Concept and Principles of a Contract

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What constitutes a contract – A contract is “a meeting of minds between two persons whereby one binds himself, with respect to the other, to give something or to render some service.”[1]

Principle of autonomy – The principle of autonomy provides that the contracting parties are free to establish “such 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.”[2]

Medel v. Court of Appeals
G.R. No. 131622, 27 November 1998

Plaintiffs loaned to defendants a sum of money amounting to Php500,000.00, with a stipulated rate of interest at 5.5% per month or 66% per annum. When plaintiffs instituted a collection suit, defendants challenged the validity of the interest rate.

HELD: The stipulated rate of interest at 5.5% per month on the P500,000.00 loan is “excessive, iniquitous, unconscionable and exorbitant.” Notwithstanding, such rate is not “usurious” because Circular No. 905 of the Central Bank (adopted on 22 December 1982) has expressly removed the interest ceilings prescribed by the Usury Law. Thus, Usury Law is now “legally inexistent.” That being the case, interest can now be charged “as lender and borrower may agree upon.”

Even if there is no Usury Law, “the interest at 5.5% per month, or 66% per annum, stipulated upon by the parties in the promissory note is iniquitous or unconscionable, and, hence, contrary to morals… if not against the law.” As a result, the stipulation is void. In such a case, the courts have the power to reduce equitably the liquidated damages, whether intended as an indemnity or a penalty if they are iniquitous or unconscionable. The interest is accordingly lowered to a reasonable 12% per annum, and an additional 1% a month penalty charge as liquidated damages.

Principle of mutuality – The principle of mutuality provides that both contracting parties must be bound by the contract.[3] Hence, the contract’s validity or compliance cannot be left to the sole will of either party.[4]

Philippine National Bank v. Sps. Rocamora
G.R. No. 164549, 18 September 2009

Plaintiff Philippine National Bank (PNB) loaned to defendant Sps. Agustin and Pilar Rocamora the aggregate amount of Php100,000.00. Per their agreement as reflected in the promissory notes, the defendants were to pay the principal amount plus interest rate at 12% per annum, plus a penalty of 5% per annum in case of delayed payments. Defendants executed a real estate mortgage to secure the loan. Both the promissory note and real estate mortgage contained an escalation clause allowing PNB to increase the 12% interest rate at any time without notice, within the limits allowed by law.

After plaintiff initiated a collection suit for failure of defendants to pay, and after foreclosing on the mortgaged property, the bank claimed that it was still entitled to a deficiency claim of Php206,297.47. The defendants refused to pay claiming that the bank “practically created” the deficiency when it increased the interest rate from 12% to 42% per annum. In response thereto, plaintiff claimed that the defendants had given their implied acceptance to the increase when they did not contest such after receiving such notice through demand letters and attached statements of accounts.

HELD: PNB’s deficiency claim is denied for violating the principle of mutuality. The bank’s claim of implied acceptance is invalid. The bank increased the interest rate without the consent of the defendants.

“Escalation clauses are valid and do not contravene public policy. These clauses are common in credit agreements as means of maintaining fiscal stability and retaining the value of money on long-term contracts.” In order to avoid a one-sided situation as a result of escalation clause, it is required that there be an inclusion in the parties’ agreement of “a de-escalation clause that would authorize a reduction in the interest rates corresponding to downward changes made by law or by the Monetary Board.”

Despite the validity of escalation clauses, “these clauses do not give creditors the unbridled right to adjust interest rates unilaterally.” It is a rule that “any increase in the rate of interest made pursuant to an escalation clause must be the result of an agreement between the parties. The minds of all the parties must meet on the proposed modification as this modification affects an important aspect of the agreement. There can be no contract in the true sense in the absence of the element of an agreement, i.e., the parties’ mutual consent. Thus, any change must be mutually agreed upon, otherwise, the change carries no binding effect. A stipulation on the validity or compliance with the contract that is left solely to the will of one of the parties is void; the stipulation goes against the principle of mutuality of contract under Article 1308 of the Civil Code.” Consequently, “even with a de-escalation clause, no matter how elaborately worded, an unconsented increase in interest rates is ineffective if it transgresses the principle of mutuality of contracts.” (Emphasis supplied.)

Philippine National Bank v. Court of Appeals
G.R. No. 107569, 18 November 1998

 “PNB successively increased the stipulated interest so that what was originally 12% per annum became, after only two years, 42%.  In declaring the increases invalid… We cannot countenance petitioner bank’s posturing that the escalation clause at bench gives it unbridled right to unilaterally upwardly adjust the interest on private respondents’ loan.  That would completely take away from private respondents the right to assent to an important modification in their agreement, and would negate the element of mutuality in contracts.”

Here, PNB did not make any attempt “to secure the conformity of private respondents to the successive increases in the interest rate.  Private respondents’ assent to the increases cannot be implied from their lack of response to the letters sent by PNB, informing them of the increases.  For as stated in one case, no one receiving a proposal to change a contract is obliged to answer the proposal.”

Philippine National Bank v. Court of Appeals
G.R. No. 88880, 30 April 1991

“In order that obligations arising from contracts may have the force of law between the parties, there must be mutuality between the parties based on their essential equality. A contract containing a condition which makes its fulfillment dependent exclusively upon the uncontrolled will of one of the contracting parties, is void. Hence, even assuming that the P1.8 million loan agreement between the PNB and private respondent gave the PNB a license (although in fact there was none) to increase the interest rate at will during the term of the loan, that license would have been null and void for being violative of the principle of mutuality essential in contracts. It would have invested the loan agreement with the character of a contract of adhesion, where the parties do not bargain on equal footing, the weaker party’s (the debtor) participation being reduced to the alternative ‘to take it or leave it.’ Such a contract is a veritable trap for the weaker party whom the courts of justice must protect against abuse and imposition.” (Emphasis supplied.)

Principle of relativity – The principle of relativity provides that generally only the parties and their successors in interest are bound by the contract.[5] The exception is when the rights and obligations arising from the contract are not transmissible by their nature, by stipulation, or by provision of law.[6]

Same; Stipulation in favor of a third person – If there is a stipulation in favor of a third person, the latter has the right to demand fulfillment if he has communicated his acceptance to the debtor before its revocation.[7] The contracting parties must have clearly and deliberately conferred a favor upon a third person.[8] Thus, a mere incidental benefit or interest is not enough.[9]

Best Legal Practices

  • Obtain consent of third party to perfect a stipulation in his favor – The consent of the third party should be obtained to perfect a stipulation in his favor. Consequently, the third person should also made a signatory to the contract.

Determination of performance of obligations – A third party may be assigned to determine whether either or both party has performed their respective obligations.[10] The decision becomes binding once it is made known to both contracting parties.[11] However, the determination is not obligatory if it is evidently inequitable.[12] If so, the courts are to decide what is equitable under the circumstances.[13]

Perfection of a contract – As a general rule, contracts are perfected by mere consent.[14] From the moment of consent, the parties are bound not only to the fulfillment of what has been expressly stipulated but also to all the consequences which, according to their nature, may be in keeping with good faith, usage and law.[15] The exception are: (a) when delivery of the object of the obligation is required to perfect a contract, as in real contracts;[16] or (b) when a formal contract is required.[17]

Best Legal Practices

  • Execute written contracts – While contracts may be perfected by mere consent, it is best that an agreement be put in writing and executed by the parties. This written document is the best evidence of the contract. Refrain from relying on receipts – Receipts are not contracts as they only serve as evidence of payment. By itself, a receipt does not neceessarily establish a contract. At best, it is only a corroborating evidence.

[1] CIVIL CODE. Article 1305.

[2] Ibid. Article 1306; See Transfield Philippines, Inc., v. Luzon Hyrdo Corporation, et al., G.R. No. 146717, 22 November 2004.

[3] Manila International Airport Authority v. Ding Velayo Sports Center, Inc., G.R. No. 161718, 14 December 2011, citing Allied Banking Corporation v. Court of Appeals, 348 Phil. 382 (1998).

[4] CIVIL CODE. Article 1308.

[5] Ibid. Paragraph 1, Article 1311; See National Power Corporation v. Province of Quezon, et al., G.R. No. 171586, 15 July 2009; Starbright Sales Enterprises, Inc., v. Philippine Realty Corporation, et al., G.R. No. 177936, 18 January 2012.

[6] Ibid. Paragraph 1, Article 1311.

[7] CIVIL CODE. Paragraph 2, Article 1311. A stipulation in favor of a third person is also called a stipulation pour atrui.

[8] Ibid. Paragraph 2, Article 1311.

[9] Ibid.

[10] CIVIL CODE. Article 1309.

[11] Ibid.

[12] CIVIL CODE. Article 1310.

[13] Ibid.

[14] CIVIL CODE. Paragraph 2, Article 1315.

[15] Ibid.Bona fides exigit ut quod convenit fiat. Good faith demands that what is agreed upon shall be done. Kung ang tao ay tapat kanyang tutuparin ang napagkasunduan(Armando G. Yrasuegi v. Philippine Airlines, Inc., G.R. No. 168081, 17 October 2008).

[16] CIVIL CODE. Paragraph 2, Article 1316. The following contracts require delivery for them to be perfected: deposit, pledge, commodatum, insurance.

[17] Ibid. Article 1356.

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