Corporation Law: The Revised Corporation Code of the Philippines - Sec 31

 THE REVISED CORPORATION CODE  OF THE PHILIPPINES

Republic Act No. 11232 

TITLE III -  BOARD OF DIRECTORS/TRUSTEES AND OFFICE

Section 31.  Dealings of Directors, Trustees or Officers with the Corporation. 

A contract of the corporation with one (1) or more of its directors, trustees, officers or their spouses and relatives within the fourth civil degree of consanguinity or affinity is voidable, at the option of such corporation, unless all the following conditions are present:

(a) The presence of such director or trustee in the board meeting in which the contract was approved was not necessary to constitute a quorum for such meeting;

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

(c) The contract is fair and reasonable under the circumstances;

(d) In case of corporations vested with public interest, material contracts are approved by at least a majority of the independent directors voting to approved the material contract; and

(e) In case of an officer, the contract has been previously authorized by the board of directors.

Where any of the first three (3) conditions set forth in the preceding paragraph is absent, in the case of a contract with a director or trustee, such contract may be ratified by the vote of the stockholders representing at least two-thirds (2/3) of the outstanding capital stock or of at least two-thirds (2/3) of the members in a meeting called for the purpose: Provided, That full disclosure of the adverse interest of the directors or trustees involved is made at such meeting and the contract is fair and reasonable under the circumstances.

1. Self-dealing.

• Self-dealing directors, trustees, or officers are those who personally contract with the corporation in which they are directors, trustees or officers.
• It is discouraged because the directors, trustees, and officers have fiduciary relationship with the corporation, and there can be no real bargaining where the same person/s is/are acting on both sides of the trade.
• "Fidelity in the agent is what is aimed at, and as a means of securing it, the law will not permit the agent to place himself in a situation in which he may be tempted by his own private interest to disregard that of his principal."
•  It was further explained:
• "A director is a fiduciary. So is a dominant or controlling stockholder or group of stockholders. Their powers are powers in trust. Their dealings with the corporation are subjected to rigorous scrutiny and where any of the contracts or engagements with the corporation is challenged the burden is on the director or stockholder not only to prove the good faith of the transaction but also to show its inherent fairness from the viewpoint of the corporation and those interested therein. The essen[c]e of the test is whether or not under the circumstances the transaction carries the earmarks of an arm's length bargain. If it does not, equity will set it aside. Referring directly to the duties of a director of court stated. 'He who is in such a fiduciary position cannot serve himself first and his cesuis second. He cannot manipulate the affairs of his corporation to the detriment and in disregard of the standards of common decency and honesty. He cannot by the intervention of a corporate entity violate the ancient precept against serving two masters. He cannot by the use of the corporate device avail himself of privileges normally permitted outsiders in a race of creditors. He cannot utilize his inside information and his strategic position for his own preferment. He cannot violate rules of fair play by doing indirectly through the corporation what he could not do directly. He cannot use his power for his personal advantage and to the detriment of the stockholders and creditors no matter how absolute in terms that the power may be and no matter how meticulous he is to satisfy technical requirements. For the power is at all times subject to the equitable limitation that it may not be exercised for the aggrandizement, preference, or advantage of the fiduciary to the exclusion or detriment of the cestuis. Where there is a violation of those principles, equity will undo the wrong or intervene to prevent its consummation."

1.01. Status of Contract: Generally Voidable. 

• The contract between the corporation and the self-dealing director, trustee or officer is voidable at the option of the corporation. 
• It is not required that:
• there is intent to defraud
• the contract results in corporate losses
• there is actual damage
• The self-dealing contract is still generally voidable despite the absence of fraud. 
• Actual damage is also not required to make the self-dealing contract voidable. 
• The contract is still voidable although the stockholders and directors are aware that the contract is self-dealing so long as substantive and procedural fairness as required by Section 31 are absent. 

a. Conditions to Make the Contract Valid. 

• However, the contract is valid if the following requirements for its validity are present:
1. The presence of the self-dealing director/trustee in the Board meeting wherein the contract was approved was not necessary to constitute a quorum; 
2. The vote of such director/trustee in said Board meeting was not necessary for the approval of the contract; 
3. The contract is fair and reasonable under the circumstances; 
4. In case of corporations vested with public interest, material contracts are approved by at least two-thirds (2/3) of  the entire membership of the Board, with at least a majority of the independent directors voting to approve the material contract; and 
5. In the case of an officer, there was previous authorization by the Board of Directors or Trustees.
• The law does not consider the contracts void and does not impose more stringent voting requirements because of the following view reflected in the deliberations in the legislature:
• " ... while contracts between corporations and its directors, trustees or officers must be viewed with caution, such contracts are not necessarily undesirable. As a matter of fact, very often, such contracts are to the advantage and benefit of the corporation. It is not a rare occasion where a director or an officer of a corporation decides to enter into a contract with a corporation and agrees on more beneficial terms to the corporation precisely because of the trust relationship."

1.02. Ratification. 

• A safe harbor provision is the provision allowing ratification. 
• Even if not all the requirements are met, the contract with the self-dealing director, trustee or officer may still be ratified by a vote of stockholders representing at least 2/3 of the outstanding capital stock or by the vote of least 2/3 of the members in a meeting called for the purpose.
• In order that ratification may be considered valid and effective, it is however necessary that the following conditions are present:
1. There must be full disclosure of the adverse interest of the directors/trustees involved that is made at the stockholders'/members' meeting;
2.  The contract must be fair and reasonable under the circumstances. 
• Section 31 of the RCCP states that the stockholders or members may ratify the contract even if any one of the first three conditions enumerated therein (see Paragraph 1.0l(a) herein) is absent. 
• This appears to be a clerical error because the third requirement for a valid contract — that is, that the contract is fair and reasonable under the circumstances — cannot be absent. 
• This requirement cannot be absent because of the proviso in Section 31 that for purposes of ratification by the stockholders/members, there must not only be "full disclosure of the adverse interest of the directors or trustees involved" but also, "the contract [must be] fair and reasonable under the circumstances."
• Balinghasay v. Castillo, G.R. No. 185664, April 8, 2015:
• The requirements for the ratification of the contract with the corporation for the operation of ultrasound equipment were not complied with. Hence, the Supreme Court ordered the erring directors to account for and return to the corporation all the income that could have been earned by the corporation due to the operation of the ultrasound equipment. However, in the interest of the principle against unjust enrichment, the directors were allowed to retain ownership of the machine. 

1.03. Fair and Reasonable. 

• Even if the self-dealing director did not vote for the approval of the contract and even if his presence was not necessary for the existence of a quorum, the contract may be considered voidable if it is not fair and reasonable under the circumstances.
•  Fairness typically requires that the transaction reflect terms one would expect in an arm's length transaction, which means generally that a self-dealing director must treat his corporation's interest as his own.
• The director should neither take any advantage from his position on both sides of the transaction nor act in conflict with the corporation's interest to even the slightest extent.
• The burden is on the self-dealing director to prove that the transaction is fair and reasonable.
• Fairness is more encompassing than the adequacy of consideration because it includes the entirety of the transaction.
• "Fair and reasonable" means that there is substantive or intrinsic fairness in the transaction. 
• This involves two aspects:
1. Objective fairness which means that "the self-dealing transaction must replicate an arm's-length market transaction by falling into a range of reasonableness" including the price or consideration;
2. Value to the corporation which means that "the transaction must be of particular value to the corporation, as judged by the corporation's needs and the scope of the business."
• Under this rule, even if the self-dealing director did not vote, the contract is still voidable if the director did not disclose the disastrous consequences of the contract. 
• Disclosure is sine qua non; the efficacy of the approval of the impartial directors is necessarily dependent on the Board's knowledge of all material facts.
• The self-dealing director cannot remain silent, while the rest of the directors are discussing the contract, knowing that there are circumstances that may give rise to the precise evils that may eventually develop.

PROBLEMS:

Leonardo is the Chairman and President, while Rafael is a Director of PL Corporation. On one occasion, PL Corporation represented by Leonardo, and NM Enterprises, a single proprietorship owned by Rafael, entered into a dealership agreement whereby PL Corporation appointed NM Enterprises as exclusive distributor of its products in Northern Luzon. Is the dealership agreement valid? Explain.

No. The dealership agreement is voidable at the option of PL Corporation. The dealership will be considered valid only if the following requirements are present: 

1. The presence of the self-dealing director (Rafael) in the Board meeting approving the contract was not necessary for constituting a quorum for such meeting; 
2. The vote of Rafael at such Board meeting was not necessary for the approval of the contract; and 
3. The dealership contract is fair and reasonable under the circumstances. In the present case, the facts do not indicate that the dealership contract was approved by the Board of Directors of PL Corporation before it was signed or, assuming such approval, that the requirements under the law are present. (1996 Bar)

Pedro owns 70% of the subscribed capital stock of a company which owns an office building. Paolo and Juan own the remaining stock equally between them. Paolo also owns a security agency, a janitorial company, and a catering business. In behalf of the office building company, Paolo engaged his companies to render their services to the office building. Are the service contracts valid? Explain. 

No. The service contracts are not valid; they are voidable at the option of office building company, in which Paolo has nominal interest (only 15% of the outstanding capital stock), as provided in Section 32, in relation to Section 31 of the Revised Corporation Code because they are self-dealing transactions and/or transactions between companies with interlocking directors. While not stated in the facts, since Paolo was able to engage the services of his companies, he is presumably either a Board member or an officer of the office building company. As owner of the service companies, he is also presumably a director thereof. 

Thus, the service contracts are voidable at the option of the office building company, unless all the following conditions are present:

1. The presence of Paolo in the Board meeting in which the contracts were approved was not necessary to constitute a quorum for such meeting;
2.  The vote of Paolo was not necessary for the approval of the contracts; 
3.  The contracts are fair and reasonable under the circumstances; and 
4. In case Paolo is an officer of the office building company, the contracts have been previously authorized by the Board of Directors. 

The contracts may also be ratified by the vote of the stockholders representing at least 2/3 of the outstanding capital stock of the office building company in a meeting called for the purpose where any of the first two conditions mentioned above is absent, provided that the contracts are fair and reasonable under the circumstances and that full disclosure of the adverse interest of the director involved is made at such meeting. (2008 Bar)