FIN 103 – CREDIT AND COLLECTION

RECOVERY OF CREDIT GRANTED

PART I

INTRODUCTION
This chapter is primarily about the remedies available to a creditor in case of non-payment. It will
propose remedies on unpaid debt, based on the following assumptions:

1. The loan or credit transaction has been consumed.

2. There was complete transfer of possession (by delivery) or both ownership and possession;
questions on goods in transmit will not be covered here.
3. The seller has discharged with his obligation to deliver a determinate thing, but the buyer refuses
to, or cannot, pay.
4. There are no product defects or violations of warranties on the part of the seller.

These limitations are imposed because there are so many voluminous transactions in contracts of
sale and credit that are non-recurring or are very uncommon. If they are included, all points of the law
should also be included, and that should require another book. Examples of non-recurring and
uncommon incidents are: non-performance by buyer while goods are in transit: insolvency of buyer
while goods are in transit; effects of partial delivery; product defects, among others.

Most collection problems are the result of simple non-payment, which is a major concern for credit
and collection managers.

To facilitate the understanding of this chapter, it is important to again classify credit:

1. Simple loan or mutuum

a. Loans of fungible and consumable things
b. Cash loan
2. Credit on consumer durables: appliances.
3. Credit on movables: vehicles.
4. Credit on immovables (real estate), credit secured by immovable

Loans of fungible or consumable things. Fungible things are products expressed in units of measure,
like weight, number, or volume: cooking oil, rice, salt, canned goods. Consumable are classified
according their nature. Loans of fungible and consumable things are technically called mutuum.
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 The borrower's obligation is to give back the items borrowed with similar items provided that they
are of the same kind, quality, and quantity. The exact items borrowed cannot be returned because
they will be consumed and the return of exactly the same items is not possible. While this type of
transaction occurs, in the world of commerce, this is very uncommon. This book will not deal on this at
all.

A P10,000 cash loan, while also to be consumed or used, has to be paid back in the same kind, (in
cash) and the same quantity P10,000.

Note that for fungibles, obligation of the borrower is to return; in a cash loan, the obligation of the
borrower is to pay the loan.

Cash loan. In a cash loan, the borrower's obligation is to pay back the loan in the same currency,
and in the same amount, unless otherwise provided. For example, a dollar-denominated loan could
be paid back in pesos, or vice-versa. Cash loans are either secured or unsecured. This kind of
transaction is a loan, and should be governed by Civil Code provisions on sales.

Credit for merchandise. In a cash loan, cash is given by the lender and he is to be paid back also
in cash. In merchandise credit, the supplier provides merchandise and the debtor pays him back in
cash. A transaction for merchandise credit is a sale, and should be governed by Civil code provision
on sales

Almost all merchandise credit is unsecured. And if secured, the security is not the merchandise but
another property of the debtor, such as real estate.

In merchandise credit, as well as in a cash loan, the ownership and possession of the object of the
credit (cash in a loan and merchandise in a credit transaction) must be transferred to the debtor or
borrower. If a borrower does not own the cash given to him in a loan, he cannot spend it. If a debtor
does not own the merchandise supplied to him on credit terms, he cannot sell it. No one can sell what
he does not own. There are exceptions, of course, such as transactions on a trust receipt basis. These
distinctions might appear trivial and insignificant, but later as we move on to durables and movables,
the student will appreciate its usefulness and relevance.

Credit for consumer durables. Example of durables are TV and refrigerators which are sold by
appliance companies on installment basis. The document used in installment sales of durables, but not
movable, is a deed of Conditional Sale', or 'Sale with Reservation of Title', which transfers the possession
of the TV's and ref's but withholds or reserves the ownership, which is retained by the seller.

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 Compared to cash and merchandise, durables and movables are not consumed. Cash is to be
spent while merchandise have to be sold. Durables, however, remain with the buyer for a considerable
period of time. More importantly, durables and movables provide actual benefits that the possessors
enjoy every single day. Thus, the motivation to pay is stronger in consumer durables; but because the
buyers or possessors typically have marginal incomes (or incomes just a bit higher than their expenses),
the risk of non-payment is very high. The major motivator in installment accounts is the continued
possession of the item purchased.

Credit on sale of movables. Examples are motorcycles sold by appliances companies and financed
by them, and cars sold by car dealers and financed by banks. In consumer durables, the ownership is
retained by the appliance company for its protection against non- payment. Movables, however,
have to be sold on an absolute basis to the buyers. The law on mortgages (Art. 2085, paragraph 2)
required that the mortgagor must be the absolute owner of the thing mortgaged.
The only way to do that is by using to the buyer an Absolute Deed of Sale. Then the buyer, and new
owner, can mortgage it back to the seller.

There are movables that cannot be registered with the LTO, like graders and loaders. A mortgage
document is possible but difficult to enforce because they are not registered. The document used is
Deed of Conditional Sale.

Credit on immovables or real estate. There are 2 kinds:

1. Installment sales on a piece of property, like a subdivision lot or similar properties; this is a sale
transaction.
2. Cash loan secured by real estate.

There are many factors that determine what recovery efforts should be undertaken in case of non-
payment:
1. Nature of the thing which is the object of the credit: cash or merchandise.
2. If loan is secured or unsecured.
3. If secured, nature of property used as security: personal property, movable, immovable,
incorporeal rights.
4. Nature of the documents used: mortgage, pledge, trust, receipt.
5. Nature of the relationship between buyer and seller.
6. Nature of the lender / seller's main business.
7. Special circumstances attending the sale or credit transaction.

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PART II FRIENDLY RECOVERY EFFORTS

An enterprise, whether it is a bank, a retailer, or an appliance company, is in business in the long

term. It is a "going concern" and its perpetuation or long-term existence is a primary objective of its
owners.

When an account becomes a problem, it is definitely unwise to take drastic steps immediately,
if an amicable, or friendly, option available. It is also unwise to disturb a seller-buyer or lenderborrower
relationship that took years to nurture and develop.

The debtor's motivation to pay. Is the non-paying debtor sill motivated to pay? In a cash loan
with a real estate mortgage, the debtor is motivated to pay for 2 reasons

1. He may need more bank financing in the near future, or

2. The market value of the property mortgaged is substantially more than the balance of
the loan.

Let us use, as an example, a P1,000,000 real estate property mortgaged for P 500,000 (50% loan
value) at 24% annual interest. If the term is for one year, the loan balance at the end of the credit term
will be P 620,000 (P 500,000 principal plus interest of 24% or P 120,000). At that point, the borrower is
strongly motivated to pay because he wants to keep his property which is worth much more than the
loan balance. At the end of 3 years, however, with no payment, the loan balance becomes P 860,000
(P 500,000 principal plus 24% x 3 years, or P 360,000).

In a credit transaction for merchandise between, say, a wholesaler and retailer, the
debtorretailer is motivated to pay back because he wants to continue his profitable relationship with
the wholesaler, or he either expects a higher credit limit or better terms (90 days to 120 days). Also, he
wants to protect his credit standing so that other wholesalers will also take him as a credit customer.
Trade references are crucial to new credit applications.

In the case of end-users or consumers, the motivation to pay back is always very low. It is for this
reason that appliances are sold by withholding ownership. But for as long as the TV or refrigerator serves
a useful purpose or creates a necessary convenience on which the buyer is dependent (telenovelas
series, cold water in the morning, the. personal motorized transport), the buyer's motivation to pay
would still be considerable.

For goods that are actually consumed, like food and drinks in KTV Bar, the motivation to pay will
continue if the debtor intends to patronize the same establishment for some time. This is, however, not
very predictable, and that is the reason why KTV bars and restaurants are, almost always, in the cash-
only business.
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 SOME FRIENDLY EFFORTS AT RECOVERY ARE:

1. Term extension.
2. Merchandise return or swap.
3. Condonation of penalties and surcharges.
4. Restructuring
a) Simple
b) Document substitution
5. Deposit of durables and movables at the branch store.
6. Debtor substitution.
7. Dacion en pago.
8. Addition of guarantor or surety.
9. Securitization.

These above options are practicable only if the debtor or borrower is still willing to pay, and is
only unable to do so temporarily, such as in a situation where sales are down due to seasonal
fluctuations, or due to a temporary unexpected and unintended financial setback, or because of a
non-recurring event, like a typhoon or flood.

If the creditor is convinced, or if circumstances indicate so, that the debtor does not want to
pay, no matter what, the above options will not work. If the creditor is aware that the debtor is on the
verge of bankruptcy, or has lost his job permanently, or closed his business establishment because of a
damaging lawsuit, using any of the above options would only be prolonging the agony, and in the
case of interest bearing loans, extending the term only increase the loan balances to a point that the
borrowers would prefer that the bank forecloses on the property.

Term extension. A creditor simply adds a few more days, or weeks, even a month, to the due
date of an account. This gives the debtor extra time to recognize his resources and make good on his
obligation. Thus is particularly helpful if the bulk of the merchandise sold on credit remains unsold, or if
the debtor is experiencing an unusual or temporary cash flow problem. Term extension could also be
used in bank loans; the extension however, should be for a very short period of time because interest,
penalties and surcharges could accumulate very quickly.

Merchandise return-swap. If most of the merchandise remains unsold, the wholesaler-creditor

could take back the merchandise from the debtor. This is advisable if the goods cannot be sold in the
area where the debtor's locality, or the merchandise has become obsolete, or out of fashion. This is a
good option if the goods could be sold somewhere else. The underlying assumption here is that the
seller does not want to destroy his relationship with the buyer, who may have been a very good

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customer for many years. Rather than wait for the time when drastic efforts have to be undertaken, it
is better to work out something for the mutual benefit of the seller and the buyer. A swap arrangement
is also a good option; the unsold merchandise is -retaken by the seller and new merchandise provided
to its customer.

Condonation of penalties and surcharges. In this arrangement, the seller or the lender is willing
to condone, or not to collect, all penalties and surcharges, and perhaps part of the interest, also, in
exchange for the full payment of the account. In this set-up, the debtor must be given a definite period
of time to take advantage of this offer.
Even government entities, particularly LGU's, use this technique for the speedy collection of
property and local business taxes.

Restructuring. There are 2 ways: a) simple restructuring, where the terms are extended and the
monthly payments reduced to affordable levels, b) Document substitution.

An example of document substitution is by changing the debtor's account from accounts

receivable to notes receivable. If the debtor originally owes merchandise documented by a charge
sales invoice, in which case the account is classified as accounts receivable-trade, the creditor would
now require the debtor to sign a promissory note, thus changing the account into notesreceivable
trade. This change would not mean anything if the debtor has no intention of paying; however, if the
debtor has no intention of turning his back on the obligation.

There are 2 advantages of a note receivable, compared to a simple trade receivable: first, it
strengthens the financial condition of the creditor; a note receivable is considered to be more reliable
than a trade receivable; second, the promissory note of the debtor, if negotiable, could be used by
the creditor to pay its own debts, or use the promissory note as collateral for a bank loan.

Novation or change in the credit agreement. In a contract of sale on credit for merchandise,
the ownership and possession of said merchandise is transferred to the buyer. Recovery will be difficult
and expensive because the only course of action available to the seller, if the buyer refuses to pay, is
by a civil case. Some civil cases take years to be resolved. If the merchandise remains unsold, what a
creditor can do is take back the ownership of the merchandise, leaving the possession to the buyer.
The creditor could change the contract to one of trusteeship, per Presidential Decree No. 115. This
particularly applies to situations where the buyer has a history of selling the goods obtained on credit
for cash a remitting for a very long time.

Deposit of durables and movables at the branch office. In situations where installment payments have
remained unpaid for many months, it would be practical to request the buyer to deposit the items
purchased to be deposited at the branch store, with the promise that surcharges and penalties will be
suspended. The pressure of collection is suspended, which is good for the buyer and the seller's

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recovery of the credit granted is more or less assured being in control of the merchandise. If the buyer
is very dependent on the unit, he will do everything necessary to reclaim it.

For a motorcycle, where ownership was transferred to the buyer, and said ownership still remains
with him even if the motorcycle was temporarily deposited at the branch, the buyer's pride of
ownership and possession and the embarrassment of having been deprived of such a statusidentifier
as a motorcycle, the debtor would do everything to have his motorcycle back.

Also, with the motorcycle now in the possession of the seller (the deposit must be documented
as a voluntary act on the buyer), foreclosing on it would be much easier.

Debtor substitution. In this technique, the debtor is replaced by another debtor who has an
established credit reputation. As a common example, the financially stable father could replace the
son, or a mother corporation replacing a subsidiary. This will require new documentation which will
extinguish the old obligation and create a new one. (a subsidiary is another corporation partly or wholly
by another corporation, called the mother corporation).

Dacion en pago. Roughly translated this means that a debtor who has a property securing the
debt, sells the property to the creditor to settle his debt. One advantage to the seller is that he is able
to obtain a price for his property that is very close to its market value. Ha pays his debt, takes away the
pressures of collection, and he gets extra cash, too. Furthermore, his credit standing is not adversely
affected.

Addition of guarantor or surety. If the creditor believes that the debtor has a lot of financial
difficulties, debtor substitution is not possible, and that the debtor still has the intention to pay, the
addition of a guarantor, or even better, a surety, is recommended. The objective here is the protection
of the creditor's asset, particularly the safety of the principal.

Securitization. This applies to unsecured credit obligations. The creditor simply and politely
"request" the debtor to collateralize his debt, by putting up real estate or personal property as security.
The creditor, to persuade the debtor, may have to provide a very generous term extension or possible
condonation of surcharges and penalties: The advantages to the debtor are: a) discontinuation of
collection pressure b) the opportunity to have plenty of time to reorganize his financial resources, and
c) the opportunity to keep his credit reputation intact.

The advantages to the creditor are: a) protection of his asset, or safety of the principal with a
collateral, and b) there is a specific collection time frame and he may readjust his own resources
accordingly.

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PART III DRASTIC RECOVERY EFFORTS

At this point, it is just about right to reprint the classification of credit, as presented in Part I of
this chapter:

Type of Credit Options for Drastic Recovery of Credit

Cash loan, unsecured Court order to pay, Levy or
Garnishment, replevin
Merchandise credit, unsecured Court order to pay, Levy or
Garnishment, replevin

Consumer durables, installment Either sum of money or cancellation of sale

And repossession, replevin

Movables, chattel mortgage Foreclosure, replevin

Trust receipt Criminal prosecution

Real estate sale on installment Cancellation of the sale

Loan secured by real estate Foreclosure

Credit obtained thru deceit Criminal prosecution

Court order to pay, then levy or garnishment. The unpaid seller or creditor may ask the court to
order the debtor to pay. If the debtor cannot pay in cash, certified check or other mode of payment
acceptable to the judgment obligee (the creditor), the court will levy upon the properties of the
judgment obligator (the debtor) which may be disposed of for value to satisfy the judgment. (1997
Rules of Civil Procedure, Rule 39, Section 9).

A levy is an essential act by which the property is set apart for satisfaction of the judgment and
taken into custody of the law (Delta Motors Corp. vs. CA, supra, 211-212). There is another type of levy
which is called garnishment. Garnishment applies to the properties of the debtor where third parties
are involved, for example debtor has a P 1.0 M time deposit in a bank. This deposit account was the
result of a transaction involving the bank, the depositor is their creditor. The bank has nothing to do with
the debtor's obligation, but the court can intervene and disturb this depositor-bank relationship by
substituting the judgment obligee (the creditor in a claim for unpaid debt) as the new creditor of the
bank, for all or part of the debtor's deposit. The same is true with wages, where the 3rd party involved
is the employer; instead of paying the employee for wages due, the wages, or part of it, are paid to
the judgment obligee (the creditor).

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 Consumer durables. Article 1484 of the Civil Code states: "in a contract of sale of personal
property, the price of which is payable in installments, the vendor (seller) may exercise any of the
following remedies:

First, exact fulfillment of the obligation, should the vendee fail to pay two or more installments.
Second, cancel the sale, should the vendee (buyer) fail to pay 2 more Installments.
Third, foreclose the chattel mortgage on the thing sold, if one has been constituted, should the
vendor fail to pay 2 or more installments. In this case, he shall have no further action against the
purchaser to recovery any unpaid balance on the price.

The seller may go to court which will compel the buyer to pay. In law, this is called the remedy
of specific performance. This remedy is referred to sometimes as the sum of money option; the seller
wants his money back. Once the seller chooses this option, he is prevented from using the 2nd and 3rd
remedies.

Movables. Movables are covered by the same article, particularly paragraph 3 on foreclosure
of chattel mortgage. It must be noted that the same paragraph states: "the seller shall have no further
action against the installment buyer to recover any unpaid balance". The seller cannot go after the
buyer for the unpaid balance.

Trust receipts. Because of the explicit provisions of PD 115, criminal prosecution is the best remedy
for non-payment.

Real estate sale on installment. This refer to the sale of subdivision lots, and similar real estate
properties. To protect real estate installment buyers, Republic Act No. 6552 provides that if the buyer
has paid at least 2 years of installments the buyer is entitled:

1. To pay, without interest, the unpaid installments within the total grace period earned by him,
which is hereby fixed at the rate of one month of every one year of installment payment;
provided that this right shall be exercised by the buyer only once every 5 years of the life of
the contract and extensions, if any.
2. If the contract is cancelled, the seller shall refund to the buyer 50% of the total payments
made, and after 5 years of installments, 5 % a year thereafter, but not to exceed 90% of total
payments made.

To explain the above, let us use an example. Mr. L has paid 24 monthly installments for a subdivision
lot. He is now entitled to pay for the full balance, if he chooses, within 2 months. If the contract is
cancelled by the seller (obviously due to slow payments), Mr. L must be refunded half or 50% of all the
payments he has made. The unpaid seller's remedy is cancellation of the sale, clearly allowed by law.

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 If the sale on installment is for a subdivision lot, and both the ownership and possession has not been
transferred yet, as is always the case in this kind of transaction, the seller keeps the title on the property,
which he can sell to someone else, and yet, he has obtained 50% of the buyer's money.
If the sale is for a condominium unit or a house and lot, the usual transaction is for the seller to transfer
the possession and ownership of the unit to the buyer, who in turn will mortgage it to a bank. The bank
will release the proceeds of the mortgage to the seller.

In this case, the usual remedy for an unpaid seller is foreclosure. There are 2 kinds of foreclosure:

a. Judicial foreclosure. This is foreclosure through the Regional Trial Court of any province or
city where the property is located.

b. Extrajudicial foreclosure. This is possible if there is a provision in the mortgage contract

giving the mortgage (creditor) the power upon default (non-payment) to foreclose
extrajudicially. The sale of the property that was mortgaged could be made without a
court order.

Repossession. For consumer durables such as appliances, the most common recovery
technique is by repossession of the installment unit. This means that the sale has been cancelled. The
document used for appliance installment sales is the Deed of Conditional Sale with Reservation of title.
The sale is simply cancelled and the unit repossessed. The buyer's liability is also extinguished.

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