to the grandfather rule. A change in the rules of the game

will have a tremendous adverse impact on investor confidence in the Philippines.

One final note. Redmont involved mining companies that require 60% Filipino ownership because these mining companies apparently

applied for a Mineral Production Sharing Agreement (which can be granted to Philippine nationals only). In Redmont, the SEC appears

to have reached the conclusion that the 60-40 Filipino-alien equity ownership was in doubt because the foreign investor provided

“practically all the funds” of the Philippine mining companies. My own view is that the fact that the foreign investor may have

contributed a big chunk of the corporate funds should not, by itself, put the 60-40 Filipino-alien equity ownership in doubt. The

important consideration is whether the Filipino stockholders legally and beneficially own and control 60% of the shares in the relevant

company (and do not otherwise act as dummies for the foreigners). If the foreigner wishes to provide greater financial support for the

mining project, that should be fine for as long as Filipinos remain the legal and beneficial owner of 60% of the shares in the mining

company (or in a layered structure, the investing company). We should not deprive Filipinos of the ability to enter into contracts with

foreigners whereby foreigners provide greater funding to projects that remain under Filipino control.

Jr, H. M. (2010, July 26 and August 25). Lexoterica: A Philippine Blawg. Retrieved February 1, 2013, from Lexoterica

Blawg Website: http://lexoterica.wordpress.com/2010/07/26/how-to-determine-the-nationality-of-a-corporation/

LEGAL NOTE 0133: THE GODFATHER RULE IN CORPORATION LAW. SOURCE: HEIRS OF WILSON P. GAMBOA, PETITIONERS, VS. FINANCE SECRETARY MARGARITO B. TEVES, FINANCE UNDERSECRETARY JOHN P. SEVILLA, AND COMMISSIONER RICARDO ABCEDE OF THE PRESIDENTIAL COMMISSION ON GOOD GOVERNMENT (PCGG) IN THEIR CAPACITIES AS CHAIR AND MEMBERS, RESPECTIVELY, OF THE PRIVATIZATION COUNCIL, CHAIRMAN ANTHONI SALIM OF FIRST PACIFIC CO., LTD. IN HIS CAPACITY AS DIRECTOR OF METRO PACIFIC

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ASSET HOLDINGS INC., CHAIRMAN MANUEL V. PANGILINAN OF PHILIPPINE LONG DISTANCE TELEPHONE COMPANY (PLDT) IN HIS CAPACITY AS MANAGING DIRECTOR OF FIRST PACIFIC CO., LTD., PRESIDENT NAPOLEON L. NAZARENO OF PHILIPPINE LONG DISTANCE TELEPHONE COMPANY, CHAIR FE BARIN OF THE SECURITIES AND EXCHANGE COMMISSION, AND PRESIDENT FRANCIS LIM OF THE PHILIPPINE STOCK EXCHANGE, RESPONDENTS. (G.R. NO. 176579, 09 OCTOBER 2012, CARPIO, J.) SUBJECT/S: DEFINITION OF CAPITAL IN CORPORATION LAW; THE GODFATHER RULE (BRIEF TITLE: HEIRS OF GAMBOA VS. TEVES) ===================== SUBJECTS/DOCTRINES/DIGEST: WHAT IS THE GRANDFATHER RULE? COMPLIANCE WITH THE CONSTITUTIONAL LIMITATION(S) ON ENGAGING IN NATIONALIZED ACTIVITIES MUST BE DETERMINED BY ASCERTAINING IF 60% OF THE INVESTING CORPORATION’S OUTSTANDING CAPITAL STOCK IS OWNED BY “FILIPINO CITIZENS”, OR AS INTERPRETED, BY NATURAL OR INDIVIDUAL FILIPINO CITIZENS. IF SUCH INVESTING CORPORATION IS IN TURN OWNED TO SOME EXTENT BY ANOTHER INVESTING CORPORATION, THE SAME PROCESS MUST BE OBSERVED. ONE MUST NOT STOP UNTIL THE CITIZENSHIPS OF THE INDIVIDUAL OR NATURAL STOCKHOLDERS OF LAYER AFTER LAYER OF INVESTING CORPORATIONS HAVE BEEN ESTABLISHED. XXXXXXXXXXXXXXXXXXXXXXXXXXX IS THE GRANDFATHER RULE APPLICABLE TO THIS CASE? YES. EVEN SEC APPLIED IT. Significantly, the SEC en banc, which is the collegial body statutorily empowered to issue rules and opinions on behalf of the SEC, has adopted the 60-40 ownership requirement in favor of Filipino citizens mandated by the Constitution for certain economic activities. This prevailing SEC ruling, which the SEC correctly adopted to thwart any circumvention of the required Filipino “ownership and control,” is laid down in the 25 March 2010 SEC en banc ruling in Redmont Consolidated Mines, Corp. v. McArthur Mining, Inc., et al.,15 to wit: The avowed purpose of the Constitution is to place in the hands of Filipinos the exploitation of our natural resources. Necessarily, therefore, the Rule interpreting the constitutional provision should not diminish that right through the legal fiction of corporate ownership and control. But the constitutional provision, as interpreted and practiced via the 1967 SEC Rules, has favored foreigners contrary to the command of the Constitution. Hence, the Grandfather Rule must be applied to accurately determine the actual participation, both direct and indirect, of foreigners in a corporation engaged in a nationalized activity or business. XXXXXXXXXXXXX

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WHAT IS TRANSCENDENTAL IN THE CASE AT HAND AND WHY? THE INTERPRETATION OF THE TERM “CAPITAL” IN SECTION 11, ARTICLE XII OF THE CONSTITUTION HAS FAR-REACHING IMPLICATIONS TO THE NATIONAL ECONOMY. IN FACT, A RESOLUTION OF THIS ISSUE WILL DETERMINE WHETHER FILIPINOS ARE MASTERS, OR SECOND-CLASS CITIZENS, IN THEIR OWN COUNTRY. WHAT IS AT STAKE HERE IS WHETHER FILIPINOS OR FOREIGNERS WILL HAVE EFFECTIVE CONTROL OF THE PHILIPPINE NATIONAL ECONOMY. XXXXXXXXXXXXXXXXXXXXXXX PANGILINAN ET AL CONTEND THAT THE TERM “CAPITAL” IN SECTION 11, ARTICLE XII OF THE CONSTITUTION HAS LONG BEEN SETTLED AND DEFINED TO REFER TO THE TOTAL OUTSTANDING SHARES OF STOCK, WHETHER VOTING OR NON-VOTING. IS THEIR CONTENTION CORRECT? NO. THE SUPREME COURT HAS NEVER YET INTERPRETED THE MEANING OF “CAPITAL” IN THE CONTEXT OF SECTION 11, ARTICLE XII OF THE CONSTITUTION. For more than 75 years since the 1935 Constitution, the Court has not interpreted or defined the term “capital” found in various economic provisions of the 1935, 1973 and 1987 Constitutions. There has never been a judicial precedent interpreting the term “capital” in the 1935, 1973 and 1987 Constitutions, until now. Hence, it is patently wrong and utterly baseless to claim that the Court in defining the term “capital” in its 28 June 2011 Decision modified, reversed, or set aside the purported long-standing definition of the term “capital,” which supposedly refers to the total outstanding shares of stock, whether voting or non-voting. …………………… To repeat, until the present case there has never been a Court ruling categorically defining the term “capital” found in the various economic provisions of the 1935, 1973 and 1987 Philippine Constitutions. XXXXXXXXXXXXXXXXXX PANGILINAN ET AL CONTENDS THAT SEC AND DOJ HAVE ALWAYS INTERPRETED CAPITAL TO REFER TO THE TOTAL OUTSTANDING SHARES OF STOCK WHETHER VOTING OR NOT. IS THEIR CONTENTION CORRECT? NO. DOJ AND SEC HAVE ISSUED CONFLICTING INTERPRETATIONS. . . . . .

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The opinions of the SEC, as well as of the Department of Justice (DOJ), on the definition of the term “capital” as referring to both voting and non-voting shares (combined total of common and preferred shares) are, in the first place, conflicting and inconsistent. XXXXXXXXXXXXXXX IS THERE ANY DOJ OPINION WHICH IS CONSISTENT WITH THE SC RULING, BEING NOW CONTESTED, ON THE MATTER? YES IN DOJ OPINION NO. 130 DATED 07 OCTOBER 1985, DOJ RULED THAT THE RESULTING OWNERSHIP STRUCTURE OF THE SUBJECT CORPORATION WOULD BE UNCONSTITUTIONAL BECAUSE 60% OF THE VOTING STOCK WOULD BE OWNED BY JAPANESE WHILE FILIPINOS WOULD OWN ONLY 40% OF THE VOTING STOCK, ALTHOUGH WHEN THE NON-VOTING STOCK IS ADDED, FILIPINOS WOULD OWN 60% OF THE COMBINED VOTING AND NON-VOTING STOCK. In DOJ Opinion No. 130, s. 1985,10 dated 7 October 1985, the scope of the term “capital” in Section 9, Article XIV of the 1973 Constitution was raised, that is, whether the term “capital” includes “both preferred and common stocks.” The issue was raised in relation to a stock-swap transaction between a Filipino and a Japanese corporation, both stockholders of a domestic corporation that owned lands in the Philippines. Then Minister of Justice Estelito P. Mendoza ruled that the resulting ownership structure of the corporation would be unconstitutional because 60% of the voting stock would be owned by Japanese while Filipinos would own only 40% of the voting stock, although when the non-voting stock is added, Filipinos would own 60% of the combined voting and non-voting stock. ……………… In short, Minister Mendoza categorically rejected the theory that the term “capital” in Section 9, Article XIV of the 1973 Constitution includes “both preferred and common stocks” treated as the same class of shares regardless of differences in voting rights and privileges. Minister Mendoza stressed that the 60-40 ownership requirement in favor of Filipino citizens in the Constitution is not complied with unless the corporation “satisfies the criterion of beneficial ownership” and that in applying the same “the primordial consideration is situs of control.” XXXXXXXXXXXXX IS THERE ANY SEC OPINION WHICH IS CONSISTENT WITH THE SC RULING, BEING NOW CONTESTED, ON THE MATTER? YES. IN OPINION NO. 23-10 DATED18 AUGUST 2012, SEC APPLIED THE VOTING CONTROL TEST, THAT IS USING ONLY THE VOTING STOCK TO DETERMINE WHETHER A CORPORATION IS A PHILIPPINE NATIONAL. On the other hand, in Opinion No. 23-10 dated 18 August 2010, addressed to Castillo Laman Tan Pantaleon & San Jose, then SEC General Counsel Vernette G. Umali-Paco applied the Voting Control Test, that is, using only the voting stock to determine whether a corporation is a Philippine national. XXXXXXXXXXXXXXXXXXX

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WILL THE OPINION ISSUED BY A SEC LEGAL OFFICER OR A SEC COMMISSIONER ESTABLISH PRECEDENCE? NO. THEIR OPINION APPLIES ONLY TO A PARTICULAR CASE. IT IS THE OPINION OF THE WHOLE COMMISSION THAT ESTABLISHES A PRECEDENCE. XXXXXXXXXXXXXX The opinions issued by SEC legal officers do not have the force and effect of SEC rules and regulations because only the SEC en banc can adopt rules and regulations. As expressly provided in Section 4.6 of the Securities Regulation Code,12 the SEC cannot delegate to any of its individual Commissioner or staff the power to adopt any rule or regulation. Further, under Section 5.1 of the same Code, it is the SEC as a collegial body, and not any of its legal officers, that is empowered to issue opinions and approve rules and regulations. XXXXXXXXXXXXXXXXXXXX WHAT WAS THE MAIN RULING IN THE 28 JUNE 2011 DECISION OF THE SC REGARDING THIS CASE? THAT THAT THE 60-40 OWNERSHIP REQUIREMENT IN FAVOR OF FILIPINO CITIZENS IN THE CONSTITUTION TO ENGAGE IN CERTAIN ECONOMIC ACTIVITIES APPLIES NOT ONLY TO VOTING CONTROL OF THE CORPORATION, BUT ALSO TO THE BENEFICIAL OWNERSHIP OF THE CORPORATION. MERE LEGAL TITLE IS INSUFFICIENT TO MEET THE 60 PERCENT FILIPINO OWNED “CAPITAL” REQUIRED IN THE CONSTITUTION. FULL BENEFICIAL OWNERSHIP OF 60 PERCENT OF THE OUTSTANDING CAPITAL STOCK, COUPLED WITH 60 PERCENT OF THE VOTING RIGHTS, IS REQUIRED. THE LEGAL AND BENEFICIAL OWNERSHIP OF 60 PERCENT OF THE OUTSTANDING CAPITAL STOCK MUST REST IN THE HANDS OF FILIPINO NATIONALS IN ACCORDANCE WITH THE CONSTITUTIONAL MANDATE. OTHERWISE, THE CORPORATION IS “CONSIDERED AS NON-PHILIPPINE NATIONAL[S]. BOTH THE VOTING CONTROL TEST AND THE BENEFICIAL OWNERSHIP TEST MUST BE APPLIED TO DETERMINE WHETHER A CORPORATION IS A “PHILIPPINE NATIONAL.” http://jabbulao.com/2012/11/04/legal-note-0133-the-godfather-rule-in-corporation-law/ Corporate Securities Info Control test vs grandfather rule By Raul J. Palabrica Jr. Philippine Daily Inquirer 11:49 pm | Thursday, January 17th, 2013 Last week, the Supreme Court issued an entry of judgment on its ruling in June 2011 on the issue of foreign ownership in PLDT where it held

that the 60-40 (percent) nationality requirement in public utility corporations, in favor of Filipinos, refers to common shares entitled to vote in the

election of directors, not to the totality of the company’s capital stock.

With the denial of the motions for reconsideration, that decision, per the entry of judgment, became final and executory as of Oct. 18, 2012.

Unlike previous entries of judgment (which simply state the case number and names of the parties), the instant entry bore the note that the 40

percent foreign ownership cap relates “only to common shares and not to total outstanding capital stock (common and non-voting preferred

shares).”

The special mention, in effect, sets aside the tribunal’s statement in its denial of the motions for reconsideration that “…the 60-40 ownership

requirement in favor of Filipinos must apply separately to each class of shares, whether common, preferred non-voting, preferred voting or any

other class of shares.”

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This statement drew strong reaction from the business community. It said the inclusion of stocks, other than common, in determining

compliance with the ownership rule would discourage foreign investments.

The clarification in the entry of judgment was a welcome relief to the business community.

Application

With this development, the SEC has gained more flexibility in crafting the rules and regulations that will govern the ownership of corporations

engaged in nationalized businesses.

In this effort, it has to find a middle ground between complying with the tribunal’s instructions on the enforcement of the nationality rules and the

need to make the country’s investment climate more attractive to foreign investors.

For one, the SEC has to take a close look at its approach in determining the nationality of corporations for purposes of verifying compliance

with the ownership benchmark.

At present, it uses two methods in addressing this issue: the control test and grandfather rule.

Under the control test, if, on the basis of the documents submitted, it can be seen that at least 60 percent of a corporation ’s capital is owned by

Filipinos, the corporation will be considered of Philippine nationality.

Once the 60 percent Filipino ownership is established, no further inquiries will be made on the citizenship of the rest of the stockholders.

The grandfather rule, on the other hand, provides that the nationality of the stockholders is material or critical in determining the nationality of a

corporation or its compliance with our laws on permissible foreign investments.

Criteria

Under this rule, the stocks owned by or registered in the name of foreigners are sorted out and added to determine if they meet the allowable

maximum percentage of foreign ownership in nationalized businesses, e.g., 30 percent for advertising companies, 25 percent for recruitment

agencies and 60 percent for financing companies.

The past rulings of the SEC show that it applies the control test in determining a corporation’s nationality, unless there are questions about the

true character of such ownership.

If there are, the corporation is “grandfathered,” meaning, the nationality of the owners of the stocks under question is exam ined to determine if it

meets the nationality requirements.

With the PLDT ruling already in force, the SEC may have to set aside the control test and apply the grandfather rule to corporations engaged in

nationalized businesses.

For this purpose, it can require the key officials of the affected companies to submit sworn statements of their compliance with the minimum

requirement on ownership of common shares by Filipino citizens.

But the problem is it is difficult to take affidavits at their face value. It is common knowledge that most Filipinos have little regard for written

statements even if made under oath and notary publics will notarize any document for the right price.

Examination

If caught lying in a sworn statement (which is a big if), the person concerned can raise any of the following defenses: lack of knowledge of the

significance of his statement, that he signed upon a lawyer’s advice, and that he acted in good faith in claiming compliance with the law.

The more worrisome part of the problem is, the record of conviction in our country for perjury or false affirmation in sworn statements is dismal.

Hardly anybody goes to prison for that crime.

Unless the SEC wants to take a chance on the credibility of sworn statements, it has no recourse but apply the grandfather rule to all covered

corporations.

It’s tough, but it has no choice. Otherwise, it runs the risk of being dressed down by the tribunal for not performing its duty to monitor

compliance by corporations with the nationality rules.

If the examination involves only natural persons, the task is easy. The birth certificates or passports of the people will be the best proof of their

nationality.

Unfortunately, it’s not going to be a walk in the park for corporations that are stockholders of corporations covered by the nationality rules.

When the corporations under review consist of two or more corporations with different areas of registration which, in turn, consist of

corporations as stockholders, will the examination be limited to the first layer of stockholder-corporations or would also cover the second or third

layer, if any?

Layering of corporations (or using corporations as stockholders of other corporations in different stages of organization) is a common practice in

the business community. Unless used for unlawful purposes, it’s perfectly legal.

The SEC has to make sure that, in applying the grandfather rule in its monitoring activities, the business of business is not unduly hampered.

For comments, send your e-mail to rpalabrica@inquirer.com.ph.

PLDT ownership review worries foreign investors By Abigail L. Ho Philippine Daily Inquirer 12:03 am | Thursday, July 21st, 2011 The recent Supreme Court ruling on the extent of foreign ownership in Philippine Long Distance Telephone Co. has further increased

uncertainty among foreign investors wanting to infuse capital into the country.

According to Henry Schumacher, European Chamber of Commerce of the Philippines vice president for external affairs, the problem was not

yet so big that foreign investors were already thinking of packing their bags and leaving the country.

However, he explained that the local investment environment had become even more uncertain for foreign investors, considering the

uncertainties that they were already facing, including those related to sanctity of contracts and inconsistent policies of the national and local

governments.

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“[The high court ruling] has not shaken things to that extent yet. It’s the control test versus the grandfather rule, in this case. This just adds

another question mark [for foreign investors here]. The government, the Cabinet, and the [Supreme Court] will have to come up with a clear

ruling on this. This has created a lot of uncertainty. We need to clarify that,” Schumacher told reporters in an interview Wednesday.

The high tribunal last month ordered the Securities and Exchange Commission to scrutinize PLDT’s ownership structure to see if the country’s

biggest telecommunications firm was violating the constitutional cap on foreign ownership in public utilities.

The Constitution limits foreign ownership in public utilities, except those specifically exempted by law such as power and oil refining, to 40

percent.

In its full-court decision, the Supreme Court effectively changed the definition of “capital” as used by PLDT and other local companies w ith

foreign stakeholders in defining their ownership structure.

According to the ruling, “capital” should only refer to voting shares or common shares and not the total outstanding capital stock. This meant the

exclusion of preferred or nonvoting shares.

PLDT chairman and chief executive Manuel Pangilinan earlier admitted that if this were the definition of “capital” to be used, then 64 percent of

PLDT was owned by foreigners. However, including preferred shares in the computation, only 13 percent of the company was owned by

foreigners.

"Grandfather Rule" - the method by which the percentage of Filipino equity in a corporation engaged in nationalized and/or partly nationalized areas of activities, provided for under the Constitution and other nationalization laws, is computed in cases where there are corporate shareholders. The present liberal application of the rule embodies the control test: Shares belonging to corporations or partnerships at least 60% of the capital of which is owned by Filipino citizens shall be considered as of Philippine nationality. But if percentage of Filipino ownership in the corporation or partnership is less than 60% only the number of shares corresponding to such percentage shall be counted as of Philippine nationality. Nationalized Corporations: 100% Filipino Owned Mass media which includes radio, television and print media (Sec. 11 (1), Art XVI, 1987 Constitution)

1. Rural Banks - 100% of its capital stock (R.A. 720, as amended) 2. Rice and Corn Industry (R.A. 3018, as amended) 3. Security, watchman, and detective Agency (R.A. 5487)

70% Filipino Owned Advertising Industry; (Sec. 11 (2), Art. XVI, 1987 Constitution)

1. Banks other than rural banks and new banks established by consolidation of branches or agencies of foreign banks in the Philippines (R.A. 337)

2. Private Development Banks (R.A. 4093) 3. Savings and Loans Associations (R.A. 3779 and 4378, as amended)

60% Filipino Owned Financing Companies - 60% of the capital stock (R.A. 5980)

1. Fishing and Business activity relating to Fishery Industry - 60% of the capital stock (PD 43 and 704) 2. Exploration, Development and Utilization of Natural Resources (Sec. 2 Art. XII, 1987 Constitution) 3. Ownership of Lands (Sec. 2 Art. XII, 1987 Constitution) 4. Operation of Public Utility (Sec. 11 Art. XII, 1987 Constitution) 5. Educational Institutions other than those established by religious groups (Sec. 4 (2) Art. XIV, 1987 Constitution) 6. Any business reserved by Congress (Sec. 10 Art. XII, 1987 Constitution)

Majority Owned by Filipinos - Investment House (P.D. 129) http://remvs.multiply.com/journal/item/13/Grandfather Rule?&show_interstitial=1&u=%2Fjournal%2Fitem The Need for Stability in Administrative Interpretations: The Control Test for Corporate Nationality (Part 1) By action for economic reforms • July 25, 2011 • Yellow Pad • 1 Comment Malaluan is a lawyer, co-founder and trustee of AER; Lumba is a lawyer, teaches at the UP College of law and is a fellow of AER. This piece was published in the July 25, 2011 edition of the BusinessWorld, pages S1/4 to S1/5. The public tends to look at current economic performance. But what really matters, for development to benefit all, is the country’s long-run economic performance. Some emphasize the relatively high growth rates prior to the global economic crisis as an indication of good performance. Yet we have learned from the past that the Philippines is capable of growth spurts that could not however be sustained even for the medium term.

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In short, the Philippines’ long-run growth rate is far from satisfactory, and we are still searching for ways to ignite the country’s long-run growth potential. What is indisputable, though, is that foreign direct investments (FDIs) play a critical role in propelling an economy on a trajectory of sustained long-term growth. In the process, a virtuous cycle is created in which the economy becomes more receptive to investments involving transfers of technology and innovations. This, in turn, enhances productivity and creates jobs, raises incomes and reduces poverty, increases purchasing power of consumers and the size of domestic markets, and attracts even more investments. But not all FDIs are good. They must be brought within specific regulatory regimes that address actual and identifiable problems, such as those on the environment and human rights. Also, their true impact on growth, employment, and structural transformation must be constantly monitored and evaluated. Still, we all lament the country’s dismal performance in attracting FDIs. FDIs in Activities with Nationality Restriction To attract FDIs, the Securities and Exchange Commission (SEC) in a 2 November 1989 en banc meeting resolved to adopt as a method for determining corporate nationality the opinion by the Department of Justice dated 19 January 1989 (Opinion No. 018, s. 1989), which states in relevant part: Shares belonging to corporations or partnerships at least 60% of the capital of which is owned by Filipino citizens shall be considered as of Philippine nationality, but if the percentage of Filipino ownership in the corporation or partnership is less than 60% only the number of shares corresponding to such percentage shall be counted as of Philippine nationality. Thus, if 100,000 shares are registered in the name of a corporation or partnership at least 60% of the capital stock or capital respectively, of which belong to Filipino citizens, all of the said shares shall be recorded as owned by Filipinos. But if less than 60% or, say, only 50% of the capital stock or capital of the corporation or partnerships, respectively belongs to Filipino citizens, only 50,000 shares shall be counted as owned by Filipinos and the other 50,000 shares shall be recorded as belonging to aliens. The first part of the rule which applies when a corporation is at least 60% Filipino-owned, commonly referred to as the “control test”, constitutes an interpretation that is favorable to foreign investors. Under this test, a corporation at least 60% Filipino investing in another corporation is deemed to be of Philippine nationality with respect to its entireequity in the corporation in which it invests. This is in contrast to the second part of the rule, commonly referred to as the “grandfather rule”, which applies when less than 60% of capital is Filipino-owned. In such instances, the investing corporation’s equity in the investee corporation shall be deemed Filipino only to the same extent that the investing corporation is Filipino-owned. Doubt Created by Redmont and Medusa The control test has been consistently applied by the SEC and relied upon by investors for more than two decades. However, in 2010 a doubt was created in the applicability of the control test by the March 2010 case of Redmont Consolidated Mines Corporation v McArthur Mining Corporation ( SEC En Banc Case No. 09-09-177 dated 25 March 2010)decided by the SEC en banc (for brevity, “Redmont”) and a December 2010 opinion issued by the SEC General Counsel concerning Medusa Mining Limited (SEC-OGC Opinion No. 10-31 dated 9 December 2010) (for brevity, “Medusa”). In Redmont, the SEC en banc appears to suggest the abandonment of the control test in favor of the grandfather rule. Thus: We believe, that a revisit of the Control Test vis-à-vis the Grandfather Rule as enunciated in the 1967 SEC Rules, is in order. x . . . . . x . . . . . x The avowed purpose of the Constitution is to place in the hands of Filipinos the exploitation of our natural resources. Necessarily, therefore, the Rule interpreting the constitutional provision should not diminish that right through the legal fiction of corporate ownership and control. But the constitutional provision, as interpreted and practiced via the 1967 SEC Rules, has favored foreigners contrary to the command of the Constitution. Hence, the Grandfather Rule must be applied to accurately determine the actual participation, both direct and indirect, of foreigners in a corporation engaged in a nationalized activity or business… In Medusa, the SEC General Counsel took what was merely a suggestion in Redmont a step further by essentially declaring the control test unconstitutional and henceforth abandoned. To quote: However, we now opine that the control test must not be applied in determining if a corporation satisfies the Constitution’s citizenship requirements in certain areas of activities. The control test creates a legal fiction where if 60% of the shares of an investing corporation are owned by Philippine citizens then all of the shares or 100% of that corporation’s shares are considered Filipino owned for purposes of determining the extent of foreign equity in an investee corporation engaging in an activity restricted to Philippine citizens. In other words, Philippine citizenship is being unduly attributed to foreign individuals who own the rest of the shares in a 60% Filipino equity corporation investing in another corporation. Thus, applying the control test effectively circumvents the Constitutional mandate that corporations engaging in certain activities must be 60% owned by Filipino citizens… The Control Test for Corporate Nationality (Part 2) By action for economic reforms • August 1, 2011 • Yellow Pad • Leave a comment Malaluan is a lawyer, co-founder and trustee of AER; Lumba is a lawyer, teaches at the UP College of law and is a fellow of AER. This piece was published in the August 1, 2011 edition of the BusinessWorld, pages S1/4 to S1/5.

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Control Test Remains in Force But a closer look at Redmont reveals that the decision does not represent an abandonment of the control test. The application of the control test is further elaborated in DOJ Opinion No. 020, s. 2005 dated 5 May 2005: In other words, based on the said SEC Rule and DOJ Opinion, the Grandfather Rule or the second part of the SEC Rule applies only when the 60-40 Filipino-foreign equity ownership is in doubt (i.e. in cases where the joint venture corporation with Filipino and foreign stockholders with less than 60% Filipino stockholders [or 59%] invests in other joint venture corporation which is either 60-40% Filipino-alien or 59% less Filipino). Stated differently, where the 60-40 Filipino-foreign equity ownership is not in doubt, the Grandfather Rule will not apply.” In Redmont, the SEC found that out of the authorized capital stock of the corporations in question, the domestic corporations paid nothing for the stocks they subscribed to in each of the corporations, and the foreign corporation “provided practically all the funds.” The SEC concluded that doubt exists in this particular case, thus calling for the application of the grandfather rule. This is confirmed by new SEC Chairperson Teresita Herbosa in a letter to Action for Economic Reforms dated 27 June 2011. She stated: “We advise that the decision in the Redmont case amply elucidates the Commission’s position on how to determine the qualification of a corporation to engage in nationalized economic activities. To reiterate and clarify, the Commission is not abandoning the control test as the general rule. However, in cases where compliance with the citizenship restrictions is doubtful, as in the Redmont case, the Commission will apply the grandfather rule considering that applying the control test would result in circumvention of the Constitutional and statutory restrictions on foreign capital.” (emphasis supplied) More important, there was a change in position on the part of the SEC Office of the General Counsel in a later opinion dated 19 April 2011 (SEC-OGC Opinion No. 11-26). While not ruling on a query on the legality of certain investments subject of the request for opinion, it discussed “for purposes of information” the rules applicable to foreign participation in investments. In its discussion, it reiterated the control test as a standing rule. The clarification made by the SEC Chairperson in the letter dated 27 June 2011, and the SEC OGC opinion dated 19 April 2011, put to rest any doubt on the applicability of the control test occasioned by Redmont and Medusa. In sum, the control test remains in force. SEC Cannot Unilaterally Abandon the Control Test Indeed, the SEC, and much less the SEC OGC, cannot unilaterally abandon the control test in favor of the grandfather rule. First, there are obvious practical difficulties in abandoning the control test that has been consistently applied by the SEC and relied upon by investors for more than two decades. Second, apart from these considerations, it is doubtful whether the SEC can, at this time and by mere administrative fiat, legally do away with the control test since it has been embodied in a law – the Foreign Investments Act (FIA). To quote: [T]he term Philippine national shall mean a citizen of the Philippines; or a domestic partnership or association wholly owned by citizens of the Philippines; or a corporation organized under the laws of the Philippines of which at least sixty percent (60%) of the capital stock outstanding and entitled to vote is owned and held by citizens of the Philippines; x x x (Sec 3 (a), Republic Act No. 7042 as amended by Republic Act No. 8179) (emphasis supplied) As confirmed in several SEC opinions, (see SEC Opinion dated 23 November 1993 and SEC-OGC Opinion No. 17-07 dated 27 September 2007) the cited provision is the statutory embodiment of the control test. What used to be a mere administrative practice has now been elevated to the level of a statutory imperative rendering it beyond the SEC’s authority to abandon. The FIA itself states: Section 12. Consistent Government Action. – No agency, instrumentality or political subdivision of the Government shall take any action in conflict with or which will nullify the provisions of this Act, or any certificate or authority granted hereunder. Moreover, it is the NEDA and not the SEC that is authorized to adopt the appropriate metric because it is the sole entity vested with the power to issue rules implementing the FIA. It has already issued said rules, wherein, in Rule I, Section 1 (b), it adopted the control test. The government has the discretion to select from a range of options what would be in the best interest of the country, as long as it is consistent with the relevant constitutional restriction to reserve control to Filipinos. Assuming that the 60% Filipino equity in a corporation investing in another corporation is not held by dummies, they can outvote the foreign equity and control its entire equity in the corporation it invests in. This is what the control test essentially means: control of a corporation results in control over its equity in another corporation. Consistency and Stability of Rules In deciding an investment destination, investors look at how the investment climate in the Philippines has improved over time, and also how it stands vis-à-vis other countries. The perception remains that rules here are more predisposed to changes. The inconsistency and instability evoked by rulings or issuances such as Redmont and Medusagive the Philippines this bad international reputation.

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We need to send a credible signal that rules and administrative interpretations will be applied consistently. Such institutionalization and stability of rules is a challenge not just for SEC, but the Philippine government as a whole.