Misconception on PDRs

The decision of the Securities and Exchange Commission (SEC) to revoke the certificates of incorporation of Rappler, Inc. and Rappler Holdings Corp. (RHC) for alleged violation of nationality rules arising from a Philippine Depositary Receipts (PDR) agreement they entered into misappreciates the true nature of the financial instrument that some wholly or partially nationalized companies use to raise capital.

A PDR is a document that gives its holder, in consideration for the payment of a certain price, the right to “own” the stocks of a company and to receive their dividends or interest. In spite of that right, however, title over the stocks remains with the company.

A depositary agent receives payments from the PDR holders and remits them to the company, and collects the dividends or interest from the company and pays them to the PDR holders.

If the holder wants to exercise his right, he is entitled to either the delivery of the stocks or payment of the proceeds of the sale of the stocks that correspond to the PDR.

The exercise of this right is, however, subject to the condition that it is allowed by Philippine law, i.e., it will not violate ownership or nationality restrictions to which the company is subject to.

Thus, if the exercise will result in, say, breach of 100-percent Filipino ownership of a mass media company, the PDR holder cannot compel the issuance of stocks to him and he is obliged to accept instead the monetary value of the stocks. This condition is spelled out in the subscription agreement that the PDR holder has to sign prior to the acceptance of his investment.

This restriction though has not dampened enthusiasm for PDRs from foreign investors because they are issued by Philippine companies with proven managerial and profit-making capabilities that assure their holders of satisfactory dividends or interest. And when they want to exit, the PDR holders can look forward to receiving the market value of their investment.

This mechanism has enabled Philippine companies that are required by law to maintain certain ratios in their stock ownership, e.g., at least 60 percent Filipino for public utility companies and 100 percent for mass media entities, to solicit and accept investments from the international financial market without violating nationality rules.

The rule of the thumb in PDRs is, they should only supplement the issuer’s capital requirements and not constitute its principal funding source. Thus, the percentage of PDRs issued by local companies in relation to their capital stock or equity ranges from 10 to 20 percent.

Initially used by PLDT in 1988—dubbed then as Global Depositary Receipts and later American Depositary Receipts because the bulk of its investors came from the United States—this funding scheme has since been (and continues to be) used by, among others, ABS-CBN Corp., GMA Network, Inc., and Globe Telecoms, to raise capital from international sources.

Going back to the Rappler case, RHC is the majority stockholder of Rappler. The former issued PDRs covering the latter’s stocks to Omidyar Network Fund LLC, a foreign company.

A provision of the PDR agreement with Omidyar reads:

“12.2 The Issuer undertakes to cause the Company from the date hereof and while the ON PDRs [Omidyar PDRs] are outstanding: x x x

“1.2.2.2 not to, without prior good faith discussion with ON PDR Holders and without the approval of the PDR Holders holding at least two thirds (2/3s) of all issued and outstanding PDRs, alter, modify or otherwise change the Company Articles of Incorporation or By-Laws or take any other action where such alteration, modification, change or action will prejudice the rights in relation to the ON PDRs;”

According to SEC, these provisions show that Omidyar exercises some degree of control in the management of Rappler, and therefore contrary to the constitutional provision that the management of mass media companies should be totally in Filipino hands.

This conclusion overlooks the fact that PDRs are, like hedge funds, investment instruments whose holders invest in to earn profits and not to gain control of the company. Thus, when the holders are no longer satisfied with receiving dividends or interest and the listed price of their PDRs or that of the stocks of the company goes high enough to allow a satisfactory return on their investment, they are quick to sell their PDRs.

The critical element to consider in determining the true objective of the provision cited by SEC to justify its action is the phrase “where such alteration, modification, change or action will prejudice the rights in relation to the ON PDRs”

The clear intent of this clause is to bar RHC from doing anything that may prejudice the financial interests of Omidyar or make it difficult for RHC to comply with its obligations under the PDR agreement, not to exercise any modicum of control over RHC.

Except for some variation in wording, this provision is standard (or de cajon as bankers call it) in local and international financial agreements because they are meant to assure the creditor or investor that the debtor would refrain from engaging in acts that may impair its ability to meet its financial obligations.

When an investor, like a PDR holder, extends credit to a borrower-company, it relies on the representations made by the latter during the investment solicitation on, for example, its corporate structure, business plans and projections, in deciding on whether to invest or not.

Thus, it is only fair that if the debtor decides to make changes or alters its corporate objective or manner of doing business, it should seek clearance from the creditor or investor before doing so. No investor worth his salt would agree to a contrary arrangement.

It is in this context, not in an overstretched interpretation of management control, that SEC should have looked at the provision that formed the basis for its conclusion that Rappler and RHC violated the requirements on nationality ownership.

Going by SEC’s logic, mass media companies that have outstanding loans with foreign financial institutions, including Philippine banks with foreign investors, that contain provisions similar to the disputed clause may be in danger of losing their certificates of incorporation for violation of nationality rules.

If this happens, expect nationalized Philippine companies to become pariahs in the international financial market.

The SEC’s exuberant definition of management control and misreading of the PDR mechanism has opened a Pandora’s Box for the affected companies. Mercifully, the Court of Appeals or Supreme Court can prevent this from happening.