Castro vs. Tan

A stipulated interest rate of 5% per month compounded monthly (60% per annum) is unconscionable, contrary to morals, and void ab initio under Article 1306 of the Civil Code, notwithstanding the lifting of the Usury Law ceiling by Central Bank Circular No. 905, and must be equitably reduced to the legal rate of 12% per annum; where the foreclosure was premised on an overstated debt inflated by such iniquitous interest, the foreclosure proceedings are nullified and the mortgagee ordered to reconvey the property conditioned on payment of the correct obligation.

Petitioners spouses Isagani and Diosdada Castro were lenders who extended a ₱30,000 loan to respondent Angelina de Leon Tan and her late husband Ruben Tan, secured by a real estate mortgage over a 240-square-meter residential lot in Malolos, Bulacan covered by TCT No. T-8540. The loan agreement, denominated Kasulatan ng Sanglaan ng Lupa at Bahay, stipulated 5% monthly interest compounded monthly. The dispute arose from the enforceability of that interest rate after default and the subsequent extrajudicial foreclosure of the mortgaged property. Central Bank Circular No. 905, s. 1982, which suspended the Usury Law ceiling on interest effective January 1, 1983, forms the regulatory backdrop against which the parties' stipulation must be evaluated.

On February 17, 1994, respondent Angelina de Leon Tan and her husband Ruben Tan, the registered owners of a 240-square-meter residential lot in Barrio Canalate, Malolos, Bulacan covered by Transfer Certificate of Title No. T-8540, obtained a loan of ₱30,000 from petitioners spouses Isagani and Diosdada Castro. The loan was secured by a real estate mortgage embodied in a document denominated Kasulatan ng Sanglaan ng Lupa at Bahay. Under the Kasulatan, the spouses Tan undertook to pay the mortgage debt within six months, or until August 17, 1994, with an interest rate of 5% per month, compounded monthly.

Ruben Tan died on September 2, 1994, leaving respondent Tan solely responsible for the loan. She failed to pay upon maturity. Thereafter, she offered to pay petitioners the principal amount of ₱30,000 plus a portion of the interest, but petitioners refused and instead demanded payment of the total accumulated sum of ₱359,000. On February 5, 1999, petitioners caused the extrajudicial foreclosure of the real estate mortgage and emerged as the only bidder in the auction sale. The redemption period expired without respondent Tan having redeemed the property, and title was consolidated in favor of petitioners. After a writ of possession was issued, the Sheriff ejected respondents from the property and delivered possession to petitioners.

On September 26, 2000, respondent Tan, joined by her co-heirs — the spouses Clemente, the spouses Carpio, the spouses Soliman, and Julius Amiel Tan — filed a Complaint for Nullification of Mortgage and Foreclosure and/or Partial Rescission of Documents and Damages before the Regional Trial Court of Malolos, Bulacan, alleging that the interest rate imposed on the principal was unconscionable. The trial court found the interest rate iniquitous and partially rescinded the Kasulatan to reduce the interest to 12% per annum, with an additional 1% monthly penalty as liquidated damages, and allowed redemption for ₱200,000. The Court of Appeals affirmed, further allowing redemption notwithstanding the lapse of the redemption period on grounds of equity and substantial justice.

• Freedom to Stipulate Interest: Petitioners contended that with the removal by the Bangko Sentral of the ceiling on interest rates through Central Bank Circular No. 905, s. 1982, lenders and borrowers could validly agree on any interest rate, rendering the stipulated 5% monthly compounded interest lawful and enforceable.
• Sanctity of Contract: Petitioners maintained that the Kasulatan was entered into freely and voluntarily, with a meeting of the minds on the principal, interest, and security, and that the Court of Appeals should have respected its provisions; they stressed that the law will not relieve a party from the effects of an unwise, foolish, or disastrous contract entered into with full awareness.
• Statutory Redemption Period: Petitioners argued that the Court of Appeals erred in extending the period of redemption in violation of Act No. 3135, which provides a one-year period for redemption of foreclosed real property.

• Unconscionable Interest: Respondents asserted that the appellate court correctly struck down the stipulated interest as excessive and contrary to morals, if not against the law.
• Limits on Contractual Freedom: Respondents pointed out that while a contract has the force of law between the parties, this holds only when the terms, clauses, and conditions are not contrary to law, morals, public order, or public policy.
• Necessity of Redemption: Respondents insisted that to disallow them to redeem the property would render meaningless the declaration that the stipulated interest is null and void.

• Validity of Stipulated Interest Rate: Whether the Court of Appeals erred in nullifying the 5% monthly compounded interest rate voluntarily agreed upon and expressly stipulated in the mortgage contract.
• Unilateral Alteration of Contract: Whether the Court of Appeals erred in unilaterally changing the terms and conditions of the mortgage contract by reducing the stipulated interest.
• Extension of Redemption Period: Whether the Court of Appeals erred in extending the period of redemption in favor of respondents in violation of Act No. 3135.
• Liquidated Damages: Whether the award of 1% per month as liquidated damages has any legal basis.

• Validity of Stipulated Interest Rate: No. The 5% monthly interest compounded monthly (60% per annum) is excessive, iniquitous, unconscionable, and exorbitant — contrary to morals and the law, and void ab initio under Article 1306 of the Civil Code; the legal interest of 12% per annum was correctly imposed in its place.
• Unilateral Alteration of Contract: No. There was no unilateral alteration; the void stipulation is deemed inexistent from the beginning, and substitution of the legal interest rate is consonant with justice and supported by precedent.
• Extension of Redemption Period: Rendered moot. The foreclosure proceedings were nullified because the amount demanded as the outstanding loan was overstated by the iniquitous interest, and it was not shown that respondents failed to pay the correct amount of their obligation.
• Liquidated Damages: No. The Kasulatan contains no stipulation on liquidated damages, and neither party alleged or proved any agreement thereon; the award was without legal basis and must be deleted.

• Validity of Stipulated Interest Rate: While Central Bank Circular No. 905 suspended the Usury Law ceiling on interest effective January 1, 1983, giving parties wide latitude to stipulate on interest rates, nothing in the circular grants lenders carte blanche authority to raise interest rates to levels that would enslave borrowers or hemorrhage their assets. Stipulations authorizing iniquitous or unconscionable interest are contrary to morals, if not against the law. In Medel vs. Court of Appeals, the Court annulled 5.5% monthly (66% per annum) and 6% monthly (72% per annum) interest rates as excessive and reduced them to 12% per annum. In Ruiz vs. Court of Appeals, a 3% monthly interest was declared excessive and reduced to 12% per annum. The 5% monthly compounded interest in this case is even higher than the 3% monthly rate invalidated in Ruiz; it is therefore void ab initio for violating Article 1306 of the Civil Code, which permits parties to establish stipulations provided they are not contrary to law, morals, good customs, public order, or public policy. The legal interest of 12% per annum was correctly imposed in lieu of the void stipulation.

• Unilateral Alteration of Contract: Petitioners' reliance on the voluntariness of the agreement and the principle that the law will not relieve a party from an unwise contract was rejected. Freedom of contract is not absolute but subject to reasonable legislative regulation aimed at promoting public health, morals, safety, and welfare, as held in Abe vs. Foster Wheeler Corporation. Article 1306 of the Civil Code expressly limits contractual autonomy to stipulations not contrary to law, morals, good customs, public order, or public policy. Because the compounded 5% monthly interest is iniquitous and unconscionable, it is a void stipulation deemed inexistent from the beginning; the debt is considered without the stipulated interest, and the legal interest of 12% per annum is imposed in its place. This is not a unilateral alteration of contract terms but the application of law to a void provision.

• Extension of Redemption Period: After the loan matured, respondent Tan attempted to pay the principal of ₱30,000 plus some interest, but petitioners refused and demanded ₱359,000 — an amount grossly inflated by the excessive interest. The trial court also noted her offer of ₱200,000 to redeem the property. Despite considerable effort, she failed to redeem because she could not raise the inflated amount. Applying Heirs of Zoelo Espiritu vs. Landrito, which is on all fours with this case, the Court held that where debtors were not given an opportunity to settle their debt at the correct amount without the iniquitous interest, no foreclosure proceedings may be instituted. A foreclosure sale is conditioned upon a finding of the correct amount of the unpaid obligation and the debtor's failure to pay that amount. Since the amount demanded was overstated, it was not shown that respondents failed to pay the correct amount; the foreclosure proceedings were therefore nullified, and the registration of the foreclosure sale declared invalid and incapable of vesting title. The issue of extending the redemption period was rendered moot by this nullification.

• Liquidated Damages: Although the issue of liquidated damages was not squarely raised by either party — respondents having failed to file their appellees' brief — the Court ruled on the matter in the exercise of its appellate jurisdiction, applying the principle that an unassigned error closely related to an error properly assigned will be considered notwithstanding failure to assign it. Article 2226 of the Civil Code defines liquidated damages as those agreed upon by the parties to a contract to be paid in case of breach. A cursory reading of the Kasulatan revealed no stipulation on liquidated damages, and neither party alleged or proved any agreement thereon. The award was therefore without legal basis and was deleted.

• Unconscionable Interest Rates — Stipulated interest rates, though voluntarily agreed upon and notwithstanding the suspension of the Usury Law ceiling by Central Bank Circular No. 905, s. 1982, are void ab initio if they are excessive, iniquitous, unconscionable, and exorbitant, contrary to morals and Article 1306 of the Civil Code. The legal interest of 12% per annum is imposed in lieu of the void stipulation. The Court has invalidated rates of 66% per annum (Medel vs. Court of Appeals), 72% per annum (Spouses Solangon vs. Salazar), 36% per annum (Ruiz vs. Court of Appeals), and 60% per annum compounded monthly (this case), while sustaining rates of 21% per annum (Bautista vs. Pilar Development Corp.) and 24% per annum (Garcia vs. Court of Appeals).

• Freedom of Contract and Its Limits — Freedom of contract is not absolute but subject to reasonable legislative regulation aimed at the promotion of public health, morals, safety, and welfare. Article 1306 of the Civil Code 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. A stipulation violating these limitations is void and deemed inexistent from the beginning.

• Foreclosure Premised on Overstated Debt — Where a foreclosure is premised on an outstanding loan amount inflated by an iniquitous and unconscionable interest rate, and the debtor was not given an opportunity to settle the debt at the correct amount, the foreclosure proceedings are nullified. A foreclosure sale is conditioned upon a finding of the correct amount of the unpaid obligation and the debtor's failure to pay that amount. The registration of an invalid foreclosure sale cannot vest title over the mortgaged property.

• Liquidated Damages Require Stipulation — Under Article 2226 of the Civil Code, liquidated damages are those agreed upon by the parties to a contract to be paid in case of breach. Absent any stipulation in the contract and absent any allegation or proof of an agreement on liquidated damages, an award thereof has no legal basis.

• "While we agree with petitioners that parties to a loan agreement have wide latitude to stipulate on any interest rate in view of the Central Bank Circular No. 905 s. 1982 which suspended the Usury Law ceiling on interest effective January 1, 1983, it is also worth stressing that interest rates whenever unconscionable may still be declared illegal. There is certainly nothing in said circular which grants lenders carte blanche authority to raise interest rates to levels which will either enslave their borrowers or lead to a hemorrhaging of their assets." — This passage articulates the controlling doctrine that the lifting of the Usury Law ceiling does not immunize unconscionable interest rates from judicial intervention, and is the most frequently cited formulation of this principle in subsequent jurisprudence.

• "Since the Spouses Landrito, the debtors in this case, were not given an opportunity to settle their debt, at the correct amount and without the iniquitous interest imposed, no foreclosure proceedings may be instituted." — Quoted from Heirs of Zoilo Espiritu vs. Landrito, this passage establishes the rule that foreclosure is invalid where the debtor was denied the opportunity to pay the correct amount of the obligation, a principle applied in this case to nullify the foreclosure proceedings.

• "Being a void stipulation, it is deemed inexistent from the beginning. The debt is to be considered without the stipulation of the iniquitous and unconscionable interest rate. Accordingly, the legal interest of 12% per annum must be imposed in lieu of the excessive interest stipulated in the agreement." — This passage defines the legal consequence of a void interest stipulation: the debt is treated as if no interest was agreed upon, and the legal rate is substituted, clarifying that the reduction is not a unilateral alteration of contract but the application of law to a void provision.

• Medel vs. Court of Appeals, 359 Phil. 820 (1998) — Controlling precedent. The Court annulled stipulated interest rates of 5.5% per month (66% per annum) and 6% per month (72% per annum) as excessive, iniquitous, unconscionable, and exorbitant, reducing them to 12% per annum. Applied directly in this case to support the nullification of the 5% monthly compounded rate.
• Ruiz vs. Court of Appeals, 449 Phil. 419 (2003) — Controlling precedent. A 3% monthly interest was declared excessive and reduced to 12% per annum. The 5% monthly rate in this case was found even higher, warranting the same treatment.
• Heirs of Zoilo Espiritu vs. Landrito, G.R. No. 169617, April 3, 2007, 520 SCRA 383 — Controlling precedent, described as "on all fours" with the instant case. Established that where debtors were not given an opportunity to settle their debt at the correct amount without iniquitous interest, no foreclosure may be instituted, and the foreclosure sale and registration thereof are invalid.
• Spouses Solangon vs. Salazar, 412 Phil. 816 (2001) — Followed. The Court invalidated a 6% monthly (72% per annum) interest rate and reduced it to 12% per annum, reinforcing the principle that unconscionable interest rates are illegal despite the suspension of the Usury Law.
• Abe vs. Foster Wheeler Corporation, 110 Phil. 198 (1960) — Cited for the principle that freedom of contract is not absolute but subject to reasonable legislative regulation aimed at promoting public health, morals, safety, and welfare.
• Cuaton vs. Salud, G.R. No. 158382, January 27, 2004, 421 SCRA 278 — Cited for the principle that unassigned errors closely related to assigned errors may be considered by the appellate court, supporting the Court's ruling on liquidated damages despite the issue not being squarely raised.

• Article 1306, Civil Code — Allows contracting parties to establish stipulations, clauses, terms, and conditions as they deem convenient, provided they are not contrary to law, morals, good customs, public order, or public policy. Applied as the basis for declaring the 5% monthly compounded interest void ab initio for being contrary to morals.
• Article 2226, Civil Code — Defines liquidated damages as those agreed upon by the parties to a contract to be paid in case of breach. Applied to determine that the award of 1% monthly liquidated damages was without legal basis, the Kasulatan containing no stipulation thereon.
• Central Bank Circular No. 905, s. 1982 — Suspended the Usury Law ceiling on interest effective January 1, 1983, giving parties wide latitude to stipulate on interest rates. The Court acknowledged this circular but held that it does not grant lenders carte blanche authority to impose unconscionable rates.
• Act No. 3135 — Governs the extrajudicial foreclosure of real estate mortgages and provides a one-year redemption period. Petitioners invoked it to argue against extension of the redemption period, but the issue was rendered moot by the nullification of the foreclosure proceedings.

Antonio T. Carpio (Chairperson, per Special Order No. 775 dated November 3, 2009), Teresita J. Leonardo-De Castro (additional member per Special Order No. 776 dated November 3, 2009), Arturo D. Brion, and Roberto A. Abad concurred. No separate concurring opinions were written.