Shouldn't the Philippines repeal the "60/40 Law" (and change its Constitution) to encourage investments?

Dear Filipino,

The Philippines cornered the least amount of foreign direct investments among seven selected economies in Southeast Asia in 2009, according to the International Monetary Fund (IMF) in its first global survey on FDIs. On a global scale, the Philippines ranked 60th out of 72 countries included in the Coordinated Direct Investment Survey.

Question: Considering that investments are needed to bolster economic growth -- e.g., $10B for infrastructure alone -- how should the Philippines become more investor friendly? How about repealing the 60/40 Law? This is one scuttlebutt that is impeding investors from coming in!

Mike T.

Dear Mike,

What prompted a guy like you with a “harvard.edu” email handle to ask a lowly blogger like me? Aren’t you guys supposed to hail from the “Know-it-all Capital of the Universe”?

Just a little good-natured ribbing there, of course. ;-)

Anyway, thanks for your question, but the “60/40 Law” you’re asking about is actually part of a HUGE issue that I really want to talk about with more breadth here. [For readers looking for more depth on a particular legal sub-issue, I recommend approaching knowledgeable legal professionals practicing in the Philippines.]

First, some Philippine constitutional background.

Under the heading “National Economy and Patrimony,” Section 1 of Article XII of the Philippine Constitution provides:

The goals of the national economy are a more equitable distribution of opportunities, income, and wealth; a sustained increase in the amount of goods and services produced by the nation for the benefit of the people; and an expanding productivity as the key to raising the quality of life for all, especially the underprivileged.

The State shall promote industrialization and full employment based on sound agricultural development and agrarian reform, through industries that make full and efficient use of human and natural resources, and which are competitive in both domestic and foreign markets. However, the State shall protect Filipino enterprises against unfair foreign competition and trade practices.

In the pursuit of these goals, all sectors of the economy and all regions of the country shall be given optimum opportunity to develop. Private enterprises, including corporations, cooperatives, and similar collective organizations, shall be encouraged to broaden the base of their ownership.

I added the italicization in the indented paragraphs above because I found those blurbs very admirable and impressive-sounding. And if the drafters of the Constitution really meant what they wrote, let’s give them some credit. Unfortunately however, when it comes to formulating laws in accordance with lofty stated policies, negative unintended consequences always pose a risk; in the Philippines, this problem becomes even more compounded by problems stemming from implementation.

So let’s talk about the main implementing law behind the constitutionally sanctioned policy of protecting local industry from “unfair foreign competition”: The Foreign Investments Act (FIA) of 1991 (as amended).

The FIA requires “the formulation of a regular Foreign Investment Negative List [FINL] covering investment areas/activities which may be opened to foreign investors and/or reserved to Filipino nationals.”

If you’re a “former Filipino” and now a citizen of another country and you haven’t yet gotten your dual citizenship or reclaimed your Filipino citizenship, you may want to pay particular attention to this “FINL.” This “negative list” is really a list of occupations, trades and investments where foreign participation is either limited or off-limits altogether. So if you are harboring any dream of someday going back to the Philippines to practice your trade, set up a sari-sari store or other small business, or invest, this list is very important to you.

Subject to all sorts of exceptions and asterisks which I won’t discuss here, the latest “negative list” under Executive Order No. 858 signed in 2010 includes the following:

I.  No Foreign Equity Allowed: Mass media (except recording); practice of all professions (engineering, medicine and allied professions, accountancy, architecture, criminology, chemistry, customs brokerage, environmental planning, forestry, geology, interior design, landscape architecture, law, librarianship marine deck/engine officers, master plumbing, sugar technology, social work, teaching, agriculture, fisheries, and guidance counseling); retail trade enterprises with paid-up capital of less than US$2.5M; cooperatives; private security agencies; small-scale mining; utilization of marine resources; ownership, operation and management of cockpits; manufacture, repair, stockpiling and/or distribution of nuclear weapons; manufacture, repair, stockpiling and/or distribution of biological, chemical and radiological weapons and anti-personnel mines; and manufacture of firecrackers and other pyrotechnic devices.

II.  Up to 20% Foreign Equity Allowed: Private radio communications.

III.  Up to 25% Foreign Equity Allowed: Private recruitment, whether for local or overseas employment; contracts for the construction and repair of locally-funded public works; contracts for the construction of defense-related structures.

IV.  Up to 30% Foreign Equity Allowed: Advertising.

Now, here’s where the term “60/40 Law” got coined:

V.  Up to 40% Foreign Equity Allowed: Exploration, development and utilization of natural resources; ownership of private lands; operation and management of public utilities; ownership, establishment and administration of educational institutions; culture, production, milling, processing, trading excepting retailing, of rice and corn and the by-products thereof; contracts for the supply of materials, goods and commodities to government-owned or controlled corporation, agency or municipal corporation; project proponent and facility operator of a BOT project requiring a public utilities franchise; operation of deep sea commercial fishing vessels; adjustment companies; ownership of condominium units; manufacture, repair, storage, and/or distribution of products and/or ingredients requiring Philippine National Police (PNP) or Department of National Defense (DND) clearance; manufacture and distribution of dangerous drugs; sauna and steam bathhouses, massage clinics and other like activities; all forms of gambling; domestic market enterprises with paid-in equity capital of less than the equivalent of US$200,000; domestic market enterprises which involve advanced technology or employ at least fifty (50) direct employees with paid-in-equity capital of less than the equivalent of US$100,000.

VI. Up to Sixty Percent (60%) Foreign Equity Allowed: Financing companies and investment houses regulated by the SEC.

Quite understandably, the restrictions are based on the premise that it is in the country’s best interests for these areas of concern to remain under the control of Filipino citizens and/or Filipino corporations.

And I for one think the premise makes some sense. A lot of countries, even the most advanced ones, also have some very restrictive laws about who can own what in order to protect their national interests. That’s why you have members of the US Congress intervening and threatening legislative action whenever a Chinese company is rumored to acquire a key American company. That’s why Scandinavian countries have very strong key local industries largely protected from foreign competitors.

When I was living in London in the middle of the last decade, a common refrain from locals, whether homeowner or renter, was the cost of housing. Why? Because wealthy foreigners from Arab states, among others, were gobbling up properties left and right, thereby driving up prices to levels completely out of reach for the locals.

We don't want that to happen in the Philippines, of course. But the problem with the Philippine situation, as you can see, is that the “negative list” is pretty broad-based and leaves little room for foreign professionals and investors to actively participate in the Philippine economy -- the kind of participation which may be necessary to globalize the country’s industries and spur economic growth.

This inevitably brings up the question of whether the law is indeed serving the country and its citizens as intended.

In one study about competitiveness of countries in attracting foreign investments, the Philippines did not only rank at the bottom – 6th out of the ASEAN-6 – in having a favorable regulatory regime, its score is not even close to its nearest competitor, Indonesia:

(Source: InvestPhilippines)

So while I am not in favor of completely doing away with the whole list, what I’m in favor of is a systematic, intensive but expeditious review of the list to see which areas have restrictions that need to be maintained and which areas can and should be fully liberalized, and thereafter a quick governmental action to effect the necessary changes. Although politically messy, this “action” will need to come in the form of Charter Change – there appears to be no getting around to it – if we must revamp the current law.

And revamp it we really must.

Why? Now, I know this is serious stuff but in honor of a favorite comedian, David Letterman, whose show, Late Night with David Letterman, officially debuted on February 1, 1982, let me present to you my...

Top 10 Reasons to Revamp the Philippines’ Foreign Investments Act:

[10] Lack of control over their investment understandably discourages foreign investors.

The restrictions mentioned above are the biggest barriers to foreign investments in the Philippine economy. It’s a fairly simple calculus really: When foreign investors are faced with a choice to put their money in two countries where risks are almost identical but where one country requires majority control to be in the hands of the locals, investors would naturally choose the other country which allows them to determine what happens exactly with their funds.

[9] The amount of available local capital is insufficient to meet the national demand for it.

It is no secret that many of the infrastructure-related projects needed by the country require billions of dollars in funding and that the available free capital among the local investors is simply not sufficient to meet the demand. In fact, it is impossible to meet the demand if the country will just rely on local capital, period.

How can it be possible? As of end-2010, the total stock market capitalization of the entire Philippine Stock Exchange (which means all the companies listed in the country’s stock market) is only PHP 8.87 trillion. This figure translates to just about US $200B, a sum not even 65% of the present market capitalization of one US company, Apple, Inc.  Put another way, the owners of Apple can swap the company with all the companies listed in the Philippine stock market and still have about $100B left.

[8] There is a shortage of actual companies/individuals who can partner with foreigners willing to invest.

Not only is the actual amount of local capital insufficient, but the list of actual Philippine companies and/or individuals who may have the wherewithal to partner with willing foreign investors is also short. Who among the locals can pony up the required 60% in big capital-intensive projects to allow them to serve as joint venture partners of foreign investors willing to enter the Philippine market? Thus, because of the current law, the legal ability of a foreign investor to fund a project is limited by the amount raised by his local partner.

To illustrate, let’s say a restricted project costs $100. Even if a foreign investor can put up the maximum allowed by law – i.e., $40 -- the law still requires his Filipino partner to come up with the other $60. If the Filipino can only raise $30, the maximum the investor can bring in is $20, not $70, leading to the collapse of the joint venture, or the project altogether. Where the project survives, the shortcuts taken to comply with the funding requirements naturally affect the quality of the finished project.

[7] The current law allows the local oligarchs to have their choicest pickings because of limited competition.

In her book 2003 book "World on Fire" (excerpted in a Prospect Magazine essay entitled "Vengeful Majorities"), Prof. Amy Chua wrote: “When foreign investors do business in the Philippines, they deal almost exclusively with Chinese” because “[a]part from a handful of corrupt politicians and a few aristocratic Spanish mestizo families, all of the Philippines’ billionaires are of Chinese descent.”

It’s true: If you’re a Chinese Filipino oligarch in the Philippines, the deals are literally walking to your doorsteps and lining up for your review. But the main reason for that is this 60/40 Law, whose provenance, interestingly enough, can be traced back to American Commonwealth times. Because the Chinese Filipino oligarchs who dominate the Philippine economy are the ones with the funds who can put up the required “Filipino” capital investment, naturally, foreign investors who want to come in are forced to approach them first for partnership possibilities, or the foreigners can’t come in at all.

This dynamic allows these oligarchs to have first crack at studying investment options as to where they can put their money. And with the limited competition, they are almost assured of hefty returns, thereby further concentrating wealth among the handful of them. In fact, in some situations where there is virtually no competition, it is easy to imagine how foreign investors and their local oligarch partners can even practically hold the Philippine government hostage and make it agree to concessions and guarantees that virtually eliminate risk for the investors.

[6] Inflexibility of equity-sharing encourages corruption and other law-breaking (e.g., use of “dummies,” etc.).

In an environment already rife with political corruption, the restrictions placed on foreign investors and their Filipino partners which limit allowable equity structures further stoke law-breaking, bribery and corruption.

A common tactic to get around the restrictions on equity participation is the use of “dummy” Filipino partners. Here, the local partners (often, the oligarchs mentioned above) “own” 60% of the entire venture on paper but the project is, in actuality, mostly (if not fully) funded, operated and managed by the foreigners despite their being just “minority” partners. This type of situation leaves projects vulnerable to extortion from regulators who learn about these arrangements, abuse by one partner over the other just to maintain the front of a legally compliant partnership, or worse, the collapse of the project altogether and ugly lawsuits thereafter.

There is an “Anti-Dummy Law” to counter the use of dummies, but because of inconsistent and/or lack of adequate supervision and enforcement, it appears to an outside observer to be often largely ignored.

[5] Cumbersome compliance issues lead to legal maneurings which may not be compliant with the spirit of the law and just add friction to what can otherwise be a smooth transaction.

The law has led to all sorts of legal squabbles including the most basic: What does “Filipino” mean? In areas reserved to Filipino citizens or domestic corporations whose capital is at least 60% owned by Filipinos, the “Filipino” classification is critical, as shown by the PIATCo-Fraport AG airport controversy where one of the main issues is whether there were violations of the Anti-Dummy Law.

The Philippine Department of Justice has adopted the “control test” in establishing the nationality of corporate stockholders covered by the law: If at least 60% of the corporate capital is owned by Philippine citizens, all the corporate shares, including those owned by foreigners, are considered Filipino. But if the percentage of Filipino ownership goes below 60%, only the number of shares that corresponds to that percentage is treated as Filipino. In other words, if one can show that at least 60% of the capital is owned by Filipinos, no further inquiries are made on the nationality of the owners of the remaining 40%. This means that when this ownership-restricted corporation invests in another ownership-restricted corporation, the investing corporation is treated as a “Filipino” investor.

Now, compare this test from the “grandfather rule,” which is still followed in some instances. Under this rule, the nationality of the individual stockholders or the owner of the stocks of the corporate shareholder affects the status of the restricted corporation in which the investment was made.

How to make sense of the two rules? According to SEC Commissioner Raul J. Palabrica, the current rule seems to be this: The "control test" is the main standard to determine the nationality of corporations but the "grandfather rule" will be applied if there are questions about compliance with Filipino ownership requirements.

One creative strategy to circumvent the ownership restrictions is the use of “global depository receipts” or GDRs in which investee companies would sell to foreign investors interest-bearing “depository receipts” using the stocks of the restricted investee companies as collateral.

Technically, the nationality rule is not violated because the stocks remain in the company’s name but the investors are assured of hefty returns on their investment without breaching the nationality rule. But it should be obvious that GDRs are, for all intents and purposes, “foreign investments” which should be covered under the nationality rule if the government is indeed serious about cracking down on these types of legal maneuvers which may be compliant with the letter of the law but not its spirit. Additionally, GDRs only increase the friction in business transactions for the companies trying to raise funds, adding unnecessary cost in terms of time and money to what would otherwise be simple transactions.

[4] Revamp of the law can increase the competitiveness of local industries and create jobs.

Foreigners are not only reluctant to invest their money if they do not have control, they are also concerned about intellectual theft if they are to divulge their corporate secrets to Filipino partners in a partnership where they are in the minority. This often entails their dialing back of their investment of intellectual capital in the form of industrial/product design, technology and market knowhow.

Allowing these profit-seeking foreigners to own their local subsidiaries outright 100% can translate to increased competitiveness for the local industries affected because the oligarchs who presently rule their industries will be forced to up their game. With increased competition, the affected industries will modernize, grow and, in the process, create jobs for locals.

[3] Revamp of the law can increase the country’s exports.

The current law is really anti-trade, and here’s why.

One way for the country to grow its export-oriented manufacturing industries is to enter into bilateral trade agreements (BTAs) with the right countries, especially with those whom the Philippines already enjoys robust trading. But the current law poses a hindrance to signing of BTAs because the Philippines’ counterparties will definitely demand preferential terms and more openness on the part of the country to allow investors from their countries to come in unencumbered by restrictive investment laws.

[2] The current law discourages even “former” Filipinos from investing or returning to the Philippines to set up their businesses or practice their professions.

While there is now a dual citizenship law which allows Filipinos who became naturalized citizens of other countries to reclaim their lost Filipino citizenship, many of them choose not to do so for various reasons. But because they are considered foreigners under the law, they are therefore prevented from setting up small businesses (e.g., retail trade enterprises less then $2.5M in capital; see the list above) under their own name and/or practice their professions in the Philippines. This is unfortunate considering these “former” Filipino professionals have much to share with the land of their birth, having learned immensely from their exposure in globalized and highly competitive industries all over the world.

[1] To retain the current law is to maintain the status quo.

‘Nuff said.

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