OBLIGATIONS AND CONTRACTS; CONTRACTS; GENERAL PROVISIONS; CONTENT AND SUBJECT MATTER;

BINDING EFFECT

1. Principle of Mutuality

Article 1308 of the Code provides the contract must bind both contracting parties and its validity or compliance
cannot be left to the will of one of them. This is what jurisprudence refers to as the principle of mutuality of
contracts.

The Court has explained that Article 1308 is a virtual reproduction of Article 1256 of the old Civil Code but it was so
phrased as to emphasize the principle that the contract must bind both parties. It added:

This, of course is based firstly, on the principle that obligations arising from contracts have the force of
law between the contracting parties and secondly, that there must be mutuality between the parties based
on their essential equality to which is repugnant to have one party bound by the contract leaving the other
free therefrom.

Furthermore:

Its ultimate purpose is to render void a contract containing a condition which makes its fulfillment
dependent exclusively upon the uncontrolled will of one of the contracting parties.

But the Court has clarified that:

Not all contracts though which vest to one party their determination of validity or compliance or the right
to terminate the same are void for being violative of the mutuality principle. Jurisprudence is replete with
instances of cases where this Court upheld the legality of contracts which left their fulfillment or
implementation to the will of either of the parties. In these cases, however, there was a finding of the
presence of essential equality of the parties to the contracts, thus preventing the perpetration of injustice
on the weaker party.

In GF Equity v. Valenzona, the petitioner terminated the employment of respondent before the end of the two year
term invoking a stipulation in the contract which stated:

If at any time during the contract, the COACH, in the sole opinion of the CORPORATION, fails to exhibit
sufficient skill or competitive ability to coach the team, the CORPORATION may terminate this contract.

The Court held that this condition clearly transgresses the principle of mutuality of contracts. It leaves the
determination of whether respondent failed to exhibit sufficient skill or competitive ability to coach solely on the
opinion of the petitioner.

Jurisprudence provides that the unilateral determination and imposition of increased rates is violative of the
principle of mutuality of contracts ordained in Article 1308 of the Civil Code.

In Floirendo v. Metrobank, the Court held that the increases of interest rate unilaterally imposed by respondent
without petitioners assent were violative of the principle of mutuality of contracts.

In this case, the petitioner executed a promissory note in favor of respondent which provided that the rate of
interest stipulated may be increased, decreased, or otherwise changed from time to time by the Bank without
advance notice in the event of changes in the interest rate prescribed by law or the Central Bank of the Philippines,
in the rediscount rate of member banks with the Central Bank of the Philippines, in the interest rates on savings and
time deposits, in the reserve requirements, or in the overall costs of funding or money.

The Court held that the monthly upward / downward adjustment of interest rate was left to the will of respondent
bank alone and therefore violated the essence of mutuality of the contract.

The Court explained that in New Sampaguita Builders Construction, Inc. (NSBCI) v. Philippine National Bank, it ruled
that the escalation clauses giving respondent an unbridled right to adjust the interest independently and upwardly
would completely take away from petitioner the right to assent to an important modification in their agreement,
hence, would negate the element of mutuality in their contracts. Such escalation clause would make the fulfillment
of the contracts dependent exclusively upon the uncontrolled will of respondent bank and is therefore void.

The Court noted that in Philippine National Bank v. Court of Appeals, it declared the escalation clause in the Credit
agreement whereby the Bank reserves the right to increase the interest rate within the limit allowed by law at any
time depending on whatever policy it may adopt in the future void:

It is basic that there can be no contract in the true sense in the absence of the element of agreement, or
of mutual assent of the parties. If this assent is wanting on the part of one who contracts, his act has no
more efficacy than if it had been done under duress or by a person of unsound mind.

Similarly, contract changes must be made with the consent of the contracting parties. The minds of all the
parties must meet as to the proposed modification, especially when it affects an important aspect of the

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agreement. In the case of loan contracts, it cannot be gainsaid that the rate of interest is always a vital
component, for it can make or break a capital venture. Thus, any change must be mutually agreed upon,
otherwise, it is bereft of any binding effect.

We cannot countenance petitioner banks posturing that that 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.

It must be noted however that the provision in this case requires that such increase or decrease in rates must be
in the event of changes in the interest rate prescribed by law or the Central Bank of the Philippines, in the
rediscount rate of member banks with the Central Bank of the Philippines, in the interest rates on savings and time
deposits, in the interest rates on the banks borrowings, in the reserve requirements, or in the overall costs of
funding or money. So without these changes, the bank could not change the rates. Thus, it may be argued that the
change in rates was not based on the sole will of the bank. But this was not considered by the Court.

In PNB v. Court of Appeals, the Court ruled that the unilateral action of the PNB in increasing the interest rate on the
respondents loan violated the mutuality of contracts. In this case, the respondent executed promissory notes which
authorized the PNB to increase the stipulated 18% interest per annum within the limits allowed by law at any time
depending on whatever policy PNB may adopt in the future.

In Allied Banking Corp. v. Court of Appeals, the lease contract between petitioner and respondent provided in its
Provision No. 1 that the term of this lease shall be fourteen (14) years commencing from April 1, 1978, and may be
renewed for a like term at the option of the lessee.

The Court agreed with petitioner that Provision No. 1 of the lease contract was mutually agreed upon hence valid
and binding on both parties, and exercise by petitioner of its option to renew the contract was part of their
agreement and in pursuance thereof.

The Court further explained that:

An express agreement which gives the lessee the sole option to renew the lease is frequent and subject to
statutory restrictions, valid and binding on the parties. This option, which is provided in the same lease
agreement, is fundamentally part of the consideration in the contract and is no different from any other
provision of the lease carrying an undertaking on the part of the lessor to act conditioned on the
performance by the lessee. It is a purely executory contract and at most confers a right to obtain a renewal
if there is compliance with the conditions on which the right is made to depend. The right of renewal
constitutes a part of the lessee's interest in the land and forms a substantial and integral part of the
agreement.

Therefore, the validity of the provision is based on the fact that such provision was a fundamental part of the
consideration of the contract.

The Court further explained:

The fact that such option is binding only on the lessor and can be exercised only by the lessee does not
render it void for lack of mutuality. After all, the lessor is free to give or not to give the option to the lessee.
And while the lessee has a right to elect whether to continue with the lease or not, once he exercises his
option to continue and the lessor accepts, both parties are thereafter bound by the new lease agreement.
Their rights and obligations become mutually fixed, and the lessee is entitled to retain possession of the
property for the duration of the new lease, and the lessor may hold him liable for the rent therefor. The
lessee cannot thereafter escape liability even if he should subsequently decide to abandon the premises.
Mutuality obtains in such a contract and equality exists between the lessor and the lessee since they
remain with the same faculties in respect to fulfillment.

Thus, the Court justified the non-violation of the mutuality principle on the fact that the lessor, presumably at the
time of negotiation of the contract, was free to give or not to give the option.

The Court pointed out that the Court was confronted with a similar problem in Ledesma v. Javellana, where the
lessee was given the sole option to renew the lease, but the contract failed to specify the terms and conditions that
would govern the new contract. When the lease expired, the lessee demanded an extension under the same terms
and conditions. The lessor agreed to the renewal of the contract but refused to accede to the claim of the lessee
that the renewal should be under the same terms and conditions as the original contract.

The Court in Ledesma said that based on the case of Hicks v. Manila Hotel Company, such a clause does not permit
the defendant, upon the renewal of the contract in which the clause is found, to insist upon different terms than
those embraced in the contract to be renewed and that a stipulation to renew always relates to the contract in
which it is found and the rights granted thereunder, unless it expressly provides for variations in the terms of the
contract to be renewed. It added that the same principle is upheld in American Law:

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The rule is well-established that a general covenant to renew or extend a lease which makes no provision
as to the terms of a renewal or extension implies a renewal or extension upon the same terms as provided
in the original lease.

In the case of Allied, there is nothing in the contract as reported in the case which suggests that upon renewal, the
terms and conditions may be revisited.

The Court in this case, further ruled that if it were to adopt the contrary theory that the terms and contions to be
embodied in the renewed contract were still subject to mutual agreement by and between the parties, then the
option which is an integral part of the consideration for the contract would be rendered worthless it explained:

For then, the lessor could easily defeat the lessee's right of renewal by simply imposing unreasonable and
onerous conditions to prevent the parties from reaching an agreement, as in the case at bar. As in a
statute no word, clause, sentence, provision or part of a contract shall be considered surplusage or
superfluous, meaningless, void, insignificant or nugatory, if that can be reasonably avoided. To this end, a
construction which will render every word operative is to be preferred over that which would make some
words idle and nugatory.

2. Principle of Relativity

a. General Rule

The Code provides that, as a general rule, contracts take effect only between the parties, their assigns and heirs.

In other words, under the principle of relativity of contracts which provides that contracts can only bind the parties
who entered into it, a contract cannot favor or prejudice a third person, even if he is aware of such contract and has
acted with knowledge thereof. Where there is no privity of contract, there is no obligation or liability to speak about
and thus no cause of action arises.

Thus, only the parties, as against each other, may violate a contract. Therefore, in an action upon that contract, the
real parties in interest, either as plaintiff or as defendant, must be parties to said contrac.t in other words, a party
who has not taken part in the contract cannot sue or be sued for performance or for cancellation thereof, unless he
shows that he has a real interest affected thereby.

In cases where the contract is binding on an heir, he is not liable beyond the value of the property he received from
the decedent.

But contracts will not take effect on assigns and heirs if the rights and obligations arising from the contract are not
transmissible:

By their nature; or
By stipulation; or
By provision of law.

Regarding whether there is transmissibility, in DKC Holdings v. CA the Court quoted Tolentino:

Among contracts which are intransmissible are those which are purely personal, either by provision of
law, such as in cases of partnerships and agency, or by the very nature of the obligations arising
therefrom, such as those requiring special personal qualifications of the obligor. It may also be stated that
contracts for the payment of money debts are not transmitted to the heirs of a party, but
constitute a charge against his estate. Thus, where the client in a contract for professional services of
a lawyer died, leaving minor heirs, and the lawyer, instead of presenting his claim for professional services
under the contract to the probate court, substituted the minors as parties for his client, it was held that the
contract could not be enforced against the minors; the lawyer was limited to a recovery on the basis of
quantum meruit.

The Court also quoted American jurisprudence:

(W)here acts stipulated in a contract require the exercise of special knowledge, genius, skill, taste, ability,
experience, judgment, discretion, integrity, or other personal qualification of one or both parties, the
agreement is of a personal nature, and terminates on the death of the party who is required to render such
service.

The Court further explained that:

It has also been held that a good measure for determining whether a contract terminates upon the death
of one of the parties is whether it is of such a character that it may be performed by the promissor's

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personal representative. Contracts to perform personal acts which cannot be as well performed by others
are discharged by the death of the promissor. Conversely, where the service or act is of such a character
that it may as well be performed by another, or where the contract, by its terms, shows that performance
by others was contemplated, death does not terminate the contract or excuse nonperformance.

An example of a contract that is transmissible is a lease contract. A lease contract is not essentially personal I
character. Thus, the rights and obligations therein are transmissible to the heirs.

In Estate of K.H. Heady v. Luzon Surety, the Court explained that under our law, the general rule is that a partys
contractual rights and obligations are transmissible to the successors. It added:

The rule is a consequence of the progressive "depersonalization" of patrimonial rights and duties that, as
observed by Victorio Polacco, has characterized the history of these institutions. From the Roman concept
of a relation from person to person, the obligation has evolved into a relation from patrimony to patrimony,
with the persons occupying only a representative position, barring those rare cases where the obligation is
strictly personal, i.e., is contracted intuitu personae, in consideration of its performance by a specific
person and by no other.

The Court further pointed out that the three exceptions under Article 1311 were not applicable. First, the contract in
this case was a contract of surety or guaranty. The nature of the obligation did not warrant the conclusion that the
decedents peculiar individual qualities were contemplated as a principal inducement for the contract. The creditor,
when it accepted the decedent as surety expected nothing but reimbursement.

As regards the second exception, or the intransmissibility by stipulation of the parties, the Court explained:

Being exceptional and contrary to the general rule, this intransmissibility should not be easily implied, but
must be expressly established, or at the very least, clearly inferable from the provisions of the
contract itself. (emphasis supplied)

However, the Court found that the text of the agreements sued upon nowhere indicated that they are non-
transferable.

Furthermore, the Court said:

Because under the law (Article 1311), a person who enters into a contract is deemed to have contracted
for himself and his heirs and assigns, it is unnecessary for him to expressly stipulate to that effect; hence,
his failure to do so is no sign that he intended his bargain to terminate upon his death.

As for the third exception or in transmissibility by operation of law, this involves those cases where the law
expresses that the rights or obligations are extinguished by death. In this case, the lower court sought to infer such
a limitation from Article 2056, to the effect that one who is obliged to furnish a guarantor must present a person
who possesses integrity, capacity to bind himself, and sufficient property to answer for the obligation which he
guarantees. The Court countered however that:

It will be noted, however, that the law requires these qualities to be present only at the time of the
perfection of the contract of guaranty. It is self-evident that once the contract has become perfected and
binding, the supervening incapacity of the guarantor would not operate to exonerate him of the eventual
liability he has contracted; and if that be true of his capacity to bind himself, it should also be true of his
integrity, which is a quality mentioned in the article alongside the capacity.

It explained that this is confirmed by Article 2057, which states:

Article 2057. If the guarantor should be convicted in first instance of a crime involving dishonesty or
should become insolvent, the creditor may demand another who has all the qualifications required in the
preceding article. The case is excepted where the creditor has required and stipulated that a specified
person should be the guarantor.

The Court explained that under this article, the supervening dishonesty of the guarantor does not terminate the
contract but merely entitles the creditor to demand a replacement of the guarantor. But this is optional to the
creditor. Thus, Article 2057 is incompatible with the trial courts stand that the requirement of integrity in the
guarantor or surety makes the latters undertaking strictly personal, so linked to his individuality that the guaranty
automatically terminates upon his death. The Court is saying that the personal integrity of the guarantor or surety
is not crucial to the continuing validity of the contract as it can subsist should it be lost.

b. Exceptions

i. Stipulation in favor of third party

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An exception to the rule that contracts only take effect between parties is a contract containing some stipulation in
favor of a third person, or a stipulation pour autrui. In this case, the third person is one not principally or subsidiarily
obligated in a contract, in which they had no intervention. To qualify, the stipulation must not convey a mere
incidental benefit or interest. The fairest test in determining whether the third persons interest in a contract is a
stipulation pour autrui or merely an incidental interest is to examine the intention of the parties as disclosed by
their contract.

The contracting parties must have clearly and deliberately conferred a favor upon a third person. Thus, the nature
of the benefit or interest granted to the third person and the intent of the contracting parties must be considered in
determining whether what is involved is a stipulation pour atrui.

But even if a stipulation qualifies as such, the third person may only demand the stipulations fulfillment if he
communicated his acceptance to the obligor before its revocation. In sum, the Code provides for the following
requisites in order for a third person to demand fulfillment of the stipulation pour autrui:
The third person communicates acceptance before the stipulation is revoked;
The stipulation is not a mere incidental benefit or interest; and
Contracting parties clearly and deliberately conferred a favor.

In addition to this, jurisprudence provides for the following requisites:

That the stipulation in favor of a third person should be a part, not the whole, of the contract;
that the favorable stipulation should not be conditioned or compensated by any kind of obligation
whatever; and
Neither of the contracting parties bears the legal representation or authorization of third party.

In Florentino v. Encarnacion, the Court said:

While a stipulation in favor of a third person has no binding effect in itself before its acceptance by the
party favored, the law does not provide when the third person must make his acceptance. As a rule, there
is no time at such third person has after the time until the stipulation is revoked.

In this case, the Court found that there was acceptance because of the enjoyment of benefits for almost 17 years
without questions form any quarters. The Court held that this can only be construed as an implied acceptance of
the stipulation pour autrui before its revocation.

The Court reiterated that the acceptance does not have to be in any particular form.

ii. In case of contracts creating real rights

The Code provides that in contracts creating real rights, third persons who come into possession of the object of the
contract are bound thereby, subject to the provisions of the Mortgage Law and the Land Registration Laws.

Tolentino explains that a real right directly affects property subject to it and hence whoever comes into possession
of such property must respect that real right.

Padilla explains that the rule means that innocent third parties who obtained the property for value and without
notice must be protected.

iii. In case of creditors

Creditors are protected in cases of contracts intended to defraud them. Padilla interprets this as saying that
contracts intended to defraud creditors shall not adversely affect them. This means that creditors, even though they
are not parties to a contract may be prejudiced by them. In such a case, the creditors may appeal to the courts to
seek a remedy for the prejudicial contract.

One way creditors are protected is the remedy of rescission. The Code provides that contracts undertaken in fraud
of creditors when the latter cannot in any other manner collect the claims due them are rescissible.