Tag: Penal Clause

Advance Rentals and Bank Closure: Understanding Contractual Penalties and Equitable Reduction

The Supreme Court held that a clause in a lease contract mandating the forfeiture of advance rentals upon the lessee’s premature termination due to business closure is a penal clause subject to equitable reduction. This means that while such forfeiture clauses are generally valid, courts can reduce the amount to be forfeited if it is deemed iniquitous or unconscionable, especially when the premature termination is due to circumstances beyond the lessee’s complete control and involves the interests of innocent third parties like depositors and creditors. The decision underscores the court’s power to balance contractual obligations with equitable considerations, ensuring fairness and preventing unjust enrichment.

Prime Savings Bank’s Closure: Can Advance Rentals Be Forfeited?

Spouses Jaime and Matilde Poon owned a commercial building in Naga City and leased it to Prime Savings Bank for ten years. The bank paid a large sum of advance rental fees. The contract stipulated that if the bank closed, the lessors, the Spouses Poon, had the right to terminate the lease and retain the advance rentals. Barely three years into the lease, the Bangko Sentral ng Pilipinas (BSP) ordered Prime Savings Bank closed due to financial irregularities. The bank vacated the premises, and the Philippine Deposit Insurance Corporation (PDIC), acting as the bank’s liquidator, demanded the return of the unused advance rentals, arguing that the bank’s closure was a force majeure event. The Spouses Poon refused, citing the contract’s forfeiture clause. The legal question before the Supreme Court was whether the forfeiture clause was enforceable and whether the PDIC was entitled to a refund of the unused advance rentals.

The Supreme Court denied the Petition, clarifying several key principles. First, the Court addressed the issue of whether the bank’s closure constituted a fortuitous event or an unforeseen event under Articles 1174 and 1267 of the Civil Code, respectively. The Court distinguished this case from Provident Savings Bank v. CA, where the bank’s closure was deemed arbitrary and in bad faith. In the present case, the BSP’s action was pursuant to Section 30 of Republic Act No. 7653, and the bank was partly accountable for its closure. Therefore, the closure was not independent of the bank’s will, negating the element of a fortuitous event. The Court also found that the closure was not an unforeseen event, as the parties had contemplated the possibility of business deterioration during the ten-year lease term. As Jaime Poon testified:

He told me that I don’t have to worry I will have P6,000,000 advances.

Moreover, the Supreme Court examined the applicability of Article 1267 of the Civil Code, which pertains to unforeseen events that make the performance of a service so difficult as to be manifestly beyond the contemplation of the parties. The Court cited Tagaytay Realty Co., Inc. v. Gacutan, laying down the requisites for applying Article 1267, including that the event could not have been foreseen, it makes performance extremely difficult, it is not due to the act of any party, and the contract is for a future prestation. While the difficulty of performance was evident, the Court found that the closure was foreseeable and not independent of the bank’s actions. Thus, Article 1267 did not apply.

Building on this, the Court determined that the forfeiture clause in the contract was indeed a penal clause. A penal clause serves two main purposes: to provide for liquidated damages and to strengthen the coercive force of the obligation by threatening greater responsibility in case of breach. The testimony of Jaime Poon confirmed that the forfeiture of advance rentals was intended as liquidated damages. The Court noted that the contract also stipulated the return of unused rentals if the property was foreclosed, demonstrating a reciprocal penalty arrangement. This mutual obligation reinforced the importance of adhering to the fixed term of the lease.

While acknowledging the validity of the penal clause, the Supreme Court addressed the critical issue of whether the penalty should be equitably reduced under Article 1229 of the Civil Code. This article allows judges to reduce penalties when the principal obligation has been partly or irregularly complied with, or when the penalty is iniquitous or unconscionable. The Court recognized that the lease period was for the benefit of both parties, and a breach by either party would result in the forfeiture of remaining advance rentals. However, the Court emphasized that the PDIC initiated the case to recover assets for the benefit of the bank’s depositors and creditors. This consideration of the interests of innocent third parties justified the equitable reduction of the penalty.

The Court balanced the principle of freedom of contract with the need to protect depositors and creditors. As the Court articulated:

The judge shall equitably reduce the penalty when the principal obligation has been partly or irregularly complied with by the debtor. Even if there has been no performance, the penalty may also be reduced by the courts if it is iniquitous or unconscionable.

The Court noted that the reasonableness of a penalty depends on the circumstances, and factors such as the nature of the obligation, the mode of breach, and the relationship of the parties should be considered. The Court highlighted that strict adherence to contractual freedom would lead to injustice, depriving depositors and creditors of potential funds. Furthermore, the Spouses Poon were not prevented from using their building for other profitable ventures. The Court concluded that a 50% reduction of the penalty was warranted to prevent unjust enrichment and protect the rights of innocent parties. The decision underscores the court’s role as a guardian of both law and equity.

Finally, the Court upheld the trial court’s denial of damages and attorney’s fees claimed by the Spouses Poon. The Court noted that actual and compensatory damages must be proven with a reasonable degree of certainty, and no such proof was presented. Additionally, the Court found no evidence of wanton, reckless, or malicious conduct that would justify the award of moral and exemplary damages. In line with prevailing jurisprudence, the Court imposed a legal interest of 6% per annum on the monetary award from the finality of the decision until full payment.

FAQs

What was the key issue in this case?	The key issue was whether a forfeiture clause in a lease contract, requiring the lessee to forfeit advance rentals upon premature termination due to business closure, was enforceable, and whether the penalty could be equitably reduced.
Did the Supreme Court consider the bank’s closure a fortuitous event?	No, the Supreme Court did not consider the bank’s closure a fortuitous event because it was partly due to the bank’s actions and not entirely independent of its will.
What is a penal clause in a contract?	A penal clause is a provision that stipulates a penalty, such as forfeiture of deposits, in case of non-performance or inadequate performance of the principal obligation, acting as liquidated damages and a coercive measure.
Can courts reduce penalties stipulated in contracts?	Yes, under Article 1229 of the Civil Code, courts can equitably reduce penalties when the principal obligation has been partly complied with or when the penalty is iniquitous or unconscionable.
Why did the Supreme Court reduce the penalty in this case?	The Supreme Court reduced the penalty to protect the interests of the bank’s depositors and creditors, considering the PDIC’s role as a fiduciary and the need to prevent unjust enrichment.
What is the significance of the PDIC’s involvement in this case?	The PDIC’s involvement as the bank’s liquidator highlighted the broader public interest in recovering assets for depositors and creditors, influencing the Court’s decision to reduce the penalty.
What was the final ruling of the Supreme Court?	The Supreme Court denied the Petition, affirming the Court of Appeals’ decision with a modification imposing a legal interest of 6% per annum on the monetary award from the finality of the decision until full payment.
Did the Spouses Poon receive compensation for the bank’s early termination of the lease?	Yes, the Spouses Poon were allowed to retain 50% of the unused advance rentals as compensation, as the Court deemed the complete forfeiture iniquitous.
What factors did the Court consider when reducing the penalty?	The Court considered the nature of the obligation, the mode of breach, the relationship of the parties, and the overriding interests of the bank’s depositors and creditors.

In conclusion, the Supreme Court’s decision in Spouses Jaime and Matilde Poon v. Prime Savings Bank underscores the importance of balancing contractual obligations with equitable considerations, especially when the interests of vulnerable parties are at stake. While forfeiture clauses are generally enforceable, courts retain the power to prevent unjust enrichment and ensure fairness. This case serves as a reminder that contractual freedom is not absolute and must yield to the principles of equity and social justice.

For inquiries regarding the application of this ruling to specific circumstances, please contact ASG Law through contact or via email at frontdesk@asglawpartners.com.

Disclaimer: This analysis is provided for informational purposes only and does not constitute legal advice. For specific legal guidance tailored to your situation, please consult with a qualified attorney.
Source: Spouses Jaime and Matilde Poon, Petitioners, vs. Prime Savings Bank Represented by the Philippine Deposit Insurance Corporation as Statutory Liquidator, Respondent, G.R. No. 183794, June 13, 2016

April 24, 2017

Contractual Obligations: Enforceability and Limitations in Philippine Law

The Supreme Court held that a notarized agreement (Kasunduan) for the sale of land is valid and enforceable, even if the consideration is perceived as inadequate, provided there is no vitiation of consent. The Court emphasized the importance of upholding contractual obligations made in good faith, unless they are contrary to law, morals, good customs, public order, or public policy. Parties are bound by the literal meaning of their contract when its terms are clear and leave no doubt as to their intention. The decision clarifies the extent to which courts will enforce contractual terms, particularly in real estate transactions, and underscores the principle that parties are expected to honor their agreements.

Real Estate Agreement or Unjust Enrichment? Examining Contractual Validity

This case arose from a dispute over two agreements: an Agreement and a Kasunduan. The respondents, facing financial difficulties in a case to reclaim land, sought legal assistance from Atty. Edmundo Zepeda and financial support from Manuel Uy Ek Liong. In exchange, they agreed to give Atty. Zepeda and Manuel 40% of the realties or monetary benefits from the case via an Agreement. On the same day, a Kasunduan was also made to sell the remaining 60% share to Manuel for P180,000.00. When Manuel died, his heirs sought to enforce the Kasunduan, but the respondents resisted, claiming the agreements were unconscionable and contrary to public policy. The central legal question is whether the Kasunduan is a valid and enforceable contract, particularly given the respondents’ claim that the agreed price was inadequate compared to the current market value of the land.

The Supreme Court found that the Court of Appeals (CA) erred in ruling on the validity of the Agreement, to which Atty. Zepeda was a party, because he was not properly impleaded in the suit. The Court emphasized that no person should be affected by a proceeding where they are not a party. Thus, the CA should not have invalidated the Agreement without Atty. Zepeda having the opportunity to present his side. In relation to this point, Article 1491 (5) of the Civil Code prohibits lawyers from acquiring by purchase or assignment the property or rights involved in litigation in which they intervene. However, this prohibition applies only during the pendency of the suit. It generally does not cover contracts for contingent fees where the transfer takes effect only after the finality of a favorable judgment.

The Court then clarified that the Agreement and the Kasunduan are independent contracts with different parties, objects, and causes. A contract requires (a) consent of the contracting parties, (b) an object certain which is the subject matter of the contract, and (c) a cause of the obligation which is established. The Agreement was for legal services and financial assistance in exchange for 40% of the suit’s avails, while the Kasunduan was for the sale of 60% of the land for P180,000.00. Given these distinctions, the CA erred in not independently determining the validity of the Kasunduan.

Under Article 1306 of the Civil Code, parties can establish stipulations, clauses, terms, and conditions as they may deem convenient, provided they are not contrary to law, morals, good customs, public order, or public policy. The RTC correctly found the Kasunduan to be a valid and binding contract. It was partially executed with respondents’ receipt of P1,000.00. The Kasunduan concerned the sale of the former’s 60% share in the subject parcel, less the 1,750-square meter portion to be retained, for the agreed consideration of P180,000.00. As a notarized document, the Kasunduan carries evidentiary weight, and respondents signed it with full knowledge of its contents.

Philip’s claim that respondents were forced to sign the Agreement and the Kasunduan did not show vitiation of consent that would warrant avoiding the contract. He simply meant that respondents felt constrained to accede to the stipulations insisted upon by Atty. Zepeda and Manuel. Respondents’ main objection to the enforcement of the Kasunduan was the perceived inadequacy of the P180,000.00 consideration. They claimed the Kasunduan was tantamount to unjust enrichment. In their 22 March 1993 letter to petitioners, respondents cited prices then prevailing for the sale of properties in the area and offered to sell their 60% share for the price of P500.00 per square meter.

In the absence of new stipulations, the parties are bound by the original terms of the Kasunduan. Obligations arising from contracts have the force of law between the contracting parties, who are expected to abide in good faith. When the terms of the contract are clear and leave no doubt as to the intention of the parties, the literal meaning of its stipulations should govern. Courts have no authority to alter a contract by construction or to make a new contract for the parties. Courts will not relieve a party from the adverse effects of an unwise or unfavorable contract freely entered into. As the Court has previously stated, “

Obligations arising from contracts have the force of law between the contracting parties and should be complied with in good faith.”

The Kasunduan contained a penal clause stating that a party who violates any of its provisions shall pay the aggrieved party a penalty of P50,000.00, plus attorney’s fees and litigation expenses. This is an accessory undertaking to assume greater liability in case of breach, strengthening the obligation and providing liquidated damages. Under Articles 1226 and 1227 of the Civil Code,

“In obligations with a penal clause, the penalty shall substitute the indemnity for damages and the payment of interests in case of noncompliance, if there is no stipulation to the contrary.”

Also,

“The debtor cannot exempt himself from the performance of the obligation by paying the penalty, save in the case where this right has been expressly reserved for him.”

Since respondents did not reserve the right to pay the penalty instead of performing their obligation, the RTC correctly ordered them to execute and deliver a deed of conveyance over their 60% share in the subject parcels. The disposition was modified to exclude the 1,750-square meter portion to be retained.

Since the parties fixed liquidated damages at P50,000.00 in case of breach, that amount suffices as indemnity, without further need of compensation for moral and exemplary damages. In obligations with a penal clause, the penalty generally substitutes the indemnity for damages. The RTC’s award of attorney’s fees of P50,000.00 was proper because the penal clause included a liability for said award, and petitioners proved they incurred said sum in engaging their lawyer.

FAQs

What was the key issue in this case?	The key issue was whether the Kasunduan, an agreement for the sale of land, was a valid and enforceable contract, despite the respondents’ claim that the consideration was inadequate.
*What did the Supreme Court rule regarding the Kasunduan?*	The Supreme Court ruled that the Kasunduan was a valid and enforceable contract. The Court emphasized the importance of upholding contractual obligations made in good faith, as long as they are not contrary to law, morals, good customs, public order, or public policy.
What is the significance of Article 1306 of the Civil Code in this case?	Article 1306 allows parties to establish stipulations, clauses, terms, and conditions as they may deem convenient, provided they are not contrary to law, morals, good customs, public order, or public policy. This principle supported the Court’s decision to uphold the validity of the Kasunduan.
What did the Court say about contracts with penal clauses?	The Court clarified that a penal clause is an accessory undertaking to assume greater liability in case of breach of an obligation, strengthening the obligation and providing liquidated damages. The penalty generally substitutes the indemnity for damages and the payment of interests in case of non-compliance.
Can a debtor exempt himself from performing the obligation by paying the penalty?	The debtor cannot exempt himself from the performance of the obligation by paying the penalty, save in the case where this right has been expressly reserved for him. In this case, the respondents did not reserve the right to pay the penalty instead of performing their obligation under the Kasunduan.
What does the case say about the autonomy of contracts?	The Court emphasized the autonomous nature of contracts, stating that the Agreement and the Kasunduan are independent contracts with different parties, objects, and causes. Given these distinctions, the CA erred in not independently determining the validity of the Kasunduan.
Why was the Court of Appeals decision reversed?	The Court of Appeals erred by ruling on the validity of the Agreement without Atty. Zepeda, a party to that agreement, being properly impleaded in the suit. The Supreme Court emphasized that no person should be affected by a proceeding where they are not a party.
What is the effect of a notarized document?	As a notarized document, the Kasunduan carries evidentiary weight. The respondents signed it with full knowledge of its contents.

This case reinforces the principle that contractual obligations, freely entered into, must be honored and upheld in Philippine law. Parties are expected to exercise due diligence in understanding and agreeing to the terms of contracts, as courts will generally enforce these terms absent a clear showing of illegality, fraud, or coercion. The decision also highlights the importance of proper legal procedures in resolving contractual disputes, particularly the need to implead all relevant parties before making a binding judgment.

For inquiries regarding the application of this ruling to specific circumstances, please contact ASG Law through contact or via email at frontdesk@asglawpartners.com.

Disclaimer: This analysis is provided for informational purposes only and does not constitute legal advice. For specific legal guidance tailored to your situation, please consult with a qualified attorney.
Source: Heirs of Manuel Uy Ek Liong vs. Mauricia Meer Castillo, G.R. No. 176425, June 05, 2013

June 5, 2013

Equitable Reduction of Penalties in Lease Agreements: Balancing Contractual Freedom and Fairness

The Supreme Court has ruled that while contractual stipulations, including penal clauses in lease agreements, are generally binding, courts have the power to equitably reduce penalties if they are deemed unconscionable. This decision emphasizes that even when a lessee breaches a contract, the forfeiture of security deposits must be proportionate to the gravity of the violation, ensuring fairness and preventing unjust enrichment. This principle protects lessees from excessive penalties while upholding the integrity of contractual agreements.

Security Deposits on the Line: When Can a Landlord Forfeit Your Funds?

Erminda F. Florentino, doing business as “Empanada Royale,” leased commercial spaces from Supervalue, Inc., in several SM Malls. The contracts contained similar terms, including a security deposit and a clause allowing Supervalue to terminate the lease and forfeit the deposit for any breach. Supervalue terminated the leases, citing violations such as unauthorized product sales and inconsistent operating hours, and subsequently refused to return Florentino’s security deposits totaling P192,000. The central legal question was whether Supervalue was justified in forfeiting the entire security deposit due to Florentino’s alleged breaches, or if such a penalty was excessive and unconscionable.

The Regional Trial Court (RTC) initially ruled in favor of Florentino, ordering Supervalue to return the security deposits. However, the Court of Appeals (CA) reversed this decision, finding that the breaches justified the forfeiture based on the lease agreement’s terms. The Supreme Court then stepped in to review the CA’s decision, focusing on the application of penal clauses and the court’s power to mitigate them.

The Supreme Court acknowledged the general principle of contractual freedom, where parties are free to establish stipulations and clauses as they deem fit. However, this freedom is not absolute. The Court emphasized that penal clauses, designed to ensure compliance and provide liquidated damages, are subject to equitable reduction under Article 1229 of the Civil Code. This article states:

Art. 1229. The judge shall equitably reduce the penalty when the principal obligation has been partly or irregularly complied with by the debtor. Even if there has been no performance, the penalty may also be reduced by the courts if it is iniquitous or unconscionable.

Building on this principle, the Court referenced Ligutan v. Court of Appeals, which established standards for determining whether a penalty is unconscionable. These standards include considering the type, extent, and purpose of the penalty, the nature of the obligation, the mode of breach, its consequences, and the parties’ relationship.

In Florentino’s case, the Supreme Court found the complete forfeiture of the security deposit to be excessive. Although Florentino had committed breaches, the Court reasoned that the severity of these violations did not warrant the total loss of the deposit. Therefore, it exercised its discretion to reduce the penalty, ordering Supervalue to return 50% of the security deposits to Florentino. The Court highlighted that the full forfeiture would constitute a usurious and iniquitous penalty, disproportionate to the actual harm suffered by Supervalue.

Regarding the improvements made by Florentino on the leased premises, the Court considered Section 11 of the lease agreement:

Section 11. ALTERATIONS, ADDITIONS, IMPROVEMENTS, ETC. The LESSEE shall not make any alterations, additions, or improvements without the prior written consent of LESSOR; and all alterations, additions or improvements made on the leased premises, except movable or fixtures put in at LESSEE’s expense and which are removable, without defacing the buildings or damaging its floorings, shall become LESSOR’s property without compensation/reimbursement but the LESSOR reserves the right to require the removal of the said alterations, additions or improvements upon expiration of the lease.

The Court noted that Florentino failed to obtain Supervalue’s prior written consent before making improvements. Citing Fernandez v. Court of Appeals, the Court reiterated that verbal agreements to extend leases are inadmissible under the parole evidence rule and unenforceable under the statute of frauds. Lessees are generally expected to improve leased spaces to suit their business needs, independent of any inducement from the lessor. The court determined Florentino was not entitled to reimbursement for the improvements.

Moreover, the Court clarified that Article 1678 of the Civil Code, which provides for reimbursement of improvements, must be read in conjunction with Articles 448 and 546. These articles apply to builders in good faith—those who believe they own the land. Since Florentino was a lessee, she could not claim to be a builder in good faith. The Supreme Court cited Geminiano v. Court of Appeals, stating:

Being mere lessees, the private respondents knew that their occupation of the premises would continue only for the life of the lease. Plainly, they cannot be considered as possessors nor builders in good faith.

Therefore, Supervalue was not obligated to reimburse Florentino for the improvements.

Finally, the Court denied Florentino’s claim for attorney’s fees. Attorney’s fees are typically awarded when a party is compelled to litigate due to another party’s unjustified actions. Here, the Court found that Supervalue had a reasonable basis for refusing to return the security deposits and reimburse the costs of improvements, negating the justification for awarding attorney’s fees.

FAQs

What was the key issue in this case?	The central issue was whether Supervalue was justified in forfeiting Erminda Florentino’s entire security deposit due to breaches of their lease agreements, or if the penalty was unconscionable. The Court also considered if Supervalue was obligated to reimburse Florentino for improvements made to the leased property.
What is a penal clause in a contract?	A penal clause is an accessory undertaking in a contract designed to ensure performance by imposing a greater liability in case of breach. It serves as liquidated damages and strengthens the obligation’s coercive force.
Can courts reduce penalties stipulated in contracts?	Yes, Article 1229 of the Civil Code allows courts to equitably reduce penalties in two instances: when the principal obligation has been partly or irregularly complied with, and when the penalty is iniquitous or unconscionable.
How did the Court determine if the penalty was unconscionable?	The Court considered factors like the type, extent, and purpose of the penalty, the nature of the obligation, the mode of breach, its consequences, the parties’ relationship, and other relevant circumstances. The goal is to assess if the penalty is disproportionate to the breach.
Was Florentino considered a builder in good faith?	No, Florentino was not considered a builder in good faith because as a lessee, she knew her occupation of the premises was limited to the lease term and could not have believed she owned the property. Builders in good faith are those who believe they own the land they build on.
Why was Florentino not reimbursed for the improvements she made?	Florentino did not obtain Supervalue’s prior written consent before making the improvements, as required by the lease agreement. Additionally, as a lessee, she could not claim reimbursement as a builder in good faith under Articles 448 and 546 of the Civil Code.
What was the Court’s final ruling on the security deposit?	The Supreme Court ruled that Supervalue could only forfeit 50% of the total security deposit, finding the full forfeiture unconscionable. Supervalue was ordered to return the remaining 50% to Florentino.
When are attorney’s fees awarded in legal cases?	Attorney’s fees may be awarded when a party is compelled to litigate or incur expenses to protect their interests due to the unjustified act of the other party. In this case, attorney’s fees were denied because Supervalue had a reasonable basis for its actions.

This case clarifies the balance between upholding contractual agreements and ensuring equitable outcomes in lease disputes. While lessors can include penal clauses to protect their interests, courts retain the authority to prevent unjust enrichment by reducing excessive penalties. This decision reinforces the principle that contractual freedom is not absolute and must be exercised within the bounds of fairness and reasonableness.

For inquiries regarding the application of this ruling to specific circumstances, please contact ASG Law through contact or via email at frontdesk@asglawpartners.com.

Disclaimer: This analysis is provided for informational purposes only and does not constitute legal advice. For specific legal guidance tailored to your situation, please consult with a qualified attorney.
Source: ERMINDA F. FLORENTINO VS. SUPERVALUE, INC., G.R. No. 172384, September 12, 2007

September 12, 2007