Extinguishing an obligation with another obligation - A Law Each Day(Keeps Trouble Away)

This is another case of a loan and the rate of interest that may be legally imposed and charged. It is the case of the couple Romy and Tessie who borrowed money from a financing company to partially finance the purchase of a house and lot from a subdivision developer.

As evidence of the loan they executed a "Promissory Note (PN) with Assignment of Credit" on Dec. 22, 1978 obligating themselves to pay jointly and severally the amount of P100,000 in monthly installments of P1,378.83 with interest at the rate of 12 percent per annum and three percent service carge for a period of 20 years. In the same promissory note, the couple authorized the financing company to increase the rate of interest and/or service charges without notice to them in the event that a law, Presidential Decree or Circular should be enacted increasing the lawful rate of interest and service charges on the loan. Payment of the loan was secured by a second mortgage on the house and lot, the first mortgage being in favor of the subdivision developer.

At the time Romy and Tessie executed the PN, the interest of 12 percent was the maximum rate fixed by the Usury law which was then still in force. However, the following year, on Dec. 1, 1979, the Central Bank issued circular 705 which fixed the effective rate of interest on loan transactions with maturities of more than 730 days to 21 percent per annum. This was reiterated in a subsequent circular no. 712 issued on Jan. 28, 1980.

Thereafter, Romy and Tessie failed to pay several installments. To update their loan they executed another PN in favor of the financing company on Sept. 20, 1982 in the amount of P442,326.43 covering the unpaid principal and interest in the first note. This PN had a higher interest rate of 21 percent per annum, reduced period of 16 years and a higher monthly amortization of P2,176.68. On the upper right hand of the second PN appears a typewritten entry cancelling the first PN.

After about one more year, the spouses again failed to pay the installments. This prompted the financing company to assign the second PN to the subdivision developer. The developer in turn sued Romy and Tessie to collect the unpaid balance of the rate with interest at 21 percent per annum.

Romy and Tessie contended among others that the subdivision developer is entitled to collect interest at the rate of 12 percent only and not 21 percent. They argued that the two Promissory Notes constitute only one transaction, the second PN being merely an extension of and derives its existence from the first PN. Hence, the second PN is governed by the stipulation of the first PN. Were they correct?

No. The first Promissory Note was cancelled by the express terms of the second Promissory Note. To cancel is to strike out, to revoke, rescind or abandon, to terminate. In fine the first note was revoked and terminated. Simply put, it was novated. The extinguishment of an obligation by the substitution or change of the obligation by a subsequent one which extinguishes or modifies the first is a novation.

Novation has four essential requisites: (1) the existence of a previous valid obligation; (2) the agreement of all parties to the new contract; (3) the extinguishment of the old contract and (4) the validity of the new one. In the instant case, all the four requisites have been complied with. The first PN was a valid and subsisting contract when Romy and Tessie executed the second PN. The second PN absorbed the unpaid principal and interest in the first PN which amount became the principal debt therein payable at a higher interest rate, with a higher amortization and a shorter term of 16 years. Both parties voluntarily accepted the terms of the second note; and also in the same note, they unequivocally stipulated to extinguish the first note. The first PN was cancelled and replaced by the second PN. The second note became the new contract governing the parties' obligations.

When the second PN was executed on Sept. 20, 1982, CB Circular 705 and 712 were already in effect. These circulars fixed the effective interest rate for second loan transactions with maturities of more than 730 days, i.e. two years, at 21 percent per annum. The interest rate of 21 percent provided in the second PN was therefore authorized under these circulars (Spouses Bautista vs. Pilar Development Corp. G.R. No. 135046 Aug. 17, 1999).

Atty. Sison's e-mail address is: [email protected].