The Independent Directors

THE Securities Regulation Code (SRC) institutionalized within the PHC (publicly held corporation) sector the system of “independent director” (ID) which it defines as “a person other than an officer or employee of the corporation, its parent or subsidiaries, or any other individual having a relationship with the corporation, which would interfere with the exercise of independent judgment in carrying out the responsibilities of a director.”
Since the SRC does not provide for the particular role and duties of IDs as such, the questions that arose were thus:
• What is the nature and extent of the special role of IDs “to exercise independent judgment”?
• To whom do IDs owe their duty “to exercise independent judgment”?
• Does it mean that regular directors in PHCs are not bound by the duty “to exercise independent judgment,” which is specifically assigned to IDs?
The 2015 Implementing Rules and Regulations of the Securities Regulation Code (“SRC IRR”), expands the meaning of “ID” thus: “a person who, apart from his fees and shareholdings, is [1] independent of management and [2] free from any business or other relationship which could, or could reasonably be perceived to, materially interfere with his exercise of independent judgment in carrying out his responsibilities as a director in any covered company,” and includes, among others, any person who:
a. Is not a director or officer of the corporation or of its related companies [i.e., another company which is its holding company, its subsidiary, or a subsidiary of its holding company], or any of its substantial shareholders, other than as an ID of any of the foregoing;
b. Is not a substantial shareholder [i.e., the beneficial owner of more than two percent (2%) of any class of the equity security] of the corporation or of its related companies or any of its substantial shareholders;
c. Is not a relative of any director [i.e., spouse, parent, child, brother, sister, and the spouse of such child, brother or sister], officer or substantial shareholder of the corporation, any of its related companies or any of its substantial shareholders;
d. Is not acting as a nominee or representative of any director or substantial shareholder of the corporation, any of its related companies or any of its substantial shareholders;
e. Has not been employed in any executive capacity by that PHC, any of its related companies or by any of its substantial shareholders within the last two (2) years;
f. Is not retained as professional adviser by that PHC, any of its related companies or any of its substantial shareholders within the last two (2) years;
g. Is not retained as professional adviser, by that PHC, any of its related companies or by any of its substantial shareholders, either personally or through his firm; or
h. Has not engaged and does not engage in any transaction with the corporation or with any of its related companies or with any of its substantial shareholders, whether by himself or with other persons or through a firm of which he is a partner or a company of which he is a director or substantial shareholder, other than transactions which are conducted at arms length and are immaterial.
Other than requiring that an ID must be one of the three members in the Nomination Committee, the SRC IRRs do not provide for any particular role or obligation on the part of IDs in the PHC setting.
From the foregoing, we can discern that the “independence” of an ID comes from the utter lack of official, professional or business connection with the Management, substantial shareholders, or with the PHC itself (other than that of being a director and holding qualifying shares) which would interfere with the exercise of independent judgment in carrying out the responsibilities of a director. He is one who must be completely independent from the management and operation of the company at the time he stands qualified to be elected into the Board.
Under the SRC, the duty of an ID to exercise independent judgment means is twofold: (a) to act independent of what may be the self-serving interests of the controlling shareholders acting through a majority of the Board and the Management; and (b) to avoid being in any sort of conflict-of-interests situation in exercising business judgment in arriving at decisions. What strikes our attention from this textual construct is the fact that such “duty to exercise independent judgment” also pertains to regular directors, who, under their fiduciary duty of loyalty, are also supposed to act for the benefit of the corporation and cannot choose their own or their colleagues’ self-serving interests to the detriment of the corporation and its stockholders at large. The main difference is that regular directors do not become disqualified from office by the fact of being in conflict-of-interests situations, whereas, such circumstances render IDs utterly unqualified for their office.
Such measure of independence comes from the fact that there could arise no situation in his directorship dealings with the company, or in exercising his business judgment with respect to company dealings, that would put him in any degree to a conflict-of-interest situation of any kind. It seems therefore that the defining characteristic of an ID, from all the rest of the members of the Board, is that he would be “above suspicion” from any and all kinds of conflict-of-interests dealings; that utterly lacking in any dealings with the company, he would supposedly have no choice but to exercise independent judgment.
The SRC role for an ID is a clear break from the rationale behind the requirement under Section 23 of the Corporation Code that every director, as a minimum qualification for a director to be elected into office and to remain qualified during his tenure, “must own at least one (1) share of the capital stock of the corporation of which he is a director, which shares shall stand in his name on the books of the corporation.” This particular qualification requirement of the Corporation Code has been used as the basis to show that one who serves as a director must be one who is not a stranger to the corporation and the stockholders, that he must come from among their ranks and therefore would serve for the benefit of the stockholders; and that by requiring that directors must possess proprietary interest in the corporation, it is expected that he will be motivated to act for the best interest of the corporation and the stockholders.
In Western Institute of Technology v. Salas, the Supreme Court gave the rationale on why, as a general rule, directors serve the corporation gratuitously: “There is no argument that directors or trustees, as the case may be, are not entitled to salary or other compensation when they perform nothing more than the usual and ordinary duties of their office. This rule is founded upon a presumption that directors/trustees render service gratuitously, and that the return upon their shares adequately furnishes the motives for service, without compensation.”
In order to qualify for their office, IDs are still required to own a qualifying share in the corporation, but it is clear that such shareholdings remain “nominal,” since it is provided that he is automatically disqualified when he holds securities in the company in excess of 2% of the entire issue. It must be noted, however, that a 2% beneficial interest in the entire security issuance of a PHC is not always a “nominal” amount, and if an ID is allowed to have that much, then it really does not make sense why his office is instituted separately from directors who are elected by the minority shareholders. Especially so when the Corporation Code provides for specific rules to protect the interests of the corporation and the stockholders in instances when a director or officer engages in self-dealing transactions with the corporation, or when he appropriates a business opportunity that should pertain to the corporation.
Nevertheless, the essence of the role of an ID in PHCs is that he serves in a dispassionate manner, and that the “return upon his shares or investment in the company” is not the motivating factor for rendering fiduciary duties to the company. The logical question that therefore arises is what is the motivating factor for IDs in their oversight function in PHCs, and to whom do they primarily owe their added oversight function.
The SRC requires that PHCs must have “at least two (2) IDs or such IDs shall constitute at least twenty percent (20%) of the members of such board, whichever is the lesser,” which mathematically makes the highest number of ID in any PHC to never exceed two (2) individuals.
In a 5-person PHC Board—which is the smallest Board size allowed under the Corporation Code — the presence of one (i.e., 20% of 5) ID cannot hope to overcome the vote of the clear 4-person majority of the controlling stockholders in the PHC Board. On the other hand, in a 15-person PHC Board—the maximum Board size allowed for stock corporations under the Corporation Code—there can only be two (2) IDs since the “whichever is the lesser” clause under Section 38 of the SRC would not allow the IDs to constitute 20% (or 3 members) of the Board members. On the other hand, when it comes to stock exchanges, SRC IRRs require them to have “at least three (3) IDs … to effectively carry out” their special role in serving the investing public.
Such carefully crafted language of the SRC IRRs affirms that the primary role of IDs in PHCs is not to exercise a too-looming voting right block against majority Board members, much less to prevail over the management of the company, but merely to exercise oversight function against corporate opportunism by the controlling stockholders for the benefit of the public investors.
There seems little doubt therefore that the special oversight role of IDs under SRC is primarily for the benefit of the public investors, both equity and debt-securities holders.
The other important point to consider is that the SRC does not embody in its provisions the Stakeholder Theory, for its primary purpose is to protect the investing public, i.e., the holders of the PHCs securities, thus: “The State shall establish a socially conscious, free market that regulates itself, encourage the widest participation of ownership in enterprises, enhance the democratization of wealth, promote the development of the capital market, protect investors, ensure full and fair disclosure about securities, minimize if not totally eliminate insider trading and other fraudulent or manipulative devices and practices which create distortions in the free market.” The oversight role of IDs is to protect the public investors from the corporate opportunism that may be attempted by the controlling stockholders. In other words, the SRC operates under the doctrine of maximization of investors’ value.
SRC’s structure for IDs is a more effective mechanism of ensuring minority representation in the PHC Boards than the cumulative voting system under the Corporation Code since the SRC ensures at least two (2) members in such Board whose main function is to protect public investors, even in situations where the minority or public do not hold enough equity to elect even one member of the Board, or lack the resources to mount an effective proxy-solicitation campaign to get enough voting power to gain representation in the Board. The system of IDs under the SRC overcomes the free rider and high transaction costs issues besetting the system of cumulative voting.
It should be pointed out that there is no attempt under the SRC to exempt IDs from their primary duties and functions that are imposed upon the regular members of the Board, and that their oversight functions do not insulate them from fulfilling their duties and functions as voting members of the Board of Directors upon whom has been imposed the exercise of business judgment in pursuing the affairs and transactions of the company. In fact, the SRC and its IRR impose a stricter regimen on IDs when compared with regular directors in that while the latter may find themselves in a conflict-of-interest situation which does not per se disqualify them from their directorship, an ID becomes disqualified by the mere fact that he has a conflict-of-interest situation in the instances provided for in the SRC IRR.
The article reflects the personal opinion of the author and does not reflect the official stand of the Management Association of the Philippines or the MAP.

Cesar L. Villanueva is the Vice Chair of the Corporate Governance Committee of the MAP, the Founding Partner of the Villanueva Gabionza & Dy Law Offices, and the former Chair of the Governance Commission for GOCCs (GCG).
cvillanueva@vgslaw.com
map@map.org.ph