Escalation clauses: Fair or over-the-top?

(Conclusion)

The Supreme Court declared as void another escalation clause, which authorizes the lessor, seller, or some other party to raise the base price up to a fixed percentage, in view of specified cost increases, in Spouses Limso v. Philippine National Bank.

In this case, Spouses Robert and Nancy Limso (“Spouses Limso”) and Davao Sunrise Investment and Development Corporation (DSIDC) took out a P700-million loan, consisting of a revolving credit line of P300 million and seven-year long-term loan of P400 million. It is secured by real estate mortgages (REM) from the Philippine National Bank (PNB).

Finding it difficult to pay their loan, Spouses Limso and DSIDC requested that it be restructured. After negotiations, Spouses Limso, DSIDC, and PNB executed a Conversion, Restructuring, and Extension Agreement (the “Agreement”). It states, among others, that Spouses Limso shall pay PNB interest on the loans referred to therein at the annual rate set, and reset on a monthly basis, by PNB.

Despite the restructuring of their loan, and after several demand letters from PNB, Spouses Limso and DSIDC were still unable to pay. This constrained PNB to file a petition for the extrajudicial closure of the REM instituted by Spouses Limso and DSIDC.

After the corresponding foreclosure sale, in which PNB emerged as the highest bidder, but before the sheriff could issue the provisional certificate of sale, Spouses Limso and DSIDC filed a complaint for reformation or annulment of contract against PNB and the Register of Deeds of Davao City.

The trial court ruled in favor of Spouses Limso and DSIDC, declaring, among others, that the interest rate provisions in the Agreement are unreasonable and unjust because the imposable interest rates were to be solely determined by PNB. Furthermore, the arbitrary imposition of interest rates may increase Spouses Limso and DSIDC’s total loan obligation to an amount that would be beyond their capacity to pay.

Upon appeal, the Court of Appeals ruled that there was no mutuality between the parties because the interest rates were unilaterally determined and imposed by PNB.

In its appeal before the Supreme Court, PNB argued that the imposed interest rates were valid. It supposedly could not be said that PNB unilaterally imposed these rates since they refer to the Agreement’s escalation clauses, which by their nature, are made to depend on external factors, such as market indicators and/or government regulations affecting the cost of money. Moreover, Spouses Limso and DSIDC were notified of, and consented to, the said rates before the Agreement became effective.

Meanwhile, Spouses Limso and DSIDC argued that they were merely notified of and thus, did not consent to the increased rates imposed by PNB through its letters. Moreover, these letters appear to have been received by DSIDC’s employees who have not been authorized to do so, or have not been received at all.

The Supreme Court disregarded PNB’s arguments and declared the increased rates as void since PNB unilaterally imposed them, in violation of the principle of mutuality of contracts. Moreover, the escalation clauses in the Agreement, as well as in the REM and corresponding promissory notes, could not have otherwise validated the imposed interest rates since they failed to specify a fixed or base interest.

Meanwhile, as observed by Spouses Limso and DSIDC, PNB’s letters to them partook the nature of mere notices on the change in these rates. They did not leave any room for negotiation among PNB, Spouses Limso, and DSIDC when it came to the applicable interest rate.

Even assuming that Spouses Limso and DSIDC consented to the increased interest rates, the Supreme Court still declared them as void for being unreasonable. Spouses Limso and DSIDC would be unable to determine the imposable interest rates since they are always subject to PNB’s discretion. They would also be unable to determine the exact amount of their obligation because of the frequent changes in the imposed rates.

The Supreme Court clarified in this case, however, that only the interest rates are void and thus, deemed not written in the Agreement. Spouses Limso and DSIDC’s obligation to pay the interest on the principal loan remains.