In line with efforts to better protect minority investors and improve corporate governance, the Securities and Exchange Commission (SEC) now requires Publicly-Listed Companies (PLCs) to disclose dealings with their related parties. SEC Memorandum Circular No. 10 provides the rules on reporting material related party transactions (RPT) and the minimum requirements in drafting the RPT policies of PLCs.
All PLCs are mandated to comply with the rules when they enter into material RPTs, which are transactions with related parties amounting to 10% or more of the company’s total assets based on its latest audited financial statements.
Related parties cover “the reporting PLC’s directors, officers, substantial shareholders and their spouses and relatives within the fourth civil degree of consanguinity or affinity, legitimate or common-law” having control and significant influence over the PLC. It also may pertain to “the reporting PLC’s parent, subsidiary, fellow subsidiary, associate, affiliate, joint venture or an entity that is controlled, jointly controlled or significantly influenced or managed by a person who is a related party.”
The Circular defines RPTs as “transfer of resources, services or obligations between a reporting PLC and a related party, regardless of whether a price is charged.” The term also includes outstanding transactions entered with an unrelated party that subsequently becomes a related party.
The SEC also requires PLCs to adopt and submit a group-wide Material RPT Policy within six months from the effectivity of the Circular (which was on April 27, 2019) for existing PLCs and within six months from listing date for those listed after the effectivity. The Material RPT Policy will, at a minimum, include guidelines on the identification of related parties, coverage of material RPT policy, materiality thresholds, identification and prevention or management of potential or actual conflicts of interest which may arise out of or in connection with material RPTs, ensuring arm’s length terms, approval of material RPTs, self-assessment and periodic review of policy, disclosure requirement of material RPTs, whistleblowing mechanisms, and remedies for abusive material RPTs.
Moving forward, PLCs must also file an Advisement Report on any material RPT within three calendar days after the transaction. At a minimum, such disclosures should include the complete name of the related party, relationship of the parties, execution date, the financial or non-financial interest of the related parties, type and nature of transaction as well as description of assets involved, total assets, amount or contract price, percentage of the contract price to the total assets of the reporting PLC, carrying amount of collateral (if any), terms and conditions, rationale for entering into the transaction, and the approval obtained.
Further, a summary of material RPTs entered into during the reporting year should be disclosed in the company’s Integrated Annual Corporate Governance Report (I-ACGR).
The board of directors is responsible for ensuring that transactions with related parties are handled in a sound and prudent manner, with integrity and in compliance with applicable laws and regulations to protect the interest of the company’s shareholders and other stakeholders. Hence, a director or officer of a corporation shall be disqualified from serving as such in another corporation if he or she is found to have facilitated abusive material RPTs based on a final judgment by a court.
To clarify, abusive material RPTs are those that are not entered at arm’s length and unduly favor a related party. To prevent this, the PLC’s Material RPT Policy shall have clear guidelines in ensuring the arm’s length nature of the transaction. The Board of Directors shall appoint an external independent party to evaluate the fairness of the terms of the material RPT before its execution. The policy shall also include guidance for an effective price discovery mechanism to ensure that transactions are engaged into at terms that promote the best interest of the company and its shareholders.
The Circular also provides penalties for other violations of these rules. Non/late filing of or incomplete/incorrect signatures in the Material RPT Policy will result in the imposition of a basic penalty amounting to P10,000 and a monthly penalty of P1,000 which will accrue until the policy is submitted to the SEC.
The SEC also imposes fines of up to P40,000, in addition to a daily penalty of up to P400, for non/late filing of Advisement Reports and a fine up to P20,000, in addition to a daily penalty of up to P400, for incomplete/incorrect Report. This is a serious requirement that should be addressed as early as possible, because a fourth offense for the same violation will constitute grounds for suspension or revocation of the company’s registration or secondary license.
Questions now arise on the scope of the transactions covered by the rules. It should be noted that the Bureau of Internal Revenue (BIR) also issued transfer pricing (TP) regulations, which provide guidelines in determining the appropriate revenues and taxable income of parties involved in related party transactions by prescribing the “arm’s length principle” as the standard to determine transfer prices of related parties. Hence, only those related party transactions with an impact on revenues and taxable income are covered by the BIR TP rules.
The SEC Circular, however, seems to be broader when regarding the nature of the covered transactions given that it encompasses all transfers of resources, services or obligations between a reporting PLC and a related party. But when talking about the value of the transaction, the SEC Circular limits the coverage to transactions with related parties amounting to 10% or higher of the company’s total assets, while there is no such threshold under the BIR TP rules.
The SEC also has yet to clarify the standards to determine the arm’s length nature of the material RPTs. While the Circular requires that the material RPT policy shall have clear guidelines in ensuring the arm’s length terms, there is no established definition for what is considered arm’s length. It would seem that the SEC equates the same to “fairness” as the Circular also requires the appointment of an external independent party to evaluate the fairness of the terms of the material RPT.
We note again that the BIR TP regulations prescribe the methods for determining arm’s length price for related party transactions. The regulations, which apply to both cross-border and domestic transactions of associated enterprises, are largely based on the arm’s length methodologies set under the Organization for Economic Cooperation and Development (OECD) Transfer Pricing Guidelines. It thus remains to be seen whether BIR methodologies may be adopted in determining the arm’s length nature of the material RPTs to comply with SEC rules.
There are also concerns on the disclosures required in the Advisement Report. Although the Circular provides the minimum information that must be included in the report, issues on the completeness and correctness of the information contained therein may still arise. Thus, PLCs should be circumspect in preparing the Advisement Report as even an incomplete or incorrect report warrants a penalty. It behooves the SEC to provide more guidance on the rules given the penalties that may be imposed on PLCs for noncompliance.
While some may feel that these new guidelines add more onerous reporting requirements, we should understand the underlying intent to protect the corporate sector, the securities, the capital market participants, the securities and investment instruments market, and the investing public from transactions detrimental to and practices inconsistent with business development.
Despite much work still needed to be done to improve our country’s ranking, the SEC is optimistic that the new rules will help improve the Philippines’ performance in the World Bank Group’s Ease of Doing Business survey, especially in the indicator for Protecting Minority Investors. The Philippines improved to 132nd out of 190 economies in terms of protecting minority investors in the Doing Business 2019 report from 146th in the preceding report, even as its overall rank dropped 11 spots to 124th from 113th between years.
This article is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinion expressed above are those of the authors and do not necessarily represent the views of SGV & Co.
Joyce A. Francisco is a Tax Senior Director of SGV & Co.