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E. Defective Contracts

1. Rescissible contracts

a. CONCEPT

Contracts validly agreed upon may be rescinded in the cases established by law. (Article 1380, Civil Code)

The term “rescission” is found in

1) Article 1191 of the Civil Code, the general provision on rescission of reciprocal obligations;

2) Article 1659, which authorizes rescission as an alternative remedy, insofar as the rights and obligations of the lessor and the lessee in contracts of lease are concerned; and

3) Article 1380 with regard to the rescission of contracts. (Pryce Corporation v. PAGCOR, G.R. No. 157480, 06 May 2005)

1) Rescissible contracts

The following contracts are rescissible:

1) Those which are entered into by guardians whenever the wards whom they represent suffer lesion by more than one-fourth of the value of the things which are the object thereof;

2) Those agreed upon in representation of absentees, if the latter suffer the lesion stated in the preceding number;

3) Those undertaken in fraud of creditors when the latter cannot in any other manner collect the claims due them;

4) Those which refer to things under litigation if they have been entered into by the defendant without the knowledge and approval of the litigants or of competent judicial authority;

5) All other contracts specially declared by law to be subject to rescission. (Article 1381, Civil Code)

a) With court-approval

Rescission referred to in Nos. 1 and 2 of Article 1381 shall not take place with respect to contracts approved by the courts. (Article 1386, Ibid.)

2) Payments made in a state of insolvency

Payments made in a state of insolvency for obligations to whose fulfillment the debtor could not be compelled at the time they were effected, are also rescissible. (Article 1382, Ibid.)

3) Subsidiary action

The action for rescission is subsidiary; it cannot be instituted except when the party suffering damage has no other legal means to obtain reparation for the same. (Article 1383, Ibid.)

b. PRESCRIPTION

1) The 4-year prescription

The action to claim rescission must be commenced within four years.(Article 1389, Ibid.)

For persons under guardianship and for absentees, the period of four years shall not begin until the termination of the former’s incapacity, or until the domicile of the latter is known. (Paragraph 2, Article 1389, Ibid.)

c. EFFECTS OF RESCISSION

1) Scope of rescission

Rescission shall be only to the extent necessary to cover the damages caused. (Article 1384, Ibid.)

2) Return of things

Rescission creates the obligation to return the things which were the object of the contract, together with their fruits, and the price with its interest; consequently, it can be carried out only when he who demands rescission can return whatever he may be obliged to restore. (Article 1385, Ibid.)

Neither shall rescission take place when the things which are the object of the contract are legally in the possession of third persons who did not act in bad faith.(Paragraph 2, Article 1385, Ibid.)

In this case, indemnity for damages may be demanded from the person causing the loss. (Paragraph 3, Article 1385, Ibid.)

d. IN FRAUD OF CREDITORS

1) Presumption

a) Alienation by gratuitous title

All contracts by virtue of which the debtor alienates property by gratuitous title are presumed to have been entered into in fraud of creditors, when the donor did not reserve sufficient property to pay all debts contracted before the donation. (Article 1387, Ibid.)

2) Alienation by onerous title

Alienations by onerous title are also presumed fraudulent when made by persons against whom some judgment has been issued. The decision or attachment need not refer to the property alienated, and need not have been obtained by the party seeking the rescission. (Paragraph 2, Article 1387, Ibid.)

3) Liability of transferee in bad faith

Whoever acquires in bad faith the things alienated in fraud of creditors, shall indemnify the latter for damages suffered by them on account of the alienation, whenever, due to any cause, it should be impossible for him to return them. (Article 1388, Ibid.)

If there are two or more alienations, the first acquirer shall be liable first, and so on successively.(Paragraph 2, Article 1388, Ibid.)

2. Voidable contracts

a. CONCEPT

Voidable contracts are binding, unless they are annulled by a proper action in court.(Paragraph 2, Article 1390, Ibid.)

1) Voidable contracts

The following contracts are voidable or annullable, even though there may have been no damage to the contracting parties:

1) Those where one of the parties is incapable of giving consent to a contract;

2) Those where the consent is vitiated by mistake, violence, intimidation, undue influence or fraud. (Article 1390, Ibid.)

These contracts are binding, unless they are annulled by a proper action in court. They are susceptible of ratification.(Paragraph 2, Article 1390, Ibid.)

b. PRESCRIPTION

1) The 4-year prescription

The action for annulment shall be brought within four years.(Article 1391, Ibid.)

a) Intimidation, violence, undue influence

In cases of intimidation, violence or undue influence, the counting of prescription shall be from the time the defect of the consent ceases. (Paragraph 3, Article 1391, Ibid.)

b) Mistake, fraud

In case of mistake or fraud, the counting of prescription shall be from the time of the discovery of the same. (Paragraph 4, Article 1391, Ibid.)

c) Minors or incapacitated persons

When the action refers to contracts entered into by minors or other incapacitated persons, the counting of prescription shall be from the time the guardianship ceases. (Paragraph 5, Article 1391, Ibid.)

c. RATIFICATION

1) Extinguishes action to annual a voidable contract

Ratification extinguishes the action to annul a voidable contract. (Article 1392, Ibid.)

Voidable contracts are susceptible of ratification. (Paragraph 2, Article 1390, Ibid.)

a) Cleanses all defects

Ratification cleanses the contract from all its defects from the moment it was constituted. (Article 1396, Ibid.)

2) How done

Ratification may be effected expressly or tacitly. (Article 1393, Ibid.)

It is understood that there is a tacit ratification if, with knowledge of the reason which renders the contract voidable and such reason having ceased, the person who has a right to invoke it should execute an act which necessarily implies an intention to waive his right. (Ibid.)

3) By whom

a) By either/both party – with exceptions

The action for the annulment of contracts may be instituted by all who are thereby obliged principally or subsidiarily. However, persons who are capable cannot allege the incapacity of those with whom they contracted; nor can those who exerted intimidation, violence, or undue influence, or employed fraud, or caused mistake base their action upon these flaws of the contract. (Article 1397, Ibid.)

b) By a guardian

Ratification may be effected by the guardian of the incapacitated person. (Article 1394, Ibid.)

4) No conformity required from party who has no right to bring action

Ratification does not require the conformity of the contracting party who has no right to bring the action for annulment. (Article 1395, Ibid.)

d. EFFECTS OF NULLITY

1) Restoration, restitution

a) Thing subject matter of the contract

b) Fruits

c) Price with interest

An obligation having been annulled, the contracting parties shall restore to each other the things which have been the subject matter of the contract, with their fruits, and the price with its interest, except in cases provided by law.(Article 1398, Ibid.)

In obligations to render service, the value thereof shall be the basis for damages. (Paragraph 2, Article 1398, Ibid.)

As long as one of the contracting parties does not restore what in virtue of the decree of annulment he is bound to return, the other cannot be compelled to comply with what is incumbent upon him.(Article 1402, Ibid.)

2) Liability of incapacitated party

When the defect of the contract consists in the incapacity of one of the parties, the incapacitated person is not obliged to make any restitution except insofar as he has been benefited by the thing or price received by him. (Article 1399, Ibid.)

3) Loss of thing through fault of party obliged to return

a) Return fruits

b) Return value of thing at time of loss

c) Pus interest

Whenever the person obliged by the decree of annulment to return the thing can not do so because it has been lost through his fault, he shall return the fruits received and the value of the thing at the time of the loss, with interest from the same date. (Article 1400, Ibid.)

4) Extinguishment of action for annulment

a) If loss is through fraud or fault of person who has right to institute action

The action for annulment of contracts shall be extinguished when the thing which is the object thereof is lost through the fraud or fault of the person who has a right to institute the proceedings. (Article 1401, Ibid.)

If the right of action is based upon the incapacity of any one of the contracting parties, the loss of the thing shall not be an obstacle to the success of the action, unless said loss took place through the fraud or fault of the plaintiff. (Paragraph 2, Article 1402, Ibid.)

3. Unenforceable contracts

a. CONCEPT

1) Unenforceable contracts

The following contracts are unenforceable, unless they are ratified:

(1) Those entered into in the name of another person by one who has been given no authority or legal representation, or who has acted beyond his powers;

(2) Those that do not comply with the Statute of Frauds as set forth in this number. In the following cases an agreement hereafter made shall be unenforceable by action, unless the same, or some note or memorandum, thereof, be in writing, and subscribed by the party charged, or by his agent; evidence, therefore, of the agreement cannot be received without the writing, or a secondary evidence of its contents:

(a) An agreement that by its terms is not to be performed within a year from the making thereof;

(b) A special promise to answer for the debt, default, or miscarriage of another;

(c) An agreement made in consideration of marriage, other than a mutual promise to marry;

(d) An agreement for the sale of goods, chattels or things in action, at a price not less than five hundred pesos, unless the buyer accept and receive part of such goods and chattels, or the evidences, or some of them, of such things in action or pay at the time some part of the purchase money; but when a sale is made by auction and entry is made by the auctioneer in his sales book, at the time of the sale, of the amount and kind of property sold, terms of sale, price, names of the purchasers and person on whose account the sale is made, it is a sufficient memorandum;

(e) An agreement of the leasing for a longer period than one year, or for the sale of real property or of an interest therein;

(f) A representation as to the credit of a third person.

(3) Those where both parties are incapable of giving consent to a contract. (Article 1403, Ibid.)

2) Ratification

In a contract where both parties are incapable of giving consent, express or implied ratification by the parent, or guardian, as the case may be, of one of the contracting parties shall give the contract the same effect as if only one of them were incapacitated. (Article 1407, Ibid.)

If ratification is made by the parents or guardians, as the case may be, of both contracting parties, the contract shall be validated from the inception. (Paragraph 2, Article 1407, Ibid.)

3) Non-assailable by third persons

Unenforceable contracts cannot be assailed by third persons.(Article 1408, Ibid.)

b. STATUTE OF FRAUD

1) Ratification

Contracts infringing the Statute of Frauds, referred to in No. 2 of Article 1403, are ratified by the failure to object to the presentation of oral evidence to prove the same, or by the acceptance of benefit under them. (Article 1405, Ibid.)

2) Public document

When a contract is enforceable under the Statute of Frauds, and a public document is necessary for its registration in the Registry of Deeds, the parties may avail themselves of the right under Article 1357. (Article 1406, Ibid.)

If the law requires a document or other special form, as in the acts and contracts enumerated in the following article, the contracting parties may compel each other to observe that form, once the contract has been perfected. This right may be exercised simultaneously with the action upon the contract. (Article 1357, Ibid.)

4. Void or inexistent contracts

a. CONCEPT

The following contracts are inexistent and void from the beginning:

1) Those whose cause, object or purpose is contrary to law, morals, good customs, public order or public policy;

2) Those which are absolutely simulated or fictitious;

3) Those whose cause or object did not exist at the time of the transaction;

4) Those whose object is outside the commerce of men;

5) Those which contemplate an impossible service;

6) Those where the intention of the parties relative to the principal object of the contract cannot be ascertained;

7) Those expressly prohibited or declared void by law. (Article 1409, Ibid.)

1) No ratification

These contracts cannot be ratified. (Paragraph 2, Article 1409, Ibid.)

2) No waiver of defense of illegality

Neither can the right to set up the defense of illegality be waived. (Paragraph 2, Article 1409, Ibid.)

3) No prescription

The action or defense for the declaration of the inexistence of a contract does not prescribe. (Article 1410, Ibid.)

b. ILLEGAL OR UNLAWFUL CONTRACT

1) If illegal cause or object constitutes a criminal offense

When the nullity proceeds from the illegality of the cause or object of the contract, and the act constitutes a criminal offense, both parties being in pari delicto, they shall have no action against each other, and both shall be prosecuted. Moreover, the provisions of the Penal Code relative to the disposal of effects or instruments of a crime shall be applicable to the things or the price of the contract.(Article 1411, Ibid.)

This rule shall be applicable when only one of the parties is guilty; but the innocent one may claim what he has given, and shall not be bound to comply with his promise. (Paragraph 2, Article 1411, Ibid.)

2) If unlawful act or forbidden cause does not constitute a criminal offense

If the act in which the unlawful or forbidden cause consists does not constitute a criminal offense, the following rules shall be observed:

1) When the fault is on the part of both contracting parties, neither may recover what he has given by virtue of the contract, or demand the performance of the other’s undertaking;

2) When only one of the contracting parties is at fault, he cannot recover what he has given by reason of the contract, or ask for the fulfillment of what has been promised him. The other, who is not at fault, may demand the return of what he has given without any obligation to comply his promise. (Article 1412, Ibid.)

3) Repudiation

When money is paid or property delivered for an illegal purpose, the contract may be repudiated by one of the parties before the purpose has been accomplished, or before any damage has been caused to a third person. In such case, the courts may, if the public interest will thus be subserved, allow the party repudiating the contract to recover the money or property. (Article 1414, Ibid.)

4) One party incapable of consent

Where one of the parties to an illegal contract is incapable of giving consent, the courts may, if the interest of justice so demands allow recovery of money or property delivered by the incapacitated person. (Article 1415, Ibid.)

5) Prohibited only, not illegal per se

When the agreement is not illegal per se but is merely prohibited, and the prohibition by the law is designated for the protection of the plaintiff, he may, if public policy is thereby enhanced, recover what he has paid or delivered. (Article 1416, Ibid.)

a) Price of article or commodity

When the price of any article or commodity is determined by statute, or by authority of law, any person paying any amount in excess of the maximum price allowed may recover such excess. (Article 1417, Ibid.)

6) Divisible contract

In case of a divisible contract, if the illegal terms can be separated from the legal ones, the latter may be enforced. (Article 1420, Ibid.)

7) When defense unavailable to third persons

The defense of illegality of contract is not available to third persons whose interests are not directly affected. (Article 1421, Ibid.)

8) Resulting contract

A contract which is the direct result of a previous illegal contract, is also void and inexistent. (Article 1422, Ibid.)

5. Distinguish: resolution and rescission of contracts

a. RESOLUTION  v. RESCISSION

Resolution was originally used in Article 1124 of the old Civil Code, and that the term became the basis for rescission under Article 1191 (and, conformably, also Article 1659). (Pryce Corporation v. PAGCOR, G.R. No. 157480, 06 May 2005)

There is a distinction in law between cancellation of a contract and its rescission. To rescind is to declare a contract void in its inception and to put an end to it as though it never were. It is not merely to terminate it and release parties from further obligations to each other but to abrogate it from the beginning and restore the parties to relative positions which they would have occupied had no contract ever been made. (Huibonhoa v. CA, G.R. Nos. 95897 and 102604, 14 December 1999)

The termination or cancellation of a contract would necessarily entail enforcement of its terms prior to the declaration of its cancellation in the same way that before a lessee is ejected under a lease contract, he has to fulfill his obligations thereunder that had accrued prior to his ejectment. However, termination of a contract need not undergo judicial intervention. (Huibonhoa v. CA, G.R. Nos. 95897 and 102604, 14 December 1999)

1) Article 1191

a) Breach of faith

b) Principal action

The rescission on account of breach of stipulations is not predicated on injury to economic interests of the party plaintiff but on the breach of faith by the defendant, that violates the reciprocity between the parties. It is not a subsidiary action, and Article 1191 may be scanned without disclosing anywhere that the action for rescission thereunder is subordinated to anything other than the culpable breach of his obligations to the defendant. This rescission is a principal action retaliatory in character, it being unjust that a party be held bound to fulfill his promises when the other violates his. As expressed in the old Latin aphorism: “Non servanti fidem, non est fides servanda.” Hence, the reparation of damages for the breach is purely secondary. (JBL Ryes, Concurring Opinion, in Universal Food Corporation v. CA, G.R. No. L-29155, 13 May 1970, cited in Pryce Corporation v. PAGCOR, supra.)

2) Article 1381

a) Based on lesion or economic prejudice

b) Subsidiary action

On the contrary, in rescission by reason of lesion or economic prejudice [under Article 1381], the cause of action is subordinated to the existence of that prejudice, because it is the raison d’etre as well as the measure of the right to rescind. (JBL Ryes, Concurring Opinion, in Universal Food Corporation v. CA, G.R. No. L-29155, 13 May 1970, cited in Pryce Corporation v. PAGCOR, supra.)

Hence, where the defendant makes good the damages caused, the action cannot be maintained or continued, as expressly provided in Articles 1383 and 1384. But the operation of these two articles is limited to the cases of rescission for lesion enumerated in Article 1381 of the Civil Code of the Philippines, and does not, apply to cases under Article 1191. (JBL Ryes, Concurring Opinion, in Universal Food Corporation v. CA, G.R. No. L-29155, 13 May 1970, cited in Pryce Corporation v. PAGCOR, supra.)

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