Will ‘corporate layering’ for nationalized investments be a thing of the past?

ON DEC. 9, 2010, the Office of the General Counsel (OGC) of the Securities and Exchange Commission (SEC) issued an opinion concerning Medusa Mining Limited which puts into question the longtime practice of “corporate layering” as a means of addressing the foreign ownership limits prescribed by the Constitution and other laws for certain areas of economic activity.

Briefly, Medusa is an Australian company, which is an investor in a joint venture that is a holder of a mineral production agreement. Medusa owns 40 percent of the joint venture while local firm Philsaga Mining Corp. owns the remaining 60 percent. Philsaga, in turn, is owned 40 percent directly by Medusa.

Medusa also indirectly owns 60 percent of Philsaga through the layering of the 60 percent equity through Philippine subsidiaries, namely, Medusa Exploration and Development Corp. (MEDC) and Medusa Overseas Holding Corp. (MOHC).

The issue is whether this kind of corporate structure complies with the 1987 Constitution and the Philippine Mining Act, which require at least 60 percent ownership by Philippine citizens for mineral production sharing agreements.

The constitutional provision at issue is Article XII, Section 2, which governs the “exploration, development and utilization of natural resources.” It states that “[t]he State may directly undertake such activities, or it may enter into co-production, joint venture, or production-sharing agreements with Filipino citizens, or corporations or associations at least 60 per centum of whose capital is owned by such citizens.” The Mining Act mirrors this constitutional requirement by providing that a corporation whose capital is at least 60 percent owned by Philippine citizens is qualified as a contractor in mineral production agreements with the state.

Citizenship

In resolving the issue, the OGC observed that both the Constitution and the Mining Act use the term “citizens.” It then looked at Article III of the Constitution, which deals with citizenship, to determine who are citizens of the Philippines.

“Section 1. The following are citizens of the Philippines:

1. Those who are citizens of the Philippines at the time of the adoption of this Constitution;

2. Those whose fathers or mothers are citizens of the Philippines;

3. Those born before Jan. 17, 1973, of Filipino mothers, who elect Philippine citizenship upon reaching the age of majority; and

4. Those who are naturalized in accordance with law.”

The OGC noted that “only natural persons are susceptible of citizenship” under the provision. Since the “enumeration is exhaustive,” there can be “no other (sic) Philippine citizens other than those falling within the enumeration provided by the Constitution.” The OGC then concluded that “for purposes of the Constitutional and statutory restrictions on foreign participation in the exploitation of natural resources, a company investing in a mining joint venture can never be considered as a Filipino citizen.”

In support of its opinion, the OGC cited Pedro R. Pating vs San Jose Petroleum Incorporated (G.R. No. L-14441, Dec. 17, 1966), decided by the Supreme Court en banc in 1966, which, according to the OGC, held that “a corporation investing in another corporation engaged in a nationalized activity cannot be considered as a citizen for purposes of the Constitutional provision restricting foreign exploitation of natural resources.”

Also, the OGC distinguished between “citizenship” and “nationality.” It stated that both the Constitution and the Mining Act use the phrase Philippine ‘citizens’ and not Philippine ‘nationals’ as used in other statutes such as the Foreign Investments Act (FIA).

According to the OGC, “[t]he term “Philippine national” as used in the FIA is not synonymous or equivalent to the concept of “Philippine citizen” as used in the Constitution and the Mining Act.”

Grandfather rule vs control test

In issuing the opinion, the OGC disregarded the liberal rule or “control test” in favor of the strict test or “grandfather rule” in determining compliance with foreign ownership limits for certain areas of economic activities.

The control test, which originated from a DOJ opinion, basically states that “shares belonging to corporations or partnerships at least 60 percent of the capital of which is owned by Filipino citizens shall be considered as of Philippine nationality.” The strict test or “grandfather rule,” on the other hand, requires that the citizenship of the individuals or natural persons who ultimately own or control the shares of stock of the corporation must be looked into for purposes of determining compliance with the Filipino ownership requirement.

For example, in the Medusa case, after using the grandfather rule in analyzing the ownership structure of all of the different companies, the OGC concluded that “the mining joint venture is 87.04 percent foreign-owned, while only 12.96 percent owned by Philippine citizens.”

Therefore, the 60 percent ownership by Philippine citizens required by the Constitution and the Mining Act has not been complied with.

In no uncertain terms, the OGC stated that “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.” According to the OGC, “[t]he control test creates a legal fiction where if 60 percent of the shares of the investing corporation are owned by Philippine citizens then all of the shares or 100 percent 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 percent 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 percent owned by Filipino citizens.”

Some questions

The Medusa opinion has raised eyebrows in the local business community and even among foreign investors. Of course, there are a lot of questions raised on the opinion. Why did the OGC suddenly abandon the more liberal control test, which has been long recognized by no less than the DoJ and SEC en banc, at a time when the Aquino administration needs foreign investors for its public-private partnership (PPP) program?

Was the opinion pre-cleared with the SEC commissioners and is there a subtle message being relayed to the Aquino administration? From a legal standpoint, can an OGC opinion overrule prior rulings of the SEC en banc that expressly sanctioned the control test? Did the OGC make unwarranted distinction between citizenship and nationality? Did the OGC correctly read the San Jose Petroleum case?

Is the opinion limited to areas of economic activities nationalized by the Constitution? Does the opinion, which deals with mining, apply to land ownership where the Constitution does not expressly and directly impose a foreign ownership restriction? What will happen to longtime corporate structures that were put in place in good-faith reliance upon the control test? Is “corporate layering” being totally outlawed and will it soon be a thing of the past?

These and other questions have to be answered for the guidance of the investors.

(The author, formerly the president and CEO of the Philippine Stock Exchange, is now the co-managing partner and head of the corporate and special projects department of Accralaw. He may be contacted at [email protected].)