The oversight functions of independent directors

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Cesar L. Villanueva

M. A. P. Insights

THE corporate system of “Independent Directors” does not exist under the current version of the Corporation Code of the Philippines, where the aspect of “minority representation” is covered by the requirement of cumulative voting, which makes it mathematically possible for minority shareholders to pursue minority representation in the Board of Directors. This is understandable since the primary role of the Corporation Code (CC) since its enactment in 1980 is to be the “general enabling law” referred to in our Constitution by which private corporations of all types may be organized for private interests, covering all types of corporations, stock and nonstock, close or family-owned, and not merely limited to “publicly-held corporations” (PHCs).

In 2000, Congress promulgated the Securities Regulation Code (SRC), that provided for the statutory duties and obligations to report on company finances and operations, on dealings with equity acquisitions, as well as providing protection of stockholders through the institution of the “independent directors” for PHCs which it classifies into (a) “publicly-listed companies” (PLCs) whose shares are listed in the exchange; and (b) “public companies” (PCs), which are non-listed corporations with assets of at least P50 million and having 200 or more stockholders with at least 100 shares each.

In April 2002, the adoption of corporate governance principles and best practices specifically for the PHC sector formally commenced when the Securities and Exchange Commission (SEC) through Resolution No. 135, s. 2002, promulgated the original Code of Corporate Governance (“original CG Code”).

The original CG Code defined “Corporate Governance” as “a system whereby shareholders, creditors and other stakeholders … ensure that management enhances the value of the corporation as it competes in an increasingly global market place,” thereby ushering into our jurisdiction the application of the Stakeholder Theory, as it provided that every PHC director “assumes certain responsibilities to various constituencies or stakeholders, who have the right to expect that the institution is being run in a prudent and sound manner.” The original CG Code instituted within the corporate governance framework the role of independent directors, as well as the delineation between executive directors and non-executive directors.

The Code of Corporate Governance for Publicly-Listed Companies (“CG Code for PLCs”) formalized a more process-driven definition of “Corporate Governance” which retained the Stakeholder Theory within its framework, thus:

Corporate Governance — the system of stewardship and control to guide organizations in fulfilling their long-term economic, moral, legal and social obligations towards their stakeholders.

Corporate governance is a system of direction, feedback and control using regulations, performance standards and ethical guidelines to hold the Board and senior management accountable for ensuring ethical behavior — reconciling long-term customer satisfaction with shareholder value — to the benefit of all stakeholders and society.

Its purpose is to maximize the organization’s long-term success, creating sustainable value for its shareholders, stakeholders and the nation.

The paper revisits the oversight role of independent directors as they have evolved under the SRC and the SEC CG Codes, and assesses the efficacy of the fiduciary roles that independent directors play in the promotion of corporate governance within the PHC sector.

There are provisions in the CC that provide statutory checks against corporate opportunism on the part of the directors/trustees, senior officers, and the controlling stockholders, which should be discussed in vetting the rationale for the system of independent directors in PHCs.

1. Minority Representation in the Board of Directors

The aspect of “minority representation” in the governing Board is covered by the system of cumulative voting for directors, that makes it mathematically possible for minority shareholders to pool their voting power to a pre-computed number of nominees to ensure that they would have minority representation in the Board of Directors. Consonant with such principle, the CC also provides that the majority stockholders have no power to remove, except for cause, a director elected by cumulative voting.

In the author’s work on PHILIPPINE CORPORATE LAW, he has commented on the cumulative voting system as follows:

“Cumulative voting is reckoned to be equitable since it allows stockholders the opportunity for representation on the Board of Directors in proportion to their holdings. Such minority representation is believed not to interfere with the principle of majority rule since the number of directors elected by each group will vary with its proportion of ownership. It is also believed that minority interests have a voice on the Board since stockholders and management often have different goals. Finally, it is believed that since corporate and securities laws generally create a balance of power in favor of insiders and controlling interest, some countervailing power in the hands of outside minority interest is desirable.

“On the other hand, the system of cumulative voting has been criticized by other sectors because it tends to promote partisan representation in the Board, which is inconsistent with the notion that a director properly represents all interest groups in the corporate setting. It is said to breed disharmony in the Board which dissipates the energies of management and leads to an atmosphere of uncertainty at the top level. Often, cumulative voting is used by persons who are motivated by narrow, selfish interests.”

Although the system of cumulative voting is mandatory for stock corporations, and cannot be taken-away by any provision in the articles of incorporation or by-laws, it does not always result in proper minority representation in the Board based on the following reasons:

First, minority representation in the Board would only happen when the minority stockholders have a sufficient pool of voting shares to be able to mathematically capture one seat in the Board. Since cumulative voting allows for proportional Board representation, then in a 5-man Board of Directors, a minority group would have to have at least voting power equivalent to 20% of the entire outstanding capital stock in order to capture one seat. The average float for PHC right now among PSE-listed companies is at 10%, which is sought to be raised to 20% by the SEC.

Secondly, it may be difficult, if not expensive, to do a process of proxy solicitation among a diverse and spread-out group of minority stockholders, who often have no financial motivation to exert additional efforts and expend additional resources to protect their small investments in the company, which cover the perennial costs of transaction and free rider dilemma.

Thirdly, directors elected through the system of cumulative voting by the minority stockholders may not have the qualifications of being independent of representing the other stakeholders of the PHC, since they are in the Board precisely upon the mandate of minority shareholders, an aspect of the agency problem.

For purposes of this paper, the most important consideration that has to be analyzed is that the system of cumulative voting under the CC may not always operate in tandem, and may in fact be in conflict, with the system of independent directors established under the SRC.

2. Minority Veto Power on Important Corporate Acts

Although the rule that “majority vote prevails in both Board and stockholders’ resolutions” remains the cornerstone of governance under the CC, in the following corporate acts or transactions, the minority stockholders, who are able to cast a negative vote that exceed one-third (1/3) of the entire voting power in the company, can prevent the majority vote from prevailing, thus:

(a) Amendment of the articles of incorporation;

(b) Increase or Decrease of the capital stock;

(c) Incurring or creating bonded indebtedness;

(d) Investment in non-primary purpose business or enterprise;

(e) Declaration of stock dividends (instead of cash or property dividends) from the unrestricted retained earnings;

(f) Having the corporate business managed by another corporation which has common shareholders or interlocking directors with the company to be managed;

(g) Merger or consolidation with another company.

The effectiveness of the minority shareholders’ veto power against the majority shareholders on the afore-enumerated strategic corporate actions is limited only to situations where the minority shareholders hold more than one-third (1/3) of the voting power in the company. Absent such minimum veto power, the protection granted by the CC to majority stockholders’ corporate opportunism would be allowing judicial review to correct conflict-of-interests or self-dealing transactions by the directors/trustees, senior officers, or controlling stockholders.

3. Judicial Review Mechanism Over Conflict-of-Interests Situations of the Board and Management

The CC provides the following checks on conflict-of-interest situations that allow for judicial review as a means to overcome corporate opportunism on the part of directors/trustees and officers of the company. The main mechanism of minority shareholders would be the common-law right of filing a derivative suit in behalf of the corporation against the self-dealing directors/trustees, officers and/or controlling stockholders.

a. Duty of Loyalty

The duty of loyalty that is imposed upon directors/trustees and officers requires that whenever they find themselves in a conflict-of-interest situation in pursuing the corporate affairs, then they must choose the interest of the corporation over their own interest, otherwise they become liable for breach of their fiduciary duty.

The CC provides that when a director, trustee or officer attempts to acquire or acquires, in violation of his duty, any interest adverse to the corporation in respect of any matter which has been reposed in him in confidence, as to which equity imposes a liability upon him to deal in his own behalf, he shall be liable as a trustee for the corporation and must account for the profits which otherwise would have accrued to the corporation.

The CC also provides that where a director, by virtue of his office, acquires for himself a business opportunity which should belong to the corporation, thereby obtaining profits which should belong to the corporation, he must account to the latter for all such profits by refunding the same, notwithstanding the fact that the director risked his own funds in the venture; unless his act has been ratified by a vote of the stockholders owning or representing at least two-thirds (2/3) of the outstanding capital stock.

Our SC in Gokongwei, Jr. v. SEC, referred to the breach of the duty of loyalty as the “Doctrine of corporate opportunity,” thus: “The doctrine of ‘corporate opportunity’ is precisely a recognition by the courts that the fiduciary standards could not be upheld where the fiduciary was acting for two entities with competing interests. This doctrine rest fundamentally on the unfairness, in particular circumstances, of an officer or director taking advantage of an opportunity for his own personal profit when the interest of the corporation justly calls for protection.”

Gokongwei, Jr. used the “Doctrine of corporate opportunity” as the legal basis to uphold a provision in the by-laws of San Miguel Corporation (SMC) disqualifying from membership in the Board of Directors of stockholders who owned competing businesses, thus: “It is obviously to prevent the creation of an opportunity for an officer or director of SMC, who is also the officer or owner of a competing corporation, from taking advantage of the information which he acquires as director to promote his individual or corporate interests to the prejudice of SMC and its stockholders, that the questioned amendment of the by-laws was made. Certainly, where the two corporations are competitive in a substantial sense, it would seem improbable, if not impossible, for the director, if he were to discharge effectively his duty, to satisfy his loyalty to both corporations and place the performance of his corporation duties above his personal concerns.”

b. Self-Dealing Safeguards

Under the CC, a contract of a company with one or more of its directors/trustees or officers is voidable at the option of the company acting through its Board, unless all the following conditions are present, thus:

(a) Presence of such director/trustee was not necessary to constitute a quorum in the board meeting approving such contract;

(b) Vote of such director or trustee was not necessary for the approval of the contract;

(c) Contract is fair and reasonable under the circumstances;

(d) In the case of an officer, contract had been previously authorized by the Board.

Where any of the first two conditions set forth above is absent, in the case of a contract with a director or trustee, such contract may be ratified by the vote of the stockholders representing at least two-thirds (2/3) of the outstanding capital stock, in a meeting called for the purpose. However, in order that such ratificatory vote would be valid, it is required that there be full disclosure made of the adverse interest of the directors or trustees involved.

c. Contracts Between Corporations with Interlocking Directors

The CC also provides that, except in cases of fraud, and provided the contract is fair and reasonable under the circumstances, a contract between two or more corporations having interlocking directors shall not be invalidated on that ground alone.

The essence of the policy under the CC is that dealings between two corporations that have interlocking directors are not per se deemed fraudulent or voidable; however, if the interest of the interlocking directors in one corporation is merely nominal (less than 20% of the outstanding capital stock), he shall be subject to the same ratificatory vote required from stockholders and members, as in the case of dealings of directors, trustees and officers with their corporation.

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 Management Association of the Philippines (MAP), the former Chair of the Governance Commission for GOCCs and the Founding Partner of the Villanueva Gabionza & Dy Law Offices.