Atty. Ricardo N. Fernandez, Jr.

August 3, 1990 Atty. Ricardo N. Fernandez, Jr. Gozon, Fernandez, Defensor & Parel 15th Floor, Sagittarius Condominium H.V. dela Costa Street Salcedo Village, Makati Metro Manila S i r : This refers to your letter dated May 4, 1990 requesting opinion on the queries posed therein: You stated that your client is the buyer of approximately 93% of the common stock, 100% of the preferred Class B stocks of Paramount Finance Corporation (PFC). You further state that the purchase and sale of these shares are pending approval of the Central bank to which your client has submitted a Rehabilitation Plan for PFC. llcd Records show that PFC has an authorized capital stock of P210 Million broken down as follows: Class of Share No. of Share Par Value Total Par Value Common A 490,000 P100 P49,000,000.00 Common B 210,000 100 21,000,000.00 Preferred A 12,000 5,000 60,000,000.00 Preferred B 8,000 10,000 80,000,000.00 720,000 P210,000,000.00 The following are the important features of the foregoing classes of shares: 1. Class A Common and class A Preferred shares are issuable solely to Philippine nationals. 2. Preferred A shares are non-voting, entitled to 10% cumulative dividends and redeemable at the option of the corporation within three (3) years from date of issuance. If redemption does not take place at the end of the third year, the holder shall have the right to convert said shares to common shares of the same number and par value subject to applicable Philippine laws on the date of conversion. 3. Preferred B shares are non-voting, entitled to 14% of cumulative dividends, and redeemable at the option of the Corporation not earlier than eight (8) years but not later than fifteen (15) years from date of issuance. If redemption does not take place by the end of the 15th year, the holder shall have the right to convert said shares to common shares of the same number and par value subject to applicable Philippine laws prescribing a nationality requirement for stock ownership on date of conversion. Your queries are: 1. In the conversion of Class A preferred stocks into common shares, would the holder get for each class A preferred share 50 common class A shares or would the holder get one common class A share for each class A preferred share? 2. Can PFC amend its articles of incorporation by decreasing its authorized capital stock to P50 Million from the present P210 Million by having only 2 classes of shares common A and common B with the par value of P100 each? If the answer is in affirmative, it would mean that the preferred shares would be eliminated as class of shares of stock. Would such amendment be legally feasible assuming that the required number of votes of 2/3 of the outstanding capital stock approves the amendment? llcd 3. If yes, what would be the rights of the preferred shareholder? Would the appraisal right under Title X of the Corporation Code be all the right of the dissenting preferred stockholder? If so, is the prohibition to pay the fair value of the share in the absence of unrestricted retained earnings absolute? Could the corporation make payment out of additional capital assuming that there are no unrestricted retained earnings? 4. Would the dissenting preferred stockholder also have the right to convert his preferred shares into common subject to applicable Philippine laws on the date of conversion pursuant to the pertinent provision in the articles of incorporation of the corporation? If the answer is yes, would the conversion be such according to the answer to Question No. 1. Your client is buying into PFC at P1.49 per Class A and B share and P121.36 per Class B preferred share which are very much less their respective par value, should not the conversion ratio for the preferred Class A be at the same reduced proportion as what the sellers would receive to be fair to the buyer and to the sellers? Regarding query No. 1, corporate records show that the preferred shares of the corporation, particularly preferred B shares, were created to accommodate a substantial investment of the National Bank of Detroit (NBD), a foreign company, in the capital of PFC. Considering that under RA 5980, at least 60% of the capital of financing companies must be owned by Filipinos, it was then necessary that the number of shares issued to NBD should not exceed 40% of the total outstanding shares of PFC. To accomplish this, the part value of the preferred B shares was increase to P10,000 per share so that the number of shares issued to NBD would not exceed 40% of the total outstanding shares although their total par value would exceed 40% of the aggregate par value of shares outstanding. It can therefore be construed that in the conversion of preferred shares to common shares, it was intended that the holders of the preferred shares would have the same proportionate interest, as represented by the "number of shares" held in the Corporation, after conversion. Clearly, the purpose is to ensure that the percentage of interest in PFC by Filipinos and non-Filipinos is maintained at the level allowed by law . In this connection, it is worth mentioning that it is a generally accepted principle that when construing a provision, the reason for its adoption should be kept in mind, and the same should be construed with reference to its intended scope and purpose. Hence, the provisions in PFC's articles of incorporation providing for the conversion of preferred shares to common shares "of the same member and par value" should be interpreted to mean that each preferred A share shall be converted to one common share with a par value of P5,000 and that each preferred B share be converted to one common share with a par value of P10,000 . Obviously, such conversion would necessitate the amendment of PFC's articles of incorporation for the purposes of creating common shares with par value per share of P5,000 and P10,000. As regards question No. 2, whether or not PFC can be allowed to decrease its authorized capital stock will depend on the purpose on how it will carry out such decrease. There may be no objection to the decrease of its authorized capital stock if its purpose is merely to reduce its existing deficit since no creditors would thereby be prejudiced. On the other hand, if the purpose of the decrease of the authorized capital stock is to redeem outstanding shares, it cannot be done because it would mean paying PFC's stockholders ahead of its creditors to the prejudice of the latter. It is worth mentioning that as a rule, purchase or redemption of shares are subject to the general restriction in favor of priority of creditors and may not be made when a corporation is insolvent or if such purchase or redemption will cause insolvency or inability to meet debts and liabilities as they accrue . (SEC Opinion Inc., citing Ballantine on Corp., sec. 263, p.620 citing Mueller v. Kreantor & Co., Inc., 131 N.J. Eq. 475, 25A (2d) 874). Redemption of shares is, therefore, subject to the limitation quoted hereunder: "The obligation to redeem is at all times subject to the implied condition that it will not render the corporation insolvent in the sense that it would be unable to meet the debts as they mature in the usual course of business." (11 Fletcher, Cyc. Corps., 1971 Rev. Vo., sec. 5310, p. 593, citing Kraft v. Rochambeau Holdings Co., 210 Md. 325, 125 A2d 287) prcd "Before shares can be redeemed, three obligations must be overcome: (1) there must be no violation of the contract of those shareholders, (2) it must not constitute a preferential treatment of those shareholders, and (3) it must not prejudice creditors (Agbayani, Commercial Laws of the Philippines, Vol. 3, 1984 ed., p. 103, citing Stevens) For the protection of creditors, the most general limitation is that redemption shall not be paid out of capital but only from surplus (Agbayani, citing Phorlick, 339 and Stevens, p. 439), but there is a statutory authority that it can be made even out of capital, provided that the assets remaining after subscription are equal to the corporate debts plus the amount of the capital stock item, if the same is redeemed by the cancellation of the redeemed shares ." (Agbayani, citing Stevens, 440) In all the foregoing, it clearly appears that the "trust fund doctrine" is strictly adhered to. "Corporate assets are a trust fund for creditors to the extent that creditors are entitled to payment before the distribution of capital to shareholders." (Ballantine on Corporations, Sec. 264, p. 621) The importance of the above doctrine has been emphasized by the Commission in its Rules Governing Redeemable and Treasury Shares by providing that: "Redeemable shares may be redeemed regardless of the existence of unrestricted retained earnings, provided that the corporation has, after such redemption sufficient assets in its book to cover debts and liabilities inclusive of capital stock ." (Sec. V(5) Emphasis supplied) Otherwise stated, under Sec. V(5) of the said SEC Rules, the corporation must not have a deficit after the redemption. Based on its audited balance sheet as of December 31, 1988, PFC has a substantial deficit amounting to P117,487,655. In view of the foregoing answer to question No. 2, we need not answer query no. 3. Relative to question No. 4, if the stockholder opts to convert his preferred shares to common, the pertinent provisions of the articles of incorporation of the corporation must be complied with and the conversion must be done in accordance with our answer to question No. 1. It has to be stressed that "the charter of the corporation, whether it is created by a special act or formed under a general corporation law, is a contract (1) between the state and the corporation (2) between the corporation and the stockholders and (3) between the stockholders and the state." (Martin, Commentaries and Jurisprudence of the Philippine Commercial Laws Vo. 4, 1981 Edition p. 78 citing Government vs. Manila Railroad Co., G.R. No. 30646, January 30, 1929, 52 Phil. 699) Such being the case, any provision therein cannot be changed without the formalities required under existing laws. "All the terms of the preferred share contract must be set forth in the certificate of incorporation and cannot be added to or changed by the by-laws, stock certificates or corporate resolution." (Ballantine Corporations p. 63 citing Geshill v. Glady's Belle Oil Co. 16 Del Ch. 289, 146 Atl. 337) Accordingly, the corporation cannot adopt any manner of conversion of preferred shares to common that is contrary to the provisions of the articles of incorporation and the Corporation Code of the Philippines. LexLib Very truly yours, (SGD.) RODOLFO L. SAMARISTA Associate Commissioner