Cesar C. Cruz & Partners

March 31, 2003 SEC OPINION NO. 11-03 Cesar C. Cruz & Partners 3001 Ayala Life-FGU Center 6811 Ayala Avenue Makati City Attention: Cesar C. Cruz Partner Gentlemen : This pertains to your letter submitted on behalf of your clients who are member-brokers of the Philippine Stock Exchange (PSE), calling our attention to certain provisions of Memorandum Circular No. 16, Series of 2002 ("Guidelines on the Nomination and Election of Independent Directors") which you find objectionable. The provisions are the following: 1.) Section III(B) which provides that: "The Exchange/s are required to have at least three (3) independent directors and an independent director-President. To effectively carry out the provisions of Section 33.2(g) of the Securities Regulation Code, the independent director must not be allowed to solicit votes for himself or for others or be subject to election by the stockholders until the shares are listed, or Exchange's outstanding capital stock are no longer majority owned by the brokers." 2.) Section IV(A) which states that: "The members of the Nomination Committee of the Exchange shall be cleared by the Commission;" 3.) Section IV(F)(v) which states that: "The covered companies shall amend its by-laws in accordance with the foregoing requirements as soon as practicable." Issues It is your position that Sec. III(B) of Memorandum Circular No. 16, Series of 2002 is defective for unduly depriving the shareholders of the stock exchange of their right to elect directors under Sec. 23 and Sec. 24 of the Corporation Code. Specifically, you are questioning Sec. III(B) because SEC requires the PSE to first comply with certain conditions before PSE's shareholders are allowed to elect the independent directors. With respect to Sec. IV(A), you argue that the provision requiring prior clearance by the Commission of the membership of the Nominations Committee practically constitutes a "veto power" that tampers on the power of the Board to determine the membership of the Nominations Committee. On Sec. IV(F)(v), it is your position that the said section is defective as it decrees the performance of an act which, in your opinion, rests on the discretion of the stockholders. Preliminary Consideration As a preliminary consideration, it is important to stress that the Securities Regulation Code (SRC) treats exchanges as a special specie of corporation and subjects them to rules not otherwise applicable to regular corporations. The stock exchange performs a function vital to the national economy, a function vested with public interest. It is said that the economy moves on the basis of the rise and fall of the stocks traded and thus, the integrity of the exchange overseeing these transactions can never be over emphasized. It is for this reason that the SRC provides for stricter rules on exchange regulation. The SRC devotes a whole chapter (Chapter IX) on exchanges and other securities trading markets, and it is replete with provisions designed to professionalize the exchange, encourage greater public participation, ensure increased transparency, greater responsibility and improve corporate governance. 1 These provisions are not found in the Corporation Code and are meant as additional legal requirements applicable only to exchanges. It is thus incorrect to argue that the provisions of the Corporation Code alone govern the operation of exchanges. While the Corporation Code applies to corporations in general, the SRC is a special law that primarily governs the regulation of exchanges. It is a canon of statutory construction that a special law prevails over a general law regardless of their dates of passage and the special law is to be considered as an exception to the general law. 2 As between a specific statute and a general statute, the former must prevail since it evinces the legislative intent more clearly than a general statute does. 3 Powers of the SEC over Exchanges The Commission has the clear and express power to regulate, supervise and control exchanges as the PSE. This is provided under Sec. 5.1(e) of the SRC, which reads: "The Commission shall act with transparency and shall have the powers and functions provided by this Code, Presidential Decree No. 902-A, the Corporation Code, the Investment Houses Law, the Financing Company Act and other existing laws. Pursuant thereto the Commission shall have, among others, the following powers and functions: xxx xxx xxx (e) Supervise, monitor, suspend or take over the activities of exchanges, clearing agencies and other SROs;" Supervision entails overseeing or the power or authority to see that subordinate subject performs its duties. If the latter fails or neglects to fulfill them the former may take such action or step as prescribed by law to make them perform its duties. 4 In this specific instance, the SEC can even take over the management of the exchange as authorized by the SRC. In addition, the same Sec. 5 of the SRC clothes the Commission with other powers such as to "prepare, approve, amend or repeal rules, regulations and orders, and issue opinions and provide guidelines on and supervise compliance with such rules, regulations and orders" [Par. (g)]; and, "exercise such other powers as may be provided by law as well as those which may be implied from, or which are necessary or incidental to the carrying out of, the express powers granted the Commission to achieve the objectives and purposes of these laws" [Par. (n)] . At this point, it is imperative that the SEC reminds the PSE that while the PSE has already converted itself to a shareholder-owned or stock corporation, it has not fully completed all the requirements for its demutualization as contemplated under the SRC, e . g .listing of its shares in the exchange, divestment of the stockbrokers/dealers of their shareholdings to represent the required industry or business group control of up to 20% of the voting rights of the exchange. It is for this reason that the SEC should continue to exercise such powers as are provided by law as well as those incidental to such powers and see to it that the PSE fully complies with the requirements of its demutualization; otherwise, its objective to improve its operation and to compete globally will all be frustrated. In effect, the PSE is in technical violation of the law for its non-compliance with all the requirements on demutualization and the SEC is only exercising its oversight function under the present and actual situation. HICSaD More importantly, Section 33.2(g) of the SRC confers on the Commission even the authority and discretion to define the kind of governance structure for PSE, to wit: "Registration of an Exchange shall be granted upon compliance with the following provisions: xxx xxx xxx g) For the board of the Exchange to include in its composition (i) the president of the Exchange, and (ii) no less than fifty one percent (51%) of the remaining members of the board to be comprised of three (3) independent directors and persons who represent the interests of issuers, investors, and other market participants, who are not associated with any broker or dealer or member of the Exchange for a period of two (2) years prior to his/her appointment. No officer or employee of a member, its subsidiaries or affiliates or related interests shall become an independent director: Provided, however, That the Commission may by rule, regulation, or order upon application, permit the exchange organized as a stock corporation to use a different governance structure : Provided, further, That the Commission is satisfied that the Exchange is acting in the public interest and is able to effectively operate as a self-regulatory organization under this Code: Provided, finally , That any registered exchange existing prior to the effectivity of this Code shall immediately comply with this requirement." (Emphasis Ours) From the above provision, the PSE is exhorted to comply immediately with the pertinent provisions on demutualization as provided in the SRC. Absent full compliance, the SEC is mandated to exercise its powers and authority over the PSE to bring about a realization of the provision of the law. Validity of the provisions of Memorandum Circular No. 16, Series of 2002: Sec. III(B) is a valid exercise of the broad powers of SEC over Exchanges and the rule-making powers of the SEC to implement the provisions of Sec. 33.2 of the SRC. Sec. III(B) was crafted to implement the intent and letter of subsections (c), (f) and (g) of Sec. 33.2 of the SRC, which we quote: "Sec. 33.2. Registration of an Exchange shall be granted upon compliance with the following provisions: xxx xxx xxx (c) Where the Exchange is organized as a stock corporation, that no person may beneficially own or control, directly or indirectly, more than five percent (5%) of the voting rights of the Exchange and no industry or business group may beneficially own or control, directly or indirectly, more than twenty percent (20%) of the voting rights of the Exchange: xxx xxx xxx (f) That the brokers in the board of the Exchange shall comprise of not more than forty-nine percent (49%) of such board and shall proportionately represent the Exchange membership in terms of volume/value of trade and paid up capital and that any natural person associated with a juridical entity that is a member shall himself be deemed a member for this purpose. ... (g) For the board of the exchange to include in its composition (i.) the president of the Exchange, and (ii) no less than fifty one (51%) of the remaining members of the board to be comprised of three (3) independent directors and persons who represent the interest of issuers, investors, and other market participants, who are not associated with any broker or dealer or member of the Exchange for a period of two (2) years prior to his/her appointment. No officer or employee of a member, its subsidiaries or affiliates or related interests shall become an independent director : Provided, however, that the Commission may by rule, regulation, or order upon application, permit the exchange organized as a stock corporation to use a different governance structure: Provided, further, That the Commission is satisfied that the Exchange is acting in the public interest and is able to effectively operate as a self-regulatory organization under this Code: Provided, finally, That any registered exchange existing prior to the effectivity of this Code shall immediately comply with this requirement." (Emphasis ours.) The above-quoted Sec. 33.2. of the SRC is not found in the old Revised Securities Act, nor in the Corporation Code. Items (c), (f) and (g) thereof are all intended to encourage greater public participation, ensure increased transparency, greater responsibility and improve corporate governance. Subsection (c) mandates that the ownership of the stocks of the exchange be broadened and democratized, thereby ensuring greater public participation. On the other hand, Subsections (f) and (g) mandate a board composition where no more than 49% of the seats shall be occupied by brokers, and no less than 51% to be comprised of (3) independent directors 5 and persons representing other sectors of the market. With respect to independent directors, their election in the Board is intended to ensure that the Board will faithfully discharge its fiduciary responsibilities to its stockholders. These provisions aim for a more representative, democratic, independent Board of Directors that is autonomous from the control of any sector of the market. These subsections of Sec. 33.2 were drafted as a single whole, meant to complement each other, such that the non-implementation of some will negate the efficacy of the implementation of the whole section. It is presumed that when a statute is passed, it is passed as a whole and not in parts or sections and is animated by one general purpose or intent. Thus, each section of the statute must be construed in connection with other parts of the statute so as to produce a harmonious whole. Sec. III(B) provides that, as a condition to the election of independent directors by the stockholders, the ownership structure of the exchange should be first democratized and made open to the general public. Incidentally, as the records will bear, the PSE has failed to comply with subsection (c) of Sec. 33.2. Contrary to the mandate of the SRC, the present PSE is still wholly owned by the brokers and dealers and is therefore, technically, in violation of the above-quoted provision. On January 7, 2003, the Commission reminded the PSE of this matter and was directed to fully comply with the ownership limit prescribed by the SRC on or before December 31, 2003. 6 It can not be overemphasized that for so long as the ownership of shares of stock of the exchange remains in the hands of brokers and closed from the public, any election of independent directors will be nothing but a sham, as the same controlling group will have the power to elect them and, thus, negating the whole intention of electing independent directors as envisioned by the SRC. Any election of independent directors under this environment will not lead to the ends which the law envisions. Sec. III(B) is a valid exercise of the rule making powers of the Commission. As you have correctly stated in your letter, "regulations adopted under legislative authority by particular department must be in harmony with the provision of the law, and for the sole purpose of carrying into effect its general provisions." 7 Neither does it violate the right of the stockholders to due process of law. For one, Sec. III(B) does not deprive the stockholders of the right to elect independent directors. At its very worse, Sec. III(B) of the Circular merely suspends this right to elect independent directors until such time that the requirements under Sec. 33.2(c) SRC and Section 33.2(c)(3) of the IRR have been complied with by the exchange. The Commission, in the exercise of its regulatory powers, can very well impose rules and regulations, as well as sanctions, to encourage and ensure the faithful compliance of the law by the exchange. Secondly, substantive due process merely requires the intrinsic validity of the rule in interfering with the rights of the person to his life, liberty and property. As have been clearly explained, Sec. III(B) is based on Sec. 33.2 of SRC, a law validly passed by Congress. The rules issued in its implementation are in pursuit and in accordance with the letter, purpose and ends of the said law. The rules were issued towards a valid governmental objective. In sum, the questioned provisions in SEC Circular Memorandum 16 are within the scope and purview of the Securities Regulation Code, specifically Sec. 33.2 and are indeed directed to attain the intent, purpose and policy of the law. In fact the SEC Circular is in line with the previously approved PSE By-laws which provide that all non-broker candidates shall be nominated by a Special Nominations Committee. Likewise, the PSE Manual on Corporate Governance provides that the NOMELEC, in consultation with SEC, shall pre-screen and shortlist all candidates. We interpreted this to mean particularly the independent directors. At this point, we bring to your attention the complaint filed on March 21, 2002 by Ramon Garcia, Joseph Roxas and Trinidad Kalaw against the Non Brokers director of the PSE, the broker members of the PSE Board of Directors for 2001 and members of the NOMELEC of PSE for the March 9, 2002 elections, docketed as Civil Case No. 02-02 with the Regional Trial Court of Pasig City, (Br. 158). Part of the undisputed facts was that out of nineteen (19) names nominated for non-broker directors, the NOMELEC of PSE recommended the approval of eight (8) non-broker candidates to the PSE Board following the Election Rules and Procedures which was approved by the PSE Board and the SEC. These eight, whose nominations were approved by the PSE Board were: Tomas Apacible, Joaquin Bernas, Mario Camacho, Peter Favila, Monico Jacob, Ernest Leung, Eugenio Lopez III, and Cayetano Paderanga Jr. During the March 9, 2002 stockholders' meeting for election of the PSE Board, the PSE Chairman proclaimed as duly elected members of the PSE Board for 2002-2003 the seven (7) broker-directors elected by the stockholders and the eight (8) non-broker candidates who were not voted upon by the stockholders but were deemed elected. Plaintiffs alleged that failure to actually elect the eight defendant non-broker directors violated the plaintiffs' right to vote and be voted upon, thus making the March 09, 2002 election of non-broker directors null and void. In the Decision dated June 7, 2002, the Court ruled as follows: ". . . It is undeniable from the records that the NOMELEC has been given the leeway to choose who are eligible to become non-broker directors of the PSE. The Amended PSE By-laws itself provide that the non-broker directors shall be nominated by a Special Nominations Committee, which is defendant NOMELEC. By virtue of this authority, NOMELEC could have by itself submitted its list of nominees for non-broker directors. Yet, NOMELEC instead opted to solicit recommendations from the stockholders in its hope to acquire the services of the most qualified non-broker directors who can help the PSE. It made clear, however, that it shall fairly and independently evaluate the nominees' respective qualifications and come out with its final and official list of candidates as required by the PSE By-laws and consistent with the underlying objective of the SRC (see Item D of the PSE Election Rules and Procedure). With respect to the contention that there was no actual voting conducted with respect to the candidates for non-broker directors, the reason to uphold the validity of their proclamation is obvious: it will be nothing more than a futile exercise. ...However, the circumstances of this case, for practical purposes, warranted the deviation from the rules. The fact remains that whatever could have happened on March 9, 2002, the eight non-broker candidates would still be proclaimed as non-broker directors. It would have been different if each candidate was required under the election rules to secure a minimum number of votes in order to be deemed elected, in which case actual voting would still be indispensable. In this case, however, each of the eight non-broker directors would still have been considered elected even if they secure only one vote or even none at all. Thus, defendant Guevara as NOMELEC Chairman merely exercised his sound discretion in declaring that the eight (8) non-broker candidates were already deemed elected. xxx xxx xxx WHEREFORE, this case is dismissed. No award of damages, but plaintiffs shall pay the cost of suit." Sec. IV(A) and Sec. IV(F)(v) are valid exercise of the Commission's supervisory powers The Commission can require the exchange to submit the membership composition of its nomination committee (for the nomination and election of independent directors).Such prerogative, reiterated in the questioned Sec. IV(A) of the Circular, is inherent in the regulatory powers of the Commission over the exchange. In fact, the Commission is duty-bound to ensure that the exchange and other corporations covered by the questioned Circular comply with the requirements of the law and rules and regulations pertaining to the nomination committee, both as to membership and qualifications and manner of selection of the committee members. Lastly, we see no legal infirmity in Section IV(F)(v). Contrary to your belief, the mandatory provisions of the SRC as articulated in the questioned Circular are, by operation of law, binding on all covered corporations whether these provisions are reflected in the by-laws or not. Even if these provisions of the SRC and its implementing rules and regulations are not integrated into the by-laws, these are deemed read into it. Sec. IV(F)(v) merely directs the covered companies to amend their by-laws to make it conform to the provisions of the SRC and its implementing rules and regulations. For your information and guidance. TcDHSI Very truly yours, (SGD.) VERNETTE UMALI-PACO General Counsel Footnotes 1. For instance, the SRC mandates that exchanges should be organized as a stock corporation and directing the demutualization of the existing exchange within one (1) year from the effectivity of the Code [Sec. 33.2 (a)]. It also mandates stock ownership limits on individuals, industries and businesses, and brokers [Sec. 33.2 (c), (f) and (g)], thereby ensuring greater public participation. The SRC also requires that the president and other management of the exchange shall be persons who are not members and are not associated in any capacity, directly and indirectly with any broker or dealer or member or listed company of the exchange [Sec. 33.2 (h)] 2. Butuan Sawmill, Inc. vs. City of Butuan ,No. L-21516, April 29, 1966, 16 SCRA 755. 3. Fietsan vs. Court of Appeals ,G.R. 81552, May 28, 1990. 4. Reynaldo R. San Juan vs. CSC et al .,G.R. No. 92299, April 19, 1991. 5. Sec. 38 of the SRC defines an independent director as "a person other than an officer or employee of the corporation, its parent or subsidiaries, or any other individual having a relationship with the corporation, which would interfere with the exercise of independent judgment in carrying out the responsibilities of a director." 6. Letter of the Commission to Mr. Ernest Leung, President of the PSE, dated January 7, 2003. 7. United States vs. Tupasi Molina (1914).