Can Shareholders Challenge Watered Stock Issuances?
Introduction
Shareholders may challenge shares issued to company founders or other investors for less than their par or issued value. Such an issuance is commonly described as watered stock because the corporation receives consideration that is insufficient in relation to the shares issued.
The Revised Corporation Code of the Philippines provides both a rule against watered stocks and civil liability for directors or officers who authorize, consent to, or knowingly fail to object to the unlawful issuance. However, the proper remedy depends on whether the injury was suffered by the corporation as a whole or by a shareholder in an individual capacity.
What Is a Watered Stock Issuance?
Under Section 61 of the Revised Corporation Code, stocks must not be issued for a consideration less than their par value or issued price. Consideration may consist of cash, property, labor performed for the corporation, or other lawful consideration, subject to statutory requirements.
When property is used as consideration, the property must be actually received by the corporation, necessary or convenient for its lawful purposes, and fairly valued at an amount equal to the par or issued value of the shares issued. The valuation is initially determined by the stockholders or board of directors and remains subject to approval by the Securities and Exchange Commission.
An issuance may therefore be considered watered when the corporation receives property or another form of consideration whose fair value is lower than the par or issued value of the shares delivered. The prohibition is concerned with the actual value received by the corporation, not merely the parties’ private valuation.
Governing Law on Watered Stocks
Section 61 of the Revised Corporation Code of the Philippines prohibits the issuance of shares for less than their par or issued price. Section 64 imposes liability on directors and officers who participate in the issuance of watered stocks.
A director or officer may be held liable when that person:
- consents to the issuance of shares for a consideration below the shares’ par or issued value;
- consents to the issuance of shares for noncash consideration valued above its fair value; or
- knows that the consideration is insufficient but fails to make and file a written objection with the corporate secretary.
The liability is solidary with the stockholder concerned for the difference between the value actually received by the corporation and the par or issued value of the shares. This liability is owed to the corporation or its creditors, not automatically to every shareholder individually.
See the Revised Corporation Code of the Philippines and “Ient, et al. v. Tullett Prebon (Philippines), Inc.,” G.R. No. 189158, 27 November 2017.
Can Founders’ Shares Be Challenged?
Founders’ shares may carry rights and privileges that are not available to other shares. Section 7 of the Revised Corporation Code permits these special rights, subject to statutory limits.
Special rights attached to founders’ shares do not authorize an issuance below the shares’ lawful par or issued value. A share issuance may still be attacked if the corporation received insufficient consideration, if the stated property valuation was inflated, or if the transaction unlawfully altered the corporation’s capital structure.
Founders’ shares also cannot be used to evade restrictions under the Anti-Dummy Law, the Foreign Investments Act, constitutional limitations, or other applicable laws. Any special voting right over the election of directors must also comply with the period and statutory restrictions imposed by the Revised Corporation Code.
What Civil Action Should a Shareholder File?
The proper action generally depends on the nature of the injury. If the alleged watered issuance diminished the corporation’s assets, diluted the corporation’s capital structure, or injured all shareholders collectively, the corporation is ordinarily the real party in interest.
In that situation, the shareholder should ordinarily bring a derivative suit on behalf of the corporation, subject to the applicable requirements for derivative actions. The corporation must generally be included as an indispensable party because the relief sought belongs to the corporation.
A shareholder ordinarily may not pursue a personal action merely because the value or percentage of the shareholder’s investment was reduced by the alleged issuance. The wrong must be distinct and personal to that shareholder before an individual action may be proper.
In “Florete, Jr., et al. v. Florete, et al.,” G.R. No. 174909, 28 January 2016, the Supreme Court treated claims involving the issuance of shares, the corporation’s capital structure, and the liability of directors for watered stocks as injuries to the corporation itself. The Court held that such claims are generally pursued through a derivative action rather than an individual or class suit.
Action for Nullity of the Share Issuance
A shareholder may seek the declaration of nullity of an issuance when the shares were issued in violation of the Revised Corporation Code, the articles of incorporation, the bylaws, or other applicable legal requirements.
The relief may include cancellation of the unlawfully issued shares, restoration of the corporation’s prior capital structure, and other appropriate orders. The court must examine the actual transaction, including the consideration received, the valuation process, the authority of the approving corporate bodies, and the effect of the issuance on the corporation and its shareholders.
A case seeking to annul shares, dissolve a corporation, or appoint a receiver is generally an action incapable of pecuniary estimation when the principal relief is not the recovery of a specific sum of money. The fact that monetary consequences may follow does not necessarily convert the action into one for collection.
In “Lu v. Lu Ym, et al.,” G.R. No. 153690, 15 August 2011, the Supreme Court characterized an action for the declaration of nullity of a share issuance, receivership, and dissolution as incapable of pecuniary estimation because the principal relief concerned the validity of the corporate acts rather than the recovery of money.
Derivative Suit Versus Individual Action
| Type of injury | Usual remedy |
|---|---|
| The corporation received property worth less than the shares issued | Derivative action on behalf of the corporation |
| The issuance diluted the ownership of shareholders generally | Derivative action or other appropriate corporate remedy |
| A shareholder’s separate contractual or statutory right was personally violated | Individual action, if the facts establish a direct injury |
| The issuance violates the articles, bylaws, or corporate authorization requirements | Action to annul or invalidate the issuance, ordinarily involving the corporation |
The distinction is important because filing the wrong type of action may result in dismissal. A complaint that seeks to restore the corporation’s capital structure but excludes the corporation as a party may fail for lack of a proper cause of action or for failure to implead an indispensable party.
Who May Be Held Civilly Liable?
The corporation may pursue recovery against directors, officers, and the stockholder who participated in the watered issuance, subject to proof of the statutory elements. The recoverable amount is generally the difference between the fair value received and the par or issued value of the shares.
Directors and officers may avoid liability based on their written objection only if the objection was made upon knowledge of the insufficient consideration and filed with the corporate secretary in the manner required by law. Silence or passive participation may expose a responsible director or officer to solidary liability.
The statutory liability is civil in character. In “Ient, et al. v. Tullett Prebon (Philippines), Inc.,” G.R. No. 189158, 27 November 2017, the Supreme Court explained that provisions imposing specified civil consequences on directors and officers do not, by themselves, create criminal liability under the general penal provision of the Corporation Code.
Evidence Needed to Challenge the Issuance
A shareholder considering an action should obtain documents showing the terms and approval of the issuance. The following records are commonly important:
- the articles of incorporation and amendments;
- the corporation’s bylaws and share classifications;
- board and stockholder resolutions approving the issuance;
- subscription agreements and certificates of stock;
- proof of payment or delivery of the property used as consideration;
- appraisals, valuation reports, and financial statements; and
- the corporation’s stock and transfer books and SEC filings.
The evidence should establish both the value of the consideration actually received and the legal or corporate value assigned to the shares. A mere allegation that the founders received an unfair advantage may be insufficient without proof of an unlawful issuance or a specific violation of corporate law.
Property-for-Share Issuances
Property may lawfully be used as consideration for shares, but the transaction must satisfy the requirements of the Revised Corporation Code. The corporation must actually receive the property, and the property must be necessary or convenient for the corporation’s lawful purposes.
The property must also be fairly valued at an amount equal to the par or issued value of the shares. The valuation should be supported by reliable records and must comply with applicable SEC requirements. An inflated valuation may create watered stocks even when the transaction is documented as a property contribution.
The SEC has emphasized that a corporation cannot treat partial delivery of the agreed consideration as substantial compliance when the result would be an issuance below the shares’ issued price. In SEC Admin Case No. 10-10-216, 2019, the SEC treated the failure to transfer the full agreed property consideration as a basis for preventing the issuance of watered stock.
Typical Scenarios
Property Contributed at an Inflated Value
A founder transfers land represented to be worth ₱20 million and receives shares with an issued value of ₱20 million. If the land’s fair value is only ₱12 million, the issuance may be watered by ₱8 million, subject to proof and the applicable corporate approvals.
Shares Issued Without Actual Consideration
If shares are issued to a founder but the promised cash or property is never delivered, the corporation may challenge the issuance and seek the corresponding civil remedies. The absence of actual consideration is particularly significant because the corporation has received nothing equivalent to the shares issued.
Partial Property Transfer
If a subscription requires the transfer of several properties but only some are transferred, the corporation should not treat the transaction as fully paid when the value received is below the shares’ issued price. The issuance may expose the approving directors and the recipient stockholder to liability.
Recommended Steps for a Shareholder
- Secure corporate records and identify the exact shares issued, the recipient, and the stated consideration.
- Obtain an independent valuation of the property or other noncash consideration.
- Determine whether the injury is to the corporation generally or directly to the shareholder.
- Demand that the board investigate, correct, or challenge the issuance when appropriate.
- Assess the requirements for a derivative action, including demand and party-joinder requirements.
- Consider an action for nullity, cancellation of shares, accounting, restitution, or damages based on the proven facts.
Care should be taken not to frame a corporate injury solely as a personal claim. The complaint should identify the corporation’s injury, the challenged corporate acts, the responsible directors or officers, the stockholder-recipient, and the specific relief sought.
Conclusion
Shareholders may challenge watered stocks issued to company founders, but the usual remedy is a corporate action brought derivatively rather than a personal claim for dilution. The central inquiry is whether the corporation received consideration equal to the shares’ par or issued value.
Where the issuance is unlawful, the shareholder may seek cancellation or nullity of the shares and recovery of the deficiency for the corporation. Directors and officers who knowingly participate in, approve, or fail to object in writing to the issuance may incur solidary civil liability under the Revised Corporation Code.
Before filing suit, the shareholder should obtain the corporate records, establish the fair value of the consideration, identify the correct parties, and select a remedy consistent with the nature of the injury.
About Nicolas and De Vega Law Offices
Nicolas and de Vega Law Offices is a full-service law firm in the Philippines. You may visit us at the 16th Flr., Suite 1607 AIC Burgundy Empire Tower, ADB Ave., Ortigas Center, 1605 Pasig City, Metro Manila, Philippines. You may also call us at +632 84706126, +632 84706130, +632 84016392 or e-mail us at [email protected]. Visit our website https://ndvlaw.com.
