Section 5. Compensation

Compensation is the extinguishment to the concurrent amount of the debts of two persons who, in their own right, are debtors and creditors of each other. 

Object and importance of Compensation

Prevention of unnecessary suits and payment thru the mutual extinction by operation of law of concurring debts. 

1. Compensation is a specie of abbreviated payment, which gives to each of the parties a double advantage: 

• Facility of payment- avoids the employment of enumeration. 

• Guaranty for the effectiveness of the credit, if one of the parties pays without waiting to be paid by the other, he could be made a victim of fraud or insolvency. 

2. It supposes a more convenient and less expensive realization of two payments, it is often called simplified payment. 

3. Economic utility, its advantages for credit and for saving the use of money in transactions. 

4. Guaranty against fraud, assuring the enforcement of some credits which otherwise may not be enforced. 

Compensation distinguished from Payment. 

• In compensation, partial payment is always permitted while in payment, it must be complete and indivisible as a rule. 

• In compensation, the mode may take place by operation of law while in payment, it involves action or delivery of the amount paid (act of the parties) 

• In compensation, it is not required that the parties have the capacity to give or to receive, as the case may be, while in order that there may be a valid payment, the parties must have the free disposal of the thing due and capacity to alienate it and to receive payment. 

Compensation distinguished from merger. 

1. As to the number of persons: 

• In confusion, there is only one person in whom is merged the qualities of creditor and debtor. 

• In compensation, there must be two persons who are mutually creditor and debtor of each other. b.

2. As to the number of obligations: 

• In confusion, there can be only one. 

• In compensation, there must be two. 

Compensation distinguished from counterclaim or set-off. 

A set-off or counterclaim must be pleaded to be effectual, whereas compensation takes place by mere operation of law and extinguishes the two debts reciprocally.

Kinds of Compensation

By its effect or extent.

• Total- when both obligations are of the same amount.

• Partial- when the two obligations are of different amounts.

• By its cause or origin:

• Legal- when it takes place by operation of law even without the knowledge of the parties.

• Voluntary- when it takes place by agreement of the parties.

• Judicial- when it takes place by order from a court of litigation.

• Facultative- when it can be set up only by one of the parties.

Example: 

Chowqueen owes MacBonald 10M. MacBonald on another occasion owed Chowqueen 15M pesos. MacBonald is liable to Chowqueen with 5M.

Requisites of legal compensation

Article 1270 enumerates the requirements or requisites for legal compensation. 1.The parties are principal creditors and principal debtors of each other.

 EXAMPLE: 

1. Katherine owes Charlene 1,000. ₱Charlene owes Katherine1,000. ₱

Compensation will take place because Katherine and Charlene are principal debtors and creditors of each other.

2. John owes Eunice with Camil as guarantor. Eunice owes Camil1,000. ₱

There will be no compensation between Eunice and Camil because while Eunice is principally liable to Camil, Camil is merely subsidiarily liable to Eunice. Hence, Camil can demand payment from Eunice,

Compensation against the government 

1. Taxes – as a general rule, taxes, being obligation of public interest and governed by special laws, are not subject to set off or compensation.

2. Contractual obligations – Contractual obligations of the government may be compensated. However, in review of rules or regulations relating to public finance, both claims must involve the same office, agency or subdivision of the government 

Legal compensation

• Takes place by operation of law even against the will of the interested parties and even w/ their consent.

• Takes place the moment there exists a reciprocal concurrence of debts and all the requisites of law are present.

Voluntary/conventional compensation

Affords the parties the freedom to agree on terms.

Example

Reyes owes Tayong ₱50,000 secured by a guarantor, Caabay; Pantonial owes Reyes ₱10,000. When both debts fall due and partial compensation should take place, with Reyes paying Tayong ₱40,000 w/c fails due to Reyes insolvency, Tayong may sue Caabay. Should Tayong sue Caabay for the whole amt. of Reyes indebtedness of ₱50,000, Caabay may set up partial compensation as a defense, so that Caabay may pay only ₱40,000.

Compensation is the extinguishment to the concurrent amount of the debts of two persons who, in their own right, are debtors and creditors of each other.

Kinds of Compensation

By its effect or extent.

• Total- when both obligations are of the same amount

• Partial- when the two obligations are of different amounts.

• By its cause or origin:

• Legal- when it takes place by operation of law even without the knowledge of the parties.

• Voluntary- when it takes place by agreement of the parties.

• Judicial- when it takes place by order from a court of litigation.

• Facultative- when it can be set up only by one of the parties.

For Example:

Reyes  owes Tayong  the amount 1000
Tayong  owes Reyes the amount 1000

If two debts are of the same amount, there is total compensation.

Reyes owes Tayong amount 1000
Tayong owes Reyes amount 700

If two debts are unequal, the one who’s lacking shall be liable for the unsettled debt.

Article 1282 states that the parties have the ability to settle their debts through a mutual agreement, even if the debts are not yet due for payment. This provision of law is also an exception to the general rule as stated in Article 1279 that only debts that are due and demandable can be compensated.

VOLUNTARY COMPENSATION

• In this article, the concept of Voluntary Compensation, also known as Conventional Compensation, is introduced. Voluntary Compensation occurs when two parties agree to settle a debt or obligation, even if all the usual legal conditions for compensation are not present.

• There are no specific requirements or conditions for this kind of compensation, but it should be noted that the mutual agreement in the parties' contract must be valid in order to proceed with the compensation, as stated in Article 1306.

EXAMPLE

Hanna owes Binnie P3,000, which is due next month. Hanna is concerned about the potential impact of interest on the debt and approaches Binnie to discuss an early settlement. They agree that Hanna will pay Binnie P3,000 today rather than next month. This way, Binnie gets her money back and Hanna saves money. Their agreement to compensate debts before its due is in compliance with Article 1282.

In a legal dispute involving an obligation, a party who has a claim for damages against the other party has the right to offset the said damages. This right can be exercised by proving the validity of the claim and clearly stating the precise amount to which they are entitled.

JUDICIAL COMPENSATION

• The article introduces the concept of Judicial Compensation, which is a kind of compensation that takes place when a court issues a final judgment in a lawsuit. If the court's judgment declares that one party is entitled to damages, that party may offset these damages against their obligation to the other party, provided that they are able to prove the validity of their claim for damages and the amount thereof.

• Both parties involved are required to provide valid evidence in support of their respective claims. Thus, if a party wants to offset their obligation by stating a claim for damages, it is important for them to provide proof of the validity of the said claim. When both parties fail to provide evidence to support their claim, the act of offsetting is considered inappropriate and cannot take place.

• It is also important to note the distinction between set-off or offset and compensation. Set-off must be pleaded to be effectual, whereas Compensation takes place by the mere operation of law. 

EXAMPLE

Ben owes Ann an amount of P10,000. Upon Ann's request for payment, Ben neglected to fulfill his obligation. Ann caused damage to Ben's property amounting to P9,000 as a result of her anger. Ben can set off his claim by proving it in court, and reduce his obligation to only P1,000 instead of the original debt which is P10,000.  This is in accordance with the principles outlined in Article 1283, which allow for the offsetting of claims and obligations in a legal dispute when there are valid claims for damages involved.

In case the two parties have outstanding debts, and if one or both of these debts appear to be rescissible or voidable, it is possible for the parties to seek compensation from one another prior to the formal rescission of these debts through a legal process. This enables the involved parties to resolve the issues more efficiently.

COMPENSATION OF RESCISSIBLE OR VOIDABLE DEBTS

• Obligations that are classified as either Rescissible or Voidable, as stated in Articles 1381 and 1390, remain legally binding and valid until such time that the court officially declares them to be rescinded or annulled.

• Before the rescission or annulment takes place, the parties involved may still compensate for any outstanding debts that they have with one another.

Example

Suppose that Mary and Berry made an agreement. Mary borrowed P10,000 from Berry in order to open a small shop, and Berry sold Mary a refrigerator for P4,000, but she pressured Mary into purchasing it, making the transaction voidable.

Eventually, it becomes clear that Berry's actions during the transaction were unfair and could make the second agreement voidable. 

Instead of going through a lengthy legal process to determine the validity of both agreements, Mary and Berry decide to compensate their debts. They decided that Mary would deduct her loan of P10,000 from the purchase price of the refrigerator, which is P4,000. As a result, she now owes Berry only P6,000, and Mary acknowledges that the refrigerator sale remains valid. By compensating against each other's debts, they were able to solve their problems more quickly and save time and money on legal fees.

THREE CASES COVERED BY THE ARTICLE

CASE #1

ASSIGNMENT WITH THE CONSENT OF THE DEBTOR

• Addresses the situation that arises when a debt is transferred to a third party with the permission or consent of the original debtor.

ILLUSTRATION #1

Let's say that Cathy owes Perr P20,000, and that debt is due on the 25th of December. At the same time, Perr owes Cathy P15,000, and that debt is also due on the 25th of December. Perr transferred his right to collect the P20,000 debt owed by Cathy to a third party named Rie on December 1st, and Cathy gave her permission for this assignment.

On December 25th, when the debt is due, Cathy cannot use compensation against Rie, the assignee. In other words, Cathy is still obligated to pay Rie the full P20,000, despite Perr owing Cathy P15,000. Therefore, Cathy must pay Rie P20,000, but she can still collect P15,000 from Perr.

However, there is a significant exception. If Cathy consented to the assignment to Rie, Cathy explicitly reserved her right to use compensation against Rie, then Cathy would only be liable for the net amount. In this case, Cathy would still owe P5,000 to Rie, as she could offset the P15,000 Perr owed her from the P20,000 she owed Perr.

CASE #2

ASSIGNMENT WITH THE KNOWLEDGE BUT WITHOUT THE CONSENT OF DEBTOR

• Addresses the situation that arises when a debt is transferred to a third party without the consent of the debtor but with the knowledge of the debtor.

ILLUSTRATION #2

Assume Love owes Lee P10,000 with a due date of December 10 and Lee owes Love P5,000 with a due date of December 5. Lee assigns her right to Joy without Love's consent on December 8, but with a notice to Love on that date. Lee's debt matured on December 5 before the assignment on December 8, so Joy can only collect P5,000 from Love on December 10.

If the assignment had been made on December 1, Love would be required to pay Joy P10,000 on December 10. However, because the assignment is made prior to the due date of Lee's obligations to Love, Love is not required to pay Joy P10,000 on December 10.

CASE #3 

ASSIGNMENT WITHOUT THE KNOWLEDGE OF THE DEBTOR

• Addresses the situation that arises when a debt is transferred to a third party without the knowledge of the debtor.

ILLUSTRATION #3

In continuation of the second illustration, it is assumed that the assignment in question was made without Love's knowledge, and her awareness of said assignment only occurred on December 11th.

In this particular scenario, Love has the ability to establish and set up the compensation of credits both prior to and after the assignment. The crucial time frame pertains to Love's gaining of knowledge regarding the assignment, not when the assignment was due. In case, that Love becomes aware of the assignment after the maturation of the debts, she may invoke or raise the defense of compensation. However, if Love becomes aware of the assignment prior to the maturation of the debts, she is forbidden from doing so.

COMPENSATION WHERE DEBTS PAYABLE AT DIFFERENT PLACES

• This article applies to legal compensation. The financial commitments associated with foreign exchange and transportation costs are referred to as indemnity. After the expenses have been settled, the outstanding debts can be repaid as well. The individual who raises the defense of compensation is liable for the payment of said compensation.

EXAMPLE

Suppose there are two friends, Hanna and Montano, who owe each other money. Hanna owes Montano $100 in US Dollars and Montano owes Hanna P10,000 in Philippine Peso. If Hanna claims compensation, then she must pay for the expenses of exchange.

Another example is that Jack had to deliver 100 crates of fresh mangoes to Jill in Palawan. Jill on the other hand, also owes Jack in Baguio 100 crates of the same type of fresh mangoes. Delivery of the mangoes to Palawan will cost P15,000, while delivery to Baguio will cost only P10,000. In the event that Jack files a claim for damages, he will be responsible for compensating Jill P5,000 for the costs associated with shipping the mangoes to Palawan.

• This article states that compensation cannot be used when one of the debts arises from a depositum or from the obligations of a depositary or bailee in commodatum. In other words, when the debts are related to lending or borrowing items for temporary use, compensation is not allowed.

• Another thing is that compensation also cannot be used against a creditor who has a claim for support that is provided gratuitously, meaning without charge or for free. However, there are some exceptions that may allow compensation in some cases outlined in Article 301.

EXAMPLE

Assume Bob lent his friend Ben P10,000 to use for a trip. During the same weekend, Ben lends Bob his watch in exchange for an equal amount of money. If Bob fails to return the watch, Ben can file suit against him for P10,000 in damages, as he is not entitled to compensation as a depository.

DEBTS WHICH CANNOT BE COMPENSATED

1. Where one of the debts arises from a depositum-A deposit is constituted from the moment a person receives a thing belonging to another with the obligation of safely keeping it and of returning the same. (Art. 1962.)

“Article 1288 distinguishes between a depositum and a typical bank deposit, as the former has a specific legal definition that differs from the latter.”

Example:

X owes Y P500, but Y also owes X the same amount for a ring that X had deposited with Y.  As Y is the depositary, they cannot claim legal compensation if X fails to pay the debt. Instead, Y must take action against X to recover the P500 owed to them. This implies that Y cannot offset their obligation against X's debt, making it necessary to file a separate lawsuit for the recovery of the amount owed.

2. Where one of the debts arises from a commodatum- Commodatum is a gratuitous contract whereby one of the parties delivers to another something not consumable so that the latter may use the same for a certain time and return it. (Art. 1933.)

Example:

In a similar scenario, X borrowed Y’s car, but Y owes X P10,000.00. 

The law aims to prevent any breach of trust and confidence from the borrower or depositary. In this case, Gray can offset the value of the ring against Dan's debt, allowing for a more straightforward resolution without the need for a separate lawsuit.

3. Where one of the debts arises from a claim for support due by gratuitous title- “Support comprises everything that is indispensable for sustenance, dwelling, clothing, medical attendance, education and transportation, in keeping with the financial capacity of the family.

Example:

B is the father of A, a minor who is legally entitled to receive support from Blue. However, A now owes B P5,000.00, creating a complicated situation. Unfortunately, B cannot use what A owes him to compensate for his obligation to provide support because the law prohibits compensation of support with debt owed by the recipient (A) to the obligor (B).

RULES ON APPLICATION OF PAYMENTS APPLICABLE TO ORDER OF COMPENSATION:

Compensation is similar to payment. If a debtor has various debts which are susceptible of compensation, he must inform the creditor which of them shall be the object of compensation. In case he fails to do so, then the compensation shall be applied to the most onerous obligation. (Arts. 1252, 1254.)

EXAMPLE:

X is indebted to Y in the amount of:

(1) P500.00 without interest due today;

(2) P500.00 with interest of 14% due to also today; and

(3) P500.00 with interest of 12% due yesterday.

Y owes X P1,000.00 due today

In the context of payment application, X is considered the debtor and is required to communicate to Y which of the three debts should be compensated. In the event that X fails to provide such information, Y must allocate the compensation to X's second obligation, which carries a 14% interest rate and is therefore the most burdensome obligation.

UNDER ARTICLE 1279 IN ORDER THAT COMPENSATION MAY BE PROPER, IT IS NECESSARY:

• That each one of the obligors be bound principally, and that he be at the same time a principal creditor of the other;

• That both debts consist in a sum of money, or if the things due are consumable, they be of the same kind, and also of the same quality if the latter has been stated;

• That the two debts be due;

• That they be liquidated and demandable;

• That over neither of them there be any retention or controversy, commenced by third persons and communicated in due time to the debtor.