MODULE I-WEEK 2

CHAPTER 4-EXTINGUISHMENT OF OBLIGATIONS

SECTION 5-Compensation
Article 1278-1290

Mindanao State University-Iligan Institute

of Technology
Class: HTM108

Topic: Law on Obligations and Contracts

CHAPTER 4- EXTINGUISHMENT OF OBLIGATIONS

General Provisions Article 1231
SECTION 1 Payment or Performance Articles 1232-1251
SUBSECTION 1. Application of Payments Article 1252-1254
SUBSECTION 2. Payment by Cession Article 1255
SUBSECTION 3. Tender of Payment and Consignation Article 1256-1261
SECTION 2 Loss of the Thing Due Article 1262- 1269
SECTION 3 Condonation or Remission of the Debt Article 1270-1274
SECTION 4 Confusion or Merger of Rights Article 1275-1277
SECTION 5 Compensation Article 1278-1290
SECTION 6 Novation Article 1291-1304
II.Learning Objectives
At the end of the Chapter, the student should be able to:

1. Master the different modes of extinguishing obligations, as well as the respective requisites;

2. Understand their effects and consequences on the rights of the debtor.

SECTION 5. - Compensation
Art. 1278. Compensation shall take place when two persons, in their own right, are creditors and debtors of
each other. (1195)

COMPENSATION- shall take place when two persons, in their own rights are creditors and debtors of each other.
COMPENSATION CONFUSION
1. As to number of persons there must be two persons there is only one person in
whom the quality of creditor
and debtor is merged
2. As to number of there must be two obligations there is only one obligation
obligation

Kinds of Compensation:
1. As to cause
a. Legal – takes effect by operation of law provided all the requisites prescribed by law are present.
 b. Voluntarily – takes place by virtue of the agreement of the parties.
c. Judicial – takes place only through court orders.

2. As to effect
a. Total – when both debts are completely extinguished because the debt are the same amount
b. Partial – the debts are not the same amount hence after compensation, a balance remains outstanding.

Ex. RENZO owes LILY the amount of P10, 000. LILY owes RENZO the amount of P7, 000.00. Both debts are
due and demandable today. Here, the compensation takes place partially, that is, to the concurrent amount
of P7, 000.00. So, RENZO is liable to LILY for only P3, 000.00.

Art. 1279. In order that compensation may be proper, it is necessary:

(1) That each one of the obligors be bound principally, and that he be at the same time a principal creditor
of the other;
(2) 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;
(3) That the two debts be due;
(4) That they be liquidated and demandable;
(5) That over neither of them there be any retention or controversy, commenced by third persons and
communicated in due time to the debtor. (1196)

Requisites of a Proper Compensation or Legal Compensation:

1. The parties are principal creditor and principal debtor of each other;
Ex. LELIA owes JOHNSON P10, 000 payable on Dec. 20, 2020. JOHNSON on the other hand owes LELIA
P10, 000 also due and payable on Dec. 30, 2000. These two obligation become due on Dec. 30, 2020
compensation takes place because both LELIA and JOHNSON are principal creditor and principal debtor of
each other.

2. Both debts consists in a sum of money or of consumable things of the same kind and quality;
Ex. SOLOMON obliged himself to deliver to IYA 100 sacks of rice on October 30, 2000. IYA, on the other
hand, has an obligation to deliver 100 sacks of rice to SOLOMON on October 20, 2000. 1There is
compensation because they are consisting of consumable things.

3. The two debts are due and demandable;

Ex. ROCKY owes LACE P10, 000 payable on October 30, 2000. LACE owes ROCKY P10, 000 payable also on
October 30, 2000. There is compensation when the obligation becomes due on October 30, 2000.

4. The two debts liquidated; and the liquidated means that the amount of debt has already been fixed
and determined, while the word demandable means when it is due;

5. There be no retention or controversy means a third person who is claiming to be a creditor.

Ex. JAM owes SEVEN P10, 000 and Seven owes Jam P10, 000 but JAM’s credit of P10, 000 has been
garnished by TOMMY who claims to be an unpaid creditor of JAM. SEVEN has been duly notified of the
controversy. Any possible compensation is in the meantime suspended. If TOMMY wins her claim,
there can be no compensation. If he loses, the controversy is resolved, and then compensation can take
place.
Art. 1280. Notwithstanding the provisions of the preceding article, the guarantor may set up compensation
as regards what the creditor may owe the principal debtor. (1197)

Guarantor May Set Up Compensation

This is an exception to Article 1279, part. 1 because the article allows setting up compensation as regard what the
creditor may owe to the principal debtor.

Ex. LEO owes TOP P10, 000. IVAN is the guarantor of LEO. TOP owes LEO P10, 000. When LEO sues TOP
for P 4,000 and TOP cannot pay, IVAN will be liable for only P6, 000 because he can set the P4, 000 credit
of TOP as the basis of partial compensation.

Art. 1281. Compensation may be total or partial. When the two debts are of the same amount, there is a total
compensation. (n)

TOTAL COMPENSATION- is when the amount due are equal or of the same amount, hence both obligations are
extinguished.

Ex. KARLO is indebted to VANZ the amount of P10, 000 due on Dec. 19, 2000. VANZ is likewise indebted
to KARLO in the amount of P10, 000 due on Dec. 19, 2000. There is here a total compensation; hence, both
debts will be extinguished.

PARTIAL COMPENSATION- is when the amount are not the same after compensation took place, there is a
balance remains.
Ex. KARLO owes VANZ P10, 000 due on Dec. 19, 2010. On the other hand, VANZ owes KARLO P6, 000
due also on Dec. 19, 2010 and when the due date arrives, there is a balance of P4, 000 that will remain after
compensation takes place.

Art. 1282. The parties may agree upon the compensation of debts which are not yet due. (n)

Compensation by Agreement Of the Parties

This is a voluntary compensation as an execution to the general rule that only debts which are due and demandable
can be compensated.(Art.1279)

Ex. JESSI owes LEONARA P10, 000 due on Nov. 30, 2001. On the other hand, LEONORA owes JESSI P10,
000 due on Dec. 30, 2011. There can be no compensation since the debt of LEONORA is not yet due,
however by voluntary agreement that there will be compensation between the two of them, then
compensation will take place.
 Art. 1283. If one of the parties to a suit over an obligation has a claim for damages against the other, the
former may set it off by proving his right to said damages and the amount thereof. (n)

JUDICIAL COMPENSATION- is one whereby a money debt of a person may be allowed by the court to be
compensated with a claim of damages by another.

Ex. RYDER owes REX P1, 000. When RYDER demanded payment, REX failed to pay. In anger, RYDER
damaged the property of REX to the extent of P800. REX can set off the obligation of RYDER to pay him
damages in the amount of P800 against his debt of P1, 000.

Art. 1284. When one or both debts are rescissible or voidable, they may be compensated against each other
before they are judicially rescinded or avoided. (n)

Compensation Of Rescissible or Voidable Debts

Rescissible and voidable obligations are valid until they are judicially rescinded or avoided and prior rescission or
annulment, the debts may be compensated.

Ex. LINA owes RINA P 10, 000. Subsequently, LINA, through fraud was able to make RINA sign a
promissory note that RINA is indebted to LINA for the same amount. The debt of LINA is valid, but that of
RINA is voidable. Before the debt of RINA is nullified, both debts may be compensated against each other
if all the requisites for legal compensation are present.

If suppose the debt of RINA is later annulled by the court, LINA is still liable considering compensation had
already taken place because the effect of annulment is retroactive, it is as if there was no compensation.

Art. 1285. The debtor who has consented to the assignment of rights made by a creditor in favor of a third
person, cannot set up against the assignee the compensation which would pertain to him against the
assignor, unless the assignor was notified by the debtor at the time he gave his consent, that he reserved his
right to the compensation.

If the creditor communicated the cession to him but the debtor did not consent thereto, the latter may set
up the compensation of debts previous to the cession, but not of subsequent ones.

If the assignment is made without the knowledge of the debtor, he may set up the compensation of all
credits prior to the same and also later ones until he had knowledge of the assignment. (1198a)

When Compensation has taken place before assignment:

If an extinguished obligation has been assigned by the creditor to third person, the debtor can raise the defense of
compensation with respect to the debt.
The remedy of the assignee is against the assignor.

Ex. SKYLER owes IRISH P5, 000 due yesterday. IRISH owes SKYLER P3, 000 due also yesterday. Both debts are
extinguished up to amount of P3, 000. Hence, SKYLER still owes IRISH P2, 000 today. If IRISH assigns his
right to TON, latter can collect only P2, 000 from SKYLER. However, if SKYLER gave his consent to the
assignment before it was made on he will be liable to TON for P5, 000 but he can still collect the P2, 000 owed
by IRISH. It is as if no compensation took place.

Where Compensation has taken place after assignment:

There are three cases of compensation which take place after an assignment of rights made by the creditor. They
are:

1. Assignment with consent of debtor

Ex. SAINT owes IRIS P5, 000 due Dec. 19. IRIS owes SAINT P3, 000 due Dec. 19. IRIS assigned his right to
THUNDER, the assignee, the compensation which would pertain to him against IRIS, the assignor. SAINT is
still liable to THUNDER for P5, 000 but he can still collect the P2, 000 debt from IRIS. However, if SAINT
while consenting to the assignment, reserved his right to the compensation, he would be liable only P2, 000
to THUNDER.
2. Assignment with the knowledge but without the consent of debtor
Ex. SAINT owes IRIS P1, 000 due Dec. 1. IRIS owes SAINT P2, 000 Dec. 10. SAINT owes IRIS P1, 000 due
Dec. 15. IRIS assigned his right to THUNDER on Dec. 12. SAINT notified IRIS but the latter did not give his
consent to the assignment, how much can THUNDER collect from SAINT? IRIS can set up the
compensation of debts on Dec. 10 which was before the cession on Dec. 12. There being partial
compensation, the assignment is valid only up to the amount of P1, 000 but IRIS cannot raise the defense of
compensation with respect to the debt of SAINT due on Dec. 15 which has not yet matured. So, on Dec. 12,
Ivy is liable to THUNDER for P1, 000. Come Dec. 15, SAINT will liable for his debt of P1, 000 to IRIS.

3. Assignment without the knowledge of the debtor

Ex. In the preceding example, let us suppose that the assignment was made without the knowledge of IRIS
who learned of the assignment only on Nov. 16. In this case, IRIS can set up the compensation of credits
before and after the assignment. The crucial time is when IRIS acquired knowledge of the assignment and
not the date of the assignment. If IRIS learned of the assignment after the debts had already matured, he
can raise the defense of compensation, otherwise, he cannot.

Art. 1286. Compensation takes place by operation of law, even though the debts may be payable at different
places, but there shall be an indemnity for expenses of exchange or transportation to the place of payment.
(1199a)

Compensation where debts payable at different places.

This legal compensation does not refer to the difference in the value of the things in their respective places but to
the expenses of monetary exchange and expenses of monetary exchange and expenses in transportation. Once these
expenses are liquidated, the debts also become compensated.
The indemnity shall be paid by the person who raises the defense of compensation.

Ex. RYAN owes LINDY $1, 000 payable in Manila. LINDY owes RYAN P38, 000(equivalent amount) payable
in Manila. If SOLOMON claim compensation, he must pay for the expenses of exchange.

Art. 1287. Compensation shall not be proper when one of the debts arises from a depositum or from the
obligations of a depositary or of a bailee in commodatum.
Neither can compensation be set up against a creditor who has a claim for support due by gratuitous title,
without prejudice to the provisions of paragraph 2 of Article 301. (1200a)

Art. 1288. Neither shall there be compensation if one of the debts consists in civil liability arising from a
penal offense. (n)

Instances when legal compensation is not allowed by law:

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

Ex. RAIN owes LIZA P1, 000. LIZA in turn owes RAIN P1,000 representing the value of a diamond ring
deposited by RAIN with LIZA which failed to return.

In this case, LIZA, who is the depository, cannot claim legal compensation even if RYAN fails to pay his
obligation. The remedy of LIZA is to file an action against RAIN for the recovery of the amount of P1,000.
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. 1993)

Ex. In the preceding case, if LIZA borrowed the ring of RAIN, LIZA cannot refuse to return the ring on the
ground for compensation because no compensation can take place when one of the debts arises from a
commodatum.

3. Where one of the debts arises from a claim for support by gratuitous title- Support compromises
everything that is indispensable for sustenance, dwelling, clothing, medical attendance, education and
transportation, in keeping with the financial capacity of the family. (Art. 194, FC)

Ex. SAINT donates to IYA an allowance of P2, 000 a month for five years for the latter’s support. However,
previous to the donation, IYA already owed SAINT P10, 000 which was due and unpaid.

In this case, SAINT cannot say that IYA “In as much as you owe me P10, 000, I will not pay your allowance
from ten months.” (Memorandum Of the Code of Commision, March 8, 1951, pp 13-14).

4. Where one of the debts consists in civil liability arising from a penal clause. “If one of the debts
 consists in civil liability arising from a criminal offense, compensation would be improper and inadvisable
because the satisfaction of such obligation is imperative.” (Report of the Code Commision, p. 134)

Ex. TOM owes SAINT P1, 000. SAINT stole the ring of TOM worth P1, 000. Here, compensation by SAINT is
not proper.
But TOM, the offended party, can claim the right of compensation. The prohibition in Art. 1288 pertains
only the accused but not to the victim of the crime.

Art. 1289. If a person should have against him several debts which are susceptible of compensation, the
rules on the application of payments shall apply to the order of the compensation. (1201)

Rules on application of payments apply 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)

Ex. JOHN is indebted to LINA in the amount of:

a. P1, 000 without interest due today;
b. P1,000 with interest of 18% due also today;
c. P1, 000 with interest of 16% due yesterday.
LINA owes JOHN P1, 000 due today.

For purposes of the application of payment, JOHN is the debtor. He must specify to LINA which of the three debts
should be compensated. If he fails to inform LINA, then LINA should apply the compensation to the second
obligation of JOHN which the obligation bearing the 18% interest because it is the most onerous obligation.

Art. 1290. When all the requisites mentioned in Article 1279 are present, compensation takes effect by
operation of law, and extinguishes both debts to the concurrent amount, even though the creditors and
debtors are not aware of the compensation. (1202)

Consent of parties not required in legal compensation:

1. Compensation takes place automatically by mere operation of law- from the moment all the requisites
mentioned in Art. 1279 concur, compensation takes place automatically even in the absence of agreement
between the parties, and extinguishes reciprocally both debts to the amount of their respective sums. It
takes place by operation of law from the day all the necessary requisites concur, without need of consent on
the part of the parties, and even without their knowledge.

2. Full legal capacity of parties not required- As it takes place by operation of law and without any act of the
parties, it is not required that the parties have full legal capacity (see Art. 37) to give or to receive, as the
case may be.
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3. Soriano, Fidelito R.(2011).Obligations and Contracts.GIC Enterprises
4. www.lawphil.net
5. www.supremecourt.gov.ph