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AN INQUIRY INTO THE DEVELOPMENT OF SECURITIES

REGULATION IN THE PHILIPPINES

RAYMOND REYES ROQUE

INTRODUCTION

A healthy capital market is indispensable to the development of a strong

economy. Operation of large private business enterprises and the

implementation of complex commercial projects would not be possible if not for

the much needed capital to finance them which, more often than not, are derived

from the capital markets. Equity contributions from the stockholders are simply

not enough to cover the capital requirements of their respective companies.

Even the government sometimes taps the market for funds to augment their

scarce resources to enable them to discharge their essential governmental

functions. Traditional sources of funding such as banks and other financial

institutions could not possibly keep up with the financing demand of these entities

without the backing of the capital markets, especially those that require capital on

long-term basis.

On the other hand, the importance of capital market can also be viewed in

a negative manner. Disruptions and crashes within and of the market could

deliver dire consequences to the socio-economic life of the people within the

state which, at the extreme, could lead to massive unemployment and

widespread poverty. This is vividly illustrated by what happened to the United

States in the latter part of the 1920s and lasted until almost the latter part of the

Juris Doctor, University of the Philippines College of Law (2011 expected); Bachelor of Science in Business Management and Entrepreneurship, San Beda College (2002, with academic distinction)

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1930s. The New York Stock Market Crash of 1929 triggered a chain of events

that plunged the United States into the worst depression in the history of the

country. The negative effects of the Great Depression eventually spilled over and

experienced in other national economies of the western world.1

Meanwhile, it is said that to make a capital market to flourish, it is critical to

craft an effective legal framework by which to govern it. Legislative controls must

be put in place to prevent the activities within the market from getting out of hand

to the detriment not only of the direct participants therein but also of the public at

large. It is only proper that a field of economic activity which has a tremendous

effect on public interest be placed under government regulation. But while it is

desirable to regulate capital markets, such regulation should not be excessive so

as not to stifle the growth and development of the very thing being regulated. The

proper balance between regulation and freedom to act ought to be achieved and

such balance must be embodied by the law enacted for that purpose. It is to this

endeavor where this paper seeks to contribute.

This paper looks at the development of Philippine securities regulation as

a response to the need of extending protection to the investing public. The

current structure of the Philippine securities regime will likewise be examined in

light of other statutory policy such as the democratization of economic wealth as

well as the issue concerning the internationalization of the securities market

brought about by the globalization phenomenon.

The first part of this paper traces the evolution of securities regulation in

the Philippines through a summary of legislative enactments and jurisprudence in

order to provide a more comprehensive and historical perspective to the current

and future efforts geared toward the improvement of our capital market regime. 1 Richard H. Pells & Christina D. Romer, Great Depression, ENCYCLOPEDIA BRITANNICA, available at http://www.britannica.com/EBchecked/topic/243118/Great-Depression (last visited Jan. 9, 2011)

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This is also to show that the central goal of Philippine securities regulation is to

give protection to the investing public. The paper will then move on to give a

highlight of the competing regulatory philosophies in the regulation of capital

markets. The author will examine the origins of these policies, their structures

and features as applied in the United States, United Kingdom and Philippine

jurisdictions. A discussion on the criticisms of both of these policies as contained

in existing studies will also be provided. The aim is to prove that the shift towards

full disclosure policy might not result to the intended protection of investors. In

the third part, the author will demonstrate that the adoption of full disclosure

philosophy is, in a way, misaligned with one of the declared policies of the

present Code, i.e. the democratization of wealth. The fourth part aims to outline

some of the policy considerations regarding the integration of Philippine domestic

securities market within the global securities regulatory framework. On a final

note, this paper provides a conclusion.

THE EVOLUTION OF PHILIPPINE SECURITIES LAWS AND JURISPRUDENCE

SECURITIES ENFORCEMENT VIA MERGER OF PRINCIPLES OF SPANISH

CONTRACT LAW AND AMERICAN CORPORATE LAW

Even prior to the passage of the first securities law in the Philippines, the

Supreme Court was already confronted with an issue relating to securities in the

case of Strong v. Gutierrez Repide.2 A Filipino author once said that it was the

first insider trading case ever decided and prosecuted in the Philippines.3 In fact,

2 6 Phil. 680 (1906); 213 U.S. 419 (1909)3 Anna Leah Fidelis Castañeda, From Merit to Disclosure Regulation: The Shifting Bases of Philippine Securities Law, 42 ATENEO L. J., 290, 295 (1998). It was actually mentioned in this article that the case was the first and the last insider trading case ever decided and prosecuted inthe Philippines. This, however, is not updated anymore since an insider trading case was filed in 2001 against Dante Tan concerning the BW Resources stock manipulation scandal that nearly brought the Philippine stock market to its knees. The latter case however ended in a dismissal.See, Edmer Panesa, SC oks dismissal of Dante Tan charges in BW Resources case, MANILA

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Repide likewise provided the US Supreme Court the initial opportunity to decide

an insider trading case since the Philippines was still under American rule during

that time and the case was brought to them on appeal.4

In Repide, the plaintiffs brought an action against the defendant to recover

800 shares of stock of a sociedad anonima called Philippine Sugar Estates

Development Company Limited. They anchored their cause of action on two

grounds, namely: (1) that the sale was effected by their agent without having

authority to do so; and (2) that the purchase of the shares by the defendant was

attended by fraud or deceit, thus vitiating the plaintiffs’ consent. It was alleged

that at the time the sale of the shares was made, the company, through the

defendant as the company’s administrator general, was in the middle of a

negotiation with the United States Government for the sale of the company’s sole

asset, the friar lands. This fact was not disclosed to the plaintiffs or to their agent.

The shares were sold for $16,000 Mexican currency but two to three months

later, the value of the shares went up to US$76, 256.

The Philippine Supreme Court ruled in favor of the plaintiffs, on the ground

of lack of authority of the agent in making the sale. The Court stated that the

allegation of deceit cannot be given credence since it found out that the manager

of the company has no special duty over the stocks of the individual stockholders

which are recognized as the stockholders’ personal properties.5

The US Supreme Court on appeal however, decided the case differently.

It held the defendant guilty of fraud or deceit in purchasing the shares of stock.

This fraud or deceit, according to the Court, avoids the contract of sale citing as

its legal basis Article 1265 of the Civil Code. It held that the deceit “need not be

BULLETIN, Aug. 1, 2010, available at http://www.mb.com.ph/node/270104/ (last visited Nov. 16, 2010)4 Randy James, A Brief History of Insider Trading, TIME.COM, Nov. 9, 2009, available at http://www.time.com/time/business/article/0,8599,1936562,00.html (last visited Nov. 16, 2010)5 Strong v. Gutierrez Repide, 6 Phil. 680, 690 (1906)

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by means of misrepresentations in words. It exists where the party who obtains

the consent does so by means of concealing or omitting to state material facts,

with intent to deceive, by reason of which omission or concealment the other

party was induced to give a consent which he would not otherwise have given.”6

This rule applies to the case by virtue of a combination of relevant circumstances

surrounding the sale resulting to an imposition of a duty to disclose on the part of

the defendant. The Court declared:

“It is here sought to make defendant responsible for his actions, not alone and simply…as a director, but because, in consideration of all the existing circumstances …, it became the duty of the defendant, acting in good faith, to state the facts before making the purchase. That the defendant was a director of the corporation is but one of the facts upon which the liability is asserted, the existence of all the others in addition making such a combination as rendered it the plain duty of the defendant to speak. He was not only a director, but he owned three fourths of the shares of its stock, and was, at the time of the purchase of the stock, administrator general of the company, with large powers, and engaged in the negotiations which finally led to the sale of the company's lands … to the government at a price which very greatly enhanced the value of the stock. He was the chief negotiator for the sale of all the lands, and was acting substantially as the agent of the shareholders of his company by reason of his ownership of the shares of stock in the corporation and by the acquiescence of all the other shareholders, and the negotiations were for the sale of the whole of the property of the company. By reason of such ownership and agency, and his participation as such owner and agent in the negotiations then going on, no one knew as well as he the exact condition of such negotiations.”7 (Underscoring supplied)

What is peculiar about this case is the fact that due to the absence of a

specific securities law governing it, both the Philippine and US Supreme Courts

handled the question of fraud or deceit by way of combining Spanish law on

contracts with American common law governing corporations. Both courts

employed American corporate law doctrines extracted from common law

jurisprudence to determine the existence of a civil law concept of fraud or deceit

6 Strong v. Repide, 213 U. S. 419, 430 (1909)7 Id., at 431-32

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from the facts of the case. It appears that the courts in a way engaged in “legal

improvisation” in resolving the case. The method employed by the courts

appears to be not entirely accurate especially if one considers the fact that what

was involved here was a sociedad anonima which is not equivalent to the

American concept of a business corporation.

Repide actually presented a valuable lesson to the legislative department

that should have prompted passage of a special piece of legislation covering the

same and similar situations. Unfortunately, this was not the case and one can

only speculate as to the reason why the legislature did not act as it should have.

What is obvious is that they missed out on the opportunity to fashion a law

grounded on Philippine local experience.

ACT NO. 2581 (PHILIPPINE BLUE SKY LAW)

Approximately eight (8) years after the US Supreme Court decided Strong

v. Repide, the Third Philippine Legislature enacted Act No. 2581 officially entitled

as “An Act to Regulate the Sale of Certain Corporation Shares, Stocks, Bonds

and Other Securities”. It is also known as the Philippine Blue Sky Law, the name

of which was derived from the various state securities law of the United States of

America. According to the Philippine Supreme Court in one case8, the purpose of

the law is “to protect the public against ‘speculative schemes which have no

more basis than so many feet of blue sky’ and against the sale of stock in fly-by-

night concerns, visionary oil wells, distant gold mines, and other like fraudulent

exploitations.”

The law is relatively short; consisting of only eleven (11) provisions. It

starts with the definition of what “securities” are, and then proceeded to a brief

8 People v. Rosenthal, 68 Phil. 328, 342 (1939)

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enumeration of which securities are deemed speculative.9 A closer reading of

Section 2 thereof shows that it does not aim to regulate all kinds of securities but

only those that are speculative in nature. It is only when the sale involves

speculative securities that the law imposes a requirement of a written permit prior

to commencement of any transaction involving the same. The required written

permit shall be secured before the then Treasurer of the Philippine Islands which

was also the agency tasked with the implementation of the law.10

The law, nonetheless, provided exemptions from the requirement. These

include those securities issued by the Philippine and United States governments

as well as foreign governments and their political subdivisions. Also included in

the exemption are those issued by public or quasi-public corporations regulated

by other government agencies such as Board of Public Utility Commissioners.

Securities of banks, trust companies, mortgage companies dealing exclusively in

bona fide mortgages on farm and city real estate, or insurance companies

authorized to do business in the Philippines are likewise exempt.11

Act No. 2581 defined “securities” as stock certificates, shares, bonds,

debentures, certificates of participation, contracts, contracts or bonds for the sale

and conveyance of lands on deferred payments or on the installment plan, or

other instruments in the nature thereof, by whatever name known or called. It

may be noticed that in this definition, the word “contract” stands by itself. This is

an unfortunate lapsus plumae since that can be construed as embracing all kinds

of contract within the understood meaning of the term under Philippine law. Thus,

every kind of contract, whether it is a sales, lease, pledge, mortgage or

antichresis, would logically be embraced by the definition and would be held as

securities. The definition provided for is no definition at all. This nevertheless, did

9 Act No. 2581, § 110 Id., § 511 Id., § 3

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not matter much for as I mentioned earlier, the law only regulates speculative

securities.

Merely a handful of Supreme Court cases have been decided and

reported under this law. Aside from the question of constitutionality12, most of the

cases mainly revolved around the proper interpretation of the term “speculative

securities”.

Section 1, second paragraph of Act No. 2581 provides that the term,

“speculative securities” shall mean and include: (a) all securities to promote or

induce the sale of which profit, gain, or advantage unusual in the ordinary course

of legitimate business is in any way advertised or promised; (b) all securities the

value of which materially depend upon proposed or promised future promotion or

development rather than on present tangible assets and conditions; (c) all

securities for promoting the sale of which a commission of more than five percent

is offered or paid; and (d) the securities of any enterprise or corporation which

has included, or proposes to include in its assets as a material part thereof

patents, formulae, good-will, promotion or other intangible assets, or which has

issued or proposes to issue a material part of its securities in payment for

patents, formulae, good-will, promotion or other intangible assets.

The Supreme Court, in the case of People v. Nimrod McKinney,13 was

given the initial opportunity to interpret the above-defined term in 1925 or nine (9)

years after the Blue Sky Law was passed. The case involves an American citizen

residing in the Philippines who, together with his two business partners

incorporated a corporation in California which was planned to engage in import-

export business in the Philippines. McKinney made deals with some people

wherein he would hire them and in return, these people would have to subscribe 12 The constitutionality of the Blue Sky Law was upheld in a number of cases foremost of which is People v. Rosenthal and Osmeña, supra note 7; see also, People v. Fernandez, 65 Phil. 675 (1938) and Robb v. People, 68 Phil. 320 (1939)13 47 Phil. 792 (1925)

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to some company shares. But unfortunately, the deals did not prosper and

eventually McKinney was charged with the violation of Blue Sky Law.

The Supreme Court held that there was no violation of the law because

the shares that were sold cannot be considered as speculative by interpreting

Section 1 of the law particularly subsection (a) thereof. It ruled that the offering of

the positions of the clerk and attorney respectively to the prospective subscriber

of shares, although involving an advantage nonetheless cannot be considered as

“unusual in the ordinary course of legitimate business” within the contemplation

of the statute. Nothing is really extraordinary in requiring the subscription of

shares in exchange for promise of employment according to the Court. The

provision is deemed to contemplate those “promises of extraordinary advantage

deriving from possibilities inherent in the stock” and this does not include promise

of employment conditioned upon the subscription by the employee to the shares

of the enterprise.

It is only in the case of People v. Fernandez14 where the Court was able

to have a rare chance to reveal what a speculative security looks like. Involved in

this case was a corporation which was allegedly formed for a benevolent purpose

of helping those people in financial need. To achieve this, the company issued

“certificates of membership” to those who would want to become members. By

becoming members, they would be entitled to receive aid from the company

should some contingent event happened to them. As a consideration, the

members have to pay the company dues upon their enrolment. The members

who were able to recruit new members are entitled to receive commissions from

the company. The Supreme Court held the certificate of memberships that were

issued by the company as speculative securities. It enumerated the

circumstances that convinced them of the speculative character of the same. The

Court held that the fact that the benefits to be received by a member amounted

14 Supra note 12

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to almost 800 percent of the amount of dues to be paid made the securities

speculative since this profit is unusual in the ordinary course of business.15 In

addition, the unusual profit to be derived by members does not depend upon

actual tangible assets or conditions of the corporation but only on the prospect of

recruiting new members.

The regulatory framework laid down by the Blue Sky Law is crude,

deficient and fraught with loopholes. Its biggest flaw, the author submits, is that it

hinges its applicability on the finding that the securities to be offered are

speculative in nature. Obviously, no one in his right mind would want their

securities to be branded as speculative in order to escape the coverage of the

law. In this kind of regulatory scheme, the damage to the public will surely be

done even before the supposed regulator could act to remedy it. The law was

really honored more in the breach than in the observance. It failed to meet its

desired aim of protecting the investing public. Because of the flawed structure of

the Blue Sky Law, Professor Rafael Morales commented in his book that “the

mining boom of the 1930s in particular, provided occasions for glib-tongued

operators [of corporate enterprises] to dupe and dump naïve investors.”16

COMMONWEALTH ACT NO. 83 (SECURITIES ACT)

For its failure to measure up to its noble goal of protecting the investing

public, the Blue Sky Law was eventually scrapped by the First National Assembly

in 1936 and replaced with another law, Commonwealth Act No. 83 (C.A. No. 83)

also known as the Securities Act.17

15 Id., at 68016 RAFAEL MORALES, THE PHILIPPINE SECURITIES REGULATION CODE ANNOTATED 4 (2005)17 The enactment of C.A. No. 83 actually spawned a controversy as to whether the law really repealed the Blue Sky Law. The repealing clause of C.A. No. 83 did not expressly repeal Act. No. 2581. That resulted to bitter litigation among interested parties. To resolve the issue, R.A. No. 635 was enacted by Congress to expressly repeal the Blue Sky Law, among others. See,VICENTE FRANCISCO, THE SECURITIES ACT ANNOTATED AND COMMENTED 1-2 (1951)

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One of the changes introduced by C.A. No. 83 is the re-definition of the

term “securities” to make it broader and more refined. But the new definition was

not without any flaws. Sibal pointed out that there seems to be something wrong

with the inclusion of promissory note within the new definition of securities when

the provision states that promissory notes would only be considered as securities

when they are accompanied by any oral or written promise that the purchasers of

said notes shall share in any of the profits of said enterprise, either directly or

indirectly.18 This qualification, according to him, implies that “even if the

promissory notes are issued for the purpose of raising funds to buy machineries,

and the like, they are not securities unless they could be made to fall under the

terms ‘bonds or debentures’ in the definition.”19

Included in the new definition is the concept of “investment contract” but

unfortunately, the law failed to provide the meaning of investment contract which,

by itself, has a distinct technical definition of its own within American jurisdiction.

Nevertheless, it may be observed that the Supreme Court somehow already

discussed in passing the meaning of investment contract in People v.

Fernandez.20 This was made to bolster its finding that the instrument involved

therein is a speculative security. It said:

“They further point out that the membership certificates issued by the corporation are not contracts, nor certificates of participation, bonds, debentures, etc. The fact, however, is that said certificates represent obligations to pay a sum of money or securities of payment so that they are in reality investment contracts. It is not true that one becomes a member without any expectation of gain. In fact, the contrary is evident, and the association itself admits members with a like intention to gain.” 21 (Emphasis and underscoring supplied)

18 Ernesto Sibal, Defects and Loopholes in the Securities Act, 5 LAWYERS J. 487 (1937)19 Id.20 Supra note 1221 Id., at 683

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Note that this case was decided under the Blue Sky Law although it was

promulgated some two (2) years after C.A. No. 83 was passed. The new

definition retained the distinction between speculative and non-speculative

securities but it increased the enumeration of speculative securities and at the

same time provided a list of what shall not be deemed as speculative securities.22

The law, unlike the former law, provided definitions of some of the terms used in

many of its provisions such as issuer23, salesman24, broker25, dealer26 and

exchange27, among others. It was under the Securities Act where the Securities

and Exchange Commission (SEC) was established, with the duty of

implementing the provisions of the said law.28

The registration and licensing requirements were made applicable to all

securities, either speculative or non-speculative. This change somehow

remedied the anomalous situation created under the Blue Sky Law as mentioned

earlier. And unlike the former law, the Securities Act not only provided for exempt

securities but likewise provides for those transactions which are exempt from the

registration and licensing requirements. The law also refined the exemption for

securities issued by foreign governments and its political subdivisions to the

effect that they must have diplomatic relations with the Philippines before the

exemption would apply.29

It is said that the function of the SEC, with respect to the registration

requirement, is merely ministerial.30. This can be inferred from the procedure for

registration laid down in Section 7 of the law wherein three (3) major

requirements are needed to be satisfied by an issuer to register its securities and

22 Com. Act No. 83, § 223 Id., § 2 (h)24 Id., § 2 (i)25 Id., § 2 (j)26 Id., § 2 (g)27 Id., § 2 (k)28 Id., § 329 Id., § 5 (3), as amended by Rep. Act No. 635.30 GONZALO SANTOS, SALIENT FEATURES OF THE REVISED SECURITIES ACT 6 (1984)

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these are: (1) filing of sworn registration statement; (2) payment of filing fees; and

(3) publication of the application for registration for once a weeks for two

consecutive weeks. After the lapse of seven (7) days after the completion of the

required period of publication, registration shall take effect. 31 However, the SEC

is tasked to determine whether the securities sought to be registered are

speculative in nature. And if the securities are indeed speculative, a license to

sell the same is further required to be issued by the SEC before the same can be

sold.

The absence of discretion on the part of the SEC, nevertheless, ends

immediately after the registration of the securities takes effect. Under Section 8

of C.A. No. 83, the SEC is empowered to suspend the registration of securities

based on the grounds provided under the said provision such as when the

registration “has become misleading, incorrect, inadequate or incomplete, or the

sale or offering for sale of the security may work or tend to work a fraud.” Upon

suspension, the SEC shall require further information from the person who filed

the registration statement to determine whether or not to revoke the

registration.32 Under Section 12 of the law, the SEC was given authority to

revoke the registration and license of securities upon finding, after due hearing,

of the existence of one of the grounds provided therein such as when the issuer

is insolvent, has violated any of the provisions of the Act or SEC orders, has

been or is engaged or is about to engage in fraudulent transactions or when the

issuer is in bad business repute, among others.

The Securities Act also aims to regulate securities market participants

such as the brokers, dealers and salesmen33 as well as the organized exchanges

31 Com. Act No. 83, § 732 Id., § 833 Id., § 14

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and the use of exchange facilities through registration of the same with the

newly-created Securities and Exchange Commission. 34

The law also contained provisions outlawing manipulative practices and

devices that tend to distort the price of securities such as wash sales,35 market

rigging or jiggling36 and matched orders37 as well as the use of exchange facilities

for fixing, pegging or stabilizing security prices.38 Other manipulative practices

prohibited under C.A. No. 83 include short sale,39 the employment of a stop-loss

order,40 and the use of artificial measures of price control without the prior

approval of the SEC.41 The Securities Act also segregated the functions of

exchange members, dealers and brokers and made it unlawful for any of these

entities to exercise functions belonging to another. 42 The aim is to prevent

conflict of interest that might arise when one performs the functions of another to

enrich themselves at the expense of the public. Exceptions to this rule are the

34 Id., § 1635 “Wash sales occur where a client places both buy and sell orders for the same amount of thesame security with a single broker.” LAWRENCE MITCHELL, THE SPECULATION ECONOMY: HOW

FINANCE TRIUMPHED OVER INDUSTRY 326 (2008); “A wash sale is also defined as a fictitious sale [of securities in an exchange] where there is no change in beneficial ownership and thus having no true economic consequence.” III PHILIP JOHNSON & THOMAS LEE HAZEN, DERIVATIVES

REGULATION 1311 (2004)36 “It refers to a series of transactions [involving securities in an exchange] which have one of the two following results: (1) creating actual or apparent activity; or (2) raising or depressing prices.”CHARLES MEYER, THE SECURITIES EXCHANGE ACT OF 1934: ANALYZED AND EXPLAINED 73 (1934)37 “A matched order occurs when orders are entered simultaneously to buy and sell the same security.” JOHNSON & HAZEN, supra note 3838 Com. Act No. 83, § 20 (6)39 “A short sale is accomplished when the investor sells securities that he does not own but has borrowed. Typically, the investor will borrow from a securities firm or institutional investor that has a long-term position in the securities. If the price falls between the time the investor sells the borrowed securities and the time the investor must deliver them to the buyer…the seller can make money. On the delivery date, the seller simply buys equivalent securities at the lower price to return the borrowed securities to the lender.” ALAN PALMITER, SECURITIES REGULATION:EXAMPLES AND EXPLANATIONS 315 (2008)40 “Stop loss order refers to an investor’s order to sell his shares if prices go below a certain level in order to minimize his loss. This is done when prices are going down at a very fast rate and are therefore expected to go down further.” NENITA MEJORADA, INVESTMENT MANAGEMENT AND

PERSONAL FINANCE 72 (2001 ed.)41 Com. Act No. 83, § 21-A as amended by Com. Act No. 28342 Id., § 22

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execution of odd-lot transactions by odd-lot dealers43, when a broker acts as a

specialist44 and the arbitrage operations of arbitrageurs.45

Another innovation in the law is the rule on margin trading.46 Margin

trading or buying on margin means borrowing money from a broker, dealer or

member of an exchange to purchase stock.47 In other words, margin trading is

the purchase of stock on credit. The law regulates margin trading because of

potential risk that it pose to the economy, if left unchecked.48 The rule aims to

limit the amount of credit that a broker, dealer or member can extend to their

customers.

The law likewise contained a provision aimed at regulating the use of

proxies but the same is only directed against members, brokers and dealers in

registered exchanges. It has been a common practice during elections of

corporate boards when stockholders as well as brokers and dealers carrying

securities for stockholders to sign proxies blindly at the stockholders’ expense for

the benefit of existing corporate management. Thus, the rationale for regulating

proxies was to stop the pernicious schemes of corporate management designed

43 An odd-lot dealer is “a member of an organized securities exchange that buys and sells securities in less than round lots.” Less than round lots mean fewer than 100 shares. DAVID

SCOTT, WALL STREET WORDS: AN A TO Z GUIDE TO INVESTMENT TERMS FOR TODAY’S INVESTORS 254(2003 ed.)44 “A specialist is a broker who deals in a particular security or securities, making his station at a single exchange without moving from place to place as do the general brokers.” III AGUEDO

AGBAYANI, COMMENTARIES AND JURISPRUDENCE ON THE COMMERCIAL LAWS OF THE PHILIPPINES 718 (1980 ed.)45 Arbitrage refers to “the simultaneous purchase and sale of an asset in order to profit from a difference in the price. It is a trade that profits by exploiting price differences of identical or similar financial instruments, on different markets or in different forms. Arbitrage exists as a result of market inefficiencies; it provides a mechanism to ensure prices do not deviate substantially from fair value for long periods of time.” Arbitrage, INVESTOPEDIA.COM, available at http://www.investopedia.com/terms/a/arbitrage.asp (last visited Jan. 16, 2011)46 Com. Act No. 83, § 18 47See, Margin Trading: What Is Buying On Margin?, INVESTOPEDIA.COM, available at

http://www.investopedia.com/university/margin/margin1.asp (last visited Jan. 13, 2011)48 SANTOS, supra note 30 at 10

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to perpetuate itself and to give the stockholders a fair opportunity to vote

intelligently on major matters of policy.49

It was also through C.A. No. 83 that the concept of insider trading was first

introduced within the Philippine jurisdiction. Section 26 of the law requires

directors, officers and principal stockholders (those who are beneficial owners of

more than ten percent of any class of security) of a corporation issuing the

securities to file with the Securities and Exchange Commission a statement of

their beneficial ownership of the company’s securities as well as the subsequent

changes in such beneficial ownership, if any, at the end of each month. The

same provision prevents the same persons as above from earning the so-called

“short-swing profits” through the unfair use of information. One Filipino author50,

however, pointed out a subtle defect in the phraseology of the provision. The

provision was made defective by the phrase “through the unfair use of

information”. This, in effect, puts the burden of proof on the plaintiff to show that

the short-swing profit of the insider was realized through the unfair use of

information, an extremely difficult task to the point of impossibility.51

Congress has provided civil and criminal liabilities for certain violations of

the law to ensure compliance with the same. However, it is on this area that

some writers52 have zeroed in their criticisms. They pointed out numerous

loopholes on the provisions that rendered them useless. It is would be beneficial

to mention some of their comments here in this article.

Section 30 mandates that “every sale…wherein the purchaser shall have

relied upon any statement which was at the time and in light of the circumstances

under which it was made false and misleading with respect to material fact

49 III AGUEDO AGBAYANI, COMMENTARIES AND JURISPRUDENCE ON THE COMMERCIAL LAWS OF THE

PHILIPPINES 685 (1979 ed.)50 Pelagio Ricalde, Towards A New Securities Act, 56 PHIL. L. J. 306 (1981)51 Id. at 31452 Sibal, supra note 18; Ricalde, supra note 50; Ricalde, infra note 53

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contained in the application, report or document filed pursuant to the

Act…voidable at the election of the purchaser…” Ricalde pointed out that the

requirement of proof of reliance by the purchaser somehow rendered the

provision nugatory for it is almost impossible for him to prove it.53 The same

section also provides that only the immediate purchaser that is, the person

purchasing such securities from the person who sold in violation of the law is

entitled, upon proof of the violation and the tender of the securities sold or the

contract made, to recover the full amount paid with interest together with taxable

court costs and reasonable attorney’s fees.54 In other words, privity of contract is

an essential requirement for the right of action under the law to exist. This is

different from the requirement under the American Federal Securities Act of 1933

on which the Securities Act was based wherein no such privity is required.55

Ricalde intimated that such was quite unfortunate considering the fact that only

issuers, dealers their directors, officers or agents who have personally

participated or aided in any way in making the sale can be held liable for material

mis-statements or omissions in the registration statement under Section 30. 56

On the other hand, Sibal opined that “practically, all the persons who will be

civilly liable under the Act would also be [criminally] liable under…the Act

provided it is shown that the violation…was done willfully or that the making of

the false statement was done willfully or knowingly.57

BATAS PAMBANSA BLG. 178 (REVISED SECURITIES ACT)

An author once described Commonwealth Act No. 83 as “in many

respects illogical and inconsistent, vague, uncertain and indefinite”58 but the

53 Pelagio Ricalde, Liability for Misrepresentations and Omissions in the Registration Statement under Section 30 of the Securities Act, 55 PHIL. L. J. 159, 182 (1980)54 Sibal, supra note 18 at 628-2955 Ricalde, supra note 50 at 32256 Ricalde, supra note 53 at 17857 Sibal, supra note 18 at 63058 Id.

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securities regime under it somehow lasted for a good forty-five years until 1982,

when in that same year, the Interim Batasang Pambansa enacted Batas

Pambansa Bilang 178 or the Revised Securities Act (RSA). The enactment of the

law was a response to the inadequacy of the former Securities Act “to meet the

problems which came with the growth of business and industry” during the more

than four decades that the former law was in effect.59

The Revised Securities Act is basically an enhancement of the existing

regulatory structure laid down in the previous securities law. Loopholes found in

the old Securities Act were plugged in the RSA but the over-all regulatory

scheme remains the same. The main regulatory tool used in the new law is still

registration of securities. All securities are required to be registered before

issuance unless the securities sought to be issued falls under one of the

exemptions60 or the transaction within which the securities sought to be issued,

qualifies as one of the exemption transactions provided under the new law.61

Registration of securities is then reinforced by the modified civil and criminal

liabilities and anti-manipulative practices provisions.62 The requirement as to

registration of brokers, dealers and salesmen63 as well as exchanges64 in the old

law was retained. The RSA also contained a rule on margin trading with minor

modification as to threshold requirement.65

The definition of securities under the RSA was broadened by integrating

the so-called commercial papers within the definition. This was to reflect the

provisions of Presidential Decree No. 678 that amended the original definition of

59 II JOSE CAMPOS JR. & MARIA CLARA LOPEZ-CAMPOS, THE CORPORATION CODE: COMMENTS,NOTES, AND SELECTED CASES 119 (1990 ed.)60 Batas Blg. 178, § 561 Id., § 662 Id., §§ 12, 13, 26-28, 29-31, 36, 44-46, 49, 51-53, 5663 Id., § 1964 Id., § 2265 Id., § 23

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securities under the old Securities Act.66 It must be remembered that under the

former definition under C.A. No. 83, promissory notes would be considered

securities only when they are accompanied by any oral or written promise that

the purchasers of said notes shall share in any of the profits of said enterprise,

either directly or indirectly.67 The issuance of commercial papers was, in addition

with the registration requirement, subject to special rules issued by the SEC with

the approval of the Monetary Board. Commodity futures contracts68 were also

included in the new definition. Under RSA, the SEC was given wide discretion in

the regulation of commodity futures contracts.69 It was empowered to promulgate

rules concerning the trading of commodity futures contract and the regulation of

persons engaged in the trading thereof. However, such rules were subject to

Monetary Board. Another modification in the new definition was the inclusion of

the catch-all phrase after an enumeration of instruments or contracts considered

as securities to the effect that “similar contracts where there is no tangible return

on investments plus profits but an appreciation of capital as well as enjoyment of

particular privileges and services” are also deemed as securities.70

The RSA also removed the distinction between speculative and non-

speculative securities which was present in the earlier legislations.71 Thus,

licensing requirement under the former law has been abandoned.

Also, the RSA for the first time defined the terms “transfer agent”72,

“underwriter”73 and “promoter”.74 It must be noted that the previous law failed to

66 SANTOS, supra note 30 at 267 See, note 17 and accompanying text68 “Commodity Futures Contract shall refer to an agreement to buy or sell a specified quantity and grade of a commodity at a future date at a price established at the floor of the exchange.” Onapal Philippines Commodities, Inc. v. Court of Appeals, 218 SCRA 281, 285 (1993)69 Batas Blg. 178, § 770 Id., § 2 (a)71 SANTOS, supra note 30 at 572 Batas Blg. 178, § 2 (p)73 Id., § 2 (q)74 Id., § 2 (r)

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define these terms despite the fact that there were important provisions where

these terms have been employed.

The SEC under RSA is empowered to make a determination if there exists

any ground to reject the registration statement, and only if there is none, where

they shall issue an order and corresponding permit that would signal that the

securities are already registered.75 This is unlike in the previous law where

registration automatically takes effect upon lapse of seven-day period after

publication of the fact of filing of the registration statement. The SEC is likewise

given the power and duty to regulate securities rating agencies by

accreditation.76

Another improvement that was introduced by the RSA in relation to the

procedure for registering securities was the inclusion of the provision allowing the

amendment of registration statements.77 Amendment of the registration

statement after the same is filed before the SEC is allowed when the same is “on

its face incomplete or inaccurate in any material respect” or when it “includes any

untrue statement of a material fact or omits to state any material fact required to

be stated therein or necessary to make the statements therein not misleading. 78

Remember that under C.A. No. 83, the SEC has the power to suspend

and to revoke the registration of securities based on specified grounds and for

the latter, after due hearing.79 Under the RSA, the SEC was given an added

power to reject the registration of securities if it determined that there are

grounds to reject it.80 It must be noted that the grounds provided by law for

rejecting registration are almost the same as those grounds for revoking the

75 Id., § 876 Id.77 Id., § 1078 Id.79 Id., §§ 8, 1280 Id., § 9

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registration. The difference between the two is that as to the latter, registration of

securities already took effect while on the former, registration is refused from the

outset.

Provisions prohibiting manipulative practices affecting security prices

under the old law were carried over to RSA. These rules were however, made

applicable even to exempt securities.81 The SEC was also given authority to

exempt certain practices which, in its view, are not prejudicial to public interest.82

Rules against insider trading under the RSA were expanded. Aside from

retaining and modifying the prohibition against short-swing profits, the new law

also added a provision identifying who is considered an insider and then

prohibited him from trading securities of an issuing company when such a person

possesses “fact of special significance” with respect to the issuing company or

the securities itself which is not generally available to the public.83

Rules relating to the so-called tender offers84, designed for the protection

of interests of minority stockholders, were provided under the Revised Securities

Act.85

Aside from civil and criminal liabilities provisions that can be invoked

before the courts, the Revised Securities Act further provides administrative

sanctions imposable via the SEC against violations of the law as well as the rules

and regulations promulgated in relation to the same.86

81 Id., § 2682 Id.83 Id., § 3084 “Tender offer is a publicly announced intention by a person acting alone or in concert with other persons to acquire equity securities of a public company.” Cemco Holdings, Inc. v. National Life Insurance Co. of the Phils., Inc., 529 SCRA 355, 369 (2007), citing MORALES, supra note 16 at 15385 Batas Blg. 178, § 3386 Id., § 46

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REPUBLIC ACT NO. 8799 (SECURITIES REGULATION CODE)

The Securities Regulation Code (SRC) was enacted by Congress in the

aftermath of the 1997 Asian Financial Crisis. The late Senator Raul Roco, the

principal sponsor of the Senate bill which eventually became the SRC,

mentioned that the timing for the enactment of the law reforming the capital

market legal framework was especially sought to avert any criticisms to the effect

that reform efforts would just do more harm than good.87 The law put in place

some structural changes in the legal framework foremost of which is the adoption

of a new regulatory philosophy from merit-based regulation to the policy of full

disclosure with the aim of combating asymmetric information problem.88

According to Lilia Bautista, “the objective for the adoption of full disclosure

approach in the Securities Regulation Code is to inculcate higher standards of

disclosure, due diligence and corporate governance by shareholders, thereby

ensuring that investors are properly apprised of the risks and merits of their

investments.”89 The law thus made it mandatory for companies issuing their

securities to the public the distribution of prospectus90 and the regular filing of

financial and operational reports.91

Once again, the definition of securities was modified under the SRC. The

new definition still contains an enumeration of the various instruments

traditionally deemed as securities however; the catch-all phrase for what can be

considered as securities under the Revised Securities Act was eliminated.92 On

the other hand, the SEC, under the new law, was given a continuing authority to

87 Senate Transcript of Session Proceedings (hereinafter “Senate TSP”), Sept. 29, 1998 at 2188 Id. at 22; The problem of asymmetric information arises when one side of a transaction has relevant and material information that the other side lacks. Id.89 Lilia Bautista, Note, Reforms on Securities Regulation, 78 PHIL. L. J. 825, 832 (2004)90 Prospectus refers to the document made by or on behalf of an issuer, underwriter or dealer to sell or offer securities for sale to the public through a registration statement filed with the SEC. SEC. REG. CODE, § 3.1191 Id.; See, SEC. REG. CODE, §§ 8, 12, 17-1892 The reason for the deletion of the catch-all phrase was not explained in the legislative proceedings for the enactment of the Securities Regulation Code.

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determine which instruments should be considered as securities although are not

yet deemed as such at the time the law was enacted.93 Derivatives94 are likewise

included within the new definition of securities. Moreover, the new law

recognized those securities which are not evidenced by a written tangible

medium or the so-called “uncertificated securities”. 95

The perceived weakness of the organizational structure of the Securities

and Exchange Commission was also remedied. First of all, the SEC, as a

collegial body, is now required to hold meetings for the conduct of its business at

least once a week, or upon the call of the Chairperson or upon request of at least

three (3) Commissioners.96 Then, the function of the SEC Chairperson was

clarified. Under the law, he/she shall be the chief executive officer of the

Commission.97 The use of the phrase “chief executive officer” implies the analogy

made by the law between the Commission itself and a private corporation. This

means that the Chairperson shall execute and administer the policies, decisions,

orders and resolutions approved by the Commission and shall have the general

executive direction and supervision of the work and operation of the Commission

and of its members, bodies, boards, offices, personnel and all its administrative

business.98 This is a departure from the practice under the RSA where the

Chairperson has the sole control and supervision of the operations of the

Commission.99 Since derivative contracts now expressly fallunder the definition of

securities, the SEC was therefore given the express mandate to regulate such

93 SEC. REG. CODE, § 3 (g)94“Derivatives or derivative securities are contracts which are written between two parties (counterparties) and whose value is derived from the value of underlying, widely-held and easily marketable assets such as agricultural and other physical (tangible) commodities or currencies or short-term and long-term financial instruments or intangible things like commodities price index (inflation rate, equity price index or bond price index.” LAXMAN MADHAO BHOLE, FINANCIAL

INSTITUTIONS AND MARKETS: STRUCTURE, GROWTH, AND INNOVATIONS 24.1 (2004 ed.)95 SEC. REG. CODE, § 3.1496 SEC. REG. CODE, § 4.597 Id., § 4.398 Id.99 Senate TSP, Sept. 29, 1998 at 26

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instruments.100 Other important changes in the structure of the SEC are the

conferment of authority to the Commission to reorganize and streamline its own

internal structure consistent with the Civil Service laws to afford it the flexibility to

perform its functions effectively and efficiently101, and the transfer of its

jurisdiction to take cognizance of intra-corporate disputes to the regular courts so

that the Commission can devote its resources to its remaining tasks.102 Another

important power that was vested by the law to the SEC was its enhanced rule-

making authority wherein it was allowed to “classify persons, securities and other

matters within its jurisdiction, prescribe different requirements for different

classes of persons, securities, or matters, and by rule or order, conditionally or

unconditionally exempt any person, security, or transaction, or class or classes of

persons, securities or transactions, from any or all provisions of this Code.”103 By

virtue of this provision, the SEC can change the numerical thresholds for the

application of some of the provisions of the Code. Take for example, the rule on

mandatory tender offers. The law fixed the threshold requirement for single direct

acquisitions at 15% and 30% for creeping acquisitions but the SEC, by way of

implementing rules, changed them to both 35% and even added the rule that

notwithstanding the fact that a single acquisition of equity securities is less than

the required threshold of 35%, it will still be covered by the tender offer rule if by

such acquisition, the acquirer would become an owner of over 51% of the

outstanding equity securities of the issuing company.104

Although the SRC adopted a new regulatory philosophy of full disclosure,

it nonetheless retained the basic regulatory framework under the RSA.

Registration of securities is still required for all securities sold or offered for sale

within the Philippines105 unless the securities themselves are exempt106 or unless

100 Id.; SEC. REG. CODE, § 11101 SEC. REG. CODE, § 7; Senate TSP, Sept. 29, 1998 at 26102 SEC. REG. CODE, § 5.2; Senate TSP, Jul. 17, 2000 at 129103 SEC. REG. CODE, § 72.1104 SEC. REG. CODE Amended Implementing Rules and Regulations (2004), Rule 19.2105 SEC. REG. CODE, § 8106 Id., § 9

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they are sold or issued under an exempt transaction.107 The Congress, however,

made some changes regarding exempt securities and exempt transactions such

as the removal of the exemption of shares of stock of banks as well as the

exemption granted to issuance of securities arising from corporate reorganization

or merger.108 The new law then granted exempted to “private placement” of

securities or the sale of securities to less than 20 persons during any twelve-

month period,109 and to sale of securities to qualified individual and institutional

buyers.110

The Congress also made some modifications in the procedure for

registration of securities. The long list of documents that are required to be

attached to the sworn registration statement upon its filing was removed, and

instead the SEC was just given the power to prescribe these requirements by

rule. The corporate secretary was now required to sign the registration statement

in addition to other officers already enumerated under the RSA.

Consistent with its adoption of full disclosure policy, the law now provides

that “any untrue statement of fact or omission to state a material fact required to

be stated therein or necessary to make the [registration] statement not

misleading shall constitute a fraud.”111 The clear purpose of this rule is to elicit

candor from the registrant as to the information disclosed via the registration

statement. This is a conclusive presumption provided by the law for such failure

on the part of the registrant and its officers and other related parties will expose

them to civil liabilities if any person suffers damage by reason of such untrue

statement or omission of material fact.112 The reckoning point for determining

liability is at the time the registration statement becomes effective.113 The only

107 Id., § 10108 Senate TSP, Sept. 29, 1998 at 24109 SEC. REG. CODE, § 10 (k)110 Id., § 10 (l)111 SEC. REG. CODE, § 12.7112 Id., § 56113 Id.

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defense provided in connection with this is for the defendant to show that the

plaintiff knew such untrue statement or omission of material fact at the time the

latter acquired the securities.114 Be that as it may, the harshness of the foregoing

rule is somehow tempered by Section 14 thereof wherein the registrant is given

the opportunity to amend the registration statement. The law clearly imposes a

positive duty to the SEC to issue an order to the registrant to file an amended

registration statement should it find that the original registration statement is on

its face, incomplete or inaccurate in any material respect.115 The SEC, however,

may conduct an examination and after notice and due hearing, suspend the

effectivity of the registration of the securities pending examination.116 Hence,

juxtaposing Sections 12117, 14118, and 56119, it can be stated that untruthful

statement or omission of material fact in registration statement will result in civil

liabilities only when a third person suffers any damage because of it. Otherwise,

such untrue statement or omission is curable by mere amendment of the

registration statement.

Meanwhile, it is quite curious that despite the adoption of full disclosure

policy, the SRC still contains various grounds for the suspension120, revocation121

and even the rejection122 of a registration statement. It is on this score where the

SRC differs from the American federal securities laws on which the former was

purportedly patterned because nowhere in these federal laws where the US

Securities and Exchange Commission was given the power to deny registration.

Rejection of registration from the outset is more a badge of merit regulation than

114 Id.115 Id., § 14.1116 Id., § 14.4117 Procedure for the Registration of Securities118 Amendments to the Registration Statement119 Civil Liabilities on Account of False Registration Statement120 SEC. REG. CODE, § 15121 Id., § 13122 Id.

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of full disclosure policy. This lends credence to the observation of one Filipino

author that Philippine securities law is rather schizophrenic.123

The reportorial requirements under the law were refined. It identified the

companies to which the reportorial requirements shall apply.124 The SEC is

authorized to prescribe the forms of these reports as well as the period when the

reports should be filed, and what information they should contain and these

reports would be in lieu of reports required under the Corporation Code.125 The

rationale for providing these requirements is to enable the shareholders of these

companies to monitor constantly the performance of the latter and to make fair

assessment of the market value of their securities.126 It also provided for

reportorial duties to holders of equity securities of these companies who meet the

prescribed threshold of 5%, or as set by the SEC.127 This latter reportorial

requirement complements the rules on tender offers as it “is aimed at alerting

existing stockholders and management to a possible threat of control or an

impending offer.”128

The SRC also integrated provisions designed for the protection of

shareholder interests. As mentioned earlier, tender offer is now mandatory once

the required thresholds are met.129 The reason for making tender offer mandatory

is to give minority stockholders “the chance of selling at a high price when

somebody wants to gain control of a listed company.”130 It also provides some

rules on how the parties in a tender offer situation should behave and proscribes

123 Castañeda, supra note 3 at 307. However, the author in that article was not clear as to what particular Philippine securities law, i. e., the Blue Sky Law, Securities Act, or the Revised Securities Act, she was referring to when she made the abovementioned statement.124 SEC. REG. CODE, § 17.2125 Id., §17.4126 Senate TSP, Sept. 29, 1998 at 24127 SEC. REG. CODE, § 18128 Rodell Molina, The Rise of Corporate Takeovers in the Philippines: Learning our Lessons from the United States and Japan, 81 PHIL. L. J. 261, 267 (2006), citing MORALES, supra note 16 at 144129 SEC. REG. CODE, § 19130 Senate TSP, Jul. 17, 2000 at 131

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some actions on the part of the offeree and the target company.131 The SRC also

contains rules governing the use of proxies.132 The rule also set the maximum

lifespan of a proxy as “no longer than five (5) years at one time.”133

The Congress also fortified the rules against insider trading by expanding

the definition of what an insider is and by refining the test of materiality of

information the possession of which makes one an insider. The definition of an

“insider” now include government employees, directors or officers of an

exchange, clearing agencies and/or self-regulatory organization who have

access to material information about an issuer or a security that is not generally

available to the public.134 Under the RSA, the phrase used pertaining to

materiality of information was when it is “fact of special significance”135 while

under the SRC, the new term is “material nonpublic information”.136 What made

the former test defective are the requirements that the information need not only

material but its effect to the price of the security should be “to a significant

extent”, and that it is not only important but must be “especially” important to a

reasonable person in determining his course of action. The inclusion of these

qualified to the test “allow wide latitude of interpretation and therefore makes the

determination of insider trading difficult.”137 Likewise, the bill creates a disputable

presumption that trading by an issuer’s officers or directors was undertaken while

131 SEC. REG. CODE, §§ 19.2, 27.4 132 Id., § 20133 Id., § 20.3134 Id., § 3.8135 A fact is "of special significance" if (a) in addition to being material it would be likely, on being made generally available, to affect the market price of a security to a significant extent, or (b) a reasonable person would consider it especially important under the circumstances in determining his course of action in the light of such factors as the degree of its specificity, the extent of its difference from information generally available previously, and its nature and reliability. Batas Blg. 178, § 30 (c)136 An information is “material nonpublic” if: (a) It has not been generally disclosed to the public and would likely affect the market price of the security after being disseminated to the public and the lapse of a reasonable time for the market to absorb the information; or (b) would be considered by a reasonable person important under the circumstances in determining his course of action whether to buy, sell or hold a security. SEC. REG. CODE, § 27.2137 Senate TSP, Sept. 29, 1998 at 23; see, LUCILA DECASA, SECURITIES REGULATION CODE

(REPUBLIC ACT NO. 8799) ANNOTATED WITH IMPLEMENTING RULES AND REGULATIONS 85 (2004)

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in possession of material nonpublic information where it is shown that the

transaction occurred within the period between the time the inside information

came into existence and its public disclosure.138 The reportorial requirements of

directors, officers and principal stockholders (those holding more than 10%

equity securities) concerning their equity holdings as well as the prohibition

against short-swing profits earned by them are also retained.139

The SRC provides for the regulation of securities market professionals140

and of exchanges and other securities trading markets141 and of clearing

agencies142 by means of registration. It recognizes an associated person143 as a

new category of securities market professional aside from dealers, brokers and

salesmen. The law laid down the procedure for the registration of these market

professionals but the law delegated to the SEC the broad power to prescribe and

proscribe requirements other than what the law contains. It can even extend

exemptions from the requirements guided by public interest and the protection of

investors.144 The SEC can also suspend, revoke, or refuse the registration of

these market professionals based on any of the grounds and in accordance with

the procedure provided by law.145 The SRC still contains the so-called “Chinese

wall” barrier separating the functions of members, brokers and dealers in a

registered exchange like in the previous laws.146 Exemption for odd-lot

transactions of the member-brokers is still provided for as well as other activities

which are in the nature of market-making.147

138 Senate TSP, Sept. 29, 1998 at 23; SEC. REG. CODE, § 27.1139 SEC. REG. CODE, § 23140 Id., §§ 28-31141 Id., §§ 32-38142 Id., §§ 41-47143 An associated person is an employee [of a broker or dealer] who directly exercises control of supervisory authority but does not exercises control of supervisory authority but does not include a salesman, or an agent or a person whose functions are solely clerical or ministerial. SEC. REG.CODE, § 3.5144 SEC. REG. CODE, § 28.3145 Id., § 29146 Id., § 34147 Id.

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As to the registration of exchanges, Section 33.2 of the SRC lists down

the substantive requirements which must be satisfied prior to registration. Among

these are:

1) that the applicant must be organized as a stock corporation;

2) that no person may beneficially own or control, directly or indirectly,

more than five percent (5%) of the voting rights of the Exchange and

no industry or business group may beneficially own or control, directly

or indirectly, more than twenty percent (20%) of the voting rights of the

Exchange;

3) that the brokers in the board of the Exchange shall comprise of not

more than forty-nine percent (49%) of such board and shall

proportionately represent the Exchange membership in terms of

volume/value of trade and paid up capital;

4) that the board of the Exchange should include in its composition the

president of the Exchange and no less than fifty one percent (51%) of

the remaining members of the board to be comprised of three (3)

“independent directors”148 and persons who represent the interests of

issuers, investors, and other market participants, who are not

associated with any broker, dealer or member of the Exchange for a

period of at least two (2) years prior to his appointment; and

5) that the president and other management of the Exchange to consist

only of persons who are not members and are not associated in any

capacity, directly or indirectly, with any broker, dealer or member or

listed company of the Exchange

148 SEC. REG. CODE, § 38

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The common underlying purpose of these provisions is to eliminate, or at

least minimize the possibility that an Exchange would be controlled by a single

industry such as the brokers or dealers. It was reported that before, the

Philippine Stock Exchange (PSE) used to be operated like an “old boys’ club” by

the brokers prior to its demutualization in 2001.149 This situation is not good for

the whole market for it tends to erode investors’ confidence towards the

Exchange and threatens it long-term viability.150

The rest of the requirements151 are likewise designed to instill some form

of discipline within the organization and also to assure the maintenance of decent

level of professionalism among the participants in the Exchange.

The rules for the regulation of margin trading152 already existing under the

former laws were basically carried over to the SRC.

One of the major innovations introduced under the SRC is the concept of

a self-regulatory organization (SRO).153 The law recognizes the enormity of the

149 Castañeda, supra note 3 at 292, 315; see, DECASA, supra note 137 at 116-17150 See, MORALES, supra note 16 at 240151 1) the expulsion, suspension, or disciplining of a member and persons associated with a member for conduct or proceeding inconsistent with just and equitable principles of fair trade, and for violations of provisions of this Code, or any other Act administered by the Commission, the rules, regulations and orders thereunder, or the rules of the Exchange; 2) fair procedure for the disciplining of members and persons associated with members, the denial of membership to any person seeking to be a member, the barring of any person from association with a member, and the prohibition or limitation of any person from access to services offered by the Exchange; 3) the transparence of transactions of the Exchange; 4) the equitable allocation of reasonable dues, fees, and other charges among members and issuers and other persons using any facility or system which the Exchange operates or controls; 5) prevention of fraudulent and manipulative acts and practices, promotion of just and equitable principles of trade, and, in general, protection of investors and the public interest; and 6) the transparent, prompt and accurate clearance and settlement of transactions effected on the Exchange. SEC. REG. CODE, § 33.2152 SEC. REG. CODE, §§ 48-50153 “A self-regulatory organization (SRO) is an organization that exercises some degree of regulatory authority over an industry or profession. The regulatory authority could be applied in addition to some form of government regulation, or it could fill the vacuum of an absence of government oversight and regulation. The ability of an SRO to exercise regulatory authority does not necessarily derive from a grant of authority from the government.” S. K. SINGH, BANK

REGULATION 109 (2009); The idea of creating self-regulatory organizations is not really new. The Securities Exchange Act of 1934 in the United States contained rules pertaining to these entities.

Page 32 of 52

task of regulating the capital market vis-à-vis the capability of a single regulatory

body to handle. Thus, in order to achieve effectivity and efficiency of regulation,

the SRC embraced the worldwide trend towards self-regulation. It welcomed the

support of the market players themselves, including the exchanges, the clearing

agencies, stockbrokers and dealers in policing their own ranks with ultimate goal

of maintaining the integrity of the entire market.154 The SROs will have the

primary responsibility of maintaining professionalism in its internal affairs,

regulating and disciplining its own members155 subject only to administration and

supervision of the SEC.156 Administration and supervision means that the SEC

would not meddle with the day-to-day affairs of the SROs and that the former

would step in only if the latter are unable to perform their functions properly.157

The rules relating to the registration, powers, responsibilities, and oversight of

SROs are contained in Sections 39 and 40 of the SRC.

Penalties for civil and criminal liabilities under the SRC have also been

increased.158 Courts are now authorized to impose treble damages based on the

amount of securities involved as well as attorney’s fees up to thirty percent (30%)

of such amount involved.159 Insider traders are not both civilly and criminally

liable.160 The law, however, contains a provision on settlement offers but these

can only be availed of if such is consistent with public interest.161

154 See, Senate TSP, Sept. 29, 1998 at 25; It may also be worthwhile to note that the late Justice William Douglas also advocated for this type of industry self-regulation. William Douglas, Protecting the Investor, 23 YALE REV. 521, 532-33 (1934)155 Id.156 Senate TSP, Jul. 17, 2000 at 134157 See, MORALES, supra note 16 at 269158 SEC. REG. CODE, §§ 63, 73159 Id., § 63160 Senate TSP, Jul. 17, 2000 at 135; SEC. REG. CODE, §§ 61, 73161 Senate TSP, Jul. 17, 2000 at 135; SEC. REG. CODE, § 55

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THE POLICY DEBATE ON SECURITIES REGULATION FRAMEWORK

The study of securities regulation is never complete without allotting a

discussion of the regulatory philosophies or policies that characterize every piece

of legislation aimed at regulating the capital market. Knowledge about the

regulatory philosophy undergirding a particular securities law usually serves as a

valuable key on how to make sense of its structure as well as its more nuanced

provisions.

There are basically two competing regulatory philosophies in the field of

securities regulation. These are the merit-based regulation and the policy of full

disclosure. Between these two policies, the latter is, however, the prevailing one

as will be discussed later on in this paper.

MERIT-BASED REGULATION

Merit-based regulation, as the term implies, refers to a securities

regulation policy wherein the government regulator is given the power to examine

the investment “merit” of a particular security before the same is sold or offered

for sale to the public, and on the basis of its findings, decide whether it will allow

the sale or offering for sale of such security.162 The idea is to eliminate, even

from the outset, those securities of dubious background and prevent its

patronage by the public. Basically, the whole concept of merit regulation

traditionally connotes a direct government response, by virtue of its police power,

to the perceived victimization of unsophisticated investors from the rural states to

the nefarious schemes of businessmen from the urban states in connection with

the purchase and sale of securities.163

162 See Mark Sargent, Report on State Merit Regulation of Securities Offerings, 41 BUS. LAW. 785, 829 (1986)163 Id. at 792

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This regulatory policy is a by-product of the various state securities laws in

the United States of America, foremost of which was enacted in the State of

Kansas in 1911 - the so-called “Blue Sky Laws”.

Under merit regulation, the securities regulator/administrator has the

discretion to deny registration of securities thus preventing their sale or offering

for sale to the public if the issuer or the security itself did not satisfy substantive

standards imposed by law. Some of the merit standards that have been

employed by various blue sky laws in the United States are those that impose

limits on underwriting commissions and offering expenses164, cheap stocks165,

options and warrants as well as the offering price of the securities. Other

standards relate to shareholder voting rights, dividend and interest coverage and

promoters investments. Blue sky laws likewise include relatively broader criteria

such as “fair, just and equitable” standard166 and those which prohibit offerings

that “would work or tend to work a fraud on the investing public”167, among others.

Because of the discretionary power of the regulator to preclude the sale of

securities under merit-based regulation, it enables him to extend protection to all

investors, whether they are sophisticated or unsophisticated. The authority of the

regulator clearly carries a strong prophylactic effect on the introduction of new

securities into capital market.

164 Conrad Goodkind, Blue Sky Law: Is There Merit in the Merit Requirements, 1976 WIS. L. REV., 79, 87 (1976)165 “A cheap stock is stock which has been issued to insiders, usually within a few years before the proposed public offering, at a price which is less than that to be paid by the public. The prohibition against unreasonable amount of cheap stock in a particular offering is said to be designed against the excessive dilution of the investment of the public.” Id. at 90-92.166 Sargent, supra note 162 at 805167 Gregory Gorder, Compromise Merit Review – A Proposal For Both Sides Of The Debate, 60 WASH. L. REV. 141, 143 (1984)

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FULL DISCLOSURE POLICY

Full disclosure policy, on the other hand, refers to the regulatory system

wherein the job of the regulator is to compel disclosure of certain information

concerning the issuer of the security as well as the security itself upon application

for registration and once the issuer complies with the required disclosure, the

regulator shall allow the registration. As opposed to merit-based regulation, the

regulator under the full disclosure policy has no authority to look into the

investment merit of the security sought to be registered. The gist of the concept

of full disclosure was best captured by the statement made by Professor Louis

Loss of Harvard when he said that “…Congress did not take away from the

citizen his inalienable right to make a fool of himself. It simply attempted to

prevent others from making a fool of him.”168

However, this is not to say that the concept of merit regulation is

diametrically opposed to the philosophy of full disclosure. As a matter of fact,

merit regulation involves, to a limited extent, certain disclosures from the

companies. But the difference lies on the purpose of disclosure. In merit

regulation, it is to supply regulator the necessary information to determine

compliance with the substantive standards imposed by the law and to enable him

to decide whether to allow or deny registration of securities. On the other hand, in

full disclosure policy, disclosure is required for the purpose of obviating, as much

as possible, information asymmetry between the companies on one hand and the

investing public on another with a view to leveling the playing field between them.

Many writers believed that the philosophy of full disclosure to have

originated from the federal securities laws of the United States. In reality, full

disclosure policy is primarily of British origin. The idea of requiring full disclosure

as a measure of protection in favor of the investing public was first enunciated in

168 LOUIS LOSS, FUNDAMENTALS OF SECURITIES REGULATION 36 (1983 ed.)

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a Report presented by the Select Committee on Joint Stock Companies of which

William Gladstone was the chairman. The Report was made in connection with

the enactment of Joint Stock Companies Act of 1844.169 The idea reached its full

bloom later on through the passage of English Companies Acts of 1900 and

1907. It was by virtue of these acts where the prospectus was first put to use as

an important regulatory device of securities regulation.170 The formulation of the

full disclosure policy in England was one of the by-products of the continuous

struggle of the British to apply legislative controls to the activities of their stock

dealers and to modernize their company laws.171 In fact, it was claimed that the

history of English securities regulation may be summarized as repeated attempts

to increase the effectiveness of the required disclosure.172

Nonetheless, it was Justice Louis Brandeis of the US Supreme Court who

was credited as the one who have provided the conceptual seed for adopting full

disclosure policy in the federal securities law of the United States. Brandeis

posited that “publicity is justly commended as a remedy for social and industrial

diseases. Sunlight is said to be the best of disinfectants; electric light the most

efficient policeman”173

It may be worth mentioning at this juncture that in the field of economics

and finance174, the philosophy of full disclosure drew support from two inter-

related economic theories known as the Efficient Capital Market Hypothesis

(ECMH) and the Rational Choice Theory (RCT). 169 Bernard Kilbride, The British Heritage of Securities Legislation In The United States, 17 SW. L.J. 258, 262 (1963)170 Id. at 267171 Id. at 258-59172 Robert Knauss, A Reappraisal of the Role of Disclosure, 62 MICH. L. REV. 607, 612 (1964)173 LOUIS BRANDEIS, OTHER PEOPLE’S MONEY AND HOW THE BANKERS USE IT 92 (1914)174 Securities regulation is one of the areas of law which drew heavily from existing bodies of knowledge of other disciplines such as economics, business and finance. In fact, there are not a few times when in this field, practice precedes the law. So, while it is desirable to limit the analysis of this study within the confines of the legal aspect of the topic, however, the presentation can never be complete without mentioning something about them. Be that as it may, to maintain fidelity to its character as a legal paper, discussion of non-legal concepts will be limited, as much as possible, to a minimum.

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ECMH, in general, states that capital markets are efficient in the sense

that they rapidly and accurately incorporate and reflect all relevant available

information into the market price of any given security.175 It assumes that market

prices react immediately to each new bit of public information that becomes

available, and therefore, the price of securities is always a reflection of their fair,

intrinsic value. 176

On the other hand, the RCT, a dominant microeconomic conceptual

tool,177 roughly states that individuals are rational; that they can perfectly process

available information about alternative courses of action, can rank possible

outcomes in order of expected utility and can choose the course of action that will

maximize their personal expected utility.178

The fusion of ECMH and RCT forms a formidable theoretical base which

strengthens the acceptance of the philosophy of full disclosure as an effective

legal framework to govern capital markets. It is important to take note that these

concepts enjoy the backing of some of the big names in economics and

finance.179 To a certain extent, these theories propagated the belief held within

the economics and finance profession that were eventually accepted as near-

175 Susanna Kim Ripken, The Dangers and Drawbacks Of The Disclosure Antidote: Toward A More Substantive Approach To Securities Regulation, 58 BAYLOR L. REV. 139, 177 (2006), citingHOMER KRIPKE, THE SEC AND CORPORATE DISCLOSURE: REGULATION IN SEARCH OF A PURPOSE 84 (1979); Ronald Gilson & Reinier Kraakman, The Mechanisms of Market Efficiency, 70 VA. L. REV.549, 554-65 (1984); Jeffrey Gordon & Lewis Kornhauser, Efficient Markets, Costly Information, and Securities Research, 60 N.Y.U. L. REV. 761, 770-72 (1985); Lynn Stout, Are Stock Markets Costly Casinos? Disagreement, Market Failure, and Securities Regulation, 81 VA. L. REV. 611, 646-48 (1995)176 Id. at 177, citing Lynn Stout, Are Stock Markets Costly Casinos? Disagreement, Market Failure, and Securities Regulation, 81 VA. L. REV. 611, 646-48 (1995); Christopher Paul Saari, Note, The Efficient Capital Market Hypothesis, Economic Theory and the Regulation of the Securities Industry, 29 STAN. L. REV. 1031, 1037-39, 1069 (1977)177 Russell Korobkin & Thomas Ulen, Law and Behavioral Science: Removing The Rationality Assumption from Law and Economics, 88 CAL. L. REV. 1051, 1060 (2000)178Supra note 100 at 156, citing Robert Ellickson, Bringing Culture and Human Frailty to Rational Actors: A Critique of Classical Law and Economics, 65 CHI-KENT L. REV. 23, 23 (1989)179 Paul Samuelson, Proof That Properly Anticipated Prices Fluctuate Randomly, 6 INDUS. MGMT.REV. 41 (1965); Louis Bachelier, Theory of Speculation, THE RANDOM CHARACTER OF STOCK

MARKET PROCESSES 17 (Paul H. Cootner ed., 1964); BURTON MALKIEL, A RANDOM WALK DOWN

WALL STREET (1973); GARY BECKER, THE ECONOMIC APPROACH TO HUMAN BEHAVIOR (1976)

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dogma within the legal circles pointing to information asymmetry as the primary

evil which creates distortion in the otherwise efficient market.180 Free flow of

information from the corporate arena to the market and to the investing public

and vice-versa must be secured for it is the vital precondition for achieving a

robust capital market. All of these points to the arguably advantageous

characteristic of the full disclosure policy in securities regulation in that it extends

protection to the investing public and restores public confidence with the market

yet it entails minimum state intervention. It affords the investors some measure of

protection without deadening their sense of responsibility in securing their own

investments.

The United States at present has a dual system of securities regulation.

On the state level, they have the various blue sky laws based on merit regulation,

while on the federal level they have the Securities Act of 1933 and Securities

Exchange Act of 1934 as well as other complementary federal laws which were

based on the philosophy of full disclosure. Here in the Philippines, we first

experienced adopting the merit-based regulation starting with Act No. 2581 up

until the Revised Securities Act. But the country eventually shifted to the policy of

full disclosure with enactment of the Securities Regulation Code in 2000.181 Thus,

it can be stated that in the United States and in the Philippines, full disclosure

philosophy is on the winning side of the competition. Parenthetically, one of the

principles embodied in the document formulated by the International

Organization of Securities Commissions (IOSCO) entitled “Objectives and

Principles of Securities Regulations” mandates that “there should be full,

accurate and timely disclosure of financial results, risk and other information

which is material to investor’s decisions.”182

180 See Ronald Gilson & Reinier Kraakman, The Mechanisms of Market Efficiency, 70 VA. L. REV.549 (1984); Donald Langevoort, Theories, Assumptions, and Securities Regulation: Market Efficiency Revisited, 140 U. PA. L. REV. 851 (1992)181 SEC. REG. CODE, § 2182 IOSCO OBJECTIVES AND PRINCIPLES OF SECURITIES REGULATION 8 (2003), available at http://www.iosco.org/library/pubdocs/pdf/IOSCOPD154.pdf (last visited Jan. 25, 2011)

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Just like any other theory, both merit regulation and full disclosure policy

are not without their corresponding share of criticisms coming from the

academics as well as from the securities practitioners. However, some of the

critics crafted their arguments based on the peculiar state-federal regulatory set-

up in the United States. Thus, this paper will present only those arguments which

are pertinent to the Philippine scenario.

ARGUMENTS AGAINST MERIT REGULATION

The main criticism against merit regulation is that it is too paternalistic. It

mistakenly assumes that the investing public is unsophisticated to make

investment decisions and can easily fall prey to unscrupulous businessmen

without intervention by the government.183 In relation to this, opponents of merit-

based regulation asserted that the policy is misguided, for requiring government

regulators to act as an investment adviser on behalf of the public. This should not

be the case according to them because the regulators have neither ample

expertise nor manpower to fulfill such a Herculean task.184

Assuming that there is a real need for the protection of unsophisticated

investors, there are still enough built-in safeguards under the full disclosure

system to protect them, so goes the argument. To be sure, these small investors

could benefit from and to a certain extent, have a “free ride” upon the knowledge,

skills and experience of the market intermediaries directly, through their

respective brokers and indirectly, through securities analysts when the latter

search for “non-excludable” securities information.185

183 Castañeda, supra note 3 at 306184 Id., at 318, citing Interview with Ramon Arnaiz of Peregrine Capital Phils. (Mar. 25, 1997); Perfecto Yasay Jr., Speech delivered, Full Disclosure v. Merit Regulation185See John Coffee, Jr., Market Failure and the Economic Case for a Mandatory Disclosure System, 70 VA. L. REV. 717 (1984) (Coffee claims that securities information can be considered an imperfect public good which is non-excludable but are important even to those who did not pay to search for it.)

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Corollary to this is the claim of danger of regulatory overkill on the part of

the administrators due to their significant unreviewable discretion combined with

the lofty goals of the law.186 This is critically worrisome for it could frustrate the

efforts not only of shady enterprises but also of legitimate business ventures to

obtain capital from the public. In other words, merit regulation imposes undue

burden on capital formation187 which could bear negative influence on the general

economic development of the country.

One argument hurled against merit regulation has a somewhat laissez-

faire flavor. Campbell, Jr. denounced the merit regulation for putting unnecessary

constraints on the freedom of people to do business as they see fit and that it

discourages entrepreneurial initiative.188 He asserted that merit regulation is

inconsistent with the very essence of a capitalistic system. That under a working

capitalistic system, entrepreneurial initiative must be encouraged, not stifled as

what merit regulation is allegedly doing.189

ARGUMENTS AGAINST FULL DISCLOSURE

Meanwhile, the first person known to have registered a criticism of the

philosophy of full disclosure and the “sunlight theory” of Justice Brandeis is

William Douglas, who later became the chairman of US Securities and Exchange

Commission and then Associate Justice of the US Supreme Court. He raised

doubts as to the sufficiency and efficacy of the disclosure device as a means for

protecting the investing public. Speaking about the then newly-enacted Securities

Act, he said:

186 Sargent, supra note 162 at 840-841187 Roberta Karmel, Blue-Sky Merit Regulation: Benefit to Investors or Burden on Commerce? 53 BROOK. L. REV. 105, 106 (1987)188 Rutherford Campbell, Jr. An Open Attack On The Nonsense of Blue Sky Legislation, 10 J.CORP. L. 553, 565-566 (1985)189 Id. at 566.

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“The truth about securities having been told, the matter is left to the investor. The Act presupposes that the glaring light of publicity will give the investors needed protection. But those needing investment guidance will receive small comfort from the balance sheets, contracts, or compilation of other data revealed in the registration statement. They either lack the training or intelligence to assimilate them and find them useful, or are so concerned with a speculative profit as to consider them irrelevant.”190

Recent attacks against the full disclosure policy come from the proponents

of behavioral economics and finance, as a necessary incident of their disapproval

of the efficient capital market hypothesis and its kindred idea of rational choice

model. They anchored their claims on the insights they derived from their studies

of the psychology of the investor. They, in the main, assert that the theories

supporting full disclosure policy do not comport to the reality of capital markets

and its constituent actors.

According to Professor Troy Paredes, disclosure of information is not

enough for a disclosure-based regulatory system to succeed. He argued that

investors, analysts, and others likewise need to use the disclosed information

effectively for the disclosures to be of value.191 The problem with the current

disclosure-based system is that it assumes that the consumers of market

information, i.e. the investors, are perfectly rational.192 More information is

thought to be always better. However, the fact of having access to market

information through mandatory disclosure is one thing; knowing how to use them

by those to whom the information are directed is another matter altogether.

Paredes pointed out the weakness of the “more information is better” motto of full

disclosure by stating that individuals have limited cognitive abilities and that their

190 William Douglas, Protecting the Investor, 23 YALE REV. 521, 523-24 (1934)191Troy Paredes, Blinded By The Light: Information Overload And Its Consequences For Securities Regulation, 81 WASH. U. L. Q. 417, 432 (2003)192 Id. at 2

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thoughts and actions are constrained by their bounded rationality.193 Furthermore,

this limitation is applicable to every individual, experts and non-experts alike.194

He cited numerous studies showing that when a decision maker is given

information, decision quality increases; but once the level of information reaches

a certain point, the quality of decision decreases no matter how much information

is supplied to the decision maker.195 In short, market participants who are at the

receiving end of disclosure system are in danger of suffering from information

overload. The US Supreme Court recognized albeit indirectly, the danger that

information overload poses on the informed decision-making of investors in a

case decided by them relating to the issue involving the standard of materiality of

information to be disclosed in proxy statements.196

In addition to the fact that individuals have limited cognitive abilities, they

are likewise saddled with a variety of cognitive biases such as overconfidence197,

over-optimism198, availability bias,199 confirmation bias200, anchoring201 and herd

193 Id. at 435. Paredes used the works of Herbert Simon concerning the concept of bounded rationality as the major source of his article’s main premise.194 Id at 455195 Id. at 441196 TSC Industries, Inc. v. Northway, Inc. 426 U.S. 438 (1976)197“It is a kind of bias where, as a rule, “most people think that they are better than average at many tasks” especially so when they already have some sort of experience in doing these tasks. Overconfidence can lead to overestimation of the validity of their knowledge and judgments. Securities market professionals are said to be more prone to this kind of bias than the common investor.” Kim Ripken, supra note 175 at 163. See, Paredes, supra note 191 at 457-58198 “This refers to a bias wherein people unrealistically believe that they are far more likely than others to experience positive life outcomes.” Kim Ripken, supra note 175 at 168199 “Availability bias is the idea that people focus on events that they are able to recall, regardless of their actual probabilities. As a result, the likelihood of the event happening may be overestimated in the person’s decision-making process if it readily available in the person’s memory.” Paredes, supra note 191 at 457-58200 “The confirmation bias involves a tendency to search for, treat kindly, and be overly impressed by information that confirms one’s initial impressions or preferences. Once [an individual] make[s] up [his] mind about something, [he] tend[s] to avoid, minimize, or reject new information that contradicts [his] previously established beliefs.” Kim Ripken, supra note 175 at 172-73, citingBELSKY & GILOVICH, infra note 204 at 130; DAVID DEJOY, Attitudes and Beliefs, WARNINGS AND RISK

COMMUNICATION 199 (Michael Wogalter et. al. eds., 1999)201 “Anchoring refers to the tendency of individuals to latch on to an idea or fact and use it as a reference point for future decisions. Once a person begins with an initial value or probability estimate, subsequent decisions are biased toward that initial reference point and people tend to resist altering the original assessment when presented with new pertinent information.” Kim

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behavior.202 These biases, one way or another, distorts the decision-making

process of individuals involving the information that they receive thus, further

negating their assumed character as perfectly rational entities postulated by the

rational choice theory.

The problem relating to effective use of disclosed information brought forth

by the above-mentioned issues is aggravated by the ever-increasing complexity

of affairs of business organizations. This complexity can clearly present

difficulties in capturing an accurate picture of corporate affairs via disclosure

documents. 203

As the affairs of business organizations have increasingly become

complex, the securities markets are also becoming more complicated. A case in

point is the derivatives market.204 Investment strategies utilizing derivatives

instruments are so complex that even if disclosure is provided sophisticated

investors or [government] regulators might not fully appreciate the risk of any

given strategy.205 An American author once mentioned206 that the contributing

factor to the happening of the subprime mortgage crisis which in recent years Ripken, supra note 175 at 173, citing GARY BELSKY & THOMAS GILOVICH, WHY SMART PEOPLE

MAKE BIG MONEY MISTAKES—AND HOW TO CORRECT THEM: LESSONS FROM THE NEW SCIENCE OF

BEHAVIORAL ECONOMICS 188 (1999); AMOS TVERSKY & DANIEL KAHNEMAN, JUDGMENT UNDER

UNCERTAINTY: HEURISTICS AND BIASES 3 (Daniel Kahneman et. al. eds. 1982); Roger Noll & James Krier, Some Implications of Cognitive Psychology for Risk Regulation, 19 J. LEGAL STUD. 747, 754-55 (1990)202 “It refers to the tendency of individuals to mimic the actions (rational or irrational) of a larger group. Individually, however, most people would not necessarily make the same choice. Case in point is the Internet Bubble in the US where many people invested in internet-related companies only because several people started doing so.” Albert Phung, Behavioral Finance: Key Concepts - Herd Behavior, INVESTOPEDIA.COM, available at http://www.investopedia.com/university/behavioral_finance/behavioral8.asp (last visited Dec. 28, 2010)203 See Kim Ripken, supra note 175 at 148, 185-86204 There is yet no derivatives market in the Philippines but there is already a plan to put up one. Philippines mulls creation of derivatives market, INQUIRER.NET, Feb. 21, 2008, available at http://business.inquirer.net/money/breakingnews/view/20080221-120262/Philippines_mulls_creation_of_derivatives_market (last visited Jan. 15, 2011)205 Steven Schwarcz, Systemic Risk, 97 GEO. L. J. 193, 219 (2008), citing ROGER LOWENSTEIN,WHEN GENUIS FAILED: THE RISE AND FALL OF LONG-TERM CAPITAL MANAGEMENT (2000)206 Id. at 219, citing Aaron Lucchetti & Serena Ng, Credit and Blame: How Rating Firms’ Calls Fueled Subprime Mess, WALL ST. J. Aug. 15, 2007, at A1

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dealt a blow to the US economy, is allegedly that "a lot of institutional

investors bought mortgage-backed securities substantially based on their

ratings without fully understanding what they bought, in part because the

market has become so complex." These somehow prove the limitation inherent

in the disclosure approach.

The purported built-in safeguard in favor the unsophisticated investors as

put forward by the full disclosure policy advocates cannot also be fully relied

upon considering that even experienced professionals are equally susceptible to

the cognitive and behavioral constraints and they too can be informationally

overloaded.207

COMMENTS

The arguments presented on both sides of the debate have their

respective merits but the opponents of full disclosure have proffered a more

compelling case. The effectiveness of disclosure to regulate capital markets had

been put in a bad light because of its failure to avert downturns and financial

crises in the countries where it is the primary regulatory tool, particularly in the

United States which is currently experiencing a virulent recession triggered by

the subprime mortgage meltdown. This obviously exposed the fact that the

disclosure device has its inherent limitations and that overreliance to its utility

seem to be unrealistic.

This is not to suggest however, that this author endorses a return to merit-

based regulation. Merit-regulation where the regulator serves as the determinant

of the investment grade of securities sought to be issued is administratively,

politically and commercially impractical given the very limited resources of

207 Kim Ripken, supra note 175 at 181

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Philippine government as well as its critical impact to the capital formation in our

country. The government obviously cannot provide the manpower with the ample

amount of expertise to perform such a scheme. Worse, a return this kind of policy

might only create a fertile ground for rent-seeking. The prospect could be that

government officials would wield unwarranted power as arbiters of public

investment while the corporate officials would be incentivized to circumvent the

application of the law through dubious legal means.

Given the apparent proclivity of our government in adopting full disclosure,

it is about time to re-examine the policy’s underlying assumptions vis-à-vis the

environment where it is employed and to determine whether the policy needed

some re-calibration taking into consideration the cognitive and behavioral

limitations of the individual investors. This is to make sure that the policy can still

deliver its expected results. The studies made by the proponents of behavioral

finance can simply be ignored since it directly challenges the theoretical

foundations of full disclosure.

The author likewise adheres to the view that the complexity of business

affairs of the issuers tends to limit the utility of disclosure. It is quite a naïve thing

to say that by just presenting financial statements and other business reports to

the public, the latter can be appraised of the true state of affairs of the enterprise.

The concern can be dismissed as being too far-fetched if we are talking about

the dealings of a neighborhood mom-and-pop grocery store but not when we

refer to the giant multinational companies with operations spanning across

different continents. Simplification of disclosure requirements cannot also be the

solution to this dilemma because to do so might just defeat the purpose of the

whole process of requiring disclosure. At the other end of the spectrum, to

require more disclosure might create the problem of information overload as

discussed on the earlier part of this paper. More than that, disclosure also entails

costs, financial or otherwise. It would not be to the best interest of the companies

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and even of the market at large, if the costs of complying with increased

disclosure requirements would exceed the benefits these companies could get

from their offerings.

In sum, this all boils down to the issue of communicational effectiveness of

disclosure in an ever-compounding environment.

FULL DISCLOSURE AND DEMOCRATIZATION OF WEALTH

One of the declared policies of the Securities Regulation Code is the

democratization of economic wealth. Democratization of wealth as envisioned by

the legislators who drafted the Code means the integration of a wide sector of the

public, especially the small ones in wealth creation through their participation in

the activities of the capital market.208 The law is not very clear however, how this

policy would be attained. Perhaps the legislators have intended that the statutory

scheme they have designed (of which mandatory disclosure is the prime

regulatory tool) under the SRC could achieve this objective.209

Unfortunately though, there seems to be theoretical and practical

misalignment between this goal of democratization of economic wealth and the

policy of full disclosure permeating the securities law. In other words,

participation of the wide sector of the Filipino population with the wealth-creating

mechanism of the capital market may not be carried out by means of full

disclosure philosophy.

208 See, Senate TSP, Sept. 29, 1998 at 20, 23 and Senate TSP, Oct. 19, 1998 at 38209 In the sponsorship speech of the late Senator Raul Roco, he pointed out that the aim of the reform of the legal framework governing the securities market should be the strengthening of public confidence in the securities market. For him, public confidence would serve as a key to the development of the securities market. And he expressed that the development [of securities market] in broadest sense, connotes broader choices for the people which development in turn, can be used as an important instrument for democratizing wealth. Senate TSP, Sept. 29, 1998 at 20

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We have earlier discussed that Philippine securities market has a very

long history of operating under the merit-based regulatory regime. But towards

the end of the 20th century, Congress has resolved to do a sudden shift in policy

by importing from American federal jurisdiction the philosophy of full disclosure

with its underlying assumptions such as the efficiency of the market and the

rationality of investors.

However, even after almost a decade from the time the SRC was enacted,

the law has yet to achieve its goal of democratizing wealth and its kindred policy

of encouraging the widest participation of ownership in enterprises. Public

participation in the stock market is still at a dismal rate of a little over 1/10 of 1

percent of the total national population.210 This is small, according to a survey

conducted by the Philippine Stock Exchange in 2008, because many other

neighboring Asian countries with far bigger stock markets have very high

proportions of their population involved in the stock market.211 In addition, the

small free float of securities typifies the Philippine market with the bulk of the

securities are dominated by a few ultra-wealthy families.212 This condition is not

favorable to the entire market since it tends to create a stranglehold on the

development of the market and adversely affects its liquidity although just

recently, the authorities have taken some steps to remedy the situation.213

Thus, it is about time that we take a critical look at full disclosure, whether

it is the optimal scheme to attain the desired democratization of wealth. Its

210 Joel Gaborni & Nina Bocalan-Zabella, Less than half of 1% of Filipinos invest in stock market, PSE study confirms, PSE News Release, Jun. 16, 2008, available at http://www.pse.com.ph/html/NewsRoom/pdf/investors%20profile.pdf (last visited Jan. 29, 2011)211 Id.212 International Monetary Fund, Philippines: Financial System Stability Assessment Update, IMF Country Report No. 10/90, at 9, ¶ 3 (Jan. 11, 2010), available at http://www.imf.org/external/pubs/ft/scr/2010/cr1090.pdf (last visited Jan. 31, 2011)213 PSE reinstated the rule on minimum public ownership as a requirement for continuous listing of companies with the Exchange that took effect last 30 November 2010. Philippine Stock Exchange, Rule on Minimum Public Ownership, PSE CONTINUOUS LISTING REQUIREMENTS, art. XVIII, § 3, available at http://www.pse.com.ph/html/NewsRoom/memos/2010/MEMO_2010-0505.pdf (last visited Jan. 31, 2011)

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underlying assumptions need to be threshed out. It was pointed out earlier that

under full disclosure, investors are assumed to be rational enough to fend for

themselves, given all the material information related to their investments. This

assumption must be tested in light of the realities in our country where a

significant number of Filipinos might not even know what a security means in the

context of the capital market. Common Filipinos such as public school teachers,

farmers, fishermen and factory workers who are the very people envisioned by

the legislators to take part in the wealth-creation mechanism of the securities

market, might not have the necessary knowledge to decipher the relevance of

financial ratios and data contained in the disclosure documents provided to

them.214 The inquiry must be done immediately for otherwise, the desired

democratization of economic wealth through the securities market would remain

a mere lofty ideal with no concrete mechanism by which it could be attained.

THE INTERNATIONALIZATION OF THE PHILIPPINE SECURITIES MARKET

With the advent of globalization215 brought about principally by

considerable advances in information and communication technology in recent

decades, geopolitical barriers among nation-states have been virtually removed

leading to a greater flow of goods, capital and services as well as the rapid

exchange of cultures and ideas among peoples of the world. One of the

perceived by-products of this worldwide phenomenon is the increasing

internationalization of securities markets. Globalization opened up opportunities

for business organizations around the world to widen their investor base which

were previously constrained within the countries where these companies

incorporate and/or operate. In the same vein, investors were also given the

214 See, supra note 208215 Former SC Associate Justice Flerida Ruth Romero defined globalization as “integration and democratization of world’s culture, economy and infrastructure through transnational investment, rapid proliferation of communication and information technologies, and the impact of free-market forces on local, regional and national economies.” Flerida Ruth Romero, Legal Challenges of Globalization, 81 PHIL. L. J. 137, 137-38 (2006), citing “Globalization,” Microsoft Encarta Reference Library 2003

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option to choose which national capital markets they should invest in. Scholars

have theorized that this mobility of capital can result in regulatory competition

among national securities markets in order to attract the flow of capital within

their respective jurisdictions.216

But notwithstanding the possibility of regulatory competition among capital

markets, most securities regimes217 remain to be territorially-oriented. And this

includes the Philippine securities regime. The SRC has no applicability to

offshore offerings even though both the issuers and investors involved therein

are Filipino citizens and/or residents.218 Decasa lamented that this territorial

limitation is one of the glaring loopholes weakening the over-all structure of the

SRC and thus, can be exploited as a “made-to-order shelter to go around the

law” by those who might have motives to do so.219

Nonetheless, the question regarding regulatory reach of domestic

securities rules, whether the same should remain confined within the national

geographical boundaries or whether there is a need to extend it offshore under

216 The regulatory competition among securities markets, as argued by commentators, could result to either of the two possibilities due to the interplay of incentives to both issuers, their managers, investors and the national governments. These are: (1) race-to-the-bottom; or (2) race-to-the-top model. The race-to-the-top model goes this way: “A securities transaction is ultimately a contract between buyer and seller of a security. It is well established that in the absence of transaction costs, buyers and sellers will select the most efficient terms for a contract. Similarly, if the parties to a securities transaction can choose among regimes, they will seek the most efficient jurisdiction—the one that offers the level of regulation that maximizes the total value of the transaction, including compliance costs…Countries competing to attract securities transactions, therefore, will strive toward the most efficient regulatory regime, leading to a race-to-the-top.” Stephen Choi & Andrew Guzman, National Laws, International Money: Regulation in a Global Capital Market, 65 FORDHAM L. REV. 1855, 1870 (1997); On the other hand, the race-to-the bottom model may arise due to the opportunistic behavior of corporate and fund managers. They might, for example, choose those markets with lax insider trading and disclosure rules that enable them to obtain profits even at the expense of the issuer. Countries competing to attract securities transactions might be constrained to lower the regulatory requirements of their securities laws, leading to a race-to-the-bottom. Choi & Guzman, supra at 1872-73217 See, Stephen Choi, Assessing Regulatory Responses to Securities Market Globalization, 2THEORETICAL INQURIES L. 613, 614 (2001)218 SEC. REG. CODE, § 8.1 states: “Securities shall not be sold or offered for sale or distribution within the Philippines, without a registration statement duly filed with and approved by the Commission...”219 DECASA, supra note 137 at 27

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certain circumstances, is but only one of the many facets of the much-broader

concern towards the establishment of the ideal approach on how best to open up

Philippine capital market to the international arena. Unfortunately, the resolution

of this delicate matter requires more than just a mere re-writing of the statute.

There are many significant sub-issues that need to be ironed out in order to

ascertain the proper strategies that would maximize the benefits of

internationalization to the Philippine securities market. These include, among

others, the installation of possible domestic prudential measures that would

mitigate the impact of an international financial contagion affecting the global

network of securities markets. The interconnectedness of national securities

markets can give rise to the danger of systemic risk whereby a trigger event such

as a crash by a national securities market or even a default of single market

player holding substantial investment such as a hedge fund or private equity can

cause a chain of bad economic consequences within the global system.220

Another consideration is the level of compliance costs for issuers and investors

since this goes into the ability of the securities market to draw foreign capital. On

the other hand, one legal obstacle that could dampen internationalization of

Philippine capital market is the Constitutional and statutory limitations on foreign

ownership of certain domestic enterprises. There must be a serious debate on

whether this limit is still retains its patriotic relevance within the context of

globalization. The integration of statutory provisions dealing with the adoption of

innovative technologies particularly in the clearing and settlement of securities

and electronic trading systems is a good step towards this process of

internationalization of the Philippine market.221

In the end, whatever approach might be chosen for the integration of

Philippine securities market into the global system, it is important that such must

not impinge on the fundamental policy of providing protection to the investing

220 Schwarcz, supra note 205 at 197221 Senate TSP, Jul. 17, 2000 at 25; SEC. REG. CODE, § 37

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public. This over-arching public policy should not be bargained away in the name

of increasing foreign capital inflows within the domestic capital market.

CONCLUSION

The evolution of securities regulation in the Philippines may be briefly

described as a history of mimicry, and importation of legal rules from American

jurisdiction with the hope of making these rules work within Philippine

condition.222 Although recently under the SRC, some progress had been made.

Some rules have been included that were product of local experiences such as

the shareholding limitation rule which was designed to prevent an Exchange from

being an “old boys club” of a single group of market participants such as the

brokers. But despite the habit of importing foreign securities laws, what is clear

from history is the legislature’s continuous desire to extend protection to the

investing public.

Thus, there is a need to re-examine the effectiveness and efficiency of the

policy of full disclosure to deliver the desired level of investor protection on the

basis of four factors, namely: (1) the entity bound to disclose; (2) the entity to

whom disclosure is directed; (3) the information to be disclosed; and lastly, (4)

the manner of disclosure. Since it was presented by this paper that the

mandatory disclosure device has its inherent limitations, it might well be prudent

to supplement it with other regulatory devices which could cover the areas where

disclosures are found wanting.

It is likewise high time that the government create programs towards the

education of the investing public so that their intended participation to the wealth-

222 See, Castañeda, supra note 3 at 320-21 (This article also made a similar observation although the paper was written during pre-Securities Regulation Code.)

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creation mechanism of the securities market may soon be realized.223 On this

point, the word of Justice William Douglas is illuminating. He said:

“…it must be remembered that investment is not only an inexact science

but an imperfect art even for the wise, and only a long, slow process of

education can bring the investor who needs protection to the stage of

obtaining substantial protection under the Act.”224

As to the matter of internationalization of securities markets, the author

has earlier presented that the integration of the Philippine market to the global

arena seems inevitable because of globalization phenomenon. However, the

strategy for integration must be carefully crafted to maximize the benefits that

can be derived from it without bargaining away the overarching goal of investor

protection.

223 It was reported that the PSE, in coordination with the Department of Education, is planning a project for the integration of lessons on how to invest in the stock market in the academic curriculum of all high school students nationwide. The purpose of the project is to widen the country’s investor base. The author of this paper believes that this is a good initial step towards investor education. Doris Dumlao, HS students to soon learn about stocks, INQUIRER.NET, Dec. 12, 2010, available at http://business.inquirer.net/money/topstories/view/20101212-308600/HS-students-to-soon-learn-about-stocks (last visited Feb. 5, 2011)224 Douglas, supra note 190 at 527