Republic of the Philippines

Isabela State University - Roxas Campus

SCHOOL OF AGRICULTURE AND AGRIBUSINESS
Roxas, Isabela

ABM 414: INVESTMENT MANAGEMENT

Chapter 1: THE BASICS OF CAPITAL MARKET

This chapter focuses on introducing the capital market by providing its basic concepts. It starts with
discussing the definition, features and importance of the role of capital market in capital formation and
economic growth of the country. It provides explanations on the language of capital market to help the
students understand more of the topic/subject. It describes the suppliers and users of funds, the
intermediaries between them and the regulators who set and implement the rules of the procedures and
market activities. Moreover, the notion of capital markets and risk-return considerations are discussed.

Generally, at the end of the chapter, the students should be able to visualize or describe the current
state of development of the Philippine stock markets. Specifically, they should be able to define, describe,
and explain the importance of capital market in capital formation and economic growth of the country; to
familiarize the basic language of capital market by giving descriptions to the important groups involved in
capital markets, and explain its notions; and lastly, to distinguish the safe and high risk securities.

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Meaning and Features

Capital markets refer to the venues where funds are exchanged between suppliers of capital and
those who demand capital for use. It is a market which deals in long-term loans, supplying industry with fixed
and working capital and finances medium-term and long-term borrowings of the central, state and local
governments.

Individuals with savings to invest, merchant banks, commercial banks, and non-bank financial
intermediaries such as insurance companies, finance houses, unit trusts, investment trusts, venture capital,
leasing financing, mutual funds, and building societies all contribute to the capital market. Furthermore, there
are issuing houses that do not contribute capital but instead underwrite a company's shares and debentures
and assist in the sale of new issues of shares and debentures.

The capital market functions through the stock exchange market. A stock exchange is a market which
facilitates buying and selling of shares, stocks, bonds, securities and debentures. It is not only a market for
old securities and shares but also for new issues shares and securities. In fact, the capital market is related
to the supply and demand for new capital, and the stock exchange facilitates such transactions.

Importance or Functions of Capital Market

The capital market is critical in immobilizing savings and channeling them into productive investments
for commerce and industry development. As a result, the capital market aids in capital formation and the
country's economic progress.

The capital market acts as an important link between savers and investors. The savers are lenders
of funds while investors are borrowers of funds. The savers who do not spend all their income are called.
“Surplus units” and the borrowers are known as “deficit units”. The capital market is the transmission
mechanism between surplus units and deficit units. It is a conduit through which surplus units lend their
surplus funds to deficit units.

Funds flow into the capital market from individuals and financial intermediaries which are absorbed
by commerce, industry and government. It thus facilitates the movement of stream of capital to be used more
productively and profitability to increases the national income.

Surplus units buy securities with their surplus funds and deficit units sells securities to raise the funds
they need. Funds flow from lenders to borrowers either directly or indirectly through financial institutions such
as banks, unit trusts, mutual funds, etc. The borrowers issue primary securities which are purchased by
lenders either directly or indirectly through financial institutions.

The capital market prides incentives to savers in the form of interest or dividend and transfers funds
to investors. Thus it leads to capital formation. In fact, the capital market provides a market mechanism for
those who have savings and to those who need funds for productive investments. It diverts resources from
wasteful and unproductive channels such as gold, jewelry, real estate, conspicuous consumption, etc. to
productive investments.

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 A well-developed capital market comprising expert banking and non-banking intermediaries brings
stability in the value of stocks and securities. It does so by providing capital to the needy at reasonable
interest rates and helps in minimizing speculative activities.

The capital market encourages economic growth. The various institutions which operate in the capital
market give quantities and qualitative direction to the flow of funds and bring rational allocation of resources.
They do so by converting financial assets into productive physical assets. This leads to the development of
commerce and industry through the private and public sector, thereby inducing economic growth.

In an underdeveloped country where capital is scarce, the absence of a developed capital market is
a greater hindrance to capital formation and economic growth. Even though the people are poor, yet they do
not have any inducements to save. Others who save, they invest their savings in wasteful and unproductive
channels, such as gold, jewelry, real estate, conspicuous consumption, etc.

The Language of Capital Markets

Along with familiarizing investors with the workings of capital markets, it is also critical that they
understand the terminology that specialists in this field use on a daily basis. In fact, even the names used to
characterize these specialists may require some clarification. These participants can be divided into four
categories: (1) fund suppliers, (2) fund users, (3) fund intermediaries, and (4) regulators who define and
enforce the regulations governing procedures and market activities.

The Suppliers of Funds

These suppliers can be individuals, businesses, institutions like life insurance companies and
pension funds, and sometimes even governments. For the sake of convenience, the term investor will be
used to cover all these different parties. The investor has managed to have available funds through savings
and accumulated wealth. In turn, these funds can be utilized, i.e., lent out, in various ways by buying different
forms of real as well as financial assets. Both types of assets represent alternative forms of investments. In
business parlance, terms like lender, financier, and creditor are also loosely substituted for the term investor.
Basically, what the investor is looking for is a return on his assets. This is usually expressed in percentage
terms, called the rate of return for the particular time that the funds are being invested. For example, a six
percent return for six months can be regarded for practical purposes the same as a twelve percent return per
annum. The tem yield is also sometimes used to denote a rate of return. Some investments are not as safe
as others. This is where the risk factor comes in. Some investors are willing to take more risks than others,
but for the most part, investors are said to be risk-averse. Therefore, gamblers and speculators do not fall
under this category since they are generally willing to take considerable risks in their ventures. At this point,
it is evident that there is a need to measure risk.

The Users of Funds

At the opposite side of the investors making investment decisions, we have the borrowers of funds
who have to make financing decisions. Again, borrowers can take various terms; individuals, households,
businesses and most of the time, governments. Individuals can incur cash deficits or shortages, for instance,
when laid off. Businesses, particularly those in highly seasonal operations, would need financing for the
buildup of inventories. Governments face the perennial problem of matching highly unstable patterns of
disbursements for operating and capital expenditures with regularized patterns of revenue collection.

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 To be able to compete and bid for the available funds in the markets, the users of funds have to
make financing decisions. The elements of these decisions are not much different for individuals, businesses,
and governments. All borrowers need to have as much information as possible to be able to borrow at the
best possible terms. To achieve this objective, the borrower has to go and study the offerings in the capital
markets, in much the same way that a shopper goes to a department store. As a matter of fact, it would not
be too ridiculous to describe the capital markets as a department store for different kinds of funding. We
might even imagine that each floor in the department store represents a range of costs of borrowing and
caters to certain types of risk categories of shoppers. From the point of view of investors, each floor
represents a certain risk-return category. As the investor goes up each floor, he expects a higher return on
his investment, but is also willing to assume additional risks in turn. This is what meant by the term risk-return
trade off.

Just as the capital markets serve to bring suppliers and users of funds together, they also provide
the means by which the lenders transform their funds into financial assets, and the borrowers receive these
funds now considered as their financial liabilities. The transfer of funds is represented by a security, i.e., a
legal contract that specifies the terms of the transfer – the rate of return for the lender (the cost of financing
that borrowers view point) and the time period that the borrower can use the principal amount. The latter is
called the maturity of the financial instrument. This can range from as short as one-day for banks borrowing
from other banks to some bonds and mortgages that mature in thirty years.

Like any market mechanism, transactions in capital markets are made when the rate of return that
investors ask for equals the cost of financing that borrowers are willing to pay. This market rate reflects the
cost of funds, or simply, the interest rate. Money has a price like any other commodity, and that price is the
interest rate. Since money can be borrowed and lent for different time periods, we can therefore say that 30-
day money will have a different price than, say, 30-year money. In a highly developed capital market, one
can find a continuous stream of securities for any maturity period. Since interest rates move all the time, a
knowledge of what factors affect their movements becomes a necessity for both borrower and lender of funds.

Expectations as to upwards, downwards, or stationary movements of interest rates make timing a

very significant factor in financing, as well as in investment decisions. Sometimes a borrower can get locked
in, in a very high interest rate loan. Therefore, flexibility is another consideration that both borrowers and
lenders take into account in arriving at their financing and investment decisions.

The Financial Intermediation Process

In any economy, there will be differences in the economic behavior of people, businesses and
governments. Some tend to spend more, some tend to save more. Even when we focus on one economic
unit, say, a business firm, it may have a deficit for some months in its business cycle, and then generate
surpluses for the rest of the year. The same goes for an individual – a person may be liquid at times, hard
pressed in others.

Such differences in savings and consumption patterns, give rise to the need for what is termed as
financial intermediation. Simply put, this term refers to those institutions that bring investors and borrowers
together in an impersonal market setting. The most common financial institution is a bank. The bank solicits
savings and other available funds from economic units that do not need them at the time. After accumulating
these funds, the bank then proceeds to lend out a portion of these funds to other economic unit who need
these funds and are willing to pay the appropriate borrowing cost. At a very basic level, this intermediary level
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of banks provides a service. Most people would think twice before lending directly to their friends because of
the risk of nonpayment and possibly the loss of friendship. To avoid this, most people are willing to get a
smaller rate of return on their bank deposits. Indirectly, they allow the banks to lend out these funds to people
they do not know, or care to know. With this service, the bank absorbs the risk of a loan default, and for this
service, the bank charges a certain amount called the spread. This is the difference between the bank’s
lending rate to bank borrowers and the deposit rate the bank pays its depositors. The other important
foundation for the existence of banks is that depositors have confidence in the bank’s ability to manage the
risks it is taking on in extending loans to borrowers. Once this confidence gets shattered, then the depositors
will prefer to transfer their funds somewhere else, say, to another bank. When this loss of confidence occurs
for the majority of depositors, there will be a bank run. This can very well jeopardize the bank's future
operations, or even its outright existence. To ensure that such disasters do not occur, banks are periodically
supervised and monitored by the Central Bank.

Most individuals and households can go through life dealing with a savings or a commercial bank on
a very basic level, that is, opening savings and/or checking accounts. Sometimes, they might apply for a
personal loan for a car or a mortgage loan for a house. Then there are also those individuals and households
who are not satisfied with what they can earn on bank deposits. They are willing to take on some more risk
in exchange for the prospect of getting a higher return on their funds. These people might put part of their
available funds in other areas like the stock market, or in government treasury bills (T-bills hereafter),
corporate obligations called commercial paper, and other money market instruments.

If we move from individuals to businesses and governments, then definitely these economic units
would have needs that banks cannot wholly satisfy. For instance, a business firm might use funds on very
short notice, or it might already have used up its credit limits in its banks. What all these lead up to is the
need for a broader range of financial services that even a full-service or universal bank can no longer fulfill.

This need gives rise to what we have referred to as the capital markets. The Philippines like most
economies has capital markets - where it differs from advanced countries is the degree of development of
these markets.

There are of course different types of banks, e.g., savings banks, commercial banks, rural banks,
development banks and investment banks. The latter does not deal in deposit taking. Instead, it performs
specialized functions of underwriting new equity issues of business corporations.

Aside from these banks, there are other financial intermediaries. The following list describes briefly
their individual characteristics:

1. Credit unions - these are relatively small consumer institutions owned entirely by their members.
Basically this is an example of economic units pooling together to enable members to achieve better
terms than those offered by banks, whether on the borrowing or lending side.

2. Pension funds - these could be private or public. Funds are collected from the working force and
disbursed to those who have retired after contributing to the fund during their working period. The
GSIS and SSS are prime examples of pension funds.

3. Finance companies - these cater to consumers and small businesses that do not have good access
to commercial banks. They can also offer specialized services to facilitate the purchase of consumer
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 goods through financing installment plans. Compared to banks, finance companies are considered
to be riskier; hence they provide higher returns to creditors and higher costs to borrowers.

The Notion of Capital Markets

Capital markets refer to all those institutions where financial instruments, called securities are traded
at some particular rate of return at varying levels or degrees of risk. Capital markets can either be primary or
secondary. Primary markets refer to the issuance of new securities which in turn represent an actual transfer
of funds from the investor to the issuer of the new security. Secondary markets refer to the trading of
outstanding, i.e., already-issued securities. Stock markets handle secondary issues for the most part but
primary issues, commonly referred to as IPO's (initial public offering) are also handled from time to time.

As a matter of fact, the economic rationale for the existence of stock markets is to provide
corporations which are listed and which trade in stock markets ready access to raising further additional or
new capital. All these corporations have to do is to issue new shares (in addition to its present amount of
outstanding shares) and the value of these new shares will be readily determined by market forces of supply
and demand for this particular corporation. On the other hand, an unlisted and untraded corporation can also
raise new equity capital if and when it wants to but the price of this additional capital has to be arrived at in
an indirect and inefficient manner. This is where an investment bank comes in. Its function is to estimate the
market value of this block of new equity.

There are also those companies which are just starting to open up to public ownership. These
companies usually also hire an investment bank to underwrite their initial public offering (IPO). The stock's
price is set by the investment bank. Once this stock starts trading in the stock exchange, market forces take
over and the success of this IPO depends mainly on how close the initial price set by the investment bank is
to what the market deems the stock is worth in the first months of trading.

The stock market's main activity is that of a secondary market where outstanding shares are bought
and sold in a continuous manner. This is why a stock market is also called a stock exchange. When an
investor buys Meralco shares, the funds do not go to Meralco anymore. Instead, it goes to the previous owner
of this particular Meralco shares. It is only when Meralco decides to issue additional new shares that Meralco
will receive the proceeds of the new stock issue.

Philippine corporations can also raise new funds by issuing bonds, i.e., long-term obligations that
promise to pay a predetermined interest rate for the duration of the bond. However, there is no secondary
bond market here for outstanding bonds, another reason why Philippine capital markets are said to be
underdeveloped. One of the requirements of an active secondary bond market is that the outstanding bond
issues should be rated in terms of the financial health of the bond issuer. Internationally, these ratings are
made by highly reliable credit agencies like Moody's or Standard and Poor. They give ratings not only for
private corporations but also for different governments, not just countries, but even states and municipalities.
Because of government participation, the bond market in North America is significantly larger than the stock
market in terms of the value of securities traded every year.

What the Philippines has is an active money market where government securities, called T-Bills and
corporate securities, called commercial papers, are traded. These markets are always competing with the
stock exchange to attract available funds within the economy. For instance, when interest rates go up, some
investors in the stock market may sell their shares to transfer their funds to interest-earning securities in the
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money markets. The latter are also called fixed-income securities because they provide a guaranteed rate of
return for the duration that funds are lent out. Thus, when an investor buys, say, 4% p.a. T-Bill for ninety
days, that investor is assured that at the end of ninety days, his funds will have earned the guaranteed rate
of return.

Risk-Return Considerations

Even an ordinary small time individual investor recognizes the wisdom of not putting all the eggs in
one basket. Most investors try to spread their funds to buy different stocks, or combine these stocks with
interest-bearing securities. This process is called diversification. By diversifying one's investments, the
combined riskiness of all this combination of assets is said to be reduced. This process constitutes a whole
field of study in finance, called portfolio management. A portfolio is simply any combination of assets. To
achieve a certain desired or target rate of return for a given period, a managed portfolio is always under
review for possible changes in its components. Big time investors, i.e., institutions like pension funds, mutual
funds, life insurance companies, commercial banks, etc., make their portfolio decisions based on certain
criteria. For instance, they may want to achieve a certain target rate of return subject to the level of risk
acceptable to them. Whether they achieve this or not is a measure of the ability of their portfolio managers
to "outperform" the market.

In terms of their risk-return characteristics, stocks are generally regarded as high-return, high-risk
securities. Within this group there are "safer" securities like public utilities and "high-flying" securities like oil
exploration shares. On the other hand, T-bills are zero risk, fixed-return securities. Normally, their returns
should be lower than those expected of stocks, considering the latter's riskiness. A very notable exception to
this rule occurred in the dying years of the Marcos dictatorship. At that time the Central Bank issued T-bills
paying as much as 40% p.a.! Of course, this is a highly anomalous situation, since nobody would even bother
to run a business if one's business cannot earn more than 40% p.a., not to mention the risks involved in
conducting the business.

Aside from the types of securities that have been discussed, another distinguishing feature of a highly
developed financial center like New York is the presence of a whole gamut of financial securities. There are
hybrid securities like convertible bonds, preferred shares, convertible preferred shares, warrants, rights,
mortgage-backed securities, options and futures. The latter two terms have their own markets which have
both witnessed tremendous growth in the last two decades.

 Convertible bonds are corporate bonds that can be exchanged for common stock in the issuing
company.
 The term "stock" refers to ownership or equity in a firm. There are two types of equity—common
stock and preferred stock. Preferred shareholders have priority over common stockholders when it
comes to dividends, which generally yield more than common stock and can be paid monthly or
quarterly. Preferred stock combines feature of debt, in that it pays fixed dividends, and equity, in that
it has the potential to appreciate in price. This appeals to investors seeking stability in potential future
cash flows.
 Convertible preferred shares can be converted into common stock at a fixed conversion ratio. Once
the market price of the company's common stock rises above the conversion price, it may be
worthwhile for the preferred shareholders to convert and realize an immediate profit. After a preferred

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 shareholder converts their shares, they give up their rights as a preferred shareholder and become
a common shareholder.
 Warrants are a derivative that give the right, but not the obligation, to buy or sell a security—most
commonly an equity—at a certain price before expiration. Warrants are long-term instruments that
also allow shareholders to purchase additional shares of stock at a discounted price, but they are
typically issued with an exercise price above the current market price. A waiting period of perhaps
six months to a year is thus assigned to warrants, which gives the stock price time to raise enough
to exceed the exercise price and provide intrinsic value.
o Call Warrants are warrants that give the right to buy a security
o Put Warrants are those that give the right to sell a security
 A rights issue is an invitation to existing shareholders to purchase additional new shares in the
company. This type of issue gives existing shareholders securities called rights. With the rights, the
shareholder can purchase new shares at a discount to the market price on a stated future date.
 A mortgage-backed security (MBS) is an investment similar to a bond that is made up of a bundle of
home loans bought from the banks that issued them. Investors in MBS receive periodic payments
similar to bond coupon payments.
 Options are based on the value of an underlying security such as a stock. As noted above, an options
contract gives an investor the opportunity, but not the obligation, to buy or sell the asset at a specific
price while the contract is still in effect. Investors don't have to buy or sell the asset if they decide not
to do so.
o Call Option is an offer to buy a stock at the strike price before the agreement expires
o Put Option is an offer to sell a stock at a specific price
 A futures contract is the obligation to sell or buy an asset at a later date at an agreed-upon price.

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 Chapter 2: STOCK MARKET RULES AND
CONVENTIONS

This chapter introduces the reader to the fundamental aspects of investing in the Philippine stock
market. It discusses the important role of the stock market, the function of the stock exchange, the role of
stockbrokers, the investors in the stock market and the mechanics of investing and trading in stocks.

Generally, at the end of the chapter, the students should be able to define securities and securities
markets; familiarize the types of securities markets; describe the role of the banker; explain stock market and
their types, and the stock market regulation; and identify the types of brokerage accounts, securities
transactions order transactions.

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 Although a stock market has been existing in the Philippines since the 1920s, it was only after the
EDSA revolution in February 1986 that the market began to attract interest in a manner that was more lasting
than it had done in the preceding forty-six years. Investors, both domestic and foreign, recognizing the
possibility of an improving trend and confidence in the Philippine economy began to invest in the country's
stock market.

Although the overall confidence in the Philippines was not total because of political uncertainties
brought about by threats from both rightist and leftist elements, the return to a democratic system
nevertheless gave the country an even chance for success in the years to come. Despite the fragile economy,
there was the possibility for the country to become a new "tiger" economy similar to the trends in Malaysia,
Thailand and Indonesia.

During the mid-1980s, there was also the beginning of an inclination of institutional investors, such
as unit trusts, pension funds and mutual funds from developed countries to consider investing in the stock
markets in Asia and Latin America. These were known as "emerging markets." They were Small and
immature markets but because of the economic trends of their respective countries, they were in the process
of becoming more developed in the next one or two decades. Indeed, these emerging stock markets have
expanded since the mid-1980s although they are not yet as mature as the larger markets in the world such
as Tokyo, New York and London.

The relatively peaceful general elections in May 1992 and the pragmatic policies of the Ramos
administration began to erase doubts about the directions of the Philippine economy and politics. Rumors
and possibilities of coups-d’état by extreme military rightists disappeared while the communist movement
was weakened by the political changes in Eastern Europe.

The attraction of investors to the Philippine economy was also influenced by continuing positive
developments in the region's other countries such as Malaysia, Singapore, Thailand and Indonesia. Indeed,
the region has the fastest growing economy in the world and this trend was expected to continue into the
next century. More and more investors were convinced of the region's competitive economies and the
Philippines would surely catch up with its neighbors as long as the positive economic policies stay in place.

The deregulation of foreign exchange which was begun by the Aquino Administration was further
pursued by the Ramos government. The telecommunications sector was opened to more competition while
the power problem was being addressed. Plans were being laid out to deregulate the oil and transportation
industries while tax reforms were being introduced. Exports of products and services were continuously being
encouraged by the government and a bill to open the financial sector to foreign banks was passed by
Congress into law. All these and more were positive signs for the Philippine economy.

By 1993, confidence appeared to be on a more solid foundation and investments both direct and
through the stock market from domestic and overseas sources began to be made not only in larger amounts
but with more consistency. The effects on the Philippine stock market were astounding as it began to
anticipate better economic growth for 1994 and beyond. In addition, there were more companies that offered
shares to the investing public through initial public offerings. These companies’ shares were eventually listed
in the stock exchange and they provided a better variety of choices for the investors. Indeed, stock market
trading became very active and overheated until its index reached an all-time peak of 3,385 points on January
4, 1994.

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 This chapter introduces the reader to the fundamental aspects of investing in the Philippine stock
market. It discusses the important role of the stock market, the function of the stock exchange, the role of
stockbrokers, the investors in the stock market and the mechanics of investing and trading in stocks.

Further readings, studies and experiences are required to gain expertise in the various roles one can
take in the stock market. A person can be a stockbroker, a securities research analyst, an investment banker,
a portfolio manager or an investor, he can be involved in operations such as accounting or settlement
functions. One can also be on the regulatory side, either with the Securities and Exchange commission or
with the stock exchange itself.

More corporations needing additional capital for expansion are expected to offer their shares to the
public and obtain listings in the stock exchange. On the other hand, new investors. both large and small, are
anticipated to increase in numbers. These trends will enlarge the stock market.

Hopefully, this introduction will serve as a catalyst for the reader to pursue a role in the stock market.

Securities and Their Markets

Securities

Securities are evidences of ownership in an enterprise or evidences of indebtedness of a person or

enterprise. Treasury bills, certificates of stock, bonds, marketable commercial papers are examples of
securities. A unique aspect for a title of Ownership to be considered as security is its marketability.
Government treasury bills issued in varying series and maturities and equity securities such as common
stocks listed in the stock exchange which are readily traded are categorized under the term securities.

Shares of stock of a closed corporation, such as a family owned one, with say ten stockholders
cannot be considered as securities. On the other hand, shares of stock of San Miguel Corporation are
considered securities because they can be easily bought and sold.

Securities Markets

"Securities markets is a general term which refers to a number of markets in which financial assets
are traded. Financial assets are basically stocks and debt instruments. A security market exists whenever
marketable financial assets are bought and sold.

Types of Securities Markets

Securities markets in the Philippines are classified into short-term and long-term markets. The money
market is the market for debt securities with maturities of less than one year. Examples of securities traded
in this market are treasury bills and commercial papers. The capital market is the market for long-term
securities like stocks and bonds.

Capital markets are either primary or secondary. In the primary market, new shares are issued and
sold to the investing public for the first time. For instance, if San Miguel Corporation (SMC) decides to sell a
new issue of common stocks and/ or preferred shares to raise equity funds, it will be a primary market
transaction. The proceeds of the sale go to SMC, the issuer. Occasionally, there is also a secondary offering
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in the primary market. This means that the securities being offered have been previously issued but are being
offered to the public for the first time by a large or controlling stockholder. An example of a secondary offering
in the primary market is the sale by the Philippine National Oil Company to the investing public of a portion
of its shares in Petron Corporation. In such a case, the proceeds of the sale go to the selling stockholder.
The secondary market is where original holders sell their shares to other investors. Thus, if Juan de la Cruz
decides to buy 50 shares of existing and outstanding shares of San Miguel Corporation, it will be a secondary
market transaction. The secondary markets include the organized security exchanges and the over-the-
counter market.

The participants in the securities markets are issuers, investment bankers, stockbrokers, dealers of
securities, individual investors, institutional investors, trust accounts, investment houses, universal banks and
anyone who buys and sells securities. Figure 3.1 shows the basic structure of the primary and
secondary markets.

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Role of the Investment Banker

The investment banker serves as a middleman in the transfer of funds between the business entity
in need of capital and he saver of funds. As a middleman the investment banker facilitates the issuance of
securities.

In some cases, the investment banker buys the whole issue from the corporation and resells them
to other security dealers and the public. This function of the investment banker is called "underwriting." When
a group of investment bankers pool together their resources to underwrite an issue, they are called the
"underwriting syndicate." In addition to purchasing and reselling securities, the investment banker may also
advise clients as to the type of security to offer and the appropriate timing of sale.

The Stock Market

The stock market is the most important and active secondary market. It is in this market that the
ultimate value of a company's stock is established. Basically, there are two types of stock markets - the
organized securities exchanges and the over-the-counter market.

Organized Securities Exchanges

A Stock exchange is an organized venue for trading registered and listed stocks. It facilitates
communication between buyers and sellers of stocks. It is owned by its members who are either individual
persons or corporations. Only members and authorized personnel are allowed to execute buying and selling
transactions. One becomes a member by buying a “seat” and complying with requirements specified in the
membership rules of the exchange. Stockbrokers contribute to the upkeep of the exchange through
membership dues and fees based on each broker s monthly trading turnover.

Established in 1927, the Manila Stock Exchange (MSE) is one of the oldest. The Makati Stock
Exchange (MKSE) was organized in 1963. The co-existence of the MSE and MKSE with their overlapping
functions is not consistent with the requirements of a developing economy with a limited equities market. In
March 1993, the members of both MSE and MKSE organized themselves into the Philippine Stock Exchange
(PSE) and agreed on a functional unification of the two trading floors thus allowing a multi-sited stock
exchange linked up via computer.

The establishment of the PSE is expected to result in a more efficient stock market. The functional
unification of the two exchanges will (a) provide common basic stock information to participants in the stock
market; (b) provide one quotation for the best bid and offer from opening to close of market; (c) ensure that
all orders are matched against the best bid/offer regardless of which system or broker was the source of the
order, and (d) guarantee that a transaction cannot be done at a price worse than the best [de los Angeles,
1994].

Over-the-Counter Market

The over-the-counter market is an intangible organization dealing with stocks that are registered
under the Revised Securities Act but are "unlisted." It is "a large collection of brokers and dealers, connected
by telephones and computers, that provides for trading of unlisted stocks" [Brigham, 1986).

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Stock Investments

The majority of securities traded in the Philippine Stock Exchange are common stocks. Other types
of securities such as preferred stocks, bonds and warrants are also traded but they constitute a negligible
portion of the daily trading turnover. As of December 31, 1994, the Philippine Stock Exchange carries a list
of 189 companies. A security has to be "listed" before it can be traded in the stock exchange. Listing involves
an application process essentially in compliance with exchange rules. Such rules mainly ensure that a listed
company is financially healthy and provides regular disclosure of material information to the exchange and
the investing public. In addition, the shares of the listed company should be widely held so that there will be
adequate trading liquidity. (Other listing requirements are discussed in the section on Stock Market
Regulation.)

Nature of Common Stock Investment

Common stock investment represents the ownership of a business entity. Ownership in a business
is proven by a stock certificate. The certificate indicates the investor's name, the total number of shares
owned, the certificate number, the par value and the total authorized capital stock of the issuing corporation.
Normally, it is signed by the corporation's chairman, president, corporate secretary and countersigned by the
stock transfer agent.

Common stock is an attractive investment alternative because it provides an income potential not
only in the form of dividends but also capital gain. Furthermore, it can be a good inflation hedge, that is, if the
total return from investment exceeds the rate of inflation [Siegel and Shim, 1986].

A major disadvantage of common stock ownership is that common stock holders are the last to be
paid in the event of corporate liquidation. Also, dividends not paid in a year do not have to be paid in a later
year.

Types of Common Stock

Some publicly-listed common stocks are divided into class A and class B shares. Class A shares are
restricted to Filipino investors while Class B shares are open to foreign investors as well as Filipinos. This
classification evolved in order to facilitate the monitoring of a listed company's foreign ownership which is
limited to 40% in most instances by the Philippine Constitution.

Common stocks listed at the stock exchange may also be classified according to certain
characteristics. Table 3.1 describes the different types of common stock according to earnings potential and
risk.

TYPE FEATURES
Blue Chips  Long record of earnings and payments
 Low risk
 Modest but dependable return
Growth Stocks  Long record of higher than average earnings and dividend payments
 Faster growth than the industry and economy as a whole
Income Stocks  Higher than average dividend payout ratio

14
  Low risk
 Moderate return
Cyclical Stocks  Movement of earnings and
Defensive Stocks  Recession-
Speculative Stocks  No record of good earnings and dividend payments
 Potential for future capital gain due to possible higher earnings

Stocks are also grouped into four industry categories at the stock exchange as follows:

1. Commercial-Industrial - which includes holding firms, corporations involved in manufacturing,

distribution and trading, banking, telecommunication, power and energy, transportation services,
construction, food, beverages and tobacco products, hotel, recreation and other services.

2. Mining - which lists those companies principally involved in mineral extraction. By tradition mining
firms are further categorized into "Big Board and "Small Board." Mining firms in production and win
a dividend record are categorized under the "Big Board" while unproductive firms are classified under
"Small Board.

3. Oil- which is a category for companies in oil exploration and production.

4. Property - which is a category for companies involved in land and property development.

Stock Transactions

Stock Market Regulation

The Securities and Exchange Commission (SEC) is tasked with regulating the securities market. It
is a quasi-judicial government agency under the administrative supervision of the Department of Finance.

It is responsible for the registration requirements of securities, the regulation of securities markets
and exchanges, the licensing of securities brokers and dealers, and the issuance of opinions and rulings
pertaining to the Revised Securities Act.

Among other things, the Revised Securities Act requires listed companies to submit corporate
information and financial statements periodically.

The Philippine Stock Exchange (PSE) is responsible for the promulgation of rules and regulations
on securities trading. It also sets specific requirements for the listing of securities in the exchange. Normally,
in order to list shares at the PSE, a company must have an authorized capital stock of P100 million with paid-
in capital of P25 million and that at least 10 percent of its subscribed shares is offered to the public with such
shares owned by at least 300 stockholders. The exchange also requires a track record of at least three years
of profitable operations of listing applicants.

Furthermore, the PSE requires that all listed companies submit a semi-annual financial report, which
may be audited or unaudited, within 60 days from the end of the 6-month period and an audited financial
report within 105 days after the end of the fiscal year of the company.

15
The Stockbroker

Stockbrokers work for brokerage houses that own seats in the stock exchange. They are duly
licensed by the Securities and Exchange Commission to buy and sell securities for individual and institutional
investors. The factors an investor should consider in choosing a stockbroker are: the financial integrity and
strength of the brokerage company, research capabilities, quality of advice regarding stock selection and
timing of purchases and sales, quality of trade executions, fee structure and efficiency in related services
such as payments, collections, accounting, and securities transfers.

Upon the suggestion of the SEC, a Securities Investors Protection Fund was established in April,
1975 in order to protect investors against loss arising from fraud by a stockbroker or from insolvency of a
stockbroker. All stockbrokers are required to contribute to the fund. Through the fund an investor may recover
a maximum of P10,000.00.

Types of Brokerage Accounts

There are generally two types of clients’ accounts in a securities company. These are the cash
account and the margin account.

The cash account is one in which transactions are settled on a cash basis. Normally, payment for
securities purchased must be received by the broker within 24-hours otherwise certificates covering the
purchase will be issued in the name of the stockbrokerage firm; if payment is not received within 5 days, the
stockbrokerage firm is automatically authorized to sell the securities.

In a margin account, the securities company extends credit. A margin account is covered by a margin
agreement which stipulates the terms and conditions for maintaining such an account. The brokerage
company charges interest on the amount owed by the investor. Under the present law, the amount of credit
that may be initially extended is limited to 50 percent of the current market price of the security.

Margin is computed as a percentage of the equity against the market value of the collateral. The
formula may be expressed as follows:

𝑽−𝑫 𝑬
𝑴= 𝒙 𝟏𝟎𝟎 or 𝑴 = 𝒙 𝟏𝟎𝟎
𝑽 𝑽

where M= the margin rate in percent

V= the market value of the collateral
D= the amount owed
E = the equity or V-D

For example, let us assume that a client buys 1,000 shares of ABC stock for P20.00 per share at
50% margin rate. His margin deposit requirement is Pl0,000.00 and the amount owed is the same. The
formula will result as follows:

20,000 − 10,000
𝑀𝑎𝑟𝑔𝑖𝑛 = 𝑥 100 = 50%
20,000
16
 A drop in the price of ABC stock to P 17.00 per share, decreases the margin to 41.18 percent
computed as follows:
17,000 − 10,000
𝑀𝑎𝑟𝑔𝑖𝑛 = 𝑥 100 = 41.18%
17,000

Thus making the investor undermargined. Depending upon the subsequent margin requirement
stipulated in the margin agreement, the investor may be required to deposit additional cash. In this example
the investor may be required to deposit additional cash amounting to P1,500 in order to bring the margin
back to 50%. {[ (17,000- 8,500) /17,000] x 100} [Roxas and Uy Tioco, 1981].

There are other types of accounts which a securities company may handle. These are the
discretionary and managed accounts. A discretionary account is one where the client gives full authority and
power to the securities company to buy and sell securities without any need for the client's consent. This type
of account must be covered by an agreement which specifies the terms and conditions by which the account
may buy and sell securities.

A managed account is one where the client entrusts money and securities to an investment manager
who because of his expertise decides where and what to invest in. The principal goal of this type of account
is the creation of an investment portfolio of securities that will maximize dividend income and capital gain.

Types of Securities Transactions

Long Purchase. A security is purchased in anticipation of a future price increase. Return will come
from dividend income over the holding period plus capital gain at the time of sale less broker's commission
and government taxes.

Short Selling. A security is sold when the price is high and purchased when the price is low. Profits
may be realized if the market price of a security declines. To make a profitable short sale a person borrows
a security to be sold from another person. When the market price falls below the selling price the borrower
buys the security in order to return it to the lender.

Buying on Margin. Investors who qualify to open margin accounts with brokers can borrow money
from the brokers to buy stocks. This is usually allowed when stock buying is being encouraged. Buying on
margin may result in a higher rate of return because one makes only a partial payment for the stock that has
appreciated in value.

Odd Lots. An odd lot is an order amount for a security that is less than the normal unit of trading for
that particular asset. Odd lots are considered to be anything less than the standard 100 shares for stocks.

Block Trade. A block trade is an order for a minimum of Five Million (P5,000.000.00) Pesos worth
of a specific stock. Block trades are generally broken up into smaller orders and executed through different
brokers to mask the true size. Block trades can be made outside the open market through a private purchase
agreement.

Order Instructions

17
 Instructions to brokers coming from a buying or selling client may be one of the following:

Market Order. An order to buy or sell stocks at the best possible price prevailing at the time the order is
given. This is generally given when the client wants immediate execution.

Limit Order. An order to buy or sell at a specific price or at a price better than the specified price.

Stop-Loss Order. A definite standing order to sell if the price drops to a specified level.

Time Order. An order to sell at a specified price during a given time period or until the cancellation of the
order.

Trade Procedures

An investor buying or selling stocks gives his or her instructions to an authorized representative of a
stockbrokerage company. This is more often than not done through the telephone. The order to buy or sell
is then relayed to the company' s trader inside the stock exchange. In a manual system, the trader, in
competition with traders of other companies. goes to the post of the particular stock to be executed and
queues the order on the blackboard. An execution is done by verbal auction and is completed by a contract.
In an automated system, the order is keyed in through a trading terminal and automatically matched.

Verbal confirmation of executions is made as soon as possible and subsequently an official

confirmation or invoice is delivered to the client.

Stock market transactions are settled on the fourth day after the trade. This means that transactions
done on Monday must be settled by Friday. Settlement of accounts are done in the clearing house. The
clearing house is an agency appointed by a stock exchange whose primary function is to facilitate the receipt
and delivery of stock certificates and payments. It is in this place that the buying broker pays for his purchases
while the selling broker delivers certificates or stock assignments corresponding to the shares sold.

Transfer of Certificates of Stock

Most listed companies have designated stock transfer agents which have the responsibility of
maintaining and updating the list of stockholders and the number of shares they each own and issuing and
delivering cash and stock dividends declared. Thus they are responsible for cancelling and issuing stock
certificates which have been sold and bought by investors.

The process of cancellation and issuance of certificates is a lengthy process usually taking weeks or
even months. An investor, however, need not wait for the new certificate to be able to sell the newly acquired
stock. All the investor needs to do is to endorse a "stock assignment separate from the certificate." The
broker, in turn, shall indicate on the same form the transfer instructions reference number.

Many investors, especially those who trade frequently, may agree to have their stock certificates
registered in the name of the stockbrokerage company. These are called "street certificates." In this case,
the investor does not hold a definitive form of ownership to an investment in a company. There are various
reasons for this practice, e.g., to facilitate settlement, reduce the paperwork for the broker, and provide some

18
degree of confidentiality of an investor's trading behavior. Cash and stock dividends corresponding to street
certificates are received by the broker and subsequently credited to the clients' accounts.

Trading Hours

Trading hours are from 9:30 a.m. to 12:15 a.m., Monday to Friday. Closing prices are indexed at
12:00 noon and any further transactions can only be done at those prices up to 12:15 a.m.

Costs of Stock Transactions

Broker’s Commission. Whether it is a buy or sell transaction, the minimum commission fee a broker
will charge is P45.00. The maximum fee is 1.5% of the gross Value of the transaction, i.e., number of shares
multiplied by the price. Depending on the size of the transaction or the investor’s yearly turnover and the
services rendered by the broker, commissions can be negotiated. Transactions involving large blocks of
shares are normally charged lower commission rates.

Government Taxes. There is a transaction tax of 3/8 of 1% that is collected by the broker on the
gross value of every selling transaction and paid to the government on the third working day alter the
transaction. Starting May 31, 1995, the transaction tax will be 1/2 of 1%. Cash dividends are not taxable but
stock dividends are taxed 3/8 of 1% when they are sold.

Documentary Stamp Tax. In the past, the documentary stamp tax was shouldered by stockbrokers.
Lately, buyers of stocks bear the cost of the documentary stamp tax. The amount of documentary stamp tax
is P2.00 for every P200.00 at par or nominal value for original issue of certificates of stock. For subsequent
stock transfers the documentary stamp tax is P1.00 for very P200.00 par value. Thus, for stocks like PLDT
which has a par value P5.00, and a market value of P1,700, the tax is not significant as a percentage of total
transaction value. However, for a stock whose price is near or below par value, the amount becomes
significant compared to the gross value of the purchase.

19
Chapter 3: PRINCIPLES OF SECURITIES REGULATION

This chapter focuses on the Revised Securities Act particularly provisions with respect to the
definition of security, registration requirements for IPOs, civil liabilities for noncompliance, with registration
requirements, and the administrative sanctions; the provisions regarding fraudulent trading activities which
include insider trading, manipulation of security prices, and artificial measures of price control; and the
provisions on the regulation of stock market professionals and the securities market. It also tackles the
Investment Company Act and the Rules of Trust.

Generally, at the end of the chapter, the students should be able to understand the Philippine
securities law as embodied in the Revised Securities Act particularly the abovementioned provisions; and the
Investment Company Act and the Rules of Trust.

20
 Securities regulation concerns itself with the regulation of the various transactions performed each
day in the securities markets by numerous participants. For instance, there are rules on the registration and
sale of securities of a corporation when it initially sells its securities to the public in a public offering. It requires
disclosure of material facts about the issuer to properly inform the public about the issuer's business
prospects. Securities law regulates the activities and establishes the responsibilities of the issuer, its officers
and directors and the underwriters. Securities law also covers the trading of securities in the secondary
market. Thus, there are laws prohibiting and penalizing fraudulent transactions, manipulative practices and
insider trading. There are also licensing and reporting requirements of securities professionals like brokers,
dealers and salesmen. Securities regulation also limits the activities of investment companies, funds,
collective accounts and trust funds which collect funds from the public for investment and reinvestment in
securities.

Because of the peculiar nature of securities, the regulation of the securities market is different from
the regulation of transactions in other types of goods, like food, drugs, alcohol and tobacco. As succinctly
summed up by one leading authority in securities law:

The distinctive features of securities give a distinctive coloration to regulation f transaction in

securities, in contrast to the regulation of transaction in other types of goods. Most goods are produced,
distributed and used or consumed: governmental regulation focuses on protecting the ultimate consumer
against dangerous articles, misleading advertising, and unfair and non-competitive pricing practices.
Securities are different.

First, securities are created, rather than produced. They can be issued in unlimited amounts, virtually
without cost, since they are nothing in themselves but represent only an interest in something else. An
important focus of securities regulation, therefore, is assuring that, when securities are created and offered
to the public, investors have an accurate idea of what that something else" is and how much of an interest in
it the particular security represents.

Second, securities are not used or consumed by their purchasers. They become a kind of currency,
traded in so-called “secondary markets" at fluctuating prices. These secondary transactions far outweigh, in
number and volume, the offerings of newly-created securities. An important focus of securities regulation,
therefore, is to assure that there is a continuous flow of information about the corporation or other entity which
is represented by securities being actively traded in the secondary markets.

Third, since the complexity of securities invites unscrupulous people to attempt to cheat or mislead
investors and traders, the securities law contains provisions prohibiting a variety of fraudulent, manipulative
or deceptive practices. These provisions have been applied to a wide range of activities, including trading on
"inside information, misleading corporate publicity, and improper dealings by corporate management.

Finally, since a large industry has grown up to buy and sell securities for investors and traders,
securities regulation is concerned with the regulation of people and firms engaged in that business, to assure
that they do not take advantage of their superior experience and access to overreach their non-professional
customers [Ratner, 1986].

Philippine securities law is embodied in the Revised Securities Act (Batas Pambansa Blg. 178) (the
"RSA") which took effect in 1982. It revised earlier Securities Act (Commonwealth Act No. 83) which took

21
effect in 1982. Both the RSA and the original Securities Act of the Philippines were patterned after the 1933
Securities Act and the 1934 Securities Exchange Act of United States.

There are other special laws which govern special transactions or participants in the securities
market. Investment companies, for example, are regulated specially by the Investment Company Act (Rep.
Act. No. 2629) which took effect in 1960). Additionally, the Securities and Exchange Commission (the "SEC"),
which has been tasked to administer the RSA, promulgates various rules regulating securities transactions
and professionals. The regulation on trading on commodity futures is covered by a special rule promulgated
by the SEC. The Central Bank has also issued its regulations governing trusts, fiduciary business, investment
management activities and collective accounts of banks. ln addition, the Philippine Stock Exchange, which
is licensed and monitored by the SEC, regulates its member brokers and listed companies through a special
boy of rules.

What is a Security

The term "security” does not only refer to common stock or "equities" of a corporation. The term is
defined in Section 2(a) of the RSA to also include bonds, debentures, notes, voting trust certificates,
commercial papers evidencing indebtedness, joint venture contracts, commodity futures contracts, stock
options, pre-need plans, proprietary or non-proprietary membership certificates and generally all types of
"investment contracts. The term "investment contract" is nowhere defined in the RSA but United States courts
have fashioned a definition for it as a contract, transaction or scheme whereby a person invests his money
in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party, it
being immaterial whether the shares in the enterprise ae evidenced by formal certificates or by nominal
interests in the physical assets employed in the enterprise." By this definition, a number of schemes, such as
the so-called "Ponzi schemes" or pyramiding schemes, have been brought within the jurisdiction of the
securities laws and their perpetrators penalized for securities fraud.

Registration Process and Initial Public Offerings

The basic philosophy of the RSA is to protect the investing public [Alinea 1981]. To achieve its goal
of protecting the public investor, the RSA adopts a philosophy of full and fair disclosure of information to allow
investor make informed investment decisions. As stated by the U.S. Supreme Court, the securities laws
embrace a “fundamental purpose… to substitute philosophy of full disclosure for the philosophy of caveat
emptor and thus to achieve a high standard of business ethics in the securities industry.” However, the United
States Congress did not take away from an investor "his inalienable right to make a fool of himself but simply
attempted to prevent others from making a fool of him [Loss, 1988].

The mandated disclosure philosophy followed by the United States securities acts and our RSA has
been criticized on the ground that those needing investment guidance would lack either the intelligence or
training to understand the financial reports and other disclosures [Id., 1934]. t has been said that in the United
States, many investors who are intended beneficiaries of the full disclosure securities acts usually do not
read nor receive the mandated filing or reports under the law and that there is implicit reliance on the
functioning of the professional investment community to justify the system as an effective mechanism for
disclosure [Beaver, 1980].

22
 The RSA, under its mandated disclosure system, requires the filing documents containing material
information with the SEC. In an initial public offering, the RSA S registration process seeks to place facts
before investing public through the medium of a registration statement and prospectus.

Section 4 of the RSA provides that no security, except exempt securities or securities sold in an
exempt transaction, can be sold or offered for sale or distribution to the public within the Philippines unless
such securities shall have been registered and permitted to be sold. Thus, prior to the date when the
registration of the securities becomes effective and a permit or license for its sale is granted, no sale or offer
for sale of the security required to be registered is allowed. The term "sale" or "sell" has been defined as
every contract of sale or disposition of a security or interest in a security, for value. The terms offer to sell”,
“offer for sale”, or “offer” include every attempt or offer to dispose of, or solicitation of an offer to buy, a security
or an interest security, for value." Following these broad definitions of the terms "sale” and "offer to sell”, the
issuer is prohibited from making any attempts to sell the security during the pre-effective stage of the
registration process. Any form of advertisements, press announcements or other selling efforts is prohibited.

Section 8 of the RSA provides that all securities required to be registered shall be registered through
the filing by the issuer or by any dealer or underwater of a registration statement. Section 8 provides a list of
information that should be either disclosed in the registration statement or attached thereto as an integral
part of the registration statement. Subsection 8(10) particularly requires the submission of a circular,
prospectus, advertisement, letter or communication to be used for the public offering of the security.

Subsections 8(27) to 8(29) require the submission of financial statements. The information required
to be disclosed must be up to date. The balance sheets must be as of a date not more than 90 days from the
date of the filing of the registration statement. If such balance sheets are not certified by an independent
certified accountant, similar statements must be submitted as of a date not more than one year prior to the
filing or the registration statement. Profit and loss statements for the latest fiscal year and the two preceding
years must be submitted." If the issuer has been in actual business for less than three years, the profit and
loss statement required to be submitted is for such time as the issuer has been in actual business.

While the RSA does not require a particular form for the registration statement, the SEC has required
issuers to follow a form called SEC Form RSA 1. With respect to the prospectus, the Philippine Stock
Exchange has required certain information to be placed in the prospectus.

The registration statement is required to be signed by the issuer, its principal executive officer, its
principal operating officer, its principal financial officer, its controller or principal accounting officer or persons
performing similar functions. As will be discussed, persons who the registration statement may be held liable
for any material misrepresentation or omission registrati0n statement.

The fact of the filing of a registration statement is required to be immediately published by the SEC
in two newspapers of general circulation, once a week for two consecutive weeks. The publication is expected
to notify and allow any interested party to file an opposition to the registration statement within ten days from
the date of publication. There have been such oppositions file which have delayed the registration of certain
issues.

If after the completion of the publication, the SEC finds the registration statement "on its face
complete" and that the "requirements and conditions for the protection of the investors have been complied

23
with,” it enters an order making the registration effective and issues a permit allowing the offer and sale of
the securities.

At this point, the issuer is free to sell or offer to0 sell the registered securities to the public. The issuer
may opt to list the securities with the Philippine Stock Exchange, m which case it must enter into a listing
application and list agreement with the exchange.

Liabilities for Noncompliance with Registration Requirements

Section 4 and Section 8 of the RSA require issuers to present facts before investing public that are
complete and accurate to allow the public to make informed and intelligent decision before he purchases the
securities sold or offered to be sold. To assure this, the RSA provides penalties on persons involved in the
preparation of the registration statement for non-disclosure of material facts or for misrepresentations in the
registration statement.

Section 12of the RSA provides the civil liabilities imposed where the issuer misrepresents or fails to
state material fact in the registration statements. It lists the persons who can be sued, who can sue, what he
must prove and the defenses available to the defendants.

(a) Who can be sued?

The following persons can be sued it the registration statement contains on its effectivity an untrue
statement 01 a material fact or omits to state a material fact required to be stated therein or necessary to
make such statements not misleading: (1) every person who signed the registration statement; (2) every
person who was a director at the time of the filing of the registration statement, supplement or amendment
thereof; (5) every person named in the registration statement as about to become a director of the issuer and
whose written consent is filed with the registration statement; (4) every expert who certifies the preparation
or the registration statement; and (6) every underwriter involved in the distribution, In addition, controlling
persons may be held jointly and severally liable with the liable persons.

(b) Who can sue and what must he prove?

The plaintiff must be one who has acquired a registered security and must show that the registration
statement, at the time it became effective, contained an untrue statement of a material fact or omitted to state
a material fact. The SEC has ruled that a fact is material if it induces or tends to induce or otherwise affect
the sale or purchase of an issuer's securities. The term “material” limits the information required to those
matters which an average prudent investor ought to reasonably be informed about before purchasing the
security registered. The plaintiff in such a suit need not prove that he purchased in reliance of the
misstatements nor that he read the registration statement. Plaintiff also need not prove that the decline in the
value of the security was caused by the misrepresentations. There is also no need to prove fraud or bad faith
except when claiming exemplary damages.

c) Defenses available

Section 12 of the RSA was adopted from Section 11 of the 1933 Securities Act of the United States
which was considered such a draconian measure at the time of its enactment that some observers thought
that it would dry up the nation’s underwriting business [Ratner, supra note 1, at 162]. The relative ease in
24
bringing a suit under this section is designed to force the issuer, the underwriters and other persons involved
in the preparation or a registration and observe due care in the statement or prospectus to disclose material
information and observe due care in the preparation of selling materials.

As defenses, the issuer or underwater being sued could prove that the alleged false statements were
true, or that the misstatements or omissions were not material or that the plaintiff knew of the misstatement
or omission at the time of his acquisition. There is also a prescriptive period for bringing such action which is
two years after the discovery of the untrue statement or the omission, or within five years after the security
was bona fide offered to the public.

Another defense that could be raised is the defense of “due diligence” which is available to all
participants, except to the issuer. In essence the defense of “due diligence" exculpates a person from liability
if "he had, after reasonable ground to believe and did believe, at the time such part of the registration
statement became effective, that the statements were true and that there was no omission to state a material
fact required be stated therein or necessary to make the statements therein not misleading. The standards
for reasonable investigation is that required of a prudent man in the management of his own property. The
underwriters, their counsels and issuer's counsel and accountants would conduct a "due diligence” review of
the issuer and a verification of the prospectus during a public offering.

(d) Damages recoverable

In case of a successful suit under Section 12 of the RSA, the damages recoverable is double the
difference between the amount paid and committed to be paid for the security. not exceeding the price at
which the security was offered to the public, and (1) the value at the time the suit was brought; (2) the price
at which the security shall have been disposed of in the market before the suit, or (3) the price at which the
security shall have been disposed of after filing the suit but before the judgement. Exemplary damages in
cases of bad faith, fraud, malevolence or wantonness may be awarded. Underwriters are not liable in excess
of the total price at which the security was offered.

Civil liabilities are further imposed under Section 13 (a) when a security is sold in violation of the
chapter on registration of securities as in a sale of unregistered security and (b) when a security is sold by
the use of a prospectus or oral communication which contains a false statement or omission of a material
fact.

Exempt Securities and Exempt Transactions

The RSA lists securities and transactions which are exempted from the registration requirements
and, therefore, also exempt from the civil liability imposed by Sections 12 and 13. Exempt securities cover
securities, including certificates of deposit, issued or guaranteed by the Philippine government, its political
subdivisions, agencies or public instrumentalities, or by persons controlled or supervised by the government
and securities issued by a foreign government with which the Philippines maintains diplomatic relations.
Securities issued by entities which are supervised and licensed by another government agency are usually
exempt securities. Thus, securities issued by banks and financial institutions licensed to engage in quasi-
banking and supervised by the Central Bank as well as securities issued by building and loan associations
are also exempt securities. Insurance or endowment policies, annuity contracts and pension plans subject to
regulation by the Insurance Commission are also exempt securities. Exempt securities also include securities
covering rights or interests in real property, including subdivision or condominium units where the sale is
25
regulated by the Ministry of Human Settlements or authorized constituent or attached agencies. The SEC is
empowered to classify additional securities as exempt securities after conducting a public hearing if it finds
that the requirement of the registration is not necessary in the public interests and the protection of investors.

The RSA also exempts from registration requirements certain transaction involving the sale of
securities. The exemption is attached to the transaction and not the security, thus, subsequent transactions
may not be exempt and may be covered by the registration requirements. Exempt transaction usually cover
isolated transactions which are private and limited in character and where no commissions or remunerations
are paid in connection with the sale of the security28 The presence of remunerations connotes the existence
of an underwriting process or programmed selling efforts additional capital stock of a corporation to existing
shareholders as part of an in the course of increasing its capital stock is an exempt transaction but not the
issuance of already authorized but still unissued capital stock. The SEC may also exempt other transactions
if it deems that requiring registration under the RSA is not necessary in the public interest and for the
protection of the investors because of the small amount involved or the limited character of the offering.

Continuing Disclosure Requirements

The RSA imposes an obligation on issuers whose securities are registered keep current the
information and documents required to be filed with registration statement. Also required to be filed are annual
reports periodicals which are necessary to update the investor on the operation of issuer's business. The
SEC prescribes that corporations whose securities are listed in the stock exchange or are registered shall
make a reasonably full, fair and accurate disclosure of every material fact relating to the corporation which is
of interest to the investors.33 The SEC also imposes as terms and conditions to the permit to sell securities
the submission of reports and the obligation to inform the SEC of certain events such as dividend declarations
and execution of material contracts.

Regulation of Trading Activities

The RSA devotes five full provisions proscribing fraudulent trading activities like manipulation of
security prices, artificial measures of price control and insider's trading.

Sections 26 to 28 of the RSA define in detail those transactions which are deemed to be manipulative
acts. Manipulation is "virtually a term of art when used in connection with securities markets." Market
manipulation is said to be probably as old as the securities markets and the practices of market "pools" led
to prohibitions imposed by the securities acts [Loss, supra note 7, at 844). The mechanics of these pools can
be described as follows:

The acts described are deemed "manipulation" and unlawful under the RSA. Effecting transactions
which create a false appearance of active trading through wash sales or sales with no change in beneficial
ownership matched sales are illegal.0 Transactions which increase (or depress) the price of a security to
induce the purchase (or sale) or which creates active trading for purposes of inducing the purchase or sale
of a security are also unlawful manipulative transactions. Circulating or disseminatıng ordinary business
information for purposes of raising or depressing the price of a security, to the effect that the price of a security
rises or falls because of market operations is also illegal. Making misleading statements by dealers and
brokers for purposes of inducing the purchase or sale of security is proscribed by the RSA. Price stabilization,
pegging or fixing is also declared to be a manipulative act and therefore unlawful. The acquisition of put, call,
straddle or other options without being bound to purchase or sell the security is also a manipulative act.
26
Persons who willfully participate in any of the aforesaid acts are liable to any person who purchases and sells
the security at the manipulated price and the victim may recover damages sustained as a result of any such
act or transaction, as well as costs of the suit and other reasonable costs.

Short sales and stop-loss orders are not per se illegal, but such transactions must be made in
accordance with the rules of the SEC.

While Sections 26 to 28 define and describe in detail the manipulative acts forbidden by the RSA,
Section 29(a) provides in general a catch-all anti- fraud provision, thus:

Sec. 29. Fraudulent Transactions

(a) It shall be unlawful for any person, directly or indirectly, in connection with the purchase or sale
of any securities -

(1) To employ any device, scheme, or artifice to defraud; or

(2) To obtain money or property by means of a unique statement of a material fact or any omission
to state a material fact necessary in order to make the statements made, in the light of the circumstances
under which they were made, not misleading:

(3) 1o engage in any act, transaction, practice, or course of business which operates or would
operate as a fraud or deceit upon any person.

This provision intends to cover all imaginable acts or transactions done in connection with the
purchase or sale of a security which operate as a fraud upon any person purchasing or selling a security.
The proscriptions provided by the provision are said to be broad to cover all types of fraudulent practice and
by the repeated use of the word “any” is obviously meant to be inclusive.

Insider Trading

Unlike the United States federal securities act, the RSA contains a specific provision on insider
trading:

Sec. 30. Insider's duty to disclose when trading- (a) It shall be unlawful for an insider to sell or buy a
security or the issuer. If he knows a fact of special significance with respect to the issuer or the security that
is not generally available, unless (1) the insider proves that the fact is generally available or (2) 1f the other
party to the transaction (or his agent) is identified, (a) the insider proves that the other party knows it, or (b)
that the other party in fact knows it from the insider or otherwise.

A fact "of special significance" is not only a fact that is material but one the "would likely, on being
made generally available, [to] affect the market price of a security to a significant extent or one that "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 specificity, the extent of its difference from information
generally available previously and Its nature and reliability."

27
 The term "insider" is broadly defined and includes (1) the issuer, (2) a director or officer of, or a
person controlling, or controlled by, or under common control with, the issuer, (3) "temporary insiders" or
persons whose relationship or former relationship to the issuer gives or gave him access to a fact of special
significance about the issuer or the security that is not generally available, a (4) "tippees in a "tipper-tippee"
situation or persons who learn such a fact of special significance from any of the foregoing insiders with
knowledge the person from whom they learn the fact is such an insider.

However, the RSA provides certain defenses. A defendant could prove that the fact is of general
knowledge. A defendant could also allege, if the other party to the transaction (or his agent) is identified, that
the other party knows it or that the other party in fact knows it from the insider or otherwise. However, since
most securities transactions are not done face-to-face but through the securities market without being able
to identify the other party, this defense could not be generally invoked

To deter insiders from taking advantage of their access to inside information a special derivative right
is given to stockholders to recover "short swing" profits from insider traders. Profits realized by directors,
officers and stockholders beneficially owning more than ten percent (10%) of any class of registered equity
security from the purchase and sale, or the sale and purchase, of any equity security of the issuer within any
period less than six months shall be recoverable by the issuer. The suit to recover the "short swing" profit
can he brought by the issuer, but since such a decision to bring an action by the issuer may be controlled by
the insiders, the RSA grants the owner of any security of the issuer to bring a derivative suit in the name and
in behalf of the issuer if the issuer fails or refuses to bring the suit within six months after the request is made
or falls to diligently prosecute the same.

Regulation of Securities Markets

It is said that there are three models for the regulation of market professionals and exchanges that
can be found in emerging markets: these are the United States, the British and the new model [Van Agtmael,
1984]. The United States model was introduced in the 1960's and the 1970's in most of Latin America, Korea,
the Philippines, Pakistan, Indonesia, Nigeria, Egypt and Turkey [Id.]. Under this system, there is a
comprehensive capital market law which covers the regulation of both primary and secondary markets, and
under which the stock exchanges, underwriters, dealers, brokers and investment managers are monitored.
Securities commissions are established which issue further, more detailed rules and regulations. The stock
exchanges may have its own listing requirements and other self-regulatory functions, but these are usually
less comprehensive than those of the securities legislation [ld.].

The British model, used with modification in Hong Kong, Singapore, Malaysia, Zimbabwe and Kenya,
relies not on comprehensive securities legislation and a securities commission, but on listing requirements,
other rules of behavior of the stock exchanges, and self-regulation of members [Id.] To be sure, the original
British model itself has undergone major changes with the passage of the United Kingdom’s Financial
Services of 1985 (the “FSA")

The FSA provides for the creation of multi-tiered system of securities regulation. The bottom-tier is
comprised of a number of self-regulatory organizations (SROs) that make and enforce rules with respect to
their respective members’ activities in the financial services industry. At the the structure is the Department
of Trade and Industry which, however, as contemplated by the FSA, has delegated many specified
Regulatory powers to a private sector designated agency, the securities and Investments Board (SIB). The
SlB, in turn, authorizes the SROs, Recognized Investment Exchanges (RIE) and Recognized Processional
28
Bodes (RIBs) and approves their rule books. The SlB also has the responsibility of establishing rules for, and
regulating the activities of, persons engaged in the investment business who choose to apply directly to it for
authorization, rather than become members of an SRO or RPB Bloomenthal, 1988-89).

Under the U.S. model, securities markets are primarily regulated by a securities act and policed by
a government agency. A self-regulatory organization such as an exchange, through a set of its own rules,
provide a secondary layer of regulation of the markets. The British model grants wider latitude to exchanges
as self-regulatory organizations with the government agency taking only a Secondary role. In several recently
organized market like Thailand and Jordan, a new approach has been followed by combining functions of
the securities commission and the stock exchanges into one organization [Van Agtmael, stupra note 56).

The RSA follows the United States model whereby the regulatory authors primarily, although not
solely, lodged in the SEC. An authorized stock exchange, such as the Philippine Stock Exchange, is a private
institution to which the RSA delegates authority to adopt and enforce rules for the conduct of its members
and responsibility to assure compliance by their members with the provision of the RSA.

When the United States Congress created the United States Securities and Exchange Commissions
in 1934, stock exchanges as private associations, had been regulating their members for up to 140 years
and rather than displace this system of self-regulation", the United States Congress superimposed the SEC
on it as an additional level of regulation [Ratner, supra note 1 at 838]. Self-regulation, at least in the United
States, has a long history in the securities industry, and is said to have established a "federally mandated
duty of self-policing by exchanges with provisions for oversight by the SEC to assure that the exchanges
meet their responsibilities. Similarly, under Section 22, (a) of the RSA, exchanges are required to be
registered with the SEC by the filing of a registration statement. One of the supporting documents required
to be filed with the SEC is an undertaking to comply and enforce compliance by the exchange's members
with the provisions of the RSA and the implementing rules and regulations of the SEC.

Regulation of Market Professionals

All brokers, dealers and salesmen who wish to engage in business in the Philippines must register
under the RSA as such. The requirement for registration and licensing of brokers, dealers and salesmen
provides for important safeguards to investors in that investors are assured that registered brokers-dealers
and their associated persons have the requisite professional training and that they must conduct their
business according to regulatory standards. The regulatory framework covering brokers and dealers is
designed to ensure that the broker-dealer is financially capable of transacting business, that customers are
treated fairly and that customers receive adequate disclosure.

(1) Financial capability

To ensure the financial capability of brokers and dealers, brokerage firms are required to have at
least a minimum paid up capital of P10 million.

To further ensure the continuing financial viability of brokers and dealers, the RSA also restricts
borrowings by members, brokers and dealers. The RSA adopts the "net capital" rule from the 1934 United
States Exchange Act making it unlawful for a broker to permit his indebtedness to all person including
customer's credit balances (but excluding indebtedness secured exempted securities), to exceed such
percentage of the net capital (exclusive of fixed assets and value of the exchange membership) employed in
29
the business, but not exceeding in any case two thousand percent (2000%), as Securities and Exchange
shall prescribe by rules. This is designed to ensure that the broker-dealer has sufficient liquid assets to satisfy
its current liabilities, particularly claims of customers [Molinari and Kibler, 1983].

To monitor compliance with the "net capital rule, the SEC requires each broker or dealer to provide
semi-annual reports giving accurate information among others, on the cash balances on hand, accounts with
other broken correspondents, securities borrowed, loaned, due from brokers, money loaned or borrowed.

Also certain margin requirements are imposed to prevent the excessive use of credit for the purchase
or carrying of securities. Margin requirements are designed to limit speculation by investors but at the same
time assure that the broker-dealer does not over-extend credit and risk collection of unpaid obligations. The
RSA mandates the SEC to promulgate rules on margin trading in accordance with the credit and monetary
policies of the Monetary Board of the Central Bank.36 The SEC provides the following margin trading
requirements:

In trading on margin, a broker shall not extend credit to his customers beyond the following maximum:

(a) On securities duly registered/and or licensed by the Insular Treasurer or by the Commission,
but not listed on any exchange, 30% of the current market value of the security;

(b) On securities duly registered and/or licensed by the Insular Treasurer/or by the Commission,
and listed on an Exchange, an amount which is the higher of -

(1) 40 per centum of the current market price of the security, or

(2) 100 per centum of the lowest market price of the security during the preceding 3o months, but
not more than 50 per centum of the current market price.

To prevent indirect violations of the margin requirements, the broker or dealer must require the
customer in non-margin transactions to pay the price or the security purchased Within such period as the
SEC shall prescribe which in no case shall exceed three trading days. Otherwise the broker can sell the
security purchased starting on the next trading day but not beyond ten trading days following the last day for
the customer to pay the purchase price.

In case a broker or dealer becomes financially distressed, a last resort of an investor would be to
seek compensation from the Securities Investors Protection Fund. The RSA mandates the creation of the
Securities Investors Protection Fund which is a trust fund contributed by the exchanges, brokers, dealers,
underwriters, transfer agents, salesmen and other persons transacting in securities, as the SEC may require,
for the purpose of compensating investors for extraordinary losses or damages they may suffer due to a
business failure, fraud, mismanagement of the persons with whom they transacted.

(2) Fair treatment of customers

Brokers and dealers are also not allowed to lend or arrange for the lending of any security carried
for the account of any customer without the written consent of such customer or in contravention of such
rules and regulations as the SEC shall prescribe.

30
 Further, brokers and dealers are not allowed to pledge, mortgage, or otherwise encumber any
security carried for the account of any customer under circumstances, (1) that will permit the commingling of
his securities without his consent, with the securities of any customer; (2) that will permit such securities to
be commingled with the securities of any person, other than a bona fide customer; or (3) that will permit such
securities to be pledged, mortgaged or encumbered for sums in excess of the aggregate indebtedness of
such customer. The SEC, by rule, requires that securities on which broker has not extended credit including
those securities which are in excess of the margin requirement, be kept separate for the customers’ account
a not commingled with other securities owned by the broker or held for other customers.

(3) Disclosures to customers

The SEC, by rule, requires a broker to report to its customer all transactions entered into for the
customer's account and to this end, he must send the customer written confirmation of purchases and sales
as promptly as possible on the very same day on which they are made. The confirmation must be sent directly
to the customer at his residence or business address or at any other address given by him. An employee or
salesman of a broker shall not be authorized to accept confirmation for or in behalf of a customer.

Oftentimes, when a broker also acts as a dealer, that is, if the broker sells securities to a customer
from its own account, a conflict of interest or perceived conflict of interest arises. Thus, there is a requirement
for brokers and dealers to disclose such fact to dispel such perception. The RSA declares it unlawful tor a
member of an exchange who is both a dealer and a broker to effect through the exchange any transaction
with respect to a security than an exempted security, unless he discloses to such customer in writing at or
before the completion of the transaction whether he is acting as a dealer for his own account, as a broker for
such customer, or a broker for some other person. A broker or dealer effecting a transaction for a customer
on an over-the-counter market, must disclose to the customer in writing whether or not he is acting as a
dealer for his own account and if he acts as a broker for such customer, cither the name of the person from
whom such security was purchased or to whom it was sold for such customer and the day and time when
such transaction took place and the amount of commission or service fees.

A broker acting as a dealer is also prohibited from entering into a transaction whereby he extends or
maintains or arranges credit for a customer on a security which was a part of new issue in the distribution of
which he participated as a member of d selling syndicate or group within six months prior to the transaction.
However, credit is not deemed extended by reason of a bona fide delayed delivery of any such security
against full payment of the entire purchase price upon such delivery within thirty-five days after the purchase.

Administrative Sanctions

The SEC is empowered to conduct investigations to determine violations of the RSA or rules
thereunder. If the SEC finds that there is a violation of the RSA or its rules or that a registrant has made a
material misstatement or omission in the registration statement, or has refused an examination into its affairs,
the SEC can suspend or revoke the registrant's certificate of registration and permit to sell securities, and
impose fines. The SEC could also issue a cease and desist order after proper investigation but without the
necessity of a public hearing if it finds that the act or practice in question may cause grave or irreparable
injury or prejudice to the investing public or may amount to fraud or a violation of the disclosure requirements
of the RSA.

31
Regulation of Investment Management Activities

Investment in securities by individuals can either be directly or indirectly made. Individuals indirectly
invest through intermediaries which collect their savings and invest them in a portfolio of financial instruments.
Banks, through their trust departments, and other financial institutions, manage common trust funds and
investment management accounts for their customers. Investment companies solicit payments from investors
to be invested common stocks or debt securities. Pension funds exact contributions from employers and
employees and invest these contributions in a variety of debt and equity securities to assure beneficiaries of
their pensions upon retirement. Insurance companies collect premiums from policy holders and invest the
collection n certain securities to assure the policy holders or their beneficiaries payment of their proceeds.

Small group of people manage the portfolio of securities of these institution investors in return for
some form of compensation. Because of the power and control which these fund managers exercise over
other people’s money, certain limitations and prohibitions are imposed on these managers of fund to prevent
or check potential abuses and overreaching. Laws and regulations seek to govern the relationship and
obligations of these people to their beneficiaries. For purposes of this book, however, only the rules relating
to investment companies and trusts and investment management activities of banks and financial institutions
will be discussed.

Investment Companies

Republic Act No. 2629, otherwise known as the Investment Company Act defines an investment
company as one "which is or holds itself out as being engaged primarily, or proposes to engage primarily, in
the business of investing, reinvesting, or trading in securities." By exception, the Investment

Company Act excludes from its coverage holding companies, closely the companies. Companies
expressly exempted by the SEC, underwriters, banks and insurance companies, and employees stock bonus,
pension and profit sharing trusts. Investment companies can either be open-ended or close-ended. Open-
ended investment companies or "mutual funds" are investment companies which offer redeemable security.
Generally, mutual funds offer on a continuous basis, at a price related to the net asset value of the fund
portfolio and stand ready to redeem the shares at any time at the shareholder request at the net asset value
or at a price based thereon.

(a) Registration of Investment Companies

An investment company is registered under the Investment Company Act with the SEC through the
filing of a registration statement. In the registration statement, a recital of the investment policy of the
company must be stated. Deviation from the stated policy requires the vote of majority of the holder of the
investment company’s voting securities. In addition, the securities of the registered investment company must
be registered under the RSA but a shorter registration statement may be allowed by the SEC.

(b) Regulation of Directors and Officers and Affiliated Persons

One of the stated policies of the Investment Company Act is to eliminate the situation whereby an
investment company is organized for the interest of directors, officers, investment advisers, depositors,
underwriters or brokers rather than for the interest of the security holders. To assure the integrity of an
investment company, certain qualifications and restrictions are imposed on its officers, directors and
32
employees. No person who has been convicted within ten years of a felony or misdemeanor involving the
purchase or sale of security can act as director, officer, member of an advisory board, investment adviser,
depositor or underwriter of an investment company.

To ensure impartiality, not more than fifty-percent (50%) of the board of directors must be investment
advisers or employees and officers of such investment advisers.9 Majority of the board of directors must not
consist of persons who are officers or directors of any one bank. Investment bankers, or affiliated persons of
an investment banker cannot be directors, officers and employees of an investment company. Even the
salaries and emoluments of directors and executive officials of Investment Companies are subject to
regulation by the SEC.

A director, officer or employee, or their affiliated persons, cannot act as the regular broker of an
investment company. Neither can these persons’ act the principal underwriter of an investment company.

Investment companies are usually managed by a separate entity called an investment adviser. To
prevent potential abuses by investment advisers, certain mechanisms are put in place by the Investment
Company Act. The contract with the investment adviser must be approved by a majority of the outstanding
voting securities of the company. The investment adviser's contract must be written and must describe the
compensation to be paid thereunder. It must have a term of only two years, unless extended annually by the
board of directors.7 The contract must be terminable at any time by the board of directors or by the vote of
two-thirds of the outstanding voting securities of the company and automatically terminated upon assignment
by the investment adviser.

For mutual funds, the underwriting agreement must also have a term of only two years unless an
extension is approved by two-thirds of the outstanding voting securities of the company and must be
automatically terminated upon the assignment by the underwriter.

Transactions between an investment company and affiliated persons are very much regulated to
prevent any possible abuse or overreaching. An investment company's affiliated person, promoter or lead
underwriter is prohibited from selling any security or property to the investment company or buy them from
the investment company or borrow money from the investment company, subject to limited exceptions.
Affiliated persons and principal underwriters of an investment company are also prohibited from entering into
transactions wherein the investment company is a joint or joint and several participants with such affiliated
person or principal underwriter in contravention of such rules and regulations as the SEC may prescribe for
the purpose of preventing participation by such registered or controlled company on a basis different from or
less advantageous than that of such other participant. Affiliated persons are also banned from receiving any
compensation from anybody as an agent, for the purchase or sale of any property, or as a broker, for the
purchase and sale of securities for the investment company, except if such sale is in the ordinary course of
such agent's or broker's business.

(c) Regulation of Activities of Investment Companies

Investment companies are required to place and maintain its securities in the custody of a bank of
good repute or a member of a stock exchange or by the investment company but only in accordance with
SEC rules. Investment companies cannot pay out dividends except from accumulated undistributed net
income or the earned surplus for the current or preceding fiscal year. Investment companies cannot lend

33
money to any person if the investment policies do not permit such a loan, or the borrower controls or is under
common control with the investment company. Neither can an investment company guarantee any obligation.

Common Trust Funds and Investment Management Activities or Banks and Financial Institutions

While the SEC regulates the activities of investment companies, the Central Bank regulates the trust
and other fiduciary businesses and investment activities of banks and financial institutions. The cardinal
principle to all and other fiduciary relationships is fidelity and the policies are directed towards confidentiality,
scrupulous care, safety and prudent management property. Banks and other trustees are generally subject
to the "prudent man rule”. The funds and properties held by trusts are required to be administered with the
skill, care, prudence and diligence necessary under the circumstances then prevailing that a prudent man,
acting n like capacity a familiar with such matters, would exercise in the conduct of an enterprise of like
character.

Trust and other fiduciary businesses, including investment management activities, of an authorized
institution must be carried out through a trust department. A trust committee is created composed of three
members of the board of directors to act within the sphere of authority provided by the by-laws or as may be
delegated by the board.

Certain practices have been declared as "unsound practices" and investment managers, trustees
and fiduciaries should desist from such activities. These include: (a) transactions with clients where the client
is the borrower of his own fund placement; (b) granting of loans or accommodations to a trust committee
member, officer and employee of the trust department; (c) borrowing from or selling assets of a trust to the
trust corporation or bank to cover portfolio losses; (d) guaranteeing the return of principal or income; (e)
granting of new loans to any borrower who has a past due account, and requiring clients to documents in
blank.

Common Trust Funds

Trust companies, banks and investment houses authorized to engage in trust activities may
establish, administer and maintain one or more common trust funds. The trustee of a common trust fund is
given the exclusive management and control of the common trust fund and the sole right at any time to sell,
convert, reinvest, exchange assets comprising the fund.

The trustee is, however, required to designate in its records the trust accounts owning the
participation in the common trust fund and the interest of such accounts. The trustee is prohibited from
negotiating and assigning the trustor's beneficial interest in the common trust fund without the prior written
consent of the trustor or beneficiary.

Trustees administering a common trust fund cannot have any interest in the fund nor grant any loan
to the fund. Investment is of a common trust fund in the security of a single person. firm or corporation is
limited to fifteen percent of the market value of the common trust fund.

Investment Management Activities

Investment management activities refer to activities resulting from an agreement for financial return
whereby the bank or an investment house binds itself to handle or manage investible funds in a representative
34
capacity as financial or managing agent, adviser, consultant or administrator. An investment management
account is required to be covered by a written contract establishing such account and containing certain
minimum provisions including the duties and powers of the investment manager, liabilities of the investment
manager, and the amount of compensation of the investment manager.

Commingling of investment management accounts is allowed but must be fully disclosed and agreed
to in writing by the client and only for the purpose of investing in government securities or in registered
commercial papers. The participation of each individual investment management account in a commingled
account should not be less than P1 million.

Investment management accounts are administered in accordance with the terms of the contract. An
investment manager may be granted discretionary powers but nevertheless, loans and investments for such
discretionary accounts are limited to government securities, loans fully secured by hold-outs and pledges of
bank deposits and loans fully secured by real estate and chattel mortgages.

An investment manager must disclose to the client and obtain the latter's authorization in writing
before it can lend, sell or transfer assets to, or buy or acquire property or debt instruments from, the
investment manager's other departments, officers, directors or stockholders. Similarly, the written consent of
the client must be obtained prior to investment of the account's assets in equities underwritten by the
investment manager or before money or property is sold, transferred or assigned or lent from one account to
another.

35