In D.M. Ragasa Enterprises, Inc. v. Banco de Oro, Inc., the Supreme Court clarified the application of penalty clauses in lease agreements when a lessee prematurely terminates the contract. The Court ruled that while an automatic termination clause in a lease contract is valid, the lessor is not automatically entitled to the full amount of remaining rentals. Instead, the lessor is limited to the specific penalties stipulated in the contract, such as forfeiture of the security deposit, unless additional actual damages can be proven. This decision highlights the importance of clearly defined penalty clauses and the need for lessors to demonstrate actual losses beyond the contractual stipulations.

Lease Interrupted: Can a Landlord Claim Full Rent After Early Termination?

The case revolves around a Lease Contract between D.M. Ragasa Enterprises, Inc. (Ragasa), as the lessor, and Banco de Oro, Inc. (BDO), formerly Equitable PCI Bank, Inc., as the lessee, for commercial space in Quezon City. The five-year lease, commencing on February 1, 1998, was pre-terminated by BDO on June 30, 2001, due to a merger that necessitated the closure of the branch occupying the leased premises. Ragasa, arguing that the pre-termination was a breach of contract, sought to collect the remaining rentals for the unexpired term, amounting to P3,146,596.42. BDO countered that its liability was limited to the forfeiture of the security deposit, as stipulated in the Lease Contract’s penalty clause. The central legal question is: What is the extent of BDO’s liability for prematurely terminating the Lease Contract?

The Supreme Court emphasized that a contract is the law between the parties, and obligations arising from it must be complied with in good faith. The parties are free 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. The court then examined the pertinent provisions of the Lease Contract.

2. The TERM of this Lease shall be for a period of five (5) years, commencing on February 1, 1998. x x x

The Court found that BDO had indeed breached the Lease Contract by serving a Notice of Pre-termination and vacating the premises before the agreed-upon term. The contract did not contain a pre-termination clause. Therefore, the Court needed to determine the appropriate remedy for Ragasa, considering the existence of penalty clauses within the Lease Contract.

The Lease Contract contained specific provisions addressing non-compliance with the lease term:

8. The TENANT voluntarily binds himself and agrees to the following without any coercion or force by the LESSOR;

x x x x

m) The full deposit shall be forfeited in favor of the LESSOR upon non-compliance of the Term of the Contract of Lease by the TENANT, and cannot be applied to Rental;

The Court clarified that the word “Term” in item 8(m) specifically refers to the duration of the lease, not just any stipulation within the contract. This distinction is critical because it narrows the scope of the penalty clause to apply specifically to the premature termination of the lease term. Article 1170 of the Civil Code states that those who contravene the tenor of their obligations are liable for damages. Given BDO’s breach, the question became: what damages was Ragasa entitled to?

Generally, when a party fails to comply with their obligations, the aggrieved party may seek rescission of the contract with damages or simply seek damages while keeping the contract in force. However, the Lease Contract also had an automatic termination clause:

p) Breach or non-compliance of any of the provisions of this Contract, especially non-payment of two consecutive monthly rentals on time, shall mean the termination of this Contract.

The Supreme Court has consistently upheld the validity of such automatic termination clauses, referencing cases like Manila Bay Club Corp. v. Court of Appeals and Riesenbeck v. Spouses Silvino Maceren, Jr. and Patricia Maceren. Because of this clause, the Lease Contract was terminated upon BDO’s unauthorized pre-termination. Ragasa could not claim damages to enforce the lease, but was only entitled to indemnification.

The Court addressed the claim for P3,146,596.42, representing the remaining rentals, explaining that entitlement to rentals after termination is generally only applicable if the lessee refuses to vacate the premises, which was not the case here. The Court then focused on the specific penalty clause, item 8(m), stating that the full deposit of P367,821.00, equivalent to three months’ rent, shall be forfeited. This forfeiture was explicitly stated not to be applicable to unpaid rentals. The Supreme Court determined that this clause was indeed a **penalty or penal clause**, designed to ensure compliance with the lease term.

The Court explained the three-fold purpose of a penal clause:

• To coerce the debtor to fulfill the obligation.
• To serve as liquidated damages.
• To punish the debtor for non-fulfillment.

The main question was whether the penalty clause in this contract was intended as a substitute for damages or as an additional punishment. Article 1226 of the Civil Code provides guidance:

Art. 1226. In obligations with a penal clause, the penalty shall substitute the indemnity for damages and the payment of interests in case of noncompliance, if there is no stipulation to the contrary.

The Court noted that item 8(m) itself did not expressly reserve an additional claim for damages. However, item 10 of the contract addressed the possibility of court litigation due to non-compliance:

10. In the event that a Court Litigation has been resorted to by the LESSOR or LESSEE, due to non-compliance of any of the foregoing provisions, the aggrieved party shall be paid by the other party, no less than fifteen thousand (P15,000) pesos, Philippine Currency, for Attorney’s fees, and other damages that the honorable court may allow.

Construing items 8(m) and 10 together, the Court determined that the parties intended for the penalty to be cumulative, meaning that in addition to the forfeiture of the deposit, Ragasa could recover attorney’s fees and other proven damages. Consequently, the Bank was liable for the forfeiture of the deposit, attorney’s fees, and any other damages suffered by Ragasa because of the breach.

Article 1227 of the Civil Code prevents the debtor from simply paying the penalty to avoid performance, unless such a right is expressly reserved. The Lease Contract did not contain such a reservation. However, Ragasa could not insist on the continuation of the lease because the automatic termination clause had been triggered. Therefore, Ragasa was only entitled to damages, which they needed to prove.

Despite the potential for additional damages, Ragasa failed to provide evidence demonstrating actual losses beyond the forfeited deposit. The Court emphasized that Ragasa had the opportunity to lease the premises to another tenant after BDO vacated, but chose not to. Article 2203 of the Civil Code requires a party suffering loss to exercise the diligence of a good father of a family to minimize damages. Since Ragasa did not demonstrate that it actually suffered the claimed damages, the Court held that it was only entitled to the forfeiture of the deposit and attorney’s fees.

FAQs

What was the key issue in this case?	The key issue was determining the extent of a lessee’s liability for prematurely terminating a lease contract containing both a penalty clause and an automatic termination clause.
What is a penalty clause?	A penalty clause is an accessory obligation in a contract that ensures performance by imposing a special prestation, usually a payment, if the obligation is not fulfilled. It serves to strengthen the coercive force of the obligation.
What is an automatic termination clause?	An automatic termination clause specifies that the contract will end immediately upon the occurrence of a specific event, such as a breach of the contract’s terms. Its validity has been affirmed by the Supreme Court.
Can a lessor claim full rentals for the unexpired term if a lease is prematurely terminated?	Generally, no. If the contract contains an automatic termination clause and the lessor does not continue to occupy the premises, the lessor is limited to the penalties stipulated in the contract and any proven actual damages.
What damages can a lessor claim if a lease is prematurely terminated?	A lessor can claim the penalties stipulated in the lease contract, such as forfeiture of the security deposit, attorney’s fees if litigation is necessary, and any other actual damages they can prove they suffered as a result of the breach.
What is the effect of Article 1226 of the Civil Code on penalty clauses?	Article 1226 states that the penalty substitutes the indemnity for damages and the payment of interests in case of noncompliance, unless there is a stipulation to the contrary. This means the penalty serves as the default compensation for the breach.
What happens if the lessor does not attempt to mitigate damages after the breach?	The lessor’s recovery may be limited, as Article 2203 of the Civil Code requires the injured party to exercise the diligence of a good father of a family to minimize the damages resulting from the act or omission.
What was the final ruling in the case of D.M. Ragasa Enterprises, Inc. v. Banco de Oro, Inc.?	The Supreme Court ruled that Banco de Oro was liable for the forfeiture of the full deposit and attorney’s fees of P15,000.00, but not for the remaining rentals because D.M. Ragasa Enterprises, Inc. failed to prove additional actual damages.

The D.M. Ragasa Enterprises, Inc. v. Banco de Oro, Inc. case underscores the importance of carefully drafting lease agreements and understanding the implications of penalty and termination clauses. While lessors have the right to seek compensation for breaches, they must also be prepared to demonstrate the actual damages they have incurred. This case helps clarify the interplay between contractual stipulations and legal principles in lease disputes.

For inquiries regarding the application of this ruling to specific circumstances, please contact ASG Law through contact or via email at frontdesk@asglawpartners.com.

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: D.M. RAGASA ENTERPRISES, INC. VS. BANCO DE ORO, INC., G.R. No. 190512, June 20, 2018