■ Difference is a fuzzy one, the two concepts refer

1. Economic Attributes of Investment Devices (William Klein & John to ends of a spectrum.
Coffee, Jr.,: BUSINESS ORGANIZATION AND FINANCE, 240-250 (2007)) ○ In the Financial literature, all outcomes are called
―probabilities.‖
Chapter 4: BASIC CORPORATE INVESTMENT DEVICES: ECONOMIC ● Default Risk
ATTRIBUTES AND FORMAL CHARACTERISTICS ○ In some contexts, the term risk is used to refer to the
possibility of nonpayment of a debt or to the possibility of
A. EXPECTED RETURN defaults.
○ People in the business and financial world do use a
● Expected return is a measure of return that uses rudimentary concept that corresponds to default risk and if only for that
concepts of probability to take account of risk or uncertainty as to reason it seems wise that we have a verbal device for
outcome. easily identifying that concept and distinguishing it from
● Suppose that you bet $1 on the flip coin. If you win, you will have what we have labelled volatility risk.
$2, and if you lose, nothing. The expected monetary value of that
investment is $1. C, YIELD
● People do, consciously or unconsciously make calculations of this
sort. Their information may be faulty. ● The rate of return that will become earned by lender if the FULL
● Still, we need a term to describe the outcome of the process of amount of interest and principal that the borrower has agreed to
considering and weighing prospects of various investment pay are PAID ON SCHEDULE
possibilities. ● It is the promised rate of return.
● Example: Suppose a bond requires the company to pay $1000 ,
B. RISK AND UNCERTAINTY bond is initially bought (and sold) for $900--less than par. Now the
purchaser will receive $100 on an investment of $900. The rate of
● Volatility Risk return is about 11 %.
○ Risk refers to the degree of dispersion or variation of - The 11% = Current yield --the promised interest payment
possible outcomes. as a percentage of initial investment
○ See example in the readings. - That percentage is of significance for tax purposes and for
○ One investment is said to be more risky than another if the people concerned with cash flow.
dispersion of potential outcomes is greater. (Volatility risk - $100 is obviously part of the investor‘s total return, part of
or variance as the term more commonly used by financial true yield often called Yield to Maturity.
experts) - Yield reflects the promised rate of return, not the expected
○ Distinction between risk and uncertainty: rate of return.
■ Risk is then used to refer to variation depending
purely on chance or more broadly, to D. RISK PREMIUM
measurements as to which there is a large body
of data or experience so that the probable ● Defined as the difference between Yield on a particular obligation
outcomes can be estimated in a purely and the prevailing market rate (yield) on an obligation with identical
mechanical way, characteristics BUT with no risk of default (like government
■ Uncertainty, by contrast, refers to estimates treasuries/bonds, remember the concept that a government is
made in situations where there is so little always solvent)
experience that the process of estimation is ● In essence you compare a risky and a risk free obligation.
highly intuitive.
 ● [Can’t read the definition from the book but Coch might ask: What - In the financial and economic literature, your attitude is
is callability? What is callable?] Callability is a feature of a security called Risk aversion. You dislike taking risks, so you
that allows the issuer to redeem the security prior to maturity by pay some price to avoid them.
calling it in, or forcing the holder to sell it back. ● Suppose that after you have given the matter a considerable
● For example, suppose that a noncallable corporate bond pays 10% thought, you conclude that you will be willing to accept $400,000 for
annually while U.S Treasury Bond with the same maturity date (and the certificate. You are willing to accept $400,000 in exchange for
noncallable by custom pays 6.5 %. The risk premium is 3.5%. the risky expected $500,000 return.
(where did that came from? 10%-6.5% = 3.5%) ● A critical axiom of modern investment analysis is that in their major
- This risk premium compensates both for the default risk investment decisions the overwhelming majority of people are risk
and for the volatility risk associated with default risk. averse.
- Since the compensation for the latter risk may be ● The amount they must be paid to accept the volatility risk is
negligible, however most of the risk premium may sometimes called the RISK PREMIUM.
represent compensation for default risk.
● The longer the duration of an obligation, the more its market price F. COMPENSATION FOR VOLATILITY RISK
will change with any change in the market rate of interest
● Accordingly, the volatility of the price of long term obligation is ● Modern theory tells us that investors are compensated
greater than that of a short term obligation. only for the volatility risk that cannot be avoided by
● One way of expressing this thought is to say that there must be diversification.
premium to compensate for the greater potential price volatility of ● Suppose for example that we compare two obligations,
long term obligations --‖Illiquidity Premium‖ one issued by the US Treasury and one by X Corporation,
● Illiquidity premium - the thought being that long term obligations are providing for payment of $100,000 one year hence with no
less liquid than short term obligations and that there is an added interest payment. Assume that the obligation are identical
amount, a premium in the long term interest rate to compensate for in all respects EXCEPT that there is a 3% chance of total
the illiquidity. default on the X corporation obligation.
- Thus the expected return on the treasury
E. RISK AVERSION obligation is $100,000 (the promised amount)
and the expected return on X corporation
● (Internet definition) In economics and finance, risk aversion is the obligation is the $97,000 (the promised amount,
behavior of humans (especially consumers and investors), who, $100,000, reduced by 3% chance of default)
when exposed to uncertainty, attempt to lower that uncertainty. It is - If the market rate for 1 year risk free obligation is
the hesitation of a person to agree to a situation with an unknown 6%, the Treasury obligation should sell for
payoff rather than another situation with a more predictable payoff $94,339.62. ($100,000/1.06)
but possibly lower expected payoff. - Assume that X corporation onlihation is also
● Suppose that a fairy princess (named Kevin) has bestowed upon priced to reduce an expected yield of 6%. =
you a certificate that gives the holder the right to recieve $91,509. ($97,000/1.06)At this price, its expected
$1,000,000 if he/she correctly calls the flip coin, there‘s a 50-50 yield will be the same as the Treasury Obligation,
chance of receiving $1,000,000 or nothing. The expected return on namely 6%
the certificate is $500,000. ● Which investment would you prefer? Your answer should be, the
- Suppose that you are free to sell the certificate, would you treasury obligations.
be willing to accept less than $500,000 for it? - Both have the same expected yield, but X Corporation‘s
obligation has some volatility risk.
- Once treasury rate is established, if X corporation expects
to sell its obligation, it will be required to lower the price at
least to a small amount so that its expected yield will be
slightly higher than 6% yield on treasury obligation.
 ○ Purpose: is to provide a borrower with an outline of the
fundamental terms and conditions relating to the lender‘s
2. Debt Instruments and Loan Documentation (Kenneth Marks, Larry willingness to enter into a loan transaction
Robbins, Gonzalo Fernandez, and John Fuunkhouser ■ The outline can vary from one page to a complex,
multipage letter
[pp 164-182] ○ The borrower may then use the letter to serve a variety of
purposes, including providing 3rd parties with evidence
DEBT INSTRUMENTS that the borrower is capable of consummating a
transaction.
● 2 broad categories: ○ In most cases the fees associated with committing to
○ Secured debt – is a loan extended to the borrower based make the loan and the fees associated with originating the
primarily on the ability of the borrower to repay the loan loan will be stated in the commitment letter.
from the cash flows of the borrower. ○ If the loan requested by the borrower is in excess of the
■ In the event that the borrower cannot pay the amount of loan desired to be advanced by the lender, the
loan, the lender acquires the title to the assets commitment letter would normally describe a syndication
pledged as security and then sell the assets. process.
■ If the proceeds are insufficient, the lender has a ■ The letter would normally name the committing
claim on the general assets of the borrower. lender as the administrative agent for arranging a
○ Unsecured debt – made when the borrower is able to syndicate of lenders who will participate in
convince the lender that the general credit of the borrower making the overall loan.
is sufficient to ensure repayment of the requested loan. ■ The letter would also state that the borrower must
● Securing the Commitment cooperate with the administrative agent and to
○ The borrower must be able to articulate the purpose for represent that the information it provided is
the loan request together with a financial plan about the complete and correct in all material aspects.
repayment of the loan. ○ There is usually a period of time between the issuance of
○ The traditional way is the preparation of a business plan the letter and the closing of the loan because there are
for the borrower that includes information regarding the oftentimes conditions of the lender (due diligence, market
borrower‘s historical performance and a forecast of the conditions, etc.)
future performance of the company ● Commitment Letter Summary of Terms and Conditions
○ Forecast includes a clear description of the use of the loan ○ Although the lenders will typically generate a commitment
together with a narrative and financials that illustrates the letter that contains general terms and conditions, a
application of the loan proceeds and the ability to repay it. summary of specific terms and conditions of the loan is
○ In evaluating the financial forecasts, a lender will make its contained is a separate document.
own determination as to whether a borrower‘s assumption ○ Terms contained in the summary includes: name of the
relating to financial performance, etc. are reasonable. borrower, guarantors, lenders, size and nature of the
● Commitment Letter committed facility, interest rates, maturity dates, security to
○ This is issued after the lender: (1) finishes its evaluation the loan, amortization schedules, covenants,
and review of a borrower‘s loan request and business plan representation and warranties, events of default, etc.
and (2) evaluates the results of any studies performed by ○ The summary provides a road map for financial officer to
outside consultants review in order to determine whether the requirements for
the lender can be met prior to negotiation of the final term.
● Fee Letter
 ○ Reason for this letter: is to maintain the confidentiality of section describing the conditions that must be satisfied for
the fees quoted as payable for the loan. the lender to make the loan.
○ The fee may include: commitment fees, underwriting fees, ● Types of Credit Facility
structuring fees, financial advisory fees, ticking fees, ○ Term loans and Revolving loans
expense reimbursements, and administrative fees. ○ Term loans
○ Commitment fees, underwriting fees, structuring fees: is ■ Is a fixed amount of money advanced to the
for the issuance of a commitment letter. This is to reflect borrower, where the borrower is expected to
the restriction on the lender‘s ability to make additional repay the loan plus interest over a specific period
loans to others because of the commitment to extend the of time.
loans. ■ Repayment terms are negotiated based on the
■ This is payable even if the loan is not closed. ability of the borrower to repay the loan based on
■ The amount of the fee depends on the risk financial projections provided by the borrower
associated to the loan. and agreed to by the lender.
○ Ticking fees are similar to payments required by lenders ■ It can be paid on lump sum at the end of the fixed
for unused capacity. This is usually charged when a period or amortized and paid in specific periodic
commitment is extended over a protracted period of time payments during the term.
and where closing is to take place at some distant time in ■ The life of the term loan in many cases matches
the future. the life of the asset acquired with the proceeds of
○ Administrative fee is for syndicated loans and loans where the loan.
the lender or agent must perform tasks throughout the life ○ Revolving loans
of the loan. ■ Loans with stated maximum loan amounts, but
○ A fee letter will generally provide that out of pocket variable amounts that can actually be drawn
expenses incurred in connection with the underwriting or down by the borrower that are determined
closing of a loan must be reimbursed by the borrower periodically by reference to certain levels of
(legal fees, consultant‘s fees, credit reports). borrower assets.
■ The asset normally used to determine the
borrower‘s available loan amount includes
account receivable and inventory.
LOAN DOCUMENTATION ■ To determine the actual loan capacity of the
borrower, the lender will review the borrowing
● Loan documentation can be as simple as a lender‘s standard base.
promissory note with blanks filled in describing the loan amount, ■ In determining the borrowing base, the lender will
interest rates, and payment schedule. give a borrower credit for percentage of the
● But for large loans the documentation may include credit accounts receivable and the inventory.
agreement, note, security agreement, collateral assignment, inter- ■ But before applying percentages to the borrowing
creditor agreement, subordination agreement, and financing base, the lender will make a calculation as to
agreements. which portions of the accounts receivable and the
● Credit agreement inventory are eligible to be included in the base.
○ Typically includes 5 or 6 sections: description of the size ■ Customary to pay down a revolving loan with the
and type of the facility, applicable interest rates, a collection of its accounts receivable such that the
covenants section, section for representations and availability of the package increases with
warranties, a section describing event of default, and a
 collections applied to the loan and decrease ■ Information about the organizational structure
when amounts are redrawn. and the capital structure is normally included in
■ Drawdowns under the revolving loan facility the representations and warranties.
continues as long as the borrower is not in ■ Examples:
default under any of the conditions of the loan ● If the borrower is a complex corporate
agreement. organization, the information regarding
● Interest Rate and Pricing Alternatives (see examples on pp 173- subsidiaries and affiliates is required to
176) protect the lender‘s access to the cash
○ The lender would ask if the borrower prefers a fixed or flows or assets that have been used to
variable rate. support the loan.
○ As the size of the loan increases, the credit quality of the ● Lender can also request for information
borrower begins to play a significantly increasing regarding the borrower‘s physical
importance in determining the interest rate that a borrower location in order to determine where to
will have to pay. make filings that relate to perfecting the
○ In larger loans within leveraged companies, the interest lender‘s security interest in any
rates depends on two factors: credit rating assigned by collateral pledged by the owner
Standard & Poor‘s or by Moody‘s, and the amount of ○ Borrower‘s financial statements
leverage (debt to equity ratio and debt to cash flow ratio). ■ Lenders rely heavily on the financial strength of
As the leverage ratio increases, the interest rate also the borrower.
increases. ■ Financial statements are used to determine
○ In facilities that are structured to finance leveraged or in whether the loan can be satisfied by the
may distressed companies, the interst rates charged will operations of the borrower.
be established by reference to a base rate plus a margin. ■ Imperative that the lender receive a strong
● Representation and Warranties affirmation from the borrower that the financial
○ The initial negotiation of the representation and warranties information submitted is accurate, true, and
provide in depth information to the lender about the correct. Thus the role of outside auditors.
business of the borrower. ■ Representations on the tax return must also be
○ The negotiation mostly revolves around the modifiers that accurate.
the borrower may make to the various information ○ Borrower‘s operations
requested by the lender. ■ This represents the largest representation of the
○ Where they cannot agree upon the materiality of the borrower.
modifier, the borrower must provide information to the ■ In many instances, these disclosures provide a
lender identifying why the borrower cannot state a forecast of the future success of a business. For
representation or warranty in the absolute. example, if a borrower discloses a significant
○ Schedule of expectations – information modifying the number of litigation, the lender will be wary to
intensity of a representation or warranty is contained here. make a loan to a borrower who is regularly sued.
An exception disclosed on the schedule permits a ■ It can also show the sophistication of the
borrower to comply to the lender‘s request of information borrower in making credit checks to its
without breaching a provision of the loan agreement by customers.
making false statements. ■ Environment representations are examined with
○ Borrower‘s organizational structure extreme care because for example if the
company‘s property is with hazardous waste, the
 lender will not take it as collateral because it - Selling assets
wants to avoid the potential clean up. - Cancelling loans owed to borrower
■ Representations as to good and valid title to its - Entering into leases for longer terms than a
property to avoid fighting with a 3rd party in case specified maximum term/ in excess of maximum
of default. lease payment
● Covenants
○ Affirmative Covenants Macrolevel limitation:
■ Relate to actions required to be taken by the Expressed for the most part in the context of a change of
borrower. control or in limitations on acquisitions of new businesses by the borrower.
■ A borrower must comply with the lender‘s
requirement to take certain actions and to provide Prepayment covenants
certain information during the term of the loan. Some events that may trigger prepayment:
■ Examples: operational aspects during the grant - Fundamental changes in the capital structure
of the loan must be maintained, access to - Sale or other types of liquidations of assets
ongoing financial information, compliance with all - Destruction of insured assets
laws.
○ Negative Covenants Financial covenants– structured by lenders to measure the performance of
■ Actions that the borrower are prohibited to do. a borrower against the business plan and against specific financial
parameters that the lender applies in connection with the underwriting of
[Pages 183-201] each loan in its loan portfolio.

Negative covenants As the financial health of a borrower declines, the number of financial
covenants stated as absolute minimums or maximums increases in order to
Lenders negotiate for defining the nature and extent of activities that give a lender several different ways to measure the borrower‘s performance
are prohibited during the loan term. The objective of these negotiations is to against business plan and forecasts.
ensure that the borrower will continue its existing business and operate the
business in a manner that is consistent with the business plan, plus the For entities presenting ratios based on interim amounts (especially those
supplemental info presented by the borrower in the loan application process. based on estimates), some adjustments to reflect year-end changes/actual
amounts are required.
This covenants may take the form of absolute prohibitions or
limitations on the level of specific activities. In distressed cases, lenders require financial ratios to be reviewed by
auditors.
Some examples of limitations are:
Borrowers being prohibited from: Liquidity ratios– measure a borrower‘s ability to meet its obligations in the
- Making capital expenditures in excess of an agreed-upon near term.
amount
- Making dividends or distributions in excess of certain Current ratio – formula: current assets over current liabilities
levels Quick ratio – (cash + accounts receivable) over current liabilities
- Making investments, loans in excess of specified amounts Net working capital – current assets minus current liabilities
- Incurring additional indebtedness in excess of
agreed-upon levels Lenders look for a ratio of 1:1 in structuring a financial covenant for a typical
- Creating additional liens healthy borrower
 Events of default may be structured to cover significant events that have
Leverage ratios– measure not only the extent that debt comprises a been assumed in the borrower‘s business plan, such as obtaining or
component of a borrower‘s capital structure and whether a borrower can maintaining regulatory approvals and licenses, securing additional equity, or
safely take on additional debt, but also the ability of the borrower to meet its entering into and closing specified contracts.
debt payments as they become due.
Cross default – Events of default that reference other agreements or loans.
Common ratio involved is that of debt to borrower‘s equity.
Remedies available upon an event of default:
As the size of the loan transaction grows, various categories must also be 1. Increase interest rate
considered. 2. Acceleration
- Minimum debt service coverage ratios 3. Pursue any guarantors simultaneously with its actions
Formula: Earnings before interest, taxes, depreciation against the borrower
and amortization (EBITDA) over interest payments (or
principal plus interest payments as an alternative) The promissory note
The basic provisions in a promissory note are:
- Minimum fixed charge coverage ratio - Name of the borrower, lender
Formula: EBITDA over fixed charges, where fixed - Amount of the loan
charges = principal + interest payments, capital - Interest rate
expenditures, taxes, dividends - Payment schedule
- Other terms
This permits a lender to evaluate the ability of a
borrower to make payment not only for debt service A PN is a negotiable instrument. As the loan size increases, the probability
(immediately preceding ratio), but to make ongoing, increases that the note will be resold in the marketplace, or syndicated and
ordinary course of business and tax payments resold in pieces.
required to maintain the health and competitive
strength of the borrower. The security agreement
In many respects, it contains the same types or categories of information as
- Maximum total leverage ratio a loan agreement.
Formula: Total Debt over EBITDA ( or senior debt
over EBITDA) In reviewing this section, lenders are careful in describing the assets subject
to the lien. Courts have ruled that if the asset is not sufficiently described, it‘s
Events of default not covered, and so the lender is moved over to the unsecured creditor
Categories of events of default will normally follow the major sections of the category.
loan agreement:
- Failure to pay principal and interest Perfection of a security interest – attained by filing the financing statement
- Breach of representation/ warranty with the secretary of state located in any state in which the borrower has
- Breach of covenants operations or where the collateral is located. (Except for negotiable
Where the breach or default is not material to the overall health of the instruments, the security involving which being perfected by mere
borrower, a lender will permit a borrower to cure the default within a possession, and intellectual property rights, by filing with the appropriate
specified period of time. Upon failure to cure such default, the borrower must agencies)
negotiate a waiver for the default or pay off the loan. Collateral assignment – When a borrower has a contract that
contains valuable rights to receive revenue or where the contract secures
rights for the borrower to operate a division or segment of its business under ● Depending on the type of entity that will be the borrower, loan
the terms of the contract, an agreement separate from the security alternatives will quickly be focused on a few choices
agreement may be entered into, known as collateral assignment. Here, the ● FOR LARGE COMPANIES WITH EXCELLENT CREDIT, national
borrower will transfer to its lender an equitable right to take advantage of the lenders will compete for their business with aggressive loan
contract and either continue to receive designated revenue or continue to proposals where the lender is secured by the genereal
operate a division or segment of the borrower‘s business after the creditworthiness of the borrower - hence, in most cases without
occurrence of an event of default. security
● FOR LOWER-MIDDLE MARKET COMPANIES, the loans are
The intercreditor agreement – Relevant when a borrower owes obligations secured either by the assets or cash flow of the borrower or by the
to two or more lenders, the intercreditor agreement is where the relative guarantee of the owners of the business
rights of the lenders and their relationship are described.

Subordination agreement – A close relative of the intercreditor

agreement. Here, instead of agreeing how to split proceeds associated with SECURED LOANS
the liquidation of assets to pay off a loan, the parties agree as to the priority
of payments among lenders. ● Secured loans can generally be described as loans tailored to
match the fixed assets or cash flows of a company
Guarantees ○ It is tied to such
● Two general categories: [1. Asset based financing; 2. Cash-
Two kinds: flow based financing]
Guarantee of payment and performance ○ 1. Asset based financing
- The differentiating characteristic of such is an ■ Traditional definition: loan extended to a borrower
ability of the lender to make a claim directly in the form of a revolving credit facility or term
against the guarantor notwithstanding the fact loan
that the lender actually loaned funds to an entity ● If based on revolving credit - the loan
different than the guarantor. focuses on the level of current assets of
a company
Guarantee of collection ○ Typically, a negotiated
- In this type of guarantee, a lender must exhaust percentage to the level of
all of its remedies against the borrower before accounts receivable and and
proceeding against the guarantor. the level of inventory are used
in order to determine the
variable levels of borrowing
capacity
[Pages 202-218] ○ Acceptable percentage levels
hover around 80% for accounts
CATEGORIES OF DEBT INSTRUMENT receivables, and 50% for
inventory
● The two categories: ○ Usually a lender will specify the
○ Secured loans types of inventory and
○ Unsecured loans receivables that do not qualify
for the inclusion of the
 calculation - this is known as - Purchase order financing and factoring are unusual in that the
ELIGIBILITY lender takes into account the creditworthiness of not only the
○ When the account receivable borrower, but also the creditworthiness of the borrower‘s customer
relates to a government ○ 2. Cash-flow based financing
agency, it is usually excluded ■ This type is considered when a borrow generates
unless the agency has given significant cash flows from an asset base that is
permission to the lender to relatively small
collect the account in an event ■ Lenders calculate the amount of borrowing
of default under the loan capacity by placing a multiple on the agreed-
agreement upon cash flows of the borrower
■ FORMS OF LENDING ● First, the borrower will provide its
● Another form of receivable lending is EBITDA to the lender
Factoring - the lender actually ● The lender will then make certain
purchases the accounts receivable adjustments to the borrower‘s
instead calculation of the EBITDA ir oner to
○ Economic consequences of normalize the calculation and better
factoring: understand the stability of the
■ One: a higher interest borrower‘s cash flows.
rate to the borrow is ● After, the borrower and the lender agree
charged upon a stabilized calculation of EBITDA,
■ Two: the factor the lender will apply its specific
typically advances a underwriting guidelines to the
lower percentage of calculation to determine the amount of
receivable up front in the loan and the schedule of
order to ensure that amortization applicable to the loan.
when all accounts are ● Interest rates are normally within a tight
settled, the accounts band for lenders falling into similar
receivable that are categories.
uncollectible will not ● With determining the loan size, a lender
exceed the amounts will test the borrower‘s financial
advanced to the statement presentation against its
borrow underwriting guidelines.
● Another form of assets based lending is ● A minimimum and maximum financial
Purchase Order Financing - lenders ratio are tested first and the ratios are
make advances based on purchase normally supplemented by ratios
orders and the lenders will typically determined byt he lender to be
charge a higher rate important to understanding the financial
○ This type takes into health of the borrower.
consideration the management ● Minimum debt coverage compares a
of the the borrower borrower‘s cash flow available to pay
debt with the expected repayment
schedule of the lender.
 ○ Typical min debt service ● The anatomy of a high yield transaction involves a borrower
coverage ration would be 1.25 intending to make an acquisition or to borrow funds to permit the
to 1. borrower to make capital expenditures in advance of generating
revenue from the newly acquired assets.
Junior Secured Loans ● The high yield market is focused on providing a component of the
capital structure of an acquiring company in connection with
● For larger leveraged transactions, the supply of capital has leveraged acquisitions.
increased significantly in the previous two years. ● High yield debt is attractive because it is unsecured debt and it is
● A junior secured loan is underwritten by a lender by examining the available at relatively attractive high pricing.
portion of a borrower‘s assets, cash flow or enterprise value that is
not used to support a senior secured loan. Mezzanine Financings (aka hybrid debt/equity)
● In evaluating enterprise value, the lender will consider the
liquidation or sale or residual value of the borrower‘s good will, ● This type is so diverse that it is difficult to describe with specificity
trademarks, patents and licenses. all the elements that might be included in the definition of
● Junior secured loans initially were limited to transactions in which mezzanine debt.
the borrower desired to make an acquisition or in a distressed ○ Thus, most writers attempt to define the mezzanine debt
recapitalization, but increasingly these loans have gained favor as would state that it resides in the capital structure of a
an instrumental part of an ongoing borrower‘s capital structure, and company between senior debt and equity and maintains
increasingly are giving mezzanine lenders significant competition some elements of debt and equity.
for funds required by a borrower to close the gap between senior ● Mezzanine finance is used primarily to bridge the gap between
secured facilities and available equity. equity and debt in acquisitions and recapitlizations.
● Mezzanine lenders rarely take control of a company
○ Though they may take equity in connection with a
mezzanine loan
UNSECURED LOANS ● The equity kicker is used as a tool to provide an overall higher
return on its investment than just the interest rate charged.
● An unsecured loan is extended by a lender where the borrower ● Similar to Anton v Oliva, where there was a loan to be repaid via
either has a long history of loan compliance with a lender or an share in percentage of profits
extremely strong labance sheet. ● In other words, it can be either a debt with equity-like repayments,
● These loans normally take the form of a line credit made available or equity with debt-like repayments
to the borrower when needed or a term loan where the amount ● FORM OF EQUITY: The form of equity taken is normally a warrant
requested is more than the borrow wants to expend at any given to purchase shares in the borrower.
time in order to preserve liquidity in the short term. ○ The purchase price of the warrant is nominal, and the
● Pricing of unsecured loans will be slighly higher than the pricing of aggregate amount of shares subject to purchased under
a comparable asset-based loan. the warrant is determined by estimating an amount of
● Although the risk might be negligible between the two types of money to be paid at the end of the loan term that, coupled
loans bfor a business with excellent credit, the capital markets and with the current and deferred interest under the mezzanine
underwriters assess the risk as being higher and as a result, the debt, will yield an overall internal rate of return to the
interest rate will be higher. mezzanine lender that satisfy its target or hurdle return
rate.
High Yield Debt ● How to determine value of warrants: by taking into consideration
the borrower‘s business plan, taking an assumed industry multiple
 and the borrowers forecasted EBITDA for the period in which the the life of the loan by issuing periodic notes to the lender equal to
mezzanine loan comes due, and using these assumed financial the deferred in- terest rate amount.
markers to determine the value of the borrower at the time the ○ This deffered payment is called PAYABLE IN KIND (PIK)
measurement is made. portion of the interest rate charged by a mezzanine
● Mezzanine lenders concentrate their initial underwriting efforts lended.
much like an equity investor. ■ PIK pay- ments are not due until the maturity of
○ This means lenders will generally extend credit to only the debt instrument.
seasoned, mature and experienced management teams ■ In addition, mezzanine debt holders may permit
with track records of success in their industry (see page borrowers to elect to make PIK pay- ments during
212) the life of the loan in lieu of the debt instrument‘s
○ Only after a mezzanine lender is satisfied with currently payable interest rate.
MANAGEMENT and WITH EQUITY SPONSORS will the ● COMPARE TO DEBT LOAN:
lender evaluate the cash flow of a borrower in order to ○ In negotiating mezzanine debt loan agreements, the
determine whether to extend mezzanine debt. components of the loan agreement will look quite
○ Sponsorship is important in leveraged transactions given similar to those contained in senior se- cured loan
the narrow opportunity for miscues in these deals. In the documentation, although security documents appear in
event of a shortfall in operations, mezzanine lenders may a rela- tively small percentage of these deals.
bring additional capital to a borrower, but these lenders ○ The main differences in the two instruments include the
want to partner with substantial private equity sponsors interest rate and the manner in which it is paid, no
that have access to their own capital to participate in any amortization of loan principal during the life of the
shortfalls. senior loan, full sub- ordination to the senior credit
● Mezzanine debt is UNSECURED and is subordinated to senior facility, and financial covenants that are less
secured debt. restrictive than those contained in the senior facility.
● Mezzanine lenders‘ participation and importance grow in sync with ○ Mezzanine loans have terms of five to seven years,
growth in multiples paid for corporate acquisition targets. always structured so that maturity falls after the maturity
○ For example, when capital markets price companies in date of the borrower‘s senior credit facility.
terms of multiples of EBITDA, as the pricing multiples ○ Loan terms are negotiated also to coincide with exit
grow from three to five times EBITDA to five to seven strategies articulated by manage- ment of the borrower in
times EBITDA, there is a spreading gap between the any business plan presented to the mezzanine lender in
amount of capital that senior lenders are willing to lend to connection with its solicitation of the lender.
a company and the amount of equity that equity sponsors ■ The exit strategies include the normal business
are willing to invest in a company. plan alternatives of sale, recapitalization, or initial
● The gap has been filled by mezzanine lenders taking po- sitions public offering.
with creative repayment structures or overall investment return
characteristics. Convertible Debt and Convertible Preferred stock
○ How: These creative structures include dividing the
mezzanine interest payments between a currently due and ● Convertible debt or preferred stock is issued by a borrower when
payable rate of interest and coupling the current pay with a lower interest rate or divi- dend is desired and the borrower is
an accrued interest amount payable in kind over the life of willing to suffer the potential dilution of the lender converting the
the loan. instrument into common equity of the bor- rower.
● When the mezzanine debt includes a deferred interest rate, a ● INTEREST RATE
borrower is deemed to be paying the deferred interest rate during
 ○ Interest or dividend rates on convertible instruments have ● Where a bridge loan is made in order to provide a growth or tech-
histori- cally been pegged at a fraction of the normal cost nology-based company time to finalize a debt or equity financing,
of capital for a borrower, because the investor is betting the bridge loan is typically coupled with one of two equity-flavored
that the value of the underlying shares of stock, into which attrib- utes.
the debt will convert, will grow in an amount that ex- ceeds ○ In addition to the stated interest rate on the bridge loan
a market rate of return for the instrument. principal outstanding, the investor extending a bridge loan
○ Pricing strategies for not only the interest or dividend rate, may require warrants as an equity kicker, or the investor
but the share conversion price vary by the strength of the may require that the loan be convert- ible into specified
borrower. equity of the borrower at the option of the investor, or both.
■ In public transactions, most of which are ■ The amount of warrants issued in connection with
structured as convertible preferred stock a bridge loan is known as warrant coverage.
securities, dividend or interest rates may be 3 to ● The stated warrant coverage
4 percent below the rate otherwise available to percentage is then applied to the
the borrower. aggregate loan amount, and the
■ For financially healthy companies, the share product of the percentage and the
conversion price may be set at a premium over loan amount is divided by an assumed
its current mar- ket price in an amount that may value per share of the borrower. The
be as much as 40 percent. In other words, the quotient yields the number of shares
company‘s share price must increase by 40 included in the warrant.
percent before the holder of the security would be ○ As the financial stability of the bor- rower increases, its
motivated to convert the instrument into equity of bargaining power increases to negotiate a strike price that
the issuer. more closely resembles the fair market value of the
company‘s equity securities.
Bridge Loans
Specialized Lending [SBA, Industrial Revenue bond, low-income
● Bridge Loan is a loan is advanced by a private or com- mercial housing finance, debtor in possession (DIP) lending]
lender that assists the borrower in bridging the time gap between its
need for cash and some well-defined liquidity event. Bridge loans ● These lenders and loan types include structures and are based on
are normally fixed amount term loans due within 12 months of loan documentation that have previously been described in this
issuance. chapter.
● While these loans may be secured or unsecured the majority of ● Lenders in this category include the commercial bankers and
bridge loans are unsecured, generally with no payments of either specialized lenders participating in the Small Business
principal or in- terest due until the maturity date of the loan for Administration (SBA) loan programs.
bridge loans with 30- to 90-day maturities and for longer-term ■ Loans extended under the auspices of the SBA
bridge loans made in the context of venture capital investments. serve the lower end of middle-market companies,
● INTEREST RATE but this segment is where the great majority of
○ Interest rates charged for bridge loans vary by industry middle-market companies reside.
and strength of the borrower, but a typical rate would be 8 ○ SBA loan programs are favored by local commercial
to 10 percent in today‘s interest rate environment for an lenders and community banks because of the guarantees
early stage company. For more mature companies, and provided in connection with qualifying loans.
perhaps counterintuitive to normal pric- ing models, the ○ In case of default
interest rate would be higher.
 ■ Consequently, in the event that an SBA borrower ● Related to industrial revenue financing is low-income housing
defaults, the local bank is only partially at risk for finance.
the potential loan loss. This backup guarantee ○ Instead of tax benefits at the state level, low-income
has increased the appetite of commercial housing regulations are promulgated at the federal
lenders, and for the 2004 calendar year more Department of Housing and Urban Devel- opment (HUD)
SBA loans were initiated than at any other time in level and the tax attributes are embedded in the Internal
the life of the SBA loan pro- gram, and the record Revenue Code.
was broken only eight months into the year. ○ In exchange for agreeing to fixed levels of rent that may
○ PROBLEM: be charged over the life of a project, a low-income housing
■ Although the SBA program is intended to provide developer will ob- tain favored financing if the project
small business with incremental access to capital meets all of the HUD requirements.
that might not otherwise be available, many small ○ These attributes are based primarily on tax credits
borrowers are excluded from the benefits of the available to the real es- tate developer and its investors.
pro- gram due to its significant underwriting and The credits may under certain circum- stances be bought
collateral requirements. Most start-up businesses and sold, and as such, provide unique incentives for
have little if any equity in the business, and as a obtaining equity investor support for the projects.
result if they want to participate in the SBA ● One final type of specialized lending relates to the distressed
programs they must pledge personal assets, financial condition borrower considering filing for a formal
most frequently in the form of second mortgages insolvency - Generally known as debtor in possession (DIP)
on their homes or pledges of their investment lending
securities ○ this type of loan is negotiated in most cases immediately
● In the absence of business assets, prior to a borrower filing bank- ruptcy. Immediately upon
personal assets, or outside guarantees, filing, the borrower will request that the bank- ruptcy court
a small business owner will not qualify approve the loan and grant priority of the DIP lender‘s
for the SBA program. security interest over all of the borrower‘s other creditors.
● Another form of specialized lending is the industrial revenue ○ this type of loan is normally reserved for dis- tressed
bond borrowers that can make the case for continued revenue
○ For companies desiring to expand their offices, factories, streams notwithstanding the insolvency filing. Large
and warehouses in a local community, there is normally a retailers and established man- ufacturers are candidates
local governmental authority that provides a mechanism for this type of loan.
for issuing debt at very low interest rates ○ Start-up companies and early stage technology
○ all of these loans are used to buy and develop real companies do not fit the profile for obtaining this type of
property projects. Lenders are in many cases incentivized credit.
to purchase this debt as part of their obligations to support
the local community development efforts Credit Rating and Reporting Agencies
○ Most of these loans are tax free to the investors and
provide lower borrowing rates to the companies ● Access to the de- scribed loan is not available unless the borrower
borrowing the funds, and the loans will be made only to has been rated by one of the two main credit rating agencies:
the extent that the borrower promises that in connection ○ Standard & Poor‘s and
with the develop- ment of the facility the company will ○ Moody‘s
generate incremental jobs for the lo- cal community. ● a borrower will make a presentation to each of the agencies, and
depending on the industry, the company‘s histori- cal financial
 performance, the leverage of the company, and various other ● can be structured as voting or nonvoting shares.
financial measurement indicators and financial ratios, the agency ● always represents an ownership interest in a company
will as- sign a rating to the company‘s debt. ● voting common stock interest in a company
● The higher the credit rating, the lower the interest rate ● entitled to vote to elect directors, and to vote on fundamental
● Each ratings system assigns a grade and a risk associated with a corporate activities such as mergers and acquisitions
com- pany‘s debt ● Sale of the stock of a company capitalized with only common
○ The grading falls into two general categories: shares, the holders of common stock
■ investment grade and ● entitled to receive their pro rata share of the proceeds of
■ junk grade. the stock sale, based on the number of shares each
○ Each grade is coupled with a risk factor label- ing the shareholder owns over the aggregate number of shares
borrower as either a higher or lower grade risk within its owned by all shareholders.
category. ● In the context of a corporate liquidation,
● High yield debt is issued by companies whose rating is in the junk ● entitled to receive the residual portion of the assets of the
grade category company only after all creditors have been paid in full.
● In addition to the rating agencies, Dun & Bradstreet is a reporting
agency that assembles information regarding the payment history PREFERRED STOCK
and debt levels of a company. In exchange for membership in the
reporting agency, a participating member may request and receive ● Traditional preferred stock represents an ownership interest in a
credit reports on any com- pany within the Dun & Bradstreet company, but in most cases, the preferred has no voting rights.
system. ● a fixed dividend and the right to receive the face value of the
○ Suppliers and vendors partici- pate in the system, and preferred stock and any dividends prior to the distribution of any
before opening accounts they will normally perform a assets to the holders of common stock.
credit check on the potential customer in order to
determine the credit terms that will be extended to the Straight preferred
customer.
● looks more like debt than equity
3. Equity, A vehicle for Financing Corporate Growth ● it is paid prior to common stock but after all debt, and it does not
share in the capital appreciation of the company.
[pages 218-228]
Non-cumulative preferred stock – there would never be an obligation to
EQUITY INSTRUMENTS pay the missed dividend.

A company can be capitalized with only common stock, but preferred stock Cumulative dividend payment – the dividend would be owed to the
is normally issued in addition to common stock and not as a stand-alone preferred stockholders and must be paid in full prior to any distributions,
equity. including dividends, to the common stockholders. Also called ―dividend in
arrears‖
Preferred stock and common stock are each entitled to receive dividends,
but where a company has outstanding preferred and common stock, the Convertible Preferred Stock
holders of preferred stock are entitled to receive dividends in priority to the
holders of common stock. ● an equity instrument that in many cases would include voting rights
based on the number of shares of com- mon stock into which the
COMMON STOCK preferred stock could be converted
 ● In contrast to straight preferred stock, convertible preferred is a. a merger or acquisition taking the form of a sale of the
based on the premise that at any given moment, a greater return company‘s stock
may be ascribed to either the face value of the preferred or the fair b. an initial public offering of the company‘s equity securities,
or
market value of the common stock into which the preferred may be
c. a recapitalization in which the investor‘s equity position is
converted. purchased or redeemed by the company.
● As a result, the holder of convertible preferred has the luxury of Different Plans
waiting until the time of an exit and then deciding whether to ● Preparing for an equity investment involves a significant amount of
demand repayment of the face value of the preferred stock, plus time and attention dedicated to generating a business, strategic,
any accrued or cumulative but unpaid dividends, or to convert the and financial plan for the company.
preferred into common shares.
Business Plan
● The election made by the holder will depend on which alternative
● describe the company‘s financial plan for using the proceeds of the
results in a higher return or greater proceeds. equity offering in a detailed budget showing inflows of capital and
expected outflows.
o For example, if a company is being sold for $1,000,000
and a preferred holder owns $100,000 of convertible Financial plan
preferred that can be converted into 20 percent of the ● a company expecting to raise capital will expend a significant
company, the holder would elect to convert into common amount of time and energy in developing a business plan.
and receive $200,000 or 20 percent of the sale proceeds. ● The business plan generally is thought of as a road map for a
potential investor to follow the thought process of the company as
Participating preferred it determines its own rationale for securing the investment.

● the holder takes priority over the common shareholders in terms of Business plans take many shapes and forms
proceeds of a sale or liquidation, and in addition, after receiving the the best plans are those that are succinct yet demonstrate that
management has a full understanding of its target market.
face value of the preferred plus any accrued or cumulative but must also provide an investor with comfort that management has
unpaid dividends, the holder is entitled to receive a pro rata portion paid attention to the smallest of details.
of any remaining assets or proceeds.
● The pro rata portion of proceeds that a participating preferred Great business plans have
holder is entitled to receive is based on the number of shares of 1. Executive summary - concisely states the premises underlying the
common stock into which the preferred could be converted divided request for investment.
2. Setup - a description of either the problem that the company
by the aggregate number of common shares.
intends to solve or the market opportunity that the company intends
to attack.
3. Statement of the company‘s objective – the company‘s solution to
Securing the Equity Investment the problem or unique value proposition that permits the company
● A company making the request for equity must be able to articulate to attack the market more aggressively than its competitors.
a reasonable financial plan describing the use of proceeds of the 4. Strategy section – includes the company‘s strategy for
investment. accomplishing its objective or solving the problem articulated by the
● Most equity requests are coupled with an analysis of the potential company.
for capital appreciation in connection with specified events. These 5. Financial section - supporting the company‘s strategy
events are typically known as exit strategies. a. Revenue forecasted by the company
b. the company‘s cost structure.
Three general exit strategies i. must line up with the requested equity investment
● These strategies have a variety of combinations and permutations or the offering will inevitably fail.
that may be attached to each category, but the basic alternatives
include: Cost Structures
 ● There are a couple of strategies used by companies in connection ● Early adoption of the start-up‘s technology or services by
with developing cost structures in support of equity requests customers willing to pay premium prices for the products or
● Fully funded business plan: services will also add value.
a. most desirable alternative
b. the company requests capital that will, under its assumed Quality of Management
financial model, be the only capital required to achieve its But what is most important to the sophisticated investor is the quality of
objective. management involved with the business.
c. The capital may be a combination of debt and equity. ● Quality in this respect means seasoned, mature, and experienced
d. Fully funded business plans are expected when the managers with a track record of success in raising capital,
proposal relates to the acquisition of a target company. commercializing products, and generating financially rewarding
● Milestones exits for prior investors.
a. In contrast, where a company‘s objective is long-term in ● A business plan that is not supported by a management team with
nature, such as a biotechnology company, the business these characteristics has little probability of successfully raising
plan must be designed to match up with significant equity capital in today‘s financial environment at any valuation for
milestones, the company.
b. the company will identify specific milestones that have
been recognized by the investment community like Where the equity investment is requested in connection with a proposed
demonstrating acceptable progress in the drug discovery acquisition or by a company with existing revenue and earnings, the
or development process. valuation process follows the traditional valuation metrics.
c. Upon achievement of the specified milestone, and ● These metrics include the discounted cash flow analysis valuation
assuming that the company correctly forecasted the costs method, the comparable company valuation method focusing on
to achieve the designated milestone, the company would earnings or EBITDA multiples, and the replacement cost method.
normally expect to go back to the investment community
to obtain financing sufficient to achieve its next series of
milestones. EQUITY INVESTMENT DOCUMENTATION
In either a fully funded case or a milestone case, the investor will conduct
significant due diligence in an effort to confirm the reasonableness of the
cost estimates. ● Because definitive documentation and final due diligence on the
● If the cost structure proposed by the company does not match an part of an investor is time-consuming and in many cases
investor‘s analysis, in most cases the investor will pass and not expensive, the company, but more frequently the investor, will
make the investment. propose a term sheet containing fundamental terms and conditions
● Where the analysis relates to value created by milestones, if there before definitive documentation is prepared.
is a difference of opinion between the company and the investor as
to whether the proposed budget permits the company to realistically
Equity Investment Term Sheet
claim value appreciation upon achieving certain milestones, the
investor may remain engaged in discussions with the company, but
only to the extent that the two parties come to an agreement on ● In the term sheet, the company and the investor will attempt to
revised budgets or milestones. create an investment structure acceptable to each of the parties.
● If the investor and company agree on budgets and the ability of The term sheet that is finally agreed upon will describe the
management to accomplish the objectives of the business plan, the securities that the investor will purchase, and the terms and
investor and the company must agree on company valuation in
conditions that must be satisfied prior to closing the transaction.
order to determine the amount of equity that will be issued in
exchange for the proposed investment. ● As the parties negotiate the terms of the deal, valuation of the
● In setting valuation for start-up companies, the process is as much company and the role of existing management in the ongoing entity
an art as it is a science. Investors look to comparably positioned will be carefully documented.
companies in similar industries as a starting point. Exclusive control
over products or potential products with large addressable markets Premoney and Postmoney Valuation
will add value to an investor‘s initial valuation discussion.
In Premoney valuation – means the value of a company before an [BASED ON THE EXAMPLE ABOVE] [NOTE THIS IS PREMONEY
investment is made. When the premoney valuation of a company is added to VALUATION]
the amount of investment, the two components are added together to obtain
the postmoney valuation. ● Understanding the impact of the option pool in this example
becomes apparent when the shares owned by current shareholders
Premoney valuation + Investment amount = Postmoney valuation is compared to the shares owned by investors immediately after the
investment is consummated.
The calculation of actual percentage of share in the valuation will depend on ● While the example looks like a 50–50 split based on the investment
the application of variables that are included in most investment term sheets. amount,
These variables include: ○ the investors own 1,000,000 shares and
○ the owners own 750,000 at the time the money is
● size of the company‘s option pool and whether it is calculated on a invested.
pre-money or post-money valuation ● In order to understand this dynamic, management and the owners
● the type of security being purchased—common stock, preferred must understand the manner in which investors define the fully
stock, or participating preferred diluted capitalization of a company.
● the existence of any outstanding convertible securities ● The fully diluted capitalization is 2,000,000 shares even though
● whether the investor is requiring a multiple return prior to sharing only 1,750,000 shares are issued and outstanding.
proceeds of an exit event with the remaining common ● A sophisticated investor always counts the option pool as being
shareholders. outstanding
○ whether or not the options have been granted and
Not understanding the implications of any of these variables can result in ○ whether or not the options granted have been exercised or
severe surprises to management and to the owners of a business raising even have a reasonable chance of being exercised.
capital. ● So the unwary owner, agreeing to create an option pool without
considering the consequences or impact on the company‘s fully
[Mainly examples; daming numbers so bear with me ang hirap] diluted capitalization, will end up with a significant surprise at
closing.
A term sheet condition requiring a 25 percent option pool
Option pool based on a postmoney calculation
 ● The resulting equity ownership retained by the owners in these Straight preferred stock
examples is dramatically different.
● In the case where no option pool is required, the amount of shares ● is essentially equivalent to debt.
issued to the investor is equal to the amount held by the owners, ● This type of preferred stock is not commonly used in today‘s private
and each group owns 50 percent of the company. investment climate, but it still has significance in the public markets.
● Where the option pool size is determined on a premoney valuation ● Straight preferred is sold to investors for a face amount, normally
basis, the owners hold approximately 42.85 percent of the company coupled with a fixed stated dividend.
immediately after the investment is closed and the investors hold
the remaining 57.15 percent of the outstanding shares. Dividend
● As options are granted and exercised, the owners and the investors
will be diluted until the option pool is exhausted and the final ● The dividend may be cumulative or noncumulative, current cash
capitalization will be owners 37.5 percent, option pool grantees pay, deferred, or payment in kind.
12.5 percent, and investors will end up with their bargained-for 50 ○ Noncumulative dividends must be declared in order for the
percent. holder of the preferred to receive the dividend payment
● The most dramatic consequences are illustrated in the postmoney amount,
example where the owners start at 33.3 percent and the investors ○ Cumulative dividends accrue whether or not the board
start at 66.7 per- cent. After the grant and exercise of the entire declares a dividend, and any accrued but unpaid
option pool, the final capitalization is dramatically different with the dividends must be paid prior to payment of any dividends
negotiated structure yielding 25 percent for the owners, 25 percent on a company‘s common stock.
for the option pool grantees, and the investors ending up with the ● A dividend with a current cash payment requirement is normally
originally agreed-upon 50 percent ownership interest in the associated with either investments in public companies or
company. investments made by private equity investors in leveraged
acquisitions.
In each of these examples, the basic valuation discussion is exactly the ○ In these cases, the company forecasts cash flow sufficient
same. to satisfy the dividend obligation, with most of these
investments being associated with larger companies
● The company‘s premoney valuation is $1,000,000 and the enjoying relatively stable and existing cash flows.
investment amount is $1,000,000. ○ Where the dividend is a current cash payment obligation
● The impact of superimposing an option pool on the premoney of a company, in many cases, particularly in connection
valuation changes the share dynamics significantly, but the most with leveraged buyouts, the company may under certain
dramatic impact is when the option pool is discussed with the circumstances satisfy its dividend obligation by issuing a
percentage being applied to the postmoney valuation. note for any dividend payment that the company is unable
to make.
Liquidation Preference ○ This payment in kind may be required either for cash flow
reasons or as the result of applying financial covenants to
● A liquidation preference is discussed in the context of a preferred its balance sheet on a pro forma basis and determining
stock offering of equity. that the dividend could not be paid without violating the
● The liquidation preferences can be stated in terms of what is known financial covenants imposed on the company by a senior
as lender.
○ straight preferred stock, ○ In connection with mezzanine financings where the
○ convertible preferred stock, or investment is structured as preferred stock, an investor
○ participating preferred stock. may determine its overall return requirements are too high
 for the company to support out of cash flow, but the return The following example assumes that an investment of $1,000,000 was made
that is required could be met by deferring a portion of the in exchange for participating preferred stock representing 50 percent of the
dividend, or interest payment when structured as equity of the company.
subordinated debt, until the end of the investment period.

Convertible preferred stock

○ structured to permit an investor to hold its investment until

a liquidity event or exit, and at the time of the exit, choose
between a return of the face amount of the preferred stock
plus accrued but unpaid dividends, or to convert the
investment into common stock and take its pro rata shares
of the proceeds of the liquidity event.
In this example, even though the holders of participating preferred stock own
EXAMPLE: ASSUME INVESTMENT OF $1,000,000 was made for
50 percent of the company, the overall percentage of proceeds received in
convertible preferred stock that equaled 50 percent of the company.
connection with the transaction is 56 percent. Calculating the impact of the
participation feature on various sale proceeds scenarios would show that as
the total return increases, the percentage of the overall proceeds retained by
the holders of participating preferred stock goes down, with the residual
percentage approaching the nominal or stated 50 percent rate in the
preceding example when the returns are significant.
● In this example, the holder of convertible stock would elect to
convert into common stock and receive $5,000,000 instead of In addition to the basic participation rights illustrated, in the current
$1,250,000 based on the original investment plus accrued but investment climate, there are two variations on the basic theme that are at
unpaid dividends. least discussed in many term sheet negotiations. One of the variations is
● Conversely, and using the same transaction assumptions, if the company friendly and one of the variations is favorable to investors.
sale proceeds had only generated $1,500,000, the holder of the
preferred stock would have elected to take $1,250,000 instead of A company favorable variation includes a preferred stock structure where
the $750,000 amount calculated by reference to 50 percent of the the investor is subject to a cap on the negotiated participation rights.
sale proceeds. In making an election to take the face amount of the
investment plus accrued but unpaid dividends, the investment looks For example, the participating preferred stock might be structured such that
more like debt than equity. an investor would receive the original investment and then a maximum of
three times the amount of the original investment in participation rights.
The liquidation preference associated with participating preferred stock can
take many shapes and forms. The effect of a cap on participation requires an investor to convert its shares
of preferred stock to common stock in order to receive an amount in excess
● The basic participating preferred stock investment returns an of the cap. By converting, the investor forgoes the participation right.
investor‘s original investment, plus accrued but unpaid dividends,
and then permits the investor to receive a pro rata share of any The election to convert to common stock essentially makes the investment a
remaining assets calculated on the assumption that the preferred convertible preferred where the returns exceed the cap.
stock holders had converted their shares into common stock.
In other words, if the return to the holder of preferred stock is capped, the ● In these types of cases, the company‘s fair market value may be
holder converts into the pro rata share of the company in order to receive a significantly less than the sum of the liquidation preferences for
larger share of the proceeds. For lower return amounts, the participation prior investments made in the company. This type of financing
feature is protected. Using the example previously assumed where a structure is known as a restart or cram-down financing.
$1,000,000 investment is made in a company with a $1,000,000 pre money
valuation, the illustrated as follows: For example, the company characteristics would include several series of
preferred stock financings, such as series A, B, C, D, and E rounds where
each round involved an investment of $1,000,000. The aggregate liquidation
preferences would therefore be $5,000,000. In the absence of an agreement
to the contrary, an investor considering a new series F round would either
share proceeds pro rata with the prior rounds and then with all the
shareholders, or the series F investor would receive its investment first, then
the remaining series A through E investors would receive their investments,
followed by all shareholders participating in any residual proceeds.

In this example, the impact of the cap resulted in the investor not receiving
the full benefit of the participation feature. Because the negotiation of a cap
adversely impacts the return available to an investor, only the strongest of
companies with the best bargaining positions will be able to achieve or to
negotiate this limiting feature.

[pp228-239]

In contrast to the company favorable variation, an investor favorable

variationis negotiated where the company is financially weak or distressed,
very early stage where the risk of failure is high, or where the company has
raised several rounds of investment, but has yet to achieve significant
milestones or revenue. In this example, even with a 2× multiple applied to the series F in- vestment,
● In this variation, the participating preferred will negotiate a multiple the holders of series F participating preferred stock would only receive 36.25
return of the original investment, after which the holder of the percent of the proceeds of the sale. As a result, in negotiating its up-front
preferred stock will participate to the extent of the negotiated pro terms and conditions, the series F investor would need to negotiate a
rata percentage of the company. multiple greater than 4× its original investment amount in order to receive a
return equal to 50 percent of the proceeds in the example.
Multiple liquidation preferencesare common also in situations where a
company has been successful in raising capital, but less successful in While the application of significant multiples to later stage cram-down
achieving milestones or significant revenue. investments is required in order to achieve desired financial return results, in
some cases required returns can never be achieved under the company‘s
assumed financial forecasts. In these cases, a later stage investor will re- investment of $1,000,000 by a preferred stock investor, if the per share initial
quire all prior preferred stockholders to convert their preferred stock to conversion price (ICP) is $1, the investor would be entitled to convert the
common stock immediately prior to the closing of the new series F investment into 1,000,000 shares of common stock. Applying weighted
investment average antidilution protection to this assumed investment would generate
the following calculation based on the associated assumptions of a dilutive
Voting Rights investment to determine a new conversion price (NCP).
In the privately held company context, almost all preferred stock investments
include the right to vote shares based on the number of shares of common
stock into which the investor may convert the preferred stock.

In addition to the general right to vote, holders of preferred stock may be

granted specific voting rights with respect to the election of directors and
with respect to any negotiated negative covenants.

Protective Provisions
An owner of preferred stock holds shares issued in connection with the
negotiation of a contract between the company and the investor. These
contract rights include covenants that are generally referred to as protective
provisions. Without a specified vote by the holders of preferred stock, the
company is contractually prohibited from taking certain actions.

Included in the list of protective provisions are prohibitions on the following

actions unless the specified percentage of preferred shareholders agree with
the action:
- liquidation of the company
- amendment of the charter or bylaws in a manner that would
adversely affect the preferred stock
- creation of a class of stock senior to the preferred stock
- redemption of shares
- payment of dividends
In the weighted average–based antidilution calculation, the absolute
- borrowing money in excess of an agreed-upon maximum, or
percentage of shares held by the original investor goes down, but the
changing the size of the board of directors.
investor‘s ownership in relation to the original owner‘s goes up because the
investor is now entitled to 1,200,048 shares and the original owner‘s shares
Antidilution Provisions
remain static at 1,000,000
Antidilution provisions focus on issuances of shares at a per share price less
than the price paid by the investor for the investor‘s preferred stock. Two Full ratchet antidilution
types of antidilution protection form the basis for most investors: weighted
Under full ratchet antidilution, an investor‘s conversion price moves down to
average–based or ratchet-based antidilution.
the exact level of the newinvestment.The calculation is performed by
changing the preferred holders‘ $1.00 conversion price to the new per share
Weighted average–based antidilution
price of $.50 and dividing the investment amount of $1,000,000 by $.50
The provision relates to the manner in which the number of shares of
instead of $1.00.
preferred stock is converted into common stock. For example, assuming an
 1) Demand registrationrights are triggered by the passage of time following
Although the basic full ratchet calculation is unpleasant for existing common the initial investment date, or by the passage of time following the initial
shareholders, when a new investor‘s percentage of ownership is stated as a public offering of securities by the company.
percentage of the company assuming the investment has al- ready been
made, companies subject to full ratchet antidilution protection must perform Initial investment:
multiple calculations to determine the new conversion price. The initial passage of time is normally not less than five years. At the five-
year time frame, if the company has not registered its securities, the
This death spiral in conversion price forces many companies into a restart investors are granted the right to demand that their shares be registered.
where early stage investors are crammed down into a nominal equity posi- The registration process is time-consuming and expensive, and normally not
tion. In order to retain management, new investors must provide for re- vised an effective right of the investor unless the company is able to attract an
equity incentive compensation based on creative new series of equity that investment banker to underwrite the offering.
are permitted to participate in liquidity event proceeds after the new
investors but before all existing investors. After initial public offering:
A more effective right is the right of investors to demand registration after the
Redemption initial public offering of securities by the company. In this case, the company
As part of the planning for an exit strategy, investors negotiate provisions has gone through a significant amount of due diligence with investment
relating to a liquidity event as part of the term sheet. Inaddition to the bankers and successfully offered securities to the public. With an
traditional exit strategies of initial public offerings, mergers and acquisitions, established public market, investors have a realistic chance of liquidity.
and recapitalizations, investors will also negotiate the right to require the
company to purchase or redeem their shares after a negotiated period of 2) short-form registration rights
time if no liquidity event has occurred. After a company has been public for a year, and if the company is current
with all of its required filings, companies meeting certain minimum valuation
In order to permit the orderly liquidation of the shares, most redemption levels may take advantage of Form S-3. This form provides a mechanism for
features contain provisions that permit the company to make installment companies to register shares using an abbreviated SEC filing that is not as
payments over three years. expensive or as time-consuming as Form S-1, the form companies use in
connection with initial public offerings.
The redemption feature is subject to statutory limitations imposed on
companies that preclude redemptions unless the company is able to make 3) piggy-back or incidental registration rights
the purchase out of its capital surplus. Capital surplus is generally an - permit investors to add their securities to any offering that is being
amount equal to the equity invested in a company less cumulative operating registered by the company
losses.
In connection with an initial public offering of securities, investors who have
The feature in many cases is of little real benefit to the investor due to the received registration rights are required to enter into lockup agreements.
fact that if the company is not performing, there will be few if any funds to These agreements preclude investors from selling shares of the company‘s
satisfy the redemption obligation. stock for a period of 180 days following the effective date of a company‘s
public offering.
Registration Rights
The standard registration rights granted to an investor in a privately held This restriction is designed to permit the company and its investment
company include demand registration rights, short-form registration rights, bankers to stabilize the company‘s share price immediately following the
and piggy-back or incidental registration rights. offering by avoiding significant price swings that may be caused by sales of
shares into a thinly traded market for company shares.
Board Composition either party to terminate negotiations. Termination provisions are crafted to
Although most venture capital preferred stock investors take a minority provide investors with a defined period of time to complete their due
investment percentage in their portfolio companies, control of the board, or diligence, and it is customary for the company to provide investors with a
at least assurance that the board will act independently, is a significant period of exclusivity during which the company will not negotiate with any
negotiating term. Composition of a venture backed company‘s board may be other investors. At the end of the exclusivity period, either party is free to
negotiated to reflect this independence by naming an equal number of terminate the negotiations or seek alternative investors.
existing owners and investors to the board with one in- dependent board
member being selected by the consent of the investors and the existing The Stock Purchase Agreement
owners. The stock purchase agreement frames the parameters of the economics of
the investment transaction; provides specific baselines for the
The strategy behind this negotiation includes a recognition on the part of the representations and warranties of the company, the founders, and the
investors that they must gain the confidence of existing owners in the investors; and designates the ancillary agreements that must be obtained
decision making process. and the actions that must be taken by the company in order to close the
transaction.
Employee Stock Options
Most employee option pools are designed as qualified option pools, which Basic Investment Transaction
means that options up to the aggregate size of the pool can be granted, but The stock purchase agreement opens with a section describing the basic
the options must be granted at the then current fair market value of the structure of the securities acquisition. It is in this section that the parties
company‘s shares as determined by the board of directors. Options normally establish the obligation of the purchasers to purchase and the company to
vest over time, with vesting schedules generally extending over three or four issue the securities that have been designated in the company‘s term sheet.
years following the date of the option grant.

Founder Share Vesting

A term sheet feature that is perhaps the most con- tested term, other than [pages 240-251]
valuation, is the requirement by investors that the equity held by founders of
an early stage company vest over time. This feature is based on the premise Representations and Warranties
that much of the valuation attributed to early stage companies will only be
realized to the extent that the founders stay with the company and fulfill the ● Provide supplemental information either confirming the investor‘s
objectives of their business plan. If a founder determines not to continue with due diligence, or identifying issues that need further examination
● Serves an additional opportunity to decline to make an investment
the company, investors or the company will be granted the right to to the extent that the investor determines that the representations
repurchase some or all of the founders‘ shares. and warranties are inaccurate or false
● In some early stage investments, there is a separate section of
In negotiating this purchase right, investors are attempting to ensure that the representations and warranties relating to the founders of the
value anticipated at the time of investment will be achieved by the on- going company (opportunity for investors to find out any potential conflicts
efforts of the founders, and if not, that controlling the shares will permit the of interest)
● Investors are also asked to make representations and warranties
company to recruit replacement management without diluting the remaining
as to their authority to make the investment, the circumstances
shareholders. surrounding the investment, their financial status, and if they meet
the requirements to be accredited investors under Rule 501 of
Miscellaneous Term Sheet Provisions Regulation D
It is rare that an investor will have completed its due diligence investigation ● In order to evaluate and analyze, representations and warranties
of a target company at the time of negotiation of a term sheet. As a result, are organized into 3 broad categories: corporate organization,
term sheets are nonbinding indications of interest, with the opportunity for financial statement presentation, and company operations
Corporate Organization - Whether the company has the ability to terminate
contracts that were entered into if it needs cash to survive
● Company has right, power, and authority to issue the securities ● Investors prefer to examine all exceptions to any warranty or
● Board of directors has authorized the issuance, and all other representation, in lieu of permitting a company to modify them with
required actions in connection with the issuance have been taken materiality or knowledge (at least for early stage companies)
● Company has complied with all securities laws for each sale of ● As companies mature, the ability to list all exceptions to a warranty
securities or representation become burdensome, and investors become
● Capitalization of the company (includes not only analysis of capital more willing to establish materiality limits to the disclosure
structure before the investment, but also a pro forma capitalization schedules, unless it relates to a core asset/intellectual property
table showing the results of the investment once made)
Conditions to Closing
Financial Statement Presentation
● Parties will describe all deliveries and actions that must be taken for
● Importance increases as company matures the closing to be consummated
● Provisions relating to contingent liabilities ● All ancillary agreements required will be described, and these must
● Typically an audit for the 2 most recently completed fiscal years, be fulfilled before the closing
plus unaudited statements for interim months between the last audit ● Investor‘s due diligence must be completed prior to the closing and
and the closing (investment) date completion of the required ancillary agreements
● Includes narrative representation and warranty that there are no ● Primary route to closing involves a signing and simultaneous
liabilities or obligations, contingent or otherwise, except those set closing; in effect, the conditions to closing are a checklist
forth in the financial statements
● Also includes indication of which assets are encumbered by any Certificate of Incorporation
claims/mortgages, if any
● Bring-down representation and warranty - required by investors ● Although some investments are in common, many investments by
when there is a gap between the date of the last financial sophisticated investors involve preferred stock
statements and the date of closing ● Conditions for preferred stock are in the company‘s certificate of
incorporation
Company Operations ● It is common that there are provisions in the certificate of
incorporation that permit the board of directors to negotiate the
● Focus depends on the stage and maturity of the company terms of preferred stock and then simply file the negotiated terms;
● For later stage companies, focus is on: this is called a ―blank check preferred‖
- Existing material contracts ● If there is no blank check preferred stock available, the company
- Recurring revenue sources will need to present the terms to the stockholders for ratification
- Proprietary assets ● There are several fundamental rights and privileges granted to
- Outstanding obligations holders of preferred stock: dividends, liquidation preference,
- Contingent liabilities that may significantly affect voting, conversion, and redemption
performance
● For earlier stage companies, investor will perform significant due Dividends
diligence analysis on:
- Proprietary assets (including patent filings and intellectual ● Sample provisions:
property) - No dividends are contemplated to be paid
- Material contracts that either grant or in-license intellectual - Dividends will be paid at a specified rate only when
property declared by the board of directors
- Whether company has exclusive control over intellectual - Dividends will accrue at a specified rate whether or not
property declared by the board (known as ―cumulative‖ dividends)
- Whether company has long-term commitments requiring ● If there is an alternative dividend payout terms, include a
significant cash obligations description (ex; payment in kind)
Liquidation Preference ● The factor that determines the number of shares the investor will
receive is called the conversion price
● In this section, a preferred stock is designated straight preferred, ● A variable that can dramatically change the calculation is the
convertible preferred, or participating preferred treatment of accrued but unpaid dividends
● In early stage companies, typically participating preferred ● In most instances, the conversion price is fixed, and only adjusted
● As the company matures, typically convertible preferred in the event that the company issues shares lower than the price
● Straight preferred: holder receives the original amount plus accrued paid for the preferred stock (adjustment mechanisms: either
but unpaid dividends prior to the receipt of any return weighed average based, or ratchet-based antidilution)
● Convertible preferred: the investor can view liquidity events and ● When a small-cap public entity issues preferred stock in a private
evaluate the potential return under alternatives (if he converts his placement, usually the conversion price is not fixed but float with
preferred stock to common stock) the market; these are called private investment in public equities
● Participating preferred: generates the highest return as the investor (PIPE)
takes both of the alternatives available to a convertible preferred; ● A frequent situation that happens is the death spiral; investors
including an amount equal to the original investment plus accrued ―short‖ the public shares, which makes the prices fall, and the
but unpaid interest, and an amount equal to the holder‘s pro-rata number of shares into which the preferred stock may be converted
share of the proceeds on an as converted to common stock basis increases proportionately to the fall in price. As the number of
shares that can potentially be outstanding rises, the market further
Voting reduces the share price. Typically, as the proceeds from the stock
offering are used to satisfy existing obligations and not for growth
opportunities, the companies are relegated to penny stock status
● Preferred stock is granted voting rights in most early stage, venture
and unable to raise additional capital, and the only solution is
capital, and private equity investments
normally insolvency
● In later stage companies, voting rights are typically not granted
● Number of votes is equal to the number of shares of common stock
into which the preferred stock may be converted Redemption
● Also contains a description of the protective provisions that the
investor negotiated; these actions which require shareholder ● Provide moderate protection for investors
approval include: ● Provide a potential exit strategy where the company is not qualified
- No liquidation of business for an IPO, and the performance precludes merger or acquisition at
- No amendment to articles of incorporation an attractive price
- No creation of a class of securities senior to the preferred ● Pricing is based on either the original investment plus accrued but
stock unpaid dividends, or fair market value of common stock
- No redemption of shares
- No dividends on shares Investors’ Rights Agreement
- No borrowing in excess of specified amounts
- No increase/decrease in size of board of directors) ● Covers 4 primary rights:
a. Securities registration rights
Conversion b. Information rights
c. Preemptive rights to acquire new securities issued by the
● Normally divided into voluntary and mandatory conversion company
- Voluntary - any time d. Affirmative and negative covenants (which the company
- Mandatory - typically triggered by either an initial public must comply with)
offering (IPO) or by vote of the majority of the holders of
preferred stock to convert Registration Rights
● Conversion is the process by which an investor moves from the
debtlike preferred instrument into the common stock category, in ● Include 3 types of rights:
order to take advantage of the participating features of the common a. Demand registration rights
stock b. Incidental or piggyback registration rights
 c. Short-form registration rights Covenants
● Shares covered by these rights are known as registrable shares
● Investor expenses in connection with these offerings are for the ● Affirmative covenants
company, but underwriting discounts or commissions are deducted ● Negative covenants
from the proceeds otherwise payable to the investor
● Demand registration rights are granted at time of purchase of the Shareholders’ Agreement
preferred stock, but rights do not vest until the earlier out of two
specified periods of time have lapsed (stated as either a fixed
● Covers 2 categories of agreements
amount of time such as 5 years, or the passage of 180 days after
● First type: investors and company are granted the right to purchase
the effective date of the company‘s IPO)
shares of stock that owners desire to sell
● Incidental, piggyback, or company registration mean the same right
● Second type: voting matters (in which the parties agree to vote their
- a right that allows the holder of registrable shares to add shares to
shares in accordance with the terms of the agreement).
any offering of securities for cash that is proposed by the company
● The vote requirement that is associated with an acquisition is
(with certain exceptions)
known as a drag-along right; investors negotiate this right in order
● Short-form registrations provide an opportunity for investors to take
to avoid conflicts with minority owners
advantage of SEC rules permitting streamlined registration
guidelines
● Conditions applicable to an IPO registration include:
a. Lockup agreements, in which investors agree not to sell
stock within 180 days from the effective date of an
opening
b. Blackout periods (with respect to company and short-form
registration) in which the company may suspend a
registration statement if the board of directors determines
that it would be detrimental to continue with the
registration

Information RIghts

● These rights enable investors with minority positions to obtain

ongoing information
● Include obligation to provide monthly and quarterly unaudited
financials, annual audited financial statements, and annual budgets
delivered 30 days before the beginning of any fiscal year

Preemptive Rights

● These rights protect the investor‘s pro-rata percentage ownership

of the company
● Called by a variety of names (first right of refusal, right of first offer,
option to purchase, or preemptive right)
● The company must first provide notice to an investor of any
issuance of securities
● The investor has a fixed term to elect to purchase the offered
securities
● If the offer is declined, the company may sell on the same terms
within a set period of time
Interpretation of Contracts Article 1379. The principles of interpretation stated in Rule 123 of the Rules
of Court shall likewise be observed in the construction of contracts. (n)
Article 1370. If the terms of a contract are clear and leave no doubt upon
the intention of the contracting parties, the literal meaning of its stipulations
shall control.
RULE 130
If the words appear to be contrary to the evident intention of the parties, the
latter shall prevail over the former. (1281) Rules of Admissibility

Article 1371. In order to judge the intention of the contracting parties, their 4. Interpretation Of Documents
contemporaneous and subsequent acts shall be principally considered.
(1282) Section 10. Interpretation of a writing according to its legal meaning. — The
language of a writing is to be interpreted according to the legal meaning it
Article 1372. However general the terms of a contract may be, they shall not bears in the place of its execution, unless the parties intended otherwise. (8)
be understood to comprehend things that are distinct and cases that are
different from those upon which the parties intended to agree. (1283) Section 11. Instrument construed so as to give effect to all provisions. — In
the construction of an instrument, where there are several provisions or
Article 1373. If some stipulation of any contract should admit of several particulars, such a construction is, if possible, to be adopted as will give
meanings, it shall be understood as bearing that import which is most effect to all. (9)
adequate to render it effectual. (1284)
Section 12. Interpretation according to intention; general and particular
Article 1374. The various stipulations of a contract shall be interpreted provisions. — In the construction of an instrument, the intention of the
together, attributing to the doubtful ones that sense which may result from all parties is to be pursued; and when a general and a particular provision are
of them taken jointly. (1285) inconsistent, the latter is paramount to the former. So a particular intent will
control a general one that is inconsistent with it. (10)
Article 1375. Words which may have different significations shall be
understood in that which is most in keeping with the nature and object of the Section 13. Interpretation according to circumstances. — For the proper
contract. (1286) construction of an instrument, the circumstances under which it was made,
including the situation of the subject thereof and of the parties to it, may be
Article 1376. The usage or custom of the place shall be borne in mind in the shown, so that the judge may be placed in the position of those who
interpretation of the ambiguities of a contract, and shall fill the omission of language he is to interpret. (11)
stipulations which are ordinarily established. (1287)
Section 14. Peculiar signification of terms. — The terms of a writing are
Article 1377. The interpretation of obscure words or stipulations in a presumed to have been used in their primary and general acceptation, but
contract shall not favor the party who caused the obscurity. (1288) evidence is admissible to show that they have a local, technical, or otherwise
peculiar signification, and were so used and understood in the particular
Article 1378. When it is absolutely impossible to settle doubts by the rules instance, in which case the agreement must be construed accordingly. (12)
established in the preceding articles, and the doubts refer to incidental
circumstances of a gratuitous contract, the least transmission of rights and Section 15. Written words control printed. — When an instrument consists
interests shall prevail. If the contract is onerous, the doubt shall be settled in partly of written words and partly of a printed form, and the two are
favor of the greatest reciprocity of interests. inconsistent, the former controls the latter. (13)

If the doubts are cast upon the principal object of the contract in such a way Section 16. Experts and interpreters to be used in explaining certain
that it cannot be known what may have been the intention or will of the writings. — When the characters in which an instrument is written are
parties, the contract shall be null and void. (1289) difficult to be deciphered, or the language is not understood by the court, the
evidence of persons skilled in deciphering the characters, or who understand
the language, is admissible to declare the characters or the meaning of the
language. (14)

Section 17. Of Two constructions, which preferred. — When the terms of an

agreement have been intended in a different sense by the different parties to
it, that sense is to prevail against either party in which he supposed the other
understood it, and when different constructions of a provision are otherwise
equally proper, that is to be taken which is the most favorable to the party in
whose favor the provision was made. (15)

Section 18. Construction in favor of natural right. — When an instrument is

equally susceptible of two interpretations, one in favor of natural right and
the other against it, the former is to be adopted. (16)

Section 19. Interpretation according to usage. — An instrument may be

construed according to usage, in order to determine its true character. (17)
SIMPLE LOAN In the meantime, the action derived from the original obligation shall
CHAPTER 2 be held in the abeyance

Simple Loan or Mutuum Art. 1250. In case an extraordinary inflation or deflation of the
currency stipulated should supervene, the value of the currency at
Article 1953. A person who receives a loan of money or any other fungible the time of the establishment of the obligation shall be the basis of
thing acquires the ownership thereof, and is bound to pay to the creditor an payment, unless there is an agreement to the contrary.
equal amount of the same kind and quality. (1753a)
Article 1956. No interest shall be due unless it has been expressly
****Fungible - Those which are usually dealt with by number, weight, or stipulated in writing. (1755a)
measure, so that any given unit or portion is treated as the equivalent of any
other unit or portion. Article 1957. Contracts and stipulations, under any cloak or device
● Those which may be replaced by a thing of equal quality and whatever, intended to circumvent the laws against usury shall be void. The
quantity. (ex. Rice, oil, sugar). borrower may recover in accordance with the laws on usury. (n)
● If it cannot be replaced with an equivalent thing, then it is non-
fungible. Article 1958. In the determination of the interest, if it is payable in kind, its
Consumable things (def). Those which cannot be used without being value shall be appraised at the current price of the products or goods at the
consumed. time and place of payment. (n)

Whether a thing is consumable or not depends upon its nature. Whether a Article 1959. Without prejudice to the provisions of article 2212, interest due
and unpaid shall not earn interest. However, the contracting parties may by
thing is fungible or not depends on the intention of the parties.
stipulation capitalize the interest due and unpaid, which as added principal,
shall earn new interest. (n)
Article 1954. A contract whereby one person transfers the ownership of ● Art. 2212. Interest due shall earn legal interest from the time it is
non-fungible things to another with the obligation on the part of the latter to judicially demanded, although the obligation may be silent upon this
give things of the same kind, quantity, and quality shall be considered a point.
barter. (n)
Article 1960. If the borrower pays interest when there has been no
Article 1955. The obligation of a person who borrows money shall be stipulation therefor, the provisions of this Code concerning solutio indebiti, or
governed by the provisions of articles 1249 and 1250 of this Code. natural obligations, shall be applied, as the case may be. (n)
If what was loaned is a fungible thing other than money, the debtor owes Article 1961. Usurious contracts shall be governed by the Usury Law and
another thing of the same kind, quantity and quality, even if it should change other special laws, so far as they are not inconsistent with this Code. (n)
in value. In case it is impossible to deliver the same kind, its value at the
time of the perfection of the loan shall be paid. (1754a)
Solidbank Corporation, (now Metropolitan Bank and Trust Company) v.
● Art. 1249. The payment of debts in money shall be made in the Permanent Homes, Inc., 625 SCRA 275 (2010)4
currency stipulated, and if it is not possible to deliver such currency,
then in the currency which is legal tender in the Philippines. Permanent Homes was granted a P60M Omnibus Line facility from
Solidbank (broken down into P59M time loan, P1M domestic bills purchase)
to finance its Buena Vista Townhomes (Merville, Paranaque) project. The
The delivery of promissory notes payable to order, or bills of
facility was secured by REM; initially over 3 townhouse units, but by the time
exchange or other mercantile documents shall produce the effect of
the complaint was filed, 36 units were mortgaged. Of the total amount,
payment only when they have been cashed, or when through the P41.5M was availed by Permanent Homes via 3 PNs, which all had
fault of the creditor they have been impaired. provisions authorizing Solidbank to increase/decrease the interest rates
based on prevailing rates; however, there was a standing agreement by the
parties that any increase/decrease of rates would be subject to mutual prevailing market rates, and that the interest rates were not unilaterally
agreement by the parties. For the availments, the interest rates moved imposed but were offered by all commercial banks as approved by the
between 14.25%-34% on various dates in 1997. Permanent filed complaint Monetary Board.
to annul the interest rates on the ground that it was violative of mutuality of
agreement, to fix interest rates, for accounting of payments made so as to Appeal is partly meritorious. The binding effect of any agreement is based
determine amount of refund, and to release the remaining available balance. on 2 principles: (1) that any obligation arising from contract has the force of
The trial court ruled in Solidbank‘s favor, finding that it was a subterfuge to law between the parties and (2) there is mutuality between the parties based
lay the blame of the failure of the Buena Vista project on Solidbank. on their essential equality. Any contract that is so heavily weighed in favor of
However, the CA reversed, underscoring the validity of basis of increase of one party as to be unconscionable is void, and any stipulation regarding the
interest rates and of principle of mutuality of contracts. validity or compliance of the contract which is left solely to the will of one of
the parties is likewise invalid. Escalation clauses, which are stipulations
The Usury Law has been rendered ineffective by Central Bank Circular 905; allowing increase in interest rates, are not void per se, but may be void if
however, although interest rates are no longer subject to a ceiling, the lender they grant the creditor the unbridled right to adjust the interest rate
does not have unbridled license to impose interest rates. The lender and independently and upwardly. While the ceiling on interest rates has been
borrower should agree on the imposed rate, and such rate should be in taken away due to Central Bank Circular 905, nothing grants lenders carte
writing. Per the provisions of the PNs, the stipulations of interest rate are blanche authority to raise interest rates to levels that will either enslave
valid because (1) the parties mutually agreed on said stipulations (2) borrowers or lead to hemorrhaging of assets. In this case, the trial and
repricing takes effect only upon Solidbank‘s written notice to Permanent of appellate courts, in upholding the validity of the escalation clause,
the new interest rate and (3) Permanent has the option to prepay if it and underscored the fact that there was actually no fixed rate of interest as this
Solidbank do not agree on the new interest rate. There is no showing that was made dependent on prevailing rates in the market. Here, the escalation
either party coerced the other to enter into the loan agreements; the terms clause authorizing Chinabank to adjust the rate of interest based on law or
were mutually and freely entered into. Moreover, Solidbank‘s range of regulation issued by the Central Bank should be read together with the
lending rates were consistent with the prevailing rates. The SC also statement after the first paragraph where no rate of interest is fixed as it
recognizes that Solidbank admitted that it did not promptly send Permanent would be based on prevailing market rates. Evidently, the parties intended
written repriced rates, but rather verbally advised the change over the that any adjustment in rates would be determined by market rates and not
phone, and only advised on the repriced rates after the period had begun. dictated by Chinabank‘s policy. There is no indication that petitioners were
Thus, Solidbank‘s computation of interest due from Permanent should be coerced into agreeing with the foregoing provisions. That notwithstanding,
adjusted to take effect only upon Permanent‘s receipt of the written notice the Court still holds that the escalation clause is void because it grants
from Solidbank. Petition partially granted; RTC decision affirmed with Chinabank the power to impose an increased rate of interest without written
modification that the repricing of the interest rates should take effect only notice to and consent of petitioners. Chinabank‘s monthly telephone calls
upon Permanent‘s receipt of written notice of the adjustment; records are not enough; a detailed billing statement based on the new rates should
remanded for computation of proper interest payments. have been provided, and an appropriate form must also be signed by
petitioners to indicate their conformity to the new rates. Compliance with
these requisites is essential to preserve mutuality of contracts. In this case,
the original amount of the loan almost doubled in only 16 months; further,
Spouses Juico v. China Banking Corporation, 695 SCRA 520 (2013)5 . the penalty charges are also excessive and unconscionable and should be
reduced to only 1% per month. As such, the Statement of Accounts as of
foreclosure date should be modified. Petition partially granted; spouses
Petitioner-spouses obtained a loan totalling P10M(+) via 2 PNs secured by
Juico ordered to pay P4.76M as deficiency amount.
REM over their property located at White Plains, QC. When they failed to
pay the monthly amortizations, Chinabank demanded payment of the full
amount together with accrued monthly interests. As of Feb. 23, 2001, total
amount due (inclusive of principals, penalties and interests) totaled P19.2M,
and the property was sold the same date for P10.3M. On May 8, 2001, Villa Crista Monte Realty & Development Corporation v. Equitable PCI
petitioners received a demand letter for the deficiency (P8.9M). As this Bank (now known as Banco de Oro Unibank, Inc.), G.R. No. 208336.
demand letter went unheeded, Chinabank filed complaint for sum of money, November 21, 2018
and RTC rendered decision in its favor, such affirmed by the CA, finding that
petitioners agreed to the stipulation that interest would be based on
IN 1994, plaintiff was organized to engage in the business of real estate However, this is a disputable presumption, and you can overturn this by
development. After developing the Tivoli Royale Country Clubhouse in Old showing that there really is mutuality of contract, such as when the lender
Balara, QC, it eventually purchased and consolidated title over 21.5 hectares actually lowers the interest rate in repricing.
of land. It subsequently obtained a P80M credit facility from Equitable PCI
(now BDO), secured by REM over 80,000 sqm of its property. In 1995, it PLEDGE, CHATTEL MORTGAGE, ANTICHRESIS
obtained an additional P50M credit accommodation, and subsequently
subdivided its property into 174 lots, and asked for the release of 133 of the TITLE XVI
lots from the mortgage, since 41 are enough to cover, to which EPCIB
agreed. In 1997, Petitioner obtained several availments from the credit PLEDGE, MORTGAGE AND ANTICHRESIS
facility, all covered by PNs. Subsequently, EPCIB wrote petitioner informing
it of increase of rates, ostensibly anchored on the provisions in the PNs
regarding monthly repricing. Petitioner stopped paying its loan obligations
totaling P129.7M, prompting EPCIB to initiate foreclosure proceedings. CHAPTER 1
Petitioner filed for annulment of the PNs and the mortgage agreements, and
later for also of the auction sale. RTC rendered in EPCIB‘s favor, such Provisions Common to Pledge and Mortgage
affirmed by the CA.
Article 2085. The following requisites are essential to the contracts of
pledge and mortgage:
Both the trial and appellate courts were in unison in finding that the PNs and
REMs are valid, as well as the subsequent foreclosure proceedings. On the
(1) That they be constituted to secure the fulfillment of a principal obligation;
main issue in contention (the provision in the PNs on repricing of interest
rates), such provision is known as an escalation clause. Escalation clauses (2) That the pledgor or mortgagor be the absolute owner of the thing pledged
are not void per se. In this case, there is no express de-escalation clause in or mortgaged;
the PNs; however, the repricing notes sent by EPCIB indicate that it
previously had adjusted interest rates downward. Such actual downward (3) That the persons constituting the pledge or mortgage have the free
adjustment eliminates any one-sidedness in the contract with the borrower. disposal of their property, and in the absence thereof, that they be legally
As such, the Court should uphold the validity and enforceability of the authorized for the purpose.
escalation clause despite the absence of a corresponding de-escalation
clause. This is not a situation where the borrower did not stand on equality Third persons who are not parties to the principal obligation may secure the
latter by pledging or mortgaging their own property. (1857)
with the lender bank. Contrary to petitioner‘s position, there was mutuality of
contract between itself and EPCIB. Respondent sent notices to petitioner
Article 2086. The provisions of article 2052 are applicable to a pledge or
every time it increased the interest rates, and afforded it time to reject or mortgage. (n)
accept the new interest rates. Petition denied.
● Art. 2052. A guaranty cannot exist without a valid obligation.
SUMMARY OF CASES:
Nevertheless, a guaranty may be constituted to guarantee the
Escalation clause + no de-escalation clause = disputable presumption that performance of a voidable or an unenforceable contract. It may also
there is violation of mutuality of contract guarantee a natural obligation.

Escalation clause + no de-escalation clause + provision for prepayment of Article 2087. It is also of the essence of these contracts that when the
principal obligation becomes due, the things in which the pledge or mortgage
contract = still disputable presumption that there is violation of mutuality of
consists may be alienated for the payment to the creditor. (1858)
contract
Article 2088. The creditor cannot appropriate the things given by way of
pledge or mortgage, or dispose of them. Any stipulation to the contrary is
null and void. (1859a) CHAPTER 2

● ―Pactum commissorium‖ Pledge

Article 2089. A pledge or mortgage is indivisible, even though the debt may Article 2093. In addition to the requisites prescribed in article 2085, it is
be divided among the successors in interest of the debtor or of the creditor. necessary, in order to constitute the contract of pledge, that the thing
pledged be placed in the possession of the creditor, or of a third person by
Therefore, the debtor's heir who has paid a part of the debt cannot ask for common agreement. (1863)
the proportionate extinguishment of the pledge or mortgage as long as the
debt is not completely satisfied. Article 2094. All movables which are within commerce may be pledged,
provided they are susceptible of possession. (1864)
Neither can the creditor's heir who received his share of the debt return the
pledge or cancel the mortgage, to the prejudice of the other heirs who have Article 2095. Incorporeal rights, evidenced by negotiable instruments, bills
not been paid. of lading, shares of stock, bonds, warehouse receipts and similar documents
may also be pledged. The instrument proving the right pledged shall be
From these provisions is excepted the case in which, there being several delivered to the creditor, and if negotiable, must be indorsed. (n)
things given in mortgage or pledge, each one of them guarantees only a
determinate portion of the credit. Article 2096. A pledge shall not take effect against third persons if a
description of the thing pledged and the date of the pledge do not appear in
The debtor, in this case, shall have a right to the extinguishment of the a public instrument. (1865a)
pledge or mortgage as the portion of the debt for which each thing is
specially answerable is satisfied. (1860) Article 2097. With the consent of the pledgee, the thing pledged may be
alienated by the pledgor or owner, subject to the pledge. The ownership of
Article 2090. The indivisibility of a pledge or mortgage is not affected by the the thing pledged is transmitted to the vendee or transferee as soon as the
fact that the debtors are not solidarily liable. (n) pledgee consents to the alienation, but the latter shall continue in
possession. (n)
Article 2091. The contract of pledge or mortgage may secure all kinds of
obligations, be they pure or subject to a suspensive or resolutory condition. Article 2098. The contract of pledge gives a right to the creditor to retain the
(1861) thing in his possession or in that of a third person to whom it has been
delivered, until the debt is paid. (1866a)
Article 2092. A promise to constitute a pledge or mortgage gives rise only to
a personal action between the contracting parties, without prejudice to the Article 2099. The creditor shall take care of the thing pledged with the
criminal responsibility incurred by him who defrauds another, by offering in diligence of a good father of a family; he has a right to the reimbursement of
pledge or mortgage as unencumbered, things which he knew were subject the expenses made for its preservation, and is liable for its loss or
to some burden, or by misrepresenting himself to be the owner of the same. deterioration, in conformity with the provisions of this Code. (1867)
(1862)
Article 2100. The pledgee cannot deposit the thing pledged with a third
person, unless there is a stipulation authorizing him to do so.

The pledgee is responsible for the acts of his agents or employees with
respect to the thing pledged. (n)

Article 2101. The pledgor has the same responsibility as a bailor in

commodatum in the case under article 1951. (n)
 ● Art. 1951. The bailor who, knowing the flaws of the thing loaned, The pledgee is bound to advise the pledgor, without delay, of any danger to
does not advise the bailee of the same, shall be liable to the latter the thing pledged. (n)
for the damages which he may suffer by reason thereof.
Article 2108. If, without the fault of the pledgee, there is danger of
Article 2102. If the pledge earns or produces fruits, income, dividends, or destruction, impairment, or diminution in value of the thing pledged, he may
interests, the creditor shall compensate what he receives with those which cause the same to be sold at a public sale. The proceeds of the auction shall
are owing him; but if none are owing him, or insofar as the amount may be a security for the principal obligation in the same manner as the thing
exceed that which is due, he shall apply it to the principal. Unless there is a originally pledged. (n)
stipulation to the contrary, the pledge shall extend to the interest and
earnings of the right pledged. Article 2109. If the creditor is deceived on the substance or quality of the
thing pledged, he may either claim another thing in its stead, or demand
In case of a pledge of animals, their offspring shall pertain to the pledgor or immediate payment of the principal obligation. (n)
owner of animals pledged, but shall be subject to the pledge, if there is no
stipulation to the contrary. (1868a) Article 2110. If the thing pledged is returned by the pledgee to the pledgor
or owner, the pledge is extinguished. Any stipulation to the contrary shall be
Article 2103. Unless the thing pledged is expropriated, the debtor continues void.
to be the owner thereof.
If subsequent to the perfection of the pledge, the thing is in the possession
Nevertheless, the creditor may bring the actions which pertain to the owner of the pledgor or owner, there is a prima facie presumption that the same
of the thing pledged in order to recover it from, or defend it against a third has been returned by the pledgee. This same presumption exists if the thing
person. (1869) pledged is in the possession of a third person who has received it from the
pledgor or owner after the constitution of the pledge. (n)
Article 2104. The creditor cannot use the thing pledged, without the
authority of the owner, and if he should do so, or should misuse the thing in Article 2111. A statement in writing by the pledgee that he renounces or
any other way, the owner may ask that it be judicially or extrajudicially abandons the pledge is sufficient to extinguish the pledge. For this purpose,
deposited. When the preservation of the thing pledged requires its use, it neither the acceptance by the pledgor or owner, nor the return of the thing
must be used by the creditor but only for that purpose. (1870a) pledged is necessary, the pledgee becoming a depositary. (n)

Article 2105. The debtor cannot ask for the return of the thing pledged Article 2112. The creditor to whom the credit has not been satisfied in due
against the will of the creditor, unless and until he has paid the debt and its time, may proceed before a Notary Public to the sale of the thing pledged.
interest, with expenses in a proper case. (1871) This sale shall be made at a public auction, and with notification to the
debtor and the owner of the thing pledged in a proper case, stating the
Article 2106. If through the negligence or wilful act of the pledgee, the thing amount for which the public sale is to be held. If at the first auction the thing
pledged is in danger of being lost or impaired, the pledgor may require that it is not sold, a second one with the same formalities shall be held; and if at
be deposited with a third person. (n) the second auction there is no sale either, the creditor may appropriate the
thing pledged. In this case he shall be obliged to give an acquittance for his
entire claim. (1872a)

Article 2113. At the public auction, the pledgor or owner may bid. He shall,
moreover, have a better right if he should offer the same terms as the
highest bidder.
Article 2107. If there are reasonable grounds to fear the destruction or
impairment of the thing pledged, without the fault of the pledgee, the pledgor
The pledgee may also bid, but his offer shall not be valid if he is the only
may demand the return of the thing, upon offering another thing in pledge,
bidder. (n)
provided the latter is of the same kind as the former and not of inferior
quality, and without prejudice to the right of the pledgee under the provisions
of the following article.
Article 2114. All bids at the public auction shall offer to pay the purchase auction shall take place within one month after such demand. If, without just
price at once. If any other bid is accepted, the pledgee is deemed to have grounds, the creditor does not cause the public sale to be held within such
been received the purchase price, as far as the pledgor or owner is period, the debtor may require the return of the thing. (n)
concerned. (n)
Article 2123. With regard to pawnshops and other establishments, which
Article 2115. The sale of the thing pledged shall extinguish the principal are engaged in making loans secured by pledges, the special laws and
obligation, whether or not the proceeds of the sale are equal to the amount regulations concerning them shall be observed, and subsidiarily, the
of the principal obligation, interest and expenses in a proper case. If the provisions of this Title. (1873a)
price of the sale is more than said amount, the debtor shall not be entitled to
the excess, unless it is otherwise agreed. If the price of the sale is less, CHAPTER 3
neither shall the creditor be entitled to recover the deficiency,
notwithstanding any stipulation to the contrary. (n)
Mortgage
Article 2116. After the public auction, the pledgee shall promptly advise the
Article 2124. Only the following property may be the object of a contract of
pledgor or owner of the result thereof. (n)
mortgage:
Article 2117. Any third person who has any right in or to the thing pledged
(1) Immovables;
may satisfy the principal obligation as soon as the latter becomes due and
demandable. (n)
(2) Alienable real rights in accordance with the laws, imposed upon
immovables.
Article 2118. If a credit which has been pledged becomes due before it is
redeemed, the pledgee may collect and receive the amount due. He shall
apply the same to the payment of his claim, and deliver the surplus, should Nevertheless, movables may be the object of a chattel mortgage. (1874a)
there be any, to the pledgor. (n)
Article 2125. In addition to the requisites stated in article 2085, it is
indispensable, in order that a mortgage may be validly constituted, that the
document in which it appears be recorded in the Registry of Property. If the
instrument is not recorded, the mortgage is nevertheless binding between
the parties.

Article 2119. If two or more things are pledged, the pledgee may choose The persons in whose favor the law establishes a mortgage have no other
which he will cause to be sold, unless there is a stipulation to the contrary. right than to demand the execution and the recording of the document in
He may demand the sale of only as many of the things as are necessary for which the mortgage is formalized. (1875a)
the payment of the debt. (n) ARTICLE 2120. If a third party secures an
obligation by pledging his own movable property under the provisions of
Article 2126. The mortgage directly and immediately subjects the property
article 2085 he shall have the same rights as a guarantor under articles 2066
upon which it is imposed, whoever the possessor may be, to the fulfillment of
to 2070, and articles 2077 to 2081. He is not prejudiced by any waiver of
the obligation for whose security it was constituted. (1876)
defense by the principal obligor. (n)
Article 2127. The mortgage extends to the natural accessions, to the
Article 2121. Pledges created by operation of law, such as those referred to
improvements, growing fruits, and the rents or income not yet received when
in articles 546, 1731, and 1994, are governed by the foregoing articles on
the obligation becomes due, and to the amount of the indemnity granted or
the possession, care and sale of the thing as well as on the termination of
owing to the proprietor from the insurers of the property mortgaged, or in
the pledge. However, after payment of the debt and expenses, the
virtue of expropriation for public use, with the declarations, amplifications
remainder of the price of the sale shall be delivered to the obligor. (n)
and limitations established by law, whether the estate remains in the
possession of the mortgagor, or it passes into the hands of a third person.
Article 2122. A thing under a pledge by operation of law may be sold only (1877)
after demand of the amount for which the thing is retained. The public
Article 2128. The mortgage credit may be alienated or assigned to a third upon the enjoyment of the property, except when there is a stipulation to the
person, in whole or in part, with the formalities required by law. (1878) contrary. (1883)

Article 2129. The creditor may claim from a third person in possession of Article 2137. The creditor does not acquire the ownership of the real estate
the mortgaged property, the payment of the part of the credit secured by the for non-payment of the debt within the period agreed upon.
property which said third person possesses, in the terms and with the
formalities which the law establishes. (1879) Every stipulation to the contrary shall be void. But the creditor may petition
the court for the payment of the debt or the sale of the real property. In this
Article 2130. A stipulation forbidding the owner from alienating the case, the Rules of Court on the foreclosure of mortgages shall apply.
immovable mortgaged shall be void. (n) (1884a)

Article 2131. The form, extent and consequences of a mortgage, both as to Article 2138. The contracting parties may stipulate that the interest upon the
its constitution, modification and extinguishment, and as to other matters not debt be compensated with the fruits of the property which is the object of the
included in this Chapter, shall be governed by the provisions of the Mortgage antichresis, provided that if the value of the fruits should exceed the amount
Law and of the Land Registration Law. (1880a) of interest allowed by the laws against usury, the excess shall be applied to
the principal. (1885a)
CHAPTER 4
Article 2139. The last paragraph of article 2085, and articles 2089 to 2091
Antichresis are applicable to this contract. (1886a)

Article 2132. By the contract of antichresis the creditor acquires the right to CHAPTER 5
receive the fruits of an immovable of his debtor, with the obligation to apply
them to the payment of the interest, if owing, and thereafter to the principal Chattel Mortgage
of his credit. (1881)
Article 2140. By a chattel mortgage, personal property is recorded in the
Article 2133. The actual market value of the fruits at the time of the Chattel Mortgage Register as a security for the performance of an obligation.
application thereof to the interest and principal shall be the measure of such If the movable, instead of being recorded, is delivered to the creditor or a
application. (n) third person, the contract is a pledge and not a chattel mortgage. (n)

Article 2134. The amount of the principal and of the interest shall be Article 2141. The provisions of this Code on pledge, insofar as they are not
specified in writing; otherwise, the contract of antichresis shall be void. (n) in conflict with the Chattel Mortgage Law shall be applicable to chattel
mortgages. (n)
Article 2135. The creditor, unless there is a stipulation to the contrary, is
obliged to pay the taxes and charges upon the estate.

He is also bound to bear the expenses necessary for its preservation and
repair.
ACT NO. 1508
The sums spent for the purposes stated in this article shall be deducted from
the fruits. (1882) AN ACT PROVIDING FOR THE MORTGAGING OF PERSONAL
PROPERTY, AND FOR THE REGISTRATION OF THE MORTGAGES SO
Article 2136. The debtor cannot reacquire the enjoyment of the immovable EXECUTED
without first having totally paid what he owes the creditor.
SECTION 1. The short title of this Act shall be "The Chattel Mortgage Law."
But the latter, in order to exempt himself from the obligations imposed upon
him by the preceding article, may always compel the debtor to enter again
SECTION 2. All personal property shall be subject to mortgage, agreeably to possession of said mortgagor, to wit: (Here insert specific description of the
the provisions of this Act, and a mortgage executed in pursuance thereof property mortgaged.)
shall be termed a chattel mortgage.
"This mortgage is given as security for the payment to the said ______,
SECTION 3. A chattel mortgage is a conditional sale of personal property as mortgagee, of promissory notes for the sum of ____________ pesos, with
security for the payment of a debt, or the performance of some other (or without, as the case may be) interest thereon at the rate of ___________
obligation specified therein, the condition being that the sale shall be void per centum per annum, according to the terms of __________ certain
upon the seller paying to the purchaser a sum of money or doing some other promissory notes, dated _________, and in the words and figures following:
act named. If the condition is performed according to its terms the mortgage (Here insert copy of the note or notes secured).
and sale immediately become void, and the mortgagee is thereby divested
of his title. "(If the mortgage is given for the performance of some other obligation aside
from the payment of promissory notes, describe correctly but concisely the
SECTION 4. A chattel mortgage shall not be valid against any person except obligation to be performed.)
the mortgagor, his executors or administrators, unless the possession of the
property is delivered to and retained by the mortgagee or unless the "The conditions of this obligation are such that if the mortgagor, his heirs,
mortgage is recorded in the office of the Register of Deeds of the province in executors, or administrators shall well and truly perform the full obligation (or
which the mortgagor resides at the time of making the same, or, if he resides obligations) above stated according to the terms thereof, then this obligation
without the Philippine Islands, in the province in which the property is shall be null and void.
situated: Provided, however, That if the property is situated in a different
province from that in which the mortgagor resides, the mortgage shall be "Executed at the municipality of _________, in the Province of ________,
recorded in the office of the Register of Deeds of both the province in which this _____ day of ___________, 19_____.
the mortgagor resides and that in which the property is situated, and for the
purposes of this Act the city of Manila shall be deemed to be a province.
"__________________________
SECTION 5. A chattel mortgage shall be deemed to be sufficient when
(Signature of mortgagor.)
made substantially in accordance with the following form, and shall be
signed by the person or persons executing the same, in the presence of two
witnesses, who shall sign the mortgage as witnesses to the execution "In the presence of
thereof, and each mortgagor and mortgagee, or, in the absence of the
mortgagee, his agent or attorney, shall make and subscribe an affidavit in "____________________________________
substance as hereinafter set forth, which affidavit, signed by the parties to
the mortgage as above stated, and the certificate of the oath signed by the "___________________________________"
authority administering the same, shall be appended to such mortgage and
recorded therewith. (Two witnesses sign here.)

FORM OF CHATTEL MORTGAGE AND AFFIDAVIT. FORM OF OATH.

"This mortgage made this ____ day of ______, 19____, by "We severally swear that the foregoing mortgage is made for the purpose of
_______________, a resident of the municipality of ______________, securing the obligation specified in the conditions thereof, and for no other
Province of ____________, Philippine Islands, mortgagor, to purpose, and that the same is a just and valid obligation, and one not
____________, a resident of the municipality of ___________, Province of entered into for the purpose of fraud."
______________, Philippine Islands, mortgagee, witnesseth:
FORM OF CERTIFICATE OF OATH.
"That the said mortgagor hereby conveys and mortgages to the said
mortgagee all of the following-described personal property situated in the "At ___________, in the Province of _________, personally appeared
municipality of ______________, Province of ____________, and now in the ____________, the parties who signed the foregoing affidavit and made
oath to the truth thereof before me.
"_____________________________________" provided by law, the person entitled to redeem may recover of the person
whose duty it is to discharge the same twenty pesos for his neglect and all
(Notary public, justice of the peace, or other damages occasioned thereby in an action in any court having jurisdiction of
the subject-matter thereof.
officer, as the case may be.)
SECTION 9. [No personal property upon which a chattel mortgage is in force
shall be removed from the province in which the same is located at the time
SECTION 6. When a corporation is a party to such mortgage the affidavit
of the execution of the mortgage without the written consent of the
required may be made and subscribed by a director, trustee, cashier,
mortgagor and mortgagee, or their executors, administrators, or assigns.]
treasurer, or manager thereof, or by a person authorized on the part of such
corporation to make or to receive such mortgage. When a partnership is a
party to the mortgage the affidavit may be made and subscribed by one SECTION 10. [A mortgagor of personal property shall not sell or pledge such
member thereof. property, or any part thereof, mortgaged by him without the consent of the
mortgagee in writing on the back of the mortgage and on the margin of the
record thereof in the office where such mortgage is recorded.]
SECTION 7. The description of the mortgaged property shall be such as to
enable the parties to the mortgage, or any other person, after reasonable
inquiry and investigation, to identify the same. SECTION 11. [A mortgagor shall not execute a second or subsequent
mortgage of personal property while the same is subject to the previously
existing mortgage given by such mortgagor unless the existence of such
If the property mortgaged be "large cattle," as defined by section one of Act
previous mortgage is set forth in the subsequent mortgage.]
Numbered Eleven hundred and forty-seven, and the amendments thereof,
the description of said property in the mortgage shall contain the brands,
class, sex, age, knots of radiated hair commonly known as remolinos, or SECTION 12. [If a mortgagor violates either of the three last preceding
cowlicks, and other marks of ownership as described and set forth in the sections he shall be fined a sum double the value of the property so
certificate of ownership of said animal or animals, together with the number wrongfully removed from the province, sold, pledged or mortgaged, one half
and place of issue of such certificates of ownership. to the use of the party injured and the other half to the use of the Treasury of
the Philippine Islands, or he may be imprisoned for a period not exceeding
six months, or punished by both such fine and imprisonment, in the
If growing crops be mortgaged the mortgage may contain an agreement
discretion of the court.]
stipulating that the mortgagor binds himself properly to tend, care for and
protect the crop while growing, and faithfully and without delay to harvest the
same, and that in default of the performance of such duties the mortgagee SECTION 13. When the condition of a chattel mortgage is broken a
may enter upon the premises, take all the necessary measures for the mortgagor or person holding a subsequent mortgage, or a subsequent
protection of said crop, and retain possession thereof and sell the same, and attaching creditor may redeem the same by paying or delivering to the
from the proceeds of such sale pay all expenses incurred in caring for, mortgagee the amount due on such mortgage and the reasonable costs and
harvesting, and selling the crop and the amount of the indebtedness or expenses incurred by such breach of condition before the sale thereof. An
obligation secured by the mortgage, and the surplus thereof, if any, shall be attaching creditor who so redeems shall be subrogated to the rights of the
paid to the mortgagor or those entitled to the same. mortgagee and entitled to foreclose the mortgage in the same manner that
the mortgagee could foreclose it by the terms of this Act.
A chattel mortgage shall be deemed to cover only the property described
therein and not like or substituted property thereafter acquired by the SECTION 14. The mortgagee, his executor, administrator, or assign, may,
mortgagor and placed in the same depository as the property originally after thirty days from the time of condition broken, cause the mortgaged
mortgaged, anything in the mortgage to the contrary notwithstanding. property, or any part thereof, to be sold at public auction by a public officer at
a public place in the municipality where the mortgagor resides, or where the
property is situated, provided at least ten days' notice of the time, place, and
SECTION 8. If the mortgagee, assign, administrator, executor, or either of
purpose of such sale has been posted at two or more public places in such
them, after performance of the condition before or after the breach thereof,
municipality, and the mortgagee, his executor, administrator, or assign, shall
or after tender of the performance of the condition, at or after the time fixed
notify the mortgagor or person holding under him and the persons holding
for the performance, does not within ten days after being requested thereto
subsequent mortgages of the time and place of sale, either by notice in
by any person entitled to redeem, discharge the mortgage in the manner
writing directed to him or left at his abode, if within the municipality, or sent
by mail if he does not reside in such municipality, at least ten days previous SECTION 1. Section fifteen of Act Numbered Fifteen hundred and eight is
to the sale. hereby amended to read as follows:

"SEC. 15. Every register of deeds shall keep a journal of documents

presented and a book of records of chattel mortgages; shall certify on each
The officer making the sale shall, within thirty days thereafter, make in mortgage left for record the date, hour, and minute when the same was by
writing a return of his doings and file the same in the office of the register of him received; record in such book any chattel mortgage, transfer, or
deeds where the mortgage is recorded, and the register of deeds shall discharge, which shall be presented to him, in duplicate, the original to be
record the same. The fees of the officer for selling the property shall be the filed and the duplicate to be returned to the person concerned. The record
same as in the case of sale on execution as provided in Act Numbered One shall be effected by making an entry, which shall be given a correlative
hundred and ninety, and the amendments thereto, and the fees of the number, setting forth the names of the mortgagee and the mortgagor, the
Register of Deeds for registering the officer's return shall be taxed as a part sum or obligation guaranteed, date of the instrument, name of the notary
of the costs of sale, which the officer shall pay to the Register of Deeds. The acknowledging the same, and a note that the property mortgaged is
return shall particularly describe the articles sold, and state the amount mentioned in detail in the instrument filed, giving the proper file number
received for each article, and shall operate as a discharge of the lien thereon thereof; shall certify the officer's return of sale upon any mortgage; making
created by the mortgage. The proceeds of such sale shall be applied to the reference upon the margin of the record of such officer's return to the volume
payment, first, of the costs and expenses of keeping and sale, and then to and page of the record of the mortgage, and a reference of such return on
the payment of the demand or obligation secured by such mortgage, and the the record of the mortgage itself, and give a certified copy thereof, when
residue shall be paid to persons holding subsequent mortgages in their requested, upon the payment of the lawful fees for such copy; and certify
order, and the balance, after paying the mortgages, shall be paid to the upon each mortgage officer's return of sale or discharge of mortgage, both
mortgagor or person holding under him on demand. on the original and on the duplicate, the date, upon the margin of the record
of such officer's return to the volume and page of the record of the mortgage,
If the sale includes any "large cattle," a certificate of transfer as required by and a reference of such return on the record of the mortgage itself, and give
section sixteen of Act Numbered Eleven hundred and forty-seven shall be a certified copy thereof, when requested, upon the payment of the lawful
issued by the treasurer of the municipality where the sale was held to the fees for such copy; and certify upon each mortgage officer's return of sale or
purchaser thereof. discharge of mortgage, both on the original and on the duplicate, the date,
certified copies of such records and of filed instruments or documents shall
be receivable as evidence in any court, as provided in Act Numbered One
SECTION 15. (amended)
hundred and ninety. The register of deeds for each province or the city of
Manila, as the case may be, shall be entitled to receive the following fees for
SECTION 16. This Act shall take effect on August first, nineteen hundred services under the provisions of this Act:
and six.
"For record of filing of any document, twenty-five centavos.
Enacted: July 2, 1906
"For filing and recording each chattel mortgage, including the necessary
||| (The Chattel Mortgage Law, Act No. 1508, [July 2, 1906]) certificates and affidavits, the fees established in the following schedule shall
be collected:

"For each mortgage, the amount of which is three hundred pesos or less,
three pesos.

ACT NO. 2496 "From three hundred and one to six hundred pesos, three pesos and fifty
centavos.
AN ACT TO AMEND SECTION FIFTEEN OF ACT NUMBERED FIFTEEN
HUNDRED AND EIGHT, ENTITLED "THE CHATTEL MORTGAGE LAW," "From six hundred and one to eight hundred pesos, four pesos.
BY ESTABLISHING A NEW SCHEDULE FOR THE REGISTRATION OF
CHATTEL MORTGAGES
"From eight hundred and one to one thousand pesos, four pesos and fifty "For recording each notice of embargo, including the necessary index and
centavos. annotations, three pesos.

"From one thousand and one to one thousand five hundred pesos, five "For recording each release, including the necessary index and references,
pesos. forty centavos.

"From one thousand five hundred and one to two thousand pesos, five "For recording each release of embargo, including the proper annotations,
pesos and fifty centavos. forty centavos.

"From two thousand and one to two thousand five hundred pesos, six pesos. "For recording each sheriff's return of sale, including the index and
references, for each one hundred words, twenty centavos.
"From two thousand five hundred and one to three thousand pesos, six
pesos and fifty centavos. "For certified copies of records, such fees as are allowed by law for copies of
records kept by the register of deeds, that is ten centavos for each one
"From three thousand and one to four thousand pesos, seven pesos and fifty hundred words.
centavos.
"For any kind of certificate on a declaration or statement, fifty centavos.
"From four thousand and one to five thousand pesos, eight pesos and
seventy-five centavos. SECTION 2. Any Acts or parts of Acts inconsistent with the provisions of this
Act are hereby repealed.
"From five thousand and one to eight thousand pesos, ten pesos.
SECTION 3. This Act shall take effect on its passage.
"From eight thousand and one to ten thousand pesos, eleven pesos and
twenty-five centavos. Enacted, February 5, 1915.

"From ten thousand and one to twelve thousand pesos, twelve pesos and ||| (Amendments to Section 15 of Act No. 1508 (Chattel Mortgage Law), Act
fifty centavos. No. 2496, [February 5, 1915])

"From twelve thousand and one to fourteen thousand pesos, fourteen pesos.

"From fourteen thousand and one to sixteen thousand pesos, fifteen pesos
and fifty centavos.
Reyes v. Heirs of Benjamin Malance, 801 SCRA 485 (2016) 6
"From sixteen thousand and one to eighteen thousand pesos, seventeen
pesos. FACTS:

"From eighteen thousand and one to twenty thousand pesos, eighteen Petition for review on certiorari was filed by spouses Reyes and Maravillo
pesos and fifty centavos. assailing the CA ruling directing the Magtalas sisters (herein petitioners) to
surrender and turn-over the physical possession of disputed land to
"From twenty thousand to twenty-five thousand pesos, twenty pesos. respondents, heirs of Benjamin Malance upon payment of Php 4,320.84
representing the remaining debt of Benjamin Malance from a loan he
"From twenty-five thousand pesos upward, twenty-five pesos. obtained from the said sisters.

"For recording each instrument of sale, conveyance, and transfer of a The facts of the case indicate that in consideration of the amount of Php
mortgage credit, whatever be the amount, three pesos. 600,000, under a Kasulatan Ng Ukol sa Utang dated June 26, 2006 the
Magtalas sisters shall have the right to the fruits of the subject land for six (6) (c) the creditor retains enjoyment of such property until the debtor has totally
years or until the loan is fully paid. paid what he owes;and

After Benjamin passed away on September 29, 2006,his siblings, the (d) should the obligation be duly paid, then the contract is automatically
Malance heirs, inspected the subject land and discovered that the Magtalas extinguished, proceeding from the accessory character of the agreement.
sisters, their respective husbands, and their father, Fidel G. Magtalas were
cultivatingthe same on the basis of the Kasulatan. Due to doubts Up to the date of the Court‘s decision, only the amount of Php 326,351.07 is
surrounding the authenticity of the said Kasulatan, the Malance heirs filed a deemed to have been paid on Benjamin's loan, leaving an unpaid amount
Complaint for Recovery of Possession, Declaration of Nullity of the of Php 273,648.93. The debt not having been totally paid, petitioners
Kasulatan and Damages withPrayer for Writ of Preliminary Injunction and are entitled to retain enjoyment of the subject land. Article 2136 ofthe
TRO against petitioners, before the Malolos City RTC. Civil Code reads:

RTC - Dismissed the complaint for failure of the Malance heirs to Art. 2136. The debtor cannot reacquire the enjoyment of the immovable
substantiate their claim that Benjamin's signature was forged, and upheld without first having totally paid what he owes the creditor. Consequently,
the validity of the Kasulatanon the ground that it is a notarized document the Malance heirs' complaint for recovery of possession, declaration of
which enjoys the presumption nof regularity in its execution, declaring it as a nullity of the Kasulatan, and damages against petitioners must be
contract ofantichresis binding upon Benjamin's heirs and conferring on the dismissed.
Magtalas sisters the right to retain the subject land until the debt is paid.
As to the Court‘s disposition, the CA ruling is modified as follows:
CA – Upheld the RTC, validating the Kasulatan as a contract of antichresis,
but modifying the ruling to the effect that Benjamin Malance only had an (a) declaring that the unpaid loan balance of Benjamin Malance's (Benjamin)
outstanding debt of Php 4,320.84.Consequently, it directed the Magtalas to petitioners Charito M. Reyes and Vilma M. Maravillo (the Magtalas sisters)
sisters to surrender and turn-over the physical possession of the subject is Php 273,648.93 as herein computed;
land to the Malance heirs upon payment by the latter of the outstanding loan.
(b) dismissing the counterclaim of petitioners the Magtalas sisters and their
ISSUE: WHETHER OR NOT the contract between Benjamin Malance and respective husbands, Roberto Reyes and Domingo Maravillo, Jr., on the
the Magtalas sisters is a Contract of Antichresis? (YES) ground of prematurity, without prejudice; and

RULING: (c) directing the Magtalassisters, as antichretic creditors, to henceforth

render an annual accounting to respondents Heirs of Benjamin Malance,
The SC concurs with the RTC's finding, as affirmed by the CA, that the namely: Rosalina M. Malance, Bernabe M. Malance, Bienvenido M.
Kasulatan is a validcontract of antichresis. Article 2132 of the Civil Code Malance, and Dominga M. Malance, as represented by Bienvenido Malance,
provides: of the annual net yield from the subject land, until such time that they have
completely collected the outstanding loan balance of Benjamin's debt.
Art. 2132. By the contract of antichresis the creditor acquires the right to
receive the fruits of an immovable of his debtor, with the obligation to apply Marquez v. Elisan Credit Corporation, 755 SCRA 31 (2015)
them to the payment of the interest, if owing, and thereafter to the principal
of his credit. FACTS: On December 16, 1991, Nunelon Marquez (Marquez) obtained a
loan from Elisan Credit Corporation (Elisan Credit) for PHP 53,000.00
Antichresis involves an express agreement between parties whereby:
payable in 180 days. The petitioner signed a promissory note which provided
that it is payable in weekly installments and subject to 26% annual interest.
(a) the creditor will have possession of the debtor's real property given as
security; In case of non-payment, the petitioner agreed to pay a 10% monthly penalty
based on the total amount unpaid and another 25% of such amount for
(b) such creditor will apply the fruits of the said property to the interest owed attorney‘s fees. To further secure payment of the loan, the petitioner
by the debtor, if any, then to the principal amount; executed a chattel mortgage over a motor vehicle. Subsequently, the
petitioner obtained another loan from the respondent for PHP 55,000.00
evidenced by a promissory note and a cash voucher. The promissory note Article 1176 falls under Nature and Effect of Obligations while Article 1253
covering the second loan contained exactly the same terms and conditions falls under Application of Payments, (Extinguishment of Obligations. The
as the first promissory note. When the second loan matured, the petitioner structuring of these provisions, properly taken into account, means that
had only paid PHP 29,960.00. Due to liquidity problems, Marquez asked Article 1176 should be treated as a general presumption subject to the more
Elisan Credit if he could pay in daily installments until the second loan is paid specific presumption under Article 1253. Article 1176 is relevant on
which was granted. As of September 1994 or 21 months after the second questions pertaining to the effects and nature of obligations in general, while
loan‘s maturity, the petitioner had already paid a total of PHP 56,440.00, an Article 1253 is specifically pertinent on questions involving application of
amount greater than the principal but despite this, Elisan Credit filed a payments and extinguishment of obligations.
judicial complaint for judicial foreclosure of the chattel mortgage because the
petitioner allegedly failed to settle the balance of the second loan despite Correlating the two provisions, the rule under Article 1253 that payments
demand. The respondent further alleged that pursuant to the terms of the shall first be applied to the interest and not to the principal shall govern if two
promissory note, the petitioner‘s failure to fully pay upon maturity triggered facts exist: (1) the debt produces interest (e.g., the payment of interest is
the imposition of 10% monthly penalty and 25% attorney‘s fees. The expressly stipulated) and (2) the principal remains unpaid. The exception is
Municipal Trial Court (MTC) found for the petitioner and held that the second a situation covered under Article 1176, i.e., when the creditor waives
loan was fully extinguished as of September 1994. The court held that when payment of the interest despite the presence of (1) and (2) above. In such
a creditor accepts the performance or payment of an obligation, knowing its case, the payments shall obviously be credited to the principal.
incompleteness or irregularity and without expressing any protest or
objection, the obligation is deemed fully complied with. The Regional Trial However, in this case, there was no waiver of interest on the part of Elisan
Court initially affirmed the decision of the MTC but reversed itself acting on Credit. The fact that the official receipts did not indicate whether the
Elisan Credit‘s motion for reconsideration and ruled that, pursuant to Article payments were made for the principal or the interest does not prove that
1253 of the Civil Code, if the debt produces interest, payment of the principal Elisan Credit waived the interest.
shall not be deemed to have been made until the interests have been
covered. The Court of Appeals appealed the trial court‘s ruling. Pledge vs. Chattel Mortgage: PAMECA Wood Treatment Plant, Inc v.
Court of Appeals 310 SCRA 281 (1999)8
ISSUE: Whether or not Marquez has fully paid his obligation--NO
Petitioner Pameca obtained a loan of USD267,881.67, or the equivalent of
RULING: There is a need to analyze and harmonize Article 1176 and Article P2M, from respondent DBP, payable via installment, and for security, a
1253 of the Civil Code to determine whether the daily payments made after chattel mortgage was constituted over properties of Pameca in Dumaguete,
the second loan's maturity should be credited against the interest or against consisting of inventories, furniture, and equipment. Upon Pameca‘s default,
the principal. Article 1176 and Article 1253 respectively provides that: The DBP caused extrajudicial foreclosure, and subsequently filed to collect the
receipt of the principal by the creditor, without reservation with respect to the deficiency claim. RTC granted DBP‘s deficiency claim, such affirmed by the
interest, shall give rise to the presumption that said interest has been paid. CA.
xxx. If the debt produces interest, payment of the principal shall not be
deemed to have been made until the interests have been covered. The SC affirms CA‘s decision. Petitioners are not the first ones to put forth the
aforementioned provisions appear to be contradictory but they in fact theory of the applicability of article 2115 to foreclosures of chattel mortgage.
support, and are in conformity with each other. Thus, the settlement of the In the leading case of Ablaza v. Ignacio, the SC already ruled that article
first issue depends on which of these presumptions prevails under the given 2115 does not apply to foreclosures of chattel mortgage, as it is contrary to
facts of the case. There are two undisputed facts crucial in resolving the first the Chattel Mortgage Law. Section 14 of said law expressly entitles the
issue: (1) the petitioner failed to pay the full amount of the second loan upon mortgagor to the balance of the proceeds, and there is also a corollary
maturity; and (2) the second loan was subject to interest, and in case of obligation on the part of the mortgagor to pay the deficiency in case of
default, to penalty and attorney's fees. reduction in price at public auction. Neither does article 1484 apply to this
case, as such applies only to sale of personal property the price of which is established in Sections 36 and 37 of this Act, or, in special cases, increase
paid in installments. Furthermore, there is no merit in petitioners‘ submission the maximum ratios established therein. (78)
that the auction sale is void on grounds of fraud and inadequacy of price; it is
also clear that petitioners signed the PN as co-makers, and thus they are SECTION 43. Authority to Prescribe Terms and Conditions of Loans
and Other Credit Accommodations. — The Monetary Board may,
jointly and solidarily liable. Petition denied, CA affirmed.
similarly, in accordance with the authority granted to it in Section 106 of the
New Central Bank Act, and taking into account the requirements of the
economy for the effective utilization of long-term funds, prescribe the
maturities, as well as related terms and conditions for various types of bank
loans and other credit accommodations. Any change by the Board in the
maximum maturities shall apply only to loans and other credit
CREDIT WORTHINESS accommodations made after the date of such action. cdtai

(The General Banking Law of 2000, Republic Act No. 8791, [May 23, 2000]) The Monetary Board shall regulate the interest imposed on microfinance
borrowers by lending investors and similar lenders, such as, but not limited
SECTION 40. Requirement for Grant of Loans or Other Credit to, the unconscionable rates of interest collected on salary loans and similar
Accommodations. — Before granting a loan or other credit credit accommodations. (78a)
accommodation, a bank must ascertain that the debtor is capable of fulfilling
his commitments to the bank.

Toward this end, a bank may demand from its credit applicants a statement
of their assets and liabilities and of their income and expenditures and such
information as may be prescribed by law or by rules and regulations of REPUBLIC ACT NO. 9510
Monetary Board to enable the bank to properly evaluate the credit
application which includes the corresponding financial statements submitted AN ACT ESTABLISHING THE CREDIT INFORMATION SYSTEM, AND
for taxation purposes to the Bureau of Internal Revenue. Should such FOR OTHER PURPOSES
statements prove to be false or incorrect in any material detail, the bank may
terminate any loan or other credit accommodation granted on the basis of SECTION 1. Title. — This Act shall be known as the "Credit Information
said statements and shall have the right to demand immediate repayment or System Act".
liquidation of the obligation.
SECTION 2. Declaration of Policy. — The State recognizes the need to
In formulating rules and regulations under this Section, the Monetary Board establish a comprehensive and centralized credit information system for the
shall recognize the peculiar characteristics of microfinancing, such as cash collection and dissemination of fair and accurate information relevant to, or
flow-based lending to the basic sectors that are not covered by traditional arising from, credit and credit-related activities of all entities participating in
collateral. (76a) the financial system. A credit information system will directly address the
need for reliable credit information concerning the credit standing and track
SECTION 41. Unsecured Loans or Other Credit Accommodations. — record of borrowers.
The Monetary Board is hereby authorized to issue such regulations as it may
deem necessary with respect to unsecured loans or other credit The operations and services of a credit information system can be expected
accommodations that may be granted by banks. (n) to: greatly improve the overall availability of credit especially to micro, small
and medium-scale enterprises; provide mechanisms to make credit more
SECTION 42. Other Security Requirements for Bank Credits. — The cost-effective; and reduce the excessive dependence on collateral to secure
Monetary Board may, by regulation, prescribe further security requirements credit facilities.
to which the various types of bank credits shall be subject, and, in
accordance with the authority granted to it in Section 106 of the New Central
Bank Act, the Board may by regulation, reduce the maximum ratios
The State shall endeavor to have credit information provided at the least (h) "Credit Report" refers to a summary of consolidated and evaluated
cost to all participants and shall ensure the protection of consumer rights information on creditworthiness, credit standing, credit capacity, character
and the existence of fair competition in the industry at all times. and general reputation of a borrower.

An efficient credit information system will also enable financial institutions to (i) "Government Lending Institutions" refers to existing and future
reduce their over-all credit risk, contributing to a healthier and more stable government financial institutions (GFIs), government-owned and -controlled
financial system. corporations (GOCCs) primarily engaged in lending activities.

SECTION 3. Definition of Terms. — For purposes of this Act (j) "Negative Credit Information" refers to information/data concerning the
poor credit performance of borrowers, such as, but not limited to, defaults on
(a) "Accessing Entity" refers to any submitting entity or any other entity loans, adverse court judgments relating to debts and reports on bankruptcy,
authorized by the Corporation to access basic credit data from the insolvency, petitions or orders on suspension of payments and corporate
Corporation. ASEcHI rehabilitation.

(b) "Basic Credit Data" refers to positive and negative credit information (k) "Non-Accessing Entity" refers to an entity other than a Submitting Entity,
provided by a borrower to a submitting entity in connection with the Special Accessing Entity or Borrower that is authorized by the Corporation to
application for and availment of a credit facility and any information on the access credit information from a Special Accessing Entity.
borrower's creditworthiness in the possession of the submitting entity and
other factual and objective information related or relevant thereto in the (l) "Outsource Entity" refers to any accredited third-party provider to whom
submitting entity's data files or that of other sources of information: Provided, the Corporation may outsource the processing and consolidation of basic
That in the absence of a written waiver duly accomplished by the borrower, credit data pertaining to a borrower or issuer of debt or convertible securities
basic credit data shall exclude confidential information on bank deposits under such qualifications, criteria and strict confidentiality guidelines that the
and/or clients funds under Republic Act No. 1405 (Law on Secrecy of Bank Corporation shall prescribe and duly publish. cIaCTS
Deposits), Republic Act No. 6426 (The Foreign Currency Deposit Act),
Republic Act No. 8791 (The General Banking Law of 2000)and their (m) "Positive Credit Information" refers to information/data concerning the
amendatory laws. DTAHSI credit performance of a borrower, such as, but not limited to, information on
timely repayments or non-delinquency.
(c) "Borrower" refers to a natural or juridical person, including any local
government unit (LGU), its subsidiaries and affiliates, that applies for and/or (n) "Relevant Government Agencies" refers to the Department of Finance,
avails of a Credit Facility. Department of Trade and Industry, Bangko Sentral ng Pilipinas, Insurance
Commission and the Cooperative Development Authority.
(d) "BSP" refers to the Bangko Sentral ng Pilipinas, created under Republic
Act No. 7653. (o) "SEC" refers to the Securities and Exchange Commission.

(e) "Corporation" refers to the Credit Information Corporation established (p) "Special Accessing Entity" refers to a duly accredited private corporation
under Section 5 of this Act. engaged primarily in the business of providing credit reports, ratings and
other similar credit information products and services.
(f) "Credit Facility" refers to any loan, credit line, guarantee or any other form
of financial accommodation from a submitting entity: Provided, That for (q) "Submitting Entity" refers to an entity which provides credit facilities such
purposes of this Act, deposits in banks shall not be considered a credit as, but not limited to, banks, quasi-banks, trust entities, investment houses,
facility extended by the depositor in favor of the bank. financing companies, cooperatives, non-governmental, micro-financing
organizations, credit card companies, insurance companies and government
(g) "Credit Rating" refers to an opinion regarding the creditworthiness of a lending institutions. IEDHAT
borrower or of an issuer of debt security, using an established and defined
ranking system.
SECTION 4. Establishment of the Credit Information System. — In Negative information shall be corrected and updated within fifteen (15) days
furtherance of the policy set forth in Section 2 of this Act, a credit information from the time of payment, liquidation or settlement or debts.
system is hereby established:
(i) Special Accessing Entities shall be accredited by the Corporation in
(a) Banks, quasi-banks, their subsidiaries and affiliates, life insurance accordance with such standards and rules as the SEC in coordination with
companies, credit card companies and other entities that provide credit the relevant government agencies, may prescribe.
facilities, are required to submit basic credit data and updates thereon on a
regular basis to the Corporation. (j) Special Accessing Entities shall be entitled access to the Corporation's
pool of consolidated basic credit data, subject to the provisions of Sections 6
(b) The Corporation may include other credit providers to be subject to and 7 of this Act and related implementing rules and regulations.
compulsory participation: Provided, That all other entities qualified to be
submitting entities may participate subject to their acceptance by the (k) Special Accessing Entities are prohibited from releasing basic credit data
Corporation: Provided, further, That in all cases, participation under the received from the Corporation or credit reports and credit ratings derived
system shall be in accordance with such standards and rules that the SEC in from the basic credit data received from the Corporation, to non-accessing
coordination with the relevant government agencies, may prescribe. CHEIcS entities unless written consent or authorization has been obtained from the
Borrower: Provided, however, That in case the borrower is a local
(c) Participating submitting entities are required to regularly submit to the government unit (LGU) or its subsidiary or affiliate, the special accessing
Corporation any negative and positive credit information that tends to update entity may release credit information on the LGU, its subsidiary or affiliate
and/or correct the credit status of borrowers. The Corporation shall fix the upon written request and payment of reasonable fees by a constituent of the
time interval for such submission: Provided, That such interval shall not be concerned LGU.
less than fifteen (15) working days but not more than thirty (30) working
days. (l) Outsource Entities, which may process and consolidate basic credit data,
are absolutely prohibited from releasing such data received from the
(d) The Corporation should regularly collect basic credit data of borrowers at Corporation other than to the Corporation itself.
least on a quarterly basis to correct/update the basic credit data of said
borrowers. (m) Accessing Entities shall hold strictly confidential any credit information
they receive from the Corporation.
(e) The Corporation may also access credit and other relevant information
from government offices, judicial and administrative tribunals, prosecutorial (n) The borrower has the right to know the causes of refusal of the
agencies and other related offices, as well as pension plans administered by application for credit facilities or services from a financial institution that uses
the government. basic credit data as basis or ground for such refusal. ADaSEH

(f) Each submitting entity shall notify its borrowers of the former's obligation (o) The borrower, for a reasonable fee, shall have, as a matter of right, ready
to submit the latter's basic credit data to the Corporation and the disclosure and immediate access to the credit information pertinent to the borrower. In
thereof to the Corporation, subject to the provisions of this Act and the case of erroneous, incomplete or misleading credit information, the subject
implementing rules and regulations. HIDCTA borrower shall have the right to dispute the erroneous, incomplete, outdated
or misleading credit information before the Corporation. The Corporation
(g) The Corporation is in turn authorized to release consolidated basic credit shall investigate and verify the disputed information within five (5) working
data on the borrower, subject to the provisions of Section 6 of this Act. days from receipt of the complaint. If its accuracy cannot be verified and
cannot be proven, the disputed information shall be deleted. The borrower
(h) The negative information on a borrower as contained in the credit history and the accessing entities and special accessing entities who have received
files of borrowers should stay in the database of the Corporation unless such information shall be informed of the corresponding correction or
sooner corrected, for not more than three (3) years from and after the date removal within five (5) working days. The Corporation should use a
when the negative credit information was rectified through payment or simplified dispute resolution process to fast track the settlement/resolution of
liquidation of the debt, or through settlement of debts through compromise disputed credit information. Denial of these borrowers' rights, without
agreements or court decisions that exculpate the borrower from liability. justifiable reason, shall entitle the borrower to indemnity.
SECTION 5. Establishment of the Central Credit Information (f) The Chairman of the SEC shall be the Chairman of the board of directors
Corporation. — There is hereby created a Corporation which shall be of the Corporation. Whenever the Chairman of the SEC is unable to attend a
known as the Credit Information Corporation, whose primary purpose shall meeting of the board, he/she shall designate an Associate Commissioner of
be to receive and consolidate basic credit data, to act as a central registry or the SEC to act as his/her alternate.
central repository of credit information, and to provide access to reliable,
standardized information on credit history and financial condition of The powers and functions of the Corporation shall be exercised by a board
borrowers. of directors composed of fifteen (15) members. The directors representing
the government shares shall be appointed by the President of the
(a) The Corporation is hereby authorized to adopt, alter, and use a corporate Philippines.
seal which shall be judicially noticed; to enter into contracts; to incur
liabilities; to lease or own real or personal property, and to sell or otherwise (g) The directors and principal officers of the Corporation, shall be qualified
dispose of the same; to sue and be sued; to compromise, condone or by the "fit and proper" rule for bank directors and officers. To maintain the
release any liability and otherwise to do and perform any and all things that quality of management of the Corporation and afford better protection to the
may be necessary or proper to carry out the purposes of this Act. system and the public in general, the SEC in coordination with the relevant
government agencies, shall prescribe, pass upon and review the
(b) The authorized capital stock of the Corporation shall be Five hundred qualifications and disqualifications of individuals elected or appointed
million pesos (Php500,000,000.00) which shall be divided into common and directors of the Corporation and disqualify those found unfit. After due notice
preferred shares which shall be non-voting. The National Government shall to the board of directors of the Corporation, the SEC may disqualify,
own and hold sixty percent (60%) of the common shares while the balance suspend or remove any director who commits or omits an act which render
of forty percent (40%) shall be owned by and held by qualified investors him unfit for the position. In determining whether an individual is fit and
which shall be limited to industry associations of banks, quasi-banks and proper to hold the position of a director of the Corporation, due regard shall
other credit-related associations including associations of consumers. The be given to his integrity, experience, education, training, and competence.
amount of Seventy-five million pesos (Php75,000,000.00) shall be CaHAcT
appropriated in the General Appropriations Act for the subscription of
common shares by the National Government to represent its sixty percent The members of the board of directors must be Filipino citizens and at least
(60%) equity share and the amount of Fifty million pesos thirty (30) years of age. In addition, they shall be persons of good moral
(Php50,000,000.00) shall be subscribed and paid up by such qualified character, of unquestionable integrity, of known probity, and have attained
investors in accordance with Section 5 (d) hereof. TAaCED competence in the fields of law, finance, economics, computer science or
information technology. In addition to the disqualifications imposed by the
(c) The National Government may subscribe or purchase securities or Corporation Code, as amended, no person shall be nominated by the
financial instruments that may be issued by the Corporation as a supplement National Government if he has been connected directly with a banking or
to capital. financial institution as a director or officer, or has substantial interest therein
within three (3) years prior to his appointment. DcaECT
(d) Equal equity participation in the Corporation shall be offered and held by
qualified private sector investors but in no case shall each of the qualified (h) The board of directors shall appoint such officers and employees as are
investor represented by an association of banks, quasi-banks and other not otherwise provided for in this Act, define their duties, fix their
credit-related associations including the associations of consumers have compensation and impose disciplinary sanctions upon such officers and
more than ten percent (10%) each of the total common shares issued by the employees, for cause. The salaries and other compensation of the officers
Corporation. and employees of the Corporation shall be exempt from the Salary
Standardization Law. Appointments in the Corporation, except to those
(e) The SEC in coordination with relevant government agencies, shall which are policy-determining, primarily confidential or highly technical in
prescribe additional requirements for the establishment of the Corporation, nature, shall be made only according to the Civil Service Law.
such as industry representation, capital structure, number of independent
directors, and the process for nominating directors, and such other (i) The Corporation shall acquire and use state-of-the-art technology and
requirements to ensure consumer protection and free, fair and healthy facilities in its operations to ensure its continuing competence and capability
competition in the industry. CITcSH to provide up to date negative and positive credit information; to enable the
Corporation to relay credit information electronically as well as in writing to
those authorized to have access to the credit information system; and to The Corporation shall be authorized to release and disclose consolidated
insure accuracy of collected, stored and disseminated credit information. basic credit data only to the Accessing Entities, the Special Accessing
The Corporation shall implement a borrower's identification system for the Entities, the Outsource Entities and Borrowers. Basic credit data released to
purpose of consolidating credit information. Accessing Entities shall be limited to those pertaining to existing Borrowers
or Borrowers with pending credit applications. Credit information shall not be
(j) The provisions of any general or special law to the contrary released to entities other than those enumerated under this Section except
notwithstanding, the importation by the Corporation of all equipment, upon order of the court.
hardware or software, as well as all other equipment needed for its
operations shall be fully exempt from all customs duties and from all other SECTION 7. Educational Campaign. — A continuing nationwide
taxes, assessments and charges related to such importation. educational campaign shall be developed and undertaken by the
Corporation to promote the benefits of a credit information system to the
(k) The Corporation shall have its principal place of business in Metro economy; to create awareness on the rights of consumers/borrowers to
Manila, but may maintain branches in such other places as the proper access their credit reports collected, stored and disseminated by the
conduct of its business may require. Corporation; to disseminate the rights of the borrowers to dispute any
incorrect/inaccurate credit information in the database file of the Corporation;
(l) Any and all acquisition of goods and services by the Corporation shall be to familiarize consumers of the procedure in collecting, storing and
subject to Procurement Laws. disseminating credit information of borrowers by the Corporation; and to brief
consumers of other related information.
(m) The National Government shall continue to hold sixty percent (60%) of
the common shares for a period not to exceed five (5) years from the date of SECTION 8. Rules and Regulations. — For purposes of creating a healthy
commencement of operations of the Corporation. After the said period, the balance between the need for reliable credit information and safeguarding
National Government shall dispose of at least twenty percent (20%) of its consumer protection, ensuring free and healthy competition in the industry,
stockholdings in the Corporation to qualified investors which shall be limited the SEC in coordination with relevant government agencies and existing
to industry associations of banks, quasi-banks and other credit-related industry stakeholders, shall issue the implementing rules and regulations
associations, including associations of consumers. The National (IRRs), which shall be reviewed, revised and approved by the Oversight
Government shall offer equal equity participation in the Corporation to all Committee to ensure consistency and compliance with the provisions of this
qualified investors. When the ownership of the majority of the common Act, embodying among others:
voting shares of the Corporation passes to private investors, the
stockholders shall cause the adoption and registration with the SEC of the (a) The basic credit data shall be limited or confined in form and content to
amended articles of incorporation within three (3) months from such transfer an objective and factual information and shall exclude any subjective
of ownership. IDTSaC information or opinion; DCAEcS

SECTION 6. Confidentiality of Credit Information. — The Corporation, the (b) Restrictions on the use and transfer of credit information;
submitting entities, the accessing entities, the outsource entities, the special
accessing entities and the duly authorized non-accessing entities shall hold (c) Rights of the borrowers to access their respective credit information and
the credit information under strict confidentiality and shall use the same only to dispute the factual accuracy of such credit information;
for the declared purpose of establishing the creditworthiness of the borrower.
Outsource entities, which may process and consolidate basic credit data, are (d) Requirements and standards for the establishment of the Corporation
absolutely prohibited from releasing such data received from the Corporation including, but not limited to, ownership, industry representation, independent
other than to the Corporation. directors and process of nomination of directors;

The accreditation of an accessing entity, a special accessing entity and/or an (e) Accreditation standards for submitting and special accessing entities and
outsource entity which violates the confidentiality of, or which misuse, the non-accessing entities;
credit information accessed from the Corporation, may be suspended or
revoked. Any entity which violates this Section may be barred access to the (f) Sanctions to be imposed by the Corporation on:
credit information system and penalized pursuant to Section 11 of this Act.
(i) The submitting entities for non-submission of reports and for delayed After the Oversight Committee approved the implementing rules and
and/or erroneous reporting; regulations, it shall thereafter become functus officio, and therefore cease to
exist: Provided, That the Congress may revive the Congressional Oversight
(ii) Accessing entities, special accessing entities, outsource entities and duly Committee in case of a need for any major revision/s in the implementing
authorized non-accessing entities, for breaches of the confidentiality of, rules and regulations.
misuse of, the credit information obtained from the credit information system;
and SECTION 10. Indemnity in Favor of the Corporation, its Officers and
Employees. — Unless the Corporation or any of its officers and employees
(iii) Violations of other applicable rules and regulations: Provided, That these is found liable for any willful violation of this Act, bad faith, malice and/or
administrative sanctions shall be in the form of fines in amounts as may be gross negligence, the Submitting Entities, Accessing Entities, Special
determined by the Corporation but in no case to exceed Thirty thousand Accessing Entities, Outsource Entities and duly authorized non-accessing
pesos (Php30,000.00) a day for each violation, taking into consideration the entities shall hold the Corporation, its directors, officers and employees free
attendant circumstances, such as the nature and gravity of the violation or and harmless to the fullest extent permitted by law and shall indemnify them
irregularity. Imposition of administrative sanctions shall be without prejudice for any and all liabilities, losses, claims, demands, damages, deficiencies,
to any criminal and other sanctions as may be applicable under this Act and costs and expenses of whatsoever kind and nature that may arise in
relevant laws; connection with the performance of their functions without prejudice to any
criminal liability under existing laws.
(g) Suspension or cancellation of the rights of any Accessing Entity or
Special Accessing Entity to access Credit Information from the Corporation: SECTION 11. Penalties. — Any person who willfully violates any of the
Provided, That the SEC in coordination with relevant government agencies provisions of this Act or the rules and regulations promulgated by SEC in
and existing industry stakeholders, may issue subsequent regulations coordination with the relevant government agencies shall, upon conviction,
consistent with the IRR as approved by the Congressional Oversight suffer a fine of not less than Fifty thousand pesos (Php50,000.00) nor more
Committee. than One million pesos (Php1,000,000.00) or imprisonment of not less than
one (1) year nor more than five (5) years, or both, at the discretion of the
In addition, the SEC may regulate access to the credit information system court.
as well as the fees that shall be collected by the Corporation from the
Accessing and Special Accessing Entities, taking into consideration the SECTION 12. Inviolable Nature of the Secrecy of Bank Deposits and/or
policy of lowering the cost of credit, promoting fair competition, and the need Client Funds. — Pursuant to Republic Act No. 1405 (Law on Secrecy of
of the Corporation to employ state-of-the-art technology; and acHDTA Bank Deposits), Republic Act No. 6426 (The Foreign Currency Deposit Act),
Republic Act No. 8791 (The General Banking Law of 2000), Republic Act
(h) The basic credit data about a borrower shall be limited to credit No. 9160 (Anti-Money Laundering Law)and their amendatory laws, nothing
information existing on the date of the enactment of this Act and thereafter. in this Act shall impair the secrecy of bank deposits and/or client funds and
investments in government securities or funds.

SECTION 13. Annual Report. — The SEC shall submit an annual report to
Congress on the status of the implementation of this Act.

SECTION 14. Principal Government Agency. — The SEC shall be the

SECTION 9. Congressional Oversight Committee. — There is hereby lead government agency to implement and enforce this Act. As lead agency,
created a congressional oversight committee, composed of seven (7) the SEC shall consult and coordinate with other relevant government
members from the Senate and seven (7) members from the House of agencies in the adoption of all rules and regulations for the full and effective
Representatives. The Members from the Senate shall be appointed by the implementation and enforcement of this Act, taking into account the policy
Senate President with at least three (3) Senators representing the minority. objectives contained in Section 2 hereof. IHCDAS
The Members from the House of Representatives shall be appointed by the
Speaker with at least three (3) members representing the minority.
SECTION 15. Separability Clause. — Should any provision of this Act or
the application thereof to any person or circumstance be held invalid, the
other provisions or sections of this Act shall not be affected thereby.
SECTION 16. Repealing Clause. — This Act repeals Presidential Decree
No. 1941 in its entirety. All laws, decrees, executive orders, rules and mortgagor. Pursuant to this provision, spouses Co obtained on 4
regulations or parts thereof which are inconsistent with this Act are hereby March 1994 a second loan from respondent bank in the amount of
repealed, amended or modified accordingly. P150,000.00 due in three months or on 2 June 1994. When the two
loans remained unpaid after becoming due and demandable, respondent
SECTION 17. Effectivity Clause. — This Act shall take effect fifteen (15) bank instituted extrajudicial foreclosure proceedings. The bank sought the
days following its publication in the Official Gazette or in two (2) national satisfaction solely of the first loan although the second loan had also
newspapers of general circulation. become due. The bank won the bid (for P142k), which did not include the
amount of the 2nd loan. Petitioners then exercised the right of redemption
as successors-in-interest of the judgment debtor. Stepping into the shoes
of spouses Co, petitioners tendered on 9 August 1995 the amount of
P155,769.50. Respondent bank objected to the non-inclusion of the
second loan (in the computation of the tendered amount).
Finer Points on Mortgages

Loan Limits on Real Estate: R.A. 8791, ―THE GENERAL BANKING LAW W/N the redemption amount includes the 2nd loan even if it is not
OF 2000‖ § 37 included in the respondent‘s application for ELF? Yes!

SECTION 37. Loans and Other Credit Accommodations Against Real In the case of Tad-Y v. Philippine National Bank, the parties entered
Estate. — Except as the Monetary Board may otherwise prescribe, loans intoa mortgage contract containing a provision that future loans would
and other credit accommodations against real estate shall not exceed also be secured by the mortgage. This Court ruled that since the
seventy-five percent (75%) of the appraised value of the respective real mortgage contract containing the blanket mortgage clause was
estate security, plus sixty percent (60%) of the appraised value of the
already annotated on the TCT of the mortgaged property,
insured improvements, and such loans may be made to the owner of the real
estate or to his assignees. (78a)||| (The General Banking Law of 2000, subsequent loans need not be separately annotated on the said TCT
Republic Act No. 8791, [May 23, 2000]) in order to bind third parties. However, we note the curious fact that
respondent bank's petition for extrajudicial foreclosure was solely for the
Blanket Mortgage Clause: satisfaction of the first loan although the second loan had also become
due and demandable. The bank did not include in its bid the second
· Tecklo v. Rural Bank of Pamplona, Inc., 621 SCRA 262 (2010) loan of P150,000.For its failure to include the second loan in its
application for extrajudicial foreclosure as well as in its bid at the
SPS. TECKLO v. RURAL BANK OF PAMPLONA (CHLO) public auction sale, respondent bank is deemed to have waived its
June 18, 2010 | Carpio, J. | Blanket Mortgage Clause lien on the mortgaged property with respect to the second loan. Of
course, respondent bank may still collect the unpaid second loan, and the
PETITIONER: SPOUSES BENEDICT and MARICEL DY TECKLO interest thereon, in an ordinary collection suit before the right to collect
RESPONDENTS: RURAL BANK OF PAMPLONA, INC. represented by prescribes.
its President/Manager, JUAN LAS
DOCTRINE: The mortgage contract containing the blanket mortgage
SUMMARY: Spouses Roberto and Maria Antonette Co obtained from clause was already annotated on the TCT of the mortgaged property,
respondent Rural Bank of Pamplona, Inc. a P100,000.00 loan due in three subsequent loans need not be separately annotated on the said TCT in
months or on 20 April 1994. The loan was secured by a real estate order to bind third parties.
mortgage. One of the stipulations in the mortgage contract was that
the mortgaged property would also answer for the future loans of the FACTS:
1. Spouses Roberto and Maria Antonette Co obtained from a. Respondent bank elevated the case to the Court of
respondent Rural Bank of Pamplona, Inc. a P100,000.00 loan due Appeals insisting that the foreclosed mortgage also
in three months or on 20 April 1994. The loan was secured by a secured the second loan of P150,000.00.
real estate mortgage on a 262-square meter residential lot owned 9. CA ruled that the redemption amount should have included the
by spouses Co located in San Felipe, Naga City and covered by second loan even though it was not annotated on the TCT of the
Transfer Certificate of Title (TCT) No. 24196. mortgaged property.
2. The mortgage was registered in the Register of Deeds of Naga City
on 21 January 1994 and duly annotated on the TCT of the ISSUE:
mortgaged property as Entry No. 58182. 1. W/N the redemption amount includes the 2nd loan even if it is
a. One of the stipulations in the mortgage contract was not included in the respondent‘s application for ELF? Yes!
that the mortgaged property would also answer for the
future loans of the mortgagor. RULING: WHEREFORE, we GRANT the petition.
b. Pursuant to this provision, spouses Co obtained on 4
March 1994 a second loan from respondent bank in RATIO:
the amount of P150,000.00 due in three months or on
2 June 1994. 1. Petitioners pointed out that the second loan was not annotated as
3. When the two loans remained unpaid after becoming due and an additional loan on the TCT of the mortgaged property.
demandable, respondent bank instituted extrajudicial foreclosure Petitioners argued that the second loan was just a private contract
proceedings. between respondent bank and spouses Co, which could not bind
4. In its 5 September 1994 petition for extrajudicial foreclosure, third parties unless duly registered. Petitioners stressed that
respondent bank sought the satisfaction solely of the first loan respondent bank's application for extrajudicial foreclosure referred
although the second loan had also become due. w At the public solely to the first loan.
auction scheduled on 19 December 1994, respondent bank offered 2. The mortgage contract in this case contains the following
the winning bid of P142,000.00, which did not include the second blanket mortgage clause:
loan. a. That as security for the payment of the loan or advance in
5. Petitioners then exercised the right of redemption as successors-in- the principal sum of ONE HUNDRED THOUSAND
interest of the judgment debtor. PESOS ONLY (P100,000.00) PESOS, Philippine
6. Stepping into the shoes of spouses Co, petitioners tendered on 9 Currency, and such other loans or advances already
August 1995 the amount of P155,769.50 obtained and/or still to be obtained by the
7. Respondent bank objected to the non-inclusion of the second loan. MORTGAGOR/S, either as MAKER/S, CO-MAKER/S,
It also claimed that the applicable interest rate should be the rate SURETY/IES OR GUARANTOR/S from the
fixed in the mortgage, which was 24% per annum plus 3% service MORTGAGEE payable on the date/s stated in the
charge per annum and 18% penalty per annum. However, the corresponding promissory note/s and subject to the
Provincial Sheriff insisted that the interest rate should only be 12% payment of interest, other bank charges, and to other
per annum. Respondent bank then sought annulment of the conditions mentioned thereon, x x x.
redemption, injunction, and damages in the Regional Trial Court 3. A blanket mortgage clause, which makes available future loans
(Branch 61) of Naga City docketed as Civil Case No. RTC 96-3521. without need of executing another set of security documents, has
8. RTC ruled that he second loan, not having been annotated on the long been recognized in our jurisprudence. It is meant to save time,
TCT of the mortgaged property, could not bind third persons such loan closing charges, additional legal services, recording fees, and
as petitioners. other costs. A blanket mortgage clause is designed to lower the
cost of loans to borrowers, at the same time making the business of
 lending more profitable to banks. Settled is the rule that mortgages lien on the mortgaged property with respect to the second
securing future loans are valid and legal contracts. loan. Of course, respondent bank may still collect the unpaid
4. It is the act of registration which creates a constructive notice to the second loan, and the interest thereon, in an ordinary collection suit
whole world and binds third persons. By definition, registration is before the right to collect prescribes.
the ministerial act by which a deed, contract, or instrument is 10. In order to effect redemption, the judgment debtor or his successor
inscribed in the records of the office of the Register of Deeds and -in-interest need only pay the purchaser at the public auction sale
annotated on the back of the TCT covering the land subject of the the redemption amount composed of (1) the price which the
deed, contract, or instrument purchaser at the public auction sale paid for the property and (2)
5. A person dealing with registered land is not required to go beyond the amount of any assessment or taxes which the purchaser may
the TCT to determine the liabilities attaching to the property. He is have paid on the property after the purchase, plus the applicable
only charged with notice of such burdens on the property as are interest.
duly annotated on the TCT. To require him to do more is to defeat
one of the primary objects of the Torrens system.
6. As to whether the second loan should have been annotated on the
TCT of the mortgaged property in order to bind third parties, the
case of Tad-Y v. Philippine National Bank is in point.
a. The case involved a mortgage contract containing a · Dragnet Clause and the ―Reliance on the Security Test‖:
Paradigm Development Corporation of the Philippines, v. Bank of
provision that future loans would also be secured by
the Philippine Islands.826 SCRA 267 (2017)1
the mortgage. This Court ruled that since the mortgage
contract containing the blanket mortgage clause was PARADIGM DEVELOPMENT CORPORATION OF THE PHILIPPINES v
already annotated on the TCT of the mortgaged BANK OF THE PHILIPPINES ISLANDS
property, subsequent loans need not be separately June 7, 2017| Reyes, J. | Dragnet Clause and the ―Reliance on the
annotated on the said TCT in order to bind third Security Test‖
parties.
7. However, we note the curious fact that respondent bank's petition
for extrajudicial foreclosure was solely for the satisfaction of the first PETITIONER: PARADIGM DEVELOPMENT CORPORATION OF THE
loan although the second loan had also become due and PHILIPPINES (PDCP)
demandable. RESPONDENTS: BANK OF THE PHILIPPINES ISLANDS (BPI)
8. In its Appellant's Brief filed in the Court of Appeals, respondent
bank even admitted that the second loan was not included in its bid SUMMARY: Sengkon Trading (Sengkon), a sole proprietorship owned by
at the public auction sale. To quote from page 5 of the Appellant's Anita Go, obtained a loan from Far East Bank and Trust Company
Brief filed by respondent bank: (FEBTC) under a credit facility denominated as Omnibus Line in the
a. For failure to pay the first loan, the mortgage was amount of P100 Million on several sub-facilities. FEBTC again granted
foreclosed and the property covered by TCT No. 24196 Sengkon another credit facility, denominated as Credit Line, in the amount
was sold at public auction on December 19, 1994, for of P60 Million as contained in the "Agreement for Credit Line." Two real
estate mortgage (REM) contracts were executed by PDCP President
P142,000, which was the bid of the mortgagee bank. The
Anthony L. Go (Go) to partially secure Sengkon's obligations under this
bank did not include in its bid the second loan of Credit Line.
P150,000.
9. For its failure to include the second loan in its application for Sengkon defaulted in the payment of its loan obligations. FEBTC
extrajudicial foreclosure as well as in its bid at the public demanded payment from PDCP. PDCP responded by requesting for
auction sale, respondent bank is deemed to have waived its segregation of Sengkon's obligations under the Credit Line and for the
pertinent statement of account and supporting documents. PDCP of the amounts secured by its properties assumes critical significance.
proposed to pay approximately P50 Million, allegedly corresponding to the The lack of proof that the availments subject of the foreclosure
obligations secured by its property, for the release of its properties but proceedings were within the coverage of PDCP's REMs explains FEBTC's
FEBTC pressed for a comprehensive repayment scheme for the entirety omission.
of Sengkon's obligations. Negotiations fell through, so initiated
foreclosure proceedings against the mortgaged properties of PDCP. According to the CA, since the REMs contain a dragnet clause, then
PDCP discovered that FEBTC extra-judicially foreclosed the first and PDCP's properties can be made to answer even if the PNs supporting the
second mortgage without notice to it as mortgagor. PDCP filed for Petition for Extrajudicial Foreclosure of Mortgage refer to Sengkon's
annulment of the mortgage and foreclosure, main contention is that: (1) obligations in its other credit facilities.
FEBTC assured it that the mortgaged properties will only secure the
Credit Line sub-facility of the Omnibus Line; (2) the subject [REMs] were A dragnet clause is a stipulation in a REM contract that extends the
foreclosed to answer not only for obligations incurred under SENGKON's coverage of a mortgage to advances or loans other than those already
Credit Line but also for other obligations of SENGKON and other obtained or specified in the contract.
companies which were not secured by said mortgages (see Fact 15 for
the complete allegations). In Prudential Bank case, the issue was critical issue is whether the
"blanket mortgage" clause applies even to subsequent advancements for
RTC Ruling: Nullified the REM‘s and the foreclosure proceedings. Nullified which other securities were intended:
st
the foreclosure proceedings because the original copies of the promissory o 1 answer: a "dragnet clause" so worded as to be broad
notes (PNs), which were the basis of FEBTC's Petition for Extrajudicial enough to cover all other debts in addition to the one
Foreclosure of Mortgage, were not presented in court and no notice of the specifically secured will be construed to cover a different
extrajudicial foreclosure sale was given to PDCP. debt, although such other debt is secured by another
mortgage.
nd
CA Ruling: Reversed the RTC Ruling: (1) The fact that FEBTC failed to o 2 answer: a mortgage with such a clause will not secure a
submit the original copies of the PNs that formed the basis of its Petition note that expresses on its face that it is otherwise secured
for Extrajudicial Foreclosure of Mortgage cannot affect the validity of as to its entirety, at least to anything other than a deficiency
foreclosure because the validity of the obligations represented in those after exhausting the security specified therein, such
PNs was never denied by Sengkon nor by PDCP; (2) Even if the deficiency being an indebtedness within the meaning of the
obligations of Sengkon in credit facilities (other than the Credit Line) were mortgage, in the absence of a special contract excluding it
included, since the REMs contain a dragnet clause, these other from the arrangement.
obligations were still covered by PDCP's REMs.
nd
The 2 answer is better. Thus, when the mortgagor takes another loan for
Issue (in relation to the syllabus): W/N FEBTC‘s foreclosure covered the which another security was given it could not be inferred that such loan
specific obligations secured by PDCP's properties? -NO was made in reliance solely on the original security with the "dragnet
clause," but rather, on the new security given. This is the "reliance on the
No evidence to support the conclusion that the PNs were in fact security test."
availments under the Credit Line secured by PDCP's properties. The PNs
that were used by FEBTC in its Petition for Extrajudicial Foreclosure of PDCP's REMs indeed contain a blanket mortgage clause in the following
Mortgage were all executed beyond the extended duration of Sengkon's language.
Credit Line. In this case, the parties do not dispute that what the REMs secured were
only Sengkon's availments under the Credit Line and not all of Sengkon's
While FEBTC wrote a letter dated September 18, 1997, which is a few availments under other sub-facilities which are also secured by other
days short of the date of the earliest PN (September 23, 1997), addressed collaterals.
to STI, approving the renewal of the debtor's Credit Line subject to the
condition that the Line "shall be partially secured" by the PDCP's Since the liability of PDCP's properties was not unqualified, the PNs, used
mortgaged properties, it is worthy to note that this letter did not bear the as basis of the Petition for Extrajudicial Foreclosure of Mortgage should
conforme of the debtor, lending credence to the trial court's observation. sufficiently indicate that it is within the terms of PDCP's limited liability. In
In this light, FEBTC's failure to heed PDCP's request for the segregation this case, the PNs failed to make any reference to PDCP's availments, if
 12. When the subsequent negotiations fell, FEBTC on April 5,
any, under its Credit Line. In fact, it did not even mention Sengkon's 2000, initiated foreclosure proceedings against the mortgaged
securities under the Credit Line. properties of PDCP before the RTC Quezon City.
13. PDCP discovered that FEBTC extra-judicially foreclosed on
June 20, 2000 the first and second mortgage without notice to
it as mortgagor and sold the mortgaged properties to FEBTC
FACTS: as the lone bidder.
1. February 1996 - Sengkon Trading (Sengkon), a sole a. On August 8, 2000, this was registered with the ROD
proprietorship owned by Anita Go, obtained a loan from Far 14. PDCP filed a complaint for Annulment of Mortgage,
East Bank and Trust Company (FEBTC) under a credit facility Foreclosure, Certificate of Sale and Damages with the RTC of
denominated as Omnibus Line in the amount of P100 Million Quezon City, against BPI, successor-in-interest of FEBTC,
on several sub-facilities as follows: (i) Discounting Line for P20 alleging that the REMs and their foreclosure were null and
Million; (ii) Letter of Credit/Trust Receipt (LC-TR) Line for P60 void.
Million; and (iii) Bills Purchased Line for P8 Million. a. PDCP alleged that FEBTC assured it that the
2. This was embodied in the document denominated as mortgaged properties will only secure the Credit Line
"Agreement for Renewal of Omnibus Line." sub-facility of the Omnibus Line. With this
3. April 19, 1996 - FEBTC again granted Sengkon another credit understanding, PDCP President Go allegedly agreed
facility, denominated as Credit Line, in the amount of P60 to sign on two separate dates a pro-forma and blank
Million as contained in the "Agreement for Credit Line." REM, securing the amount ofP42.4 Million and P8
4. Two real estate mortgage (REM) contracts were executed by Million, respectively.
PDCP President Anthony L. Go (Go) to partially secure b. PDCP claimed that it had no intent to be bound
Sengkon's obligations under this Credit Line. under the second REM, which was not intended to be
st a separate contract, but only a means to reduce
a. 1 REM (April 22, 1996) secured the amount of P8
M registration expenses. But because of its refusal to
nd extend the liability of the properties beyond the Credit
b. 2 REM (December 19, 1997) secured P42.4M
5. September 18, 1997 Letter - FEBTC informed Sengkon Line, FEBTC registered the second REM as well.
regarding the renewal, increase and conversion of its P100 15. In asking for the nullity of the REMs and the foreclosure
Million Omnibus Line to P150 Million LC-TR Line and P20 proceeding, PDCP alleged:
Million Discounting Line, the renewal of the P60 Million Credit a. THAT although the [REM] of April 22, 1996 for Php
Line and P8 Million Bills Purchased Line. 8.0 Million was not a separate security but was merely
6. FEBTC also approved the request of Sengkon to change the intended to reduce registration expenses, FEBTC,
account name from SENGKON TRADING to SENGKON [BPI's] predecessor-in-interest, fraudulently and in
TRADING, INC. violation of the original intent and agreement of the
7. Sengkon defaulted in the payment of its loan obligations. parties, made it appear that said [REM] of April 22,
8. September 8, 1999 Letter - FEBTC demanded payment from 1996 was separate and distinct from that of
PDCP amounting to P244,277,199.28 plus interest and other December 18, 1997 and caused the registration of
charges. both mortgages with separate considerations totaling
9. PDCP responded by requesting for segregation of Sengkon's Php 50.4 Million;
obligations under the Credit Line and for the pertinent b. THAT the subject [REMs] were foreclosed to answer
statement of account and supporting documents. not only for obligations incurred under SENGKON's
10. During negotiations, PDCP proposed to pay approximately Credit Line but also for other obligations of
P50 Million, allegedly corresponding to the obligations secured SENGKON and other companies which were not
by its property, for the release of its properties but FEBTC secured by said mortgages;
pressed for a comprehensive repayment scheme for the c. THAT no notice was given to or received by [PDCP]
entirety of Sengkon's obligations. of the projected foreclosure x x x since the notice of
11. Negotiations were put on hold because BPI acquired FEBTC said foreclosure was sent by defendant SHERIFF to
and assumed the rights and obligations of the latter. an address (333 EDSA, Quezon City) other than
 [PDCP's] known address as stated in the [REMs] d. Novation could not have taken place from FEBTC's
themselves (333 EDSA Caloocan City) x x x; mere act of approving Sengkon's request to change
d. THAT, contrary to the then prevailing Supreme Court account name from Sengkon to STI.
Circular AM 99-10-05-0 x x x, only one (1) bidder was e. The fact that FEBTC failed to submit the original
present and participated at the foreclosure sale[; and] copies of the PNs that formed the basis of its Petition
e. THAT, without the knowledge and consent of for Extrajudicial Foreclosure of Mortgage cannot
[PDCP], obligation of SENGKON has been affect the validity of foreclosure because the validity of
transferred to STI[,] a juridical personality separate the obligations represented in those PNs was never
and distinct from SENGKON, a single proprietorship. denied by Sengkon nor by PDCP.
This substitution of SENGKON as debtor by STI x x x f. Even if the obligations of Sengkon in credit facilities
effectively novated the obligation of [PDCP] to (other than the Credit Line) were included, since the
FEBTC. REMs contain a dragnet clause, these other
16. RTC Ruling: Nullified the REM‘s and the foreclosure obligations were still covered by PDCP's REMs.
proceedings.
a. Availments under the Credit Line, secured by ISSUE/s: WoN the ruling of the CA was correct? - NO
PDCP's properties, may be made only within one
year, or from April 19, 1996 to April 30, 1997. While RULING: Petition is GRANTED. CA ruling set aside. RTC Ruling
BPI claimed that the period of said credit line was AFFIRMED.
extended up to July 31, 1997, PDCP was not notified
of the extension and thus could not have consented to
RATIO:
the extension.
1. The registration of the REMs, even if contrary to the
b. No evidence had been adduced to show that
supposed intent of the parties, did not affect the validity of
Sengkon availed of any loan under the credit line up
the mortgage contracts
to July 31, 1997.
● The registration of the REM contract is not essential to its
c. Novation took place in this case, which resulted in
validity.
discharging the latter from its obligations as third-
● Per Article 2125 of the CC: If the instrument is not
party mortgagor.
recorded, the mortgage is nevertheless binding between
d. Nullified the foreclosure proceedings because the
the parties.
original copies of the promissory notes (PNs), which
● In Mobil Oil Philippines, Inc. v. Diocares, et al., the Court
were the basis of FEBTC's Petition for Extrajudicial
declared that: even if the instrument were not recorded,
Foreclosure of Mortgage, were not presented in court
"the mortgage is nevertheless binding between the
and no notice of the extrajudicial foreclosure sale was
parties." The law cannot be any clearer. Effect must be
given to PDCP.
given to it as written. The mortgage subsists; the parties
17. CA Ruling: Reversed the RTC Ruling.
are bound. As between them, the mere fact that there is
a. The fact that PDCP surrendered the titles to the
as yet no compliance with the requirement that it be
mortgaged properties to FEBTC only shows that
recorded cannot be a bar to foreclosure.
PDCP intended to mortgage all of these properties;
● That the REMs were intended merely as "partial security"
b. if it were true that FEBTC assured PDCP that it
does not make PDCP's argument more plausible because
would be registering only one of the two REMs in
as aptly observed by the CA, the PDCP's act of
order to reduce registration expenses, then each of
surrendering all the titles to the properties to FEBTC
the two REMs should have covered the four
clearly establishes PDCP's intent to mortgage all of the
properties but it was not. On the contrary, the four
four properties in favor of FEBTC to secure Sengkon's
properties were spread out with one REM covering
obligation under the Credit Line.
one of the four properties and the other REMs
● The signature of PDCP's President coupled with its act of
covering the remaining three properties;
surrendering the titles to the four properties to FEBTC is
c. PDCP never complained to FEBTC regarding the
proof that no fraud existed in the execution of the contract.
registration of the two REMs even after it discovered
At most, FEBTC's act of registering the mortgage only
the same.
 amounted to dolo incidente which is not the kind of fraud extended to cover future advances, unless the
that avoids a contract. document evidencing the subsequent advance
refers to the mortgage as providing security
2. No novation took place therefor or unless there are clear and supportive
● PDCP failed to prove by preponderance of evidence that evidence to the contrary.
Sengkon was already expressly released from the ○ This is especially true in this case where the
obligation and that STI assumed the former's obligation. advances were not only several but were covered
● The Deed of Assumption which was supposed to embody by different sub-facilities.
STI's assumption of all the obligations of Sengkon under ● In Prudential Bankcase, the issue was critical issue is
the line, including but not necessarily limited to the whether the "blanket mortgage" clause applies even to
repayment of all the outstanding availments thereon, as subsequent advancements for which other securities were
well as all applicable interests and other charges, was not intended:
st
signed by the parties. ○ 1 answer: a "dragnet clause" so worded as to
be broad enough to cover all other debts in
3. The trial court’s finding that Sengkon did not avail under addition to the one specifically secured will be
the Credit Line taints the foreclosure of the mortgage. construed to cover a different debt, although such
● In this case, there was simply no evidence to support the other debt is secured by another mortgage.
nd
conclusion that the PNs were in fact availments under the ○ 2 answerl: a mortgage with such a clause will
Credit Line secured by PDCP's properties. not secure a note that expresses on its face that
● The PNs that were used by FEBTC in its Petition for it is otherwise secured as to its entirety, at least
Extrajudicial Foreclosure of Mortgage were all executed to anything other than a deficiency after
beyond the extended duration of Sengkon's Credit Line (or exhausting the security specified therein, such
until July 1997). deficiency being an indebtedness within the
● While FEBTC wrote a letter dated September 18, 1997, meaning of the mortgage, in the absence of a
which is a few days short of the date of the earliest PN special contract excluding it from the
(September 23, 1997), addressed to STI, approving the arrangement.
nd
renewal of the debtor's Credit Line subject to the condition ○ The 2 answer is better. Thus, when the
that the Line "shall be partially secured" by the PDCP's mortgagor takes another loan for which another
mortgaged properties, it is worthy to note that this letter security was given it could not be inferred that
did not bear the conforme of the debtor, lending credence such loan was made in reliance solely on the
to the trial court's observation. original security with the "dragnet clause," but
● In this light, FEBTC's failure to heed PDCP's request for rather, on the new security given. This is the
the segregation of the amounts secured by its properties "reliance on the security test."
assumes critical significance. The lack of proof that the ● PDCP's REMs indeed contain a blanket mortgage clause
availments subject of the foreclosure proceedings were in the following language:
within the coverage of PDCP's REMs explains FEBTC's ○ That, for and in consideration of credit
omission. accommodations obtained from the [FEBTC], and
● According to the CA, since the REMs contain a dragnet to secure the payment of the same and those
clause, then PDCP's properties can be made to answer that may hereafter be obtained, the principal of all
even if the PNs supporting the Petition for Extrajudicial of which is hereby fixed at x x x PESOS x x x,
Foreclosure of Mortgage refer to Sengkon's obligations in Philippine Currency, as well as those that the
its other credit facilities. [FEBTC] may extend to the [PDCP], including
● A dragnet clause is a stipulation in a REM contract that interest and expenses or any other obligation
extends the coverage of a mortgage to advances or loans owing to the [FEBTC], whether direct or indirect,
other than those already obtained or specified in the principal or secondary, as appears in the
contract. accounts, books and records of the [FEBTC] x x
○ Where there are several advances, however, a x.
mortgage containing a dragnet clause will not be
 ● The parties do not dispute that what the REMs secured
were only Sengkon's availments under the Credit Line and
not all of Sengkon's availments under other sub-facilities Guaranty:
which are also secured by other collaterals.
○ Since the liability of PDCP's properties was not CIVIL CODE ARTS. 2047 -2081
unqualified, the PNs, used as basis of the
Petition for Extrajudicial Foreclosure of Mortgage
TITLE XV
should sufficiently indicate that it is within the
terms of PDCP's limited liability. In this case, the
PNs failed to make any reference to PDCP's GUARANTY
availments, if any, under its Credit Line. In fact, it
did not even mention Sengkon's securities under CHAPTER 1
the Credit Line.
○ The foregoing observations clearly support the Nature and Extent of Guaranty
trial court's observation that FEBTC's foreclosure
did not actually cover the specific obligations Article 2047. By guaranty a person, called the guarantor, binds himself to
secured by PDCP's properties. the creditor to fulfill the obligation of the principal debtor in case the latter
should fail to do so.
4. FEBTC’s failure to send personal notice to the mortgagor
is fatal to the validity of the foreclosure proceedings.
● In the present case, the parties provided in their REMs If a person binds himself solidarily with the principal debtor, the provisions of
that: Section 4, Chapter 3, Title I of this Book shall be observed. In such case the
○ 12. All correspondence relative to this mortgage, contract is called a suretyship. (1822a)
including demand letters, summonses,
subpoenas, or notifications of any judicial or Article 2048. A guaranty is gratuitous, unless there is a stipulation to the
extrajudicial action shall be sent to the [PDCP] at contrary. (n)
______________ or at the address that may
hereafter be given in writing by the [PDCP] to the Article 2049. A married woman may guarantee an obligation without the
[FEBTC]. x x x. husband's consent, but shall not thereby bind the conjugal partnership,
● The above establishes the agreement between the except in cases provided by law. (n)
parties that personal notice is required before FEBTC may
proceed with the foreclosure of the property and thus, Article 2050. If a guaranty is entered into without the knowledge or consent,
FEBTC's act of proceeding with the foreclosure despite or against the will of the principal debtor, the provisions of articles 1236 and
the absence of personal notice to the mortgagor was its 1237 shall apply. (n)
own lookout.
● That the portion on the mortgagor's address was left in Article 2051. A guaranty may be conventional, legal or judicial, gratuitous,
blank cannot be simply swept under the rug as "an or by onerous title.
expression of general intent" that cannot prevail of the
parties' specific intent not to require personal notice. It may also be constituted, not only in favor of the principal debtor, but also in
● If PDCP did not intend to require personal notice, on top of favor of the other guarantor, with the latter's consent, or without his
the statutory requirements of posting and publication, then knowledge, or even over his objection. (1823)
said provision should not have at all been included in the
mortgage contract.
Article 2052. A guaranty cannot exist without a valid obligation.

Nevertheless, a guaranty may be constituted to guarantee the performance

of a voidable or an unenforceable contract. It may also guarantee a natural
obligation. (1824a)
Article 2053. A guaranty may also be given as security for future debts, the Article 2058. The guarantor cannot be compelled to pay the creditor unless
amount of which is not yet known; there can be no claim against the the latter has exhausted all the property of the debtor, and has resorted to all
guarantor until the debt is liquidated. A conditional obligation may also be the legal remedies against the debtor. (1830a)
secured. (1825a)
Article 2059. The excussion shall not take place:
Article 2054. A guarantor may bind himself for less, but not for more than
the principal debtor, both as regards the amount and the onerous nature of (1) If the guarantor has expressly renounced it;
the conditions.
(2) If he has bound himself solidarily with the debtor;
Should he have bound himself for more, his obligations shall be reduced to
the limits of that of the debtor. (1826) (3) In case of insolvency of the debtor;

(4) When he has absconded, or cannot be sued within the Philippines unless
he has left a manager or representative;

(5) If it may be presumed that an execution on the property of the principal

Article 2055. A guaranty is not presumed; it must be express and cannot debtor would not result in the satisfaction of the obligation. (1831a)
extend to more than what is stipulated therein.
Article 2060. In order that the guarantor may make use of the benefit of
If it be simple or indefinite, it shall compromise not only the principal exclusion, he must set it up against the creditor upon the latter's demand for
obligation, but also all its accessories, including the judicial costs, provided payment from him, and point out to the creditor available property of the
with respect to the latter, that the guarantor shall only be liable for those debtor within Philippine territory, sufficient to cover the amount of the debt.
costs incurred after he has been judicially required to pay. (1827a) (1832)

Article 2056. One who is obliged to furnish a guarantor shall present a Article 2061. The guarantor having fulfilled all the conditions required in the
person who possesses integrity, capacity to bind himself, and sufficient preceding article, the creditor who is negligent in exhausting the property
property to answer for the obligation which he guarantees. The guarantor pointed out shall suffer the loss, to the extent of said property, for the
shall be subject to the jurisdiction of the court of the place where this insolvency of the debtor resulting from such negligence. (1833a)
obligation is to be complied with. (1828a)
Article 2062. In every action by the creditor, which must be against the
Article 2057. If the guarantor should be convicted in first instance of a crime principal debtor alone, except in the cases mentioned in article 2059, the
involving dishonesty or should become insolvent, the creditor may demand former shall ask the court to notify the guarantor of the action. The guarantor
another who has all the qualifications required in the preceding article. The may appear so that he may, if he so desire, set up such defenses as are
case is excepted where the creditor has required and stipulated that a granted him by law. The benefit of excussion mentioned in article 2058 shall
specified person should be the guarantor. (1829a) always be unimpaired, even if judgment should be rendered against the
principal debtor and the guarantor in case of appearance by the latter.
CHAPTER 2 (1834a)

Effects of Guaranty Article 2063. A compromise between the creditor and the principal debtor
benefits the guarantor but does not prejudice him. That which is entered into
between the guarantor and the creditor benefits but does not prejudice the
SECTION 1
principal debtor. (1835a)

Effects of Guaranty Between the Guarantor and the Creditor Article 2064. The guarantor of a guarantor shall enjoy the benefit of
excussion, both with respect to the guarantor and to the principal debtor.
(1836)
 Article 2069. If the debt was for a period and the guarantor paid it before it
became due, he cannot demand reimbursement of the debtor until the
expiration of the period unless the payment has been ratified by the debtor.
(1841a)
Article 2065. Should there be several guarantors of only one debtor and for
the same debt, the obligation to answer for the same is divided among all. Article 2070. If the guarantor has paid without notifying the debtor, and the
The creditor cannot claim from the guarantors except the shares which they latter not being aware of the payment, repeats the payment, the former has
are respectively bound to pay, unless solidarity has been expressly no remedy whatever against the debtor, but only against the creditor.
stipulated. Nevertheless, in case of a gratuitous guaranty, if the guarantor was
prevented by a fortuitous event from advising the debtor of the payment, and
the creditor becomes insolvent, the debtor shall reimburse the guarantor for
The benefit of division against the co-guarantors ceases in the same cases
the amount paid. (1842a)
and for the same reasons as the benefit of excussion against the principal
debtor. (1837)
Article 2071. The guarantor, even before having paid, may proceed against
the principal debtor:

(1) When he is sued for the payment;

SECTION 2
(2) In case of insolvency of the principal debtor;
Effects of Guaranty Between the Debtor and the Guarantor
(3) When the debtor has bound himself to relieve him from the guaranty
Article 2066. The guarantor who pays for a debtor must be indemnified by within a specified period, and this period has expired;
the latter.
(4) When the debt has become demandable, by reason of the expiration of
The indemnity comprises: the period for payment;

(1) The total amount of the debt; (5) After the lapse of ten years, when the principal obligation has no fixed
period for its maturity, unless it be of such nature that it cannot be
(2) The legal interests thereon from the time the payment was made known extinguished except within a period longer than ten years;
to the debtor, even though it did not earn interest for the creditor;
(6) If there are reasonable grounds to fear that the principal debtor intends to
(3) The expenses incurred by the guarantor after having notified the debtor abscond;
that payment had been demanded of him;
(7) If the principal debtor is in imminent danger of becoming insolvent.
(4) Damages, if they are due. (1838a)
In all these cases, the action of the guarantor is to obtain release from the
Article 2067. The guarantor who pays is subrogated by virtue thereof to all guaranty, or to demand a security that shall protect him from any
the rights which the creditor had against the debtor. proceedings by the creditor and from the danger of insolvency of the debtor.
(1834a)
If the guarantor has compromised with the creditor, he cannot demand of the
debtor more than what he has really paid. (1839) Article 2072. If one, at the request of another, becomes a guarantor for the
debt of a third person who is not present, the guarantor who satisfies the
Article 2068. If the guarantor should pay without notifying the debtor, the debt may sue either the person so requesting or the debtor for
latter may enforce against him all the defenses which he could have set up reimbursement. (n)
against the creditor at the time the payment was made. (1840)
SECTION 3. Article 2080. The guarantors, even though they be solidary, are released
from their obligation whenever by some act of the creditor they cannot be
Effects of Guaranty as Between Co-Guarantors subrogated to the rights, mortgages, and preference of the latter. (1852)

Article 2073. When there are two or more guarantors of the same debtor Article 2081. The guarantor may set up against the creditor all the defenses
and for the same debt, the one among them who has paid may demand of which pertain to the principal debtor and are inherent in the debt; but not
each of the others the share which is proportionally owing from him. those that are personal to the debtor. (1853)

If any of the guarantors should be insolvent, his share shall be borne by the
others, including the payer, in the same proportion.

The provisions of this article shall not be applicable, unless the payment has
been made by virtue of a judicial demand or unless the principal debtor is
insolvent. (1844a)
Surety:
Article 2074. In the case of the preceding article, the co-guarantors may set
up against the one who paid, the same defenses which would have CIVIL CODE ARTS. 1207-1222
pertained to the principal debtor against the creditor, and which are not
purely personal to the debtor. (1845) ARTICLE 2075. A sub-guarantor, in SECTION 4
case of the insolvency of the guarantor for whom he bound himself, is
responsible to the co-guarantors in the same terms as the guarantor. (1846)
Joint and Solidary Obligations

Article 1207. The concurrence of two or more creditors or of two or more

debtors in one and the same obligation does not imply that each one of the
CHAPTER 3 former has a right to demand, or that each one of the latter is bound to
render, entire compliance with the prestation. There is a solidary liability only
Extinguishment of Guaranty when the obligation expressly so states, or when the law or the nature of the
obligation requires solidarity. (1137a)
Article 2076. The obligation of the guarantor is extinguished at the same
time as that of the debtor, and for the same causes as all other obligations. Article 1208. If from the law, or the nature or the wording of the obligations
(1847) to which the preceding article refers the contrary does not appear, the credit
or debt shall be presumed to be divided into as many shares as there are
Article 2077. If the creditor voluntarily accepts immovable or other property creditors or debtors, the credits or debts being considered distinct from one
in payment of the debt, even if he should afterwards lose the same through another, subject to the Rules of Court governing the multiplicity of suits.
eviction, the guarantor is released. (1849) (1138a)

Article 2078. A release made by the creditor in favor of one of the Article 1209. If the division is impossible, the right of the creditors may be
guarantors, without the consent of the others, benefits all to the extent of the prejudiced only by their collective acts, and the debt can be enforced only by
share of the guarantor to whom it has been granted. (1850) proceeding against all the debtors. If one of the latter should be insolvent,
the others shall not be liable for his share. (1139)
Article 2079. An extension granted to the debtor by the creditor without the
consent of the guarantor extinguishes the guaranty. The mere failure on the Article 1210. The indivisibility of an obligation does not necessarily give rise
part of the creditor to demand payment after the debt has become due does to solidarity. Nor does solidarity of itself imply indivisibility. (n)
not of itself constitute any extension of time referred to herein. (1851a)
Article 1211. Solidarity may exist although the creditors and the debtors
may not be bound in the same manner and by the same periods and
conditions. (1140)

Article 1212. Each one of the solidary creditors may do whatever may be Article 1219. The remission made by the creditor of the share which affects
useful to the others, but not anything which may be prejudicial to the latter. one of the solidary debtors does not release the latter from his responsibility
(1141a) towards the co-debtors, in case the debt had been totally paid by anyone of
them before the remission was effected. (1146a)
Article 1213. A solidary creditor cannot assign his rights without the consent
of the others. (n) Article 1220. The remission of the whole obligation, obtained by one of the
solidary debtors, does not entitle him to reimbursement from his co-debtors.
Article 1214. The debtor may pay any one of the solidary creditors; but if (n)
any demand, judicial or extrajudicial, has been made by one of them,
payment should be made to him. (1142a) Article 1221. If the thing has been lost or if the prestation has become
impossible without the fault of the solidary debtors, the obligation shall be
Article 1215. Novation, compensation, confusion or remission of the debt, extinguished.
made by any of the solidary creditors or with any of the solidary debtors,
shall extinguish the obligation, without prejudice to the provisions of article If there was fault on the part of any one of them, all shall be responsible to
1219. the creditor, for the price and the payment of damages and interest, without
prejudice to their action against the guilty or negligent debtor.
The creditor who may have executed any of these acts, as well as he who
collects the debt, shall be liable to the others for the share in the obligation If through a fortuitous event, the thing is lost or the performance has become
corresponding to them. (1143) impossible after one of the solidary debtors has incurred in delay through the
judicial or extrajudicial demand upon him by the creditor, the provisions of
Article 1216. The creditor may proceed against any one of the solidary the preceding paragraph shall apply. (1147a)
debtors or some or all of them simultaneously. The demand made against
one of them shall not be an obstacle to those which may subsequently be Article 1222. A solidary debtor may, in actions filed by the creditor, avail
directed against the others, so long as the debt has not been fully collected. himself of all defenses which are derived from the nature of the obligation
(1144a) and of those which are personal to him, or pertain to his own share. With
respect to those which personally belong to the others, he may avail himself
Article 1217. Payment made by one of the solidary debtors extinguishes the thereof only as regards that part of the debt for which the latter are
obligation. If two or more solidary debtors offer to pay, the creditor may responsible. (1148a)
choose which offer to accept.
Escaño v. Ortigas, Jr., 526 SCRA 26 (2007)
He who made the payment may claim from his co-debtors only the share
which corresponds to each, with the interest for the payment already made. In 1980, PDCP agreed to extend a loan to Falcon Minerals USD 320k, under
If the payment is made before the debt is due, no interest for the intervening the condition that 3 stockholder-officers (respondent Ortigas Jr, George A.
period may be demanded. Scholey and George T. Scholey) execute an Assumption of Solidary
Liability. In the meantime, some other officers (including petitioners Escano
When one of the solidary debtors cannot, because of his insolvency, and Silos) executed Guaranty Agreements separately. 2 years later, an
reimburse his share to the debtor paying the obligation, such share shall be agreement developed to cede control of Falcon to Escano and Silos (and
borne by all his co-debtors, in proportion to the debt of each. (1145a) other person Matti); part of the consideration of the sale was that Ortigas
and his team wanted to relieve themselves of liability from their previous joint
Article 1218. Payment by a solidary debtor shall not entitle him to and solidary agreement, and as such, an Undertaking was executed under
reimbursement from his co-debtors if such payment is made after the which Escano, Silos, and Matti, calling themselves ―SURETIES‖, agreed to
obligation has prescribed or become illegal. (n) assume the obligations of Ortigas. Falcon eventually availed of a loan of
USD 178.6k from PDCP, and also executed a Deed of Chattel Mortgage. In accordance with the A, Kawasaki, on behalf of the consortium, obtained a
However, Falcon defaulted, and after PDCP foreclosed the chattel letter of credit and gave it to the Republic as a form of guarantee for the
mortgage, there remained a deficiency of P5M which Falcon failed to satisfy. consortium‘s faithful performance of its obligation. The Republic then made
PDCP filed sum of money against Falcon, Ortigas, Escano, Silos, Silverio, an advance payment of Php 9.3m, or 15% of the Php 62m contract price.
and Inductivo (two other officers who signed Guaranty Agreements); Ortigas
filed a cross-claim against Silos and Matti, predicated on the 1982 For the release of FFMCCI‘s share in the advance payment, as in
Undertaking. Escano, Ortigas, and Silos all sought to enter into settlements accordance also with A, FFMCCI secured from CCC Insurance, a SURETY
with PDCP, and eventually did. Ortigas pursued his claim against Escano, BOND – as a counter guarantee for the amount of advance payment
Silos, and Matti, and the RTC ordered, via a Summary Judgment, the three FFMCCI would receive from Kawasaki, and a PERFORMANCE BOND – to
to pay him P1.3M. Escano and Silos appealed to the CA, which however guarantee completion of FFMCCI‘s scope of work. Because of this, FFMCCI
affirmed the RTC‘s judgment received its share.

Under the terms of the Undertaking, petitioners ―irrevocably agree and Sometime in 1989, FFMCCI ceased performing its work after suffering
undertake to assume all of OBLIGORs‘ said guarantees to PDCP‖. The clear financial problems and/or business reverses. Kawasaki, pursuant to a new
intent of the Undertaking was for petitioners and Matti to relieve the burden agreement, took over the unfinished work, with Kawasaki receiving all the
on Ortigas and his fellow ―OBLIGORS‖ as soon as possible. benefits from the transferred portion of work.

However, Articles 1210 and 1207 of the Civil Code provide that in case of Kawasaki then informed CCCIC of FFMCCI‘s cessation of operations and
concurrence of multiple parties in the same obligation, the presumption is demanded payment covered by the bonds aforementioned. Due to CCCIC‘s
that the obligation is only joint. It is incumbent on the party alleging that the inaction, Kawasaki now filed its complaint for collection.
obligation is indeed solidary to prove such by preponderance of evidence. In
this case, there is no provision in the Undertaking expressly stipulating that The RTC ruled in favor of CCCIC, stating that the bonds (both the surety and
petitioners agreed to bind themselves solidarily, and thus the obligation is performance bonds), were mere counter guarantees, requiring the exercise
presumed to be joint, and Ortigas has to prove otherwise. Ortigas relies on of the Republic of its right against the letter of credit (the first guaranty
the fact that petitioners and Matti identified themselves in the Undertaking as issued to the Republic) , before the cause of action of Kawasaki would
―SURETIES‖. However, the term ―surety‖ has a specific meaning in law; Art. accrue. And that by virtue of Article 2079, the 43-day extension granted by
2047 defines such as a person who binds himself solidarily with a principal the Republic to finish the project, absent CCCIC‘s consent, extinguishes the
debtor. In this case, the obligations established in the Undertaking do not latter‘s obligation.
partake of the nature of a suretyship. For the conclusion espoused by
Ortigas to hold, in light of the general presumption in favor of joint liability,
The CA reversed said decision.
the Court would have to be satisfied that, between petitioners and Matti,
there is one who stands as primary obligor and another as surety who has
the right to full reimbursement; however, there is nothing on the Undertaking Hence this petition.
which shows such. Petition partially granted; Order of RTC modified by
declaring that petitioners and Matti are only jointly liable Issue: Whether the subject bonds (surety and performance bonds in favor of
Kawasaki) were mere counter guarantees dependent on the Republic‘s
· CCC Insurance Corporation v. Kawasaki Steel Corp.,.759 exercise of its right under the first guaranty (consortium‘s letter of credit in
SCRA 332 (2015) favor of the Republic) – No

Kawasaki and FFMCCI formed a consortium (Kawasaki-FFMCCI Whether Article 2079 (wording by the law only mentions guarantees) applies
Consortium, A) for the purpose of contracting with the Republic of the to a suretyship also – Yes, but there‘s a circumstance present here that
Philippines for the construction of a fishing port in Pangasinan. made Art. 2079 inapplicable to this specific case

After the award of the fishing port project to the consortium, the latter Held:
entered into a Contract Agreement with the Republic. (Construction
Contract, B).
Art. 2047. By guaranty a person, called the guarantor, binds himself to the stipulation. In this case, the Surety and Performance Bonds are enforceable
creditor to fulfill the obligation of the principal debtor in case the latter should by and against the parties FFMCCI (the obligor) and CCCIC (the surety), as
fail to do so. well as the third person Kawasaki (the obligee) in whose favor said bonds
had been explicitly constituted; while the related Consortium Agreement
If a person binds himself solidarily with the principal debtor, the provisions of binds the parties Kawasaki and FFMCCI. Since the Republic is neither a
Section 4, Chapter 3, Title I of this Book shall be observed. In such case the party to the Surety and Performance Bonds nor the Consortium Agreement,
contract is called a suretyship. (Emphasis supplied.) any action or omission on its part has no effect on the liability of CCCIC
under said bonds.
Jurisprudence also defines a contract of suretyship as "an agreement where
a party called the surety guarantees the performance by another party called The Surety and Performance Bonds state that their purpose was "to secure
the principal or obligor of an obligation or undertaking in favor of a third the full and faithful performance on [FFMCCI' s] part of said undertaking,"
person called the obligee. particularly, the repayment by FFMCCI of the downpayment advanced to it
by Kawasaki (in the case of the Surety Bond) and the full and faithful
Specifically, suretyship is a contractual relation resulting from an agreement performance by FFMCCI of its portion of work in the Project (in the case of
whereby one person, the surety, engages to be answerable for the debt, the Performance Bond).These are the only undertakings expressly
default or miscarriage of another, known as the principal." guaranteed by the bonds, the fulfillment of which by FFMCCI would release
CCCIC from its obligations as surety; or conversely, the non-performance of
which would give rise to the liabilities of CCCIC as a surety.
It bears stressing, however, that although the contract of suretyship is
secondary to the principal contract, the surety's liability to the obligee is
nevertheless direct, primary, and absolute. The Surety and Performance Bonds do not contain any condition that
CCCIC would be liable only if, in addition to the default on its undertakings
by FFMCCI, the Republic also made a claim against the PCIB Letter of
At the outset, the Court ascertains that there are two principal contracts in
Credit furnished by Kawasaki, on behalf of the Kawasaki-FFMCCI
this case: (1) the Consortium Agreement wherein Kawasaki and FFMCCI
Consortium. The Court agrees with the observation of the Court of Appeals
agreed to jointly enter into a contract with the Republic for the Project, each
that "it is not provided, neither in the Consortium Agreement nor in the
assuming the performance of specific scopes of work in said Project; and (2)
subject bonds themselves that before KAWASAKI may proceed against the
the Construction Contract whereby the Republic awards the Project to the
bonds posted by [FFMCCI] and CCCIC, the Philippine government as
Kawasaki-FFMCCI Consortium. While there is a connection between these
employer must first exercise its rights against the bond issued in its favor by
two contracts, they are each distinguishable from and enforceable 32
the consortium."
independently of one another: the first governs the rights and obligations
between Kawasaki and FFMCCI, while the second covers contractual
relations between the Republic and the Kawasaki-FFMCCI Consortium. The The Court cannot give any additional meaning to the plain language of the
Surety and Performance Bonds from CCCIC guaranteed the performance by undertakings in the Surety and Performance Bonds. The extent of a surety's
FFMCCI of its obligations under the Consortium Agreement; whereas the liability is determined by the language of the suretyship contract or bond
Letter of Credit from PCIB warranted the completion of the Project by the itself. Article 1370 of the Civil Code provides that "[i]f the terms of a contract
Kawasaki FFMCCI Consortium. At the crux of the instant controversy are the are clear and leave no doubt upon the intention of the contracting parties,
Surety and Performance Bonds issued by CCCIC in relation to the the literal meaning of its stipulations shall control.
Consortium Agreement.
There is no basis for the interpretation by CCCIC of the word "counter-
The Court reiterates that a surety's liability is determined strictly by the terms guarantee" in Article 10 of the Consortium Agreement. The first paragraph of
of contract of suretyship, in relation to the principal contract between the Article 10 of the Consortium Agreement provides that Kawasaki, as the
obligor and the obligee. Hence, the Court looks at the Surety and Consortium Leader, shall arrange, at its own cost but on behalf of the
Performance Bonds, in relation to the Consortium Agreement. Kawasaki-FFMCCI Consortium, for all necessary bonds and guarantees
under the Construction Contract with the Republic. The same paragraph
requires, in turn, that FFMCCI, at its own cost, to furnish Kawasaki with
According to the principle of relativity of contracts in Article 1311 of the Civil
suitable counter-guarantees for the repayment by FFMCCI for the advance
Code,a contract takes effect only between the parties, their assigns, and
payment from Kawasaki and performance by FFMCCI of its portion of work
heirs; except when the contract contains a stipulation in favor of a third
in the Project. Clearly, the "guarantees" and "counter-guarantees" were
person, which gives said person the right to demand fulfillment of said
securities for the fulfillment of the obligations of the Kawasaki-FFMCCI Here, however, there are two sets of transactions in the present case
Consortium to the Republic under the Construction Contract and of FFMCCI covered by two different contracts: the Consortium Agreement between
to the Consortium Leader Kawasaki under the Consortium Agreement, Kawasaki and FFMCCI and the Construction Contract between the Republic
respectively. The CCCIC Surety and Performance Bonds were not counter- and the Kawasaki-FFMCCI Consortium. The Surety and Performance Bonds
guarantees to the PCIB Letter of Credit. In fact, in the event that the guaranteed the performance of the obligations of FFMCCI to Kawasaki
Republic did make a claim on the PCIB Letter of Credit, the second under the Consortium Agreement. The Republic was not a party in either the
paragraph of Article 10 of the Consortium Agreement stipulates that Surety and Performance Bonds or the Consortium Agreement. Under these
Kawasaki and FFMCCI would still have to determine their respective circumstances, there was no creditor-debtor relationship between the
responsibilities, reimbursements, and/or compensations according to the Republic and FFMCCI and Article 2079 of the Civil Code did not apply. The
provisions of the Consortium Agreement, instead of simply allowing extension granted by the Republic to Kawasaki modified the deadline for the
Kawasaki to recover on the "counter-guarantees" of FFMCCI. completion of the Project under the Construction Contract, but had no effect
on the obligations of FFMCCI to Kawasaki under the Consortium
It is not disputed that FFMCCI, due to financial difficulties, was unable to Agreement, much less, on the liabilities of CCCIC under the surety and
repay the advance payment it received from Kawasaki and to finish its scope performance bonds.
of work in the Project, thus, FFMCCI defaulted on its obligations to
Kawasaki. Given the default of FFMCCI, CCCIC as suretybecame directly,
primarily, and absolutely liable to Kawasaki as the obligee under the Surety
and Performance Bonds. · Trade and Investment Development Corporation of the
Philippines v. Philippine Veterans Bank, G.R. No. 233850. July 1,
A surety is an insurer of the debt, whereas a guarantor is an insurer of the 2019 5.7. Trust Receipts:
solvency of the debtor. A suretyship is an undertaking that the debt shall be
paid; a guaranty, an undertaking that the debtor shall pay. Stated differently, Respondent Philippine Veterans Bank (PVB) filed a complaint for specific
a surety promises to pay the principal's debt if the principal will not pay, while performance against TIDCORP, alleging that:
a guarantor agrees that the creditor, after proceeding against the principal, ● in 2011, PVB, together with other banking institutions (Series A
may proceed against the guarantor if the principal is unable to pay. A surety Noteholders), entered into a Five-Year Floating Rate Note Facility
binds himself to perform if the principal does not, without regard to his ability Agreement (NFA) with debtor Philippine Phosphate Fertilizer
to do so. A guarantor, on the other hand, does not contract that the principal Corporation (PhilPhos), up to the aggregate amount of P5 billion.
will pay, but simply that he is able to do so. In other words, a surety Under the said NFA, respondent PVB committed the amount of P1
undertakes directly for the payment and is so responsible at once if the billion.
principal debtor makes default, while a guarantor contracts to pay if, by the ● To secure payment of the Series A Notes, petitioner TIDCORP, with
use of due diligence, the debt cannot be made out of the principal debtor. the express conformity of PhilPhos, executed a Guarantee
Agreement Whereby petitioner TIDCORP agreed to guarantee the
As regards the applicability of Article 2079 payment of the guaranty obligation to the extent of ninety (90%) of the
outstanding Series A Notes, including interest, on a rolling successive
Jurisprudence stated that "[a]n extension granted to the debtor by the three-month period commencing on the first drawdown date and
creditor without the consent of the guarantor extinguishes the guaranty," ending on the maturity date of the Series A Notes.
equally applies to both contracts of guaranty and suretyship. ● In 2013, Typhoon Yolanda made landfall in Central Visayas, which
resulted in widespread devastation in the province of Leyte where
The theory behind Article 2079 is that an extension of time given to the PhilPhos' manufacturing plant was situated. Due to the damage
principal debtor by the creditor without the surety's consent would deprive brought by said typhoon to PhilPhos' manufacturing facilities, it failed
the surety of his right to pay the creditor and to be immediately subrogated to resume its operations.
to the creditor's remedies against the principal debtor upon the maturity date. ● Thus, in 2015, PhilPhos filed a Petition for Voluntary Rehabilitation
The surety is said to be entitled to protect himself against the contingency of under the FRIA before the RTC Rehabilitation Court. The
the principal debtor or the indemnitors becoming insolvent during the Rehabilitation Court issued a Commencement Order, which included
extended period. a Stay Order.
● Respondent PVB then filed its Notice of Claim with petitioner
TIDCORP. However, TIDCORP declined to give due course to
 respondent PVB's Notice of Claim, invoking the Stay Order issued by The Guarantee Agreement unequivocally states that petitioner TIDCORP
the Rehabilitation Court. waived its right of excussion under Article 2058 of the Civil Code and that,
PVB also alleged that petitioner TIDCORP waived the benefit of excussion consequently, the Series A Noteholders can claim under the Guarantee
as provided in the Guarantee Agreement. Agreement DIRECTLY against petitioner TIDCORP without having to
exhaust all the properties of PhilPhos and without need of any prior recourse
In its answer, TIDCORP petitioner TIDCORP argued that the RTC cannot against PhilPhos.
validly try the case because of the Rehabilitation Court's Stay Order, which
enjoined the enforcement of all claims, actions and proceedings against Under a normal contract of guarantee, the guarantor binds himself to the
PhilPhos. creditor to fulfill the obligation of the principal debtor in case the latter should
fail to do so. The guarantor who pays for a debtor, in turn, must be
PVB filed a motion for summary judgement which the RTC granted, holding: indemnified by the latter. However, the guarantor cannot be compelled to
as made manifest in the pleadings, supporting affidavits, and admissions on pay the creditor unless the latter has exhausted all the property of the
record, there was no genuine issue as to any material fact posed by debtor and resorted to all the legal remedies against the debtor. This is
petitioner TIDCORP with respect to its liability under the Guarantee what is otherwise known as the benefit of excussion.Conversely, if this
Agreement, except as to the amount of damages. Thus, the RTC found that benefit of excussion is waived, the guarantor can be directly compelled by
respondent PVB was entitled to a judgment in its favor as a matter of law. the creditor to pay the entire debt even without the exhaustion of the debtor's
Issues: properties.
1. WON the Stay Order of the Rehabilitation Court divested the
RTC of jurisdiction – NO In other words, a guarantor who engages to directly shoulder the debt of the
2. WON provision of the FRIA on the non-application of a stay debtor, waiving the benefit of excussion and the requirement of prior
order with respect to the enforcement of claims against presentment, demand, protest or notice of any kind, undoubtedly makes
sureties and other persons solidarity liable with the debtor himself/herself solidarily liable to the creditor.
applies to petitioner TIDCORP. --- YES
A surety is one who directly, equally, and absolutely binds himself/herself
1. The Stay Order of the Rehabilitation Court did not divest the RTC's with the principal debtor for the payment of the debt.
jurisdiction to hear and decide respondent PVB's Complaint.
one of the hallmarks of a contract of guaranty is its subsidiary character –
Section 18(c) of the FRIA explicitly states that a stay order shall not apply "that the guarantor only answers if the debtor cannot fulfill his obligation;
"to the enforcement of claims against sureties and other persons hence the benefit of excussion in favor of the guarantor. What differentiates
solidarity liable with the debtor, and third party or accommodation a surety from a guaranty is that in the former, "a surety is principally liable,
mortgagors as well as issuers of letters of credit, x x x." while a guarantor is only secondarily liable."
Thus, when a stay order is issued, the rehabilitation court is only empowered
In the instant case, without any shadow of doubt, petitioner TIDCORP had
to suspend claims against the debtor, its guarantors, and sureties who are
expressly renounced the benefit of excussion and in no uncertain terms
not solidarily liable with the debtor. Hence, the making of claims against
made itself directly and principally liable without any qualification to the
sureties and other persons solidarily liable with the debtor is not
Series A Noteholders and without the need of any prior recourse to
barred by a stay order.
PhilPhos.
2. Above-quoted FRIA provision applicable to TIDCROP as it became a
In effect, the nature of the guarantee obligation assumed by petitioner
surety by virtue of its waiver of the benefit of excussion
TIDCORP under the Guarantee Agreement was transformed into a
suretyship. This is the case because the defining characteristic that
Upon a simple perusal of the Guarantee Agreement, to which petitioner distinguishes a guarantee from a suretyship is that in the latter, the obligor
TIDCORP readily admitted it is bound, the answer to the aforementioned promises to pay the principal's debt if the principal will not pay, while in the
question becomes a clear and unmistakable yes. Petitioner TIDCORP former, the obligor agrees that the creditor, after proceeding against the
indubitably engaged to be solidarity liable with PhilPhos under the principal and exhausting all of the principal's properties, may proceed
Guarantee Agreement. against the obligor
 · Trust Receipts Law (PRES. DECREE NO. 115) Metropolitan Bank & Trust Corporation v. Jimmy Go, et al, 538 SCRA
337(2007)
Osental v. People of the Philippines, G.R. No. 225697. September 5,
2018. Metrobank, through its Assistant Vice- President Leonardo B. Lejano,
executed a Credit Line Agreement in favor of its client, BGB Industrial Textile
FACTS: Mills, Inc. (BGB) in the total amount of P10,000,000.00.
Osental was charged with estafa. The said accused received in
trust from Maria Te the amount of P262,225 under a Trust Receipt As security for the obligation, private respondent Benjamin Go, being an
Agreement with an express obligation on the part of Osental to purchase dry officer of BGB, executed a Continuing Surety Agreement in favor of
goods ready-to-wear (RTW) to be sold on commission basis and deliver the Metrobank, binding himself solidarily with BGB to pay Metrobank the said
proceeds of the sale of return the goods unsold to Te. Osental allegedly amount of P10,000,000.00.In November 1988, private respondent Jimmy
failed to remit the proceeds of the sale or return the goods. Go, as general manager of BGB, applied for eleven (11) commercial letters
Osental claimed she had contacts in Manila and Iloilo from whom of credit to cover the shipment of raw materials and spare parts. Accordingly,
she could acquire the RTW goods. Te delivered to her the money. Te Metrobank issued the 11 irrevocable letters of credit to BGB.
entered into a trust receipt agreement with Osental. Upon the due date of
the Trust Receipt Agreement, Osental failed to deliver the proceeds or the By the terms of the trust receipts, BGB agreed to hold the goods in trust for
unsold goods despite demand. Metrobank and, in case of sale of the goods, to hand the proceeds to the
Osental denied the genuineness and due execution of the trust bank to be applied against the total obligation object of the trust receipts.
receipt agreement and denied being involved in the business of buying RTW However, on maturity dates of the trust receipts, because the goods
goods. Osental denied receiving the cash and instead claimed that she remained unsold, BGB and Jimmy and Benjamin Go failed to satisfy their
purchased gift checks from Te. obligation.
The RTC found Osental guilty of estafa ruling that Osental failed to
prove that her signature in the trust receipt agreement was forged. Forgery Metrobank filed three (3) separate complaints against BGB, for collection of
cannot be presumed and must be proved through clear and convincing sum of money equivalent to the value of the goods subject of the trust
evidence. CA affirmed. receipts. Later, Metrobank instituted 11 criminal charges against Jimmy and
ISSUE: WON Osental is guilty of estafa? - YES Benjamin Go for violation of Presidential Decree No. 115 (Trust Receipts
RULING: [READ SECTION 4 of P.D 115 above] Law) before the Office of the City Prosecutor of Manila.
There are two possible situations in a trust receipt transaction.
1. Money received under the obligation involving the duty to deliver it
After preliminary investigation, the Office of the City Prosecutor
(entregarla) to the owner of the merchandise sold
recommended that the case be dismissed case saying that the liability of
2. Merchandise received under the obligation to return it to the owner
respondents is only civil in nature i.e., to return the merchandise subject of
Failure of the entrustee to turn over the proceeds of the sale of the goods,
the 11 trust receipts, considering that they were never sold, and to pay their
covered by the trust receipt to the entruster or to return said goods if they
obligation under the letters of credit.
were not disposed of in accordance with the terms of the trust receipt shall
be punishable as estafa. Section 13 of PD 115 states that the penalty for
estafa shall be imposed on a person who violates the enumerated ISSUE:Whether or not respondents are guilty of violation of PD No. 115
undertakings under Section 4. (Decree PROVIDING FOR THE REGULATION OF TRUST RECEIPTS
The four elements of estafa under the Revised Penal Code were TRANSACTIONS)--NO
established. (money/goods received, misappropriation/conversion, prejudice
of another, demand by the offended party). Osental received money in RULING
trust for the purchase of RTW goods as evidenced by the trust receipt
agreement. The RTC and CA correctly ruled that there is a marked similarity First, In order that respondents Jimmy and Benjamin Go may be validly
between Osental's signature in the trust receipt agreement with Osental's prosecuted for estafa under Article 315, paragraph 1(b) of the Revised Penal
sample signatures in her Pag-IBIG identication card and daily time record. Code, in relation to Section 13 of the Trust Receipts Law, the following
elements must be established:
 (a) they received the subject goods in trust or under the obligation to sell the
same and to remit the proceeds thereof to Metrobank, or to return the goods
if not sold; ButMetrobank did not exercise this option. Instead, it filed three (3)
complaints to collect the value of the merchandise. Jimmy and Benjamin Go
(b) they misappropriated or converted the goods and/or the proceeds offered to return the merchandise to Metrobank even before these civil
of the sale; cases were filed. Then, Jimmy and Benjamin Go reiterated the offer to return
the goods in their answer to the civil complaints. Again, Metrobank did not
(c) they performed such acts with abuse of confidence to the damage and accept the offer, and instead filed the 11 criminal complaints for alleged
prejudice of Metrobank; and violation of the Trust Receipts Law to be prosecuted as estafa under Article
315, paragraph 1(b) of the Revised Penal Code. This chain of events
(d) demand was made on them by Metrobank for the remittance of the validates the finding of the Court of Appeals that Metrobank is not interested
proceeds or the return of the unsold goods. in the return of the goods but only in collecting the money it extended to the
respondents.
The Office of the City Prosecutor and the Secretary of Justice had identical
findings that the element of misappropriation or conversion is absent, and
that Jimmy and Benjamin Go could not deliver the proceeds of the sale of
the merchandise to Metrobank because the goods remained unsold. Both Furthermore, the trust receipts uniformly contain the following provision:
offices similarly found that the failure of the respondents to account for the
proceeds of the sale or of the goods only created a disputable presumption
that either the proceeds or the goods themselves were converted or
misappropriated, but the presumption was overturned when the goods were ―Failure on the part of the ENTRUSTEE to account to the
offered to be inventoried and returned as they remained intact in the BANK/ENTRUSTER for the goods/documents/instruments received in trust
warehouse at the Bataan Export Processing Zone.Accordingly, they both and/or for the proceeds of the sale thereof within thirty (30) days from
ruled that the liability of Jimmy and Benjamin Go was merely civil in nature, demand made by the BANK/ENTRUSTER shall constitute an admission that
and the criminal complaints were dismissed for lack of probable cause. the ENTRUSTEE has converted or misappropriated said
goods/documents/instruments for the personal benefit of the ENTRUSTEE
CA made a factual finding that Jimmy and Benjamin Go offered to return the and to the detriment and prejudice of the BANK/ENTRUSTER, and the
goods even prior to the filing of the civil cases against them, although the BANK/ENTRUSTER is forthwith authorized to file and prosecute the
offer was not accepted because Metrobank appeared more interested in corresponding and appropriate action, civil or criminal, against the
collecting the amount it advanced under the letters of credit. It also found ENTRUSTEE‖
that Metrobank failed to prove its demand for the return of the goods.

These findings appear to be supported by the evidence on record. The

prosecution for estafa under Article 315, paragraph 1(b) of the Revised Yet, not one of the 11 criminal complaints was accompanied by a demand
Penal code, cannot prosper because the second letter to show that Metrobank demanded the remittance of the proceeds of
(misappropriation/conversion) and the fourth (demand) elements of the the sale of the goods or the return of goods, if unsold.
offense are not present.

Second. The trust receipts subject of this case partake of the nature of
This Court also observes that the same trust receipts provide that contracts of adhesion.
Metrobank has the option to take possession of the goods upon default of
Jimmy and Benjamin Go on any of their obligations and to sell them, with the
proceeds thereof to be applied to the principal obligation and also to the
expenses to be incurred by Metrobank in selling the same.
In this case, the trust receipts were prepared solely by Metrobank with
Jimmy and Benjamin Go having no choice but to adhere entirely to their
provisions. In fact, the trust receipts stipulated that the goods subject thereof Facts:
were the exclusive property of Metrobank, contrary to the essence of a trust
receipt. · Security Bank filed a Complaint for Sum of Money (with
Application for Issuance of a Writ of Preliminary Attachment)
against respondents Great Wall Commercial Press Company,
Inc. (Great Wall) and its sureties, Alfredo Buriel Atienza,
A trust receipt is considered a security transaction designed to provide Fredino Cheng Atienza, and Spouses Frederick Cheng Atienza
financial assistance to importers and retail dealers who do not have and Monica Cu Atienza.
sufficient funds or resources to finance the importation or purchase of
merchandise, and who may not be able to acquire credit except through o The complaint sought to recover from respondents
utilization, as collateral, of the merchandise imported or purchased.It is a their unpaid obligations under a credit facility covered
document in which is expressed a security transaction where the lender, by several trust receipts and surety agreements, as
having no prior title to the goods on which the lien is to be constituted, and well as interests, attorney's fees and costs.
not having possession over the same since possession thereof remains in
the borrower, lends his money to the borrower on security of the goods · Security Bank argued that in spite of the lapse of the maturity
which the borrower is privileged to sell, clear of the lien, with an agreement date of the obligations, respondents failed to pay their
to pay all or part of the proceeds of the sale to the lender. It is a security obligations.
agreement pursuant to which a bank acquires a security interest in the
goods. It secures a debt, and there can be no such thing as security interest · RTC granted the application for a writ of preliminary
that secures no obligation. attachment of Security Bank, which then posted a bond in the
amount of ₱10,000,000.00.

· Great Wall, et al filed their Motion to Lift Writ of Preliminary

The subject trust receipts, being contracts of adhesion, are not per se invalid Attachment Ad Cautelam, claiming that the writ was issued with
and inefficacious. But should there be ambiguities therein, such ambiguities grave abuse of discretion based on the following grounds: (1)
are to be strictly construed against Metrobank, the party that prepared them. Security Bank's allegations in its application did not show a
prima facie basis therefor; (2) the application and the
accompanying affidavits failed to allege at least one
circumstance which would show fraudulent intent on their part;
There is no doubt as to the obligation of Jimmy and Benjamin Go to turn and (3) the general imputation of fraud was contradicted by
over the proceeds of the sale of the goods or to return the unsold goods. their efforts to secure an approval for a loan restructure.
However, an ambiguity exists as to when this obligation arises, whether
upon maturity of the trust receipts or upon demand by Metrobank. A strict · RTC denied respondents' motion to lift, explaining that the
construction of the provisions of the contracts of adhesion dictates that the Credit Agreement and the Continuing Suretyship Agreement
reckoning point should be the demand made by Metrobank. contained provisions on representations and warranties.

· CA lifted the writ of preliminary attachment.

The fact of demand made by Metrobankwas not established by competent o The CA opined that the non-return of the proceeds of
evidence. Except for the bare allegation that it did so in the 11 criminal the sale and/or the goods subject of the trust receipts
complaints, no letter of demand accompanied all of the criminal complaints. did not, by itself, constitute fraud and that, at most,
these were only averments for the award of damages
once substantiated by competent evidence. It also
stressed that respondents' act of offering a repayment
· Security Bank Corporation v. Great Wall Commercial Press proposal negated the allegation of fraud. The CA held
Company, Inc. 816 SCRA 224 (2017)12 that fraud must be present at the time of contracting
 the obligation, not thereafter, and that the rules on the · The allegations of Security Bank in support of its application
issuance of a writ of attachment must be construed for a writ of preliminary attachment are as follow:
strictly against the applicant.
o During the negotiation for the approval of the loan
· Security Bank now argues that there are sufficient factual application/ renewal of Respondents the latter through
and legal bases to justify the issuance of the writ of preliminary Alfredo Buriel Atienza, Fredino Cheng Atienza and
attachment. It claims that it was misled by respondents, who Sps. Frederick Cheng Atienza and Monica Cu
employed fraud in contracting their obligation, as they made Atienza, assured SBC that the loan obligation covered
the bank believe that they had the capacity to pay; that by the several Trust Receipts shall be paid in full on
respondents also committed fraud in the performance of their or before its maturity date pursuant to the terms and
obligation when they failed to tum over the goods subject of the conditions of the aforesaid trust receipts. However,
trust receipt agreements. Respondents as well as the sureties failed to pay the
aforesaid obligation.
Issue:
o In addition, the assurance to pay in full the obligation is
WHETHER OR NOT THE COURT OF APPEALS ERRED IN NULLIFYING further solidified by the warranty of solvency
THE WRIT OF PRELIMINARY ATTACHMENT ISSUED BY THE TRIAL provisions of the Credit Agreement
COURT - YES
o Without said representations and warranties, including
Ruling: the Continuing Suretyship Agreement, the plaintiff
would not have approved and granted the credit
· A writ of preliminary attachment is a provisional remedy facility to Respondents. It is thus clear that
issued upon the order of the court where an action is pending. Respondents, Alfredo Buriel Atienza, Fredino Cheng
Through the writ, the property or properties of the defendant Atienza and Sps. Frederick Cheng Atienza and
may be levied upon and held thereafter by the sheriff as Monica Cu Atienza, misled SBC and employed fraud
security for the satisfaction of whatever judgment might be in contracting said obligation.
secured by the attaching creditor against the defendant.
o Despite the above covenants, defendants failed to pay
· RULE 57, Preliminary Attachment, Section 1. Grounds upon nor return the goods subject of the Trust Receipt
which attachment may issue. - At the commencement of the Agreements.
action or at any time before entry of judgment, a plaintiff or any
proper party may have the property of the adverse party o Knowing fully well that they are already in default,
attached as security for the satisfaction of any judgment that Respondents and defendants sureties submitted a
may be recovered in the following cases: xxx (d) In an action repayment proposal. Through their lawyer, they
against a party who has been guilty of a fraud in contracting likewise requested the bank for a meeting to discuss
the debt or incurring the obligation upon which the action is their proposal. However, as it turned out, the
brought, or in the performance thereof; proposed repayment proposal for their loan was only
intended to delay legal action against them.
· For a writ of preliminary attachment to issue under the
above-quoted rule, the applicant must sufficiently show the · The Court finds that Security Bank was able to substantiate
factual circumstances of the alleged fraud. its factual allegation of fraud, particularly, the violation of the
trust receipt agreements, to warrant the issuance of the writ of
· Fraudulent intent cannot be inferred from the debtor's mere preliminary attachment.
non-payment of the debt or failure to comply with his
obligation. There were violations of the trust receipts agreements
 · While the Court agrees that mere violations of the warranties · Previously, Section 1 (d), Rule 57 of the 1964 Rules of Court
and representations contained in the credit agreement and the provided that a writ of preliminary attachment may be issued
continuing suretyship agreement do not constitute fraud under "[i]n an action against a party who has been guilty of a fraud in
Section 1(d) of Rule 57 of the Rules of Court, the same cannot contracting the debt or incurring the obligation upon which the
be said with respect to the violation of the trust receipts action is brought xxx" Thus, the fraud that justified the issuance
agreements. of a writ of preliminary attachment then was only fraud
committed in contracting an obligation (dolo casuante). When
· A trust receipt transaction is one where the entrustee has the the 1997 Rules of Civil Procedure was issued by the Court,
obligation to deliver to the entruster the price of the sale, or if Section l(d) of Rule 57 conspicuously included the phrase "in
the merchandise is not sold, to return the merchandise to the the performance thereof." Hence, the fraud committed in the
entruster. There are, therefore, two obligations in a trust receipt performance of the obligation (dolo incidente) was included as
transaction: the first refers to money received under the a ground for the issuance of a writ of preliminary attachment.
obligation involving the duty to turn it over (entregarla) to the
owner of the merchandise sold, while the second refers to the · Accordingly, the alleged fraud committed by respondents in
merchandise received under the obligation to "return" it the performance of their obligation should have been
(devolvera) to the owner. considered by the CA. Security Bank detailed in its complaint
that respondents, knowing fully well that they were in default,
· Security Bank's complaint stated that Great Wall, through its submitted a Repayment Proposal. Then, they requested for a
Vice President Fredino Cheng Atienza, executed various trust meeting with the bank to discuss their proposal. For unknown
receipt agreements in relation to its loan transactions. The trust reasons, they did not meet the representatives of the Security
receipts stated that in consideration of the delivery to the Bank.
entrustee (Great Wall) of the possession of the goods, it
obligates itself to hold in trust for the bank the goods, to sell the
goods for the benefit of the bank, to tum over the proceeds of
the sale to the bank, and to return the goods to the bank in the
event of non-sale.

· Upon the maturity date, however, respondents failed to

deliver the proceeds of the sale to Security Bank or to return · BDO Unibank, Inc. v. Choa, G.R. No. 237553. July 10, 2019
the goods in case of nonsale.

· The Court is of the view that Security Bank's allegations of

BDO v. CHOA (CHLO)
violation of the trust receipts in its complaint was specific and
sufficient to assert fraud on the part of respondents. These July 10, 2019 | Leonen, J. | Compensation
allegations were duly substantiated by the attachments thereto
and the testimony of Security Bank's witness.
PETITIONER:BDO UNIBANK, INC.
RESPONDENTS: ANTONIO CHOA

Fraud in the performance of SUMMARY: An Information was filed before the Regional Trial Court of
Pasig City against Choa, then president and general manager of Camden
the obligation must be Industries, Inc. (Camden) for violating the Trust Receipts Law, to the
prejudice of BDO Unibank, Inc. (BDO). Choa allegedly executed several
considered Trust Receipt Agreements in favor of Equitable PCI Bank (now Banco De
Oro-ECI, Inc.), with the due sum of P7.875,904.96. The terms of which the
accused agreed to sell the same with express obligation to remit to the
 4. The witnesses testified, among others, that per Civil Case No.
complainant bank proceeds of the sale and/or turn over the same if not
70098, entitled "CAMDEN Industries, Inc. v. Equitable PCI Bank"
sold or disposed of in accordance with the said Trust Receipt Agreements
(Pasig civil case), which had been elevated to the Court of Appeals,
on demand, but the accused once in possession in the said good
BDO supposedly owed Camden the judgment award of P90 million.
misappropriated the proceeds. The prosecution presented Gerard K.
a. The subject trust receipts are for the account of CAMDEN
Santiago (Santiago) and Froilan Carada (Carada) as its witnesses. From
Industries[;]
another trial (the Civil case), it was shown that BDO owned Camden P90
b. The complainant bank did not sue CAMDEN for the
Million as judgment award. It was also evidenced that Camdem owed a
liability. The only one they sued was CAMDEN's
money claim of P20 Million to BDO. Upon filing of demurrer of evidence,
President, the accused;
respondent argued that since P20M is being claimed by the bank, the
c. CAMDEN sued the bank and was awarded P90M plus.
amount can be offset by the P90M plus judgment against the bank.
The bank was ordered to pay CAMDEN the same amount.
Prosecution, however, argued that compensation is not allowed since
The case is now on appeal to the Court of Appeals;
Choa's civil liabilities stemmed from his criminal violations of the Trust
d. Upon the other hand, the money claim of the bank against
Receipts Law, they could not be the subject of compensation.
CAMDEN and/or for the accused is P20M plus;
W/N Compensation is allowed? The court didnt really answer.
e. On clarificatory question by the court, the prosecution
witness Gerard Santiago [a]dmitted that currently the bank
The court reiterated that the issue here is whether Camden violated the
is a judgment debtor of CAMDEN in the amount of P90M
Trust Receipt Agreements when it failed to deliver the proceeds of the
plus while the bank's claim against CAMDEN/accused is
sale of the goods to petitioner, or to return the goods should the
P20M plus[.
merchandise remain unsold. Moreover, the Pasig civil case, which held
5. Prosecution argued that compensation is not allowed since Choa's
petitioner as a judgment debtor of Camden, has yet to attain finality. As
civil liabilities stemmed from his criminal violations of the Trust
such, it cannot be the basis of a judgment.
Receipts Law, they could not be the subject of compensation.
a. Prosecution added that the decision of the trial court,
DOCTRINE:
which had awarded Camden P90 million, was reversed
and set aside by the Court of Appeals
FACTS: 6. RTC found that:
7
1. On February 28, 2008, an Information was filed before the a. the amounts BDO and Camden owed each other—BDO's
Regional Trial Court of Pasig City against Choa, then president and P90 million judgment debt to Camden, and Camden's P20
general manager of Camden Industries, Inc. (Camden). He was million judgment debt to BDO—may be legally
charged with violating Presidential Decree No. 115, or the Trust compensated;
Receipts Law, to the prejudice of BDO Unibank, Inc. (BDO). b. BDO failed to prove that Choa was liable for
2. Choa allegedly executed several Trust Receipt Agreements in favor P7,875,904.96, and that this amount formed part of the
of Equitable PCI Bank (now Banco De Oro-ECI, Inc.), with the due P20 million trust receipt; and
sum of P7.875,904.96. The terms of which the accused agreed to c. BDO failed to prove Choa's criminal intent in not paying or
sell the same with express obligation to remit to the complainant turning over the goods.
bank proceeds of the sale and/or turn over the same if not sold or 7. CA denied the petition, and prosecutions subsequent MR.
disposed of ina accordance with the said Trust Receipt Agreements
on demand, but the accused once in possession in the said good ISSUE:
misappropriated the proceeds.
3. The prosecution presented Gerard K. Santiago (Santiago) and 1. [Pertinent to our discussion ] W/N there can be compensation
Froilan Carada (Carada) as its witnesses. between the judgment debt in Camden‘s favor and the
respondent‘s civiliability arising from a case?
 theirs but the direct liability of the corporation they
RULING: WHEREFORE, the Petition is DENIED. represent. As an exception, directors or officers are
personally liable for the corporation's debts only if they so
RATIO: contractually agree or stipulate.

1. Again, the issue here is whether Camden violated the Trust Receipt Payment:
Agreements when it failed to deliver the proceeds of the sale of the
goods to petitioner, or to return the goods should the merchandise CIVIL CODE ARTS. 1233, 1236-1238, 1240, 1242, 1243-1251
remain unsold. Moreover, the Pasig civil case, which held petitioner
as a judgment debtor of Camden, has yet to attain finality. As
93 Article 1233. A debt shall not be understood to have been paid unless the
such, it cannot be the basis of a judgment. thing or service in which the obligation consists has been completely
delivered or rendered, as the case may be. (1157
2. On to his liability:
3. Based on the prosecution's evidence, this Court cannot grant Article 1236. The creditor is not bound to accept payment or performance
petitioner's Complaint. by a third person who has no interest in the fulfillment of the obligation,
a. The prosecution's evidence consists of copies of: (1) Trust unless there is a stipulation to the contrary.
Receipt Agreement Nos. 006, 007, 008, 009, 024, 025,
04(5, and 047 between Equitable PCI Bank, Inc.— Whoever pays for another may demand from the debtor what he has paid,
petitioner's predecessor-in-interest—and Camden, with except that if he paid without the knowledge or against the will of the debtor,
respondent signing as its representative; (2) a copy of the he can recover only insofar as the payment has been beneficial to the
debtor. (1158a)
Demand Letter dated May 22, 2003 addressed to Camden
and respondent; (3) Camden's Statement of Account as of
Article 1237. Whoever pays on behalf of the debtor without the knowledge
March 31, 2011; (4) the Certificate of Filing of the Articles or against the will of the latter, cannot compel the creditor to subrogate him
and Plan of Merger dated May 25, 2007 between in his rights, such as those arising from a mortgage, guaranty, or penalty.
petitioner and Equitable PCI Bank, Inc.; (5) the Plan of (1159a)
Merger dated December 28, 2006 between petitioner and
Equitable PCI Bank, Inc.; (6) Santiago's Judicial Affidavit; Article 1238. Payment made by a third person who does not intend to be
102 reimbursed by the debtor is deemed to be a donation, which requires the
and (7) Carada's Judicial Affidavit.
4. Although these pieces of evidence show that respondent signed the debtor's consent. But the payment is in any case valid as to the creditor who
has accepted it. (n)
Trust Receipt Agreements, they do not show that he signed them in
his personal capacity. On the bottom right corner of the agreements
are two (2) lines: one for the "NAME OF CORPORATION," and the
other for "AUTHORIZED SIGNATURE." In all agreements,
"Camden Inds." was handwritten as the name of the corporation,
while respondent's signature appeared as the authorized signature. Application of Payment:
Clearly, respondent affixed his signature only as Camden's
representative. CIVIL CODE ARTS. 1252-1254
5. Moreover, there was no guaranty clause or a similar clause on the
page that he signed that would have made him personally liable in SUBSECTION 1. Application of Payments
103
case of default of the company. In Tupaz IV v. Court of Appeals:
a. A corporation, being a juridical entity, may act only through Article 1252. He who has various debts of the same kind in favor of one and
its directors, officers, and employees. Debts incurred by the same creditor, may declare at the time of making the payment, to which
these individuals, acting as such corporate agents, are not of them the same must be applied. Unless the parties so stipulate, or when
the application of payment is made by the party for whose benefit the term SECTION 5
has been constituted, application shall not be made as to debts which are
not yet due. Compensation

If the debtor accepts from the creditor a receipt in which an application of the Article 1278. Compensation shall take place when two persons, in their own
payment is made, the former cannot complain of the same, unless there is a right, are creditors and debtors of each other. (1195)
cause for invalidating the contract. (1172a)
Article 1279. In order that compensation may be proper, it is necessary:
Article 1253. If the debt produces interest, payment of the principal shall not
be deemed to have been made until the interests have been covered. (1173)
(1) That each one of the obligors be bound principally, and that he be at the
same time a principal creditor of the other;
Article 1254. When the payment cannot be applied in accordance with the
preceding rules, or if application can not be inferred from other
(2) That both debts consist in a sum of money, or if the things due are
circumstances, the debt which is most onerous to the debtor, among those
consumable, they be of the same kind, and also of the same quality if the
due, shall be deemed to have been satisfied.
latter has been stated;
If the debts due are of the same nature and burden, the payment shall be
(3) That the two debts be due;
applied to all of them proportionately. (1174a)
(4) That they be liquidated and demandable;

(5) That over neither of them there be any retention or controversy,

commenced by third persons and communicated in due time to the debtor.
(1196)

Article 1280. Notwithstanding the provisions of the preceding article, the

guarantor may set up compensation as regards what the creditor may owe
the principal debtor. (1197)

Article 1281. Compensation may be total or partial. When the two debts are
PAYMENT BY CESSION: of the same amount, there is a total compensation. (n)

CIVIL CODE ART.1255 Article 1282. The parties may agree upon the compensation of debts which
are not yet due. (n)
SUBSECTION 2. Payment by Cession
Article 1283. If one of the parties to a suit over an obligation has a claim for
Article 1255. The debtor may cede or assign his property to his creditors in damages against the other, the former may set it off by proving his right to
payment of his debts. This cession, unless there is stipulation to the said damages and the amount thereof. (n)
contrary, shall only release the debtor from responsibility for the net
proceeds of the thing assigned. The agreements which, on the effect of the Article 1284. When one or both debts are rescissible or voidable, they may
cession, are made between the debtor and his creditors shall be governed be compensated against each other before they are judicially rescinded or
by special laws. (1175a) avoided. (n)

COMPENSATION: Article 1285. The debtor who has consented to the assignment of rights
made by a creditor in favor of a third person, cannot set up against the
CIVIL CODE ARTS. 1278 -1290 assignee the compensation which would pertain to him against the assignor,
unless the assignor was notified by the debtor at the time he gave his
consent, that he reserved his right to the compensation.

If the creditor communicated the cession to him but the debtor did not
consent thereto, the latter may set up the compensation of debts previous to
the cession, but not of subsequent ones.

If the assignment is made without the knowledge of the debtor, he may set
up the compensation of all credits prior to the same and also later ones until
he had knowledge of the assignment. (1198a)

Article 1286. Compensation takes place by operation of law, even though

the debts may be payable at different places, but there shall be an indemnity
for expenses of exchange or transportation to the place of payment. (1199a)

Article 1287. Compensation shall not be proper when one of the debts
arises from a depositum or from the obligations of a depositary or of a bailee
in commodatum.

Neither can compensation be set up against a creditor who has a claim for
support due by gratuitous title, without prejudice to the provisions of
paragraph 2 of article 301. (1200a)

Article 1288. Neither shall there be compensation if one of the debts

consists in civil liability arising from a penal offense. (n)

Article 1289. If a person should have against him several debts which are
susceptible of compensation, the rules on the application of payments shall
apply to the order of the compensation. (1201)

Article 1290. When all the requisites mentioned in article 1279 are present,
compensation takes effect by operation of law, and extinguishes both debts
to the concurrent amount, even though the creditors and debtors are not
aware of the compensation. (1202a)

Novation: CIVIL CODE ARTS. 1291

Article 1291. Obligations may be modified by:

(1) Changing their object or principal conditions;

(2) Substituting the person of the debtor;

(3) Subrogating a third person in the rights of the creditor. (1203)

Taxation profession may be allowed as a deduction or treated as a capital
expenditure.
Interest as a Deduction from Gross Income: NATIONAL INTERNAL
REVENUE CODE §34 (B) Revenue Regulation No. 13-2000

Section 34. Deductions from Gross Income. – Except for taxpayers November 20, 2000
earning compensation income arising from personal services rendered
under an employer-employee relationship where no deductions shall be REVENUE REGULATIONS NO. 13-00
allowed under this Section, in computing taxable income subject to income
tax under Sections 24(A); 25(A); 26; 27(A), (B), and (C); and 28(A)(1), there
shall be allowed the following deductions from gross income:
SUBJEC : Implementing Section 34(B) of the Tax Code of 1997 on
(B) Interest. – T the Requirements for Deductibility of Interest Expense from
the Gross Income of a Taxpayer
(1) In General. – The amount of interest paid or incurred within a taxable
year on indebtedness in connection with the taxpayer‘s profession, trade or
business shall be allowed as deduction from gross income: Provided,
however, That the taxpayer‘s otherwise allowable deduction for interest
expense shall be reduced by forty-two percent (42%) of the interest income
subjected to final tax: Provided, That effective January 1, 2009, the
percentage shall be thirty-three percent (33%)13.
TO : All Internal Revenue Officers and Others Concerned
(2) Exceptions. – No deduction shall be allowed in respect of interest under
the succeeding subparagraphs:

1. (a) If within the taxable year an individual taxpayer

reporting income on the cash basis incurs an indebtedness on
which an interest is paid in advance through discount or otherwise: SECTION 1. Scope. — Pursuant to the provisions of Section 244 of the Tax
Provided, That such interest shall be allowed as a deduction in the Code of 1997, these Regulations are hereby promulgated to implement the
year the indebtedness is paid: Provided, further, That if the provisions of Section 34(B) of the same Code on the requirements for
indebtedness is payable in periodic amortizations, the amount of deductibility of interest expense from the gross income of a corporation or an
interest individual engaged in trade, business or in the practice of profession.

1. which corresponds to the amount of the principal SECTION 2. Definition of Terms. — For purposes of these Regulations,
amortized or paid during the year shall be allowed as deduction in the following words and phrases shall have the following meanings, viz:
such taxable year;
(a) Interest — shall refer to the payment for the use or forbearance or
2. (b) If both the taxpayer and the person to whom the detention of money, regardless of the name it is called or denominated. It
payment has been made or is to be made are persons specified includes the amount paid for the borrower's use of money during the term of
under Section 36 (B); or the loan, as well as for his detention of money after the due date for its
repayment. cAaETS
3. (c) If the indebtedness is incurred to finance petroleum
exploration. (b) Taxpayer — shall refer to a person, whether natural or juridical, engaged
in trade, business or in the exercise of profession, except one earning
(3) Optional Treatment of Interest Expense. – At the option of the taxpayer, compensation income arising from personal services rendered under an
interest incurred to acquire property used in trade, business or exercise of a employer-employee relationship.
SECTION 3. Requisites for Deductibility of Interest Expense. — In Thirty-nine percent (39%) beginning January 1, 1999; and
general, subject to certain limitations, the following are the requisites for the
deductibility of interest expense from gross income, viz: Thirty-eight percent (38%).beginning January 1, 2000 and thereafter.

(a) There must be an indebtedness; This limitation shall apply regardless of whether or not a tax arbitrage
scheme was entered into by the taxpayer or regardless of the date when the
(b) There should be an interest expense paid or incurred upon such interest bearing loan and the date when the investment was made for as
indebtedness; long as, during the taxable year, there is an interest expense incurred on
one side and an interest income earned on the other side, which interest
(c) The indebtedness must be that of the taxpayer, income had been subjected to final withholding tax. This rule shall be
observed irrespective of the currency the loan was contracted and/or in
(d) The indebtedness must be connected with the taxpayer's trade, business whatever currency the investments or deposits were made. DTAIaH
or exercise of profession;
Illustration: Supposing on January 15, 1998, Company A, who has a deposit
(e) The interest expense must have been paid or incurred during the taxable account with BCD Bank, obtained a loan from XYZ Financing Corporation in
year; connection with the operation of its business. Assume that Company A's net
income for the year 1998 before the deduction of the interest expense
amounted to P1,000,000. For the year 1998, the interest income it derived
(f) The interest must have been stipulated in writing;
from the said deposit with BCD Bank amounted to P180,000 on which a final
tax of P36,000 had been withheld. Its interest expense on the loan obtained
(g) The interest must be legally due; from XYZ Financing Corporation during the same year amounted to
P150,000.
(h) The interest payment arrangement must not be between related
taxpayers as mandated in Sec. 34(B)(2)(b), in relation to Sec. 36(B), both of Under this illustration, the deductible interest expense, the taxable income
the Tax Code of 1997; and the income tax due of Company A shall be computed as follows:

(i) The interest must not be incurred to finance petroleum operations; and

(j) In case of interest incurred to acquire property used in trade, business or

exercise of profession, the same was not treated as a capital expenditure.
1998
SECTION 4. Rules on the Deductibility of Interest Expense. —

(a) General Rule. — In general, the amount of interest expense paid or

incurred within a taxable year on indebtedness in connection with the
taxpayer's trade, business or exercise of profession shall be allowed as a
deduction from the taxpayer's gross income.

(b) Limitation. — The amount of interest expense paid or incurred by a Net income before interest expense P1,000,000
taxpayer in connection with his trade, business or exercise of a profession
from an existing indebtedness shall be reduced by an amount equal to the
following percentages of the interest income earned which had been
subjected to final withholding tax depending on the year when the interest Less: Interest expense P150,000
income was earned, viz:

Forty-one percent (41%) beginning January 1, 1998;

 (d) Other cases where interest expense is not deductible from gross
income. — No interest expense shall be allowed as deduction from gross
Less: 41% of interest income from income in any of the following cases:

(1) If within the taxable year, an individual taxpayer reporting income on the
cash basis incurs an indebtedness on which an interest is paid in advance
deposit (41% x P180,000) 73,800 through discount or otherwise: Provided, That such interest shall be allowed
as a deduction in the year the indebtedness is paid: Provided, further, That if
the indebtedness is payable in periodic amortization, the amount of interest
which corresponds to the amount of the principal amortized or paid during
———— the year shall be allowed as deduction in such taxable year.

Illustration: Mr. Cruz, a self-employed individual, consistently employs the

cash-basis accounting method in keeping his books of accounts. Assuming
Deductible interest expense 76,200 that on January 1, 1998, he contracted a loan of P1,000,000 from XYZ Bank
for use in his business operations. Terms: Payable in two (2) years at 15%
interest per annum, payable in advance. On January 1, 1998, he received
from the bank the proceeds of his loan in the sum of P700,000, net of
interest paid in advance in the amount of P300,000.
————
In general, the interest expense shall be taken for the taxable year in which
"paid or incurred" or "paid or accrued" depending upon the method of
accounting upon the basis of which the net income is computed, unless in
Taxable income P923,800 order to clearly reflect the income, the deduction should be taken as of a
different period. Thus, a self-employed individual is allowed to deduct from
his gross income the entire amount of interest expense actually paid during
the taxable year. However, if the interest expense is paid in advance and the
———— accounting method used by the self-employed individual is the cash-basis
accounting method, such interest expense paid in advance shall only be
allowed as deduction in the year when he has fully paid his liability. So that if
the said debtor has fully paid his loan as of the end of the taxable year 1999,
Income tax due for taxable year 1998 (34%) P314,092 his interest expense paid in advance on January 1, 1998 in the amount of
P300,000 shall only be allowed as deduction from his gross income in the
taxable year 1999.

======== On the other hand, even if the interest expense is paid in advance but the
indebtedness is payable in periodic amortization, the amount of interest
expense which corresponds to the amount of the principal amortized or paid
during the respective years 1998 and 1999 shall be allowed as deduction in
(c) Interest on Unpaid Taxes. — Provisions of Sec. 4(b) hereof to the such respective taxable years. EATcHD
contrary notwithstanding, interest incurred or paid by the taxpayer on all
unpaid business-related taxes shall be fully deductible from gross income (2) If both the taxpayer and the person to whom the payment has been
and shall not be subject to the limitation on deduction heretofore mentioned. made or is to be made are persons specified under Sec. 36(B) of the Tax
Thus, such interest expense incurred or paid shall not be diminished by the Code of 1997, viz:
percentage of interest income earned which had been subjected to final
withholding tax.
(i) Between members of a family. For purposes of this paragraph, the family ||| (Implementing Section 34(B) of the Tax Code of 1997 on the
of an individual shall include only his brothers and sisters (whether by the Requirements for Deductibility of Interest Expense from the Gross Income of
whole or half-blood), spouse, ancestors and lineal descendants; or a Taxpayer, Revenue Regulations No. 13-00, [November 20, 2000])

(ii) Between an individual and a corporation more than fifty percent (50%) in Indirect Taxes:
value of the outstanding stock of which is owned, directly and indirectly, by
or for such individual; or Distribution or transfer of goods to creditors in payment of debt:
Revenue Regulation No. 16-2005 §4.106-7(a)(2)(ii)
(iii) Between two corporations more than fifty percent (50%) in value of the
outstanding stock of each of which is owned, directly or indirectly, by or for SECTION 4.106-7. Transactions Deemed Sale. —
the same individual; or
(2) Distribution or transfer to
(iv) Between the grantor and a fiduciary of any trust; or aCTHEA
ii. Creditors in payment of debt or obligation.
(v) Between the fiduciary of a trust and the fiduciary of another trust if the
same person is a grantor with respect to each trust; or

(vi) Between a fiduciary of a trust and a beneficiary of such trust.

(3) If the indebtedness on which the interest expense is paid is incurred to

finance petroleum exploration in the Philippines. The non-deductible interest
expense herein referred to pertains to interest or other consideration paid or
incurred by a Service Contractor engaged in the discovery and production of
indigenous petroleum in the Philippines in respect of the financing of its
petroleum operations, pursuant to Section 23 of P.D. No. 8, as amended by Extent of VAT exemption on interest: NATIONAL INTERNAL REVENUE
P.D. No. 87, otherwise known as "The Oil Exploration and Development Act CODE §109 (M), (V);
of 1972."
Section 109. Exempt Transactions
(e) Optional treatment of interest expense on capital expenditure. — At
the option of the taxpayer, interest expense on a capital expenditure incurred (M) Gross receipts from lending activities by credit or multi-purpose
to acquire property used in trade, business or exercise of a profession may cooperatives duly registered with the Cooperative Development Authority
be allowed as a deduction in full in the year when incurred, the provisions of
Sec. 36 (A)(2) and (3) of the Tax Code of 1997 to the contrary (V) Services of bank, non-bank financial intermediaries performing quasi-
notwithstanding, or may be treated as a capital expenditure for which the banking functions, and other non-bank financial intermediaries
taxpayer may claim only as a deduction the periodic amortization of such
expenditure. Revenue Regulation No. 16-2005 §4.109- 1(B)(1)(m), (v) 14

SECTION 5. Repealing Clause. — The provisions of any revenue SECTION 4.109-1. VAT-Exempt Transactions. —
regulations or any revenue issuance or ruling inconsistent with these
Regulations are hereby repealed, amended, or modified accordingly. (B) Exempt transactions. —
SECTION 6. Effectivity Clause. — These Regulations shall take effect
(1) Subject to the provisions of Subsection (2) hereof, the following
immediately. transactions shall be exempt from VAT:
(m) Gross receipts from lending activities by credit or multi-purpose
cooperatives duly registered and in good standing with the Cooperative
Development Authority, (c) On royalties, rentals of property, real or personal, 7%
profits, from exchange and all other items treated as
(v) Services of banks, non-bank financial intermediaries performing quasi- gross income under Section 32 of this code
banking functions, and other non-bank financial intermediaries such as
money changers and pawnshops, subject to percentage tax under Secs. 121
and 122, respectively, of the Tax Code;
(d) On net trading gains within the taxable year on 7%
||| (Consolidated Value-Added Tax Regulations of 2005, Revenue foreign currency, debt securities, derivative and other
Regulations No. 16-05, [September 1, 2005]) similar financial instruments

Percentage Taxes; Gross Receipts Tax:

Provided, however, That in case the maturity period referred to in paragraph
(a) is shortened thru pre-termination, then the maturity period shall be
NATIONAL INTERNAL REVENUE CODE §121, 122 (As amended by
reckoned to end as of the date of pre-termination for purposes of classifying
REPUBLIC ACT NO. 9337)
the transaction and the correct rate of tax shall be applied accordingly.
Section 121. Tax on Banks and Non-Bank Financial Intermediaries
Provided, finally, That the generally accepted accounting principles as may
Performing Quasi-Banking Functions.29 – There shall be collected a tax
be prescribed by the Bangko Sentral ng Pilipinas for the bank or non-bank
on gross receipts derived from sources within the Philippines by all banks
financial intermediary performing quasi-banking functions shall likewise be
and non-bank financial intermediaries in accordance with the following
the basis for the calculation of gross receipts.
schedule:
Nothing in this Code shall preclude the Commissioner from imposing the
(a) On interest, commissions and discounts from lending activities as well as
same tax herein provided on persons performing similar banking activities
income from financial leasing, on the basis of remaining maturities of
instruments from which such receipts are derived:
Section 122. Tax on Other Non-Bank Financial Intermediaries.30 –
There shall be collected a tax of five percent (5%) on the gross receipts
derived by other non-bank financial intermediaries doing business in the
Maturity period is five years or less 5% Philippines, from interest, commissions, and discounts from lending
activities, as well as income from financial leasing, shall be taxed on the
basis of remaining maturities of the instruments from which such receipts are
derived, in accordance with the following schedule:
Maturity period is more than five years 1%

Maturity period is five years or less 5%

(b) On dividends and equity shares and net income of 0%

subsidiaries Maturity period is more than five years 1%
Provided, finally, That the generally accepted accounting principles as may (f) Assignment or transfer of any mortgage, lease or policy of insurance, or
be prescribed by the Securities and Exchange Commission for other non- the renewal or continuance of any agreement, contract, charter, or any
bank financial intermediaries shall likewise be the basis for the calculation of evidence of obligation or indebtedness, if there is no change in the maturity
gross receipts. date or remaining period of coverage from that of the original instrument.

Nothing in this Code shall preclude the Commissioner from imposing the SECTION 55. Section 179 of the NIRC, as amended, is hereby further
same tax herein provided on persons performing similar financing activities. amended to read as follows:

Documentary Stamp Tax Rates: "SEC. 179. Stamp Tax on All Debt Instruments. — On every original issue of
debt instruments, there shall be collected a documentary stamp tax of One
NATIONAL INTERNAL REVENUE CODE §179, §180, §199 (f) as peso and fifty centavos (P1.50) on each Two hundred pesos (P200), or
amended by REPUBLIC ACT NO. 10963 §55 (debt instruments); fractional part thereof, of the issue price of any such debt instruments:
Provided, That for such debt instruments with terms of less than one (1)
Section 179. Stamp Tax on All Debt Instruments. – On every original year, the documentary stamp tax to be collected shall be of a proportional
issue of debt instruments, there shall be collected a documentary stamp tax amount in accordance with the ratio of its term in number of days to three
of One peso and fifty centavos (PhP1.50) on each Two hundred pesos hundred sixty-five (365) days: Provided, further, That only one documentary
(PhP200), or fractional part thereof, of the issue price of any such debt stamp tax shall be imposed on either loan agreement, or promissory notes
instruments: Provided, That for such debt instruments with terms of less than issued to secure such loan.
one (1) year, the documentary stamp tax to be collected shall be of a
proportional amount in accordance with the ratio of its term in number of "xxx xxx xxx." (Tax Reform for Acceleration and Inclusion (TRAIN),
days to three hundred sixty-five (365) days: Provided, further, That only one Republic Act No. 10963, [December 19, 2017])
documentary stamp tax shall be imposed on either loan agreement, or
promissory notes issued to secure such loan.

For purposes of this section, the term debt instrument shall mean §57 (bills of exchange or drafts).
instruments representing borrowing and lending transactions including but
not limited to debentures, certificates of indebtedness, due bills, bonds, loan SECTION 57. Section 181 of the NIRC, as amended, is hereby further
agreements, including those signed abroad wherein the object of contract is amended to read as follows:
located or used in the Philippines, instruments and securities issued by the
government of any of its instrumentalities, deposit substitute debt "SEC. 181. Stamp Tax upon Acceptance of Bills of Exchange and
instruments, certificates or other evidences of deposits that are either Others. — Upon any acceptance or payment of any bill of exchange or
drawing interest significantly higher than the regular savings deposit taking order for the payment of money purporting to be drawn in a foreign country
into consideration the size of the deposit and the risks involved or drawing but payable in the Philippines, there shall be collected a documentary stamp
interest and having a specific maturity date, orders for payment of any sum tax of Sixty centavos (P0.60) on each Two hundred pesos (P200), or
of money otherwise than at sight or on demand, promissory notes, whether fractional part thereof, of the face value of any such bill of exchange, or
negotiable or non-negotiable, except bank notes issued for circulation. order, or the Philippine equivalent of such value, if expressed in foreign
currency."
Section 180. Stamp Tax on All Bills of Exchange or Drafts. – On all bills
of exchange (between points within the Philippines) or drafts, there shall be ||| (Tax Reform for Acceleration and Inclusion (TRAIN), Republic Act
collected a documentary stamp tax of Sixty centavos (PhP0.60) on each No. 10963, [December 19, 2017])
Two hundred pesos (PhP200), or fractional part thereof, of the face value of
any such bill of exchange or draft.

Section 199. Documents and Papers Not Subject to Stamp Tax. – The
provisions of Section 173 to the contrary notwithstanding, the following
instruments, documents and papers shall be exempt from the documentary
stamp tax: Thin Capitalization Issues:
Look up definition of Thin Capitalization in Black’s Dictionary; 1.2 The magnitude of revenue lost has become so alarming that there is a
need to immediately address this problem. It is a fact that, because these
- When debt owed by a corporation to its shareholders is large in companies are more interested in their net income as a whole (rather than
relationship to its capital structure (i.e., stock and shareholder equity), as individual corporations) there is a desire to minimize tax payments by
the I.R.S. may contend that the corporation is thinly capitalized. In taking advantage of the loopholes in our tax system and by making use of
effect, this means that some or all of the debt will be reclassifled as schemes that allow them to move around the law in order to reduce their tax
equity. The immediate result is to disallow any interest deduction to the obligations.
corporation on the reclassified debt. To the extent of the corporation's
earnings and profits, interest payments and loan repayments are treated 1.3 It is therefore necessary to conduct a joint and coordinated examination
as dividends to the shareholders. I.R.C. No. 385 of interrelated group of companies in order to identify the tax avoidance
schemes and be able to prescribe the necessary measures in order to avoid
the erosion of revenues.

Revenue Audit Memorandum Order No. 1-98 (July 7, 1998) 2. GENERAL GUIDELINES

REVENUE AUDIT MEMORANDUM ORDER NO. 1-98 2.1 General Procedures. The provisions laid down in Volume 1 of the
Handbook on Audit Procedures and Techniques must be followed with
respect to:

SUBJEC : Audit Guidelines and Procedures in the Examination of a. Basic reportorial requirements; and
T Interrelated Group of Companies
b. general audit procedures and techniques.

2.2 Special Audit Procedures. In addition, focus must be made on the

following audit issues (detailed audit procedures are laid down in Section 3
of this RAMO ):

2.2.1 Use of tax shelters (such as a foundation or a tax-exempt company) in

TO : All Revenue Officers Concerned order to avail of tax exemptions or of lower tax rates; dctai

2.2.2 Shifting income and/or expenses in favor of a related company with

special tax privileges (e.g. BOI Incentives, Tax Holidays, and etc.);

2.2.3 Transfer pricing in inter-company supply of goods (tangible and

This RAMO is issued as a basic guideline for the joint and coordinated
intangible) and services;
examination of interrelated group of companies under Revenue
Memorandum Order No. 61-98. prLL
2.2.4 Inter-company loans and advances, and financing arrangements
where the interest charged for the use of money is not at arm's length;
1. BACKGROUND
2.2.5 Arbitrary cost-sharing arrangements for common expenses;
1.1 The remarkable decrease in collection from interrelated group of
companies has seriously affected the collection efforts of the Bureau.
Statistics showed that while 'inter-related transaction' accounts for a big 2.2.6 Tax avoidance through resale and agency arrangements; and
percentage of the transfer of goods and services in the country, the revenue
collection from related-party groups continue to go on a downtrend. 2.2.7 Thin capitalization and earning stripping.

2.3 Use of Section 50 of the NIRC , as amended

2.3.1 The authority for allocating income and expenses between or among d. Economic conditions — refers to the prevailing conditions in the market.
related parties is laid down in Section 50 of the NIRC, as amended. This
Section gives the Commissioner of Internal Revenue the authority to make 2.5 Definition of Terms —
allocation of income and expenses between or among controlled group of
companies, if a related taxpayer has not reported its true taxable income. 2.5.2 The term 'controlled' for purposes of this RAMO shall mean any kind of
control, direct or indirect, whether legally enforceable and however
2.3.2 The purpose of Section 50 is to ensure that taxpayers clearly reflect exercisable or exercised. It is the reality of the control which is decisive, not
income attributable to controlled transactions and to prevent the avoidance its form or the mode of its exercise or ownership. A presumption of control
of taxes with respect to such transactions. It places a controlled taxpayer in arises if income and expenses have been arbitrarily shifted.
tax parity with an uncontrolled taxpayer by determining the arm's-length
price of inter-company transactions. LLphil 2.5.3 The term 'controlled taxpayer' means any one or two or more
organizations or trade, or businesses owned or controlled directly or
2.4 Determination of Arm's Length Price — indirectly by the same interests;

a. The method to be used in determining the arm's-length price depends on 2.5.4 The term 'true taxable income' means, the taxable income which would
the type of transaction — whether the transaction involves a transfer of have been reported by the controlled taxpayer, had it in the conduct of its
property, services, loans, advances, rentals or other arrangements. affairs dealt with the other member or members of the group at arm's-length.
Accordingly, proper judgment must be used taking into consideration the cdasia
peculiarity of the transaction and the presence of available information that
would reliably determine the correct income of a controlled taxpayer. 3. AUDIT PROCEDURES

b. The different methods of determining the arm's length price of a controlled 3.1 Transfer Pricing in interrelated supply of goods or services. This is
transaction under the OECD Rules on transfer pricing may be used as a relevant if one of the related-party enjoys certain privileges such as tax
reference. This includes the use of Comparable Uncontrolled Price Method, exemption, lower tax rates, incentives, or is a losing company.
Resale Method, Cost-plus Method and Gross Profit Margin Method (these
are discussed in detail in the next Section).
3.1.1 In General. — The method to be used in determining the arm's-length
price of a controlled transaction shall rely primarily on the best judgment of
c. In addition, the following must be considered: the examiner after taking into consideration the prevailing circumstances as
well as the availability of information at the time of transaction.
Data and Assumptions — consider the completeness and accuracy of
available data and information and the reliability of assumptions that are to 3.1.2 As a guide, the methods under the OECD Guidelines on transfer
be made. Pricing may be used, as follows:

Comparability — consider similar transactions between unrelated parties. a. The comparable uncontrolled price method (CUP) — this evaluates the
Factors of comparability to be considered in the examination include: arm's length by reference to the amount charged in a comparable
uncontrolled transaction. In evaluating comparability, consider the following:
a. Functional analysis — factors such as product design and engineering,
manufacturing, production and process, marketing and distribution, • trademark
advertising and etc.
• product differences
b. Contractual terms — this include sales and purchase agreements,
volume, nature of warranties, credit and payment terms and other
• geographical differences, and
commercial arrangements.
• extraordinary market conditions;
c. Risks — market risks including fluctuations in demand, financial risks,
collection risk and commercial risks.
b. The Resale Price Method (RPM) — it evaluates arm's length by reference 3.2.3.3 Where one member of a group of controlled entities makes a loan or
to the gross profit margin realized in comparable transactions. advance directly or indirectly, or otherwise becomes the creditor of another
member of such group, an arm's length price for the use of money should be
c. The Cost Plus Method (CPM) — it evaluates the arm's-length by adding charged. The same is true in the case of indebtedness arising in the ordinary
the appropriate gross profit to the controlled taxpayer's cost of producing the course of business such as sales, leases, provision of services and other
property involved in the controlled transaction and then impose the similar extension of credits.
applicable profit rate.
3.3 Performance of Services for Another
d. The Profit Split Method — this is done simply by dividing the profit
between the members involved in the transaction taking into consideration 3.3.1 In general — under this scheme, one member of the group performs
the extent of their participation in the realization of the transaction. marketing, managerial, administrative, technical or other services for the
benefit of, or on behalf of another member of the group without charge or at
3.2 Loans and Advances, and financing arrangements between or among a charge which is not arm's-length.
related parties—
3.3.2 To determine the arm's length price for the service, the "Benefit Test"
3.2.1. In General. When one member of a group makes a loan or advance may be considered. Under this test, the direct benefit to the member which
directly or indirectly to, or otherwise becomes a creditor of another member received the service must be considered. It is necessary to take into account
and either party charges an interest which is not at arm's length, there may on some reasonable basis all the costs or deductions which are directly or
be a tax advantage to either the lender or borrower. indirectly related to the service performed. cdrep

3.2.2 Loans and Advances may be in the form of : 3.3.3 Where tangible or intangible property is transferred, sold, assigned,
loaned, leased or otherwise made available in any manner by one member
a. Bona fide indebtedness such as loans or advances of money or other of a group to another member of the group and services are rendered by the
considerations; transferor in connection with such transfer, the services rendered in such
transaction, provided it is not ancillary, must be valued.
b. Indebtedness arising in the ordinary course of business from sales,
leases, or the rendition of services by and between members of the group, 3.4 Sharing of Costs
or any other similar extension of credit;
3.4.1 In general. A cost sharing arrangement is an agreement under which
c. Alleged indebtedness the parties agree to share the costs in proportion to their respective share of
anticipated benefits. This is very common in joint undertaking and in
expenses such as research and development, office and factory spaces,
For purposes of this Section, an "arm's length rate of interest" is the rate of
legal and consultancy services and etc.
interest which would have been charged in independent transactions
between unrelated parties under similar circumstances. cda
3.4.2 In determining the appropriateness of the sharing arrangement, factors
such as benefits-received, size of the company, participation in the venture,
3.2.3 Financing Arrangements.
and etc. should be considered.
3.2.3.1 A common element in related-party groups is the presence of a
3.5 Thin Capitalization and Earning Stripping
finance company (usually a holding company) to provide financial services
for the members of the group.
3.5.1 In General — The most common form of tax avoidance scheme using
corporate structure is high-debt financing of thinly capitalized controlled
3.2.3.2 Financial services by a holding company may range from serving as
company. This scheme favors debt over equity as a form of financing mainly
a central lender for the group, in which capacity, it may borrow funds from
because of tax favored treatment of interest payments compared to
unrelated financial institutions and on-loan such amounts to its subsidiaries.
dividends.
It may also perform financial intermediary services for the group including
factoring and hedging.
3.5.2 Under present laws, interest payments are fully deductible against
taxable income while dividends are not. The tax advantages of interest
payments in contrast to dividend is an outright savings of 35% (34%-32% SUBJE : Updated Handbook on Audit Procedures and
under CTRP) in the form of a deductible expense against the taxable base. If CT Techniques Volume I (Revision —Year 2000)
interest payments are subjected to 20% Final Tax (while intercorporate
dividends are at 0% tax), financing through debt rather than equity would still
have an advantage equivalent to 15%.

3.5.3 In the absence of rules prescribing guidelines and presumptions as to

what constitute thin capitalization (unlike other countries), there is a
necessity to determine the reasonable ratio of debt over equity considering
all factors surrounding the case. TO : All Internal Revenue Officers and Others Concerned

4. EFFECTIVITY
IX. Balance Sheet Approach to Examination
This RAMO shall take effect immediately. c
Cash on Hand and in Bank
||| ( Audit Guidelines and Procedures in the Examination of Interrelated
Group of Companies, Revenue Audit Memorandum Order No. 1-98, [July 7,
1998]) Notes and Accounts Receivable

Allowance for Bad Debts

Inventories

Advances to Stockholders/Officers

Investments

Depreciable Assets

Allowances for Depreciation, Amortization and Other Valuations

Reserves

Intangible Assets

Prepaid Expenses and Deferred Charges

Other Assets
Revenue Audit Memorandum Order No. 1-00 Rule IX. P. 1 (March 17,
2000)] (note: ewan nasan yung P.1)
Exchange, Clearing or Suspense Accounts
REVENUE AUDIT MEMORANDUM ORDER NO. 1-00
Current and Accrued Liabilities including Notes Payable
Fixed Liabilities dividends are at 0% tax), financing through debt rather than equity would still
have an advantage equivalent to 15%.
Deferred Credits
3.5.3 In the absence of rules prescribing guidelines and presumptions as to
Loans From Shareholders/Officers/Owners what constitute thin capitalization (unlike other countries), there is a
necessity to determine the reasonable ratio of debt over equity considering
Capital Accounts all factors surrounding the case.

Capital or Owner's Equity ||| ( Audit Guidelines and Procedures in the Examination of Interrelated
Group of Companies, Revenue Audit Memorandum Order No. 1-98, [July 7,
1998])
Partners' Capital

Stockholders' Equity

Capital Stock

Retained Earnings

||| (Updated Handbook on Audit Procedures and Techniques Volume I

(Revision —Year 2000), Revenue Audit Memorandum Order No. 1-00,
[March 17, 2000])

· Oranbo Realty Corp. v. Cir, C.T.A. Case No. 5082. (January 16,
1997);

ORANBO REALTY CORPORATION vs. CIR

January 16, 1997| Acosta | Thin Capitalization

Revenue Audit Memorandum Order No. 1-98 ―Audit Guidelines and PETITIONER: ORANBO REALTY CORPORATION
Procedures in the Examination of Interrelated Group of Companies‖ RESPONDENTS: COMMISSIONER OF INTERNAL REVENUE
(July 7, 1998) §3.5
SUMMARY: Oranbo leases its properties to Aris Philippines, Inc. and
3.5 Thin Capitalization and Earning Stripping
Sehwani, Inc. from which it realized a total rental income. Out of the
3.5.1 In General — The most common form of tax avoidance scheme using income payments of Aris Philippines, Inc., a 5% expanded withholding tax
corporate structure is high-debt financing of thinly capitalized controlled was deducted by Aris.
company. This scheme favors debt over equity as a form of financing mainly
because of tax favored treatment of interest payments compared to Oranbo filed its income tax return for the calendar year ending December
dividends. 31, 1991 reflecting a net taxable income of P145,058 with an income tax
liability of P50,770.00 but with a refundable income tax in the amount of
3.5.2 Under present laws, interest payments are fully deductible against P922,311arising from the unutilized portion of the 5% expanded
taxable income while dividends are not. The tax advantages of interest
withholding tax from Aris. It filed a written claim for refund or tax credit
payments in contrast to dividend is an outright savings of 35% (34%-32%
under CTRP) in the form of a deductible expense against the taxable base. If with the Bureau BIR on April 28, 1993. Due to inaction, Oranbo filed the
interest payments are subjected to 20% Final Tax (while intercorporate
instant petition for review on March 28, 1994 in order to preserve its right
to judicially claim for the refund. Oranbo was ablel to comply with the following 3 basic requisites:
a) it filed a claim for refund within the 2 year period from date of
While the case was pending trial, CIR caused the immediate investigation payment of the tax
of Oranbo‘s request for refund. A memorandum report of investigation b) Income upon which the taxes were withheld at source were
was served finding Oranbo liable for deficiency income tax. (See Fact # 9 included as part of the income declared in the income tax return
for the full report). c) The fact of withholding is established by a copy of statement
(BIR Form 1743.1) duly issued by the payor (withholding agent) to the
Whether or not the revenue examiner's report of investigation can payee, showing the amount paid and the amount of tax withheld.
negate Oranbo’s's entitlement for the refund? -NO
Note: This case is under the topic Thin Capitalization, but the case does
For Item A: Loan with BPI. not discuss it. The only mention of the topic is in the report of the revenue
The acquisition of shares of stocks of NOMA Development cannot in any officer under Item A: ―Furthermore, the loans obtained greatly exceeds the
way reflect in the financial statements of Oranbo because NOMA stock/equity of ORANBO and should have been treated as investment in
Development Corporation was earlier dissolved on December 31, 1988. stock by the creditor bank. In our jurisdiction we follow the thin
As a matter of fact, the shares of stock acquired by Oranbo were replaced incorporation rule, whereby loans obtained in excess of capitalization shall
by real estate of NOMA Development Corporation by way of liquidating be treated as equity contribution (capital investments on the part of the
dividends due to its dissolution. lender) and not as liabilities.‖

For Item B: Loan with UCPB

1997 NIRC does not prohibit the deduction of interest on a loan incurred
FACTS:
for acquiring machinery and equipment. Neither does it compel the
1. This appeal involves Oranbo Realty Corporation's claim for
capitalization of interest payments on such a loan. It is simply silent on a
refund or tax credit of the sum of P922,311.00, representing
taxpayer's right to elect one or the other. Accordingly, the general rule that
overpaid creditable withholding tax for calendar year ended
interest payments on a legally demandable loan are deductible from gross
December 31, 1991.
income must be applied.
2. Oranbo Royalty Corporation (Oranbo) is a domestic
corporation duly organized and existing under the laws of the
For Item C: Due to Aris Philippines
Philippines with business address at 4th Floor, Sycip Law All
The Court noted that Aris Philippines, Inc. only owns 40% of the
Asia Bldg., Paseo de Roxas, Makati, Metro Manila.
outstanding stock of Oranbo. Since Aris Philippines, Inc. does not own
3. For 1991, Oranbo leases its properties to Aris Philippines, Inc.
more than 50% of the outstanding stock of Oranbo the Oranbo then it is
and Sehwani, Inc. from which it realized a total rental income in
not covered under the items not deductible as a business expense. Thus,
the amount of P19,761,612.00:
they are not related taxpayers. Also the fact that Mr. Rolf H. Schroeder, is
4. Oranbo alleged that out of the income payments of Aris
the Chairman of Oranbo and at the same time President of Aris
Philippines, Inc., a 5% expanded withholding tax was deducted
Philippines, Inc. does not mean that the corporations he represented are
by Aris in the sum of P973,081.
related taxpayers. There should be evidence to support that they are
5. April 15, 1992 - Oranbo filed its income tax return for the
related taxpayers.
calendar year ending December 31, 1991 reflecting a net
taxable income of P145,058 with an income tax liability of
Whether or not Oranbo has proven its entitlement to the refund? -
P50,770.00 (P145,058.00 x 35%) but with a refundable income
YES
tax in the amount of P922,311arising from the unutilized
portion of the 5% expanded withholding tax from Aris:
 Changes in Financial Position) showed that the taxpayer
6. This overpaid income tax for 1991 was not utilized by Oranbo acquired land in the amount of P25,821,745.00.
in 1992. Instead, it opted to file a written claim for refund or tax Since the proceeds of the loan was used in the purchase
credit with the Bureau of Internal Revenue on April 28, 1993. of real estate above the correct treatment should be to
7. Because of CIR‘s inaction Oranbo filed the instant petition for capitalize the interest expense attributable to the purchase
review on March 28, 1994 in order to preserve its right to price. It is a settled rule that the cost of money (interest
judicially claim for the refund of excess payment of creditable expense) and all other capital assets is a capital
withholding tax pursuant to Section 230 of the National expenditure.
Revenue Code, as amended. Rationale behind this rule is that land do not depreciate,
8. While the case was pending trial, CIR caused the immediate save only on some exceptional cases, in fact in most
investigation of Oranbo‘s request for refund through Referral instances it appreciates. It is therefore proper that the
Letter No. 6447/461, dated November 14, 1994, issued to expenses incurred for the acquisition of said property
Revenue Enforcement Officer Roberto Baquiran. should be capitalized as part of the cost and not charged
9. November 21, 1994 - a memorandum report of investigation to operation as current expenses.
was served by said Baquiran finding Oranbo liable for
deficiency income tax of P10,442,959.84. The report is as C. Due to Aris Philippines was series advances way back
follows: in 1984. Aris Phil. (ARIS for short) is a 40% stockholder of
"FINDINGS: ORANBO. All of this advances were used in the
We disallow the interest expense claimed for the following purchased land and in meeting working capital
reasons: requirements. The records show that advances taken are
1. Item A; Loan from BPI was incurred on July 19, 1989 sometimes settled in kind. (dacion en pago) real estate.
and the purpose of the loan was to finance the acquisition ORANBO leases all its land and building to ARIS. (See
by ORANBO (taxpayer) of all outstanding shares of stock Notes to 1991 F/S). As can be seen above, �nancial
of NOMA Devt. Corp. (see Term Loan Agreement dated pro�le, the company declared a taxable net income of
July 19, 1989 page 116). Financial statements from 1990- P145,058.00 from gross income of 19,884,420.00 or
1991 however, do not reflect these transactions (purchase measly .00729 or seventh of one-percent. The land and
of shares of stock and its disposition, the proceeds of building leased is valued at P96,744,856.00. The records
disposition, gain/loss from disposition, etc.) do not show any lease contract between the parties
This indicates that the loan is not only inexistent but also neither is there a way to establish or standards to be used
fictitious or simulated. The taxpayer should be required to to determine whether the amount of rental being paid by
submit proof of the transactions above. ARIS is based on commercial rates.
Furthermore, the loans obtained greatly exceeds the ORANBO and ARIS are related taxpayers if not commonly
stock/equity of ORANBO and should have been treated as owned by one or group of stockholder. While the taxpayer
investment in stock by the creditor bank. In our jurisdiction admits being 40% owned by ARIS the document however
we follow the thin incorporation rule, whereby loans show otherwise. In various loan document entered into by
obtained in excess of capitalization shall be treated as ORANBO with third party (BPI & UCPB), it is being
equity contribution (capital investments on the part of the represented by Mr. ROLF H. SCHROEDER as Chairman
lender) and not as liabilities. of ORANBO REALTY CORP. But in ORANBOs
transaction with ARIS, this time ORANBO is represented
Item B. Loan from UCPB, for P27,000,000.00, was by Mr. BENILDO G. HERNANDEZ as President, while
incurred on August 15, 1990 for working capital ARIS is represented by Mr. ROLF H. SCHROEDER, as
requirements. Financial statement for 1990 (Statement of President.
 properties together with its improvements without any
It is a settled rule in this jurisdiction that payment of consideration but by way of liquidating dividence in pursuance
interest between related taxpayers are not deductible to the dissolution of Noma Development Corporation‖
because of (possible) connivance. 3. Clearly, the acquisition of shares of stocks of NOMA
Development cannot in any way reflect in the financial
Taking all the above circumstances, we are left with no statements of Oranbo because NOMA Development
option but to recommend for the disallowance of the entire Corporation was earlier dissolved on December 31, 1988. As a
interest expenses claimed as deduction. matter of fact, the shares of stock acquired by Oranbo were
replaced by real estate of NOMA Development Corporation by
In view thereof, we most respectfully recommend that all way of liquidating dividends due to its dissolution.
the interest expenses claimed as deduction be disallowed
and assessment based on adjusted taxable income be For Item B: Loan with UCPB
approved." 1. CIR: interest expense pertaining to the loan from UCPB which
was used to purchase land should be capitalized.
ISSUE/s: 2. The Court did not agree. The Court cited various
1. Whether or not the revenue examiner's report of investigation jurisprudence applicable in this case: ―Although it involves the
can negate Oranbo‘s's entitlement for the refund? -NO allowance of interest on loans for the purchase of machinery
2. Whether or not Oranbo has proven its entitlement to the and equipment as a deduction from gross income, it
refund? -YES nevertheless may apply to interest expense paid on loan
contracted by herein petitioner from UCPB since it involves the
RULING: CIR is hereby ORDERED to REFUND or in the alternative to purchase of capital asset out of a loan obtained from a bank.‖
ISSUE A TAX CREDIT CERTIFICATE in favor of Oranbo the sum of 3. In the PICOP case:
P922,311 representing overpaid income tax for the year 1991. · Picop obtained loans from foreign creditors in order
to finance the purchase of machinery and equipment
RATIO: needed for its operations. In its 1977 Income Tax
Return, Picop claimed interest payments made in
st
1 Issue: Revenue examiner's report of investigation did NOT negate 1977 on these loans as a deduction from its 1977
Oranbo‘s's entitlement for the refund. gross income. CIR disallowed this deduction because
1. CIR asserts that Oranbo is not entitled to refund or tax credit the loans had been incurred for the purchase of
because of the report of the revenue officer. machinery and equipment, the interest payments on
those loans should have been capitalized instead and
For Item A: Loan with BPI claimed as a depreciation deduction. Both the CTA
1. Revenue Officer: the interest expense arising from the loan and the CA held that the interest deduction claimed
from BPI is not deductible. The financial statements for the by Picop was proper and allowable.
years 1990- 1991 do not reflect the purchase of all the · Interest payments on loans incurred by a taxpayer
outstanding shares of stock of NOMA Development (whether BOI-registered or not) are allowed by the
Corporation. Thus, reaching to a conclusion that such loan is NIRC as deductions against the taxpayer's gross
fictitious and inexistent. income (Section 30 of the NIRC).
2. In an earlier case involving Oranbo, the Court stated that: ―A · CIR invokes Section 79 of the Revenue Regulations
Deed of Conveyance was executed by Noma Development No. 2: ―Interest calculated for cos- keeping or other
Corporation (Assignor) and Oranbo Realty Corporation purposes on account of capital surplus invested in the
(Assignee) on June 29, 1990 with respect to the transfer of real business, which does not represent a charge arising
 under an interest- bearing obligation, is not allowable
deduction from gross income ‖ For Item C: Due to Aris Philippines
o But the Court said that what Section 79 1. CIR: alleges that Oranbo and Aris Philippines are related
makes clear is that interest which does taxpayers. Thus, it is disallowed the deduction of the subject
constitute a charge arising under an interest expense pursuant to Section 29 (b) (2) (ii) of the Tax
interest-bearing obligation is an allowable Code.
deduction from gross income. 2. The Court however noted that Aris Philippines, Inc. only owns
· CIR also alleges that: Section 79 is "patterned after" 40% of the outstanding stock of Oranbo. Since Aris
paragraph 1.266-1 (b), entitled "Taxes and Carrying Philippines, Inc. does not own more than 50% of the
Charges Chargeable to Capital Account and Treated outstanding stock of Oranbo then it is not covered under the
as Capital Items" of the U.S. Income Tax Regulations. items not deductible as a business expense.
It charges to capital account items pertaining to real 3. Also the fact that Mr. Rolf H. Schroeder, being the Chairman
property and also interest on a loan (but nor of Oranbo and at the same time President of Aris Philippines,
theoretical interest). Inc. does not mean that the corporations he represented are
o However the Court said that it must be read related taxpayers. There should be evidence to support that
with the related relevant provisions of the they are related taxpayers.
US Internal Revenue Code. It states that
'carrying charges' may, either be (a)
nd
capitalized in which case the cost basis of 2 ISSUE: Oranbo has proved that it is entitled to the refund/tax credit.
the capital assets will be adjusted by 1. Oranbo must comply with 3 basic requisites:
adding the amount of such interest a) it filed a claim for refund within the 2 year period
payments or, alternatively, be (b) deducted from date of payment of the tax
from gross income of the taxpayer. b) Income upon which the taxes were withheld at
· 1997 NIRC does not prohibit the deduction of interest source were included as part of the income declared
on a loan incurred for acquiring machinery and in the income tax return
equipment. Neither does it compel the capitalization c) The fact of withholding is established by a copy of
of interest payments on such a loan. It is simply silent statement (BIR Form 1743.1) duly issued by the
on a taxpayer's right to elect one or the other. payor (withholding agent) to the payee, showing the
Accordingly, the general rule that interest payments amount paid and the amount of tax withheld
on a legally demandable loan are deductible from 2. In this case, Oranbo has satisfactorily proven its claim for
gross income must be applied. refund/tax credit.
· CIR: to allow Picop to deduct its interest payments a) Oranbo has filed its claim for refund/tax credit within
against its gross income would be to encourage the two-year period with the BIR and with this Court.
fraudulent claims to double deductions from gross o The letter-claim for refund/tax credit was
income. filed with the BIR on April 28, 1993 and the
o The Court did not agree because Picop has petition for review was filed on March 28,
not claimed to be entitled to double 1994. The two- year period, in the instant
deduction of its 1977 interest payments. case, commences to run on April 15,
The CIR has neither alleged nor proved 1992, the actual date of filing Oranbo‘s
that Picop had previously adjusted its cost 1991 Annual Income Tax Return which is
basis of the machinery and equipment also the time required by law for a
purchased and claim. taxpayer to file the income tax return
 o The certificate of creditable withholding tax
at source (BIR Form 1743.1), was offered
in evidence which sufficiently established
the amount of creditable withholding tax
for the year 1991.

· Commissioner of Internal Revenue v. Court of Tax Appeals and

Oranbo Realty Corporation, CA-G.R. SP No. 44039 (October 10, 2001)
7 Revisiting the Share of Stock subscribed and paid by each on the subscription, and a statement that some
7.1 Capital Stock and Shares of Stock: REVISED CORPORATION CODE or all of the shares are without par value, if applicable;
§62
SEC. 14. Form of Articles of Incorporation. – Unless otherwise prescribed
SEC. 62. Certificate of Stock and Transfer of Shares. – The capital stock by special law, the articles of incorporation of all domestic corporations shall
of corporations shall be divided into shares for which certificates signed by comply substantially with the following form:
the president or vice president, countersigned by the secretary or assistant
secretary, and sealed with the seal of the corporation shall be issued in Seventh: That the authorized capital stock of the corporation is
accordance with the bylaws. Shares of stock so issued are personal property ______________ PESOS (P________), divided into _____ shares with the
and may be transferred by delivery of the certificate or certificates indorsed par value of ____________ PESOS (P_______________) per share. (In
by the owner, his attorney- in-fact, or any other person legally authorized to case all the shares are without par value): That the capital stock of the
make the transfer. No transfer, however, shall be valid, except as between corporation is __________________________ shares without par value.
the parties, until the transfer is recorded in the books of the corporation
showing the names of the parties to the transaction, the date of the transfer, (In case some shares have par value and some are without par value): That
the number of the certificate or certificates, and the number of shares the capital stock of said corporation consists of
transferred. The Commission may require corporations whose securities are __________________________ shares, of which
traded in trading markets and which can reasonably demonstrate their _______________________ shares have a par value of
capability to do so to issue their securities or shares of stocks in _________________ PESOS (P____________) each, and of which
uncertificated or scripless form in accordance with the rules of the _______________________ shares are without par value.
Commission.
No shares of stock against which the corporation holds any unpaid claim Eighth: That the number of shares of the authorized capital stock above-
shall be transferable in the books of the corporation. stated has been subscribed as follows:

7.2 Authorized Capital Stock: REVISED CORPORATION CODE §12,

Name of Nationa No. of Shares Amount Amount
§13(h); §14, the Seventh & Eight paragraph.
Subscriber lity Subscribed Subscribed Paid
SEC. 12. Minimum Capital Stock Not Required of Stock Corporations. –
Stock corporations shall not be required to have a minimum capital stock,
except as otherwise specifically provided by special law.

SEC. 13. Contents of the Articles of Incorporation. – All corporations

shall file with the Commission articles of incorporation in any of the official
languages, duly signed and acknowledged or authenticated, in such form
and manner as may be allowed by the Commission, containing substantially
the following matters, except as otherwise prescribed by this Code or by
special law:
xxx
(h) If it be a stock corporation, the amount of its authorized capital stock,
number of shares into which it is divided, the par value of each, names,
nationalities, and residence addresses of the original subscribers, amount
(Modify No. 8 if shares are with no-par value. In case the corporation is 2) in the case of stock dividends, it is the amount that the corporation
nonstock, Nos. 7 and 8 of the above articles may be modified accordingly, transfers from its surplus profit account to its capital account, that is, the
and it is sufficient if the articles state the amount of capital or money amount the stock dividends represent is equivalent to the value paid for its
original issuance.
contributed or donated by specified persons, stating the names, nationalities,
and residence addresses of the contributors or donors and the respective
Thereafter, NTC again issued assessments based on the Decision. The
amount given by each.) assessments included the value of stock dividends issued by PLDT based
on the schedule of capital stock submitted by PLDT.

PLDT now contends that our disposition in G.R. No. 127937 excluded stock
dividends from the SRF coverage, while the NTC asserts the contrary. It
argues that the Decision clearly delineates between capital subscribed and
7.3 Outstanding Capital Stock REVISED CORPORATION CODE §173 stock dividends to the effect that the latter are not included in the concept of
capital stock subscribed because subscribers or shareholders do not pay for
their subscriptions as no amount is received by the corporation in
SEC. 173. Outstanding Capital Stock Defined. – The term ―outstanding consideration of such issuances since these are effected as mere book
capital stock‖, as used in this Code, shall mean the total shares of stock entries, that is, the transfer from the retained earnings account to the capital
issued under binding subscription contracts to subscribers or stockholders, or stock account. To bolster its position, PLDT repeatedly used the phrase
whether fully or partially paid, except treasury shares. "actual payments" received by a corporation as a consideration for
issuances of shares which do not apply to stock dividends.

PLDT v NTC 539 SCRA 365(2007) Also, PLDT questions the assessments for violating our disposition in G.R.
No. 127937 since these assessments were identical to the previous
assessments from 1988 which were questioned by PLDT in G.R. No.
FACTS: PLDT assails the assessments made by NTC pursuant to the
127937 for being based on the market value of its outstanding capital stock.
Public Service Act (PSA), alleging that the same was contrary to a previous
ruling made by the SC.
Issues:
1) WON stock dividends are included in the SRF Coverage --- YES
Under the PSA, the NTC was authorized to collect from public 2) WON the NTC assessments are valid even if identical to the one it
telecommunications companies Supervision and Regulation Fees (SRF) of
made before --- YES
PhP 0.50 for every PhP 100 or a fraction of the capital and stock subscribed
or paid for of a stock corporation, partnership or single proprietorship of the
Held:
capital invested, or of the property and equipment, whichever is higher. 1) Stock Dividends Part of SRF Coverage
The term "capital" and other terms used to describe the capital structure of a
NTC assessed PLDT based on the market value of the outstanding capital corporation are of universal acceptance and their usages have long been
stock, including stock dividends, of PLDT. PLDT protested the assessments established in jurisprudence. Briefly, capital refers to the value of the
contending that the SRF ought to be based on the par value of its property or assets of a corporation. The capital subscribed is the total
outstanding capital stock. amount of the capital that persons (subscribers or shareholders) have
agreed to take and pay for, which need not necessarily by, and can be
The case went all the way to the SC, and it ruled in G.R. No. 127937, more than, the par value of the shares. In fine, it is the amount that the
(hereinafter the Decision): corporation receives, inclusive of the premiums if any, in consideration
of the original issuance of the shares. In the case of stock dividends, it
1) the SRF should be based neither on the par value nor the market value of is the amount that the corporation transfers from its surplus profit
the outstanding capital stock but on the value of the stocks subscribed or account to its capital account. It is the same amount that can be loosely
paid including the premiums paid therefor, that is, the amount that the termed as the "trust fund" of the corporation. The "Trust Fund" doctrine
corporation receives, inclusive of the premiums if any, in consideration of the considers this subscribed capital as a trust fund for the payment of the debts
original issuance of the shares. of the corporation, to which the creditors may look for satisfaction.
Dividends, regardless of the form these are declared, that is, cash, property for the subscription are recorded at the actual payment, including the
or stocks, are valued at the amount of the declared dividend taken from the premiums paid for the subscription of capital stock.
unrestricted retained earnings of a corporation.
Moreover, it is common practice that the values of the accounts recorded at
When stock dividends are distributed, the amount declared ceases to belong historical value or cost are not increased or decreased due to market forces.
to the corporation but is distributed among the shareholders. Consequently, In the case of properties, the appreciation in values is generally not recorded
the unrestricted retained earnings of the corporation are diminished by the as income nor the increase in the corresponding asset because the increase
amount of the declared dividend while the stockholders‘ equity is increased. or decrease is not yet realized until the property is actually sold. The same is
Furthermore, the actual payment is the cash value from the unrestricted true with the capital account. The market value may be much higher than the
retained earnings that each shareholder foregoes for additional actual payment of the par value and premium of capital stock. Still, the
stocks/shares which he would otherwise receive as required by the books of account will not reflect such increase; and vice-versa, any decrease
Corporation Code to be given to the stockholders subject to the availability of the value of stocks is likewise not reflected in the books of account. Thus,
and conditioned on a certain level of retained earnings. Elsewise put, where given the general practice that book entries of the premiums and
the unrestricted retained earnings of a corporation are more than 100% of subscriptions for capital stock are the actual value for the original issuance
the paid-in capital stock, the corporate Board of Directors is mandated to of stocks, then the NTC was correct to follow the schedule of capital stocks
declare dividends which the shareholders will receive in cash unless submitted by PLDT.
otherwise declared as property or stock dividends, which in the latter case
the stockholders are forced to forego cash in lieu of property or stocks.
7.4 Minimum paid-up and share subscription: REVISED CORPORATION
In essence, therefore, the stockholders by receiving stock dividends are CODE, §37
forced to exchange the monetary value of their dividend for capital stock,
and the monetary value they forego is considered the actual payment for the
original issuance of the stocks given as dividends. Therefore, stock SEC. 37. Power to Increase or Decrease Capital Stock; Incur, Create or
dividends acquired by shareholders for the monetary value they forego are Increase Bonded Indebtedness. – No corporation shall increase or
under the coverage of the SRF and the basis for the latter is such monetary decrease its capital stock or incur, create or increase any bonded
value as declared by the board of directors. indebtedness unless approved by a majority vote of the board of directors
and by two-thirds (2/3) of the outstanding capital stock at a stockholders‘
2) NTC Assessments Valid meeting duly called for the purpose. Written notice of the time and place of
the stockholders‘ meeting and the purpose for saidmeeting must be sent to
(Ratio in essence: merely followed the schedule of capital stocks submitted the stockholders at their places of residence as shown in the books of the
by PLDT; values of the accounts recorded at historical value or cost are not
corporation and served on the stockholders personally, or through electronic
increased or decreased due to market forces; the same holds true for capital
stock) means recognized in the corporation‘s bylaws and/or the Commission‘s rules
as a valid mode for service of notices.
PLDT should not bewail that the assailed assessments are substantially the
same assessments it protested in G.R. No. 127937. After all, it had not A certificate must be signed by a majority of the directors of the corporation
shown the actual figures of the amount of premiums and subscriptions it had and countersigned by the chairperson and secretary of the stockholders‘
received for the original issuances of its capital stock. While indeed it meeting, setting forth:
submitted a table of the comparative assessments made by the NTC to this (a) That the requirements of this section have been complied with;
Court, PLDT has not furnished the NTC nor this Court the correct figures of
(b) The amount of the increase or decrease of the capital stock;
the actual payments made for its capital stock.
(c) In case of an increase of the capital stock, the amount of capital stock or
We are not unaware that in accounting practice, the journal entries for number of shares of no-par stock thereof actually subscribed, the names,
transactions are recorded in historical value or cost. Thus, the purchase of nationalities and addresses of the persons subscribing, the amount of capital
properties or assets is recorded at acquisition cost. The same is true with stock or number of no-par stock subscribed by each, and the amount paid by
liabilities and equity transactions where the actual loan and the amount paid each on the subscription in cash or property, or the amount of capital stock
or number of shares of no-par stock allotted to each stockholder if such
increase is for the purpose of making effective stock dividend therefor 7.5.1 Shares without par value: REVISED CORPORATION CODE §6,
authorized; paragraph 5 & 7; §61, last paragraph
(d) Any bonded indebtedness to be incurred, created or increased;
(e) The amount of stock represented at the meeting; and SEC. 6. Classification of Shares. – The classification of shares, their
(f) The vote authorizing the increase or decrease of the capital stock, or the corresponding rights, privileges, or restrictions, and their stated par value, if
incurring, creating or increasing of any bonded indebtedness. any, must be indicated in the articles of incorporation. Each share shall be
equal in all respects to every other share, except as otherwise provided in
Any increase or decrease in the capital stock or the incurring, creating or the articles of incorporation and in the certificate of stock.
increasing of any bonded indebtedness shall require prior approval of the Xxxx
Commission, and where appropriate, of the Philippine Competition
Commission. The application with the Commission shall be made within six
(6) months from the date of approval of the board of directors and The shares or series of shares may or may not have a par value: Provided,
stockholders, which period may be extended for justifiable reasons. That banks, trust, insurance, and preneed companies, public utilities,
building and loan associations, and other corporations authorized to obtain
Copies of the certificate shall be kept on file in the office of the corporation or access funds from the public, whether publicly listed or not, shall not be
and filed with the Commission and attached to the original articles of permitted to issue no-par value shares of stock.
incorporation. After approval by the Commission and the issuance by the
Commission of its certificate of filing, the capital stock shall be deemed
increased or decreased and the incurring, creating or increasing of any Preferred shares of stock issued by a corporation may be given preference
bonded indebtedness authorized, as the certificate of filing may declare: in the distribution of dividends and in the distribution of corporate assets in
Provided, That the Commission shall not accept for filing any certificate of case of liquidation, or such other preferences: Provided, That preferred
increase of capital stock unless accompanied by a sworn statement of the shares of stock may be issued only with a stated par value. The board of
treasurer of the corporation lawfully holding office at the time of the filing of directors, where authorized in the articles of incorporation, may fix the terms
the certificate, showing that at least twenty-five percent (25%) of the and conditions of preferred shares of stock or any series thereof: Provided,
increase in capital stock has been subscribed and that at least twenty-five further, That such terms and conditions shall be effective upon filing of a
percent (25%) of the amount subscribed has been paid in actual cash to the certificate thereof with the Securities and Exchange Commission, hereinafter
corporation or that property, the valuation of which is equal to twenty-five referred to as the ―Commission‖.
percent (25%) of the subscription, has been transferred to the corporation:
Provided, further, That no decrease in capital stock shall be approved by the Shares of capital stock issued without par value shall be deemed fully paid
Commission if its effect shall prejudice the rights of corporate creditors. and nonassessable and the holder of such shares shall not be liable to the
corporation or to its creditors in respect thereto: Provided, That no-par value
Nonstock corporations may incur, create or increase bonded indebtedness shares must be issued for a consideration of at least Five pesos (P5.00) per
when approved by a majority of the board of trustees and of at least two- share: Provided, further, That the entire consideration received by the
thirds (2/3) of the members in a meeting duly called for the purpose. corporation for its no-par value shares shall be treated as capital and shall
not be available for distribution as dividends.
Bonds issued by a corporation shall be registered with the Commission,
which shall have the authority to determine the sufficiency of the terms A corporation may further classify its shares for the purpose of ensuring
thereof. compliance with constitutional or legal requirements.

SEC. 61. Consideration for Stocks. Xxx The issued price of no-par value
7.5 Share Value shares may be fixed in the articles of incorporation or by the board of
directors pursuant to authority conferred by the articles of incorporation or
the bylaws, or if not so fixed, by the stockholders representing at least a stated proportionate interest in the capital stock measured by value,
majority of the outstanding capital stock at a meeting duly called for the but only an aliquot part of the whole number of such shares of
purpose. the corporation issuing it.
3. Section 20(e) of the Public Service Law was deemed repealed
when the new Corporation Code took effect on May 1, 1980.
Sections 6 and 146 of the Code provide as follows
● What do no par value shares represent and why no par value a. banks, trust companies, insurance companies, public
shares are not permitted for certain companies: SEC Letter dated utilities and building and loan associations shall not
December 5, 1984 issued to Negros Navigation Company, Inc. be permitted to issue no par value shares.
by SEC Chairman Manuel G. Abello b. Under Section 148 of the Corporation Code, existing
corporations affected by the new requirements under the
Code are given a period of two years from its effectivity
FACTS:
(May 1, 1980) within which to comply with the same. Since
1. Negros Navigation Company, Inc. was incorporated under Act. No.
the corporation did not file an amendment to its articles of
1459, otherwise known as the Corporation Law — where the
incorporation acceptable to the Commission on or before
issuance of NO PAR value shares by public utilities was not
May 1, 1982, the Commission will consider the limitation
prohibited, provided said companies where authorized by the Public
laid down by Section 6 of the Corporation Code as written
Service Commission (Section 20, Public Service Law) It has an
into the said articles on May 1, 1980.
authorized capital stock of 260,000 no par value shares, of which
4. Generally, it would appear that Negros Navigation Co., Inc. has to
233,200 shares appear to have been subscribed as per the audited
reclassify its authorized capital stock from no par to par value
financial statement of the company as of December 31, 1983.
shares as of May 1, 1980.
2. When the Corporation Code took effect on May 1, 1980, public
5. EXCEPTION: PUBLIC SERVICE LAW:On the other hand,
utilities are no longer authorized to issue no par value shares
sometimes we go beyond the language of the statute and seek the
notwithstanding approval of the regulatory board. Inasmuch as
assistance of extrinsic aids in its construction. In this regard, the
Negros Navigation Co., Inc. was registered under the former
intent of the legislature is of supreme importance.
Corporation Law (Act #1459), on the basis of no par value capital
a. As aptly stated by Minister Mendoza:
structure, it now seeks exemption from Section 6 of the new
b. "There is a difference between a public utility as a
Corporation Code.
corporation on the one hand, and banks, trust companies,
insurance companies and building and loan associations
ISSUES/QUERIES
on the other. If one may identify the unifying
1. Can the 232,666 issued and outstanding shares and the 534
characteristics of banks, trust companies, insurance
subscribed shares remain as no par value shares inasmuch as the
companies and building and loan associations, it is a
owners and subscribers bought/subscribed to said shares on the
relationship or a high degree of trust between the
basis of a no par value under the former Corporation Law? – Yes,
corporate entity as such; and in the case of banks, the
issued no par can be retained.
depositors; in the case of trust companies, the
2. Since the balance of 26,800 unsubscribed shares have been
beneficiaries; as well as the trustors, in the case of
authorized as no par value shares by the SEC, can said shares be
building and loan associations. However, in the case of a
issued still on a no par value basis? = No, unissued no par must
public utility corporation, that kind of trust
be converted to par value shares by filing an amended AOI
relationship really does not exist. Rather, the nature of
the business of this public utility corporation is affected
RULING:
with a public interest because the services it renders are
1. Under Act. No. 1459, otherwise known as the Corporation Law,
to the public in general. But there is no trust relationship
public utilities were not prohibited from issuing no par value shares,
between the public in general and the public utility
provided they were so authorized under Section 20(e) of the Public
corporation.
Service Law.
6. It was evident from the Batasan deliberation that considering the
2. No par value shares as the name implies, is a stock without
nature of the business of banks, trust companies, insurance
any nominal or par value stated in terms of dollars or dollar's
companies and building and loan associations, the amount of their
worth; and a share of such stock does not purport to represent any
 capital should be made more or less easily identifiable by the Pachecos did not sell the property, there was no sale but merely an
public. exchange of land for shares of stock in their own corporation.
7. And, in order not to leave any ambiguity, for others may argue ● Respondents argue that Delpher is a corporate entity separate and
that the Public Service Act, being a special law, is not
distinct from the Pachecos. It cannot be said that Delpher is the
implicitly repealed by Sec. 6 of the Corporation Code, and
consequently the rule on implied repeal should not apply, upon Pacheco‘s alter ego or conduit. That Delfin, having treated Delpher
suggestion of Assemblyman Fuentebella the words "public utilities" as such a separate and distinct corporate entity, is not a party who
were inserted in the subject proviso of Section 6 of the Corporation may allege that this separate corporate existence should be
Code (Consideration of C.B. No. 3 on second reading, dated disregarded and that there was actual transfer of ownership interest
February 25, 1980). over the leased property when the same was transferred to Delpher
8. In the light of the legislative intent on the matter, it is opined that in exchange for the latter‘s shares of stock
anent your first query, Negros Navigation Co., Inc. may retain the
total of 233, 200 no par value shares which have been already
issued by the corporation as of December 31, 1983. (See ISSUE: WON the Deed of Exchange executed by the Pachecos and
attached financial statements of the company as of December 31, Delpher was meant to be a contract of sale, which prejudiced
1983). respondent’s right of first refusal. (NO)
9. Your second query is answered in the negative. And, as anticipated
in your third query, you have to file with this Commission the RATIO:
amended articles of incorporation of Negros Navigation Co., ● The Delpher Trades Corporation is a business conduit of the
Inc., duly executed in accordance with Section 16 of the
Corporation Code, converting its 26,800 unsubscribed no par Pachecos. What they really did was to invest their properties and
value shares into shares with par value. It is, however, vital that change the nature of their ownership from unincorporated to
in the conversion of no par value shares to shares with par value, incorporated form by organizing Delpher Trades Corporation to
there should be no alteration of interest giving rise to any take control of their properties and at the same time save on
substantial change in each shareholder's percentage interest in the inheritance taxes.
total assets of the corporation. ● The Deed of Exchange of property cannot be a considered a
contract of sale since there was no transfer of actual ownership
● Rationale behind a no-par value share: Delpher Trades
interests by the Pachecos to a third party. The Pacheco family
Corporation v. Intermediate Appellate Court, 157 SCRA 349
merely changed their ownership from one form to another.
(1988)
● There is nothing wrong or objectionable about the estate planning
● Delfin Pacheco and his sister, Pelagia Pacheco, were the owners of
scheme resorted to by the Pachecos. ―The legal right of a taxpayer
27,169 square meters of real estate in Valenzuela the said co-
to decrease the amount of what otherwise could be his taxes or
owners leased to Construction Components International Inc.
altogether avoid them, by means which the law permits, cannot be
(CCII) the same property and providing that during the existence or
doubted.‖
after the term of this lease the lessor should he decide to sell the
● After incorporation, one becomes a stockholder of a corporation by
property leased shall first offer the same to the lessee and the letter
subscription or by purchasing stock directly from the corporation or
has the priority to buy under similar conditions
from individual owners thereof.
● CCII assigned its rights to Hydro Pipes.
● In exchange of their properties, the Pachecos acquired 2500
● A deed of exchange was executed between the Pachecos and
original unissued no par value shares of stocks of the Delpher
Delpher Trades Corp. wherein the Pachecos conveyed the leased
Trades Corporation. Consequently, the Pachecos became
lot to Delpher in exchange for 2500 shares of stock.
stockholders of the corporation by subscription.
● Hydro Pipes filed a complaint for reconveyance for alleged violation ● A no-par value share does not purport to represent any stated
of its right of first refusal.
proportionate interest in the capital stock measured by value,
● Petitioner contends that there was actually no transfer of ownership
but only an aliquot part of the whole number of such share
since Pachecos remained in control of the property and that
issuing corporation.
 ● The holder of no-par shares may see from the certificate itself
that he is an aliquot sharer in the assets of the corporation.
But this character of proportionate interest is not hidden
beneath a false appearance of a given sum in money, as in the
case of par value shares.
● The capital stock of a corporation issuing only no-par value
shares is not set forth by a stated amount of money, but
instead is expressed to be divided into a stated number of
shares, such as 1000 shares. This indicates that a shareholder
of 100 such shares is an aliquot sharer in the assets of the
corporation, no matter what value they may have to the extent
of 100/1000, or 1/10.
● Thus, by removing the par value of shares, the attention of
persons interested in the financial condition of a corporation
is focused upon the value of assets and the amount of its
debts.
● There was no attempt to state the true or current market value
of the real estate. Land valued at P300.00 per square meter Seven Oaks argued that the per centum participation by foreign nationals in
was turned over to the family’s corporation for only P14.00 a Linearworks exceeds the restrictions and actually amounts to 99.72% of the
square meter. total equity since the total amount subscribed by the Japanese nationals is
17,950,000pesos out of the total 18,000,000 pesos.
DISPOSITIVE: Petition granted.
EPD maintained that the basis for determinining the level of foreign
7.5.2 What does the Par Value of a share represent? participation is the number of shares subscribed.
● In the matter of the Petition for the Revocation of the Certificate of
Registration of Linearworks Realty Development Corporation, ISSUE: whether the determination of foreign equity participation ought to be
(Seven Oaks Properties, Inc., petitioner), SEC EN BANC CASE based on the number of shares only, or whether it should be based on the
NO. 07-10205 (EPD Reference No. 2010-177-CID) dated actual equity investment or amount subscribed (i.e. number of shares
November 25, 2010 multiplied by the par value) - NUMBER OF SHARES SUBSCRIBED, PAR
Seven Oaks Properties, Inc filed a petition for the revocation of the certificate VALUE IS IRRELEVANT
of registration of Linearworks Realty Development Corporation. Seven Oaks
alleged that Linearworks‘ equity structure was designed to circumvent the The important criteria for determining compliance with the foreign equity
constitutional and statutory limitations on foreign ownership of private lands restrictions are: (1) control and (2) beneficial ownership. In order to
in our country. determine such criteria, we need to look into the total number of shares
subscribed by Philippine citizens over the total outstanding capital stock, and
Article XII, Section 7 of the 1987 Constitution, in relation to Sections 22 and crucially, the rights, privileges or restrictions conferred upon such shares.
23 of the Commonwealth Act No. 141 provides that, in order for a
corporation to own land, at least sixty per centum of its capital stock must A share‘s par valus is simply an amount fixed as the nominal value of the
belong wholly to Filipino citizens. Since Linearworks is engaged in real interest so specified, which amount likewise indicates the sum of money or
estate activities, including ownership of land, said restrictions necessarily value of property or services which a subscriber is represented as having
apply to it. contributed to the corporation in exchange for such share in its ownership.‖
The par value of the share does not determine the rights, privileges or
restrictions of the share. This means that the par value of the subscribed million. If such an increase in the ACS is intended by the company, it may
shares is actually irrelevant in determining compliance with the constitutional undertake the following:
and statutory restrictions on foreign equity.
(1) Reverse stock split. — In SEC Opinion No. 05-01 dated 04 January
What we need to look at is the corporation‘s articles of incorporation since it 2005, we previously recognized a reverse stock split, i.e., the reduction of
provides the rights, privileges, or restrictions conferred upon the shares. In shares by increasing the par value thereof, as a valid mode of corporate
the present case, an examination of Linearworks‘ AOI reveal that while the restructuring.
shares may be classified to two types having different par value, there is no
provision conferring different rights, privileges or restrictions on each type, In the case of your company, this will involve the amendment of the
hence, the shares are equal in every rights, etc. Considering this, control Articles by changing the equity structure from an ACS of P20 million
and economic rights over the corporation and its assets are solely divided into 2 million shares with a par value of P10, to an ACS of P20
dependent upon the number of shares subscribed irrespective of par value. million divided into 400,000 shares with a par value of P50. A list of the
requirements for this step is attached hereto as Annex A; 3 and
Hence, the EPD did not err when it did not take into account the par value of
shares in determining compliance with constitutional and statutory (2) Increase the ACS. — Proceeding from the reverse stock split, the
restrictions on foreign equity. BUT SEC found it proper to investigate subject company may increase its ACS from P20 million to P100 million by
corporation for possible violations. amending its Articles and submitting the requirements provided in the list
attached hereto as Annex B. 4 The requirements for the resulting increase in
7.5.3 Equity Restructuring through the Increase of Par Value ACS are based on Section 38 of the Corporation Code, which provides:
● SEC-OGC Opinion No. 06-17 dated July 24, 2017 addressed to
New Transcend Construction & Development Corporation "Section 38. Power to increase or decrease capital stock; incur, create or
increase bonded indebtedness. — No corporation shall increase or decrease
its capital stock or incur, create or increase any bonded indebtedness
unless approved by a majority vote of the board of directors and, at a
In this SEC opinion, New Transcend wanted to restructure it‘s equity but stockholder's meeting duly called for the purpose, two-thirds (2/3) of
does not intend to increase the present number of shares. The corporation the outstanding capital stock shall favor the increase or diminution of
did not categorically state whether, in applying for the increase in par the capital stock, or the incurring, creating or increasing of any bonded
value, you intend to maintain the current number of shares (i.e., 2 indebtedness. Written notice of the proposed increase or diminution of the
million shares), 1 on the one hand, or to maintain the current ACS (i.e., capital stock or of the incurring, creating, or increasing of any bonded
P20,000,000.00), 2 on the other. Increasing the par value while maintaining indebtedness and of the time and place of the stockholder's meeting at
the number of shares will, consequently, result in the increase of the ACS. In which the proposed increase or diminution of the capital stock or the
contrast, increasing the par value while maintaining the ACS will necessarily incurring or increasing of any bonded indebtedness is to be considered,
result in the decrease in the number of shares. must be addressed to each stockholder at his place of residence as shown
on the books of the corporation and deposited to the addressee in the post
This opinion will, thus, provide a discussion on both scenarios. office with postage prepaid, or served personally.

Scenario A — Increase the par value while maintaining the number of A certificate in duplicate must be signed by a majority of the directors of the
shares corporation and countersigned by the chairman and the secretary of the
stockholders' meeting, setting forth:
Increasing the par value from P10.00 to P50.00 while maintaining the
company's 2 million shares will increase the ACS from P20 million to P100 (1) That the requirements of this section have been complied with;
(2) The amount of the increase or diminution of the capital stock;
 (3) If an increase of the capital stock, the amount of capital stock or trustees and of at least two-thirds (2/3) of the members in a meeting duly
number of shares of no-par stock thereof actually called for the purpose. SDHTEC

subscribed, the names, nationalities and residences of the persons Bonds issued by a corporation shall be registered with the Securities and
subscribing, the amount of capital stock or number of no- par stock Exchange Commission, which shall have the authority to determine the
subscribed by each, and the amount paid by each on his subscription in sufficiency of the terms thereof." (Emphasis supplied.)
cash or property, or the amount of capital stock or number of shares of no-
par stock allotted to each stock-holder if such increase is for the purpose of To clarify, two (2) separate applications, with their respective documentary
making effective stock dividend therefor authorized; requirements must be filed with the Commission for this Scenario, however,
these applications may be filed simultaneously, in which case, the same will
(4) Any bonded indebtedness to be incurred, created or increased; likewise be processed by the Commission simultaneously. Thus, the
(5) The actual indebtedness of the corporation on the day of the Company need not await the approval of the reverse stock split before it can
meeting; apply for the ACS increase, provided that all requirements for both
(6) The amount of stock represented at the meeting; and applications are complied with.
(7) The vote authorizing the increase or diminution of the capital
stock, or the incurring, creating or increasing of any Scenario B — Increase the par value while maintaining the amount of
ACS
bonded indebtedness.
Increasing the par value from P10.00 to P50.00 while maintaining the
Any increase or decrease in the capital stock or the incurring, creating or company's ACS will result in the reduction of shares (i.e., authorized,
increasing of any bonded indebtedness shall require prior approval of the subscribed and paid up) from 2 million to 400,000. To do this, the
Securities and Exchange Commission. One of the duplicate certificates shall company may undertake a reverse stock split by amending its Articles,
be kept on file in the office of the corporation and the other shall be filed with as provided in number (1) of Scenario A above.
the Securities and Exchange Commission and attached to the original
articles of incorporation. From and after approval by the Securities and The company is advised that as a consequence of the reverse stock split,
Exchange Commission and the issuance by the Commission of its certificate fractional shares may arise. In this regard, the company may do well to
of filing, the capital stock shall stand increased or decreased and the consider the treatment thereof prior to commencing the restructuring
incurring, creating or increasing of any bonded indebtedness authorized, as process, e.g., repurchase by the company of the fractional shares (as
the certificate of filing may declare: Provided, That the Securities and treasury shares) at a pre-determined price.
Exchange Commission shall not accept for filing any certificate of increase of
capital stock unless accompanied by the sworn statement of the treasurer of Both restructuring scenarios will necessarily result in the cancellation of
the corporation lawfully holding office at the time of the filing of the current stock certificates and the issuance of new ones in replacement
certificate, showing that at least twenty-five (25%) percent of such increased thereof, which reflects the new number of shares and/or par value thereof,
capital stock has been subscribed and that at least twenty-five (25%) as applicable. In this regard, the company is reminded to comply with the
percent of the amount subscribed has been paid either in actual cash to the principle of indivisibility of subscription, as enshrined in Article 64 of the
corporation or that there has been transferred to the corporation property the Corporation Code, thus:
valuation of which is equal to twenty-five (25%) percent of the subscription:
Provided, further, That no decrease of the capital stock shall be approved by "Section 64. Issuance of stock certificates. — No certificate of stock shall be
the Commission if its effect shall prejudice the rights of corporate creditors. issued to a subscriber until the full amount of his subscription together with
interest and expenses (in case of delinquent shares), if any is due, has been
Non-stock corporations may incur or create bonded indebtedness, or paid."
increase the same, with the approval by a majority vote of the board of
 ■ Section 41 of the Corporation Code
authorizes corporations to purchase or
7.5.4 Book Value: acquire their own shares out of unrestricted
● SEC Letter dated April 11, 1994 issued to Mr. Gonzales M. Mallari retained earnings for a legitimate corporate
of Aseatech, Incorporated by SEC Chairman Rosario N. Lopez purpose.
○ This is a letter from Mr. Mallari of Aseatech Inc. for an ■ The underlying reason for limiting share
opinion from the SEC purchases is the necessity of imposing
st
○ 1 question: Is it lawful for a subscriber to transfer or safeguards against the depletion of its
assign his paid-up shares to the rest of the assets and the impairment of its capital
stockholders even if his subscription is not yet fully needed for the protection of creditors. This is
paid? If allowed who will shoulder the unpaid sometimes expressed in terms of "trust fund
balance? doctrine". Also, the right of a corporation to
■ SECTION 64 of Corporate Code Issuance re-acquire or purchase its own stock is
of stock certificates. — No certificate of stock always subject to the condition that the
shall be issued to a subscriber until the full purchase shall be made in good faith and
amount of his subscription together with without prejudice to the rights of other
interest and expenses (in case of delinquent stockholders or creditors.
shares), if any is due, has been paid. ■ The Commission previously ruled that a
■ It implicitly sets forth the doctrine that a corporation may re-acquire or purchase its
subscription is one, entire and indivisible own stock only if the following conditions are
contract. It cannot be divided into portions. complied with:
■ If the stockholder has not paid the full amount a. Its capital is not thereby impaired;
of his subscription, he cannot transfer part of b. A legitimate and proper corporate
it in view of the indivisible nature of objective is advanced;
subscription contract. c. The condition of corporate affairs
■ It is only upon full payment of the whole warrants it;
subscription that a stockholder can transfer d. The transaction is designed and
the same to several transferees. However, carried out in good faith;
the entire subscription, although not yet fully e. There is intended and there results no
paid, may be transferred to a single undue advantage to a few favored
transferee, who as a result of the transfer, stockholders at the expense of the
must assume the unpaid balance. remainder,
■ But secure the consent of the corporation since f. The rights of creditors are not
the transfer of subscription right jeopardized;
contemplates a novation of contract. g. There must be unrestricted retained
earnings to acquire the same.
nd
○ 2 question: Can partially paid subscription be
rd
transferred to the issuer corporation? If allowable is ○ 3 question: What will be the basis for the
the corporation entitled to re-sell the re-acquired computation of present "book value" of shares? Is it
subscription including the unpaid shares? on the "subscribed" capital stock or "paid-up" capital?"
■ This would be in effect a re-acquisition of the ■ The "book value" per share is the amount that
shares by the corporation. would be paid on each share to retiring
 stockholders or in the event the company is (a) Actual cash paid to the corporation;
liquidated.
■ Where there is only one class of stock, the (b) Property, tangible or intangible, actually received by the corporation and
computation of the book value per share is: necessary or convenient for its use and lawful purposes at a fair valuation
total stockholders' equity divided by the equal to the par or issued value of the stock issued;
number of outstanding shares.
■ Since unpaid subscriptions are considered part (c) Labor performed for or services actually rendered to the corporation;
of the asset of the corporation which the
board may at any time declare due and (d) Previously incurred indebtedness of the corporation;
payable, the computation should be based
on the outstanding capital stock including the (e) Amounts transferred from unrestricted retained earnings to stated capital;
unpaid subscriptions, not only on the paid-up
(f) Outstanding shares exchanged for stocks in the event of reclassification
capital.
or conversion;

(g) Shares of stock in another corporation; and/or

7.5.5 Conversion of no par value shares to par value
● SEC Letter dated July 17, 1992 issued to Mr. F. G. Tagao by SEC
(h) Other generally accepted form of consideration.
Chairman Rosario N. Lope
The letter of Mr. Tagao is requesting for clarification on two
Where the consideration is other than actual cash, or consists of intangible
points: (1) no par value shares can be converted into par value
property such as patents or copyrights, the valuation thereof shall initially be
shares with a uniform/common par value provided that the total
determined by the stockholders or the board of directors, subject to the
peso amount would remain the same, and (2) the conversion of no
approval of the Commission.
par value shares would not be based on actual money contributed,
but on the latest book value of the no par value shares Shares of stock shall not be issued in exchange for promissory notes or
On the first point, such is ok provided that there is no alteration future service. The same considerations provided in this section, insofar as
of interest giving rise to a change in the stockholders‘ percentage applicable, may be used for the issuance or bonds by the corporation.
interest in the corporation. Thus, if the conversion would result in
the increase of the number of shares, they should be allocated The issued price of no-par value shares may be fixed in the articles of
proportionately to the existing shareholders. incorporation or by the board of directors pursuant to authority conferred by
On the second point, latest book value per share or average the articles of incorporation or the bylaws, or if not so fixed, by the
issue value per share will be used as the basis of the ratio for stockholders representing at least a majority of the outstanding capital stock
conversion. In this way, there would be no variance to be at a meeting duly called for the purpose.
accounted for after the conversion. In other words, the individual
allocation of shares after conversion would be based on the
average issue value of the no par value shares, and not on the
individual actual contribution of the stockholders 7.6.1 Watered Stocks: REVISED CORPORATION CODE §64
7.6 Consideration for Shares: REVISED CORPORATION CODE §61,
Section 64. Liability of Directors for Watered Stocks. - A director or officer of
a corporation who: (a) consents to the issuance of stocks for a consideration
Section 61. Consideration for Stocks. - Stocks shall not be issued for a less than its par or issued value: (b) consents to the issuance of stocks for
consideration less than the par or issued price thereof. Consideration for the the consideration other than cash, valued in excess of its fair value; or (c)
issuance of stock may be:
having knowledge of the insufficient consideration, does not file written HELD:
objection with the corporate secretary, shall be liable to the corporation or its
creditors, solidarily with the stockholder concerned for the differnce between From the evidence on record petitioner was able to prove the material
the value receive at the time of issuance of the stock and the par or issued averments in the petition. On the other hand, since the respondents were
value of the same. declared in default, for all legal intents and purposes, respondents has no
evidence at all and the evidence of the petitioner remain unrebutted.
● Transmed (Manila) Corporation v. John Does/Holders of Shares Of
Stock Certificates Nos. 001 to 009, SEC-SICD Case No. 04-95- Under the law, whenever a corporation issues shares, it must receive a
5040. June 22, 1995. consideration equal to at least their par or issued value.

This is an action to cancel and declare the shares of stock covered by In the instant case, the questioned shares of stock appears to have been
Certificates of Stock Nos. 001 to 009 as watered stocks. issued without a consideration in violation of Section 62 of the Corporation
Code. Ballantine points out the evils of stock watering. It injures the
In support thereof, petitioner alleges that it is a corporation duly organized corporation because it is deprived of needed capital and of the opportunity to
and existing under the laws of the Philippines; that it is engaged principally in sell its securities at more advantageous prices. It prejudices the other
the operation of general services contractor, promotion and development of stockholders, existing as well as the future because it dilutes their
employment opportunities, local and overseas and recruitment entity or proportionate interest in the corporation. It also injures present and future
manning agency; that it is a 100% Filipino corporation with an authorized creditors because it reduces the value of corporate assets which stand as a
capital stock of 2 Million Pesos and subscribed as well as paid up capital of substitute for the stockholders' personal liability to them.
P500,000.00 with a par value of P1,000 per share.

Upon registration of the Corporation, it‘s initial issuance was distributed to 9 7.6.2 Indivisibility of the obligation of consideration in a subscription contract:
people, denominated by Certificate of Stocks 001 to 009. ● Pacific Star Properties, Inc. v. Company Registration and
Monitoring Department, SEC En Banc Case No. 10-10-216, March
It entered into a manning agreement with Great Lake Navigation, with the 7, 2019
latter to act as general agents in securing qualified filipino licensed officers Facts: PACIFIC STAR applied for increase its Authorized Capital Stock to
and crews with the skill for navigation and performance of the vessels of its PHP 150 Million, where eighteen (18) parcels of land (lots) would be
transferred to it by the subscriber ,1 in consideration of the shares.
foreign principals.
The Company Registration and Monitoring Department (CRMD) granted the
In the course of its operation, its paid-up capital has been used up. same and issued a Certificate of Approval of Increase of Authorized Capital
Allegedly, the foreign principal and general agents promised to help and Stock. However, it later issued a Show Cause Order directing PACIFIC
STAR to explain why the Certificate of Approval should not be revoked for
induced petitioner to cause the indorsement in blank, all its stock certificates failure to transfer the 18 lots to PACIFIC STAR‘s name within the 90-day
under pretext that said foreign principal will remit new and fresh capital for its period from approval prescribed by the SEC Guidelines Covering the Use of
operation corresponding to the value of each shares. However, not a single Properties that Require Ownership Registration as Paid-up Capital (SEC
centavo was remitted. The stocks was then issued without any Guidelines) dated 15 November 1994.
consideration. The petitioner also added that the issuance and indorsement
It later thus revoked the Certificate. Pacific Star now contends that it
of said certificates constitute ultra vires acts and in violation of the AOI substantially complied with the requirement to transfer title, considering it
prohibiting transfers that would limit the ownership of Filipinos. exerted utmost efforts and succeeded in transferring title to 17 out of the
intended 18 lots, but was prevented from completing the last transfer by
―some legal and technical discrepancies‖ (i.e. payment of property taxes at
Issue: Should the stocks after indorsement without consideration, be
the wrong BIR venue, and being penalized by the BIR due to such error).
considered watered stocks? – YES
Issue: whether or not the CRMD erred in revoking the Certificate of case, the issued price was exactly 18 lots in exchange for an additional PHP
Approval of Increase of Authorized Capital Stock. --- NO. 100 Million equity. Thus, 17 lots cannot be accepted by the CRMD as
substantial compliance, since it will result in watered stock,'* i.e. an issuance
Held: The 18 lots in consideration of an additional PHP 100° Million equity for less than the issued price of 18 lots.
only comprises l subscription contract, as alleged by PACIFIC STAR itself,
and this indivisible obligation was also the basis for the issuance of the
certificate of approval of increase in authorized capital stock, viz.

PACIFIC STAR was incorporated on September 8, 1998 with an initial

capitalization of Fifty Million Pesos (PHP50,000,000.00). Thereafter,
PACIFIC STAR sought to increase its authorized capital stock to One
Hundred Fifty Million Pesos (PHP 150,000,000.00) with the subscription
thereto to be paid by way of the assignment of eighteen (18) parcels of land.
On July 27, 2004, the Securities and Exchange Commission approved the
application and issued a Certificate of Approval of Increase of Authorized
Capital Stock.10 (Emphasis supplied) 7.6.3 Untitled Lands
● Guidelines on the Use of Untitled Lands as Consideration for
As correctly argued by the CRMD, insufficient or partial consideration leads
to watered stock which is prohibited by law. The subscription contract, Shares of Stocks of a Corporation (November 2, 2006)
described by PACIFIC STAR as ―property-for-stock,‖ is only 1 indivisible 7.6.4 Payment of interest in real property held in co-ownership
obligation to transfer 18 lots in exchange for an additional PHP 100 Million ● SEC-OGC Opinion No. 21-10 dated May 26, 2010 addressed to
equity. That is what PACIFIC STAR applied for, and that is what CRMD Atty. Perpetuo M. Lotilla, Jr (Re: Interest in Co-ownership as
approved. It follows that non-fulfillment of the transfer of gh 18 lots would
result in revocation. Consideration for Shares of Stock)
FACTS:
Similarly, PACIFIC STAR‘s 2017 Manifestation, where it offered to substitute 1. Osomreh Corporation applied for registration with the SEC.
cash for the remaining land title, does not affect the CRMD‘s revocation. The 2. However, upon review of the documents, the SEC informed the
CRMD revoked the approval of 18 lots as consideration, because there were corporation that a letter of consent of the other co-owners of the
only 17 lots. The approval pertains to the terms of the subscription contract real properties must also be submitted.
presented to CRMD, and since PACIFIC STAR did not apply for approval of 3. The proportionate interest of two co-owners in a co-ownership of
―18 lots or cash,‖ it cannot now change terms. real properties was exchanged for shares of stock in Osomreh
and it for this reason that the SEC required the Corporation to
Section 63 of the Revised Corporation Code provides that only the full
amount of the subscription is acceptable as consideration for shares, viz: submit the said letter of consent.
No certificate of stock shall be issued to a subscriber until the full amount of 4. Osomreh argues that the consent of the other coowners is not
his subscription together with interest and expenses (in case of delinquent necessary considering that the interest to be exchanged for
shares), if any is due, has been paid. shares of stock pertains only to the proportionate interest of the
two co-owners. He cited the Civil code:
The principle expressed here is that a subscription contract is indivisible and a. ―Each co-owner shal have full ownership of his part …
incapable of partial fulfillment, which also means that it is not susceptible to and he may therefore alienate, assign, or mortgage it,
substantial compliance. Applying this to the facts, only l8 transferred lots— … but the alienation shall be limited to the portion
no more, no less—can warrant the Approval of Increase in Authorized which may be allotted to him.
Capital Stock. ISSUE: WON the proportionate interest may be alienated to the Corporation
– No.
Meanwhile, Section 61 of the Revised Corporation Code adds that only RULING:
―property xxx actually received by the corporation‖ is acceptable as
consideration for shares. In this case, only 17 out 18 were actually received, 1. An interest in a co-ownership may be validly alienated as provided
and there is obviously insufficient consideration for the shares subject of the in the aforesaid provision and that no consent of the other co-
subscription contract. owners is necessary for such alienation.!
Section 61 also states that ―Stocks shall not be issued for a consideration 2. However, we are of the opinion also that the said alienation is still
less than the par or issued price thereof.‖ While par is the minimum price for subject to the conditions set forth in Articles 1620 and 1623 of
a share, the issued price refers to the actual price of the subscription. In this the Civil Code
 a. A co-owner of a thing may exercise the right of ● SEC-OGC Opinion No. 28-14 dated October 13, 2014 addressed to
redemption in case the shares of all the other co- Atty. Perpetuo M. Lotilla, Jr (Re: SEC-OGC Opinion No. 10-21;
owners or of any of them, are sold to a third person. Interest in Co-ownership as Consideration for Shares of Stock)
b. The right of legal pre-emption or redemption shall not
be exercised except within thirty days from the notice
in writing by the prospective vendor, or by the vendor, · In SEC-OGC Opinion No. 10-21, it was opined that the transfer
as the case may be. of interest in a co-ownership to a corporation as consideration for
3. Although the aforesaid provisions refer to sale to third persons, the shares of stock is subject to the right of redemption or pre-emption
"exchange" of an interest in a co-ownership for shares of stock in a under Articles 1620 and 1623 of the New Civil Code of the
corporation is included therein since the said exchange also Philippines, because the exchange involves a transmission of
involves a transmission of ownership by onerous title. ownership by onerous title.
a. Consequently, the same is subject to the right of
redemption or pre-emption of the other co-owners
pursuant to Articles 1620 and 1623 of the Civil Code. · It is implied in your letter that you disagree with the Opinion, and,
2. Whenever a property or an interest therein is used as in support of your dissent, you submitted the following
consideration for the issuance of shares of stock, the said property or arguments:
interest should be free from any right of redemption or pre-emption
of the other co-owners considering that the transfer to the · 1. The Opinion expanded the coverage of Articles 1620 and 1623
corporation must be in such a manner that the property or an
of the New Civil Code. The said articles only refer to sale to third
interest therein is capable of being applied to the payment of the
corporation's debts or can be subject to levy and sale on execution for persons and do not mention transfer by onerous title. Also, as the
the satisfaction of any judgment or decree against the corporation. transferee is a corporation majority owned and controlled by the
3. to free the property or an interest therein from any right of transferor, the transferee is essentially not a third person;
redemption or pre-emption of the other co-owners, this Office deems it
necessarythat either of the following should be submitted in applications · 2. The right of redemption or pre-emption does not and
for registration where the payment for subscription is an interest in a co- cannot prevent the application of the property or interest
ownership of property:
therein as payment for debts.
a. A Waiver of Rights signed by all possible co-
owners/redemptioners stating that they are waiving
their right of redemption or pre-emption in relation to · It likewise cannot prevent levy and sale on execution. The other
the said transfer; or co-owners may only exercise their right to redeem on such cases.
b. An Affidavit, executed by the co-owner who But should they do so, they will then have to pay for the value of the
exchanged his interest for the shares of stock, stating property or interest therein. Thus, the corporation will have cash
the following: arising from the redemption or pre-emption which will be used as
1. that he has given written notice thereof to all
payment for a debt or to satisfy a levy and execution.
possible coowners/redemptioners;
2. that the same was received by them; and
3. that the 30-day period of redemption has · In previous Opinions, 4 the Commission has discussed that
already expired. T interest in a coownership can be alienated by way of
4. The said Affidavit must be accompanied by a subscription to shares of stock, subject to the following
copy of the actual Written Notice to all conditions:
possible co-owners/redemptioners and the
Proof of Receipt by them.
· 1. The property must be something which the corporation may
acquire and hold in carrying out its purpose or reasonably
necessary or convenient in the pursuit of its business;
· 2. Interest in the co-ownership must have a pecuniary value sale on execution of the property or interest. However, as long as
capable of ascertainment (at a fair valuation equal to the par or the right of legal redemption or pre-emption subsists, meaning, that
issued value of the stock issued); the period to exercise the right of legal redemption or pre-emption
has not yet expired or the coowner has not waived his right prior to
· 3. The right over the property must actually be transferred to the lapse of said period, the purchaser or transferee is not at total
the corporation and no creditors of the property held in liberty to dispose of the interest in the co-ownership to anyone
common shall be prejudiced by the transfer; and other than the co-owners who possesses the right.

· 4. The transfer shall be subject to Articles 1620 and 1623 of · Meaning, while the subsequent sale or transfer of the interest
the Civil Code. in the co-owned property to persons other than the co-owners
will be valid if the same is made by the purchaser or transferee
· With regard to your first position, it is our view that there is NO while the right is subsisting, the seller or transferor in the
expansion of the coverage of Articles 1620 and 1623 of the New subsequent sale or transfer may be held liable for ignoring the
Civil Code. right of the co-owners, especially when the co-owners sustain
injuries arising from the subsequent sale or transfer.
· First, Article 1619 of the New Civil Code provides: Legal
redemption is the right to be subrogated, upon the same terms and · Consequently, the interest so acquired through purchase or
conditions stipulated in the contract, in the place of one who transfer is not readily transferable by the buyer or transferee to
acquires a thing by purchase or dation in payment, or by any other persons aside from the co-owner during the existence of the right of
transaction whereby ownership is transmitted by onerous title. legal redemption or pre-emption.
Despite the wording of Articles 1620 and 1623 that pertains
only to sale, the very de=nition of legal redemption under · This runs counter to the very nature of the property to be
Article 1619 covers transactions where ownership is transferred to the corporation as consideration for
transmitted through onerous title. subscription to shares of stock, that is, the property or interest
therein must be capable of being applied to the payment of the
· In view thereof, to exclude this mode of transmitting ownership corporation's debts or can be subject to levy and sale on
from the coverage of the rules on legal redemption would be execution for the satisfaction of any judgment or decree
absurd. against the corporation.

· Second, the corporation is a third person, as opposed to your · . To hold otherwise would be to place the corporation in a more
theory. complicated situation in the future, which is not the intention of the
law. As well, the value of the interest in the co-ownership acquired
· It is well settled that a corporation registered under the by the corporation is in effect diminished due to the limitation on the
Corporation Code is considered a juridical person with a personality free transferability thereof for as long as the right of the co-owners
separate and distinct from that of each shareholder/members. This in relation to the transfer to the corporation still exists. Thus, it is
attribute gives rise to a fundamental principle in corporation law that important to make the interest in a co-owned property, which is
under normal conditions, the stockholders/members of a used as subscription consideration, free from any right of legal
corporation are not the same as the corporation itself, 5 regardless redemption or pre-emption.
if the stockholder owns the controlling interest in a corporation. As
to your second position, we agree that the right of redemption or · In order to achieve this, all the possible co-owners must waive
pre-emption does not and cannot prevent application of the their right to exercise legal redemption or the period within which
property or interest therein as payment for debts, or the levy and this right may be exercised must have lapsed. Further, where the
 consideration for the subscription is other than actual cash, Receivables may be treated as property payment subject to the
the valuation thereof shall initially be determined by the following:
incorporators or the board of directors, subject to approval by (1) Verification by the SEC of their existence and collectibility;
the Securities and Exchange Commission, in order to prevent (2) Since non-payment of the stocks may still be possible in the
watering of stocks. event that the creditors of the parent company fail to pay their
obligations, the shares to be issued in consideration thereof
Incidental to this power of the Commission to approve the valuation of shall be held in escrow until the actual payment of the amount.
the property or interest used as subscription payment is the authority If the aforementioned standards are complied with, then the housing
to require the submission of documents or compliance with conditions receivables of the affiliate company may be validly used as payment
for the purpose of ensuring that the value of the property or interest for the corporate shares.
therein is not below the value of the shares issued
7.6.5 Payment other than cash or property: ● SEC-OGC Opinion No.02-08 dated January 3, 2008 addressed to
● SEC Opinion No. 11-05 dated July 14, 2005 addressed to Atty. Atty. Reynald R. Suarez et al (Re.: Intangible Property as
Lucia I. L. Labad (Re.: Receivables as Consideration for Shares of Consideration for Subscription of Shares)
Stock) ○ 1. whether a pro-indiviso interest in real property can be
used as consideration for subscription of shares; and
ISSUE: Whether the housing receivables of an afiiliate company, A&P ○ 2. whether the annotation of the said pro-indiviso interest
Exponent‘s Builder‘s Inc involved in the development of subdivisions can be on the transfer certi�cate of title (TCT) covering the real
used as a ―consideration‖ for shares of stock property is su�cient proof of ownership for purposes of the
Commission's requirements.
In order that shares of stock to be issued by a corporation can be exchanged ○ First inquiry:
for property as ―receivables,‘ the requirements of Sec 62 of the Corporation ■ Ownership of a pro-indiviso interest in land or any
Code must be complied with: other real property is a real right and, at the same
time, a real property which may be conveyed by
Section 62. Consideration for stocks.- Stocks shall not be issued for a the concerned co-owner to a third person.
consideration less than the par or issued price thereof. Consideration for the ■ "Sec. 62. Consideration for Stocks. — Stocks
issuance of stock may be any or a combination of any two or more of the shall not be issued for a consideration less than
following: xxx (2) Property, tangible or intangible actually received by the the par or issued price thereof. Consideration for
corporation and necessary or convenient for its use and lawful purposes at the issuance of stock may be any or a
fair valuation equal to the par or issued value of the stock issued; combination of any two or more of the following:
■ xxx xxx xxx
The aforequoted provision prescribes that: ■ (2) Property, tangible or intangible, actually
(1) The consideration other than cash must be of such nature which received by the corporation and necessary or
can be lawfully acquired and used in furtherance of the legitimate convenient for its use and lawful purposes at
purposes of the corporation as well as necessary and proper in a fair valuation equal to the par or issued
carrying out the corporate business value of the stock issued;
(2) The property, whether tangible or intangible, must be capable of ● Where the consideration is other than
pecuniary estimation and should be transferable. actual cash, or consists of
(3) The use thereof as consideration will not result in watering of ● intangible property such as patents
stocks. or copyrights, the valuation thereof
shall initially be determined by the
incorporators or the board of
 directors, subject to approval by the ■ However, approval of the subscription by the
Securities and Exchange proper operating department, i.e. the Company
Commission. Registration and Monitoring Department, would
■ Corporations are allowed to receive intangible not merely depend on such proof of ownership
properties in exchange of capital stock provided because, as adverted to above, there are certain
that the property transferred in payment conditions required that must be substantiated by
approximates the value of the stocks acquired, documents or otherwise.
for which reason Section 62 requires that the
valuation of the property paid shall be determined 7.7 Additional Paid-In Stock
by the incorporators or the board, subject to the 7.7.1 Definition: See definition of paid-in capital in SEC Memorandum
approval of the Commission Circular No. 11 Series of 2008 (December 5, 2008) §2 last paragraph; §5
■ More speci�cally, the Commission has opined last paragraph
that interest in a co-ownership can be Paid-in Capital - the amount of outstanding capital stock and additional
alienated by way of subscription to shares of paid-in capital or premium paid over the par value of shares.
stock, subject to the following conditions: Additional Paid-in Capital shall neither be declared as dividend nor shall
● 1. that the property must be something it be reclassified to absorb deficiency except through an organizational
which the corporation may acquire restructuring duly approved by the Commission.
and hold in carrying out its purpose or 7.7.2 Filing Requirement
reasonably necessary or convenient in ● SEC-OGC Opinion No. 03-18 , addressed to Philippine Bio-
the pursuit of its business; Sciences Co., March 19, 2018
● 2. that interest in the co-ownership must ○ This is a letter from Mr. Romark Peralta and Antonio
have a pecuniary value capable of De Castro (Managers of Legal & Accounting Office) of
ascertainment (at a fair valuation equal Philippine Bio-Sciences Co.
to the par or issued value of the stock ○ Question: whether or not it is mandatory to seek the
issued); Commission‘s approval for the conversion of
● 3. that the right over the property must stockholder's advances to a corporation into
actually be transferred to the additional paid-in-capital (APIC) of the corporation
corporation and no creditors of the without issuance of new shares and for the use of
property held in common shall be such APIC to wipe out the capital deficit of the
prejudiced by the transfer; and corporation.
● 4. that the transfer shall be subject to ■ The Commission has a policy of allowing
Articles 1620 5 and 1623 6 of the Civil corporations, at their roption, to apply for the
Code. Commission‘s approval of the creation of
■ Hence, subject to the above conditions, the APIC, subject to the payment of the filing fee
answer to your �rst query is in the affirmative. applicable for such application.
○ Second inquiry: ■ In a previous opinion, the SEC stated that the
■ we are of the opinion that an annotation by the application for the approval of the creation of
Register of Deeds of a pro-indiviso interest in the the APIC is at the option of the Corporation.
name of the subscriber would be su�cient proof Meaning it is not mandatory to seek prior
of ownership of such interest for purposes of the approval of the creation.
approval by the Commission of the subscription. ■ HOWEVER, the application of the APIC that
is already reflected as such in the audited
 financial statements to wipe out the capital
deficit requires the approval of the Issue: Whether APIC (share premium) is included in the term ―paid-in equity‖
Commission upon filing of a request for - YES
equity restructuring and upon payment of the
corresponding filing fee (per SEC Memo Under Rule I, Section 1(p) of the Implementing Rules and Regulations of
Circular no. 11 of 2008). R.A. 7042, the term "paid-in equity capital" is defined as "the total investment
in a business that has been paid-in in a corporation or partnership or
investment in a single proprietorship, which may be in cash or property. It
● SEC-OGC Opinion No. 34-10, addressed to Mr. Melquiades shall refer to inward remittance or assigned capital in the case of foreign
Malabanan, December 22, 2010 (SEC filing requirement) corporations."
In this case, XYZ Corporation‘s authorized capital stock is already
fully issued and outstanding, but the corporation shows negative Further, pursuant to Rule I, Section 1(d) of the abovementioned Rules, the
equity. Its parent corporation, B Corporation, wishes to infuse an term "Investment" refers to "equity participation in any enterprise organized
additional P20M to eliminate the negative equity, as additional paid- or existing under the laws of the Philippines. It includes both original and
in capital, without issuance of shares. It is asking if this can be additional investments, whether made directly as in stock subscription, or
done, and how. indirectly through the transfer of equity from one investor to another as in
The SEC has adopted the policy of allowing corporations, at their stock purchase. Ownership of bonds (including income bonds), debentures,
option, to apply for approval for the creation of APIC, subject to notes or other evidences of indebtedness does not qualify as investment."
payment of filing fees. As this is optional, clearly, approval of the
SEC is not needed; if the corporation does wish to apply for The Commission, in its Executive Meeting on April 16, 1991, resolved as a
approval, the requirements depend on the mode of payment and matter of policy, to construe paid-in capital as used under Sec. 43 of the
are available in the SEC website. Of course, B Corporation can Corporation Code, to include payment on subscriptions in excess of
infuse the additional paid-in capital without a corresponding par. (SEC Opinion dated April 23, 1991, addressed to Atty. Ma. Melva
issuance of shares, because the purpose of APIC is to eliminate Evangelista-Valdez)
negative equity
In the case of your client, its APIC amounting to P63,500,000.00 should be
7.7.3 Inclusion in Computation of FIA compliance included in the computation of its paid-in equity capital. Based on your
● SEC Opinion No. 47-03 addressed to Emerald Headway representations, it thus appears that your client corporation complies with
Distributors Inc. (Attn.: Atty. Gemma Santos), September 30, 2003. the required minimum paid-in equity capital under R.A. 7042, as amended
and its Implementing Rules and Regulations.
This refers to your letter dated 16 September 2003 requesting confirmation
of your opinion that the term "paid-in equity, capital" under Republic
Act No. 7042 (as amended by R.A. 8179) otherwise known as the
Foreign Investments Act of 1991 (FIA), includes the additional paid-in
capital (APIC) for the purpose of determining whether an enterprise has met
the minimum required paid-in equity capital of US$200,000.00 for domestic
market enterprise.

This is in connection with the application of your client, Emerald Headway

Distributors Inc. (EHDI), for registration under FIA. You opine that the APIC
of EHDI amounting to P63,500,000.00 should be included in the computation
of the paid-in equity capital of the corporation.
 7.7.4 Reversal of APIC
● SEC Opinion No. 13-14 addressed to Toenec Philippines, Inc., Issue: whether the regulatory laws, rules and regulations being
June 11, 2014 implemented by the Commission allow the nullification of the APIC
Facts: account for the purpose of reinvesting the same, either in payment for
By the nature of its business, Toenec is required to secure and maintain a the subscription of the corporation’s unissued shares of stock, or in a
regular constructor‘s license issued by the PCAB. Thus, it is required by form of loan to the corporation.
PCAB to maintain its status as a Filipino corporation, that is, 60% of the
company‘s capital stock must be owned by Filipinos and that any foreign Held: NO. Toenec may not reverse its APIC and, subsequently, convert
equity should be limited to forty percent 40% thereof. it into a loan or pay additional subscription to capital stock, as the
same violates the Trust Fund Doctrine.
For construction fiscal year (CFY 2010-2011), it was unable to renew its
license mainly because it incurred capital deficit for the period ended 31 There are currently no express, specific rules and regulations issued by the
December 2009. Thus, the foreign stockholders of Toenec decided to infuse Commission on the nullification of APIC and its subsequent conversion into
through (Additional Paid-In Capital) APIC the amount of Php 50,000,000.00 a loan or subscribed capital. There are, however, fundamental doctrines that
purposely to eliminate Toenec‘s deficit and eventually to secure the renewal should be observed in this kind of transaction, one of which is the Trust Fund
of its PCAB license. Doctrine.

Despite the elimination of the deficit, PCAB still declined to approve Trust Fund Doctrine - subscriptions to thecapitalof corporation constitute a
Toenec‘s application for renewal of license and informed the company that fund to which creditors have a right to look for satisfaction of their claims.
the infusion of APIC resulted in increasing the foreign ownership in Toenec ● the Trust Fund pertains to the subscription to the capital stock of the
beyond the forty percent (40%) limit. According to PCAB, the capital corporation.
requirement is computed on the actual peso value of the investment of each ● However, when the corporation is insolvent, the Trust Fund
stockholder, thus, the foreign equity of Toenec breached the 40% limit when encompasses not only the subscription to the capital stock, but also
the foreign stockholders infused capital in the form of APIC. other property and assets of the corporation.
● When the corporation is solvent the corporate Trust Fund
Toenec is planning to nullify its previous APIC contribution of Php 50 Million. consists only of the “Subscribed Capital” which is the amount
In line with the objective of securing a renewed PCAB license renewed, the that the corporation receives in consideration of the issuance of
foreign stockholder would instead invest the Php 50 Million in Toenec by: shares, plus share premiums, if any.

1. Subscribing to the unissued shares of stock The nullification of APIC and its subsequent conversion into a loan violates
Toenec will take steps to increase its authorized capital stock to the Trust Fund Doctrine. This is because the APIC is considered a
accommodate the issuance of new shares. At all times, the company shall contribution of a stockholder over and above the par value of shares and
maintain a 60-40 Filipino-foreign equity stricture. Thus, both the foreign and falls under the concept of corporate Trust Fund upon its recording in the
Filipino stockholders of Tonec will contribute proportionate amounts to books of the corporation.
maintain their respective shareholding in the company. Insofar as the Php 50
million previously booked as APIC, the same shall now be invested as part of The Trust Fund Doctrine prohibits Toenec from distributing its capital to the
the subscribed capital stock. In this case, Toenec would have sufficient stockholders other than those instances provided for by the Corporation
assets to cover its liabilities, hence, no creditors will be prejudiced. Code. The reason for the prohibition is that Toenec‘s creditors have the right
2. Extending a loan agreement. to assume that, so long as there are outstanding debts and liabilities,
Alternatively, the Php 50 Million APIC may be invested in the form of loan. Toenec will not liquidate its capital to their prejudice.
Similarly, Toenec would have adequate assets to answer for all liabilities and
therefore no creditors shall be prejudiced.
Moreover, the nullification of APIC and its subsequent conversion into a loan 1. P-Four is a domestic corporation duly registered with the
can be considered as a reduction of the corporate Trust Fund as the same Commission with an authorized capital stock of P30,000,000
will be transferred from the Equity Account to the corporate Liability Account. divided into 300,000 shares with a par value of P100.00 per share.
In other words, upon APIC‘s conversion into a loan, it is as if there will be 2. The BOD proposes to increase the ACS to P2,500,020,000 by
advance payment to the stockholder/creditor of his investment which reclassifying a portion of its paid-in surplus to paid-up capital.
equates to a distribution of corporate assets to said stockholder in 3. In the process, the par value of its shares shall be increased from
preference over the other creditors of the corporation. 100 to P13,899 per share while the authorized number of shares
shall be correspondingly decreased from 300,000 to 180,000.
Further, we noticed that paragraph 14.3 of Toenec ‘s Notes to the Financial ISSUE:
Statements as of December 31, 2011 and 2012 (―Notes‖) merely disclose whether the corporation may increase its authorized capital stock by
that this APIC was contributed to support the Company‘s operations.‖ Stated increasing its par value, decreasing the number of shares and reclassifying
otherwise, the disclosure in the Notes does not make the infusion subject to its additional paid-in capital to paid-up capital of the corporation. - YES
a suspensive condition that the PCAB license would be renewed. Thus, SUBJECT TO CONDITIONS
ownership over the funds has already been transferred to the corporation. Its
nullification, despite its subsequent conversion into subscribe capital, equally OPINION:
violates the Trust Fund Doctrine. RULING:
1. Additional paid-in surplus may be applied to reduce or wipe out
When corporate Trust Fund will be used for purposes other than those deficits of the Corporation provided that after such restructuring process
enumerated in Ong Yong, i.e, to pay for the stockholders additional has been effected, the same shall be disclosed in all subsequent
subscription to capital stock, it will effectively result in the unauthorized financial statements of the Corporation for a period of at least three (3)
distribution of the corporate Trust Fund, thereby violating the Trust Funds years.
Doctrine. STOCK SPLIT DISCUSSION
2. The corporate restructuring or readjustment envisioned by P-Four
In the instant case, if the reversal of the APIC and its conversion into relates to a reverse stock split which has been described by Ballantine
subscribed capital are allowed, the same would be tantamount to the & Sterling as the name indicates, is just the opposite of stock split.
corporation using its corporate Trust Fund to pay for the subscription a. It is the pro rata combination of all the outstanding
of its stockholder for the issuance of its own shares. shares of a specified class into smaller number of
shares of that class by an amendment to articles
In NTC, it is clear that, ―until the liquidation of the corporation, no part of the stating the effect on outstanding shares".
subscribed capital may be returned or released to the stockholder (except in 3. "A reverse stock split may be required to increase the market
the redemption of redeemable shares) without violating this principle.‖ The value per share of a corporation's shares or to restructure other
corporate creditors, therefore, should have the first claim on the trust fund of outstanding debt or equity instruments issued by the corporation or
the corporation, and the stockholders have no rights to it, until all the it may be used to eliminate certain small minority stockholders."
creditors are satisfied. 4. "A stock split or reverse stock split, like a share dividend, readjusts
corporation's capital structure. Either can therefore, be used as part of a
7.7.5 Possible treatment of APIC when increasing Par Value recapitalization of a corporation."
● SEC Opinion No. 01-05 addressed to P. Four, Inc. on 5. "Correspondingly, in a reverse stock split the outstanding shares
Reclassification of Paid-in Surplus, January 04, 2005 are transformed into a smaller number of outstanding shares and again
the effect is disguised unless the par or nominal value of the shares is
Facts: changed as part of the transaction. In the absence of some feature not
associated with the typical stock split (such as an option to receive cash
rather than shares or a split or reverse split which does not result in
 proportionate change in the shareholdings of all holders of the same 2. Additional paid-in capital, however created, shall not be used to
class or series) the receipt of shares as a result of a split does not result relieve income of the current or future years of charges which would
in taxable income to either the stockholder or the corporation." otherwise be made against income.
6. Reverse stock split may be allowed as can be culled from the 3. This rule might be subject to the exception that, where upon
hereunder quoted pruvisos of the Statement of Financial Accounting reorganization, a reorganized enterprise would be relieved of charges
Standards No. 18 which laid down the generally accepted accounting that would be made against income if the existing enterprise were
standards in this jurisdiction: continued, it might be regarded as permissible to accomplish the same
a. "Stock Split" is defined a the issuance by an result without reorganization provided the facts were as fully revealed to
enterprise of its own common shares to its common and the action as formally approved as in reorganization.
shareholders without consideration and under APPLYING IT IN THIS CASE
conditions indicating that such action is prompted 1. Based on the foregoing pronouncements and citations and the legal
mainly by a desire to increase the number of presumption that the transaction is carried out in good faith on the
outstanding shares for the purpose of effecting a' strength of a legitimate and proper corporate objective, duly warranted
reduction in their unit market price and thereby, of by its corporate affairs, the proposed reverse stock split and conversion
ohtaining wider distribution and improved of additional paid-in capital to paid-up capital are thus legally feasible
marketability of the shares. subject to the following rules:
b. Reverse splits- At times, a corporation may wish to a. As a general rule, the additional paid-in capital may
raise the unit market price of its shares and reduce only be declared as stock dividend. It shall not be
the number of shares outstanding. This may be used to relieve income of the current or future years
accomplished by means of a "reverse split" in which of charges chargeable against income.
the number of shares outstanding is reduced and the b. An exception to the rule is in the case of
par value is increased proportionately. reorganization wherein a reorganized enterprise may
c. No accounting entry should be made for reverse splits be relieved of such charges against income on
unless the total par value of the shares is reduced. In condition that if the existing enterprise shall be
that case, the reduction should be reflected in continued the same result may be attained even
additional paid-in capital properly described, not in without reorganization;
income or retained earnings. c. Provided that the said facts are fully disclosed and
d. Changes in the par values of capital stock, should be formally approved as in reorganization in which
charged or credited to additional paid-in capital. If event the articles of incorporation shall be
increases in capital stock values exceed additional amended accordingly to reflect the changes in the
paid-in capital, they should be charged to .oetained capital structure
earnings. d. Provided further that the old shares totaling 300,000
will be restructured and 180,000 shares shall be
Additional Paid-In Capital issued with a par value of~13,899 per share for which
1. the common sources of additional paid-in capital are as follows: the corresponding taxes and SEC fees legally
a. Excess of par value paid for capital stock imposable shall be paid.
b. Resale or retirement of treasury shares e. Provided finally, that there shall be no impairment of
c. Distribution of stock dividends legal capital and that no prejudice shall be caused
d. The issuance of detachable stock purchase to the stockholders and creditors.
agreemnts f. Lastly, the corporation should file an application for
e. Changes in par value amendment of articles of incorporation and/or
f. Donated assets certificate of increase/decrease of capital stock, if any,
 to reflect the changes in the capital structure - the copyrights, the valuation thereof shall initially be
authorized capital stock. determined by the incorporators or the board of directors,
subject to approval by the Securities and Exchange
Commission. . . ." 3 (Emphasis supplied)
7.8 Conversion of Debt to Equity ● Clearly, Section 62 of the Corporation Code expressly
● SEC-OGC Opinion No. 03-13 dated April 17, 2013 addressed to allows a previously incurred indebtedness to be used as
Ms. Estrelita G. Gacutan at al (Re.: Previously Incurred consideration for the issuance of stocks, provided that the
Indebtedness as Payment For Subscription Of Shares) valuation of the indebtedness be determined by the board
Details: of directors, subject to approval of the Commission, in
● Short facts: Company A is a publicly listed corporation. order to prevent watering of stocks.
Company B and C are its existing shareholders, Company ● Watering of stocks is a situation wherein the
B and Company separtely extended loans to Company A consideration for subscription is not a fair valuation equal
"Term Loan Facilities". Company B and Company C will to the par or issue value of the stock. The amount of the
be extending the loans under the Term Loan Facilities to indebtedness or liabilities to be settled should be at least
assist Company A in meeting its cash/funding equal to the par value of the shares of stock which the
requirements. corporation intends to issue.
● Company A is contemplating a stock rights offering ● However, there must first be an indebtedness incurred in
("SRO", for brevity) by way of pre-emptive rights sometime order that a liability may be converted into subscription
in the first half of 2013, and Company B and Company C payment.
will be offered rights shares pursuant to the SRO. ● In this connection, the following requirements are to be
● Instead of shelling out additional money to pay for their submitted to the Commission:
respective subscriptions to the rights shares they will 1. Detailed schedule of liabilities being offset,
subscribe pursuant to the SRO, Company B and Company showing all debts and credit to such liability
C intend to convert the principal amount of the loans under account, date, nature of account and amount.
the Term Loan Facilities as subscription payments for 2. Deed of assignment executed by the creditor[s]
rights shares under the SRO. assigning the amount due to him in payment for
● While Company B and C will be allowed to pay through the unpaid subscription[s].
the conversion of liabilities into equity, the other 3. Company's book of accounts must be kept up to
stockholders participating in the SRO will pay in cash. date and be made available for examination by
• Except for the form of payment, all other terms will be the same as the Commission to determine that the liabilities
to all stockholders. represent valid and legitimate claims against the
company.
In this regard, you are requesting the following: 4. If the principal office of the corporation is located
(1) whether the previously incurred indebtedness can be used in the province, a report by an independent
as subscription for shares and under what conditions; certified public accountant must be submitted.
● Section 62. Consideration for stocks. — Stocks shall not The foregoing, however, are without prejudice to the requirements
be issued for a consideration less than the par or issued of the Financial Analysis and Audit Division (FAAD) of our
price thereof. Consideration for the issuance of stock may Company Registration and Monitoring Department (CRMD),
be any or a combination of any two or more of the considering that the request or application for approval of the
following: 4. Previously incurred indebtedness of the valuation of consideration for shares of stock other than cash is
corporation;Where the consideration is other than actual within the jurisdiction of that Department to decide. 9
cash, or consists of intangible property such as patents or
(2) whether the proposed structure of the SRO (e.g., wherein
one bloc of stockholders is allowed to pay by conversion and
others by cash) would violate the Corporation Code, Securities
Regulation Code (SRC), etc.
● In this case, the payments of Company B and Company C
for the subscriptions shall be in the form of conversion of
the previously incurred indebtedness while the payments
of the other stockholders for their subscriptions shall be in
cash.
● However, even when payment of the debt is in terms
required to be made by the corporation in money or cash,
a set-off of the debt without going through this
unnecessary formality is equivalent to a payment for the
stock in cash.
● Thus, it appears that the proposed structure of the SRO
would not violate the requirement that the offer must be on
the same terms to all stockholders.
 ● Conversion in excess of par value: SEC Opinion addressed to Mr.
S.U. Salvador, Jr., April 15,1991.

● Shareholders‘ Advances: SEC Opinion addressed to Atty. Federico

G. Noel, Jr., (KSA Realty Corporation) March 26, 2001

This SEC opinion is a response to a letter requesting confirmation on the

propriety of converting the advances of KSA's original shareholders, namely:
Kuok Philippine Properties, Inc., San Miguel Properties, Inc., A. Soriano
Corporation, Flory Company Ltd., ("original stockholders") into additional
paid-in capital.

Allegedly, KSA (a company engaged in business of property development),

undertook the construction of a condominium project. Subsequently, it
entered into an Investment Agreement with Rodamco Phil. B.V. (RPVB),
wherein it was agreed that RPBV shall hold an equity interest in the
company to the extent of twenty percent (20%) of KSA's outstanding capital
stock. Pursuant to said agreement the original stockholders contributed
money to finance the cost overruns for the completion and development of
the condominium project. These cash advances made by the original
stockholders are recorded in the books of KSA as "advances from
investors". The corporation now intends to convert these cash advances to
additional paid-in capital to provide KSA the ability to obtain loans from
banks and other financial institutions in furtherance of corporate objectives.
Hence, this request for confirmation.

On this issue, we confirm that the conversion of the advances of KSA's

stockholders into additional paid-in capital is in order. Generally
accepted accounting principles on stockholders such as (a) amount of
cash received, (b) face amount or sometimes the discounted present value
of money claims received or liabilities cancelled, or (c) fair value of non-cash
assets received including stock of an enterprise should be recorded at the
fair value of the items received with the credit going to additional paid-in
capital. If significant, such contributions may be designated as "donated
capital".

●
8 Classes of Shares of Stock Except as provided in the immediately preceding paragraph, the vote
8.1 Classification and Equality of Shares, Voting Rights: REVISED required under this Code to approve a particular corporate act shall be
CORPORATION CODE §6, 1st , 2nd, 3rd, 4th & 8th paragraphs; §23, 5th deemed to refer only to stocks with voting rights.
paragraph;
Except as provided in the immediately preceding paragraph, the vote
Section 6. Classification of Shares. - The classification of shares, their required under this Code to approve a particular corporate act shall be
corresponding rights, priviledges, restrictions, and their stated par value, if deemed to refer only to stocks with voting rights.
any, must be indicated in the articles of incorporations. Each share shall be
equal in all respects to every other share, except as otherwise provided in xxx
the articles of incorporation. Each share shall be equal in all respects to
every other share, except as otherwise provided in the articles of A corporation may further classify its shares for the purpose of ensuring
incorporation and in the certificate of stock. compliance with constitutional or legal requirements.

The share stock corporations may be divided into classes or series of Section 23. Election of Directors or Trustees
shares, or both. No share may be deprived of voting rights except those In stock corporations, stockholders entitled to vote shall have the right to
classified and issued as "preferred" or "redeemable" shares, unless vote the number of shares of stock standing in their own names in the stock
otherwise provided in this Code: Provided, That there shall be a class or books of the corporation at the time fixed in the bylaws or where the bylaws
series of shares with complete voting rights. are silent at the time of the election. The said stockholder may: (a) vote such
number of shares for as many persons as there are directors to be elected;
Holders of nonvoting shares shall nevertheless be entitled to vote on the (b) cumulate said shares and give one (1) candidate as many votes as the
following matters; number of directors to be elected multiplied by the number of shares owned;
or (c) distribute them on the same principle among as many candidates as
(a) Amendment of the articles of incorporation; may be seen fit: Provided, That the total number of votes cast shall not
exceed the number of shares owned by the stockholders as shown in the
(b) Adoption and amendment of bylaws; books of the corporation multiplied by the whole number of directors to be
elected: Provided, however, That no delinquent stock shall be voted. Unless
(c) Sale, lease, echange, mortgage, pledge, or other disposition of all or otherwise provided in the articles of incorporation or in the bylaws, members
substantially all of the corporate property; of nonstock corporations may cast as many votes as there are trustees to be
elected by may not cast more than one (1) vote for one (1) candidate.
(d) Incurring, creating, or increasing bonded indebtedness;
Nominees for directors or trustees receiving the highest number of votes
shall be declared elected.
(e) Increase or decrease of authorized capital stock;
If no election is held, or the owners of majority of the outstanding capital
(f) Merger or consolidation of the corporation with another corporation or
stock or majority of the members entitled to vote are not present in person,
other corporations;
by proxy, or through remote communication or not voting in absentia at the
meeting, such meeting may be adjourned and the corporation shall proceed
(g) Investment of corporate funds in another corporation or business in
in accordance with Section 25 of this Code.
accordance with this Code; and

(h) Dissolution of the corporation. ● SEC Memorandum Circular No. 04-04 (dated March 17, 2004), #2
on ―One Share-One Vote Policy‖
● Power of a Corporation to classify shares: SEC Opinion addressed declaring the corporate policy of paying a portion or all of
to Attys. Emmanuel Paras et al dated May 10, 2002 such earnings to the stockholders of the corporation.
○ Question: validity of the proposed capital restructuring of Hence, the condition regarding the availability of
Laguna AAA Water Corporation unrestricted retained earnings is legal.
○ The restructuring is as follows: ○ As to the convertibility feature of the preferred shares, it is
―the Preferred shares are cumulative and convertible to proposed that the "Holders of the Preferred Shares shall
Common "B" shares. The Preferred Shares are entitled to have the option to convert all or a portion of the Preferred
dividends at an agreed rate (plus dividends for any unpaid Shares into Common "B" Shares of the corporation, at any
dividends at the same agreed rate from the time the time and from time to time upon giving at least thirty (30)
unpaid dividends cumulated until they are actually paid). days written notice to the corporation, until the end of the
Such dividends (and dividends on the dividends) will be third (3rd) year from the issue date of the Preferred
paid only if the Corporation has unrestricted retained Shares. . . At the end of such three (3) year period, all
earnings. Upon conversion of the Preferred Shares into unconverted Preferred Shares shall be converted into
Common "B" Share, if all or part of such dividends (and Common "B" Shares at par value, regardless of the
dividends on the dividend) remains unpaid, the Common existence of unrestricted retained earnings but subject to
"B" Shares will be entitled to receive such unpaid the Corporation's compliance with applicable laws, rules
dividends (and dividends on the dividends) only if the and regulations. Each unconverted Preferred Share shall
Corporation has unrestricted retained earnings. Common be converted into one (1) Common "B" Share. . ."
"A" Shares (and Common "B" Shares) will be entitled to ○ Also, SEC emphasized that, ―An amendment of the
receive cash dividends only after such receipt of unpaid articles of incorporation is required to formalize the
dividends by the Common "B" Shares.‖ conversion which must not result in watering of stock . . .
○ The SEC upheld the validity of this restructuring. or issuance of stocks in excess of the authorized capital
○ The Corporation Code provides that ―the shares of stock stock of the corporation. ‖
corporations may be divided into classes or series of ○ Lastly, in amending the articles of incorporation by
shares, or both, any of which classes or series of shares reclassification and conversion of shares, the amendment
may have such rights, privileges or restrictions as may be must not be prejudicial to the interest of the creditors and
stated in the articles of incorporation.‖ stockholders.
○ From the above, the corporations are thus expressly
empowered to classify their shares of stock into classes,
or series of shares, or both, possessing such rights, 8.2 Common shares: REVISED CORPORATION CODE §6, 2nd paragraph
privileges or restrictions as may be stated in the articles of The share stock corporations may be divided into classes or series of
incorporation, subject to certain legal and statutory shares, or both. No share may be deprived of voting rights except those
limitations. classified and issued as "preferred" or "redeemable" shares, unless
○ As to the terms of payment, "there is no hard and fast rule otherwise provided in this Code: Provided, That there shall be a class or
describing the interval of time between the date for the series of shares with complete voting rights.
declaration of dividends, the date of record or stockholders ● Common shares are voting shares: SEC Opinion addressed to
entitled thereto, and the date of payment, the same being Atty. C.L. Orcullo dated December 13, 1996
left to the sound and judicious discretion of the director." This is a reply to a letter-request, requesting for an opinion on
○ Also, for a valid declaration of dividends, two requisites whether the Article 7 of Matemara Inc, a domestic corporation
must concur: (1) the existence of unrestricted retained incorporated in 1972, which denies Class A common stock the right
earnings out of which the dividends may be declared and to vote, is not violation of Section 6 of the Corp Code
distributed; and (2) the resolution of the board of directors
 Per Sec. 6, common shares cannot be deprived of the right to the Corporation Code, quoted hereunder, only "preferred
vote. In relation to such, Sec. 148 gives already-existing shares", not "common shares" can be denied the right to vote.
corporations (because the Corp. Code was enacted in 1980) 2 ●
years to revise their Articles to comply with the applicable ● "SECTION 6. Classification of shares. — The shares of
provisions; otherwise, the SEC will consider said provisions as stock of corporations may be divided into classes or series of
written into the Articles. In this case, since Matemara failed to shares, or both, any of which classes or series of shares may
amend its Articles, the Section 6 requirement is deemed written as have such rights, privileges or restrictions as may be stated in
of May 1, 1980, and after said date, the holders of common shares the articles of incorporation: Provided, That no shares may be
shall enjoy equal rights and voting power. However, if the deprived of voting rights except those classified and issued as
corporation intends to deny voting rights to ―class A common "preferred" or "redeemable" shares unless otherwise provided
shares‖, it may amend its Articles to reclassify said shares to ―non- in this Code: . . ."
voting preferred shares‖ ●
● Thus, inasmuch as the Class "C" shares in question fall in the
● Non-voting trustee of common shares: SEC Opinion addressed to classification of "COMMON" shares, it is subject to the
Atty. Norberto C. Nazareno dated,July 15, 1999 foregoing provision. Consequently, the MANDATORY feature
in the Articles of Incorporation assigning the voting rights of the
● This refers to your letter dated June 17, 1997, requesting shares to a trustee which is tantamount to a virtual denial of
comments on the proposal of Philbank to develop another the voting rights of the holders thereof would indirectly violate
classification of common shares described as follows: the intention of the above provision of the Corporation Code.
●
● 1. A portion of the authorized and unsubscribed common
shares shall be classified as Class "C". ● Further, the mandatory feature in the Articles of Incorporation
● 2. Class "C" shares shall have the same rights, privileges, assigning the voting rights to a Trustee would contradict the
or restrictions as those of Class "A" shares except that the well-settled principle that transfer of right is a personal act
voting rights of the proposed Class "C" shares shall be which can only be done by the person who is entitled to
assigned to a Trustee who shall exercise all legal rights for all exercise such right.Even assuming that the original purchasers
corporate actions.Essentially, Class "C" shares shall exercise of the stocks voluntarily agree to assign their voting rights to a
economic and financial rights except voting rights with regard trustee in accordance with the above feature, a legal question
to corporate actions. crops up because the assignment of the voting rights by the
● 3. Class "C" common shares will be separately listed in the previous stockholders may not be binding to the subsequent
stock exchange and will be offered to both local and foreign series of purchasers of the shares brought about as a result of
investors, possibly at price lower or discounted from the price the listing of the shares in the stock exchange.
of Class "A shares.
● QUERY: is the arrangement of having the voting rights of ● In the light of the foregoing, we believe that the above
common-class C shares be assigned to a voting trustee described proposal is not legally feasible.
allowable? - No
●
● While the shares to be classified as Common Class "C" are not
denied the right to vote, it has a mandatory feature that such 8.3 Founders‘ shares: REVISED CORPORATION CODE §7
voting rights shall be assigned to a "Trustee" which feature
may be construed as a virtual denial of the voting rights. In this Section 7. Founders' Shares. - Founders' shares may be given certain rights
connection, it may be worth mentioning that under Section 6 of and privileges not enjoyed by the owners of other stock. Where the exclusive
right to vote and be voted for in the election of directors is granted, it must be 1. Are the rights of preferred shares affected by the above-mentioned
for a limited period not to exceed five (5) years from the date of SEC opinion, particularly on the preference of dividend rights?
incorporation: Provided, That such exclusive right shall not be allowed if its 2. Is it legal for the corporation to retain the existing founders shares
exercise will violate Commonwealth Act No. 108, otherwise known as the and thereafter issue common shares out of the proposed increase
"Anti-Dummy Law"; Republic Act No. 7042, otherwise known as the "Foreign of capital stock to replace the preferred shares with a specific
Investments Act of 1991"; and otherwise known as "Foreign Investments Act provision that all shares shall enjoy equal rights and voting power?
3. Is it necessary to recall all shares and replace it with common
of 1991"; and other pertinent laws.
shares?

● Nature of Effect of expiry of Founders‘ shares exclusivity: SEC The limitation in the above provision refers only to the exclusive right to vote
Opinion addressed to Atty. Alejandro M. Villamil dated August and be voted for in the election of directors, a right normally enjoyed by
10, 1995 holders of common shares, the class of shares which are supposed to have
Luzon Colleges, Inc. was incorporated as a stock corporation in 1948. It has complete voting rights.
two classes of shares: founders and preferred. The articles of incorporation
of the corporation states that only founders shares have the right to vote and Thus, if such right is removed from the founders shares, the same should be
the preferred shares cannot vote except in those cases provided for by law. transferred to the common shareholders who are supposed to exercise such
Luzon Colleges, Inc. is now in the process of amending its articles of right had there been no founders shares. Take note that under Section 6 of
incorporation by extending its corporate life; increasing its capital stock; and the Corporation Code, preferred shares can be denied the right to vote.
allowing all shares to enjoy equal rights and voting power. It seeks Moreover, the SEC opinion clearly states that after the expiration of the
clarification on Sec 07 of the Corporation Code and a SEC Opinion providing limitation period, founders shares shall have equal rights with the holders of
as follows: common shares, other classes of shares not included. Therefore, preferred
shares are not affected by the above provision of the Corporation Code and
"SECTION 7. Founders' shares. — Founders' shares classified as such
the SEC opinion. To hold otherwise, would be contrary to the provision of
in the articles of incorporation may be given certain rights and privileges not
enjoyed by the owners of other stocks. Provided, that where the exclusive Section 6 of the Corporation Code which expressly allows corporations to
right to vote and be voted for in the election of directors is granted, it provide in their articles of incorporation classification of shares which may
must be for a limited period not to exceed five (5) years subject to the have such rights, privileges or restrictions as may be stated therein.
approval of the Securities and Exchange Commission.The five-year Accordingly, the present status of preferred shares remains even after the
period shall commence from the date of the aforesaid approval by the expiration of the period provided for under Section 7 of the Corporation
Securities and Exchange Commission. (Emphasis supplied)
Code, and therefore, there is no need to replace them with common shares
and the above-cited SEC opinion states in part: coming from the proposed increase of capital stock of the corporation. In
order to reflect the present status of the founders' shares, what the
". . . if a corporation does not file an amendment to its articles of corporation should do is to amend its articles of incorporation renaming the
incorporation to comply with the above-mentioned limitation period on or existing founders shares to common shares but retain the status of preferred
before May 1, 1982, the Commission will consider the limitation laid down by
shares. The proposed increase of capital stock may either be classified into
Section 7 of the Corporation Code as inserted into the articles of
common or preferred
incorporation, on May 1, 1980. (SEC Opinions dated July 11, 1983, April 26,
1982 and May 5, 1982). Accordingly, the provisions in the articles of
incorporation granting the founders' shares the exclusive right to vote ● Term of Privilege – A remedial legislation: SEC Opinion addressed
and be voted for as directors shall be effective up to April 30, 1985. to Quasha Asperilla Ancheta Peña & Nolasco dated April 5, 1988
After said date, the holders of common and founders shares shall
enjoy equal rights and voting power."(Emphasis supplied) FACTS:
1. Shareholder owns and holds founders shares in Philippine
Issues: Petrochemical Products, Inc., a corporation organized in 1969.
2. The amended articles of incorporation creating the company's ● Nature of Entitlement of Preferred Shares on Dividends: SEC
founders' shares and common shares was approved by the Commission on Opinion No. 45-03 dated September 24, 2003 addressed to Atty.
May 11, 1973. Maria Zarah R. Villanueva (℅ SAN BEDA COLLEGE OF LAW )
ISSUE: Can these founders' shares continue to have the exclusive right to
vote and be voted for as directors? If not, what is the status of these ❖ The corporation incurred losses for the years 1999, 2000, and
founders' shares vis-a-vis the common shares? – rights given to the 2001. Hence, it has no unrestricted retained earnings and was not
founder's shares had already expired. able to declare dividends.
RULING: ❖ However, in the year 2002, the company had unrestricted retained
1. Section 7 of the Corporation Code of the Philippines is a remedial earnings and the Board of Directors declared dividends for the
legislation designed to prevent the abuse of founders' shares (wherein the years 1999, 2000, 2001 in favor of all preferred cumulative
right to elect the directors is reserved only to a minority group holding the shareholders at the rate of 10% of par value payable out of surplus
founders' shares) by limiting the privilege of the owners or holders thereof to or net profits.
a period of five (5) years. ❖ QUERY: Legality of the said act of your Board and whether the
2. Existing corporations affected by the new requirements of the Code unrestricted retained earnings in 2002 should be made to
were given a period of two (2) years from effectivity thereof (May 1, 1980) answer for the non-declaration of dividends for 1999, 2000 and
within which to comply with the same. Thus, if a corporation does not file an 2001.
amendment to its articles of incorporation on or before May 1, 1982, the ❖ Subject to the terms and conditions stated in your Articles of
Commission as a matter of policy, shall consider the limitation period set Incorporation and By-laws, a preferred share of stock is one which
forth in Section 7 of the Code as written into the articles of incorporation as entitles the holder thereof to certain preferences over the holders of
of May 1, 1980. common stock. The preferences are designed to induce persons to
3. The Commission considers the limitation period of 5 years subscribe for shares of a corporation.
underlying the founders' shares as written into the articles of incorporation of ❖ Preferred shares may be commonly classified into two: (1)
Petrochemical Products, Inc., such that the exclusive right to vote and be preferred shares as to assets share which gives the holder thereof
voted for in the election of directors earlier granted to the owners/holders of preference in the distribution of the assets of the corporation in
founders' shares had expired on April 30, 1985. case of liquidation) ; and (2) preferred shares as to dividends
4. Henceforth, common shares stand on equal footing with the (share the holder of which is entitled to receive dividends on said
founders' shares, both of classes of share enjoy equal rights and voting share to the extent agreed upon before any dividends at all are paid
power. to the holders of common stock. There is no guaranty, however,
that the share will receive any dividends.)
❖ Under the Corporation Code, the board of directors of a stock
8.4 Preferred shares: REVISED CORPORATION CODE §6, 6th paragraph corporation may declare dividends only out of unrestricted
Preferred shares of stock issued by a corporation may be given preference retained earnings. (Section 43, Corporation Code) Thus, the
in the distribution of dividends and in the distribution of corporate assets in declaration of dividends is dependent upon the availability of
case of liquidation, or such other preferences: Provided, That preferred surplus profit or unrestricted retained earnings, as the case
shares of stock may be issued only with a stated par value. The board of may be.
directors, where authorized in the articles of incorporation, may fix the terms ❖ Preferences granted to preferred stockholders, do not give them a
and conditions of preferred shares of stock or any series thereof: Provided, lien upon the property of the corporation nor make them creditors of
further, That such terms and conditions shall be effective upon filing of a the corporation, the right of the former being always subordinate to
certificate thereof with the Securities and Exchange Commission, hereinafter the latter
referred to as the "Commission". ❖ Dividends are thus payable only when there are profits earned
by the corporation and as a general rule, even if there are
 existing profits, the board of directors has the discretion to Provided, That such terms and conditions shall be
determine whether or not dividends are to be declared.
❖ Shareholders, both common and preferred, are considered risk effective upon 8ling of a certificate thereof with the
takers who invest capital in the business and who can look only to Securities and Exchange Commission."
what is left after corporate debts and liabilities are fully paid
● • The intent thereof is to allow the corporation
❖ Furthermore, the dividends may be made cumulative. Cumulative, if
the profits in any year are not enough to pay the preferred "to meet changes in market conditions which
dividends the deficiency is made up from the profits of the cannot be foreseen at the time of incorporation or
subsequent year before dividends can be paid to the holders of the
common stock. later amendment of articles of incorporation". (SEC
❖ "Whatever preferential rights and privileges may thus be granted to Opinion dated 09 August 1982, Philippine Telegraph
a stockholder, the law regards them as contractual. The certificate
and Telephone Corp.)
of stock is the muniment of the shareholder's title, and evidence of
his right. It expresses the contract between the corporation and his ● • Such is clearly contemplated in the subject
co-stockholders and himself). case of iBank, as its Amended Articles of
● Terms & Conditions of a Preferred Share: SEC Opinion No. 61-03 Incorporation explicitly states that its preferred
dated November 17, 2003 addressed to the Supervision and shares "may be redeemable or non-redeemable,
Examination Department, BSP
convertible or non-convertible to common stock, as
● This refers to your letters dated 17 October and 25
may be determined by the Board of Directors by a
July 2003 requesting our comments on whether
resolution duly approved". The terms or features of
International Exchange Bank (iBank) should amend
the preferred shares apply to the entire authorized
its Articles of Incorporation by virtue of the
preferred shares, whether issued or unissued.
conversion of its preferred shares, details of which
● • When the Amended Articles of Incorporation
follow:
of iBank containing the aforequoted features of its
● FRom: Redeemable, floating rate, non-convertible
preferred shares was approved by the Commission
● To: Non-redeemable, fixed rate for 5 years,
on 22 February 2001, said features were attached to
convertible
the entire preferred shares, and not only on the
● • Commission is of the opinion that there is no
unissued preferred shares, otherwise, the
need to amend iBank's Articles of Incorporation.
abovecited purpose for which the aforequoted
Pertinent portion of Section 6 of the Corporation
provision was incorporated in Section 6 of the Code
Code of the Philippines ("the Code") provides: "The
would be defeated.
Board of Directors, where authorized in its articles of
● • Thus, there is no need to amend the Articles
incorporation, may fix the terms and conditions of
of Incorporation of iBank.
preferred shares of stock or any series thereof:
 ● • However, the Corporate Secretary should file trustee bank and not be invested in risky or
with this Commission a Certi8cate, under oath, speculative ventures."
containing the approval by Board of Directors of the
To raise funds for its business, a corporation is allowed to
resolution 8xing the terms and conditions of the
issue redeemable shares provided it is expressly so
preferred shares. (SEC Opinion dated 11 January
provided in the articles of incorporation. l Redeemable
1982, Mr. Jose C. Vitug
shares are shares usually preferred.2 Preferred shares
are designed as such to induce persons to subscribe for
shares of a corporation. The compulsory or obligatory
8.5 Redeemable shares: REVISED CORPORATION CODE §8
Section 8. Redeemable Shares. - Redeemable shares may be issued by the redeemable shares is one which requires the issuing
corporation hen expressly provided in the articles of incorporation. They are corporation to redeem or repurchase its preferred shares
shares which may be purchased by the corporation. They are shares which
at a fixed date or at the option of the holder; thus, giving
may be purchased by the corporation from the holders of such shares upon
the expiration of a fixed period, regardless of the existence of unrestricted the shareholder the right to demand a return of his
retained earnings in the books of the corporation, and upon such other terms investment.
and conditions stated in the articles of incorporation and the certificate of
stock representing the shares, subject to rules and regulations issued by the
The issuance of redeemable shares may be likened to
Commission.
● Nature of Redeemable Shares, Sinking Fund: SEC-OGC Opinion temporary borrowings which enables a corporation to
No. 03-07 dated March 7, 2007 addressed to the Office of the adjust its capital structure to meet its varying conditions. 5
Supervisory Policy Development, Bangko Sentral ng Pilipinas The Corporation Code likewise states that even if a
corporation has no unrestrIcted earnings, it may
Query: whether the Corporation Code of the
purchase the redeemable shares at a fixed period. In
Philippines (CCP) NO.1, the Rules Governing
order not to violate the trust fund doctrine, however,
Redeemable and Treasury Shares (1982), is still
this Commission provides that the corporation must,
in effect. If so, can banks and their financial allied
after such redemption, have sufficient assets in its books
subsidiaries be exempted from complying with the
to cover debts and liabilities inclusive of capital stock.
said requirements?
Although the obligatory nature of the redeemable share is
inconsistent with the nature of the shareholder status,
"Section 5.4. All corporations which have issued
which properly involves taking some risks of business, a
redeemable shares with mandatory redemption
corporation is allowed to issue mandatory
features are required to set up and maintain a
redeemable
sinking fund. The fund shall be deposited with a
shares.7 In this case, a sinking fund is required to be The Company intends to redeem and retire 2,358,690
preferred shares.
established to protect the stockholders of a 1. Whether Quadriver can redeem the preferred shares
corporation. even without retained earnings and without violating
existing laws as well as the trust fund doctrine?
The case of banks and their fmancial allied subsidiaries - The Revised Corporation Code provides that corporation
has power to acquire own shares for a legitimate purpose,
are no different from any other corporations. The provided that the corporation has unrestricted retained
creditors and the stockholders must not be put at a earnings in its books to cover the shares to be purchased
disadvantage vis-a-vis the holders of redeemable shares. or acquired. The requirement of unrestrained retained
earnings to cover shares is based on the trust fund
Be that as it may, the Bangko Sentral ng Pilipinas (BSP) doctrine which means that property and other assets
as the primary regulator of banks and their financial allied of a corporation are regarded as equity in trust for the
subsidiaries has sufficient power and authority to prohibit payment of corporate creditors. The rationale is that a
corporation‘s creditors are preferred over the stockholders.
the redemption of preferred shares if such would result in Also Section 31 of the SEC Rules Governing Redeemable
the impairment of the required capital adequacy ratio. Treasury Shares also provides the necessity of
unrestricted retained earnings to redeem, repurchase, or
With this, the BSP may suspend the redemption of reacquire its own shares. However, an exception is
Section 3(1) of the SEC Rules which provides that,
preferred shares if the situation warrants such exercise of ―when the shares are reacquired in the redemption of
power but not totally exempt the banks and their financial redeemable shares of the corporation or pursuant to
allied subsidiaries from setting up a sinking fund for the conversion right of convertible shares of the
corporation, in accordance with the provision
preferred shares with mandatory redemption features. expressly provided for in its articles of incorporation
and certificates of stock representing said sahres of
● Redemption of Redeemable Preferred Shares: the corporation. This is based on Section 8 of the
- SEC-OGC Opinion No. 20-19 dated May 27, 2019 RCC. Also, Section 5(5) of the SEC Rules states that
addressed to Quadriver Energy Corporation redeemable shares may also be redeemed, regardless of
the existence of unrestricted retained earnings, provided
FACTS: that the corporation has after such redemption, sufficient
Quadrivers Energy Corporation (Quadriver) is assets in its books to cover debts and liabilities inclusive of
engaged in the business of building, constructing, capital stock.
generating, operating, and maintaining power plants which
produce energy derived from coal, fossil, fuel, geothermal, 2. Whether Quadriver‘s redemption of the preferred shares
natural gas, biomass, solar, wind, hydroelectric,and other will not result to insolvency?
viable sources or power. It is registered with the SEC in - SEC refrained from categorically answering the question
2011. In 2016, Quadriver decreased its capital stock to because it requires determination of factual issues.
P1,012,467,000 and reclassified its shares into common However, for information purposes, the following was
and redeemable preferred shares. Sta. Clara Group, Inc. given. The right to redeem shares is subject to the
is currently the sole subscriber to the preferred shares. condition that it would not render the corporation
insolvent, and that the corporation has sufficient
 funds to satisfy its debts and liabilities. Redemption preferred shares, which will be classified as treasury
therefor may not be made where the corporation is shares. Corporate counsel is requesting for confirmation of
insolvent or if such redemption will cause insolvency or his opinion that such redemption will not result in partial
inability of the corporation to meet its debts as they liquidation of KEPHILCO, even if such redemption results
mature. Also, the SEC Rules, provide that a corporation in reduction of subscribed capital, and as such, there will
that has issued redeemable shares shall set up and be no need to reduce the capital stock of the corp.
maintain a sinking fund to be deposited with a trustee (background info) Sec. 8 of the Corp Code provides
bank which shall not be invested in risky and speculative that redeemable shares may be purchased by the
ventures. corporation, regardless of existence of unrestricted
retained earnings. The SEC RUles governing Redeemable
3. Whether the redemption of the preferred shares will not and Treasury Shares further provide that, for redeemable
result to a reduction of subscribed capital stock of shares reacquired, they shall be considered retired and no
Quadriver? longer reissuable, unless the Articles of the corporation
-SEC Rules provide that redeemable shares when say otherwise. Treasury shares may still be reissued; it is
reacquired, the same shall be considered as retired and only upon retirement of said shares that they lose their
no longer issuale, unless provided in the Articles of status and the number of authorized shares of capital
Incorporation. This is opposite of the treasury shares stock are reduced accordingly. However, while a
which may be reissued by the corporation. Thus, when the corporation is allowed to redeem its preferred shares
Articles of Incorporation is silent, redeemable preference under its Articles, such redemption should not violate the
shares shall be considered as retired and can no longer ―trust fund doctrine‖; as explained by the SC in Republic
be reissued oncec it is retired. However, it shall remain in Planters Bank v. Agana, redemption may not be made
the treasury status until removed by decreasing the where the corporation is insolvent, or such redemption will
authorized capital stock. Thus 2 types of redeemable cause insolvency. Moreover, for the protection of
preferred shares: non-reissuable and reissuable. In the stockholders, the SEC Rules provide that a corporation
case of Quadriver, the articles of incorporation is silent on that has issued redeemable shares should set up and
the reissuable nature of the redeemable preferred shares. maintain a sinking fund (where cash is gradually set aside
Thus, once they are retired, they are no longer reissuable. in order to accumulate the amount necessary to meet the
In turn, the retirement of the treasury shares redemption price at specified future dates) which should
corresponding to the redeemed preferred shares have the be set aside and deposited with a trustee bank. Finally,
effect of decreasing the capital stock of the Company. the redemption must be made in good faith and without
prejudice to the rights of other creditors or shareholders.
- SEC-OGC Opinion No. 21-09 dated August 13, 2009 Based on the evaluation of the 2007 Audited Financial
addressed to KEPCO Philippines Corporation Statements of KEPHILCO, the Office of the General
KEPCO Phils (KEPHILCO) was registered in 1995 Accountant of the SEC found that: (1) the redemption of
with authorized capital stock of P105 Million, divided into the preferred shares appears to already have been made;
10,500,000 common shares with par value of P10 each. It (2) the redemption was not made in accordance with
increased its authorized capital stock in 1998 to KEPHILCO‘s Articles because (a) they were eliminated
P1,383,750,000, divided into the original common shares from the issued capital stock, which makes it appear that
plus 127,875,000 redeemable preferred shares with par they were retired, which is not consistent with the Articles,
value of P10 each; KEPCO International Hong Kong and (b) there is no recognition of the total cost of treasury
(KEPCO HK) subscribed to all of the preferred shares. preferred shares as a deduction from equity. In view of
KEPCO HK now proposes to surrender the redeemable said findings, the SEC cannot confirm that the redemption
 of preferred stock did not result in partial liquidation of the Since treasury shares do not revert back to unissued shares, they do
corporation, due to the lack of recognition of treasury not lose their status as ―issued shares.‖These are still part of the issued
shares in the equity of KEPHILCO capital stock although no longer outstanding. This is so because the amount
Note: subsequently, KEPHILCO submitted documents paid for the acquisition of treasury shares does not represent return of
and explained that it had appropriated a fund to cover the capital to the stockholders but an investment out of retained earnings on a
redemption price, and the SEC issued another letter- salable property known as treasury shares.
opinion stating that the redemption would not result in
partial liquidation
8.6 Treasury shares: REVISED CORPORATION CODE §9 2. Because of' its buy-back program, did Company A violate Section 13
Section 9. Treasury Shares. - Treasury shares are shares of stock which of the Corporation Code on minimum stock subs cription? NO, since
have been issued and fully paid for, but subsequently reacquired by the they are still part of the issued shares. Further, requirement applies only
issuing corporation through purchase, redemption, donation, or some other during Incorporation or increase of authorized capital stock.
lawful means. Such shares may again be disposed of for a reasonable price
fixed by the board of directors. 3. Considering that Company A is now planning to make available for
● Nature of Treasury Shares: SEC-OGC Opinion No. 12-06 dated 20 subscription/sale said treasury shares, can it sell the Same directly
April 2012 addressed to Rosalino Marable without having to ask the SEC for exemption from the registration
requirements of the Revised Securities Code? – NO.
● Part of Issued Shares: SEC-OGC Opinion No. 16-16 dated June
27, 2016 addressed to Antonino Group of Companies While the re-issuance of treasury shares is not exempt per se under
Company A has an authorized capital stock of P2,750,000.00 of which Sections 5 and 6 of said RSA, the same may be exempted from
28.4028% are subscribed. Company A bought out three (3) of its registration requirements considering that said transaction is of limited
shareholders which, many argued, has effectively reduced the subscribed character as the corporation does not normally acquire its own Shares of
capital stoc k to 15.8 127% or less than the 25% minimum capital stock stocks and the number of shares to be disposed of is usually minimal.
that is required to be subscribed, pursuant to Section 13 of the Corporation However, exemption thereof is not automatic. The corporation is still
Code. The subject treasury shares were not reported or recorded in the required to secure exemption from the Commission prior to such re-
balance sheet of the corporation. issuance pursuant to Section 6(b) of the RSA.

Issues: 4. Can Company A merely amend its audited financial statements

1. Under the circumstances, may Company A treat the treasury shares (particularly its balance sheet) and indicate therein the treasury
as part of issued shares? – YES. Company A may treat the treasury shares? Yes.
shares as part of the issued shares as long as they are not cancelled or Company A should amend its audited financial statements to indicate the
retired. treasury shares with proper disclosure as to amendment. The Commission
has opined that any declaration and issuance of treasury shares as property
Treasury shares are shares that have been earlier issued and are regarded dividend shall be disclosed and properly designated as property dividend in
as property acquired and currently owned by the corporation and not by any the books of the corporation and in its financial statements
of its stockholders.' Being the owner of treasury shares, the corporation may
opt to retire, sell or distribute as property dividends said shares.

Treasury shares do not revert to the unissued shares of a corporation but

are regarded as property acquired by the corporation which may be reissued
or resold by the corporation at a price to be fixed by the Board of Directors.
9 Stock Subscriptions Section 70. Effect of Delinquency. - No delinquent stock shall be voted for,
9.1 The Subscription Contract: REVISED CORPORATION CODE §59, §60, be entitled to vote, or be represented at any stockholder's meeting, nor shall
§65, §66, §70, §71 the holder thereof be entitled to any of the rights of a stockholder except the
right to dividends in accordance with the provisions of this Code, until and
Section 59. Subscription Contract. - Any contract for the acquisition of unless payment is made by the holder of such delinquent stock for the
unissued stock in an existing corporation or a corporation still to be formed amount due on the distribution with accrued interest, and the costs and
shall be deemed a subscription within the meaning of this Title, expenses of advertisement, if any.
notwithsatnding the fact that the parties refer to it as a purchase or some
other contract. Section 71. Rights of Unpaid Shares, Nondelinquent. - Holders of
subscribed shares not fully paid which are not delinquent shall have all the
Section 60. Pre-incorporation Subscription. - A subscription of shares in a rights of a stockholder.
corporation till to be formed shall be irrevocable for a period of at least six (6)
months from the date of subscription, unless all of the other subscribers
consent to the revocation, or the corporation fails to incorporate wuthin the ● What is a Subscription Contract: SEC Opinion No. 12-03 dated
same period or within a longer period stipulated in the contract of April 14, 2003 addressed to OFW International Holdings, Inc [may
subscription. No pre-incorporation is submitted to the Commission . be skipped because it takes about the 25-25 rule}

Section 65. Interest on Unpaid Subscriptions. - Subscribers to stock shall be FIRST QUERY: Query was as to the authenticity of the stock certificates issued
liable to the corporation for interest on all unpaid subscriptions from the date by OFW International Holdings.
of subscription, if so required by and at the rate of interest fixed in the SEC: cannot make an absolute statement because SEC was unaware of the
subscription contract. If no rate of interest is fixed in the subscription surrounding facts relating to such query.
contract. If no rate of interest is fixed in the subscription contract, the 1. No certificate of stock shall be issued to a subscriber until the full
amount of his subscription together with interest and expenses (in case of
prevailing legal rate shall apply.
delinquent shares), if any is due, has been paid."
2. OFW International Holdings, Inc. is not on the list of issuers of
Section 66. Payment of Balance of Subscription. - Subject to the provisions registered or listed securities. Therefore, it is not mandated by law to file a
of the subscription contract, the board of directors may, at any time, declare registration statement nor is it required to comply with the requirements
due and payable to the corporation unpaid subscription and may collect the of Section 8 (Requirement of Registration of Securities) and Section 12
same or such percentage thereof, in either case, with accrued interest, if (Procedure of Registration of Securities) of the Securities Regulation Code.
any, as it may dem necessary. SECOND QUERY: whether or not the corporation is required to submit its own
Manual of Corporate Governance under SEC Memorandum Circular No. 2,
Payment of unpaid subscription or any percentage thereof, together with any Series of 2002 – NO
1. A perusal, however, of the primary purpose stated in the Articles of
interest accrued, shall be made on the date specified in the subscription
Incorporation of OFW International Holdings, Inc. discloses that the
contract or on the date stated in the call made by the board. Failure to pay corporation is an ordinary holding company and that it "shall not engage in
on such date shall render the entire balance due and payable and shall the business of an open-end investment company as defined in the
make the stockholder liable for interest at the legal rate on such balance, Investment Company Act (R.A. 2629 ), without first complying with the
unless a different interest at the legal rate on such balance, unless a applicable provisions of the said act; and without first engaging as a stock
different interest rate is provided in the subscription contract. The interest broker of general securities."
shall be computed from the date specified, until full payment of the 2. OFW International Holdings, Inc. is not one of those corporations
subscription. If no payment is made within thirty (30) days from the said sate, contemplated by said Circular as required to submit a Manual on
Corporate Governance. However, there is nothing that prevents an
all stocks covered by the subscription shall thereupon become delinquent
ordinary corporation, which is not required to submit a Manual of
and shall be subject to sale as hereinafter provided, unless the board of Corporate Governance, to adopt its own.
directors orders otherwise. THIRD QUERY: supposed limit set on stock subscription
SEC: 1. Whether or not calls for the balance of subscriptions may be made by
1. a subscription to the stock of a corporation has been generally defined installments;
as a contract by which the subscriber agrees to take a certain number The second paragraph of Section 67 provides:
of shares of the capital stock of a corporation, paying for the same or "Payment of any unpaid subscription or any percentage thereof, together
expressly or impliedly promising to pay for the same.
with the interest accrued, if any, shall be made on the date specified in the
2. a stock subscription is a contract between a corporation on one side
to sell a certain number of shares of its stock to the subscriber, and the contract of subscription or on the date stated in the call made by the board.
subscriber on the other side to purchase the stock from the corporation. Failure to pay on such date shall render the entire balance due and payable
3. Capital, as applied to corporations, refers to the money, property or and shall make the stockholder liable for interest at the legal rate on such
means contributed by stockholders as the form or basis for the business or balance, unless a different rate of interest is provided in the by-laws,
enterprise for which the corporation was organized and generally implies computed from such date until full payment. If within thirty (30) days from the
that such money or property or means has been contributed in payment said date no payment is made, all stocks covered by said subscription shall
for stock issued to the contributors. thereupon become delinquent and shall be subject to sale as hereinafter
4. On the other hand, subscribed capital stock refers to the portion of the
provided, unless the board of directors orders otherwise."
capital stock subscribed whether fully paid or not. It implies a subscription
contract for the acquisition of unissued stock in an existing corporation or • Thus, calls for the payment of the balance of the subscription may
a corporation still to be formed. be made on installment, because the Code itself provides that the contract of
5. Rationale for the 25-25 rule: They serve as an assurance to subscription or the call by the board of directors, as the case may be, may
a. the State of the successful prosecution of the business of require the payment of the entire unpaid subscription or only a certain
the corporation; and percentage thereof on the date specified for payment.
b. to the creditors of the corporation of the means of
obtaining satisfaction of their claims, at least to the It is worth noting, however, that Section 67 does not give the Board of
extent of the payment of the required subscription.
Directors absolute power to make a call for the payment of the unpaid
6. The 25%-25% requirements are mandatory only during
a. the pre-incorporation period (Section 13 of the subscription. The first paragraph of Section 67, in relation to Section 13 of
Corporation Code) and the Code, succinctly provides that the call for the payment of the unpaid
b. when the corporation undertakes to increase its subscriptions is required only when there is no fixed date for payment in the
authorized capital stock (Section 38). contract of subscription; otherwise, no amount of calls from the board will
7. the 25%-25% requirements do not extend to subsequent make the subscription due and payable until the arrival of the fixed date
subscriptions to the unsubscribed shares of the corporation because the provided for in the subscription contract.
evil risks of insolvency against which the law intends to safeguard the
public no longer exist
2. Whether or not stock certificates may be issued for the equivalent of the
shares partially paid in a subscription, even if the whole subscription has yet
to be fully paid or cannot be fully paid by the subscriber;
● Payment/Non-Payment of a Subscription Contract: SEC-OGC
Opinion No. 05-16 dated March 31, 2016 issued to Rural Bank of 3. Whether or not cash or stock dividends may be used to pay the balance of
Maasin (Southern Leyte), Inc. unpaid subscriptions;
ou mentioned in your letter that the Board of Directors of the Rural Bank of 4. Whether or not the whole subscription becomes delinquent upon a
Maasin (Southern Leyte), Inc. (the Corporation, for brevity) is contemplating stockholder's failure to pay an installment pursuant to a call for payment of
to make a call for the payment of the subscription for all stockholders on the balance of subscription by installment; and
installment basis; that a certain percentage of the unpaid subscriptions shall 5. Whether the procedure for the delinquency sale prescribed in Sec. 68 of
be declared due and payable at different dates. Consequently, you the Corporation Code (the Code) is mandatory in such a manner that the
requested clarification and/or confirmation on the following: board of directors of a corporation is precluded from adopting a different
procedure.
As you mentioned, the Corporation understands that: (a) a subscription is the stocks have been declared delinquent. Hence, you raised the following
one, entire, and indivisible whole contract based on the import of Section 64 sub-queries:
of the Code which states that "no certificate of stock shall be issued to a 1. Whether cash dividends may be applied to the balance of a non-
subscriber until the full amount of his subscription together with the interest delinquent subscription –NO
and expenses (in case of delinquent shares), if any is due, has been paid", Cash dividends cannot be withheld from the subscribers who have not fully
and (b) the principle of indivisibility of subscription is absolute as Section 64 paid their subscriptions unless they are delinquent on their unpaid
of the Code speaks of no exception. You thereby request for interpretation subscriptions.
of the foregoing principles in relation to the following: Basically, this is because the balance of the unpaid subscription is not yet
1. Whether stock certificates may be issued representing the amount due and demandable. The corporation may use the cash dividends to pay off
equivalent to subscriptions partially paid despite the balance being unpaid stockholders' subscription but which have not been declared delinquent only
and/or cannot be fully paid by a subscriber—NO if the stockholders concerned give their consent thereto.
Certificate of stock, shall be issued upon payment of the full amount of his 2. Whether stock dividends may be used to pay the balance of the unpaid
subscription together with the interest and expenses (in case of delinquent subscriptions. –NO
shares), if any is due. 5 This is pursuant to the doctrine of indivisibility of the A stockholder's indebtedness to a corporation under a subscription
subscription contract implicitly set forth under Section 64 of the Code, that is, agreement cannot be compensated with the amount of his shares in the
a subscription is one, entire and indivisible contract. same corporation,
The purpose of the prohibition is to prevent the partial disposition of a there being no relation of creditor and debtor with regard to such share.
subscription which is not fully paid, because if it is permitted, and the Under Section 43 (par. 1), "stock dividends shall be withheld from the
subscriber subsequently becomes delinquent in the payment of his delinquent stockholder until his unpaid subscription is fully paid." In other
subscription, the corporation may not be able to sell as many as his words, under the said provision, it is not allowed to apply stock dividend to
subscribed shares as would be necessary to cover the total amount due unpaid subscription. 12
from him, which is authorized under Section Moreover, it should be noted that the "declaration of stock dividend involves
2. Whether a stockholder may assign the balance of the subscription to a the creation and issue of new shares of stock.
third person in such a manner that the stock certificates will be issued to the The basis of the issue, insofar as payment into the corporation is not
stockholder for the paid portion and the balance to the third person who required of the recipient, is surplus assets which thus become converted into
assumes the payment of the balance of the subscription. -NO strict capital with all which that implies." Thus, a stock dividend which
"Accordingly, if the stockholder has not paid the full amount of his requires a transfer of surplus to capital account cannot be made without
subscription, he cannot transfer part of it in view of the indivisible nature of issuing new shares. Considering that the retained earnings/profits are
subscription contract. It is only upon full payment of the whole subscription already applied as payment to the new issuance of shares, the same cannot
that a stockholder can transfer the same to several transferees. be reapplied to previous subscriptions which are still unpaid. Likewise, to
However, the entire subscription, although not yet fully paid, may be allow the stocks issued pursuant to the declaration of stock dividend as
transferred to a single transferee, who as a result of the transfer, must payment to unpaid subscription would be, in effect, re-acquiring its own
assume the unpaid balance. It is necessary, however, to secure the consent shares, the proceeds of which will be applied to the unpaid subscription,
of the corporation since the transfer of subscription right contemplates a which case is not allowed under Section 41 of the Code which enumerates
novation of contract which under Article 1293 of the Civil Code of the the instances and conditions wherein a corporation can legally purchase or
Philippines cannot be made without the consent of the creditor." acquire its own shares

III. Whether or not cash or stock dividends may be used to pay the balance IV. Whether or not the whole subscription becomes delinquent upon a
of unpaid subscriptions. stockholder's failure to pay an installment pursuant to a call for payment of
In your letter, you stated your position that under Section 43 of the Code, the the balance of subscription by installment.
only time cash dividends may be applied to an unpaid subscription is when You requested that the following sub-queries be addressed:
1. Does the subscription become automatically delinquent within 30 days delinquent shares for sale under Section 68 thereof and the second one is
from the date stated in the call should the stockholder fails to pay?-YES by an action in Court to recover the unpaid subscription pursuant to Section
There is no need of a formal declaration of the Board for an unpaid 70 thereof. The unsuccessful attempt to follow the remedy by sale under
subscription to become delinquent in the event of failure to pay the unpaid said Section will not bar an action in Court to recover the unpaid subscription
subscription within the prescribed 30 day period from the date specified in pursuant to Section 70
the subscription contract or the date stated in the call.
Henceforth, the subscription becomes automatically delinquent upon the Unless the delinquent shares are sold in accordance with the Section 68, the
lapse of the 30 day period stated in the call, with the stockholder failing to ownership thereof remains with the stockholder.
pay.
● Effects of Delinquency: SEC Opinion dated March 13, 1998
2. What is the meaning of the word "unless the board of directors orders addressed to Atty. Jose A. Feria, Jr
otherwise"? Does it authorize the board of directors of a corporation to
remove the delinquency status of a particular subscription while not lifting ● THOMAS LEE HAZEN, JERRY W. MARKHAM. CORPORATIONS
the status of subscriptions similarly situated? AND OTHER BUSINESS ENTERPRISES, ―Section 5. Stock
Under the above provision, the phrase "unless the board orders otherwise" Subscriptions‖ 1418 - 1424 (2009)
means that the board of directors may order the removal of the delinquent
status of unpaid subscription. Unless, there is such an order from the board, Stock Subscription
its delinquent status remains. ● Promoters of a corporation often sell stock to potential investors in
As to whether the removal of the delinquency status could be applied only to advance of the formation of the corporation as well as after.
a particular subscription, it has been held that a call made upon some of the ● These sales are made under a subscription agreement.
subscribers is void or which requires some to pay a higher rate than the
others, pursuant to the rule that calls must operate uniformly upon all Bing Crosby Minute Maid Corp v. Eaton Recit ready
shareholders. ● Plaintiff corporation Minute Maid Corp (MMC) is a judgment creditor
A call cannot be of such a character as to permit the directors to practice of a frozen foods corporation (―X Corp‖) where Eaton is a
favoritism or act oppressively. shareholder. Plaintiff MMC seeks to recover the difference between
In like manner, if a call cannot be made discriminatorily, so should the the par value of the stock issued to it and the fair value of the
removal of the delinquency status. consideration it paid for such stock (total of 4,500 shares). The
lower court ruled in favor of the plaintiff, but the same court granted
3. Should a stockholder fail to pay an installment within 30 days from the Eaton‘s motion fo new trial. The general rule is that a shareholder
date stated in the call made by the board of directors, does that render the (Eaton in this case) is not personally liable for the debts of the
whole subscription delinquent or just the portion/percentage of the corporation (the frozen fords corporation). However, an exception
subscription which becomes due and payable?-YES to this would be: ―a subscriber who pays only a part of what he
Failure to pay on the date fixed by the board on call of subscription shall agreed to pay is liable to the creditors for the balance.‖
render the entire balance due and payable and make all the stocks covered Unfortunately, MMC cannot rely on this basis since MMC‘s appeal
by the said subscription delinquent and subject to sale at public auction. 17 did not include evidence that Eaton promised to pay all of the 4,500
shares but actually only paid a part thereof. So MMC had to rely on
V. Whether the procedure for the delinquency sale prescribed in Sec. 68 of the only other exception, which is ―that shareholders are personally
the Code is mandatory in such a manner that the board of directors of a liable for holding watered stock.‖ There are two theories supporting
corporation is precluded from adopting a different procedure.-YES this attachment of liability. First, misrepresentation theory and
If a stockholder fails to pay his unpaid subscription after a valid call, there second, statutory obligation theory.
are two (2) remedies under the Code for the corporation to enforce the
liability. The first remedy consists of permitting the corporation to put up
 ○ The misrepresentation theory is the one conclusions of law and entered judgment for the
accepted in most jurisdictions. The courts view plaintiff. In support of his motion for a new trial the
the issue of watered stock as a misrepresentation defendant assigned certain alleged defects in the
of the corporation's capital. Creditors who rely on findings as errors of law.
this misrepresentation are entitled to recover the
"water" from the holders of the watered shares. Factual circumstances:
○ In some jurisdictions where they have been
● The defendant formed a corporation to acquire his
enacted, the statutory obligation theory has
going frozen foods business. The Commissioner of
been applied. (See cases collected in 7 A.L.R.
Corporations issued a permit authorizing the
983-986; Dodd and Baker, Cases and Materials
corporation to sell and issue not more than 4,500
on Corporations (2d ed. 1951) p. 795, n. 7.) Under
shares of $10 par value stock to the defendant and
that theory the holder of watered stock is held
other named individuals in consideration of the
responsible to creditors whether or not they have
transfer of the business.
relied on an overvaluation of corporate capital.
● The permit provided that 1,022 shares be deposited in
● The SC held that in the State where the case was filed, only the escrow and not be transferred without the written consent
misrepresentation theory is used. Unfortunately, based on this of the commissioner, and that the escrowed shares not be
theor, two factual situations should be proven: 1 that the creditor sold or issued until the prospective shareholders named
(MMC) extended credit to the corporation after the wattered stock in the permit waived certain rights to dividends and to
was issued OR 2.) that the creditor did so without knowledge that
participation in any distribution of assets.
such watered stock was outstanding, which justifies the lower
court‘s order for a new trial. ● The defendant transferred his business to the
corporation. The corporation placed 1,022 shares in
escrow in his name pursuant to the provisions of the
BING CROSBY MINUTE MAID V. EATON (FULL TEXT IN CASE HE HAS permit. The remaining 3,478 shares were issued outright
QUESTIONS)
to the defendant and after three years were transferred to
● The plaintiff appeals from an order granting a new trial
the other persons named in the permit. Although the
after judgment in its favor. The defendant appeals from 1,022 shares were listed on the corporate records as held
the judgment. by the defendant (accompanied by the notation
● As a judgment creditor of a corporation, the plaintiff "escrowed"), they were never released from escrow. The
brought this action against a shareholder of the corporation had financial difficulties and executed an
corporation to recover the difference between the par assignment of its assets for the benefit of creditors to a
value of stock issued to him and the fair value of the credit association. The plaintiff recovered a judgment
consideration he paid for the stock. against the corporation for $21,246.42. A writ of execution
on the judgment was returned unsatisfied.
○ At the conclusion of the trial, the court, sitting
● The trial court found that the value to the corporation
without a jury, made findings of fact and
of the consideration from the defendant was
 $34,780.83; that 4,500 shares of stock having a par par value for the 4,500 shares registered in his name, the
value of $10 each were issued to the defendant and record on appeal discloses no evidence supporting this
he became the owner of those shares; that finding. Therefore, the defendant's liability cannot be
subsequent to the issue of the shares the corporation predicated upon the theory that a subscribing shareholder
purchased merchandise from the plaintiff and has not is liable for the full consideration agreed to be paid for the
yet paid for all of it; that some $15,000 of the shares.
judgment the [46 Cal.2d 487] plaintiff recovered from the ● The plaintiff seeks to base its recovery on the only other
corporation remains unsatisfied, and that the corporation exception to the limited liability rule that the record could
is insolvent. support, namely, liability for holding watered stock, which
● The judgment for the plaintiff was for $10,219.17-- is stock issued in return for properties or services worth
approximately the par value of the 1,022 shares of stock less than its par value. Accordingly, this case calls for an
placed in escrow. The judgment was based on the trial analysis of the rights of a creditor of an insolvent
court's conclusion that the defendant was liable for the corporation against a holder of watered stock. [4] Holders
difference between the par value of the 4,500 shares and of watered stock are generally held liable to the
the value of the consideration the defendant paid for corporation's creditors for the difference between the par
them. value of the stock and the amount paid in. [46 Cal.2d
● The plaintiff contends that the trial court's findings of fact 488]
were supported by the evidence and required a judgment ● [5] The defendant's first contention is that because of the
in its favor, and therefore that it was error to grant a new escrow he never became an owner of the 1,022 shares
trial. The defendant contends that the order granting a and that he therefore never acquired such title to the
new trial was proper because (1) the finding that he was 1,022 shares as would enable a creditor to proceed
the owner of 4,500 shares was unsupported by the against him for their par value. Section 25508 of the
evidence, and (2) the trial court failed to make a finding Corporations Code authorizes the Commissioner of
on a material issue raised by his answer. Corporations to require that shares be placed in escrow.
● [1] In this state a shareholder is ordinarily not personally This authority has frequently been exercised for the
liable for the debts of the corporation; he undertakes only protection of the public. The escrow in the present case
the risk that his shares may become worthless. (See permitted the defendant to retain some, but not all, of the
repeal of Cal. Const., art. XII, § 3, at general election, incidents of ownership in the 1,022 shares. Although he
Nov. 4, 1930; repeal of former Civ. Code, § 322, Stats. could not transfer the shares, it appears that despite the
1931, ch. 257, p. 444; Kaysser v. McNaughton, 6 Cal.2d escrow he was entitled to count them in determining the
248, 251-255 [57 P.2d 927].) There are, however, certain extent of his rights to vote and to participate in dividends
exceptions to this rule of limited liability. [2] For example, and asset distributions. The critical feature of the escrow
a subscriber to shares who pays in only part of what he for purposes of the present case is the absence of any
agreed to pay is liable to creditors for the balance. (Corp. restriction on representations that the escrowed shares
Code, §§ 1300, 1306.) [3] Although the trial court in the were outstanding and fully paid. Although the escrow
present case found that the defendant had agreed to pay contained provisions designed to protect future
 stockholders, it afforded no special protection to future ● [7a] In his answer the defendant alleged that in extending
creditors of the corporation. Therefore, the escrow did not credit to the corporation the plaintiff did not rely on the par
affect the rights of future creditors and it would appear value of the shares issued, but only on independent
that despite the escrow the defendant acquired sufficient investigation and reports as to the corporation's current
title to the 1,022 shares to permit the plaintiff to proceed cash position, its physical assets and its business
against him for their par value. experience. At the trial the plaintiff's district manager
● The defendant's second contention is that the trial court admitted that during the period when the plaintiff
failed to make a finding on a material issue raised by his extended credit to the corporation, (1) the district
answer. manager believed that the original capital of the
● The liability of a holder of watered stock has been based corporation amounted to only $25,000, and (2) the only
on one of two theories: the misrepresentation theory or financial statement of the corporation that the plaintiff ever
the statutory obligation theory. [6] The saw showed a capital stock account of less than $33,000.
misrepresentation theory is the one accepted in most These admissions would be sufficient to support a finding
jurisdictions. The courts view the issue of watered stock that the plaintiff did not rely on any misrepresentation
as a misrepresentation of the corporation's capital. arising out of the issuance of watered stock. The court
Creditors who rely on this misrepresentation are entitled made no finding on the issue of reliance. If the
to recover the "water" from the holders of the watered misrepresentation theory prevails in California, that issue
shares. (See cases collected in Ballantine, Corporations was material and the defendant was entitled to a finding
(rev. ed. 1946) § 350; Dodd and Baker, Cases and thereon. (Code Civ. Proc., § 632; see Edgar v. Hitch,
Materials on Corporations (2d ed. 1951) pp. 786-789; 11 ante, pp. 309, 312 [294 P.2d 3].) If the statutory obligation
Fletcher Cyclopedia of the Law of Private Corporations theory prevails, the fact that the plaintiff did not rely on
(rev. and perm. ed. 1932) § 5232, p. 568, n. 64, § 5233, any misrepresentation arising out of the issuance of
pp. 577-579; Bonbright, "Shareholders' Defenses Against watered stock is irrelevant and accordingly a finding on
Liability to Creditors on Watered Stock" [1925] 25 the issue of reliance would be surplusage.
Columb.L.Rev. 408, 412, 420-421.) ● It is therefore necessary to determine which theory
● Statutes expressly prohibiting watered stock are prevails in this state. The plaintiff concedes that before
commonplace today. (See statutes collected in 11 the enactment of section 1110 of the Corporations Code
Fletcher, Cyclopedia of the Law of Private Corporations (originally Civ. Code, § 299) in 1931, the
(rev. and perm. [46 Cal.2d 489] ed. 1932 § 5209.) In misrepresentation theory was the only one available to
some jurisdictions where they have been enacted, the creditors seeking to recover from holders of watered
statutory obligation theory has been applied. (See stock. (See Clark v. Tompkins, 205 Cal. 373 [270 P. 946];
cases collected in 7 A.L.R. 983-986; Dodd and Baker, Spencer v. Anderson, 193 Cal. 1, 6 [222 P. 355, 35 A.L.R.
Cases and Materials on Corporations (2d ed. 1951) p. 822]; Rhode v. Dock-Hop Co., 184 Cal. 367 [194 P. 11,
795, n. 7.) Under that theory the holder of watered stock 12 A.L.R. 437].) However, he contends that the
is held responsible to creditors whether or not they have enactment of that section reflected a legislative intent to
relied on an overvaluation of corporate capital. impose on the holders of watered stock a statutory
 obligation to creditors to make good the "water." [8] stock was issued (Clark v. Tompkins, supra, 205 Cal.
Section 1110 provides that "The value of the 373), or (2) with full knowledge that watered stock was
consideration to be received [46 Cal.2d 490] by a outstanding (Sherman v. S. K. D. Oil Co., 185 Cal. 534
corporation for the issue of shares having par value shall [197 P. 799]; Sherman v. Harley, 178 Cal. 584 [174 P.
be at least equal to the par value thereof, except that: (a) 901, 7 A.L.R. 950]. See also Spencer v. Anderson, supra,
A corporation may issue par value shares, as fully paid 193 Cal. 1, 6; Rhode v. Dock-Hop Co., supra, 184 Cal.
up, at less than par, if the board of directors determines 367, 378; R. H. Herron Co. v. Shaw, 165 Cal. 668, 671-
that such shares cannot be sold at par. ..." The statute 672 [133 P. 488, Ann.Cas. 1915A 1265]), cannot recover
does not expressly impose an obligation to creditors. from the holders of the watered stock. These decisions
Most jurisdictions having similar statutes have applied the indicate that under the misrepresentation theory reliance
misrepresentation theory obviously on the ground that by the creditor is a prerequisite to the liability of a holder
creditors are sufficiently protected against stock watering of watered stock. [7b] The trial court was therefore
schemes under that theory. (See cases collected in justified in ordering a new trial because of the absence of
Ballantine, Corporations (rev. ed. 1946) § 351, pp. 809- a finding on that issue. [46 Cal.2d 491] It is unnecessary
812; Dodd and Baker, Cases and Materials on to further consider the defendant's appeal from the
Corporations (2d ed. 1951) pp. 785-786; 11 Fletcher, judgment.
Cyclopedia of the Law of Private Corporations (rev. and ● The order granting the new trial is affirmed. The appeal
perm. ed. 1932) § 5209; Bonbright, "Shareholders' from the judgment is dismissed.
Defenses Against Liability to Creditors on Watered
Stock," [1925] 25 Columb.L.Rev. 408, 414-416, 422.) In
view of the cases in this state prior to 1931 adopting the
9.2 Pre-emptive Right - REVISED CORPORATION CODE §38
misrepresentation theory, it is reasonable to assume that Section 38. Power to Deny Preemptive Right. - All stockholders of a stock
the Legislature would have used clear language corporation shall enjoy preemptive right to subscribe to all issues or
expressing an intent to broaden the basis of liability of disposition of shares of any class, in proportion to their respective
holders of watered stock had it entertained such an shareholdings, unless such right is denied by the articles of incorporation or
intention. In this state the liability of a holder of watered an amendment thereto: Provided, That such preemptive right shall not
extend to shares issued in compliance with laws requiring stock offerings or
stock may only be based on the misrepresentation theory.
minimum stock ownership by the public; or to shares issued in good faith
● [9] The plaintiff contends that even under the with the approval of the stockholders representing two-thirds (2/3) of the
misrepresentation theory a creditor's reliance on the outstanding capital stock in exchange for property needed for corporate
misrepresentation arising out of the issuance of watered purposes or in payment of previously contracted debt.
stock should be conclusively presumed. This contention is ● Mandatory Nature
without substantial merit. If it should prevail, the - SEC-OGC Opinion No. 15-19 dated March 13, 2019
addressed to Baystreet Development Corporation;
misrepresentation theory and the statutory obligation
theory would be essentially identical. This court has held FACTS
that under the misrepresentation theory a person who
extended credit to a corporation (1) before the watered
· A Sale and Purchase Agreement (SPA) between Rodolfo shall not extend to shares to be issued
Tumbaga (Seller) and Baystreet Development in compliance with laws requiring stock
Corporation (BDC) (Buyer) on December 6, 2017 for offerings or minimum stock ownership
90% shares shares in Ron Daniell Construction by the public; or to shares to be issued
Corporation (RDCC) for P99M. in good faith with the approval of the
· BDC already paid P32M to the Seller which is equivalent stockholders representing two-thirds
to 29.10% of the shares in RDCC. (2/3) of the outstanding capital stock, in
· RDCC received a mandate from the Philippine exchange for property needed for
Contractors Accreditation Board (PCAB) to increase its corporate purposes or in payment of a
capitalization to P180M to maintain its Triple A previously contracted debt.
Accreditation. o Unless denied in the AOI, or the issuance falls
· RDCC plans to issue a new set of shares to increase its under the exceptions in Section 39, all existing
capitalization to meet the PCAB requirement. stockholders of record are entitled to exercise
their pre-emptive right to subscribe to all issues
and disposition of shares of any class of the
st
· 1 Query: How to ensure that BDC’s interest is unsubscribed portion of the authorized capital
protected and would not be diluted in the event that stock or increase of authorized capital stock in
RDCC issues additional shares? proportion to their stockholdings.
o BDC may maintain its proportionate interest in o The basis for the pre-emptive right is to maintain
RDCC by exercising its preemptive right. the proportionate interest and voting strength of
o Pre-emptive right – right granted to the existing stockholders in the corporation.
stocholders to have the first option to subscribe § Because in subscribing to shares there is
to any issuance or disposition of shares from the an understanding that the stockholder‘s
capital stock in proportion to their respective equity is fixed by the relation which the
shareholdings in the corporation. number of shares he subscribes bears
o The Corporation Code provides that the grant of to the total authorized capital stock,
pre-emptive right is mandatory, except in certain issued, unissued, subscribed,
situations as mentioned in the Code: unsubscribed, at the time of
§ Section 39. Power to deny pre-emptive subscription, and should not therefore
right. - All stockholders of a stock be diluted by the issuance of additional
corporation shall enjoy pre-emptive right shares as to affect voting rights,
to subscribe to all issues or disposition dividends, and distribution of assets,
of shares of any class, in proportion to without first giving him opportunity to
their respective shareholdings, unless subscribe to such shares in proportion
such right is denied by the articles of to his stockholdings.
incorporation or an amendment thereto: o Thus, in the absence of any provision in RDCC‘s
Provided, That such pre-emptive right AIO denying pre-emptive right and it does not
 fall under the exception in Section 39, BDC is Commission to act as private legal counsel, then
entitled to exercise its pre-emptive right to the Commission refrains from giving an opinion.
subscribe to additional shares of stock in
proportion to its stockholdings, in the event
RDCC issues a new set of shares.

nd - SEC-OGC Opinion No. 17-11 dated March 22, 2011

· 2 Query: How to secure that RDCC is only selling to
addressed to Atty. Marie Hope S. Jamero
BDC aside from holding its commitment to sell the 90% Bonlou Inc. was organized for the purpose of building
rd
share to BDC? AND 3 Query: How to execute the SPA a hospital. According to its Articles, it has an authorized
in the event of breach of Rodolfo B. Tumbaga as the capital stock of P40 Million divided into 3,000 common
Attorny-in-Fact of all shareholders in RCC in terms of shares and 1,000 preferred shares, with par value of
honoring their commitment to sell the 90%share to BDC. P10,000 per share. As of 2010, its subscribed capital
o SEC opined that under Section 5 of SEC stock is held by 149 individuals; of these, 69 subscribed to
Memorandum Circular no. 5, Series of 2003, the 30 shares each while 80 subscribed to 20 shares each.
They are now asking whether they can amend their
Commission shall refrain from rendering opinion
Articles to include a provision stating that an individual can
on the following: acquire and hold only 1 share.
§ Matters which involve substantive and There is nothing in the Corporation Code or the SEC
contractual rights of private parties who Rules that expressly prohibit the corporation from
would, in all probability, contest the restricting the number of shares that a person may own;
same in court if the opinion turns out to however, there is a need to examine the possible effects
be adverse to their interest of imposing this kind of restriction. If the proposed
§ Matters which would necessarily require a amendment is approved, how will it affect the
review and interpretations of contracts shareholdings of its current shareholders? The proposed
amendment does not state whether it will apply only
or an opinion on the validity of contracts
prospectively or not; in any case, restriction on ownership
since their interpretation of contract is of shares does not affect shares issued before the
justiciable in nature and contract review restriction unless the owners acquiesce thereto.
call for legal examination of contract Another matter that must be considered is the pre-
§ The request will entail gathering of legal emptive right of the company‘s stockholder, which is set in
materials or writing abstract essay for Section 39 of the Corporation Code. Said provision gives
the requesting party since the each stockholder the right to subscribe to all new issues of
Commission should not function or shares of any class that result from the increase in capital
resemble as legal counsel of private stock in proportion to his shareholdings, and is intended to
enable him to retain his proportionate interest in the
firms
corporation. Bonlou would have to amend the Articles to
o As the last 2 queries affect substantive and include an express denial of its stockholders‘ pre-emptive
contractual rights of the parties, entails right; without this express denial, the stockholders at the
interpretation of contract, and will constrain the time of the increase would have the right to subscribe to
the new shares in proportion to their shareholdings, and
 the proposal to limit the shareholdings to only 1 share Subsequent demands were made by the plaintiff, but the same was denied
each violates the pre-emptive right, while each stockholder as the shares have already been issued to Blair. The market price of the
who exercises the right will necessarily have more than 1 share increased over time from $450 up to $700.
share of stock, in contravention of the limitation imposed
ISSUE: Whether the plaintiff stockholder had the legal right to subscribe for
by the proposed amendment. and take the same number of shares of the new stock that he held of the old
In view of the foregoing, the proposed amendment – YES
needs to be reviewed and modified.
HELD:

● THOMAS LEE HAZEN, JERRY W. MARKHAM. CORPORATIONS Citing several jurisprudence, the Court applied them to the case in this
manner:
AND OTHER BUSINESS ENTERPRISES, ―Section 6. Preemptive
Rights‖, 1424 - 1446 (2009) The new stock came into existence through the exercise of a right belonging
Section 6. Preemptive rights wholly to the stockholders. As the right to increase the stock belonged to
them, the stock when increased belonged to them also, as it was issued for
The common law concept of preemptive rights sought to protect existing money and not for property or for some purpose other than the sale thereof
shareholders from dilution of their stock ownership through subsequent for money.
stock offerings to a few existing shareholders or to new ones.
By the increase of stock, the voting power of the plaintiff was reduced to ½,
and while he consented to the increase, he did not consent to the disposition
Stokes v. Continental Trust Co. of City of New York of the new stocks to Blair at less than its market value, nor by sale to any
person in any way except by an allotment to the stockholders.
FACTS:
The increase and sale involved the transfer of rights belonging to the
This is an action brought by a shareholder to compel the corporation to issue stockholders as part of their investment. The issue of new stock and the sale
to him at par such a proportion of an increase made in its capital stock as thereof to Blair Company was not only a transfer to them of one-half the
the number of shares held by him before such increase bore to the number voting power of the old stockholders, but also of an equitable right to one-
of all the shares originally issued, and for damages if said shares cannot be half the surplus which belonged to them. In other words, it was a partial
delivered to him. division of the property of the old stockholders.

The defendant, a banking corporation, received a proposition from Blair & The ownership of stock is in the nature of an inherent but indirect power to
Co, to increase its capital stock from $500,000 to $1,000,000 ($100 par), control the corporation.
and to sell the additional stocks to them at $450 per share.
The corporation has no rights hostile to those of the stockholders, but is the
Prior to the meeting, a circular letter was sent to each stockholder informing trustee for all including the minority. The new stock issued by the defendant
them of Blair‘s proposition, to which the plaintiff-stockholder replied. There under the permission of the statute did not belong to it, but was held by it the
was no outright denial by the bank, stating that his own proposition would be same as the original stock when first issued was held in trust for the
taken into consideration. stockholders. It has the same voting power as the old, share for share.

At the meeting called for that purpose, a resolution was approved to The stockholders decided to enlarge their holdings, not by increasing the
increase the shares. After which, the plaintiff-stockholder demanded from amount of each share, but by increasing the number of shares. The new
the defendant-bank the right to subscribe for 221 new shares at par value, stock belonged to the stockholders as an inherent right by virtue of their
and offered to pay the same immediately. Such demand was refused by the being stockholders, to be shared in proportion upon paying its par value or
bank. Another resolution was adopted, directing the sale of the additional the value per share fixed by vote of a majority of the stockholders, or
shares to Blair & Co. ascertained by a sale at public auction. While the corporation could not
compel the plaintiff to take new shares at any price, since they were
issued for money and not for property, it could not lawfully dispose of
those shares without giving him a chance to get his proportion at the 1. The common law rule in the Stokes case was changed by
same price that outsiders got theirs. He had an inchoate right to one statute. In Delaware, preemptive rights are denied unless the
share of the new stock for each share owned by him of the old stock, same rights appear in the certificate of incorporation.
provided he was ready to pay the price fixed by the stockholders. 2. Most publicly held corporations have not elected to include
preemptive rights because its inclusion impairs and delays
Of course, there is a distinction when the new stock is issued in payment for their ability to raise further capital.
property, but that is not this case. The stock in question was issued to be 3. Although rejected by most publicly owned corporations,
sold for money and was sold for money only. minority shareholders in close corporations may find
preemptive rights desireable. See Ross case.
The Corporation cannot, however, dispose of it to strangers against the
protest of any stockholder who insists that he has a right to his proportion.
Otherwise the majority could deprive the minority of their proportionate ROSS TRANSPORT v. CROTHERS
power in the election of directors and of their proportionate right to share in FACTS:
the surplus, each of which is an inherent, pre-emptive and vested right of 1. A derivative suit was filed by a stockholder of a Maryland
property. It is inviolable and can neither be taken away nor lessened corporation.
without consent, or a waiver implying consent. a. To set aside the issuance of shares of stock to four
persons.
The plaintiff had power, before the increase of stock, to vote on 221 shares 2. The corporation was organized to operate a fleet of buses.
of stock, out of a total of 5,000, at any meeting held by the stockholders for 3. New stocks were issued to the Williams Family (some of them
any purpose. By the action of the majority, taken against his will and protest, were existing officers of the company). The Williams and Ross
he now has only one-half the voting power that he had before, because the had controlling interest in the company.
number of shares has been doubled while he still owns but 221. This a. Mr. Williams testified that the stocks in question were
touches him as a stockholder in such a way as to deprive him of a right of sold to him personally under the directors resolution.
property. Blair Company acquired virtual control, while he and the other 4. No other directors meeting was held to authorize any of the
stockholders lost it. We are not discussing equities, but legal rights, for this is sales made after the original subscriptions and none of the other
an action at law, and the plaintiff was deprived of a strictly legal right. If the stockholders were given opportunity to buy.
result gives him an advantage over other stockholders, it is because he 5. The corporation argued:
stood upon his legal rights, while they did not. The question is what were his a. Such issuance was originally planed and the money
legal rights, not what his profit may be under the sale to Blair Company, but was needed to purchase additional buses. (but the
what it might have been if the new stock had been issued to him in facts show no need, the company was in fact on a
proportion to his holding of the old. The other stockholders could give their financial success as shown by several dividend
property to Blair Company, but they could not give his. declarations.)
6. The officers still denied that the corporation was in good financial
We are thus led to lay down the rule that a stockholder has an inherent right condition because the plaintiffs made no allowance for income
to a proportionate share of new stock issued for money only and not to and profit taxes.
purchase property for the purposes of the corporation or to effect a 7. The stockholders contend:
consolidation, and while he can waive that right, he cannot be deprived of it a. There were deprived of their pre-emptive rights to
without his consent except when the stock is issued at a fixed price not less purchase a proportionate amount of the remaining
than par and he is given the right to take at that price in proportion to his shares.
holding, or in some other equitable way that will enable him to protect his b. In selling to themselves and their nominees, Williams
interest by acting on his own judgment and using his own resources. This and Ross have abused their trust as officers and
rule is just to all and tends to prevent the tyranny of majorities which needs directors.
restraint, as well as virtual attempts to blackmail by small minorities which ISSUE: WON the stockholders were denied their preemptive rights – YES
should be prevented. RULING:
1. Existing stockholders are the owners of the business and are
Notes: entitled to hace that ownership continued in the same proportion.
2. It has been held that the preemptive rights do not exist where the
stock about to be issued is part of the original issue.
 a. This exception is based upon the fact that the original the only way to obtain such fund. The sale must be set aside as a
subscribers took their stock on the implied constructive fraud upon the stockholders.
understanding that the incorporators could complete
the sale of the remaining stock to obtain the capital KATZOWITZ v. SIDLER
thought necessary to start the business.
24 N.Y.2d 512, 301 N.Y.S.2d 470, 249 N.E.2d 359 (1969).
i. XPN to the XPN:
where the conditions
have changed since Three men, Isador Katzowitz, Jacob Sidler and Max Lasker, formed
the original issue several close corporations. They had been jointly engaged in several
3. Conflicting points of the parties:
a. Corporation/Officers: stocks issued were part of the corporate ventures for more than 25 years and had always been
original issue: equal partners with identical compensation from the corporations
b. Stockholders: conditions changed; no need to obtain they formed.
capital from the original issue since the corporation
became a financial success
4. SC: no need to discuss the contentions of the parties because they One such corporation is Sulburn Holding Corp. In 1961, Sulburn was
failed to recognize another controlling consideration. indebted to each stockholder to the extent of $2,500 for fees and
a. The doctrine of preemptive right is not affected by commissions earned. Instead of paying this debt, Sidler and Lasker
the identity of the purchasers of the issued
stocks. What it is concerned with is who did not wanted Sulburn to loan the money to another corporation which all
get it. But when officers and directors sell to three mencontrolled. Katzowitz dissented. Thus, in the meeting for
themselves and thereby gain an advantage, both that purpose, the only resolution passed at the meeting was that the
in value and in voting power, another situation corporation would pay the sum of $2,500 to each director.
arises, which it does not require the assertion of
the preemptive right to deal with.
b. Trustees cannot purchase at their own sale and Sidler and Lasker then held a special meeting. . The only item on the
trustees include directors of the corporation. agenda was the issuance of 75 shares of the corporation‘s common
c. General policy of the law forbidding a trustee to
become a purchaser either directly or indirectly at his
stock at $100 per ahare. The offer was to be made to stockholders
own sale in ‗accordance with their respective preemptive rights for the
i. Such transaction is entirely purpose of acquiring additional working capital‘. The amount to be
voidable at the option of the party interested raised was the exact amount owed by the corporation to its
ii. The affairs of the corporation
are generally intrusted to the exclusive shareholders.
management and control of the board of directors - The offering price for the securities was 1/18 the
and there is an inherent obligation not only that book value of the stock.
they will use their best efforts to promote the
- Only Sidler and Lasker attended the special board
interest of the shareholders but that they will in no
manner use their positions to advance their own meeting. They approved the issuance of the 75 shares.
individual interests.
iii. The transaction may not be Notice was mailed to each stockholder that they had the right to
ipso facto void, but it is not necessary to establish
that there has been actual fraud; the onus of proof purchase 25 shares of the corporation‘s stock at $100 a share. At
is upon them to establish fairness and adequacy about the same time Katzowitz received the notice, he received a
of the transaction. check for $2,500 from the corporation for his fees and commissions.
5. The transaction was null. The directors did not show that the Katzowitz did not exercise his option to buy the additional shares.
company needed that money so badly that the sale to themselves was
Sidler and Lasker purchased their full complement, 25 shares each.
This purchase by Sidler and Lasker caused an immediate dilution of it is in a declining industry or the company may be under the
the book value of the outstanding securities. direction of poor management. In these circumstances there may be
a business justification for a major disparity in issuing price and book
On August 25, 196Z the principal asset of Sulburn, a tractor trailer value in order to inject new capital into the corporation.
truck, was destroyed. On August 81, 1962 the directors unanimously
voted to dissolve the corporation. Upon dissolution, Sidler and When new shares are issued, however, at prices far below fair value
Lasker each received $18,885.52 but Katzowitz only received in a close corporation or a corporation with only a limited market for
$3,147.59. its shares, existing stockholders, who do not want to invest or do not
have the capacity to invest additional funds, can have their equity
The plaintiff instituted a declaratory judgment action to establish his interest in the corporation diluted to the vanishing point.
right to the proportional interest in the assets of Sulburn in liquidation
less the $5,000 which Sidler and Lasker used to purchase their The protection afforded by stock rights is illusory in close
shares in December, 1961. corporations. Even if a buyer could be found for the rights, they
would have to be sold at an inadequate price because of the nature
Held: By permitting the defendants to recover their additional of a close corporation. Outsiders are normally discouraged from
inveetment in Sulburn before the remaining assets of Sulburn acquiring minority interests after a close corporation has been
are distributed to the stockholders upon dissolution, all the organized. Certainly a stockholder in a close corporation in a at a
stockholders will be treated equitably. Katzowitz, therefore, total loss to safeguard his equity from dilution if no rights are offered
should receive his aliquot share of the assets of Sulburn less and he does not want to invest additional funds.
the amount invested by Sidler and Lasker for their purchase of
stock on December 27, 1961. Though it is difficult to determine fair value for a corporation’s
securities and courts are therefore reluctant to get into the
thicket, when the issuing price is shown to be markedly below
Issuing stock for less than fair value can injure existing shareholders book value in a close corporation and when the remaining
by diluting their interest in the corporation‘s surplus, in current and shareholder-directors benefit from the issuance, a case for
future earnings and in the assets upon liquidation. Normally, a judicial relief has been established. In that instance, the
stockholder is protected from the loss of his equity from dilution, corporation’s directors must show that the issuing price falls
even though the stock is being offered at less than fair value, within some range which can be justified on the basis of valid
because the shareholder receives rights which he may either business seasons.
exercise or sell. If he exercises, he has protected his interest and, if
not, he can sell the rights, thereby compensating himself for the If no such showing is made by the directors, there is no reason
dilution of his remaining shares in the equity of the corporation. for the judiciary to abdicate its function to a majority of the
board or stockholders who have not seen fit to come forward
On rare occasions stock will be issued below book value because and justify the propriety of diverting property from the
this indicia of value is not reflective of the actual worth of the corporation and allow the issuance of securities to become an
corporation. The book value of the corporation‘s assets may be oppressive device permitting the dilution of the equity of
inflated or the company may not be glamorous to the public because dissident stockholders.
 situation. The price was so fixed to make the failure to invest costly.
The defendant directors here make no claim that the price set was a However, Katzowitz at the time might not have been aware of the
fair one. No business justification is offered to sustain it. Admittedly, dilution because no notice of the effect of the issuance of the new
the stock was sold at less than book value. The defendants simply shares on the already outstanding shares was disclosed.
contend that, as long as all stockholders were given an equal
opportunity to purchase additional 8hares, no stockholder can In addition, since the stipulation entitled Katzowitz to the same
complain simply because the offering dilutes his interest in the compensation sß Sidler and Lasker, the disparity in equity interest
corporation. The defendants’ argument is fallacious. caused by their purchase of additional securities in 1961 did not
affect stockholder income from Sulburn and, therefore, Katzowitz
The corollary of a stockholder‘s right to maintain hi8 proportionate possibly was not aware of the effect of the stock issuance on his
equity in a corporation by purchasing additional shares i8 the right interest in the corporation until dissolution.
not to purchase additional shares without being confronted with
dilution of his existing equity if no valid business justification exists Other Cases:
for the dilution. 1. Schwartz v. Marten: even though preemptive rights did not apply
to treasury shares and even if the corporate charter did not provide
A stockholder‘s right not to purchase is seriously undermined if the for preemptive rights, the members of the board were required to
stock offered if worth sub8tantially more than the offering price. Any justify the sale of treasury stock by showing a bona fide business
purchase at this price dilutes his interest and impairs the value of his purpose that could not have been achieved by other means. Such
original holding. action would otherwise be a breach of fiduciary duties to the other
shareholders.
Plaintiff has a right to insist upon compliance with the law whether or
not he cares to exercise his option. He cannot block a sale for a fair
price merely because he disagrees with the wisdom of the plan but 10 Basic Taxation
10.1 Capital Gains tax on sale of shares:
he can insist that the sale price be fixed accordance with legal
10.1.1 Shares of stock not traded in the stock exchange: NATIONAL
requirements.
INTERNAL REVENUE CODE §27(D)(2), §28 (A)(7)(c). §28(B)(5)(c); as
amended by REPUBLIC ACT NO. 10963 §7; Revenue Regulations No.
Here the obvious disparity in selling price and book value was 11-18 §2.57.1 (A)(8), Revenue Regulations No. 6-2008 (April 22, 2008) §2
calculated to force the dissident stockholder into investing additional (t), §2(y), §2(h) §2(i) §2(v), §2(o), §2(p), §7 as amended by Revenue
sums. No valid business justification was advanced for the disparity Regulations No. 006-13 (April 11, 2013)
in price, and the only beneficiaries of the disparity were the two
director- stockholders who were eager to have additional capital in Sec. 27. Rates of Income Tax on Domestic Corporations -
the business. (D) Rates of Tax on Certain Passive Incomes -
(2) Capital Gains from the Sale of Shares of Stock Not Traded in the Stock
Exchange. - A final tax at the rate of fifteen percent (15%) shall be imposed
lt is no answer to Katzowitz‘ action that he was also given a chance
on net capital gains realized during the taxable year from the sale, exchange
to purchase additional shares at this bargain rate. The price was not or other disposition of shares of stock in a domestic corporation except
so much a bargain as it was a tactic, conscious or unconscious on shares sold or disposed of through the stock exchange.
the part of the directors, to place Katzowitz in a compromising
Section 28. Rates of Income Tax on Foreign Corporations. - (t) ―Acquired‖ as used in Sec. 7(c.6) of these Regulations when dealing with
(A) Tax on Resident Foreign Corporations. - wash sales of shares of stock, means acquired by purchase or by an
(7) Tax on Certain Incomes Received by a Resident Foreign Corporation. - exchange upon which the entire amount of gain or loss was recognized by
(c) Capital Gains from Sale of Shares of Stock Not Traded in the Stock law, and comprehends cases where the taxpayer has entered into a contract
Exchange. - A final tax at the rates prescribed below is hereby imposed or option within the sixty-one-day period to acquire by purchase or by such
upon the net capital gains realized during the taxable year from the sale, an exchange.
barter, exchange or other disposition of shares of stock in a domestic
corporation except shares sold or disposed of through the stock exchange: (y) ―Acquisition Cost‖ shall include the purchase price, tax assumed and the
commission paid.
Not over P100,000………………… 5%

(h) "Gross selling price" refers to the total amount of money or its equivalent
which the purchaser pays the seller as consideration for the shares of stock.
On any amount in excess of P100,000…… 10%

(i) "Gross value in money" means the "fair market value". In the case of
(B) Tax on Nonresident Foreign Corporation. - shares traded thru the stock exchange, "fair market value" shall consist of
(5) Tax on Certain Incomes Received by a Nonresident Foreign Corporation. the actual selling price at which the transaction was executed in the trading
- system and/or facilities of the Local Stock Exchange.
(c) Capital Gains from Sale of Shares of Stock not Traded in the Stock
Exchange. - A final tax at the rates prescribed below is hereby imposed (v) ―Book Value per Share‖ refers to the value per share computed by
upon the net capital gains realized during the taxable year from the sale, dividing the total Stockholders‘ Equity of a corporation or net assets of the
barter, exchange or other disposition of shares of stock in a domestic company by the number of outstanding shares or units of participation in a
corporation, except shares sold, or disposed of through the stock exchange: company. In case there are preferred shares as well as common shares, the
book value per common share is computed by deducting the liquidation
Not over P100,000………………… 5%
value of the preferred shares from the total equity of the corporation and
dividing the result by the number of common shares outstanding as of
balance sheet date. The liquidation value of the preferred shares is equal to
On any amount in excess of P100,000…… 10% the redemption price as of balance sheet date, including any premium and
cumulative preferred dividends in arrears.

(o) ―Net Capital Gain‖ means the excess of the gains from sales or
exchanges of capital assets over the losses from such sales or exchanges.

(A)Income Payments to a Citizen or to a Resident Alien Individual: (p) ―Net Capital Loss‖ means the excess of the losses from sales or
(8) Capital Gains from Sale of Shares of Stock Not Traded in the Stock exchanges of capital assets over the gains from such sales or exchanges.
Exchange. – On the net capital gains realized during the taxable year from
the sale, barter, exchange or other disposition of shares of stock in a
domestic corporation – Fifteen percent (15%) SEC. 7. SALE, BARTER OR EXCHANGE OF SHARES OF STOCK NOT
TRADED THROUGH A LOCAL STOCK EXCHANGE PURSUANT TO
SECS. 24(C), 25(A)(3), 25(B), 27(D)(2), 28(A)(7)(c), 28(B)(5)(c) OF THE
SEC.2. DEFINITION OF TERMS. — For purposes of these Regulations, the TAX CODE, AS AMENDED. —
following definitions of words and phrases are hereby adopted:
(a) Tax Rate. — The provisions of Sec. 39(B) of the Tax Code, as amended, (c.2.2) In the case of shares of stock not listed and traded in the local stock
notwithstanding, a final tax at the rates prescribed below is hereby imposed exchanges, the value of the shares of stock at the time of sale shall be the
on the sale, barter or exchange of shares of stock not traded through the fair market value. In determining the value of the shares, the Adjusted Net
Local Stock Exchange pursuant to Secs. 24(C), 25(A)(3), 25(B), 27(D)(2), Asset Method shall be used whereby all assets and liabilities are adjusted to
28(A)(7)(c) , 28(b)(5)( c) of the said Tax Code, as amended. fair market values. The net of adjusted asset minus the liability values is the
Amount of Capital Gain Tax Rate indicated value of the equity. For purposes of this section, the appraised
Not over Php 100,000…………..……… ………… 5% value of real property at the time of sale shall be the higher of –
On any amount in excess of Php 100,000 ………10% (1) The fair market value as determined by the Commissioner, or
(2) The fair market value as shown in the schedule of valued fixed by the
(b) Tax Base. — The tax imposed in Subsection (a) above shall be upon the Provincial and City Assessors, or
net capital gains realized during the taxable year from the sale, barter, (3) The fair market value as determined by Independent Appraiser.
exchange or disposition of shares of stock, except shares sold or disposed Illustrations:
of through the Local Stock Exchange which is covered by the provisions of Assume that Mr. X sold on April 30, 2013, 5000 shares of stock of ―A‖
Secs. 5 and 6 above. Corporation. ―A‖ Corporation has 10,000 outstanding shares The total assets
and liabilities of ―A‖ Corporation in its latest audited financial statements
(c) Determination of Amount and Recognition of Gain or Loss. — (AFS) are Php20,000,000 and Php5,000,000, respectively. Assuming further
(c.1) Determination of Selling Price. — In determining the selling price, the that the book value of all its assets and liabilities is also the market value
following rules shall apply: with the exception of its real property. Supposing, the market value of the
(c.1.1) In the case of cash sale, the selling price shall be the total real properties of ―A‖ Corporation are as follows:
consideration per deed of sale. Book Value per AFS MV per Tax Declaration Zonal Valuation Independent
(c.1.2) If the total consideration of the sale or disposition consists partly in Appraiser Highest of the three Adjustment
money and partly in kind, the selling price shall be sum of money and the fair Land A 2,000,000 2,500,000 5,000,000 6,000,000 6,000,000 4,000,000
market value of the property received. Land B 2,000,000 2,200,000 4,000,000 3,500,000 4,000,000 2,000,000
(c.1.3) In the case of exchange, the selling price shall be the fair market Building A 1,000,000 2,400,000 3,000,000 3,000,000 2,000,000
value of the property received. Building B 500,000 2,000,000 1,950,000 2,000,000 1,500,000
(c.1.4) In case the fair market value of the shares of stock sold, bartered, or TOTAL 5,500,000 15,000,000 9,500,000
exchanged is greater than the amount of money and/or fair market value of In the above case, the net asset of ―A‖ Corporation is Php15,000,000 while
the property received, the excess of the fair market value of the shares of the adjusted net asset is Php24,500,000 [(20,000,000 + 9,500,000)-
stock sold, bartered or exchanged over the amount of money and the fair 5,000,000]. As such, with the adjusted value per shares of stock of
market value of the property, if any, received as consideration shall be Php2,450, the fair market value of the shares sold was Php12,250,000
deemed a gift subject to the donor‘s tax under Sec. 100 of the Tax Code, as (5000 shares at Php2,450 per share).
amended.
10.1.2 Donor’s Tax on Sale of Shares for Inadequate Consideration
(c.2) Definition of "fair market value" of the Shares of Stock. — For purposes ● Revenue Memorandum Circular No. 030-19 ―Clarifying Section
of this Section, "fair market value" of the shares of stock sold shall be: 100 of National Internal Revenue Code (NIRC) of 1997, as
(c.2.1) In the case of listed shares which were sold, transferred, or Amended by Republic Act (RA) No. 10963, or the "Tax Reform
exchanged outside of the trading system and/or facilities of the Local Stock for Acceleration and Inclusion (TRAIN Law)" in Relation to Sale
Exchange, the closing price on the day when the shares are sold, of Shares of Stock Not Traded or Listed‖, dated February 28,
transferred, or exchanged. When no sale is made in the Local Stock 2019
Exchange on the day when the listed shares are sold, transferred, or This circular is issued to clarify Section 100 of National Internal
exchanged, the closing price on the day nearest to the date of sale, transfer Revenue Code (NIRC) of 1997 (the Tax Code), as amended, particularly
or exchange of the shares shall be the fair market value.
on the issue of the existence or non-existence of "deemed gift." The TRAIN Law which took effect on January 1, 2018, however,
aDSIHc provides an exception. Section 100 of the Tax Code now further states
that "[P]rovided, however, That a sale, exchange or other transfer of
Prior to enactment of the TRAIN Law, Section 100 of the Tax Code, property made in the ordinary course of business (a transaction which
reads, as follows: is a bona fide, at arm's length, and free from any donative intent), will
be considered as made for an adequate and full consideration in
"SEC. 100. Transfer for Less Than Adequate and Full Consideration. — money or money's worth." cSEDTC
Where property, other than real property referred to in Section 24(D), is
transferred for less than an adequate and full consideration in money Under the rules of statutory construction, exceptions, as a general rule,
or money's worth, then the amount by which the fair market value of should be strictly, but reasonably construed; they extend only so far as
the property exceeded the value of the consideration shall, for the their language fairly warrants, and all doubts should be resolved in
purpose of the tax imposed by this Chapter, be deemed a gift, and shall favor of the general provisions rather than the exception. 2
be included in computing the amount of gifts made during the calendar
year." The appropriate and natural office of the exception is to exempt
something from the scope of the general words of a statute, which is
The legislative intendment of the "deemed gift'' provision under otherwise within the scope and meaning of such general words.
Section 100 of the Tax Code is to discourage the parties to a sale from Consequently, the existence of an exception in a statute clarifies the
manipulating their selling price in order to save on income taxes. This intent that the statute shall apply to all cases not excepted. Exceptions
is because under the Tax Code, the measurement of gain from a are subject to the rule of strict construction; hence, any doubt will be
disposition of property merely considers the amount realized from the resolved in favor of the general provision and against the exception.
sale, which is the selling price minus the basis of the property sold. Indeed, the liberal construction of a statute will seem to require in
Hence, if the parties would declare a lower selling price per document many circumstances that the exception, by which the operation of the
of sale than the actual amount of money which changed hands, there is statute is limited or abridged, should receive a restricted construction.
foregone revenue and the government is placed at a very 3
disadvantageous position. In order to plug this tax leakage, Section
100 automatically treats the disparity between the fair market value and Thus, starting January 1, 2018, when shares of stock not traded in
selling price of the property as gift subject to donor's tax. In short, the stock exchange are sold for less than its fair market value, the excess
"deemed gift" provision compliments the income tax rule on the of the fair market value over the selling price shall be treated as gift
measurement of gain and, accordingly, works to avoid the recurrence subject to donor's tax imposed by Section 100 of the 1997 NIRC, as
of under-declaration of the selling price. amended, except when it is sold at arm's length, free from any donative
intent (in the ordinary course of business). AIDSTE
Thus, if the FMV of the shares of stock is higher than the selling price,
the excess/difference shall be treated as gift subject to donor's tax. The determination of whether the sale of shares of stock not listed and
This has been confirmed in The Philippine American Life and General traded is at arm's length is a question of fact and not of law. Since an
Insurance Company vs. Secretary of Finance, et al. 1 where the arm's length transaction is a question of fact, it therefore behooves
Supreme Court ruled that "[t]he absence of donative intent, if that be upon the party seeking to apply the exception to prove that indeed the
the case, does not exempt the sales of stock transaction from donor's sale involves no irregularity between unrelated and independent
tax since Section 100 of the NIRC categorically states that the amount parties. This would require presentation and reception of reasonable
by which the fair market value of the property exceeded the value of evidence sufficient enough to convince that the sale of the shares of
the consideration shall be deemed a gift. Thus, even if there is no stock for less than its FMV is without intent to evade tax and defraud
actual donation, the difference in price is considered a donation." the government (of the tax due therein). The evidence that should be
presented should be viewed in accordance with its relation and Investment Co. (Sino-French), OWWI Limited (OWWI),
relevance to the transaction on a case to case basis. Nikko Pacven Walden Investments Ltd. (Nikko), Info
Tech Ventures Ltd. (InfoTech), and Walden AB Ayala
All revenue officials and employees are hereby enjoined to this
Ventures Co., Inc. (WAAVCI) [collectively the
Circular as wide a publicity as possible.
"Sellers"], for confirmation that the sale by the Sellers
Date Issued: February 28, 2019. of their common shares of stock in Software Ventures
International Corporation (SVI), a Philippine
||| (Clarifying Section 100 of National Internal Revenue Code (NIRC) of corporation whose shares are not traded in the
1997, as Amended by Republic Act (RA) No. 10963, or the "Tax Reform Philippine Stock Exchange (PSE), is not subject to
for Acceleration and Inclusion (TRAIN Law)" in Relation to Sale of donor's tax under Section 7 (c) (c.1) (c.1.4) of Revenue
Shares of Stock Not Traded or Listed, Revenue Memorandum Circular Regulations No. 6-2008, in relation to Section 100 of
No. 030-19, [February 28, 2019]) the Tax Code of 1997. aCTADI
● BIR Ruling No. 557-12 (Sept. 6, 2012) Pacven Walden Ventures
III L.P · It is represented that each of the Sellers is a venture
capital fund; that a venture capital fund is engaged in
Support short digest: making investments in and providing management
Sellers were undergoing liquidation and had to sell their varioys assistance to innovative, growth-oriented businesses
shares. They are have inquired before the RDOS. who both RDOs in various industries, for the purpose of achieving
concluded that no capital gains taxes were due because the medium-to long term capital appreciation; that with
acquisition cost for the Shares were greater than both the Selling
Price and the book value of the Shares. the exception of OWWI, all the Sellers form part of
However, RDO 39 and RDO 050 concluded that, since the book value Walden International, an established global venture
of the Shares was greater than the Selling Price, the Sellers should capital firm; that at present, the Sellers hold an
be liable for donor's tax on the difference between such book value
and the Selling Price.
aggregate of 61,708,189 shares in SVI (the Shares),
THE BIR essentially agreed with the RDOS citing Revenue registered under their respective names in the books
Regulations No. 6-2008, of the corporation
• (c.1.4) In case the fair market value of the shares of stock
sold, bartered, or exchanged is greater than the amount of money ·that on March 31, 2011, the Sellers sold the Shares to the
and/or fair market value of the property received, the excess of the following purchasers (collectively, the "Purchasers")
fair market value of the shares of stock sold, bartered or exchanged
for a total consideration of US$102,435.00 (the Selling
over the amount of money and the fair market value of the property,
if any, received as consideration shall be deemed a gift subject to Price),
the donor's tax under Sec. 100 of the Tax Code, as amended." and
Sec 100 of the Tax Code.
that the sale of the Shares were prompted by the following
reasons:
(1) The Sellers are undergoing liquidation and,
Gentlemen : accordingly, need to liquidate their investment in
SVI.
· This refers to your letter dated April 29, 2011
requesting on behalf of your clients, Pacven Walden With the exception of its investment in SVI, all of Sino-
Ventures III L.P. (PW3), Sino-French Capital French's investments have been liquidated.
that since late 2009, the Sellers have been trying to · "(c) Determination of Amount and Recognition
dispose of the Shares, but have encountered a of Gain or Loss. —
number of obstacles in their various attempts to
consummate a sale; that for instance, · (c.1) Determination of Selling Price. — In
determining the selling price, the following rules
In November 2010, the Sellers and the Purchasers began shall apply:"
to negotiate for the sale of the Shares and the sale
was consummated and the Deeds of Absolute Sale · (c.1.4) In case the fair market value of the
were finally executed in March 2011. ECAaTS shares of stock sold, bartered, or exchanged is
greater than the amount of money and/or fair
· · Donor's Tax Assessment
market value of the property received, the
· After the execution of the Deeds of Absolute Sale, excess of the fair market value of the shares of
the same (together with other supporting documents) stock sold, bartered or exchanged over the
were presented to BIR Revenue District Office (RDO) amount of money and the fair market value of the
No. 39 (South Quezon City), where all the Sellers (save property, if any, received as consideration shall
for WAAVCI) are registered, and RDO No. 050 (Makati be deemed a gift subject to the donor's tax under
City) where WAAVCI is registered, for computation of Sec. 100 of the Tax Code, as amended."
capital gains tax. (Underscoring supplied)

· Upon computation, both RDOs concluded that no · corollarily, Section 100 of the Tax Code, as amended,
capital gains taxes were due because the acquisition provides thus:
cost for the Shares were greater than both the Selling
· "Section 100. Transfer for Less Than Adequate
Price and the book value of the Shares.
and full Consideration. — Where property, other
· However, RDO 39 and RDO 050 concluded that, than real property referred to in Section 24(D), is
since the book value of the Shares was greater than transferred for less than an adequate and full
the Selling Price, the Sellers should be liable for consideration in money or money's worth, then
donor's tax on the difference between such book value the amount by which the fair market value of the
and the Selling Price. property exceeded the value of the consideration
shall, for the purpose of the tax imposed by this
Based on the foregoing representations, you now
Chapter, be deemed a gift, and shall be included
request for confirmation of your opinion that the sale
by the Sellers of their common shares of stock in SVI in computing the amount of gifts made during
is not subject to donor's tax under Section 7 (c) (c.1) the calendar year."
(c.1.4) of Revenue Regulations No. 6-2008, in relation · Prescinding from the above-mentioned provisions, it
to Section 100 of the Tax Code of 1997. SDHAEC is undisputed that there is no mentioned of any
· ISection 7 (c.1.4) of Revenue Regulations No. 6-2008, exempt transaction. The provisions are clear and free
states that: from any doubt or ambiguity.
 · Hence, there is no room for interpretation. There is not listed and traded through the Local Stock Exchange, it is subject to the
only room for application. 5% and 10% net capital gains tax.

· Accordingly, the sale of shares of stock in SVI by the RMC 3-2014: Circularizing BIR Ruling DA (c-133) 431-2008
Sellers at a price lower than the book value of the
shares, undertaken for the bonafide business purpose FACTS:
of liquidation, is NEVERTHELESS SUBJECT to donor's 1. BIR Ruling was issued to Fort Bonifacio Development Corporation,
tax as provided under Section 100 of the Tax Code, as holding that the transfer of FBDC‘s real properties to the Bases Conversion
amended, in relation to Section 7 (c.1.4) of Revenue and Development Authority, in redemption of its preferred shares held by
BCDA, is not subject to income tax, VAT, donor‘s tax and DST.
Regulations No. 6-2008.
2. The Revenue District Officer (RDO Dumayas) is of the view that the
transaction is VATABLE being a transaction deemed sale since FBDC is
10.1.3 Redemption of Shares and Treasury Shares Revenue engaged in the real estate business.
Regulations No. 6-2008 (April 22, 2008) §2(w) §2(x), §9; Revenue INCOME TAX – capital gains/loss
Memorandum Circular No. 3-2014 (January 6, 2014) (note: this is a RMC 1. Redemption is repurchase, reacquisition of stock. RR 6-2008
that quotes a BIR Ruling) consolidated the ruled on taxation of shares redeemed for cancellation or
(w) ―Treasury Shares‖ are shares of stock which have been issued and fully retirement.
paid for, but subsequently reacquired by the issuing corporation by a. Preferred shares are redeemed when the issuing corporation is still
purchase, redemption which is not for cancellation, donation or through a ―going concern‖ = capital gain or capital loss shall be recognized on the
some other lawful means. Such shares may again be disposed of for a basis of the amount received at the time of redemption and the cost of the
reasonable price fixed by the board of directors. preferred shares
i. Capital gains or loss shall be subject to regular income tax
(x) ―Redeemed Shares‖ are shares bought back by the issuing corporation b. Note: this does not cover situations where a corporation voluntarily
for the purpose of retirement or cancellation. buys back its own shares, becoming treasury shares.
i. Stock transaction tax will be applied in such case
SEC. 9. TAXATION OF SHARES REDEEMED FOR CANCELLATION OR 2. On the part of BCDA, any gain realized on the redemption by FBDC
RETIREMENT. - When preferred shares are redeemed at a time when the shall be subject to corporate income tax and consequently ro creditable
issuing corporation is still in its ―going-concern‖ and is not contemplating in withholding tax.
dissolving or liquidating its assets and liabilities, capital gain or capital loss 3. On the part of FBDC, the transaction is not subject to income tax
upon redemption shall be recognized on the basis of the difference between considering that the redeeming corporation does not realize any gain or loss
the amount/value received at the time of redemption and the cost of the on the redemption of its shares.
preferred shares. VALUE-ADDED TAX – YES, deemed sale
1. It is important to determine whether the particular property is a
Similarly, the capital gain or loss derived shall be subject to the regular capital asset or and ordinary asset.
income tax rates imposed under the Tax Code, as amended, on individual 2. Considering that FBDC is a real estate developer, all real properties
taxpayers or to the corporate income tax rate, in case of corporations. used in trade are considered its ordinary assets.
a. In general, the sale of real properties held primarily for sale to
This section, however, does not cover situations where a corporation customers shall be subect to VAT.
voluntarily buys back its own shares, in which it becomes treasury shares. In i. The transfer of the subject real properties by FBDC to BCDA is
such cases, the stock transaction tax under Sec. 127(A) of the Tax Code considered a transaction deemed sale under the Tax Code.
shall apply if the shares are listed and executed through the trading system 1. ―transfer of goods or properties originally intended for sale‖
and/or facilities of the Local Stock Exchange. Otherwise, if the shares are
ii. The VAT shall be based on the gross selling price defined as the transfer of ownership or title on any share of stock in violation of the
consideration or the FMV or the properties whichever is higher aforementioned requirements shall be punished in accordance with
DOCUMENTARY TAX – yes the provisions of Title X, Chapters I and II of the Tax Code, as
1. DST on the sale and conveyances or real property amended.

REVENUE MEMORANDUM CIRCULAR NO. 37-2012

10.1.4 Procedural Aspects for Shares Not Traded in the Stock
Exchange: BACKGROUND
● Payment of Tax and Filing of Returns: Revenue Regulations Revenue Memorandum Order (RMO) No. 15-03 dated May 8, 2003
No. 6-2008 (April 22, 2008) §10(c) prescribes the
SEC. 10. TIME OF PAYMENT OF TAX AND MANNER OF FILING policies, guidelines, and procedures, including the documentary
RETURNS. — The tax imposed under Section 5 of these requirements, in the issuance of
Regulations shall be collected as follows: Certificates Authorizing Registration (CARs) for transactions
(c) Tax on Shares of Stock Not Traded through the Local Stock subject to capital gains tax on the
Exchange. — sale, barter, transfer, or assignment of shares of stock not traded in
Persons deriving capital gains from the sale or exchange of listed the Stock Exchange.
shares of stock not traded through the Local Stock Exchange as Accordingly, a CAR is necessary before any transfer of shares of
prescribed by these regulations shall file a return within thirty (30) stock not traded in the Stock
days after each transaction and a final consolidated return of all Exchange may be transferred in the books of a corporation.
transactions during the taxable year on or before the fifteenth (15th)
day of the fourth (4th) month following the close of the taxable year. On the other hand, Section 11 of RR No. 06-08 only mentions the
In the case of an individual taxpayer, the filing of the final filing with and
consolidated return of all transactions shall be during the calendar recording by the stock transfer agent or secretary of the corporation
year. However, for corporate taxpayers, the filing of the final of the receipts of payment of
consolidated return of all transactions shall be in accordance with the tax in effecting the transfer of shares in the books of the
the accounting period employed by such taxpayer which may either corporation. The provision reads:
be calendar or fiscal year basis.
―SECTION 11. Effect of Non-Payment of Tax. — No sale,
● Effect of Non-payment/Certificate Authorizing Registration exchange, transfer or
(CAR): Revenue Regulations No. 6-2008 (April 22, 2008) §11; similar transaction intended to convey ownership of, or title to any
Revenue Memorandum Circular No. 37-2012 (August 3, 2012) share of stock shall be
registered in the books of the corporation unless the receipts of
SEC.11. EFFECT OF NON-PAYMENT OF TAX. — No sale, payment of the tax
exchange, transfer or similar transaction intended to convey herein imposed is filed with and recorded by the stock transfer
ownership of, or title to any share of stock shall be registered in the agent or secretary of
books of the corporation unless the receipts of payment of the tax the corporation. It shall be the duty of the aforesaid persons to
herein imposed is filed with and recorded by the stock transfer inform the Bureau of
agent or secretary of the corporation. It shall be the duty of the Internal Revenue in case of non-payment of tax. Any stock transfer
aforesaid persons to inform the Bureau of Internal Revenue in case agent or secretary of
of non-payment of tax. Any stock transfer agent or secretary of the the corporation or the stockbroker, who caused the registration of
corporation or the stockbroker, who caused the registration of transfer of ownership
 or title on any share of stock in violation of the aforementioned (B) Tax on Shares of Stock Sold or Exchanged Through Initial Public
requirements shall be Offering. - There shall be levied, assessed and collected on every sale,
punished in accordance with the provisions of Title X, Chapters I barter, exchange or other disposition through initial public offering of shares
and II of the Tax Code, of stock in closely held corporations, as defined herein, a tax at the rates
as amended.‖ (Emphasis supplied) provided hereunder based on the gross selling price or gross value in money
The above provision has caused some confusion whether a CAR is of the shares of stock sold, bartered, exchanged or otherwise disposed in
still necessary before accordance with the proportion of shares of stock sold, bartered, exchanged
shares of stock not traded in the Stock Exchange may be or otherwise disposed to the total outstanding shares of stock after the listing
transferred. in the local stock exchange:

CLARIFICATION Up to twenty-five percent (25%) ...................................................... 4%

In order to transfer ownership of shares of stock not traded in the Over twenty-five percent (25%) but not over thirty-three
Stock Exchange, it is
necessary to secure a CAR pursuant to the process laid down in and one third percent (33 1/3%) ..................................................... 2%
RMO No. 15-03. The receipts of
the payment of the tax should also be filed with and recorded by the Over thirty-three and one third percent (33 1/3%) ......................... 1%
secretary of the corporation
The tax herein imposed shall be paid by the issuing corporation in primary
pursuant to Section 11 of RR No. 06-08.
offering or by the seller in secondary offering.

For purposes of this Section, the term 'closely held corporation' means any
corporation at least fifty percent (50%) in value of outstanding capital stock
or at least fifty percent (505) of the total combined voting power of all classes
10.1.5 Shares of stocks listed in the local exchange: NATIONAL
of stock entitled to vote is owned directly or indirectly by or for not more than
INTERNAL REVENUE CODE §127 as amended by Republic Act 10963
twenty (20) individuals.
§39; Revenue Regulation No. 9-2018 (February 13, 2018); Revenue
Regulations No. 6-2008 (April 22, 2008) §2(g), §2(j), §2(k), §2(l), §2 (m),
For purposes of determining whether the corporation is a closely held
§2(n)
corporation, insofar as such determination is based on stock ownership, the
following rules shall be applied:
Section 127. Tax on Sale, Barter or Exchange of Shares of Stock Listed and
(1) Stock Not Owned by Individuals. - Stock owned directly or indirectly by or
Traded through the Local Stock Exchange or through Initial Public Offering. -
for a corporation, partnership, estate or trust shall be considered as being
owned proportionately by its shareholders, partners or beneficiaries.
(A) Tax on Sale, Barter or Exchange of Shares of Stock Listed and Traded
through the Local Stock Exchange. - There shall be levied, assessed and
(2) Family and Partnership Ownerships. - An individual shall be considered
collected on every sale, barter, exchange or other disposition of shares of
as owning the stock owned, directly or indirectly, by or for his family, or by or
stock listed and traded through the local stock exchange other than the sale
for his partner. For purposes of the paragraph, the 'family of an individual'
by a dealer in securities, a tax at the rate of six-tenths of one percent (6⁄10 of
includes only his brothers and sisters (whether by whole or half-blood),
1%) of the gross selling price or gross value in money of the shares of stock
spouse, ancestors and lineal descendants.
sold, bartered, exchanged or otherwise disposed which shall be paid by the
seller or transferor.
(3) Option. - If any person has an option acquire stock, such stock shall be
considered as owned by such person. For purposes of this paragraph, an
option to acquire such an option and each one of a series of options shall be (g) "Local Stock Exchange" refers to any domestic organization, association,
considered as an option to acquire such stock. or group of persons, whether incorporated or unincorporated, licensed or
unlicensed, which constitutes, maintains, or provides a market place or
(4) Constructive Ownership as Actual Ownership. - Stock constructively facilities for bringing together purchasers and sellers of stocks, and includes
owned by reason of the application of paragraph (1) or (3) hereof shall, for the market place and the market facilities maintained by such exchange.
purposes of applying paragraph (1) or (2), be treated as actually owned by ―Exchange‖ is an organized domestic marketplace or facility that brings
such person; but stock constructively owned by the individual by reason of together buyers and sellers and executes trades of securities and/or
the application of paragraph (2) hereof shall not be treated as owned by him commodities, duly registered with the Securities and Exchange Commission.
for purposes of again applying such paragraph in order to make another the (Sec. 3.7, SRC)
constructive owner of such stock.
(j) "Initial Public Offering (IPO)" refers to a public offering of shares of stock
(C) Return on Capital Gains Realized from Sale of Shares of Stocks. - made for the first time in the Local Stock Exchange.

(1) Return on Capital Gains Realized from Sale of Shares of Stock Listed (k) ―Primary Offering‖ refers to the original sale made to the investing public
and Traded in the Local Stock Exchange. - It shall be the duty of every stock by the issuer corporation of its unissued Shares of Stock.
broker who effected the sale subject to the tax imposed herein to collect the
tax and remit the same to the Bureau of Internal Revenue within five (5) (l) "Secondary Offering" refers to an offer for sale to the investing public by
banking days from the date of collection thereof and to submit on Mondays the existing shareholders of their securities which is conducted during an
of each week to the secretary of the stock exchange, of which he is a IPO or a follow-on/follow-through offering.
member, a true and complete return which shall contain a declaration of all
the transactions effected through him during the preceding week and of (m) ―Follow-on/Follow-through Offering of Shares‖ refers to an offering of
taxes collected by him and turned over to the Bureau Of Internal Revenue. shares to the investing public subsequent to an IPO.

(2) Return on Public Offerings of Share Stock. - In case of primary offering, (n) ―Shares Listed and Traded through the Local Stock Exchange‖, for
the corporate issuer shall file the return and pay the corresponding tax within purposes of these Regulations, refers to all sales, trades or transactions of
thirty (30) days from the date of listing of the shares of stock in the local listed Shares of Stock executed through the trading system and/or facilities
stock exchange. In the case of secondary offering, the provision of of the Local Stock Exchange. This term includes block sale or other types of
Subsection (C)(1) of this Section shall apply as to the time and manner of sales, trades or transactions in the Local Stock Exchange and executed
the payment of the tax. through the trading system and/or facilities of the Local Stock Exchange in
accordance with the rules of the Local Stock Exchange as approved by the
(D) Common Provisions. - any gain derived from the sale, barter, exchange Securities and Exchange Commission.
or other disposition of shares of stock under this Section shall be exempt
from the tax imposed in Sections 24(C), 27(D)(2), 28(A)(8)(c), and
28(B)(5)(c) of this Code and from the regular individual or corporate income 10.1.6 Dissolution of the corporation: Revenue Regulations No. 62008
tax. Tax paid under this Section shall not be deductible for income tax (April 22, 2008) §8
purposes.
SEC. 8. TAXATION OF SURRENDER OF SHARES BY THE INVESTOR
UPON DISSOLUTION OF THE CORPORATION AND LIQUIDATION OF
ASSETS AND LIABILITIES OF SAID CORPORATION. - Upon surrender by
the investor of the shares in exchange for cash and property distributed by
the issuing corporation upon its dissolution and liquidation of all assets and ISSUE:
liabilities, the investor shall recognize either capital gain or capital loss upon whether in determining the amount to be paid as documentary stamp tax, it
such surrender of shares computed by comparing the cash and fair market is the par value of the certificates of stock or the book value of the shares
value of property received against the cost of the investment in shares. The which should be considered -- par value
difference between the sum of the cash and the fair market value of property
received and the cost of the investment in shares shall represent the capital Sec. 224. Stamp tax on original issues of certificates of stock. — On
gain or capital loss from the investment, whichever is applicable. If the every original issue, whether on organization, reorganization or for any
investor is an individual, the rule on holding period shall apply and the lawful purpose, of certificates of stock by any association, company or
percentage of taxable capital gain or deductible capital loss shall depend on corporation, there shall be collected a documentary stamp tax of one
the number of months or years the shares are held by the investor. Section peso and ten centavos on each two hundred pesos, or fractional part
39 of the Tax Code, as amended, shall herein apply in all possible situations. thereof, of the par value of such certificates: Provided, That in the case
of the original issue of stock without par value the amount of the
The capital gain or loss derived therefrom shall be subject to the regular documentary stamp tax herein prescribed shall be based upon the
income tax rates imposed under the Tax Code, as amended, on individual actual consideration received by the association, company, or
taxpayers or to the corporate income tax rate, in case of corporations corporation for the issuance of such stock, and in the case of stock
dividends on the actual value represented by each share.
10.2 Documentary Stamp Tax Rates:
10.2.1 Original Issue: NATIONAL INTERNAL REVENUE CODE §174, as CA ruling: There are three (3) classes of stocks referred to in Section 224
amended by Republic Act 10963 §51 (now 175) of the Internal Revenue Code: (a) Certificate of Stocks with par
value, (b) Certificate of Stock with no par value and (c) stock dividends. The
Section 174. Stamp Tax on Original Issue of Shares of Stock. - On every first two (2) mentioned are original issuances of the corporation, association
original issue, whether on organization, reorganization or for any lawful or company while the third ones are taken by the corporation, association or
purpose, of shares of stock by any association, company, or corporation; company out of or from their unissued shares of stock, hence are also
there shall be collected a documentary stamp tax of Two pesos (₱2.00) on originals. Undoubtedly, all the three classifications are subject to the
each Two hundred pesos (₱200), or fractional part thereof, of the par value, documentary stamp tax.
of such shares of stock: Provided, That in the case of the original issue of
shares of stock without par value, the amount of the documentary stamp tax Conformably, in the case of stock certificates with par value, the
herein prescribed shall be based upon the actual consideration for the documentary stamp tax is based on the par value of the stock; for stock
issuance of such shares of stock: Provided, further, That in the case of stock certificates without par value, the same tax is computed from the actual
dividends, on the actual value represented by each share.. consideration received by the corporation, association or company; but for
stock dividends, documentary stamp tax is to be paid "on the actual value
represented by each share."
● Lincoln Philippine Life Insurance Company Inc. v. Court of Appeals;
G.R. No. 118043. July 23, 1998; 293 SCRA 92 (1998) Since in dividends, no consideration is technically received by the
corporation, petitioner is correct in basing the assessment on the book value
Facts: thereof rejecting the principles enunciated in Commissioner of Internal
Petitioner, Lincoln Philippine, now the Jardine-CMG Life Insurance Revenue vs. Heald Lumber Co. (10 SCRA 372) as the said case refers to
Company, Inc., is a domestic corporation engaged in the life insurance purchases of no-par certificates of stocks and not to stock dividends.
business. In 1984, it issued 50,000 shares of stock as stock dividends, with
a par value of P100 or a total of P5 million. Petitioner paid documentary SC:
stamp taxes on each certificate on the basis of its par value.
Apparently, the Court of Appeals treats stock dividends as distinct from Settled is the rule that, in case of doubt, tax laws must be construed strictly
ordinary shares of stock for purposes of the then §224 of the National against the State and liberally in favor of the taxpayer. This is because
Internal Revenue Code. There is, however, no basis for considering stock taxes, as burdens which must be endured by the taxpayer, should not be
dividends as a distinct class from ordinary shares of stock since under this presumed to go beyond what the law expressly and clearly declares. That
provision only certificates of stock are required to be distinguished (into such strict construction is necessary in this case is evidenced by the change
either one with par value or one without) rather than the classes of shares in the subject provision as presently worded, which now expressly levies the
themselves. said tax on shares of stock as against the privilege of issuing certificates of
stock
Indeed, a reading of the then §224 of the NIRC as quoted earlier, starting
from its heading, will show that the documentary stamp tax is not levied 10.2.2 Transfer of Shares: NATIONAL INTERNAL REVENUE CODE §175
upon the shares of stock per se but rather on the privilege of issuing as amended by Republic Act 10963 §52
certificates of stock.
● Sec. 175. Stamp Tax on Sales, Agreements to Sell, Memoranda of
A stock certificate is merely evidence of a share of stock and not the share Sales, Deliveries or Transfer of Shares or Certificates of Stock - On
itself. all sales, or agreements to sell, or memoranda of sales, or
deliveries, or transfer of shares or certificates of stock in any
Stock dividends are in the nature of shares of stock, the consideration association, company, or corporation, or transfer of such securities
for which is the amount of unrestricted retained earnings converted by assignment in blank, or by delivery, or by any paper or
into equity in the corporation's books. From the foregoing, it is clear agreement, or memorandum or other evidences of transfer or sale
that stock dividends are shares of stock and not certificates of stock whether entitling the holder in any manner to the benefit of such
which merely represent them. There is, therefore, no reason for stock, or to secure the future payment of money, or for the future
determining the actual value of such dividends for purposes of the transfer of any stock, there shall be collected a documentary stamp
documentary stamp tax if the certificates representing them indicate a tax of One peso and fifty centavos (₱1.50) on each Two hundred
par value. pesos (₱200), or fractional part thereof, of the par value of such
stock: Provided, That only one tax shall be collected on each sale
Apparently, the former tax code sought to distinguish between stock or transfer of stock from one person to another, regardless of
dividends without par value and other transactions involving ordinary shares whether or not a certificate of stock is issued, indorsed, or delivered
of stock without par value in the second clause of the then §224 in order to in pursuance of such sale or transfer: and Provided, further, That in
prevent claims that the former are exempt from documentary stamp taxes the case of stock without par value the amount of the documentary
as, unlike in the case of ordinary shares, corporations actually receive stamp tax herein prescribed shall be equivalent to fifty percent
nothing from their stockholders in exchange for such stock dividends. Hence (50%) of the documentary stamp tax paid upon the original issue of
the provision that, in the case of stock dividends, the amount of the said stock.
documentary stamp tax must be based on the actual value of each share.
10.2.3 When one party is exempt: NATIONAL INTERNAL REVENUE
It is also an error for the Solicitor General to contend that, under the then CODE §173
§224 of the NIRC, the basis for assessment is the actual value of the
business transaction that is the source of the original issuance of stock
certificates. To the contrary, the documentary stamp tax here is not levied Section 173. Stamp Taxes Upon Documents, Loan Agreements,
upon the specific transaction which gives rise to such original issuance but Instruments and Papers. - Upon documents, instruments, loan agreements
on the privilege of issuing certificates of stock. and papers, and upon acceptances, assignments, sales and transfers of the
obligation, right or property incident thereto, there shall be levied, collected
and paid for, and in respect of the transaction so had or accomplished, the
corresponding documentary stamp taxes prescribed in the following QUERY: Based on the foregoing representations, you now request for a ruling
Sections of this Title, by the person making, signing, issuing, accepting, or as to whether or not ASE, a PEZA registered enterprise, and ASE Holding
transferring the same wherever the document is made, signed, issued, Ltd., a non-resident foreign corporation organized and existing under the
accepted or transferred when the obligation or right arises from Philippine laws of Bermuda, are exempt from the payment of documentary stamp tax
sources or the property is situated in the Philippines, and the same time on the original issuance of shares as prescribed in Section 175 of the Tax
such act is done or transaction had: Provided, That whenever one party to Code of 1997.
the taxable document enjoys exemption from the tax herein imposed, the
other party who is not exempt shall be the one directly liable for the tax. In reply thereto, please be informed that Section 175 of the Tax Code of
1997 provides that a documentary stamp tax is imposed on every original
issue of a certi�cate of stock by any association, company or corporation,
whether on organization, reorganization or for any lawful purpose. The cost
● BIR Ruling No. DA-097-04 (ASE Holding Electronics (Philippines),
of imposition is borne by the corporation issuing the stock certi�cate.
Incorporated)
(Philippine Consolidated Coconut Industries vs. Collector of Internal
Revenue, 70 Phil. 24) Accordingly, the payment of documentary stamp tax, in
ASE Holding Electronics (Philippines), Incorporated [ASE] is a domestic this instant case, is a direct liability of the issuing corporation, i.e., ASE, on
corporation duly organized and existing under and by virtue of the laws of the original issue of certificates of stock to its stockholders.
the Philippines. It is a wholly-owned subsidiary of ASE Holding Ltd. of
However, since PEZA registered enterprises are liable to the preferential tax
Bermuda; that ASE is organized in 1995 and was registered with the
rate of 5% of the gross income earned which shall be in lieu of national and
Securities and Exchange Commission (SEC) on November 24, 1995. ASE is
local taxes pursuant to Section 24 of R.A. No. 7916, otherwise known as the
registered with the Philippine Economic Zone Authority (PEZA) as an
"Special Economic Zone Act of 1995", ASE, a PEZA registered enterprise is
Ecozone Export Enterprise and was granted Income Tax Holiday (ITH),
therefore exempt from the payment of documentary stamp tax on the
among other incentives, which expired last October 15, 2001. After the lapse
original issue of stock certificates to its stockholders. (BIR Ruling No. 077-98
of the ITH, ASE shall be liable to pay 5% �final tax on gross taxable income
dated May 28, 1998 and 104-98 dated June 29, 1998) On the other hand,
as provided in Section 24 of R.A. No. 7916, in lieu of national and local taxes;
Section 173 of the Tax Code of 1997 provides that "whenever one party to
that the capital structure of ASE as of March 31, 2003 is as follows:
the taxable document enjoys exemption from the tax herein imposed, the
ACS - 255,000 shares @ P1,000. (255M php) other party thereto who is not exempt shall be the one directly liable for the
tax." Such being the case, ASE is exempt from the documentary stamp tax,
SCS - 180,000 shares @ P1,000 (180M php) but ASE Holding Ltd., although a non-resident foreign corporation, is the one
directly liable for the said tax. (BIR Ruling No. 077-98 dated May 28. 1998)
Paid up capital - 180M php
But in BIR Ruling No. 007-2000 dated January 5, 2000, this Office ruled that
Moreover, the Board of Directors passed a resolution authorizing the —
increase of the Authorized Capital Stock of ASE and the conversion of
P2,498,733,000.00 worth of advances (deposit for future subscription) from ". . . Accordingly, it is the direct liability of STC-Taiwan, as
its parent company, ASE Holding Ltd. into equity; and that on August 7, 2003, stockholder of STPI, to pay the documentary stamp tax imposed
ASE �led with the SEC its amended Articles of Incorporation and certi�cate under Section 175 of the said Code. However, since STC-Taiwan is
of increase of its authorized capital stock for approval. a non-resident foreign corporation, it is not subject to Philippine
income tax as well as to the documentary stamp tax imposed
under said Section, since under its inherent limitations taxation may
 be exercised only within the territorial jurisdiction of the taxing 1. Reduce the authorized capital stock (ACS) of GADC
authority. (see 51 Am. Jur. 88) TSIDaH from P150,000,000 divided into 150,000 shares with
a par value of P1,000 per share to P146,953,348
SUCH BEING THE CASE, this O�FFICE holds that ASE, a PEZA-registered divided into 99,444 common shares with a par value
enterprise subject to the preferential tax rate of 5% based on its gross of P1,000 per share and 778 class A preferred
income earned, and ASE Holding Ltd., a non-resident foreign corporation
shares with a par value of P61,066 per share.
which is beyond the territorial jurisdiction of the taxing authority, are exempt
● that the class A preferred shares will be
from the payment of the documentary stamp tax on the original issuance of
allocated to MRO
shares as prescribed in Section 175 of the Tax Code of 1997.
● that of the 92,191 shares owned by MRO in
GADC 47,656 shares with par value of
10.3 Some Tax Consequences P1,000.00 per share will be
reclassified/converted into 778 class A
preferred shares with par value of P61,066.
10.3.1 Treatment of Conversion of Common to Preferred Shares: BIR Ruling per share;
No. DA-030-05 (January 24, 2005) (Golden Arches Development ● that all other outstanding shares will remain
Corporation) as common shares
● that class A preferred shares shall be non-
FACTS
voting;
● Golden Arches Development Corporation (GADC) is a
● that dividends declared by the board of
domestic corporation registered with the SEC, the primary
directors of GADC, if any, on said preferred
purpose of which is to establish, maintain, operate and
shares shall have the priority over the
manage, for its own account or for the account of other
common shares, but in no event shall the
entities or individuals, restaurants, cafes, bars and general
dividends on the preferred shares
food catering services. It has an authorized capital stock of
outstanding exceed P1.00 per share;
P150,000,000 divided into 150,000 shares with a par value
● that the holder of class A preferred shares
of P1,000per share. 147,100 shares are issued and
has the option to require GADC to purchase
outstanding.
back/redeem the preferred shares at any
● McDonald's Restaurants Operations, Inc., (MRO) is a non- time after the beginning of the 19th year
resident foreign corporation duly organized and existing from the date of the issuance of such
under the laws of the State Delaware, USA. It has not been preferred shares for a total redemption
licensed to do business in the Philippines as evidenced by equivalent to the Philippine Peso value of
the Certificate of Non-Registration issued by SEC. GADC the preferred shares on the date that the
has an outstanding debt due to MRO in the amount of preferred shares were issued;
P4,140,770,111 which is reflected in the balance sheet of 2. Increase the authorized capital stock from
GADC as "Advances from a stockholder". P146,953,348 divided into 99,444 common shares
● GADC will now undertake the following corporate with a par value of P1,000 per share and 778 class
restructuring: A preferred shares with a par value of P61,066 per
 share to P1,673,603,348 divided into 99,444 give rise to a taxable transaction and, therefore, not subject
common shares with a par value of P1,000 per to income tax on the part of MRO and GADC nor DST?
share and 2,500,105 class B preferred shares with o The conversion of the common shares into preferred
a par value of P61,066.00 per share. shares shall not be subject to capital gains tax
● that the 25,000 class B preferred shares since the holders thereof merely change the form of
shall be subscribed by MRO at a price equal their shareholdings from common shares to
to its par value of P1,526,650,000 plus a preferred shares and they do not realize any gain or
premium or additional paid-in capital of economic benefit therefrom.
P1,939,480,111 or a total aggregate o The exchange of common shares into preferred
subscription price of P3,466,130,111; shares qualifies as a mere recapitalization and no
● that MRO shall pay for said subscription gain or loss is recognized therefrom.
price of P3,466,130,111.00 out of GADC's o Recapitalization has been defined as a "readjustment
outstanding debt due to MRO reflected in of existing interests in the rearrangement of the
the balance sheet of GADC as "Advance capital structure" of the company, which generally
from a stockholder" are non-taxable to both, the holders and the issuing
● that the class B preferred shares shall be corporation.
voting; o Moreover, the conversion of the subject common
● that dividends declared by the board of shares into equivalent preferred shares does not
directors of GADC, if any, on said preferred partake of the issuance of original shares of stock,
shares shall have the priority over the hence, the same is not subject to the
common shares but in no event shall the documentary stamp tax imposed under Section
dividends on the preferred shares 175 of the Tax Code of 1997.
outstanding exceed P1.00 per share; o Likewise, the reclassification of the shares from
● that the holder of class B preferred shares at common shares into preferred shares of the
any time after the beginning of the 19th year stockholders in corporation is not subject to the
from the date of the issuance of such documentary stamp tax provided the new
preferred shares for a total redemption certificates are issued to the same stockholders and
equivalent to the Philippine Peso value of the par value is not higher than the replaced
the preferred shares on the date that the certificates.
preferred shares were issued; o Such being the case, since the new certificates will
● that the corporate restructuring is subject to
also be issued to the same shareholders of MRO,
the approval of the SEC which GADC
and the aggregate par value is not higher than the
anticipates within the year 2005.
replaced certificate, the same shall not be subject to
the documentary stamp tax.
● st
1 Query: Does the reclassification/conversion of a portion
of the common stock of GADC MRO to preferred stock not
● nd
2 Query: Is the subscription by and issuance to MRO of
preferred stock of GADC at a price equal to the par value of
 the preferred shares plus a premium to be paid out of subscription of Enrile to the unissued shares which is booked as additional
GADC's outstanding payables to MRO, a capital transaction paid-in capital and not income. Although treasury stock is considered an
and, therefore, not subject to donor's tax nor to income tax. asset, it is treated as such only because (1) it cannot be considered a liability
to shareholders and (2) the company may reissue/sell the same without the
The issuance of the preferred stock is, however, subject to
legal restrictions applicable to the issuance of unissued stock. Hence, the
DST.
issuance of treasury stock, like the issuance of unissued shares, should be
o The subscription by and issuance to MRO of GADC's considered a capital stock or equity transaction, and not an asset
preferred shares plus a premium is a capital transaction, and therefore should not be a taxable transaction. In this view,
transaction and, therefore, not subject to donor's the SEC confirms the opinion that the reissuance of treasury shares by JIC
tax, as well as to income tax. to Enrile is not subject to capital gains or income tax.
o The issuance of the preferred shares, however, will be
subject to documentary stamp tax pursuant to 10.3.3 Contributions for APIC
● Investment of Money Without Issuance of New Stock: BIR
Section 174 of the Tax Code of 1997.
Ruling No. DA-398-06 (June 26, 2006) (Chevron)
Chevron Philippines, Inc. (CPI) is a corporation duly organized and existing
under the laws of the Philippines; that its parent companies are Chevron
Global Energy, Inc. (CGEI) and Traders Insurance Limited (TIL); that CGEI
is a company registered in the United States,; that it holds the equivalent of
72.79% of the outstanding capital stock of CPI; that TIL, on the other hand,
is a company registered in Bermuda, that it holds the equivalent of 27.21%
10.3.2 Reissuance of Treasury Shares: BIR Ruling No. 002-05 (July 22,
of the outstanding capital stock of CPI; that the current breakdown of the
2005) (JAKA Investments Corporation)
capital stock of CPI is as follows:
In May 2003, JAKA Investment Corporation (JIC) re-issued its entire
26,000 treasury shares to Juan Ponce Enrile, one of its shareholders. He
Amount No. of Shares Type/%
originally sold back the shares for a nominal amount of P3Million (in order to
relinquish control when he was serving in government, and now that he‘s not
part of government, he seeks the reissuance). The shares were resold at
Authorized Capital P600,000,000 60,000,000 Common
P12.045M; and simultaneous with repurchase, Enrile also subscribed to the
Stock
remaining 4,695 unissued for P10.355M. The circumstances show that the
Subscribed Capital P535,794,410 53,579,441 Common
intent of the parties is for Enrile to regain a controlling interest in JIC. This
Stock
letter is requesting for confirmation that the reissuance of treasury shares
Paid-in Capital P535,794,410 53,579,441 Common
will not give rise to a taxable transaction.
Stock
Under Sec. 55 of RR-2, whether the acquisition results in taxable gain
Unsubscribed P64,205,590 6,420,559 Common
results on the real nature of the transaction. In here, JIC does not regularly
Capital Stock
deal in buy/sell of stocks; it is a family owned corporation of the Enriles.
Par Value P10 1 Common
Under SEC Rule 68, ―Gains or losses on sales of treasury shares should not
Stockholders
be credited or charged to income‖. The long-standing account principle is
CGEI P390,000,000 39,000,000 72.79%
that gains on sales of treasury shares should be credited to additional paid-
TIL P145,794,410 14,579,441 27.21%
in capital since they are not ordinary profits. No income is earned by JIC in
the transaction since the excess amount it received over the cost of treasury
shares is intended as additional working capital. Such excess amount is no
different from the excess amount JIC received from the additional
First Tranche
That in a Special Meeting of the Board of CPI, the Board called on the Query: Does the infusion by CGEI and TIL of additional paid-in capital into
stockholders of CPI to proportionately constitute additional paid-in capital CPI, without the issuance of additional shares of stock, is not subject to
(APIC) in the amount of Sixty Million US Dollars (US$60,000,000) to be used income, donor's and documentary stamp taxes.
as additional working capital of the Company and to reduce its borrowings;
that the following Resolution was unanimously approved by the Board in the Section 56 of Revenue Regulations No. 2, otherwise known as the Income
said meeting: Tax Regulations, provides that —
"Section 56. Contribution by shareholders. — Where a corporation requires
that in a duly constituted Special Meeting of the Shareholders of CPI on additional funds for conducting its business and obtains such needed money
January 24, 2006, more than 2/3 of its entire outstanding capital stock of CPI through voluntary process payments by its shareholders, the amounts so
voted to approve. received being credited to its surplus account or to a special capital account,
will not be considered income, although there is no increase in the
that consequently, on January 26, 2006, the stockholders of CPI outstanding shares of stock of the corporation. The payments in such
proportionately remitted a total of Sixty Million Dollars (US$60,000,000) as circumstances are in the nature of voluntary assessments upon, and
follows: represent an additional price paid for, in shares of stock held by the
US$43,680,000 from CGEI individual shareholders, and will be treated as an addition to and as part of
US$16,320,000 from TIL the operating capital of the company." IEAHca

Second Tranche In applying the above-cited provisions, this Office in BIR Ruling No. DA432-
That in another Special Meeting of the Board on April 25, 2006, the Board 05 dated October 20, 2005 ruled that —
called on the Stockholders of CPI to proportionately contribute APIC anew;
." "The infusion by Tupperware Asia Pacific Holdings Pte. Ltd. (TAPH) of
that in a Special Meeting of the Stockholders of CPI held on April 25, 2006, additional paid-in capital (APIC) into DPI, in the amount of One
more than 2/3 of the entire outstanding capital stock voted. Hundred Forty Million Five Hundred and Fifty Thousand Pesos
(P140,550,000.00), without the issuance of additional shares of stock, is
that thereafter, the Stockholders of CPI proportionately remitted the total deemed a capital investment, which is not included within the purview
amount of One Hundred Thirty Million US Dollars (US$130,000,000) on April of the term "taxable income" under the Tax Code of 1997, as amended,
26, 3006, as follows: therefore, not subject to income tax. . . . ;
US$94,630,000 from CGEI
US$35,370,000 from TIL "The remittance by TAPH to DPI of the amount of P140,550,000.00
intended as an additional capital contribution by the former, to
that the aforesaid APIC contributions, without CPI issuing additional augment the working capital and cash requirements of DPI, and
shares of stock, did not change the proportionate ownership of CGEI without the issuance of shares of stock, is not subject to donor's tax,
and TIL in CPI; that they merely increased the basis of the there being no intention to donate on the part of TAPH and that the
Stockholders' stock, but not CGEI's and TIL's respective proportionate transaction is effected purely for business reasons. . . . ; and lastly,
equity in CPI; and that to reiterate, the APIC contributions were for
purposes of increasing the working capital of CPI, settle various US "Considering that the cash contribution by TAPH to DPI will not involve the
Dollar inter-company service charges and loans, and pay short-term issuance of shares of stock by DPI, the same shall not be subject to
local borrowings. DST under Section 174 of the Tax Code of 1997, as amended. . . . ."

U may start here: SUCH BEING THE CASE, this Office is of the opinion that the infusion by
CGEI and TIL of APIC into CPI, without the issuance of additional shares of
stock, is not subject to income and donor's taxes and is likewise not subject
to the corresponding documentary stamp tax under Section 174 of the Tax In 1971, the National Power Corporation (NPC) and PGI (now UPI) entered
Code of 1997, as amended. into a service contract (the Old Service Contract) whereby NPC engaged the
services of UPI for the development, operation, and utilization of geothermal
resources found within the vicinity of Tiwi, Albay, Mt. Makiling in Laguna, and
Right to Service Contract for APIC: BIR Ruling No. DA-27805 (June 23, Mt. Banahao in Quezon (the Tiwi and Mak-Ban Geothermal Fields).
2005) (Unocal)
Section 3.1 of the Old Service Contract provided that the term of this
contract shall be twenty- five (25) years renewable for another twenty- five
Summary:
(25) years upon the option of UPI under the same terms and conditions set
Letter requesting on behalf of Client Unocal Philippines Inc (UPI) an
forth herein (the Renewability Provision).
opinion on the the tax implications of the assignment by UPI of the
Geothermal Resources Sales Contract (GRSC) and, as a necessary
After the first 25 years of the Service Contract, UPI attempted to renew the
consequence, the right to enter into the New Service Contracts, in
Old Service Contract for another 25 years. However, a dispute arose on the
favor of Philippine Geothermal Production Company, Inc. (PGPC) by
proper interpretation of the Renewability Provision of the Old Service
way of additional capital contribution, but without the issuance of
Contract.
additional PGPC shares. Such assignment was a result of a Court-
approved Compromise Agreement arising out of a dispute settled by
As a result of the dispute, the parties underwent arbitration, thereby resulting
arbitration between NPC and UPI regarding an old service contract.
into a Court-approved Compromise Agreement.
Held:
As part of the settlement of the dispute between NPC and UPI, and as a
Confirmation is thus requested for the following: (ALL CONFIRMED)
concession agreed to by UPI under the Compromise Agreement so that the
1. The assignment by UPI of the GRSC to PGPC and, as a necessary
parties can enter into two new service contracts, one for Tiwi Geothermal
consequence, the right to enter into the New Service Contracts, by way of
Complex and another for the Mak-Ban Geothermal Complex, replacing the
additional capital contribution, but without the issuance of additional
Old Service Contract (the New Service Contracts), UPI undertook to form
PGPC shares, would qualify as a non-taxable capital contribution under
before the the Geothermal Resources Sales Contract (GRSC) Effective
Section 56 of Revenue Regulations No. 2 such that no taxable gain or
Date a Philippine company at least 60 percent of which shall be owned
loss shall be recognized both to the transferor and the transferee since
by Philippine nationals. (Filco).
the transfer would be made as a capital contribution;
UPI intends to use Philippine Geothermal Production Company, Inc.
2. No documentary stamp tax (DST) shall be due upon the assignment by
(PGPC) as Filcofor the purpose of transferring the GRSC and entering into
UPI to PGPC of all its rights and interests in the GRSC and the right to
the transactions described below and in the Compromise Agreement. As
enter into the New Service Contracts;
agreed upon under Sections 5.0 and 6.0 of the Compromise Agreement,
Filco (i.e., PGPC) shall eventually take over from UPI the development and
3. No donor's tax shall be due upon the assignment by UPI of all its rights
operation of the Tiwi-Mak-Ban Geothermal Complexes by entering into the
and interests in the GRSC, and the right to enter into the New Service
New Service Contracts.
Contracts, as there is no intention to donate on the part of UPI; and
As a preliminary to the eventual take-over by PGPC from UPI of the
4. The assignment by UPI to PGPC of all its rights and interests in the
development and operation of the Tiwi-Mak-Ban Geothermal Complexes,
GRSC and the right to enter into the New Service Contracts is not subject
under Section 5.1 of the Compromise Agreement, UPI shall assign the
to value-added tax (VAT).
GRSC to Filco (i.e., PGPC) before the GRSC Effective Date. Thereafter,
once PGPC becomes "Filipinized", PGPC and PSALM will execute the New
Facts: Service Contracts pursuant to Section 6.2 of the Compromise Agreement.
 2. CONFIRMED: No documentary stamp tax (DST) shall be due upon
For this purpose, UPI intends to assign the GRSC to PGPC by way of an the assignment by UPI to PGPC of all its rights and interests in the
additional capital contribution but without the issuance of additional PGPC GRSC and the right to enter into the New Service Contracts;
shares.
Section 185 of Revenue Regulations No. 26, otherwise known as the
Confirmation is thus requested for the following: (ALL CONFIRMED) Documentary Stamp Tax Regulations, provides that —
1. CONFIRMED: The assignment by UPI of the GRSC to PGPC and, as a "Sec. 185. Conveyances without consideration. — Conveyances of realty,
necessary consequence, the right to enter into the New Service not in connection with a sale, to trustees or other persons without
Contracts, by way of additional capital contribution, but without the consideration are not taxable.
issuance of additional PGPC shares, would qualify as a non-taxable
capital contribution under Section 56 of Revenue Regulations No. 2 Thus, in BIR Ruling No. DA-065-05 dated February 23, 2005, it was ruled
such that no taxable gain or loss shall be recognized both to the that —
transferor and the transferee since the transfer would be made as a "Considering that Condrado and Sergia Estrella transferred the above- listed
capital contribution; real properties without the corresponding issuance of additional shares of
stock in their favor, the foregoing will be considered as contribution of
Section 56 of Revenue Regulations No. 2 provides as follows: additional paid-in capital, not subject to documentary stamp tax as the above
"Sec. 56. Contribution by shareholders. — Where a corporation requires conveyances of realties are without any consideration and are not made in
additional funds for conducting its business and obtains such needed money connection with a sale."
through voluntary process payments by its shareholders, the amounts so
received being credited to its surplus account or to a special capital account, Such being the case, the transfer of rights in a contract, e.g., assignment of
will not be considered income, although there is no increase in the rights and interests in the GRSC as well as the right to enter into the New
outstanding shares of stock of the corporation. The payments in such Service Contracts is not subject to the documentary stamp tax.
circumstances are in the nature of voluntary assessments upon, and
represent an additional price paid for, in shares of stock held by the 3. CONFIRMED: No donor's tax shall be due upon the assignment by
individual shareholders, and will be treated as an addition to and as part of UPI of all its rights and interests in the GRSC, and the right to enter
the operating capital of the company." into the New Service Contracts, as there is no intention to donate on
the part of UPI;
No taxable gain or loss shall be recognized considered that the transfers
were made as capital contributions in the Corporation whereby the Ratio: the foregoing transfer and assignment of rights by UPI is a necessary
transferees in the transfer of the shares to the Corporation do not realize consequence of the requirement imposed under the Court-approved
taxable income and therefore are not subject to Philippine income tax. Compromise Agreement and there is no donative intent on the part of UPI.
Moreover, the capital infusion shall effect no change in the equity
shareholdings of the stockholders of the Corporation. The transfer will 4. CONFIRMED: The assignment by UPI to PGPC of all its rights and
merely increase the basis of the stockholders' stock but not their interests in the GRSC and the right to enter into the New Service
proportionate equity in the corporation. Hence, the transaction not subject to Contracts is not subject to value-added tax (VAT).
income or gift taxes.
Ratio: the subject rights and interests in the GRSC and in the New Service
Finally, considering that the infusion of the APIC will not result in the Contracts are not held primarily for sale or lease in the ordinary course of
issuance of shares of stock by the Corporation, the same shall not be trade or business of UPI, as the transfer of the aforesaid property rights is
subject to documentary stamp tax imposed under Section 175 of the Tax not being made "in the course of trade or business" of UPI.
Code of 1997.
 ● Conversion of Deposit for Future Stock Subscription to APIC: BIR
Ruling No. DA-(C-205) 525-09 (September 9, 2009) (UniPresident
● Contribution of Assets: BIR Ruling No. DA-376-05 (September 1, (Philippines) Corporation)
2005) (Rockwell)
FACTS: Query: Conversion of the deposits for future stock subscription made
1. Rockwell Leisure Club, Inc. (RLCI) is a non-profit, stock corporation by its sole corporate stockholder, Uni-President Southeast Asia
with a primary purpose of operating sports, recreational and leisure Holdings Ltd. ("UPSAHL"), into additional paid-in capital ("APIC") or
facilities for its shareholders.
paid-in-surplus of UPPC, without the issuance of additional shares of
2. Rockwell Land is a corporation duly organized and existing under
the laws of the Philippines; that it is engaged in real estate stock, is deemed a capital investment, not included within the purview
development; that Rockwell Land is a shareholder of RLCI. of the term "taxable income" under the 1997 Tax Code, as amended,
3. The Board of Directors of Rockwell Land approved the transfer at and therefore, not subject to income, donor's, and documentary stamp
cost of the Club Facilities to RLCI as additional paid-in capital (APIC) taxes. --YES!
contributed by Rockwell Land to RLCI;
a. no additional common shares from the latter company UPPC has an authorized capital stock of 6,000,000 common shares with a
will be issued to Rockwell Land;
par value of P10.00, of which all the 60,000,000 shares have already been
ISSUE: WON the transaction is subject to donor‘s tax - No
RULING: subscribed and paid-up.
1. Section 56 of Revenue Regulations No. 2 provides that where a
corporation requires additional funds for conducting its business and On the other hand, UPSAHL is a non-resident foreign corporation organized
obtains said funds through voluntary payments by its shareholders, the and existing under the laws of The Cayman .UPSAHL owns 99.99% of the
amounts so received being credited to its surplus account or to a special shares of stock of UPPC.
capital account, will not be considered income, although there is no
increase in the outstanding shares of stock of the corporation.
2. The payments in such circumstances are in the nature of voluntary During the course of its operations, UPPC received deposits for the future
assessments upon, and represent an additional price paid for, in shares stock subscription from UPSAHL to augment the working capital and cash
of stock held by the individual shareholders, and will be treated as an requirements of the Company.
addition to and as part of the operating capital of the company.
3. Corollarily, in BIR Ruling No. 586-88 dated December 19, 1988, the As of 2008, the total deposits for future stock subscription amounted
additional contribution in the form of donated surplus without the to P964,000,000.00. On November 3, 2008, the Board of Directors (BOD)
necessity of issuing additional shares of stock is deemed capital
of UPPC authorized and approved the conversion of the
investment which is not included within the purview of the term
"taxable income" and is not subject to income tax. P964,000,000.00 deposits for future stock subscription into additional
4. Additional capital contribution without necessarily issuing paid-in capital (APIC), without the issuance of shares of stock by
additional shares of stock, which merely increase the basis of the UPPC.
stockholders' stock but not their proportionate equity in the
corporation, is a transaction not subject to income or gift taxes. The deposits for future stock subscription are UPSAHL's continuing
(BIR Ruling No. 270-87 dated September 8, 1987; 127-89 dated June financial support to guarantee that UPPC will remain a going concern
13, 1989)
and were, thus, intended to augment the working capital of UPPC's
5. Accordingly, the infusion of the additional paid-in capital by
Rockwell Land into RLCI is in the nature of additional funds which will operations as the company has been incurring losses in prior periods.
be used as, and forms part of, the latter's working capital for which no The deposits for future stock subscription were intended to reverse
corresponding shares of stock will be issued. UPPC's negative working capital and negative cash flows to ascertain
6. As such, the additional paid-in capital does not constitute an UPPC's viability for continued operations.
income on the part of RLCI nor a donation on the part of Rockwell Land.
The above deposits for future stock subscription were already properly NENACO intends to cause NENACO to undertake an equity restructuring
reflected as additional paid-in capital in UPPC's 2008 Statement of program for the purpose of improving the equity of NENACO by removing
Changes In Equity of its Audited Financial Statements. from the financials of NENACO its capital deficit (accumulated negative
retained earnings).

The Board of Directors passed a resolution, approved by its stockholders,

Response: authorizing the corporation to (i) cause NENACO to convert into APIC,
without the issuance of additional shares, the credits against and advances
Capital contribution in the form of money or property without the to NENACO, at its acquisition cost; and write-off condone the difference
issuance of additional shares generally does not give rise to a taxable between the face value and acquisition cost of its credits; and (ii) to cause
event pursuant to Section 56. NENACO to offset the APIC and difference with the equity deficit
(accumulated negative retained earnings) of NENACO in order to wipe out
1. The conversion of UPSAHL's deposits for future stock subscription into the same.
APIC of UPPC, in the amount of P964,000,000.00, without the issuance of
additional shares of stock, is deemed a capital investment, not included ISSUE:
within the purview of the term "taxable income" under the Tax Code, thus, is WON the foregoing transactions comprising the equity restructuring program
not subject to income tax. of NENACO are not subject to income tax and donor‘s taxes

2. The conversion of UPSAHL's deposits for future stock subscription into RULING:
APIC of UPPC, without the issuance of shares of stock and intended to In BIR Ruling No. DA-028-05 dated January 24, 2005, where Bayan
augment the working capital and cash requirements of the Company, is not Telecommunications, Inc. ("Bayantel") similarly applied for "corporate
subject to donor's tax under Section 99 of the Tax Code; and rehabilitation" with the court, this Office confirmed that any gain resulting
from the condonation of Bayantel's debt through a court-approved
3. The conversion of UPSAHL's deposits for future stock subscription into restructuring plan is not taxable for income tax purposes. This Office
APIC of UPPC, without the issuance of shares of stock, is not subject to furthermore confirmed that any conversion of debt into equity as a result of
documentary stamp tax (DST) under Section 174 of the Tax Code. the debt restructuring plan is likewise not subject to income tax.

". . . the conversion of Bayantel's debt into equity as a result of the debt
● Conversion of Debt to APIC: BIR Ruling No. [DA-(C-274) 689-09] restructuring plan shall not give rise to a taxable income and shall only be
(November 20, 2009) (Negros Navigation Co., Inc.) considered as an additional capital investment which likewise is not subject
NENACO is under corporate rehabilitation, which is the subject of Special to donor's tax since there is no donative intent in the aforesaid transaction."
Proceedings No. 04-109532, before Branch 46 of the Regional Trial Court
(RTC) of Manila. Furthermore, BIR Ruling No. DA-444-05. which involved the conversion of
accrued interest expense into equity in the form of APIC and the
The authorized capital stock of NENACO is Four Billion Pesos condonation or suspension of interest not accrued.
divided into four billioncommon shares with a par value of One Peso per
share. The subscribed, issued and outstanding capital stock of NENACO is On the basis of the foregoing rulings, and considering further that the
P3,025,733,123.00 divided into 3,025,733,123 common shares with a par transactions pursuant to the equity restructuring program, which will be
value of One Peso per share. implemented after NENACO has secured the approval of the RTC and SEC,
are considered as
KGLI-NM Holdings, Inc. (KGLI-NM), the majority stockholder of NENACO, additional capital investments and undertaken solely for business
holding 99.04%, more or less, of the issued and outstanding capital stock of consideration, this Office hereby confirms your opinion as follows:
1. The conversion of KGLI-NM secured and unsecured credits against
and advances to NENACO into APIC as a result of the equity
restructuring program, without the issuance of additional shares of
stock, shall not give rise to a taxable income on the part of NENACO;
and
2. The write-off/condonation of the difference between the face value
and acquisition costs of such credits shall not be subject to donor's
tax, there being no donative intent on the part of KGLI-NM. Further, the
said condonation of NENACO shall not be subject to income tax since
NENACO is in a capital deficiency position.
11 Property for share exchanges (1) General Rule. - Except as herein provided, upon the sale or exchange or
11.1 Determination of Amount and Recognition of Gains and Loses: property, the entire amount of the gain or loss, as the case may be, shall be
NATIONAL INTERNAL REVENUE CODE §40; Revenue Regulations No. recognized.
62008 (April 22, 2008) §7 (c.3.2); Revenue Memorandum Order No.
172016 (May 5, 2016) (2) Exception. - No gain or loss shall be recognized if in pursuance of a plan
of merger or consolidation -

Section 40. Determination of Amount and Recognition of Gain or Loss. - (a) A corporation, which is a party to a merger or consolidation, exchanges
property solely for stock in a corporation, which is a party to the merger or
(A) Computation of Gain or Loss. - The gain from the sale or other consolidation; or
disposition of property shall be the excess of the amount realized therefrom
over the basis or adjusted basis for determining gain, and the loss shall be (b) A shareholder exchanges stock in a corporation, which is a party to the
the excess of the basis or adjusted basis for determining loss over the merger or consolidation, solely for the stock of another corporation also a
amount realized. The amount realized from the sale or other disposition of party to the merger or consolidation; or
property shall be the sum of money received plus the fair market value of the
property (other than money) received; (c) A security holder of a corporation, which is a party to the merger or
consolidation, exchanges his securities in such corporation, solely for stock
(B) Basis for Determining Gain or Loss from Sale or Disposition of Property. or securities in such corporation, a party to the merger or consolidation.
- The basis of property shall be -
No gain or loss shall also be recognized if property is transferred to a
(1) The cost thereof in the case of property acquired on or after March 1, corporation by a person in exchange for stock or unit of participation in such
1913, if such property was acquired by purchase; or a corporation of which as a result of such exchange said person, alone or
together with others, not exceeding four (4) persons, gains control of said
(2) The fair market price or value as of the date of acquisition, if the same corporation: Provided, That stocks issued for services shall not be
was acquired by inheritance; or considered as issued in return for property.

(3) If the property was acquired by gift, the basis shall be the same as if it (3) Exchange Not Solely in Kind. -
would be in the hands of the donor or the last preceding owner by whom it
was not acquired by gift, except that if such basis is greater than the fair (a) If, in connection with an exchange described in the above exceptions, an
market value of the property at the time of the gift then, for the purpose of individual, a shareholder, a security holder or a corporation receives not only
determining loss, the basis shall be such fair market value; or stock or securities permitted to be received without the recognition of gain or
loss, but also money and/or property, the gain, if any, but not the loss, shall
(4) If the property was acquired for less than an adequate consideration in be recognized but in an amount not in excess of the sum of the money and
money or money's worth, the basis of such property is the amount paid by fair market value of such other property received: Provided, That as to the
the transferee for the property; or shareholder, if the money and/or other property received has the effect of a
distribution of a taxable dividend, there shall be taxed as dividend to the
(5) The basis as defined in paragraph (C)(5) of this Section, if the property shareholder an amount of the gain recognized not in excess of his
was acquired in a transaction where gain or loss is not recognized under proportionate share of the undistributed earnings and profits of the
paragraph (C)(2) of this Section. corporation; the remainder, if any, of the gain recognized shall be treated as
a capital gain.
(C) Exchange of Property. -
(b) If, in connection with the exchange described in the above exceptions, money received by the transferor on the exchange: Provided, finally, That if
the transferor corporation receives not only stock permitted to be received the transferor receives several kinds of stock or securities, the
without the recognition of gain or loss but also money and/or other property, Commissioner is hereby authorized to allocate the basis among the several
then (i) if the corporation receiving such money and/or other property classes of stocks or securities.
distributes it in pursuance of the plan of merger or consolidation, no gain to
the corporation shall be recognized from the exchange, but (ii) if the (b) The basis of the property transferred in the hands of the transferee shall
corporation receiving such other property and/or money does not distribute it be the same as it would be in the hands of the transferor increased by the
in pursuance of the plan of merger or consolidation, the gain, if any, but not amount of the gain recognized to the transferor on the transfer.
the loss to the corporation shall be recognized but in an amount not in
excess of the sum of such money and the fair market value of such other (6) Definitions. -
property so received, which is not distributed.
(a) The term 'securities' means bonds and debentures but not 'notes" of
(4) Assumption of Liability. - whatever class or duration.

(a) If the taxpayer, in connection with the exchanges described in the (b) The term 'merger' or 'consolidation', when used in this Section, shall be
foregoing exceptions, receives stock or securities which would be permitted understood to mean: (i) the ordinary merger or consolidation, or (ii) the
to be received without the recognition of the gain if it were the sole acquisition by one corporation of all or substantially all the properties of
consideration, and as part of the consideration, another party to the another corporation solely for stock: Provided, That for a transaction to be
exchange assumes a liability of the taxpayer, or acquires from the taxpayer regarded as a merger or consolidation within the purview of this Section, it
property, subject to a liability, then such assumption or acquisition shall not must be undertaken for a bona fide business purpose and not solely for the
be treated as money and/or other property, and shall not prevent the purpose of escaping the burden of taxation: Provided, further, That in
exchange from being within the exceptions. determining whether a bona fide business purpose exists, each and every
step of the transaction shall be considered and the whole transaction or
(b) If the amount of the liabilities assumed plus the amount of the liabilities to series of transaction shall be treated as a single unit: Provided, finally , That
which the property is subject exceed the total of the adjusted basis of the in determining whether the property transferred constitutes a substantial
property transferred pursuant to such exchange, then such excess shall be portion of the property of the transferor, the term 'property' shall be taken to
considered as a gain from the sale or exchange of a capital asset or of include the cash assets of the transferor.
property which is not a capital asset, as the case may be.1avvphil.ñet
(c) The3term 'control', when used in this Section, shall mean ownership of
(5) Basis - stocks in a corporation possessing at least fifty-one percent (51%) of the
total voting power of all classes of stocks entitled to vote.
(a) The basis of the stock or securities received by the transferor upon the
exchange specified in the above exception shall be the same as the basis of (d) The Secretary of Finance, upon recommendation of the Commissioner, is
the property, stock or securities exchanged, decreased by (1) the money hereby authorized to issue rules and regulations for the purpose
received, and (2) the fair market value of the other property received, and 'substantially all' and for the proper implementation of this Section.
increased by (a) the amount treated as dividend of the shareholder and (b)
the amount of any gain that was recognized on the exchange: Provided, (c.3.2) Rules on Substituted Basis in cases of Tax-Free Exchanges of
That the property received as 'boot' shall have as basis its fair market value: Shares of Stock under Section 40(C)(2) of the Tax Code, as Amended. -
Provided, further, That if as part of the consideration to the transferor, the (c.3.2.1) Substituted Basis of Stock or Securities Received by the
transferee of property assumes a liability of the transferor or acquires form Transferor. — The substituted basis of the stock or securities received by
the latter property subject to a liability, such assumption or acquisition (in the the transferor on a tax-free exchange shall be as follows:
amount of the liability) shall, for purposes of this paragraph, be treated as (i) The original basis of the property, stock or securities transferred;
(ii) Less: (a) money received, if any, and (b) the fair market value of the other (c.3.2.4) Basis for Determining Gain or Loss on a Subsequent Sale or
property received, if any; Disposition of Property Subject of the Tax-free Exchange. — The substituted
(iii) Plus: (a) the amount treated as dividend of the shareholder, if any, and basis as defined in Section 40(C)(5) of the Tax Code as amended, and
(b) the amount of any gain that was recognized on the exchange, if any. implemented in Section (c.3.2.1) and (c.3.2.2) above, shall be the basis for
However, the property received as 'boot' shall have as basis its fair market determining gain or loss on a subsequent sale or disposition of property
value. The term "boot" refers to the money received and other property subject of the tax- free exchange.
received in excess of the stock or securities received by the transferor on a
tax-free exchange. ● Commissioner of Internal Revenue vs. Filinvest Development
If the transferee of property assumes, as part of the consideration to the Corporation and Filinvest Alabang , Inc., 654 SCRA 56 (2011) G.R.
transferor, a liability of the transferor or acquires from the latter property No. 163653; July 19, 2011
subject to a liability, such assumption or acquisition (in the amount of the
liability) shall, for purposes of computing the substituted basis, be treated as Filiinvest Development Corporation (FDC) is the owner of 90% of
money received by the transferor on the exchange. the outstanding shares of Filinvest Alabang (FAI) and 67.42% of
Finally, if the transferor receives several kinds of stock or securities, the the outstanding shares of Filinvest Land, Inc. (FLI). On 29
Commissioner is authorized to allocate the basis among the several classes
November 1996, FDC and FAI entered into a Deed of
of stocks or securities.
Exchange with FLI whereby FDC and FAI both transferred in
(c.3.2.2) Substituted Basis of the Transferred Property in the Hands of the
Transferee. — The substituted basis of the property transferred in the hands favor of FLI parcels of land appraised at P4,306,777,000.00
of the transferee shall be as follows: (i) The original basis in the hands of the in exchange of shares of stocks of FLI. FLIs ownership
transferor; structure was changed so that the outstanding capital stock
(ii) Plus: the amount of the gain recognized to the transferor on the transfer. of FLI was held 61.03% by FDC, 9.96% by FAI and 29.01%
(c.3.2.3) The Original Basis of Property to be Transferred. — The original by others. FDC also extended advances in favor of its
basis of the property to be transferred shall be the following, as may be affiliates including FAI and FLI, evidenced by instructional
appropriate: letters and journal vouchers. With this, FLI requested a ruling
(i) The cost of the property, if acquired by purchase on or after March 1,
from the BIR to the effect that no gain nor loss should be
1913;
recognized in the transfer of real properties. The BIR issued
(ii) The fair market price or value as of the moment of death of the decedent,
if acquired by inheritance; a ruling in favor of FLI. Formal Notice of Demand to pay
(iii) The basis in the hands of the donor or the last preceding owner by whom deficiency income and documentary stamp taxes, FDC
the property was not acquired by gift, if the property was acquired by received from the BIR a Formal Notice of Demand to pay
donation. If the basis, however, is greater than the fair market value of the deficiency income and documentary stamp taxes, assessed
property at the time of donation, then, for purposes of determining loss, the on the taxable gain supposedly realized by FDC from the
basis shall be such fair market value; or, Deed of Exchange it executed with FAI and FLI, on the
(iv) The amount paid by the transferee for the property, if the property was dilution resulting from the Shareholders' Agreement FDC
acquired for less than an adequate consideration in money or money's
executed with RHPL as well as the "arm's-length" interest
worth.
rate and documentary stamp taxes imposable on the
(v) The adjusted basis of (i) to (iv) above, if the acquisition cost of the
property is increased by the amount of improvements that materially add to advances FDC extended to its affiliates.
the value of the property or appreciably prolong its life less accumulated
depreciation.
(vi) The substituted basis, if the property was acquired in a previous taxfree WoN the advances extended by FDC to its affiliates are not subject
exchange under Section 40(C)(2) of the Tax Code, as amended. to income tax. The SC ruled in the affirmative.
The BIR has ruled that the ● MPJ & W.A.C.E. HOLDING CORP. is a corporation duly
organized and existing under Philippine laws, and duly
transactions between FDC, FAI and FLC complied with all the registered with the SEC.
requisites provided under Section 34 (c) (2) of the 1993 NIRC. The ○ It has an original authorized capital stock of P1
Million divided into 1,000,000 shares with a par
requisites for the non-recognition of gain or loss under the foregoing
value of P1.00 per share.
provision are as follows:
○ It increased its authorized capital stock to 20
Million divided into 20,000,000 shares with a par
1. the transferee is a corporation; value of P1.00 per share. The net increase in
2. the transferee exchanges its shares of stock for property/ies authorized capital stock has been actually
of the transferor; subscribed and the amount of P17,128,919 has
3. the transfer is made by a person, acting alone or together been paid in cash via conversion of liabilities into
with others, not exceeding four persons; and, equity and real properties.
4. as a result of the exchange the transferor, alone or together ● Manuelito P. Jugueta is the registered owner of the
with others, not exceeding four, gains control of the following properties:
transferee

The BIR was wrong to assess that FDC had deducted substantial
interest expense from its gross income, there would still be no factual
basis for the imputation of theoretical interests on the subject
advances and assess deficiency income taxes thereon. More so,
when it is borne in mind that, pursuant to Article 1956 of the Civil
Code of the Philippines, no interest shall be due unless it has been ○ Wilma DT. Jugueta is the co-owner of property
covered by TCT No. T-746147.
expressly stipulated in writing.
● The above-named assignors executed separate Deeds of
Exchange dated July 3,2012 in favor of MPJ & W.A.C.E.
Considering that taxes, being burdens, are not to be presumed
HOLDING CORP., whereby they transferred their
beyond what the applicable statute expressly and clearly declares, respective properties in exchange for the latter's 6,144,800
the rule is likewise settled that tax statutes must be construed strictly shares of stock, broken down as follows:
against the government and liberally in favor of the taxpayer.

● Before the transfer of real estate properties, the number of

● BIR Ruling No. 1113-18 (July 27, 2018) (MPJ & W.A.C.E. Holding
voting shares issued to Manuelito P. Jugueta is 8,171,619
Corp.)
consisting of 750,000 during initial incorporation and in
conversion of cash advances and loan into equity in the
amount of P2,984,119.00 and P4,437,500.00,
FACTS respectively, at issued price of P1.00 per share; that after
the transfer of real estate properties amounting to
 P3,623,380.00, the total number of his voting shares ● In this case, with the exchange of the properties of
increased to 11,794,999. Manuelito P. Jugueta alone, he already gains control of
● Whereas, the number of voting shares issued to Wilma MPJ & W.A.C.E. HOLDING CORP., as he acquires 92.9%
DT. Jugueta is 62,500 during initial incorporation and of the outstanding capital stocks. Thus, no gain or loss
increased to 2,583,920,after the transfer of real property shall be recognized in the transfer. There is also no need
amounting to P2,521,420.00, at issued price of P1.00 per to combine the shares of Manuelito P. Jugueta with that of
share the other transferor to determine the 51% stock ownership
● That as a result of the transfer, Manuelito P. Jugueta will because, as aforestated, his shares alone are more than
gain control of MPJ & W.A.C.E. HOLDING CORP. by 51%.
owning 92.9% of the total voting stocks of the said ○ Pursuant to the tax Code, transfer of property
corporation while Wilma DT. Jugueta, Jr. will own 5.6%. pursuant to Section 40 (C) (2) of the 1997 Tax
● Thus, this request for the issuance of a Certificate of Tax Code, as amended, is now exempt from the
Exemption of transfer of properties as a tax free exchange payment of DST. Thus, the transfer to Jugueta is
pursuant to Section 40 (C) of the 1997 Tax Code, as not subject to DST.
amended, in relation to RR No. 18-2001, RMO No. 32- ○ A Certificate Authorizing Registration/Tax
2001 and Legal Memorandum dated April 26, 2010. Clearance (CAR/TCL) for the real properties or
share of stock/unit of participation/interest
involved in the exchange shall be issued by the
RULING: (RDO)/Authorized Internal Revenue ONcer
● Tax Free exchange only for the transfer of Manuelito (AIRO) on the basis of this ruling to the effect that
Jugueta. the transaction qualifies as a tax-free exchange
● Section 40 (C) (2) and (6) (c) of the Tax Code of 1997, as under Section 40 (C) (2) of the National Internal
amended, no gain or loss shall be recognized if a property Revenue Code of 1997 (Tax Code of 1997),
is transferred to a corporation by a person, in exchange for specifying, among others that the transaction
stock in such a corporation of which as a result of such involved is a tax-free exchange under Section 40
exchange, said person, alone or together with others, not (C) (2) of the Tax Code of 1997; the date of
exceeding four persons, gain control of said corporation. exchange; and the substituted basis of the
○ "Control" shall mean ownership of stocks in a properties.
corporation possessing at least 51% of the total ○ Upon issuance of this letter of exemption, and
voting power of all classes of stocks entitled to upon issuance of CAR, following information is
vote. required to be annotated on the reverse side of
○ Control is determined by the amount of stocks the Transfer Certificate of Title by the Register of
received i.e., total subscribed by the transferor. Deeds having jurisdiction over the properties:
○ In determining the 51% stock ownership, only Nature of Property, TCT number, tax Declaration
those persons who transferred property for number, and the substituted bases.
stocks in the same transaction may be counted ○ Also, the assignors and MPJ & W.A.C.E.
up to a maximum of five. In short, combining all HOLDING CORP. shall enclose with their
the shares to be received by the transferors, the respective income tax returns for the taxable year
same should total to at least 51% of the voting in which the tax-free exchange occurred a copy
power of all classes of stocks of transferee of the request for ruling. Also include as a note to
corporation entitled to vote. their respective audited financial statements for
the taxable year in which the exchange occurred
 a statement to the effect that they hold such amended, which shall attach upon acceptance by the
assets/shares acquired in a tax-free exchange corporation of the stockholder's subscription regardless of
and the year in which such exchange occurred, the actual delivery of the certificates of stock.
and in the taxable years until the subject property ● The transfer of real properties (TCT Nos. 139707, 139708,
are subsequently transferred to another 164209, 010-2010000894 and 164565) of Manuelito P.
transferee. Jugueta, doing business under the name of Aeropac
○ Within ninety (90) days from receipt of this ruling, Equipment Rental, Sales & Services, to MPJ & W.A.C.E.
the parties to the transaction must submit to the HOLDING CORP. is subject to VAT based on the zonal
Law and Legislative Division, Bureau of Internal value thereof as determined by the Commissioner or the
Revenue, a certified true copy of the TCT bears fair market value as shown in the schedule of values of the
the annotation of substituted basis of the real Provincial and City Assessors, whichever is higher.
properties transferred/received in connection with ○ Revenue Regulations No. 10-2011 provides that:
this transaction, in respect of the transferred real "the exchange of goods or properties including
properties. the real estate properties used in business or
○ HOWEVER, SEC emphasized that Section 40 held for sale or for lease by the transferor, for
(C) (2) and (6) (c) of the Tax Code of 1997, as shares of stocks, whether resulting in corporate
amended, merely defers recognition of the gain control or not, is subject to VAT."
or loss from such transaction, for in determining
the gain or loss from a subsequent transaction of
the property or of the stocks involved in the
exchange, the original or historical cost of the
property or stocks is considered. ● BIR Ruling No. 515-12 (August 3, 2012) (UEM Development Phils.
○ Thus, if MPJ & W.A.C.E. HOLDING CORP. later Inc.)
sells or exchanges the real properties it acquired This letter is requesting for a ruling that exchange by Henry Sy,
in the exchange, it shall be subject to income tax Jr‘s shares of stock in One Taipan Holdings Inc and Robert
on the gains it derived from such sale or Coyuito, Jr‘s shares of stock in Pacifica21 Holdings Inc with UEM
exchange, taking into consideration that the cost Development Phils is a tax-free exchange. As a result of the
basis of the shares shall be the same as the transfer, Sy will gain control of UEM by owning 58% of voting
original acquisition cost or adjusted cost basis to stocks, while Coyuito will own 24%.
the transferors of the properties exchanged Under Sec. 40(C)(2) and (6)(c), no gain or loss shall be
therefor; and that the cost basis to the transferee recognized if the stockholders‘ holdings will total at least 51%. In
of the properties exchanged for stocks shall be this case, the transfer by Sy will result in him gaining control of
the same as it would be in the hands of the UEM alone, and no gain or loss shall be recognized for his transfer.
transferors. Coyuito, Jr‘s transfer shall be treated separately, subject to capital
● On the other hand, the transfer of Wilma DT. Jugueta shall gains tax. However, the quoted sections only defer the recognition
be treated as a separate transfer subject to capital gains of gain or loss; in a subsequent transaction, the original cost will be
tax under Section 24 (D) of the Tax Code of 1997, as considered to determine gain or loss. Moreover, to be entitled to the
amended and documentary stamp tax under Section 175 tax-free exchange under said sections, Sy must comply with the
of the same Code. following requirements (ITR with certain requirements) and UEM
● Also, the shares to be issued by MPJ & W.A.C.E. must also comply with the following requirements (ITR with certain
HOLDING CORP. are original issues subject to DST requirements), plus other documentary requirements.
imposed by Section 174 of the Tax Code of 1997, as
 However, the shares to be issued by UEM are original issues
subject to documentary stamp tax, which shall attach upon
Subscriber % of Ownership
acceptance by the corporation of the stockholder‘s subscription
regardless of actual delivery of the certificates of stock.
● BIR Ruling No. 101-12 (February 20, 2012) (Labelworx, Inc.)

Requesting a confirmatory ruling of your opinion that the

transfer of the real property by Fukuyama Manufacturing
Corporation in favor of Labelworx Incorporated, solely in
exchange for shares of stocks of the latter will neither result in Calixto U. Malapas 21.26%
a taxable gain or profit pursuant to Section 40 (C) (2) (c) of the
Tax Code of 1997.

Fukuyama Manufacturing Corporation has an authorized capital Jackson U. Malapas 13.43%

stock consisting of Ten Million shares with a par value of One
Hundred Pesos (P100.00) per share, of which Three Thousand
(3,000) shares amounting to Three Hundred Thousand Pesos Mckinley U. Malapas, Jr. 10.63%
(P300,000.00) are issued and outstanding.

Samuel U. Malapas, Jr. 10.63%

On the other hand, Labelworx Incorporated ihas an authorized
capital stock consisting of One Hundred Thousand (100,000)
shares with a par value of One Hundred Pesos (P100.00) per
Hedy P. Malapas .001%
share, of which Fifty Thousand (50,000) shares amounting to
Five Million Pesos (P5,000,000.00) are issued and outstanding.

Christine C. Malapas .001%

That on March 30, 2007, a Deed of Exchange was executed by

Fukuyama Manufacturing Corporation whereby it transfer and
assign to Labelworx Incorporated, a parcel of land, in exchange Anita T. Malapas .001%
of 39,334 originally issued shares of stock as partial payment.

Following the completion of the transfer and assignment of the

Fukuyama Manufacturing Corp. 44.03%
Fukuyama Manufacturing Corporation to Labelworx
Incorporated, the capital and shareholding structure of
Labelworx Incorporated shall be as follows:
 · In reply, please be informed that pursuant to Section 40
(C) (2) and (6) (c) of the Tax Code of 1997, no gain or
loss shall be recognized if property is transferred to a Accordingly, the transfer by Fukuyama Manufacturing
corporation by a person, in exchange for stock in such a Corporation to Labelworx Incorporated, as in this case, is
corporation of which as a result of such exchange, said subject to DST under said section.
person, alone or together with others, not exceeding
four persons, gains control of said corporation.
BIR Ruling No. 387-13 (October 22, 2013) (Anacom Management
Corporation)
· The term "control" shall mean ownership of stocks in a
Facts: Antonio P. Soriano transferred 2 properties located in Ermita, Manila
corporation possessing at least 51% of the total voting
in favor of Anarcom Management Corporation as consideration for 2,5000
power of all classes of stocks entitled to vote. Control is shares of stock therein. As a result, Soriano gained control of Anarcom,
determined by the amount of stocks received i.e., total owning 62.5% of total voting stocks in the corporation. Soriano now seeks
subscribed by the transferors. In determining the 51% an opinion on whether as a result of the transaction, he will be liable for
stock ownership, only those persons who transferred income tax/capital gains tax/expanded withholding tax/donor's tax/and value-
property for stocks in the same transaction may be added tax, and DST.
counted up to a maximum of five.
Held: NO.
Thus, the gain or loss shall be recognized on the transfer by pursuant to Section 40 (C) (2) and (6) (c) of the Tax Code of 1997, as
amended, no gain or loss shall be recognized if property is transferred to a
Fukuyama Manufacturing Corporation in exchange for shares of
corporation by a person, in exchange for stock in such a corporation of
stock of the transferee corporation, to Labelworx Incorporated,
which as a result of such exchange, said person, alone or together with
considering that as a consequence of the exchange, Fukuyama others, not exceeding four persons, gains control of said corporation.
Manufacturing Corporation does not gain control of the · The term "control" shall mean ownership of stocks in a
transferee corporation by owning not more than 51% of its total corporation possessing at least 51% of the total voting power of all
voting stocks. classes of stocks entitled to vote.
· Control is determined by the amount of stocks received i.e.,
total subscribed by the transferor. In determining the 51% stock
ownership, only those persons who transferred property for stocks
Moreover, pursuant to Section 196 of the Tax Code of 1997, a in the same transaction may be counted up to a maximum of five.
conveyance or deed whereby land is assigned or transferred to
Accordingly, no gain or loss shall be recognized on the transfer by Antonio
another person is subject to documentary stamp tax based on
Ma. P. Soriano of his real property covered by TCT No. 266405 in exchange
the consideration or value received or contracted to be paid for
for 691 shares of stock of the transferee corporation, Anacom, considering
such realty or on its fair market value determined in accordance that as a consequence of the exchange, he gained control of the transferee
with Section 6 (E) of the same Code, whichever is higher. corporation by owning 62.5% of its total voting stocks.
However, under Republic Act (R.A.) No. 9243 which took effect
on March 20, 2004, transfer of property pursuant to Section 40 It should be emphasized, however, that Section 40 (C) (2) and (6) (c) of the
(C) (2) of the 1997 Tax Code, as amended, is now exempt from Tax Code of 1997, as amended, merely defers recognition of the gain or
the payment of documentary stamp tax (DST) under Section 196 loss from such transaction, for in determining the gain or loss from a
of the Tax Code of 1997. subsequent transaction of the property or of the stocks involved in the
exchange, the original or historical cost of the property or stocks is (c) The fair market value as of the date of the exchange of
considered. the capital stock issued to the transferor.
· Thus, if Antonio Ma. P. Soriano will later sell or exchange the
shares of stock he acquired in the exchange, he shall be subject to In addition:
income tax on the gains he derived from such sale or exchange, (a) the parties, shall enclose with their respective income tax
taking into consideration that the cost basis of the shares shall be returns for the taxable year in which the tax-free exchange
the same as the original acquisition cost or adjusted cost basis to occurred a copy of the request for ruling filed with, and the
the transferor of the property exchanged therefor; and that the cost corresponding ruling issued by the Bureau of Internal
basis to the transferee of the property exchanged for stocks shall Revenue, both duly stamped received by the appropriate office
be the same as it would be in the hands of the transferor. of the Bureau of Internal Revenue.
- Such persons shall include as a note to their
In order that the parties to the exchange can avail of the non-recognition of respective audited financial statements for the taxable
gains provided for in Section 40 (C) (2) and (6) (c) of the Tax Code of 1997, year in which the exchange occurred a statement to
as amended, they should comply with the requirements hereunder the effect that they hold such assets/shares acquired
mentioned: in a tax- free exchange and the year in which such
A. The transferormust file with his income tax return for the taxable year in exchange occurred, and in the taxable years until the
which the exchange transaction was consummated, a complete statement of subject property are subsequently transferred to
all facts pertinent to the exchange, including: another transferee.
1. A description of the property they transferred, or of their (b) The parties shall, pursuant to Section 58 (E) of the Tax Code
interest in such property, with a statement of the original of 1997, as amended, also cause the Corporate Secretary to
acquisition cost/adjusted cost basis or other basis thereof at annotate at the back of the Certificates of Stock, the date
the time of the transfer; the Deed of Assignment was executed, the original or
2. The kinds of stocks received and preferences, if any; historical cost of acquisition of the shares of stock
3. The number of shares of each class received; and involved, and the fact that no gain or loss was recognized
4. The fair market value per share of each class at the date of as a result of such exchange; provided however, that any
the exchange. violation by the Register of Deeds of this condition shall be
penalized under Section 269 of the same Code.
B. On the other hand, the transferee corporation must file with its income (c) It is further required that a TCT/CCT/Share of Stock that
tax return for the taxable year in which the exchange was consummated the bears the annotationof substituted bases of the real
following: property/shares of stock transferred/received in connection
1. A complete description of the property received from the with this transaction, as duly certified by the RD/Corporate
transferor; Secretary, should be submitted to the Law Division,
2. A statement of the original acquisition cost or other basis of Bureau of Internal Revenue, 7/F National Office Building,
the property in the hands of the transferor and the adjusted Diliman, Quezon City, within ninety (90) days from the date of
cost basis thereof at the time of the transfer; and the receipt of this Certification, by any of the parties to the
3. Information with respect to the capital stock of the exchange transaction. Otherwise, this ruling shall be void and
corporation including: without effect, and the Chief, Law Division shall refer the
(a) The total issued and outstanding capital stock docket of the case to the Prosecution Division for appropriate
immediately prior to and immediately after the exchange action.
with a complete description of each class of stock;
(b) The classes of stocks and number of shares issued to the DST: transfer of property not subject to DST but issuance of shares is.
transferor in the exchange; and
11.2 Value Added Taxes: Revenue Regulation No. 16-2005 §4.106-
8(b)(1) as amended by Revenue Regulation No. 10-2011 (July 1, 2011)

https://www.bir.gov.ph/images/bir_files/old_files/pdf/59111RR%2010-
2011.pdf

11.3 Documentary stamp taxes NATIONAL INTERNAL REVENUE CODE

§199 m (as amended by REPUBLIC ACT NO, 9243)

SEC. 199. Documents and Papers Not Subject to Stamp Tax. - The
provisions of Section 173 to the contrary notwithstanding, the following
instruments, documents and papers shall be exempt from the documentary
stamp tax:

(m) Transfer of property pursuant to Section 40(c)(2) of the National Internal

Revenue Code of 1997, as amended.
12 Dividends, Surplus Retained Earnings and Improperly Accumulated Notwithstanding that the RTC and the CA did not find any irregularity in
Earnings: the OR issued in her favor,we still cannot sustain the petitioner‘s defense of
12.1 Trust Fund Doctrine – full payment of her subscription. Her OR, presented to prove the payment of
● Halley v. Printwell, Inc., 649 SCRA 116 (2011) the balance of her subscription, indicated that her supposed payment had
been made by means of a check. Thus, to discharge the burden to prove
Petitioner was incorporator and original director of Business Media payment of her subscription, she had to adduce evidence satisfactorily
Philippines, Inc. (BMPI) (subscribed 35,000 shares at P10/share for total of proving that her payment by check wasregardedas payment under the law.
P350,000, but only paid up P87,500). BMPI commissioned respondent The delivery of a bill of exchange only produces the fact of payment when
Printwell to print the magazine Philippines, Inc. that BMPI published and the bill has been encashed. To establish their defense, the respondents
sold. Printwell subsequently sued BMPI for collection of unpaid balance of therefore had to present proof, not only that they delivered the checks to the
P291,342.76 in RTC, and subsequently amended its complaint to implead petitioner, but also that the checks were encashed. The respondents failed
the original incorporators and stockholders to recover on the unpaid to do so. It is notable, too, that the petitioner and her co-stockholders did not
subscriptions. RTC rejected the defense of the stockholders that they had support their allegation of complete payment of their respective subscriptions
fully paid their subscriptions in view of irregularity in the issuance of the ORs with the stock and transfer book of BMPI. To reiterate, the petitioner was
and observing that the stockholders had used BMPI‘s corporate personality liable pursuant to the trust fund doctrine for the corporate obligation of BMPI
to evade payment. Applying the trust fund doctrine, the RTC held the by virtue of her subscription being still unpaid. Printwell, as BMPI‘s
stockholders as liable to Printwell on a pro rata basis. Everyone appealed, creditor,had a right to reach her unpaid subscription in satisfaction of its
but the CA affirmed the RTC‘s decision. claim.

Preliminarily, the RTC did not violate the Consti or the Rules of Court; However, as to her liability, the RTC declared the stockholders pro rata
its decision contained clear and distinct findings of facts, and stated the liable for the debt(based on the proportion to their shares in the capital stock
applicable law and jurisprudence, fully explaining why the defendants were of BMPI); and held the petitioner personally liable only in the amount of
being held liable to the plaintiff ₱149,955.65. However, as the prevailing rule is that a stockholder is
personally liable for the financial obligations of the corporation to the extent
Both the RTC and the CA applied trust fund doctrine against the of his unpaid subscription, in view of the petitioner‘s unpaid subscription
stockholders, correctly. The doctrine is a rule that the property of a being worth ₱262,500.00, she was liable up to that amount.
corporation is a trust fund for the payment of creditors, but such property can
be called a trust fund ‗only by way of analogy or metaphor.‘ As between the https://lawphil.net/judjuris/juri2011/may2011/gr_157549_2011.html
corporation itself and its creditors it is a simple debtor, and as between its
creditors and stockholders its assets are in equity a fund for the payment of CLV outline: we clarify that the trust fund doctrine is not limited to
its debts. The doctrine is not limited to unpaid subscriptions. The scope of reaching the stockholders’ unpaid subscriptions. The scope of the doctrine
the doctrine, when the corporation is insolvent, encompasses not only when the corporation is insolvent encompasses not only the capital stock,
capital stock but also other property and assets generally regarded in equity but also other property and assets generally regarded in equity as a trust
as a trust fund for the payment of corporate debts. All assets and property fund for the payment of corporate debts. All assets and property belonging to
held in trust by the corporation for the benefit of creditors that were the corporation held in trust for the benefit of creditors that were distributed
distributed or in the possession of stockholders may be reached by the or in the possession of the stockholders, regardless of full payment of their
creditor in satisfaction of claim. Also, under the trust fund doctrine, a subscriptions may be reached by the creditors in satisfaction of its claim.
corporation has no legal capacity to release an original subscriber to its
capital stock from his/her obligation to pay for his/her shares, without a
valuable consideration or fraudulently to the prejudice of creditors. The ● Ong Yong v. Tiu, 401 SCRA 1 (2003)
creditor is allowed to maintain an action upon any unpaid subscribers and
steps into the shoes of the corporation for the satisfaction of his debt.
 In 1994, the construction of Masagana Citymall in Pasay City was CLV outline: violation of terms embodied in a Subscription Agreement,
threatened with stoppage due to dire financial difficulties encountered by with are personal commitments, do not constitute legal ground to rescind the
First Landlink Asia Development Corporation, owned by the Tius. It was such agreement: “ in the instant case, the rescission of the Pre-Subscription
heavily indebted to PNB for P190M. To stave off foreclosure, the Tius invited Agreement will effectively result in the unauthorized distribution of the capital
the Ongs to invest. Under a pre-subscription agreement, the current assets and property of the corporation, thereby violating the Trust Fund
shareholdings of 500,000 shares held by the Tius would be increased to a Doctrine and the Corporation Code, since the rescission of a subscription
total of 2,000,000 shares, half of which would be new shares subscribed by agreement is not one of the instances when distribution of capital assets and
the Ongs while the Tius would increase their existing shareholdings from property of the corporation is allowed.” Distribution of corporate assets
450,200 to 1,000,000. The business harmony between the families did not among the stockholders cannot even be resorted to achieve “corporate
last, however; the Tius rescinded the Pre-Subscription agreement in 1996. peace.”
The Tius accused the Ongs of not paying their subscriptions, while the Ongs
accused the Tius of not undertaking their corporate duties (actually, David
Tiu and Cely Tiu). The SEC confirmed the rescission, while the CA held that 12.2 Power to Declare Dividends - REVISED CORPORATION CODE § 42
although the two families were in pari delicto, for practical considerations, it
was best to separate the two groups by rescinding the Pre-Subscription
Agreement, return the original investment to the Ongs, and award everything Section 42. Power to Declare Dividends. - The board of directors of a stock
else to the Tius. corporation may declare dividends out of the unrestricted retained earnings
which shall be payable in cash, property, or in stock to all stockholders on
The SC holds that the Tius cannot legally rescind the Pre-Subscription the basis of outstanding stock held by them: Provided, That any cash
Agreement. First, a subscription contract is a contract between the dividends due on delinquent stock shall be first be applied to the unpaid
corporation and the stockholder (in this case, between First Landlink and the balance on th subscription plus costs and expenses, while stock holders until
Ongs). Considering that the real parties are First Landlink and the Ongs, a their unpaid subscription is fully paid: Provided, further, That no stock
civil case for rescission filed by the Tius in their personal capacity cannot dividend shall be issued without the approval of stockholders representing at
prosper. Second, even granting the Tius the standing to rescind, rescission least two-thirds (2/3)of the outstanding capital stock at a regular or special
will violate the trust fund doctrine and the procedures for valid distribution of meeting duly called for the purpose.
assets and properties under the Corp. Code. The trust fund doctrine
provides that subscriptions to the capital stock of a corporation constitute a Stock corporations are prohibited from restraining surplus profits in excess of
fund to which the creditors have a right to look for the satisfaction of their one hundred percent (100%} of their paid-in capital stock, except: (a) when
claims. The distribution of corporate property and assets cannot be made to justified by the definite corporate expansion projects or programs approved
depend on the whim of stockholders. In this case, rescission of the Pre- by the board of directors; or (b) when the corporation is prohibited under any
Subscription Agreement will effectively result in unauthorized distribution of loan agreement with financial institutions or creditors, whether local or
capital assets and property of the corporation, since rescission of a foreign, from declaring dividends without their consent, and such consent
subscription agreement is not one of the instances when distribution of has not yet been secured; or (c) when it can be clearly shown that such
capital assets and property is allowed (the instances are: 1 amendment of retention is necessary under special circumstances obtaining in the
Articles of Incorporation to reduce capital stock; 2 purchase of redeemable corporation, such as when there is need for special reserve for probable
shares by the corporation; 3 dissolution and liquidation of the corporation). contingencies.
Rescission, if granted, will result to injustice, as the Ongs will have nothing
but their initial investment, while the Tius will take over a very profitable
business without much effort. MR by Ongs granted. ● SEC Memorandum Circular No. 11-08 dated December 5, 2008:
Guidelines on The Determination of Retained Earnings Available
https://lawphil.net/judjuris/juri2003/apr2003/gr_144476_2003.html for Dividend Declaration
 ● Cash Dividends and unrealized foreign exchange earnings: SEC- 3. Reconciliation of Retained Earnings for Dividend Declaration shall
OGC Opinion No. 05-19 dated March 13, 2019 addressed to Sanno not be required except
Philippines Manufacturing Corporation a. The amount of unrestricted retained earnings per
Query: Whether Sanno Philippines can declare cash dividends from the company‘s AFS is in excess of 100% of its paid-in
Retained Earnings adjusted after reconciliation of Retained Earnings capital
Available for Dividend Declaration taking into account unrealized foreign b. The company applies for approval by the
exchange gains and losses. Commission of its proposed cash and/or property
FACTS: dividends or confirmation of stock dividends.
1. Sanno adopted Philippine Accounting Standards 21 – EFFECTS
OF CHANGES IN FOREIGN EXCHANGE RATES in which it changed 4. See: Proforma Reconciliation of Retained Earnings
its functional currency from peso to USD.
a. The unrealized foreign exchange loss and net
unrealized foreign exchange gains caused balance
deficit to the retained earnings of the corporation.
2. Sanno is planning to declare cash dividends but due to the deficit, it
plans to treat the aforesaid items causing the deficit to be reconciling
items in computing retained earnings available for dividend declaration
RULING:
1. Dividends shall be declared out of unrestricted retained earnings of
the Corporation. The surplus profits or income must be a bona fide
income founded upon actual earnings or profits.
2. Actual earnings or profits shall be net income for the year
adjusted for unrealized items discussed below, which are
considered not available for dividend declaration
a. Share/equity in net income
b. Unrealized foreign exchange gains except those
attributable to cash and cash equivalents, for the time
being that they are not yet actual income prior to
realization of such foreign exchange gain
c. Unrealized actuarial gains which is the result when
the company chooses the option of recognizing
actuarial gains or lossess directly to profit or loss
statement
d. Fair value adjustment or the gains arising only from
market-to-market valuation which are not yet realized
e. Deferred tax asset
f. Adjustment due to deviation from PFRS/GAAP
g. Other unrealized gains or adjustment to the retained 5. Among the supporting documents required when applying for
earnings brought about by certain transactions approval of cash and/or property dividedns or for confirmation of stock
accounted for under PFRS dividends is the latest AFS accompanied by a reconciliation of
h. Other adjustment that the Commission may prescribe retained earnings covered by the auditor’s report.
 6. With regard to the treatment of foreign exchange loss as a purpose of dividend declaration particularly in the treatment of treasury
reconciling item, paragraph 41 of PAS 21 provides: shares.
a. These exchange differences are not recognized in
profit or loss because the changes in exchange rates While the 1982 Rules provides that the cost of treasury shares acquired from
have little or no direct effect on the present and future the redemption of redeemable shares need not be deducted from the
cash flows from operations. The cumulative amount of unrestricted retained earnings and need not be restricted from being
the exchange differences is presented in a separate declared and issued as dividends, the 2008 Guidelines includes treasury
component of equity until disposal of foreign shares (in general) as an item that is subtracted from the net income earned
operation. in order to determine 'Retained Earnings Available for Dividend Declaration.'
The said 2008 Guidelines make no distinction as to the circumstances
● Cost of Treasury Shares in the Computation of Retained Earnings surrounding the acquisition of treasury shares.
Available for Dividend Declaration: SEC-OGC Opinion No. 03-19
dated February 14, 2019 addressed to Atty. Benedicto Panigbatan Given the silence of the 2008 Guidelines regarding the exemption, your
Inquiry: confirmation that a cash dividend declaration based on the amount letter now asks for confirmation that the exemption, as embodied in the 1982
of unrestricted retained earnings without deducting the cost of treasury Rules, remains applicable thus, the cost of treasury shares arising from the
shares acquired from the redemption of redeemable preferred shares (as redemption of redeemable shares as provided for in the AOI need not be
provided for in the articles of incorporation) is valid. → YES considered and subtracted in the computation for determination of the
cost of treasury shares acquired from the redemption of redeemable shares corporation's 'Retained Earnings Available for Dividend Declaration.'
is not deducted; rather, it forms part of the 'Retained Earnings Available for
Dividend Declaration.' In effect, a dividend declaration from the unrestricted RULING
retained earnings gross of the cost of redeemed preferred shares acquired For dividend declaration, "the board of directors of a stock corporation may
pursuant to the AOI is considered as valid. declare dividends out of the unrestricted retained earnings."
"The requirement of unrestricted retained earnings to cover the shares is
Corporation (the "Declaring Corporation") has unrestricted retained earnings based on the trust fund doctrine which means that the capital stock, property
and treasury shares arising from the redemption of its 'Preferred and other assets of a corporation are regarded as equity in trust for the
Redeemable Shares' as recognized in its "AOI". The Declaring Corporation payment of corporate creditors. Hence, any disposition of corporate funds to
is proposing to declare cash dividends. The unrestricted retained earnings of the prejudice of creditors is null and void.
the declaring corporation is sufficient to support the dividend declaration Creditors of a corporation have the right to assume that so long as there are
provided that the treasury shares arising from the redemption of the shares outstanding debts and liabilities, the board of directors will not use the assets
will not be deducted. of the corporation to purchase its own stock." 2 On this premise, "the
declaration of dividends is dependent upon the availability of surplus profit or
The opinion hinges on the continued effectivity of the "Rules Governing unrestricted retained earnings, as the case may be." 3
Redeemable and Treasury Shares" (1982 Rules) issued in 1982 and on the
applicability of the exception in the same 1982 Rules with regard to the As to the reconciling items of the unrestricted retained earnings, the 1982
computation of restricted retained earnings as provided for in the SEC SEC Rules Governing Redeemable and Treasury Shares Section 4 (1)
Memorandum Circular No. 11, series of 2008 or the "Guidelines on the provides that "the amount of unrestricted retained earnings equivalent to the
Determination of Retained Earnings Available for Dividend Declaration" cost of the treasury shares being held, other than those acquired in
(2008 Guidelines). accordance with the exceptions provided in Section 3 (1) of these rules, shall
be restricted from being declared and issued as dividends." 4 Section 3 (1)
Based on the 1982 Rules and 2008 Guidelines, there appears to be a stating that "No corporation shall redeem, repurchase or reacquire its own
difference in the determination of unrestricted retained earnings for the shares, of whatever class, unless it has an adequate amount of unrestricted
retained earnings to support the cost of the said shares, except: When the
shares are reacquired in the redemption of redeemable shares of the treasury shares in the form of redeemed redeemable shares. The exception
corporation or pursuant to the conversion right of convertible shares of the (or non-deduction) is based on the nature of redeemable shares.
corporation, in accordance with the provision expressly provided for in its
articles of incorporation and certificates of stock representing said shares of "Redeemable shares may be issued by the corporation when expressly so
the corporation, in accordance with the provisions expressly provided for in provided in the articles of incorporation. They may be purchased or taken up
its articles of incorporation and certificates of stock representing said by the corporation upon the expiration of a fixed period, regardless of the
shares;" 5 existence of unrestricted retained earnings in the books of the corporation."
Given such, a corporation may not redeem its shares unless there is
Given the aforementioned provisions, the 1982 Rules explicitly provides that adequate retained earnings.
generally, treasury shares shall be deducted from the unrestricted retained
earnings to arrive at the 'Retained Earnings Available for Dividend "However, due to the special nature of a redeemable share as provided for
Declaration.' "The reason for this is that such amount of earnings equivalent in the AOI, adequate amount of unrestricted retained earnings is not
to the cost of treasury shares is not considered part of earned or surplus necessary for its redemption provided that corporation has, after such
profits that is distributable as dividends." redemption sufficient assets in its books to cover debts and liabilities
Also under the same 1982 rules, an exception has been drawn under inclusive of capital stock." 10 Hence the exception should be read with
section 4 (1) in relation to section 3 (1). Under the provided exception, Section 5 (5) of the same 1982 Rules. "The present Code allows redemption
redeemed redeemable shares, although part of the treasury shares, is not of shares even if there are no unrestricted retained earnings on the books of
subtracted from the unrestricted retained earnings to arrive at the 'Retained the corporation. This is a new provision which in effect qualifies the general
Earnings Available for Dividend Declaration.' rule that the corporation cannot purchase its own shares except out of
current retained earnings." 11 "However, while redeemable shares may be
On the other hand, 2008 Guidelines, annex "A" and SEC Rule 68, annex "C" redeemed regardless of the existence of unrestricted retained earnings, this
provided for the computation of the 'Retained Earnings Available for is subject to the condition that the corporation has, after such redemption,
Dividend Declaration.' Under both annexed guide formulae, treasury shares assets in its books to cover debts and liabilities inclusive of capital stock.
have been deducted from the unrestricted retained earnings in order to Redemption, therefore, may not be made where the corporation is insolvent
arrive at the 'Retained Earnings Available for Dividend Declaration,' in which or if such redemption will cause insolvency or inability of the corporation to
no qualification as to the type and source of the treasury shares has been meet its debts as they mature."
provided. There is also no exemption provided for under the 2008 Guidelines
and under SEC Rule 68. With this rationale in mind, the exception of Rule 3 (1) will only apply subject
to the sufficiency of assets in its books to cover debts and liabilities inclusive
While there may be a seeming conflict, the two can be harmonized following of capital stock. Given that the reason for the unrestricted of retained
the rules on statutory construction. As much as possible, laws or rules earnings for dividend declaration is the trust fund doctrine in order to protect
should be interpreted such that both are rendered effective, except when the creditors, having the exception under the 1982 Rules under section 4 (1)
they are actually inconsistent, such that one operates to repeal the other. 7 in relation to section 3 (1) which presupposes a sufficient assets (despite
Reconciling the 1982 rules and the later guidelines, the 2008 Guidelines, lack of unrestricted retained earnings), there is no need for deductibility of
although silent as to any exemption as to the deductibility of treasury shares, treasury shares arising from said exception as the redemption of said shares
did not repeal the explicit pronouncement of the 1982 Rule for the following will not detriment the creditors.
reasons:
Second, there is no conflict between the general guide formula as provided
First, the 1982 Rules, although issued more than two decades ago, continue for in 2008 Guidelines and the explicit exception under the 1982 Rules. "It is
to apply in the computation of unrestricted retained earnings for dividend well settled that a special and local statute or rules, providing for a particular
declaration and remain significant insofar as the exemption of the particular case or class of cases, is not repealed by a subsequent statute or rule,
items. Considering that Section 3 (1) recognizes the special nature of general in its terms, provisions and application, unless the intent to repeal or
alter is manifest, although the terms of the general act are broad enough to earnings which shall be payable in cash, in property or in stock to all
include the cases embraced in the special law." 12 Under this premise, the stockholders on the basis of outstanding stock held by them: . . . "
repealing provision 13 under the 2008 Guidelines, did not repeal previous
guidelines and rules of the commission which are not in conflict with the "Section 6. Classification of Shares. — . . .
current rules. In this regard, it is appropriate to note that the 2008
Guidelines, although making no distinction as to the manner in which Preferred shares of stock issued by any corporation may be given
treasury shares are acquired, only enumerates "treasury shares" as one of preference in the distribution of the assets of the corporation in case of
the items affecting the unrestricted retained earnings account from an liquidation and in the distribution of dividends, or such other preferences as
accounting perspective. It does not specifically state that all types of treasury may be stated in the articles of incorporation which are not violative of the
shares, regardless of the nature of their acquisition, should be deducted provisions of this Code: . . ."
from the unrestricted retained earnings to arrive at the 'Retained Earnings
Available for Dividend Declaration.' In this regard, no conflict is present. Under Section 43, all stockholders, without qualification as to the kind
of shares held by them, are entitled to dividends declared by the
As a summary, the annexes in the 2008 Guidelines and SEC Rule 68 should corporation, whether it be in cash, property or stock. Moreover,
be read in harmony with the 1982 Rules. To answer your query, the cost of Section 6 merely states that preferred shares are given preferential
treasury shares acquired from the redemption of redeemable shares is not right in the distribution of dividends among others. There is nothing in
deducted; rather, it forms part of the 'Retained Earnings Available for the law which prohibits preferred shares from acquiring shares of
Dividend Declaration.' In effect, a dividend declaration from the unrestricted whatever class by way of stock dividend. For so long as all the
retained earnings gross of the cost of redeemed preferred shares acquired requirements for the declaration of stock dividend are complied with,
pursuant to the AOI is considered as valid. the issuance of common shares in favor of stockholders holding
preferred shares is in order.

||| (Re: Computation of Retained Earnings Available for Dividend CONDITIONS:

Declaration, SEC-OGC Opinion No. 03-19, [February 14, 2019])
1. "there are sufficient class of shares to cover the stock Formatted: Indent: Left: 0 cm
● Issuance of common shares as dividends to preferred shares: SEC dividend declaration
Opinion No. 28-04 dated April 27, 2004 addressed to Atty. Christine 2. the requirements under Section 43 of the Corporation Code
P. Base relative to declaration of dividends are complied with
3. the stock dividends should be declared in such a manner that
The increase in the capital stock of BDO was approved on June 15, 2001. Of the rights of other classes of shares pursuant to law and the
the increase, the subscribed capital stock was fully paid by way of stock articles of incorporation are not ignored or disregarded"; and
dividend declaration, among others. Common shares of stock were issued 4. the stockholders affected consent to such declaration.
as stock dividend to preferred shareholders.

ISSUE: WON preferred shares may be given common shares as dividends -

YES
12.3 Liability of Directors for issuance of Watered Stocks: REVISED
RULING: CORPORATION CODE §64

"Section 43. Power to declare dividends. — The board of directors of a Section 64. Liability of Directors for Watered Stocks. - A director or officer of
stock corporation may declare dividends out of the unrestricted retained a corporation who: (a) consents to the issuance of stocks for a consideration
less than its par or issued value: (b) consents to the issuance of stocks for
the consideration other than cash, valued in excess of its fair value; or (c) exists from which cash dividends may be paid to
having knowledge of the insufficient consideration, does not file written stockholders?
objection with the corporate secretary, shall be liable to the corporation or its
creditors, solidarily with the stockholder concerned for the differnce between
· Sec 58 of the Corporation Code provides:
the value receive at the time of issuance of the stock and the par or issued
value of the same.

12.4 Comparative Views

● THOMAS LEE HAZEN, JERRY W. MARKHAM. CORPORATIONS
AND OTHER BUSINESS ENTERPRISES, ―Section 2. Dividends‖;
―Section 3, Other Distributions‖ and ―Section 4. Liability for
Wrongful Distributions‖, 1362 - 1418 (2009)

―Section 2. Dividends‖;
· Appellant contends that the above provision should be divided
into 2 parts: (1) the first 26 words should be applicable to the
Randall v Bailey payment of regular dividends; and (2) remaining part shall be
· The plaintiff, as trustee, seek to recover from directors and executors of applicable to such dividend as may be declared in connection
deceased directors dividends declared and paid between 1928 and 1932, with reduction of capital. Thus, the ―unless the value of its
alleging that they were paid from capital violation of the Corporation Law. assets‖ modify only the second portion. The surplus from which
· Bush Terminal Company (Terminal) owns and operate a great cash dividends may be distribute must be based on actual
ocean terminal. profits and realized gains, after provision of losses, although
· It owns land in Brooklyn (co-owned with its subsidiary, Bush conceding that it could also be paid from paid in surplus.
Terminal Buildings Company), which increased in value · The Court ruled that the word ―any dividend‖ are contained in
through the years. both parts of the sentence. Any is an all-exclusive word. When
· Terminal carried the lad at original cost until 1915, then in 1915 repeated in the same sentence one would reasonably assume
and in 1919, it reflected in the books the portion of the increase that the two words have the same meaning. They must mean a
in value of the land. No increase has since been recorded. dividends of any kind or character and both portions of the
· Trial Court: found that the land value from 1928 to 1932 was sentence must be read in that light. They must mean that no
greater than that reflected in the books. dividends may be declared or paid which shall impair capital
· The problem arises: if the directors are permitted to include the unless the value of the corporation assets ―remaining after
value of the land at the amount on the books from 1919 payment of dividends or distribution of assets, shall be at least
onwards, then there was surplus for payment of dividends, so equal to the aggregate amount of tis debt including capital or
no recovery may be made. BUT, if the land must be carried at capital stock.‖
cost, then the directors unjustifiably declared and paid · As to the legislative intent, if the Legislature had intended to
dividends which the plaintiff can recover. continue the ―surplus profit‖ test it would have said so clearly,
instead of using the words ―impair its capital or capital stock‖.
There is also no semicolon separating the two parts of the
· The issue in this case: may unrealized appreciation in
sentence.
value of fixed assets held for use in carrying on a
· As to the meaning of ―impair its capital or capital stock‖, should
corporate enterprise be taken into consideration by
be based on the definition given in the 1890 statute; ―the
directors in determining whether a corporate surplus
capital stock shall be impaired when the value of its property
 and assets after deducting the amount of its debts and to enable it to sell common stock. Rhode Island law permitted corporations
liabilities, shall be less than the amount of its paid up capital to amend dividend rights, but only upon a unanimous vote of the preferred
stock. No dividends shall be declared or paid by any stock stockholders. Community Hotel could not achieve unanimity. Instead, it
corporation, except from the surplus profits of the business, nor created a nominal corporation and attempted to merge it with Community
when its capital stock is or will be impaired.‖ Hotel. Community Hotel proposed to structure the merger transaction in a
· When the 1923 statute provided the words impair its capital or way that would remove the preferred stockholders‘ dividend rights. Under a
capital stock, and in the same sentence used words almost different Rhode Island statute, mergers required approval of only two-thirds
identical with the words contained in the 1890 statute, it is of a corporation‘s preferred stock. Bove and other preferred stockholders
reasonable to assume that the Legislature was returning to its (plaintiffs) brought suit to enjoin the merger, arguing that the merger‘s only
former definition of impairment of capital and at the same time purpose was to circumvent the unanimity requirement.
abandoning the surplus profits test.
· Having declared that dividends may be paid when there is no ISSUE 1: whether a merger which is designed for the sole purpose of
impairment of capital or capital stock and when the value of the cancelling the rights of preferred stockholders with the consent of less than
corporate assets remaining after is at least equal to the all has been authorized by the legislature. It‘s allowed!
aggregate amount of its debts including capital or capital stock, ISSUE 2: whether the right of a holder of cumulative preferred stock to
in other words from its surplus, the next question is whether dividend arrearages and other preferences may be cancelled by a statutory
surplus may consists of increases in revaluation of fixed merger.
assets.
· Surplus is the net assets of a corporation in excess of all Judgment appealed from is confirmed.
liabilities including its capital stock. It may be paid in surplus
where the stock is issued at a price above par. It may be RULING 1:
earned surplus as where it was derived wholly from Its language is clear, all-embracing and unqualified. It authorizes any two or
undistributed profits. It may also represent the increase in more business corporations which were or might have been organized under
valuation of land or other assets the general corporation law to merge into a single corporation; and it
provides that the merger agreement shall prescribe "* * * the terms and
conditions of consolidation or merger, the mode of carrying the same
into effect * * * as well as the manner of converting the shares of each
of the constituent corporations into shares or other securities of the
Morris Case corporation resulting from or surviving such consolidation or merger,
Bove Case with such other details and provisions as are deemed necessary."
Nothing in that language even suggests that the legislature intended to make
Bove. Community Hotel Corp underlying purpose a standard for determining permissibility. Indeed, the
contrary is apparent since the very breadth of the language selected
This civil action was brought to enjoin a proposed merger of The Community presupposes a complete lack of concern with whether the merger is
Hotel Corporation of Newport, Rhode Island, a defendant herein, into designed to further the mutual interests of two existing and non-affiliated
Newport Hotel Corp. corporations or whether alternatively it is purposed solely upon effecting a
substantial change in an existing corporation's capital structure.
The holders of preferred stock in Community Hotel Corporation of Newport,
R.I. (Community Hotel) (defendant) had the right to receive unpaid dividends We hold, therefore, that nothing within the purview of our statute forbids a
for 24 years before dividends could be paid on any of the corporation‘s merger between a parent and a subsidiary corporation even under
common stock. Community Hotel‘s management wanted to amend this right circumstances where the merger device has been resorted to solely for the
purpose of obviating the necessity for the unanimous vote which would
otherwise be required in order to cancel the priorities of preferred · On October 1975, the DLJ shares were distribute, thus the
shareholders. portion seeking direction not to distribute the shares is moot,
and so the Court will deal only with the request for declaratory
RULING 2: judgment or for damages.
· The complaint reveals that there is no claim of fraud or self-
In considering whether the right of a holder of cumulative preferred stock to dealing, and no contention of bad faith or oppressive conduct.
dividend arrearages and other preferences may be cancelled by a statutory · In actions which assail the acts of directors, courts will not
merger, the court reviews authorities and alludes to constitutional interfere unless the powers have been illegally executed, or
implications, holding that reservation under general corporation law to unless the acts were fraudulent or collusive and destructive to
permit, by subsequent legislation, amendment or repeal of corporate the rights of the stockholders. Mere errors of judgment are not
charters or articles of incorporation, was sufficient authority for merger sufficient.
legislation; notwithstanding its effect on the rights of the complaining
· The question of whether or not a dividend is to be declared or a
stockholders, and such legislation did not necessarily constitute an improper
distribution of some kind should be made is exclusively a
exercise of the right of amendment merely because it was subsequent to the
matter of business judgement for the BOD. The statute confers
corporate creation and the issuance of the stock affected.
to the directors this power, and the minority stockholders are
not in position to question it, as long as the directors are acting
―Section 3, Other Distributions‖
in good faith.
· A complaint will be dismissed if all that is presented is a
KAMIN v AMEX decision to pay dividends rather than pursuing some other
· This is a stockholder derivative action, the individual conduct. An allegation that some other course of action would
defendants, who are the directors of AMEX, move for an order have been more advantageous gives no cognizable cause of
to dismiss the complaint for failure to state cause of action, or action.
alternatively, a summary judgment. · Although the Business Corporation Law provides for an action
· The complaint is brought by 2 minority stockholders of AMEX, against directors for neglect or failure to perform, such neglect
asking for a declaration that a certain dividends in kind is a must be neglect of duties, not misjudgment.
waste of corporate assets, directing the defendants not to · Also, the defendants evidence proved that the objections of the
proceed with the distribution, or in alternatively, for monetary plaintiffs were carefully considered and rejected in a special
damages. meeting by the BOD. The meeting further revealed that the
· In 1972, AMEX acquired for investment 1,954,418 shares of BOD knew about the possible tax savings in case of sale, but
common stock of Donaldson, Lufken and Jenrette, Inc (DLJ) they weighed more the effects of the $25 Million loss on the
for $29.9Million. The current market value of those shares is statements of AMEX. The loss would have a negative effect on
$4Million the market value of the shares.
· In 1975, BOD declared a special dividends to all stockholders · As to the self-dealing claim, the only allegation is that the 4 of
to which the DLJ shares would be distributed in kind. the 20 BOD are also members of the Executive Incentive
· Plaintiff contends that if the shares were to be sold, it would Compensation Plan, hence they may have overstated the
sustain capital loss of $25Million, which could be offset against earnings to have bigger compensation. BUT, there is no
the taxable gains of other investments, resulting to tax savings evidence that the 4 directors controlled or dominated the other
of $8Million, which would not be available if it is distributed as 16 members.
dividends. · In this case, the plaintiffs, clearly failed to make out an
· Despite demands of the stockholders to rescind the declaration, actionable claim. Thus the complaint is dismissed.
the BOD rejected them.
 acquired all of the assets of Fluent without paying money into Fluent's
treasury. Because Novell paid the money to the shareholders of
Fluent, ProtoComm alleges that the payment amounted to a

Neimark Case payment of dividends that were not paid out of Fluent's surplus or
net profits and which left Fluent with no assets, with unreasonably
small capital, and unable to meet its obligation to ProtoComm
―Section 4. Liability for Wrongful Distributions‖
Protocom Case
As a result of the merger, Fluent was left as "a shell corporation, wholly
controlled by Novell, with no assets, no employees, no meaningful
Protocomm Corp. v. Novell
business activities of its own, no board of directors, and no observance
This case is the third generation lawsuit springing from a breach of of corporate formalities."
contract dispute between plaintiff ProtoComm Corporation
("ProtoComm") and Fluent, Inc., now Novell Advanced Services ("Fluent"). ISSUE 1: [Not that important] W/N the conveyance was fraudulent?
In January of 1993, ProtoComm filed a lawsuit against Fluent alleging a ISSUE 2: [Not important] W/N statute of limitations apply?
breach of an agreement to develop a video server software. ISSUE 3: W/N dividends was properly paid?
("ProtoComm I"). On July 24, 1996, a jury returned a verdict in ProtoComm
I in favor of ProtoComm and against Fluent for $12.5 million. The verdict Ruling 1:
was affirmed by the Court of Appeals for the Third Circuit on October 29, Four sections of the PAUFCA detail the circumstances under which a
1997. conveyance will be deemed fraudulent to creditors. Section 354
provides: "Every conveyance made and every obligation incurred by a
ProtoComm alleges that while litigation in ProtoComm I was pending, person who is or will be thereby rendered insolvent, is fraudulent as to
Novell, Inc. ("Novell") and Fluent made plans for Novell's acquisition of creditors, without regard to his actual intent, if the conveyance is made
Fluent. In letters of intent dated in the spring of 1993, Novell and or the obligation is incurred without a fair consideration."
Fluent indicated that Novell would acquire all the assets and
obligations of Fluent through a merger. According to an agreement Ruling 2:
approved by Fluent's board of directors on June 4, 1993, Fluent would be The parties agree that the applicable statute of limitations under
the surviving corporation of the merger as a wholly owned subsidiary of Pennsylvania law is, setting a two year limitation period for actions
Novell. The agreement also provided that as a condition precedent sounding in fraud. The parties dispute, however, when the limitation
to the merger, ProtoComm I must have been resolved. ProtoComm period began to run on ProtoComm's claims, or when the causes of
alleges that despite this condition precedent, the merger was action accrued. The Former Fluent Shareholders contend that the
consummated on July 7, 1993. However, the merger was restructured limitations period for claims under the PAUFCA "begins to run from the
as a stock acquisition/merger, whereby Novell purchased all of Fluent's date of the fraudulent conveyance complained of, unless such fraud has
stock for approximately $17.5 million which was paid directly to the been actively concealed by the wrongdoer. the flexibility of the PAUFCA
shareholders, not to Fluent's treasury. ProtoComm alleges that although in allowing creditors to bring suits before or after their claims have
the transaction was characterized as a stock acquisition, in reality, Novell matured, the persuasive authority of Cortez, and the dictate of the
PAUFCA that it "shall be so interpreted and construed as to effectuate its
general purposes to make uniform the law of those States which enact COURT RULING: In Johnston, the Supreme Court of Delaware held that
it," 39 Pa.Stat. § 362, this Court concludes that the Supreme Court of the plaintiffs did not have standing to pursue a claim for wrongful
Pennsylvania would hold that the two-year limitation period did not dividends under § 174 because the plaintiffs were not creditors of the
begin to run until judgment was entered in favor ProtoComm and defendant in its pre-merger form. Thus, the plaintiffs did not have
against Fluent on July 24, 1996. Thus, as ProtoComm filed its complaint standing to pursue an action against the directors of the pre-merger
in this case on July 22, 1998, ProtoComm's claims are timely and are not company under § 174. Id. However, ProtoComm did have a claim against
barred by the statute of limitations. Fluent before the alleged wrongful dividend took place; in fact, the
parties were involved in litigation over the claim. Thus, it is not beyond
Ruling 3: doubt that ProtoComm does not have standing as a creditor under § 174
Under 8 DelCode Ann. § 170(a), a corporation may pay dividends upon and thus, the claim for wrongful dividends will not be dismissed on this
the shares of its capital stock "either (1) out of its surplus ..., or (2) in case ground.
there shall be no such surplus, out of its net profits. ..." Under 8 Del.Code
Ann. § 173, "[n]o corporation shall pay dividends except in accordance The Former Fluent Shareholders contend that because § 325 applies only
with this chapter." Section 174 provides that "[i]n case of any wilful or to current stockholders of a corporation, ProtoComm cannot bring a
negligent violation of ... [section] 173 of this title, the directors under claim for wrongful dividends against them because they have not been
whose administration the same may happen shall be jointly and shareholders since 1993. However, the Former Fluent Shareholders
severally liable ... to [the corporation's] creditors in the event of its provide no case or other authority to support their position that § 325
dissolution or insolvency. applies only to current stockholders, and the Court finds no support for
their argument in the language of § 325. Thus, the Court concludes that
[Skip these next two paragraphs] the Former Fluent Shareholders' argument is not a basis to dismiss
ProtoComm argues that for the purposes of analyzing its wrongful ProtoComm's claim for wrongful dividends.
dividends claim, the transaction among the Former Fluent Shareholders,
Fluent, and Novell should be collapsed into one integrated transaction,
as in the fraudulent conveyance context. ). ProtoComm alleges that the JOHN ROEBLING’S SONS CO v MODE
Former Fluent Shareholders, rather than Fluent's treasury, received the · Plaintiff seeks to hold the defendant individually liable for a
judgment due to the plaintiff from Kent Iron & Hardware Co., an
consideration for the transfer of Fluent's assets to Novell, a transaction
insolvent corporation of the state of Delaware, upon the ground
which essentially paid a dividend to the Former Fluent Shareholders and
that the defendant was one of the directors of the said
left Fluent insolvent. corporation, and participated in an illegal dividend which was
declared and paid, not out of the net earnings or surplus of the
The Former Fluent Shareholders contend that even if the money company, but in diminution of its capital stock.
received by the Former Fluent Shareholders is considered a dividend, · Kent Iron & Hardware Co., an insolvent corporation, declared
and paid a dividend of $9,000, being 6% on the capital stock of
under Johnston v. Wolf, ProtoComm lacks standing to sue for wrongful
$150,000, not out of its net earnings, but in diminution of its
dividends because it was not a creditor of Fluent at the time the alleged
capital stock. The defendant was one of the directors who
dividend was made.
 participated and thus became liable to pay the plaintiff the full
amount of his claims of $630.60.
· The action is based on Section 7 of the Delaware Corporation Reilly Case
Law: Wood Case
Wood v. National City Bank
· The above section provides for the recovery and restoration tot
eh capital of the corporation of the entire amount illegally At some undisclosed time, the District Court for the Eastern District of
withdrawn, and, to that end, each director is made individually Kentucky appointed a receiver for the Stanton Oil Company, a Delaware
liable for such amount. Once recovered, it becomes a part of Corporation, and later the plaintiff was appointed ancillary receiver. The
the capital stock again, to be held and disposed of as such for
nature of neither suit was disclosed. The defendants were stockholders
the benefit of all concerned. This would be so if the amount
was recovered by the corporation itself before insolvency. If on from the corporation and received certain dividends from the
the other hand, the recovery is at the instance of the creditor corporation’s assets. The corporation at the time was in debt and
after insolvency or dissolution, each creditor would be entitled insolvent and unable to pay its debts. It also had no reserve above its
to his proportionate share thereof, and any action for the capital stock nor net profits, yet dividends were paid. The claims
recovery must contemplate such proportionate distribution.
amounted to more than $100,000 and receiver’s certificates issued in the
· This case, does not contemplate any such distribution because
sum of $25,000. (this was the only set of facts)
the demand of the plaintiff is without respect to any of the other
creditors. Thus, the plaintiff cannot recover a proportionate
share of the said dividend, inasmuch as that share must The court: [Yes, even the court was confused with the facts] It is
depend upon the correct ascertainment and adjustment of the impossible from the bill to learn just what the plaintiff meant to allege.
claims of all other creditors entitled. Recovery in this action of On the one hand, he may have meant only that, when the dividends
such proportionate share would be an attempt to determine the
were paid, the corporate assets did not equal its debts together with the
rights of such other creditors without any day given to them in
aggregate amount of its corporate shares, considered as a liability, and
court, and without any opportunity to be heard, either as to
their own claims, or those of the plaintiff and others. that the payments left the assets insufficient to pay the shares in full. On
· If this be a common fund, the remedy would be by proceedings the other hand, he may have meant that the assets were not at those
in equity, where all persons interested would be made parties, times enough to pay the debts; that is, that the corporation was
and the rights and liabilities of each one could be fully insolvent, as that word is used in the Bankruptcy Act (11 USCA).
considered and equitably adjusted.
Considering the liberal attitude which courts now take towards
· The remedy by action on the case, does not apply to cases
pleadings, we think that some of the language is susceptible of
arising under section 7, and that the provisions of section 7 can
only adequately and properly be enforced by proceedings in being understood in the second sense "Unable to pay its debts"
equity. It follows, that this declaration is not sufficient in law to certainly says more than that the corporation has failed to pay them in
support the plaintiff‘s claim, and that, under the demurrer, due course. It more naturally means that the assets were not enough for
judgment should be entered against the plaintiff. that purpose. We must, it is true, confess to a complete inability to
understand the relevancy of the remainder of the third article of the bill,
in which these words appear. They strongly suggest that the gist of the
suit was the receipt of dividends paid in depletion of capital, without
regard to whether the corporation was solvent or insolvent.
 depends only upon the fact of the donor's insolvency, regardless of his
The plaintiff depends upon the fact that the directors have paid, and the intent, it is voidable only at the demand of creditors existing when it is
defendants received, dividends when the corporation was insolvent. made. If holding otherwise, is an exception; it probably meant no more
Merely because this impairs the capital stock, it is commonly regarded as than that, if there be actual intent to defraud subsequent creditors, they
a wrong to creditors on the directors' part, and it is often made such by also may avoid the gift. In the case at bar the bill does not allege that
statute. We may, without discussion, assume that it would be a wrong in any of the creditors in existence when the receiver was appointed
the case at bar. Even so, it is primarily only the wrong of those who were creditors when the dividends were declared. Only in case the
commit it, like any other tort, and innocent participants are not bill had alleged this, would the question arise whether insolvency per se
accomplices to its commission. Hence it has been settled, at least for us, avoids the gift. For this reason, and this alone, the decree was right.
that, when the liability is based merely on the depletion of the capital, a
stockholder must be charged with notice of that fact.
The case has clearly not been presented in all aspects which the facts
It is apparent that this result could not have been reached if the capital may warrant, and it is always undesirable to have the merits finally
of the corporation were regarded as a trust fund for its creditors, disposed of on mere pleading, unless we can be sure that it faithfully
because a stockholder is not a purchaser, but a donee, and his bona presents them. The plaintiff will then have an opportunity to allege, if he
fides would not protect him, in the absence of some further equity, in deems it necessary, that the dividends were paid in fraud of creditors,
retaining the proceeds of a trust. Since, as we have said, a stockholder is and that some of the creditors existing when the receiver was appointed
a donee, he receives such payments charged with whatever trust they existed also when the dividends were paid.
were subject to in the hands of the corporation. In that situation it can
indeed be said with some truth that the corporate assets have become a
"trust fund. Hence, if the dividends are paid in fraud of creditors the
stockholder is so liable. ● STEPHEN M. BAINBRIDGE, CORPORATION LAW AND
ECONOMICS, ―Chapter 13 Dividends and Other Legal Arcana‖,
If the bill be regarded as presenting only an instance of a payment 768 – 796 (2002)
in fraud of creditors, the question arises whether it is enough
768-781 - Mais
merely to allege that the payment was made while the corporation
782-796 - Wendell
was insolvent. It is agreed with substantial unanimity that, when an STOCK SPLITS AND DIVIDENDS
insolvent makes a voluntary payment out of his assets, it is A stock dividend is not really a dividend at all. It is the issuance of additional
regarded as at least presumptively in fraud of his creditors. shares of the corporation at no charge to the shareholders.
Effect on the balance sheet: mere transfer from surplus to capital; it has no
other effect on the balance sheet
We shall assume, for argument, in accordance with the language of
some of the foregoing decisions, that such a transfer is fraudulent per STOCK SPLITS:
se. In Hayden v. Williams no more is mentioned than that the A stock split is effected via reduction in the par value, it has no impact on the
corporation was insolvent, and apparently no more was thought balance sheet of the corporation. Accordingly, the board need not
necessary. Even so, the bill is bad, because, when the invalidity of the gift redesignate surplus as capital.
Why do companies make use of stock splits? partnership (except a general professional partnership) of which he is a
Studies of the stock market price effect of splits show that they have limited partner, or the share of a nonresident alien individual in the net income after
informational content. It has almost no impact on returns. tax of an association, a joint account, or a joint venture taxable as a
A more plausible explanation for splits therefore focuses on their liquidity corporation of which he is a member or a co-venturer; interests; royalties (in
effect by making it possible for small investors to trade in the stock any form); and prizes (except prizes amounting to Ten thousand pesos
and thereby increasing the pool of potential investors. (P10,000) or less which shall be subject to tax under Subsection (B)(1) of
Section 24) and other winnings (except Philippine Charity Sweepstakes and
REVERSE STOCK SPLITS AND FREEZE-OUTS Lotto winnings); shall be subject to an income tax of twenty percent (20%)
on the total amount thereof: Provided, however, that royalties on books as
well as other literary works, and royalties on musical compositions shall be
12.5 Dividend tax: NATIONAL INTERNAL REVENUE CODE §24(B)(2); subject to a final tax of ten percent (10%) on the total amount thereof:
§25(A)(2); §27(D)(4); §28(A)(7)(d); §28(B) (5)(b), §73; as amended by Provided, further, That cinematographic films and similar works shall be
Republic Act 10963 §5 (on §24(B)(2): cash and/or property dividends) subject to the tax provided under Section 28 of this Code: Provided,
furthermore, That interest income from long-term deposit or investment in
Sec. 24. Income Tax Rates. - the form of savings, common or individual trust funds, deposit substitutes,
(B) Rate of Tax on Certain Passive Income.— investment management accounts and other investments evidenced by
(2) Cash and/or Property Dividends. - A final tax at the rate of ten percent certificates in such form prescribed by the Bangko Sentral ng Pilipinas (BSP)
(10%) shall be imposed upon the cash and/or property dividends actually or shall be exempt from the tax imposed under this Subsection: Provided,
constructively received by an individual from a domestic corporation or from finally, that should the holder of the certificate pre-terminate the deposit or
a joint stock company, insurance or mutual fund companies and regional investment before the fifth (5th) year, a final tax shall be imposed on the
operating headquarters of multinational companies, or on the share of an entire income and shall be deducted and withheld by the depository bank
individual in the distributable net income after tax of a partnership (except a from the proceeds of the long-term deposit or investment certificate based
general professional partnership) of which he is a partner, or on the share of on the remaining maturity thereof:
an individual in the net income after tax of an association, a joint account, or
a joint venture or consortium taxable as a corporation of which he is a
member or co-venturer. Four (4) years to less than five (5) years - 5%;

Section 25. Tax on Nonresident Alien Individual. -

Three (3) years to less than four (4) years - 12%; and
(A) Nonresident Alien Engaged in trade or Business Within the Philippines. -

(2) Cash and/or Property Dividends from a Domestic Corporation or Joint

Stock Company, or Insurance or Mutual Fund Company or Regional Less than three (3) years - 20%.
Operating Headquarter or Multinational Company, or Share in the
Distributable Net Income of a Partnership (Except a General Professional
Partnership), Joint Account, Joint Venture Taxable as a Corporation or Section 27. Rates of Income tax on Domestic Corporations. -
Association., Interests, Royalties, Prizes, and Other Winnings. - Cash and/or
property dividends from a domestic corporation, or from a joint stock (D) Rates of Tax on Certain Passive Incomes. -
company, or from an insurance or mutual fund company or from a regional
operating headquarter of multinational company, or the share of a (4) Intercorporate Dividends. - Dividends received by a domestic corporation
nonresident alien individual in the distributable net income after tax of a from another domestic corporation shall not be subject to tax.
Section 28. Rates of Income Tax on Foreign Corporations. - individual or corporate, is a taxable income or a deductible loss, as the case
may be.
(A) Tax on Resident Foreign Corporations. -
(B) Stock Dividend. - A stock dividend representing the transfer of surplus to
(7) Tax on Certain Incomes Received by a Resident Foreign Corporation. - capital account shall not be subject to tax. However, if a corporation cancels
or redeems stock issued as a dividend at such time and in such manner as
(d) Intercorporate Dividends. - Dividends received by a resident foreign to make the distribution and cancellation or redemption, in whole or in part,
corporation from a domestic corporation liable to tax under this Code shall essentially equivalent to the distribution of a taxable dividend, the amount so
not be subject to tax under this Title. distributed in redemption or cancellation of the stock shall be considered as
taxable income to the extent that it represents a distribution of earnings or
profits.

(B) Tax on Nonresident Foreign Corporation. - (C) Dividends Distributed are Deemed Made from Most Recently
Accumulated Profits. - Any distribution made to the shareholders or
(5) Tax on Certain Incomes Received by a Nonresident Foreign Corporation. members of a corporation shall be deemed to have been made form the
- most recently accumulated profits or surplus, and shall constitute a part of
the annual income of the distributee for the year in which received.
(b) Intercorporate Dividends. - A final withholding tax at the rate of fifteen
percent (15%) is hereby imposed on the amount of cash and/or property (D) Net Income of a Partnership Deemed Constructively Received by
dividends received from a domestic corporation, which shall be collected and Partners. - The taxable income declared by a partnership for a taxable year
paid as provided in Section 57 (A) of this Code, subject to the condition that which is subject to tax under Section 27 (A) of this Code, after deducting the
the country in which the nonresident foreign corporation is domiciled, shall corporate income tax imposed therein, shall be deemed to have been
allow a credit against the tax due from the nonresident foreign corporation actually or constructively received by the partners in the same taxable year
taxes deemed to have been paid in the Philippines equivalent to twenty and shall be taxed to them in their individual capacity, whether actually
percent (20%) for 1997, nineteen percent (19%) for 1998, eighteen percent distributed or not.
(18%) for 1999, and seventeen percent (17%) thereafter, which represents
the difference between the regular income tax of thirty-five percent (35%) in
1997, thirty-four percent (34%) in 1998, and thirty-three percent (33%) in
1999, and thirty-two percent (32%) thereafter on corporations and the fifteen ● Property Dividends: BIR Ruling No. 1011-18 (June 13, 2018) (M.C.
percent (15%) tax on dividends as provided in this subparagraph; Holdings Corporation)
● Stock Dividends: BIR Ruling No. 744-18 (April 30, 2018) (Ilo Land
Inc.)
12.6 IAET: NATIONAL INTERNAL REVENUE CODE §29; Revenue
Section 73. Distribution of dividends or Assets by Corporations. -
Regulations No. 2-01 (February 12, 2001) RMC No. 35-2011 (March 14,
2011)
(A) Definition of Dividends. - The term 'dividends' when used in this Title
means any distribution made by a corporation to its shareholders out of its
earnings or profits and payable to its shareholders, whether in money or in Section 29. Imposition of Improperly Accumulated Earnings Tax. -
other property.
(A) In General. - In addition to other taxes imposed by this Title, there is
Where a corporation distributes all of its assets in complete liquidation or
hereby imposed for each taxable year on the improperly accumulated
dissolution, the gain realized or loss sustained by the stockholder, whether
taxable income of each corporation described in Subsection B hereof, an
improperly accumulated earnings tax equal to ten percent (10%) of the And reduced by the sum of:
improperly accumulated taxable income.
(1) Dividends actually or constructively paid; and
(B) Tax on Corporations Subject to Improperly Accumulated Earnings Tax. -
(2) Income tax paid for the taxable year.
(1) In General. - The improperly accumulated earnings tax imposed in the
preceding Section shall apply to every corporation formed or availed for the Provided, however, That for corporations using the calendar year basis, the
purpose of avoiding the income tax with respect to its shareholders or the accumulated earnings under tax shall not apply on improperly accumulated
shareholders of any other corporation, by permitting earnings and profits to income as of December 31, 1997. In the case of corporations adopting the
accumulate instead of being divided or distributed. fiscal year accounting period, the improperly accumulated income not
subject to this tax, shall be reckoned, as of the end of the month comprising
(2) Exceptions. - The improperly accumulated earnings tax as provided for the twelve (12)-month period of fiscal year 1997-1998.
under this Section shall not apply to:
(E) Reasonable Needs of the Business. - For purposes of this Section, the
(a) Publicly-held corporations; term 'reasonable needs of the business' includes the reasonably anticipated
needs of the business.
(b) Banks and other nonbank financial intermediaries; and

(c) Insurance companies.

12.7 Rulings:
(C) Evidence of Purpose to Avoid Income Tax. - ● BIR Ruling No. 1398-18 (November 19, 2018) (Unisys Public
Sector Services Corporation)
(1) Prima Facie Evidence. - the fact that any corporation is a mere holding
company or investment company shall be prima facie evidence of a purpose The question posed is merely a confirmation that Unisys Public Sector
to avoid the tax upon its shareholders or members. Services Corporation (UPSSC) is a publicly-held corporation and therefore
exempt from the Improperly Accumulated Earnings Tax (IAET) pursuant to
(2) Evidence Determinative of Purpose. - The fact that the earnings or profits
Section 29 of the National Internal Revenue Code of 1997 (Tax Code), as
of a corporation are permitted to accumulate beyond the reasonable needs
amended, and implemented by Revenue Regulations (RR) No. 2-2001.
of the business shall be determinative of the purpose to avoid the tax upon
its shareholders or members unless the corporation, by the clear
preponderance of evidence, shall prove to the contrary.

(D) Improperly Accumulated Taxable Income. - For purposes of this Section, UPSSC is a domestic corporation and its primary purpose is to create,
the term 'improperly accumulated taxable income' means taxable income' manufacture, process, assemble, fabricate, develop, supply, license, lease
adjusted by: (without engaging in �nancial leasing), sell at wholesale for cash or on credit,
barter, exchange, trade, make advances upon, import or otherwise acquire,
(1) Income exempt from tax; distribute, integrate, market, upgrade or modify computer hardware,
computer system software programs, applications, components, devices
(2) Income excluded from gross income; and supplies, as well as to provide support, training, and consultancy
services in the use and application of these products.
(3) Income subject to final tax; and

(4) The amount of net operating loss carry-over deducted;

UPSSC is One Hundred percent (100%) owned by Unisys Holdings This kind of tax is being imposed in the nature of a penalty to the
Corporation ("UHC"), a corporation organized and existing under and by corporation for the improper accumulation of its earnings, as a form of
virtue of the laws of the United States of America, with business address at deterrent to the avoidance of tax upon shareholders who are supposed to
501 Silverside Road, Suite 18-A, Wilmington, Delaware 19809, USA. pay dividends tax on the earnings distributed to them by the corporation.
However, the IAET shall not apply to, among others, publicly-held
UHC is One Hundred percent (100%) owned by Unisys Corporation, a corporations.
publicly-held company with headquarters at Blue Bell, Pennsylvania USA;
that Unisys Corporation is traded under the ticker symbol "UIS" at the New Furthermore, Section 4 of RR No. 2-2001, "Implementing the Provision on
York Stock Exchange; and that at least �fty percent (50%) of the outstanding Improperly Accumulated Earnings Tax under Section 29 of the Tax Code of
capital stock of Unisys Corporation or at least �fty percent (50%) of the total 1997, provides:
combined voting power of all classes of Unisys Corporation's stock entitled
to vote at a meeting of stockholders is owned directly or indirectly by at least "For purposes of these Regulations, closely-held corporation are those
twenty-one (21) or more individuals. corporations at least �fty percent (50%) in value of the outstanding capital
stock or at least �fty percent (50%) of the total combined voting power of all
As of December 31, 2013, there were approximately 44.0 million shares classes of stock entitled to vote is owned directly or indirectly by or for not
outstanding and approximately 11,800 stockholders of record. As of March more than twenty (20) individuals. Domestic corporations not falling under
03, 2014, following the mandatory conversion of 2.6 million shares of the aforesaid definition are, therefore, publicly-held corporations."
preferred stock into common stock, there were approximately 51.1 million
shares outstanding and approximately 11,700 stockholders of record. For purposes of determining whether the corporation is a closely-held
corporation, it is provided that stock owned directly or indirectly by or for a
ANSWER: corporation, partnership, estate or trust shall be considered as being owned
proportionately by its shareholders, partners or beneficiaries.
t Section 29 (A) and (B) (2) (a) of the Tax Code of the imposition of IAET,
states that: — (A) In addition to other taxes imposed by this Title, there is Thus, in BIR Ruling No. 025-2002 dated June 25, 2002, this O�FFICEruled
hereby imposed for each taxable year on the improperly accumulated that such shares will be considered as being owned proportionately by the
taxable income of each corporation described in Subsection B hereof, an shareholders.Furthermore, in BIR Ruling No. 094-2013 dated March 18, 2013,
improperly accumulated earnings tax equal to ten percent (10%) of the this O�ce also ruled that to determine whether a corporation is publicly-held
improperly accumulated taxable income. or not, is to ultimately trace to the individual shareholders of the parent
company.
(B) Tax on Corporations Subject to Improperly Accumulated Earning
In applying the foregoing principle, this O�ffice holds that, UPSSC is exempt
In General. — The improperly accumulated earning tax imposed in the from the imposition of IAET even if it is not directly owned by Unisys
preceding Section shall apply to every corporation formed or availed for the Corporation considering that for purposes of determining whether it is a
purpose of avoiding the income tax with respect to its shareholders or the closely-held corporation or a publicly-held corporation, exempt from IAET, is
shareholders of any other corporation, by permitting earnings and pro�ts to ultimately traced to the individual shareholders of the ultimate parent
accumulate instead of being divided or distributed. company. Considering that UHC owns 100% of the shares of UPSSC, and
that since the ownership of UHC is ultimately traced to Unisys Corporation, a
Exceptions. — The improperly accumulated earnings tax as provided for corporation where at least �fty percent (50%) of the outstanding capital
under this Section shall not apply to: Publicly-held corporations; stock or at least 50% of the total combined voting power of all classes of
stock entitled to vote is owned directly or indirectly by more than twenty (20)
individuals, the corporation is considered publicly-held corporation as the
term is de�ned in RR No. 2- 2001. Purpose of IAET:

This kind of tax is being imposed in the nature of a penalty to the corporation
for the improper accumulation of its earnings, and as a form of deterrent to
the avoidance of tax upon shareholders who are supposed to pay dividends
tax on the earnings distributed to them by the corporation. However, the
IAET shall not apply to, among others, publicly-held corporations

How to determine whether a corporation is a closely-held corporation

or a publicly held corporation:

According to Sec. 4, of RR 2-2001, closely-held corporations are those

TAacHE
corporations at least fifty percent (50%) in value of the outstanding capital
stock or at least fifty percent (50%) of the total combined voting power of all
classes of stock entitled to vote is owned directly or indirectly by or for not
more than twenty (20) individuals. Domestic corporations not falling
under the aforesaid definition are, therefore, publicly-held
corporations.
● BIR Ruling No. 094-13 (March 18, 2013) (Cebu Air Inc.)
● BIR Ruling No. [DA-(C-005) 038-10] (March 4, 2010) (Luck Hock For purposes of determining whether the corporation is a closely-held
Venture Holdings, Inc.) corporation, it is provided that stock owned directly or indirectly by or for
a corporation, partnership, estate or trust shall be considered as being
QUERY: owned proportionately by its shareholders, partners or beneficiaries.

Whether LHVHI is a publicly held corporation making it exempt from the The ownership of a domestic corporation for purposes of determining
imposition of the IAET under the tax code - YES whether it is closely-held corporation or a publicly-held corporation is
ultimately traced to the individual shareholders of the parent company.

FACTS: Accordingly, where at least 50% of the outstanding capital or at least 50% of
the total combined voting power of all classes of stock entitled to vote in a
LUCK HOCK VENTURE HOLDINGS, INC.‘s (LHVHI) ownership structure: corporation is owned directly or indirectly by at least 21 or more individuals,
the corporation is considered publicly-held corporation as the term is defined
60% owned by Orion Land Inc. (OLI), OLI in turn being wholly owned (100%) in Revenue Regulations No. 2-2001.
by Prime Orion Philippines, Inc. (POPI)
SUCH BEING THE CASE, the ownership of a domestic corporation (like
40% owned by Gouman Philippines (GPI), GPI in turn being wholly owned LHVHI) for purposes of determining whether it is a closely-held corporation
by Gouman Hotels (GHL), GHL by GHRHS and etc (irrelevant to the ruling, or a publicly-held corporation is ultimately traced to the individual
as this pertains to the 40% share) shareholders of the ultimate parent- company.

RULING:
Since LHVHI is 60% owned by OLI, which is an indirectly wholly-owned
subsidiary of POPI, the 60% shares of LHVHI will be considered as being
owned proportionately by GHL (I think the BIR meant POPI) shareholders.

In applying the foregoing principles, it is clear that LHVHI is a publicly-held

corporation. LHVHI is 60% indirectly-owned subsidiary of its ultimate parent
company, OLI, on account of the following: (a) 40% of the capital stock of
the LHVHI is owned by GPI; (b) 100% of the capital stock of GPI is owned
by GHL; (c) 100% of the capital stock of GHL is owned by GMB.

Because the shares of OLI, the ultimate parent company of LHVHI, are
owned by more than 20 individuals, 60% of LHVHIs' shares is indirectly
owned by more than 20 individuals. It follows that at least 60% of the capital
stock of LHVHI, comprising the 60% shares indirectly owned by stockholders
of POPI, plus any shares directly owned by an individual, is owned by more
than 20 individuals. Under the premises, LHVHI qualifies as a publicly-
held corporation not subject to the improperly accumulated earnings
tax.

● BIR Ruling No. DA-(C-094) 305-09 (June 17, 2009) (Mahle Filter
Systems Corporations)
12.8 VAT: Distribution to shareholders/investors: Revenue Regulation No.
16-2005 §4.106-7(a)(2)(i)