The Supreme Court ruled that even if a contract is rescinded (cancelled), the agreement on how to calculate damages for a breach (failure to fulfill the contract) can still be used to determine the amount owed. This decision clarifies that parties are still responsible for the consequences of breaching a contract, even if the contract itself is terminated. The court emphasized that rescission doesn’t erase the responsibility for damages agreed upon in the contract. This protects the rights of the injured party and ensures that those who break contracts don’t escape the financial penalties they initially agreed to.

Fire Trucks and Broken Promises: Can Penalties Survive a Rescinded Contract?

This case, Philippine Economic Zone Authority v. Pilhino Sales Corporation, arose from a contract dispute between the Philippine Economic Zone Authority (PEZA) and Pilhino Sales Corporation. PEZA sought to acquire two fire trucks, and Pilhino won the bid to supply them. The contract stipulated a penalty of 1/10 of 1% of the total contract price for each day of delay in delivery. Pilhino failed to deliver the trucks on time, leading PEZA to file a complaint for rescission of the contract and damages. The central legal question was whether PEZA could still claim liquidated damages (pre-agreed penalties) from Pilhino, even after the contract was rescinded.

Pilhino argued that the rescission of the contract should negate any liability for liquidated damages. However, the Supreme Court disagreed, emphasizing that rescission under Article 1191 of the Civil Code allows the injured party to seek rescission “with the payment of damages in either case.” This means that the right to claim damages survives the rescission of the contract. The court explained that a contract of sale, like the one between PEZA and Pilhino, involves reciprocal obligations where the seller must deliver the item, and the buyer must pay.

When one party fails to meet their obligation, the other party has the right to seek rescission, but that doesn’t eliminate the breaching party’s responsibility for damages. The purpose of rescission is to restore both parties to their original positions before the contract, but it doesn’t allow a party to escape the consequences of their breach. The Supreme Court quoted Spouses Velarde v. Court of Appeals, stating that rescission aims to “put an end to it as though it never was. It is not merely to terminate it and release the parties from further obligations to each other, but to abrogate it from the beginning and restore the parties to their relative positions as if no contract has been made.” While mutual restitution is required, liquidated damages are not erased.

The Court further cited Laperal v. Solid Homes, Inc., which clarified that the obligation of mutual restitution does not negate a party’s liability for liquidated damages as stipulated in the contract. To allow the breaching party to escape liability would be an injustice, turning “delinquency into a profitable enterprise.” Therefore, the Supreme Court upheld the validity of the liquidated damages clause, emphasizing that parties are bound by the agreements they freely enter into. This is supported by Article 2226 of the Civil Code, which defines liquidated damages as those agreed upon to be paid in case of a breach.

The Court of Appeals had reduced the amount of liquidated damages, citing Pilhino’s attempt to offer new specifications for the fire trucks at a higher price. The Supreme Court, however, found this attempt inconsequential because it occurred after PEZA had already filed a complaint for rescission and damages. PEZA had already suffered damages due to the delay, as highlighted by Director General Lilia B. De Lima’s internal memorandum emphasizing the urgency of obtaining fire trucks due to the increasing number of enterprises in the economic zones and the onset of the El Niño phenomenon. Furthermore, accepting modified contract terms after a public bidding process would undermine the fairness of the bidding process, as it would give the winning bidder an unfair advantage.

The Supreme Court underscored that liquidated damages serve as a penalty to ensure compliance with contractual obligations. Allowing Pilhino to avoid the penalty would undermine the purpose of the liquidated damages clause and create a situation where non-compliance is more advantageous than compliance. Article 1191 of the Civil Code states that in case of breach of obligations, “the injured party may choose between the fulfillment and the rescission of the obligation, with the payment of damages in either case.”

In conclusion, the Supreme Court reversed the Court of Appeals’ decision and reinstated the Regional Trial Court’s decision, ordering Pilhino to pay liquidated damages to PEZA. The ruling reaffirms the principle that liquidated damages clauses are enforceable even after a contract is rescinded and that parties must bear the consequences of their contractual breaches.

FAQs

What was the key issue in this case?	The key issue was whether a party could still claim liquidated damages from a contract that had been rescinded due to the other party’s breach. The court ruled that the right to claim damages survives the rescission.
What are liquidated damages?	Liquidated damages are pre-agreed penalties that parties stipulate in a contract to be paid in case of a breach. They serve as a form of compensation for the injured party’s losses due to the breach.
What is rescission of a contract?	Rescission is the cancellation of a contract, restoring the parties to their original positions as if the contract never existed. It is a remedy available when one party breaches the contract.
Why did PEZA file a case against Pilhino?	PEZA filed a case against Pilhino because Pilhino failed to deliver the fire trucks as agreed upon in their contract. This breach led PEZA to seek rescission of the contract and claim damages.
Did Pilhino try to remedy the situation?	Yes, Pilhino attempted to offer new specifications for the fire trucks at a higher price, but this offer was made after PEZA had already filed a lawsuit. The court deemed it inconsequential.
How did the Court of Appeals rule in this case?	The Court of Appeals partly granted Pilhino’s appeal by reducing the amount of liquidated damages and deleting the forfeiture of its performance bond. The Supreme Court reversed this decision.
What did the Supreme Court decide?	The Supreme Court ruled in favor of PEZA, stating that Pilhino was liable for liquidated damages despite the rescission of the contract. The court reinstated the Regional Trial Court’s decision.
What is the significance of this ruling?	This ruling clarifies that rescission of a contract does not automatically erase the breaching party’s liability for liquidated damages. Parties are still responsible for the consequences of their breaches.
What is Article 1191 of the Civil Code?	Article 1191 of the Civil Code states that the injured party may choose between the fulfillment and the rescission of the obligation, with the payment of damages in either case. It provides the basis for rescission in reciprocal obligations.

This case reinforces the importance of fulfilling contractual obligations and the consequences of failing to do so. The Supreme Court’s decision provides clarity on the enforceability of liquidated damages clauses, even in cases where the contract is rescinded, safeguarding the rights of parties who are negatively affected by breaches of contract.

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Disclaimer: This analysis is provided for informational purposes only and does not constitute legal advice. For specific legal guidance tailored to your situation, please consult with a qualified attorney.
Source: PHILIPPINE ECONOMIC ZONE AUTHORITY VS. PILHINO SALES CORPORATION, G.R. No. 185765, September 28, 2016