Dear Attorney,

I hope this letter finds you well. I am writing to seek your esteemed guidance regarding the applicability and nuances of the “grandfather rule” in the Philippines, specifically as it pertains to the ownership and control of corporate entities and related shareholding structures. I am concerned about how this principle might affect a particular venture I am studying, especially in light of foreign ownership restrictions, layered shareholding, and corporate compliance with Filipino laws. As I am a private individual aiming to fully understand my rights and obligations, I would be grateful for any clarification or advice you may offer regarding the extent and application of the grandfather rule under Philippine law.

Thank you in advance for your kind attention to this matter. I look forward to any insights you can provide. Your professional input will be invaluable as I navigate these concerns.

Sincerely,
A Concerned Citizen

INTRODUCTION

The grandfather rule, a principle deeply rooted in Philippine corporate and investment law, has long guided how ownership structures of companies are scrutinized under the country’s legal framework. This rule becomes especially relevant when determining compliance with constitutional or statutory foreign ownership limitations. The rule essentially aims to “look through” or “pierce” intermediate corporate layers and investigate the real or beneficial ownership of corporate shares. Through this legal lens, regulators and the courts can determine whether foreign equity in a company exceeds allowable thresholds under existing laws and regulations.

This article provides an exhaustive treatment of the grandfather rule in the Philippines, including its origins, evolution, legal basis, interplay with other relevant regulations (e.g., the Control Test and the Layering Test), practical applications, and significant jurisprudence. In analyzing these aspects, readers will gain a clear understanding of the relevance of the grandfather rule, how it influences foreign equity ownership, and what legal practitioners and corporate entities need to consider when structuring investments to comply with Philippine requirements.

HISTORICAL BACKGROUND

The grandfather rule traces its conceptual roots to the idea of ensuring that constitutional and legal limitations on foreign ownership—especially in nationalized or partially nationalized industries—are not circumvented by sophisticated corporate structuring. The Philippine Constitution prescribes foreign ownership limitations in certain sectors. For instance:

Land ownership is restricted to Filipino nationals (subject to exceptions for condominium units and long-term leases under specified conditions).
Public utilities may only be operated if at least 60% of the capital is owned by Filipinos.
Mass media is fully restricted to Filipino nationals except for recording or certain specialized print media forms.

These restrictions aim to protect national interests and preserve key sectors for Filipino citizens, reflecting the core policy of the state to ensure control over strategic resources and industries. Over the decades, the problem arose that some foreign investors sought to circumvent these restrictions by establishing layered corporate structures. A foreign investor might hold shares in a Philippine corporation through another domestic entity or sets of shell corporations, each purportedly meeting the 60%-40% Filipino-foreign ratio. Beneath the surface, however, actual control might rest with foreign interests—contrary to the Constitution’s intent.

In response, the concept of the grandfather rule emerged to ensure that the law looked beyond the superficial layering of shares. By “grandfathering,” the rule determines the real beneficial ownership and the ultimate controlling stake in a corporation to ascertain compliance with statutory ownership caps. The rule thus embodies the principle that the final ownership composition, when all intermediate layers are disregarded, must not exceed the permissible foreign ownership threshold.

LEGAL BASIS AND FRAMEWORK

1. Constitutional Provisions

The 1987 Philippine Constitution is the supreme law guiding foreign equity restrictions. Relevant sections, such as Article XII (National Economy and Patrimony), impose limitations on foreign ownership in certain industries. While these provisions are broad, they have been elaborated upon through statutes and administrative regulations. The Constitution’s language—particularly for industries like utilities, media, and educational institutions—makes it imperative to identify the ultimate beneficial owners of Philippine corporations engaged in such sectors.

2. Statutory Law

Several laws reinforce the constitutional mandate and illustrate the application of ownership restrictions. Examples include:

Commonwealth Act No. 146 (Public Service Act), as amended, restricting foreign ownership of public utilities to a maximum of 40%.
Republic Act No. 7042 (Foreign Investments Act of 1991), as amended by RA 8179 and RA 11647, which provides the Foreign Investment Negative List, detailing which industries are subject to foreign ownership caps.
Republic Act No. 7652 (Investor’s Lease Act), setting forth limitations on land leases by foreign investors.
Corporate Code of the Philippines (Batas Pambansa Blg. 68), replaced by the Revised Corporation Code of the Philippines (Republic Act No. 11232), which outlines rules for determining capital stock ownership and clarifies the definition of outstanding capital stock for purposes of compliance.

3. Administrative Regulations and Guidelines

Regulatory agencies, such as the Securities and Exchange Commission (SEC) and the Department of Justice (DOJ), have issued opinions and circulars clarifying the application of foreign ownership tests. The SEC, in particular, plays an essential role in verifying the composition of stockholdings within corporations, ensuring that the 60%-40% ratio of Filipino to foreign equity is not violated. Certain guidelines describe not only the formalistic approach of share enumeration but also the deeper, “look-through” approach if the structure suggests potential circumvention of the law.

CORE PRINCIPLES OF THE GRANDFATHER RULE

At its simplest, the grandfather rule requires one to look at the ultimate beneficial owners of a corporation’s shares. While there are various ways to articulate it, the fundamental question is: “Who truly owns or controls each layer of shares in the corporate chain?” The application of the rule may differ slightly in scope depending on the facts and the relevant regulatory pronouncements. Generally, two tests are discussed:

Control Test: This test, at times referred to as the “Liberality Rule,” merely checks whether the immediate shares of the corporation are held at least 60% by Filipinos and no more than 40% by foreigners. If the immediate shareholding meets the 60%-40% test, further layers might not necessarily be scrutinized.
Grandfather Rule: This is the more stringent approach, focusing on the ultimate beneficial ownership and control of corporate shares. In applying the grandfather rule, each layer of corporate ownership is dissected. If a supposed “Filipino” holding corporation itself has foreign equity beyond permissible limits, the portion of that corporation’s shares that can truly be classified as “Filipino” may be proportionally discounted.

The best analogy is the creation of a genealogical chart of shareholding “ancestry.” If you keep tracing the parent entities until you reach the ultimate individuals or uncontested local/foreign split, you will arrive at the “grandfathered” composition of the corporation. If, after this process, the foreign equity is found to exceed 40%, the structure violates the foreign ownership restriction.

RELEVANT JURISPRUDENCE

One of the pioneering cases that clarified these principles was Gamboa v. Teves, G.R. No. 176579 (2011), which examined how voting shares and beneficial ownership must be calculated in the context of public utilities. While the Supreme Court of the Philippines ultimately favored a more formalistic test in certain aspects, the language also reaffirms that the spirit of the constitutional restriction is to ensure genuine Filipino control, not merely nominal shareholding.

Another important case is Narvasa v. Court of Appeals, in which the Supreme Court recognized that mere compliance with the 60%-40% ratio on paper does not automatically guarantee compliance with the Constitution if the control or beneficial interest is effectively vested in foreigners. The courts have consistently underscored that substance takes precedence over form.

In SEC Opinions, numerous illustrations exist wherein potential circumvention attempts, such as the layering of capital or the creation of preferred shares with disproportionate voting rights, were struck down if, in the final analysis, foreign interests retained de facto control. The SEC examines all relevant circumstances to ensure compliance with statutory and constitutional provisions.

ILLUSTRATIVE EXAMPLE OF GRANDFATHER RULE APPLICATION

To demonstrate how the grandfather rule might apply, consider the following hypothetical structure:

Corporation X is engaged in an industry subject to a 60%-40% foreign ownership limit.
Corporation X is owned 60% by Corporation A (purportedly Filipino) and 40% by a foreign investor, F.
Corporation A, however, is 70% owned by Filipinos, and 30% owned by another foreign investor, G.

At first glance, looking solely at Corporation X might suggest that the foreign ownership requirement is satisfied (40% foreign, 60% Filipino). But using the grandfather rule, you look at Corporation A’s composition. Since Corporation A itself is 70% Filipino, only that 70% portion of Corporation A’s ownership is truly Filipino, while 30% is foreign. Thus, if Corporation A owns 60% of Corporation X, only 42% of Corporation X (i.e., 60% × 70%) is validly considered Filipino-owned. The foreign portion for Corporation X must then be recalculated to factor in Corporation A’s foreign ownership. Ultimately, you might find that the effective foreign ownership in Corporation X is not actually 40% but higher, possibly exceeding 40% depending on how the arithmetic pans out once all layers are accounted for.

This “look-through” analysis is the foundation of the grandfather rule, ensuring that superficial compliance cannot mask a deeper or more significant foreign stake.

RATIONALE AND POLICY CONSIDERATIONS

Protection of Strategic Industries: By not merely accepting the “four corners” of a corporate share certificate and requiring an in-depth look at corporate layering, the State ensures that strategic industries remain under genuine Filipino control.
Prevention of Circumvention: Foreign investors may be tempted to engage in creative structuring to bypass limitations. The grandfather rule aims to thwart such efforts, preserving the Constitution’s policy objectives.
Legal Certainty and Fair Competition: The consistent application of the rule promotes a level playing field for all investors, local or foreign, within industries with strict ownership ceilings.
Clarity for Stakeholders: As the father of the “layered approach,” the rule clarifies how shareholding computations are made, which in turn gives guidance to companies seeking to ensure compliance or to foreign investors who want to invest in partially nationalized industries.

COMPARISON: CONTROL TEST VS. GRANDFATHER RULE

A frequent point of confusion is the distinction between the “Control Test” (sometimes also called the “Liberal or Simple Test”) and the “Grandfather Rule”:

Control Test: This method is a straightforward percentage-based approach applied to the immediate shares that investors hold in a corporation. So long as the direct ownership structure stays within the 60%-40% ratio, it may be accepted as compliant without further inquiry. This test was favored in certain older interpretations, partly to encourage foreign investment by creating a simpler compliance mechanism.
Grandfather Rule: In contrast, the grandmother/father rule digs into all layers of ownership. This approach is more conservative and more effectively upholds the original intent of the constitutional provisions on foreign ownership. It is generally considered the gold standard for verifying the ultimate composition of foreign investment in sensitive industries.

While older SEC Opinions seemed to lean more heavily on the Control Test, subsequent jurisprudence, particularly in the context of high-value or sensitive industries, underscores the necessity of applying the grandfather rule if there are indications of potential circumvention. Thus, in practice, the controlling standard in many borderline cases tends to be the stricter one—especially if the corporation is engaged in industries explicitly restricted by the Constitution.

KEY STEPS IN APPLYING THE GRANDFATHER RULE

Identify the Constitutionally or Statutorily Restricted Industry: Determine whether the corporation is engaged in an industry with specific foreign ownership caps.
Examine the Immediate Shareholding: Look at the corporation’s record of shareholdings to see if, on paper, the ownership structure meets the 60%-40% or other prescribed ratio.
Dig Deeper: If there is any suspicion that the direct shareholdings do not reflect the true beneficial owners, trace the ownership layers. This includes checking for:
- Other corporations owning shares.
- The composition of those corporations’ shareholders.
- Sub-corporations, sub-subsidiaries, or holding companies that lead eventually to the ultimate individual shareholders.
Compute Effective Shareholding: Multiply the percentages at each level to identify the “true” or “ultimate” foreign-owned portion of the subject corporation.
Determine Compliance: If the final result shows foreign equity exceeding the permissible ratio, the structure is deemed non-compliant, potentially subject to sanctions or forced divestment.

COMMON PITFALLS AND BEST PRACTICES

Mislabeling or Masking True Ownership: One pitfall is placing shares under nominal Filipino shareholders who are effectively acting as trustees for foreign beneficiaries. This practice is fraught with legal risks and may result in the corporation facing enforcement actions.
Preferred Shares with Varying Voting Rights: Some corporations create classes of shares that vest disproportionate voting power in foreigners, even if the nominal ownership percentages appear to comply. Regulators and courts will look at this arrangement skeptically, often applying the grandfather rule to uncover whether effective control remains in foreign hands.
Failure to Monitor Ongoing Compliance: Even if the corporation was initially set up in compliance with the restrictions, changes in the shareholding structure over time (e.g., transfers or expansions) might lead to inadvertent violations. Regular audits of the ownership structure are advised.
Underestimating the SEC’s Stance: Companies sometimes assume that the SEC will not apply the strict approach. However, the risk remains that, upon investigation or complaint, the regulator could apply the grandfather rule. Businesses should plan accordingly and structure their shareholdings in good faith.
Professional Advice: Because of the complexity of layered structures and potential legal exposure, seeking early professional advice—both legal and accounting—is essential. This helps mitigate the risk of inadvertent noncompliance and reputational harm.

RECENT DEVELOPMENTS AND THE FUTURE OF THE GRANDFATHER RULE

In recent years, various legislative amendments have been introduced to relax certain foreign ownership restrictions, especially in the context of the Philippine economy’s need for increased foreign capital. Notable are the amendments to the Public Service Act (through Republic Act No. 11659) and the Retail Trade Liberalization Act, which have opened the door to a more extensive foreign participation in certain sectors. However, these reforms do not entirely negate the constitutional constraints for public utilities and other strategic industries.

The Supreme Court and the SEC continue to navigate the tension between attracting foreign investment and preserving Filipino national interests. The grandfather rule remains a potent tool in balancing these objectives. The rule is likely to persist, especially for industries considered central to national sovereignty or public interest.

ILLUSTRATION: “IMAGE ILLUSTRATION PO NG GRANDFATHER RULE”

For purposes of a visual illustration (though described textually here), imagine a corporate ownership chart:

Foreign Investor (F1)                  Filipino Investor (P1)
                    |                                 |
              50%   |                                 |   50%
                    v                                 v
                Holding Co. A (70% F1, 30% P1)    Holding Co. B (100% P2)
                    |                                 |
              60%   |                                 |   40%
                    v                                 v
                    Target Corporation (T)

On the surface, the Target Corporation (T) is owned 60% by Holding Co. A and 40% by Holding Co. B, which might look like compliance with a hypothetical foreign ownership limit of 40%. A deeper look, however, reveals that Holding Co. A is itself 70% foreign-owned. Hence, only 30% of that 60% can be “grandfathered” as Filipino. By multiplying:

60% (Holding Co. A’s share in T) × 30% (Holding Co. A’s Filipino portion) = 18% effectively Filipino in T from Holding Co. A
The remaining 42% in T from Holding Co. A is effectively foreign-owned
With Holding Co. B being purely Filipino (for this illustration), that 40% is 100% Filipino

Thus, T’s final tally is:

18% Filipino (from Holding Co. A)
42% Foreign (from Holding Co. A)
40% Filipino (from Holding Co. B)

Summing these, T ends up with 58% Filipino and 42% Foreign—exceeding the maximum allowable limit of 40% foreign under the Constitution for that industry. Therefore, T is non-compliant. This example underscores how the grandfather rule recalculates the final foreign shareholding of each ownership layer.

ENFORCEMENT AND PENALTIES

Where the SEC or other government agencies discover a violation of foreign equity limitations, the following consequences may ensue:

Administrative Fines: The SEC can impose monetary penalties against non-compliant corporations.
Revocation of Certificate of Incorporation: In extreme or willful cases, the SEC may revoke the corporation’s primary franchise.
Forced Divestiture: The foreign investor might be required to divest shares to Filipino nationals within a prescribed period to bring the entity back into compliance.
Civil or Criminal Liability: If the violation involves fraudulent acts—like falsifying documents or using dummies—liability may extend beyond administrative penalties, potentially leading to criminal charges.

STRATEGIC CONSIDERATIONS FOR BUSINESSES AND INVESTORS

Upfront Structuring: For foreign investors, meticulous planning at the outset—ensuring that each layer of a planned corporate structure legitimately meets the local ownership requirement—avoids compliance headaches later.
Periodic Review: Corporate structures should be revisited periodically, especially if new investors come in, existing investors leave, or if there are expansions or reorganizations.
Legal and Accounting Advice: Collaboration between legal counsel and accounting professionals is vital to assess the “look-through” shareholding structure.
Documentary Transparency: Proper documentation of share transfers, shareholder agreements, and corporate records is crucial. This fortifies the corporate position if the SEC or courts scrutinize the arrangement.

PRACTICAL TIPS FOR FILIPINO COMPANIES AND FOREIGN PARTNERS

Maintain a Genuine Filipino Majority: If your venture operates in a sector subject to 60%-40% ownership rules, ensure that the Filipino partners not only hold majority equity on paper but also exercise genuine control (e.g., representation in the board of directors, day-to-day management, operational oversight, and so on).
Avoid Nominee Arrangements: Using Filipino nominees or dummies is a legally risky route. These arrangements are prone to legal challenge, and courts tend to void them if discovered.
Check the Negative List: Before structuring any investment, consult the Foreign Investment Negative List published by the government to verify the precise allowable percentages.
Be Wary of Overly Complex Layers: Excessive layering might signal attempts to evade the rules, which can provoke stricter scrutiny from regulators.
Obtain Clarificatory Opinions: When in doubt, requesting an SEC Opinion can provide clarity on specific ownership structures.

CONCLUSION

The grandfather rule in the Philippines is a critical principle ensuring that the country’s constitutional and statutory restrictions on foreign ownership are genuinely upheld. By looking through each layer of corporate ownership, the rule prevents nominal structures from subverting the policy goals embedded in the Constitution—namely, the preservation of essential industries for Filipino nationals. In contrast to the simpler Control Test, the grandfather rule imposes a stricter, more transparent method of scrutinizing ownership compositions.

For legal practitioners, investors, and businesses, understanding the grandfather rule is essential to structuring compliant investments in restricted sectors. By tracing ownership to the ultimate beneficial owners, the rule brings clarity to complex shareholding arrangements and helps maintain the integrity of laws regulating foreign participation in the Philippine economy. Although legislative reforms may relax certain restrictions in the future, the fundamental purpose and function of the grandfather rule remain highly relevant, particularly in industries deemed strategic or imbued with public interest.

Ultimately, navigating the grandfather rule requires meticulous diligence, transparency, and professional insight. Whether you are a Filipino entrepreneur ensuring your venture adheres to national requirements or a foreign investor aiming to participate lawfully in Philippine markets, comprehending the intricate details of this rule is vital to achieving long-term stability and legal compliance.

Disclaimer: This article is offered for general informational and educational purposes only. It is not intended as legal advice, nor does it create an attorney-client relationship. Specific questions regarding application of the grandfather rule to your particular circumstances should be directed to qualified legal counsel.