Opinion No. 06-19 RE : Validity of provision restricting transferability of shares in close corporations

. ,', .. ~. }. • ,fl~ ". Republic of the Philippines SECURITIES AND EXCHANGE COMMISSION " SEC Buildin'g, EDSA, Greenhills, Mandaluyong City, Metro Manila 13 March 2006 SEC Opinion No. 06-19 Validin} of prom"sion restricting transferabilin} of shares in close corporation s DE BORJA MEDIALDEA BELLO GUEV ARRA 21st FIr. Wynsum Corporate Plaza F. Ortigas, Jr. Road (formerly Emerald Ave.) Ortigas Center, -PasigCity 1605 i ' • Attn: Atty. Ma. Rosario C.Z. Nava Atty. Marc Francis E. Marasigan Gentlemen: This refers to your letter dated 02 February 2006, requesting opinion relative to the validity of a provision in the articles of incorporation of your client, Cafe Italianni's (Mall of Asia), Incorporated. The questioned provision is originally worded as follows: "Encumbrance of Shares. The shareholders may mortgage, pledge, or otherwise encumber all 'or part of their shares in the Corporation; provided that, the other parties shall give their written consent thereto; provided further that, written notice to the other parties shall be sufficient if the mortgagee or pledgee is a banking or financial institution."

" .:,:~~~~.,~~,1,~',(/:_--~1~,:t:f"<, co, ,,_"~ '15,(; . ~~.a,tif was pointed out to you that part of the' c:~*cf;~!:~!9t:requiringprior written consent of the other . r.~'(a9~~sIi~reholder may encumber his shares is not valid, as it .' :.Miolat 'D~,"of(fn~e'transferabilityof shares. It was suggested that you . i~jn~Y~'J!}.~:~$$l¥ir~Inii1t of "prior written consent" and replace the same with '~Ptib.•. c.r~.,.> .. ..• ""--- ,.;fitt~il::~:otice. ,,' ,.< ". X}'-',/" .... Itis}o/",~~r following reasons: position that the abovementioned provision is valid for the 1. Your c1ieI}.t"isa close corporation. As an exception to the general'rule in Section 63 on the free transferability of shares of stock, Section 98 of the Corporation Code allows reasonable restrictions to be placed upon the right to transfer shares of a close corporation. Hence, if Section 98 allows restrictions to be placed upon the transfer of shares of a close corporation, with more reason can it be interpreted as permitting reasonable restrictions to be placed upon the lesser right to encumber the shares. 2. While shares of stock are personal property and shareholders have the right to exercise acts of ownership over the shares, "Y'hichinclude the right to alienate and encumber the same, they are not prfduded from waiving this right, such waiver not being contrary to any law or public policy. By previously signing a Joint Venture Agreement with the disputed provision, Cafe Italianni's (Mall of Asia), Inc.'s stockholders are presumed to have considered and appreciated the full consequences of said stipulation and voluntarily consented to be bound thereby. In doing so, it is your contention that they have effectively waived their right to encumber their shares without restriction. 3. The use of certain restrictions on the transfer or other disposition of shares in an agreement between stockholders, such as a joint venture agreement, and the inclusion of the same in the articles of incorporation or by-laws, are among the devices instaIled to safeguard the interest of the stockholders. They ensure succession of interest that is particularly relevant in close corporations such as Cafe ItaIianni's (Mall of Asia), Incorporated. 4. The disputed provision does not unduly restrict the right to encumber the shates considering that consent is required only if the proposed pledgee or mortgagee is not a bank or other financial institution. Mere notice is required in cases where the mortgagee or pledgee is a bank or other financial institution. 5. Cafe Italianni's (Mall of Asia), Inc. is merely complying with the requirement set forth in Section 98 which requires th~t restrictions on the right to transfer shares appear in the articles of incorporation and in/the by-laws, as well as in the certificate of stock; otherwise, the same. shan not be binding on an y @

i . ~~~~i~1J11t~a',~irovision in Cafe ,}",,!!,!;,~,9:!8:~W~:~.~ti?n is,m~:antJoprotect not ~/J~ltt{¥~nI<p()~ingthird>Rersonswho may !tmqf;!,g~gees'oftl~e ,.---<;;'%'Pt -'.',;--i', stocks as well.. .';':-;,,' .,!c!,,;g'Jl;;lS!~~l~\~!p~~,ithevalidity(or invalidity) of the questioned provision,';i,t. ustg\cleat:IY~1pr,esented,by -' ",'::0.:,: ,,:,Y_:;:-~-,~fj;f,~;<~> -'7.:_,,:,: .. --;,/:,'L;-'">---"-- ,', '>;- .'" :(. ,,' the applicant corporation that it is indeed a clo~.e'z:cgrpo!ation.'The Jeatures or elements of a close corporation, as required by Section 961 of the Corporation Code, must be shown in the corporation's articles of incorporation. An examination of Cafe Italianni's (Mall of Asia) Corporation's articles of incorporation confirms that subject corporation is a close corporation by virtue of the provisions governing the issuance and transfer of shares of the corporation embodied in the ninth section thereof. Considering the special circumstances attending a close corporation, it is oftentimes justifiable, and at times imperative, for its stockholders to protect themselves from future conflicts by placing restrictions on the right of each one of them to transfer his share to an outsider. It is perl~a,psfor this reason that the Corporation Code explicitly allows such restrictiontin, and in fact makes it an attribute of the close corporation.2 This is embodied in Section 98 of the Corporation Code, which provides as follows: "SECTION 98. Validity of restrictions on transfer of shares. - Restrictions on the right to transfer shares must appear in the articles of incorporation and in the by-laws as well as in the certificate of stock; otherwise, the same shall not be binding on any purchaser thereof in good faith. Said restrictions shall not be more onerous than granting the existing stockholders or the corporation the option to purchase the shares of the transferring stockholder with such reasonable terms, conditions or period stated therein. If upon the expiration of said period, the existing 1 SECTION 96. Definition and applicahility of Title. - A close corporation, within the meaning of this Code, is one whose articles of incorporation provide that: (1) All of the corporation's issued stock of all classes, exclusive of treasury shares, shall be held of record hY.l1ot more than a specified number of persons, not exceeding twenty (20): (2) All of the issued stock of all classes shall be subject to one or more specified restrictions on transfer permitted hy this Title; and (3) The corporation shall not list in any stock exchange or make any puhlic offering of any of its stock of any class. Notwithstanding Ihe foregoing, eI corporation shelll he deemed not a close corporeltion when at least two-thirds (2/3) of its voting slock or voting rights is owned or controlled by anolher corporation which is not a close corporation within the meaning of Ihis Code. 2 SEC letter to Atty. Victor Africa, 5 May 1986. .

, -,.~, .. , 0",' -'k,<y Accorairyg!y;ktli~~~oihmission,as a matter of policy, allows restrictions on transfer of shares~intlleartides of incorporation if the same is necessary and convenient'to,.'the attairlluent of the objective for which the company was incorporated, .unless palpably unreasonable under the circumstances. The underlying test asto whether the resh-iction is valid and enforceable is whether the restriction is sufficiently reasonable as to justify the restriction overriding the general policy against restraint on alienation of personal property.3 It is for this reason that close corporations are allowed restriction clauses. In addition, restrictions shall not be more onerous than granting the existing stockholders or the corporation the option to purchase the shares of the transferring stockholder with such reasonable terms, conditions or period stated therein. The Commission has held that the reasonable option period ma)' range from 30 to 60 days or even more, depending on the circumstances surrounding the case.4 The disputed provision, as presented in your ~etter, does not provide for an option period for the existing stockholders/ corporation and the transferring stockholder who desires to transfer/ encumber his stocks. It only provides that the other parties shall give their written consent thereto before such encumbrance can be realized. The Commission had previously opined that a restriction clause is not valid and enforceable if it absolutely prohibits the sale or transfer of stock without the consent of the Board of Directors and/or stockholders, as this would violate the general law on free alienability of shares of stock as personal property.s The above principle on restrictions on the transferability of shares applies in the case of transfer of shares of stock by way of pledge or mortgage, which transfers are recognized under Section 55 of the Corporation Code, quoted hereunder: SECTION 55. Rigllt to vote of pledgors, mortgagors aHd If administrators. - In case of pledged or mortgaged shares in stock corporations, the pledgor or mortgagor shall have the right to attend and vote at meetings of stockholders, unless tl{epledgee or mortgagee is expressly given such right in writing which is r~ oSEC letter to Atlys. l3ienvenido I. Somera, Jr. ,lilt! Cynlhia D. NllvaU\mhrosio, 4 July '/91)5, SEC Icllpr In Atty. Merle P. Cunanan, 20 Febl'llary 1995 ' 4 SEC letter to Atty. Helen C. De Leon-Manzano, 8 June 1995 5 SEC letter to Sycip Salazar Hernandez and Gatmaitan, 28 August 1995 ~

~~,~~~.",qr~~~,ritioned\~iScussion; we decline to confirm the ..... "":~~.!,fiPP:~"4yith.r~~pect to the questioned provision on encu.ri}S!~~~\'d'i;; ..,.,.•Jslar~sdn.tl~e articles of incorporation of your client, Cafe Ita1ianni's'1i~~~II"'ofA~iCl),Incorporated.The provision, as it stands, does not provide foran~option:period to be exercised by the other stockholders or the corporation vi~~a;'"is the transferring stockholder. The result of the absence of such option period is to absolutely prohibit the mortgage,' pledge or encumbrance of such stock without the written consent of the other stockholders. This violates the general law on free alienability of shares of stock as personal property. ver2:' VERNETTf: G. UMALI-PACO Gen~ral Counsel l:;