Grandfather rule: A test for public utilities?

Not known to many, the Supreme Court rendered a sequel to Gamboa vs Teves, a 2011 decision affirmed in 2012, that defined the term “capital” for purposes of determining whether a public utility complies with the foreign ownership limit under the Constitution.

This is the case of “In the Matter of the Corporate Rehabilitation of Bayan Telecommunications Inc.” (G.R. Nos. 175418-20, December 5, 2012), which was consolidated with other cases relating to the rehabilitation of Bayan Telecommunications Inc. (Bayantel). In this case, The Bank of New York filed a creditor-initiated petition to rehabilitate Bayantel. In due course, the receiver recommended the rehabilitation of Bayantel by, among others, converting part of the company’s debt into equity. However, the rehabilitation receiver imposed, as a condition, that the resulting equity ownership of foreign creditors should not exceed the 40-percent foreign ownership limit under the 1987 Constitution.

The Bank of New York disagreed, explaining that the acquisition of shares by foreign creditors would be done, both directly and indirectly, to meet the control test under RA 7042, or the Foreign Investments Act of 1991 (FIA).

The control test deals with a situation where a corporation and its non-Filipino stockholders own stocks in an SEC-registered company. It provides that, where at least 60 percent of the capital stock outstanding and entitled to vote of each of both corporations is owned and held by citizens of the Philippines and at least 60 percent of the members of the board of directors of each of both corporations are Filipino citizens, the investee company is considered a Philippine national.

The “grandfather rule,” on the other hand, requires that the citizenship of individuals or natural persons who ultimately own or control the shares of stock of the corporation must be considered for purposes of determining compliance with the Filipino ownership requirement.

Under the proposed structure for Bayantel, the foreign creditors would convert part of Bayantel’s debt to common stock of the company. As a result, they would own 40 percent of the outstanding capital stock of Bayantel, while the remaining 40 percent of the shares would be registered to a holding company that would retain the other 60 percent equity reserved for Filipino citizens. According to The Bank of New York, this structure would comply with the control test under the FIA and, therefore, would not violate the Filipinization requirement prescribed by the Constitution for public utilities.

The issue was whether or not the proposed structure  would violate the foreign ownership limit imposed by the Constitution for public utilities.

The relevant provision is Article XII, Section 11 of the 1987 Constitution, which states that “[n]o franchise, certificate, or any other form of authorization for the operation of a public utility shall be granted except to citizens of the Philippines or to corporations or associations organized under the laws of the Philippines at least sixty per centum of whose capital is owned by such citizens.”

In ruling on the issue, the Supreme Court cited its 2011 en banc decision in Gamboa, which interpreted the term “capital” as referring only to shares of stock (whether common or preferred shares) that are entitled to vote in the election of directors. The court held that two steps must be taken to determine whether the conversion of debt to equity violates the constitutional limit on foreign ownership of a public utility: First, identify which class of shares the debt will be converted into, whether common shares, preferred shares that have the right to vote in the election of directors, or non-voting preferred shares; Second, determine the number of shares with voting rights held by foreign entities prior to conversion. If upon conversion, the total number of shares held by foreign entities exceeds 40 percent of the capital stock with voting rights, the constitutional limit on foreign ownership is violated.

The Supreme Court observed that the proposed structure would give foreigners a 77.7-percent effective ownership of the common shares of Bayantel. It then ruled that the structure would violate the foreign ownership restriction for public utilities set by the Constitution.

The FIA expressly recognizes the control test in determining the nationality of a corporation in which there are foreign investors. Yet, the Supreme Court disregarded the argument of The Bank of New York that its proposed structure is compliant with this test. The court stated that the proposed structure “is precisely the scenario proscribed by the Filipinization provision of the Constitution.” It is also worth noting that in its 2012 Gamboa decision, the Court cited with approval the en banc ruling of the SEC in Redmont Consolidated Mines Corp. vs. McArthur Mining Inc., et al. (SEC en banc case No. 09-09-177, March 25, 2010), which stated that “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.” Interestingly, all members of the First Division who rendered the Bayantel decision participated in the 2012 Gamboa decision which, as stated above, quoted with approval the Redmont decision of the SEC. In fact, four of them—Justices Martin S. Villarama, Teresita Leonardo-de Castro, Lucas P. Bersamin and Jose Portugal Perez—concurred in the 2012 Gamboa decision.

My question is: Does it now mean that a public utility, or any corporation that is nationalized under the Constitution, can no longer invoke the control test to determine whether it is in compliance with the foreign ownership limit imposed by the Constitution? Otherwise stated, is the grandfather rule now the test for said companies?

If so, it would be a huge setback to the Aquino administration’s drive to attract more foreign investments into the country.

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