McCullough vs. Veloso

A debtor is not released from his obligation by the mere transfer of the mortgaged property to a third person who assumes the mortgage debt, absent the creditor’s express consent to substitute the new debtor. Stipulated attorney’s fees in a contract, although not binding as between attorney and client, may be moderated by the court to a reasonable sum based on the amount involved and the work required.

On March 23, 1920, E. C. McCullough & Co., Inc. sold the “McCullough Building” — land and improvements — to Mariano Veloso for P700,000. Veloso paid P50,000 in cash and executed a mortgage over the property to secure the P650,000 balance, payable in staggered installments, with interest at 7% per annum. The contract included a stipulation for 10% attorney’s fees should judicial collection become necessary and an acceleration clause making the entire debt due upon default. Veloso later sold the property to Joaquin Serna, who agreed to assume the unpaid balance. Serna made payments totaling P250,000 but thereafter defaulted, prompting the creditor to sue for the full liquidated balance.

• The Original Sale and Mortgage: On March 23, 1920, E. C. McCullough & Co., Inc. sold the “McCullough Building” to Mariano Veloso for P700,000. Veloso paid P50,000 in cash at execution. The balance of P650,000 was to be paid in installments — P50,000 on May 1, 1920, and P100,000 annually thereafter from October 31, 1920 to April 1, 1925 — with 7% annual interest payable semi-annually. Veloso also undertook to insure the property for at least P500,000, to pay all taxes, and to pay 10% of the debt as attorney’s fees should judicial collection be necessary. He mortgaged the property to secure these obligations, and the encumbrance was annotated on Certificate of Title No. 13274. The contract provided for acceleration: upon default in any stipulation, the entire unpaid balance and interest would become immediately due.

• The Second Sale to Serna: On August 21, 1920, Veloso sold the same property to Joaquin Serna for P100,000, with Serna agreeing to respect the existing mortgage in favor of the plaintiff and to assume Veloso’s obligation to pay the unpaid balance on the original purchase price as the installments fell due.

• Payments and Default: Veloso paid an additional P50,000 on the P650,000 balance. Serna made several payments aggregating P250,000. Thereafter, neither Veloso nor Serna made further payments on the later installments. By virtue of the default and the acceleration clause, the entire obligation became due, and Veloso lost the benefit of the installment terms.

• Liquidation of the Debt: Accountants Clarke & Larkin liquidated Veloso’s obligation, fixing the amount due as of March 26, 1923 at P510,047.34. The accuracy of this sum was undisputed. The plaintiff then commenced the present action to recover that amount plus 10% attorney’s fees and to foreclose the mortgage.

• Novation: Whether the sale of the mortgaged property by Veloso to Serna, coupled with Serna’s assumption of the mortgage debt, operated to novate the original obligation by substituting Serna as debtor and thereby releasing Veloso.

• Creditor’s Consent: Whether the plaintiff’s failure to oppose the sale to Serna and its acceptance of payments from Serna constituted the express consent required to effect a novation by substitution.

• Foreclosure Against the Original Debtor: Whether the mortgage could be foreclosed and a deficiency judgment rendered against Veloso despite the transfer of the property to Serna.

• Attorney’s Fees: Whether the trial court properly reduced the stipulated 10% attorney’s fee to P2,000, and if not, what amount was reasonable.

• Novation: No novation occurred. Under Article 1205 of the Civil Code, novation by substitution of a debtor requires the consent of the creditor. The plaintiff did not intervene in the contract between Veloso and Serna and gave no express consent to the substitution. Novation cannot be presumed; it must be express.

• Creditor’s Consent: The plaintiff’s non-opposition to the sale carried no legal significance. A mortgage is merely an encumbrance; the mortgagor retains ownership and the right to dispose of the property. The creditor could not have prevented the sale, and the mortgage follows the property regardless of the possessor under Article 1876 of the Civil Code. The acceptance of payments from Serna was merely payment by a third person, which does not affect the creditor-debtor relationship between the plaintiff and Veloso except to extinguish the obligation to the extent paid.

• Foreclosure Against the Original Debtor: The original debtor remains primarily liable on the debt despite the transfer. Under the Mortgage Law of 1889 (Articles 135 and 136) referenced in the Civil Code, a creditor may demand payment from the third possessor only after a demand on the debtor and the debtor’s failure to pay, and even then, the third possessor may abandon the property. Nothing in the later Mortgage Law of 1893 altered the fundamental principle that the debtor’s personal obligation subsists. The foreclosure order and the writ of execution against Veloso’s other properties for any deficiency were therefore proper.

• Attorney’s Fees: Following Bachrach vs. Golingco (39 Phil. 138), stipulated attorney’s fees in a contract may be reduced to a reasonable amount. Considering the size of the debt — over half a million pesos — and the work required to collect it through judicial proceedings, P15,000 was a reasonable sum. The trial court’s award of P2,000 was accordingly increased.

• Novation by substitution of debtor (Art. 1205, Civil Code) — For a novation that substitutes a new debtor in place of the original debtor to be effective against the creditor, the creditor must give express consent. Such consent cannot be implied from mere knowledge of the transfer or acceptance of partial payments from the third person. Novation is never presumed.

• Mortgage follows the property (Art. 1876, Civil Code) — A mortgage is a real right that attaches to the property irrespective of changes in ownership. The mortgagor’s sale of the encumbered property neither extinguishes the mortgage nor releases the debtor from personal liability on the secured obligation.

• Payment by a third person (Art. 1158, Civil Code, related principle) — A third person who pays the debt of another may create a juridical relation between himself and the debtor, but the payment does not, without the creditor’s consent, alter the vinculum juris between the original debtor and the creditor, except to discharge the obligation to the extent of the payment.

• Reasonableness of stipulated attorney’s fees (Bachrach vs. Golingco doctrine) — A contractual stipulation for attorney’s fees, though binding between the parties as a measure of damages, is subject to judicial moderation. The court may reduce the fee to a reasonable amount considering the amount in controversy and the legal work entailed.

• “In order that this novation may take place, the law requires the consent of the creditor (art. 1205 of the Civil Code). The plaintiff did not intervene in the contract between Veloso and Serna and did not expressly give his consent to this substitution. Novation must be express, and cannot be presumed.” — This passage encapsulates the ratio decidendi on the novation issue, underscoring the necessity of the creditor’s express consent.

• “The mortgage is merely an encumbrance upon the property and does not extinguish the title of the debtor, who does not, therefore, lose his principal attribute as owner, that is, the right to dispose. … the fact that the plaintiff recognized the efficaciousness of that sale cannot prejudice him, which sale the defendant had the right to make and the plaintiff cannot oppose and which, at all events, could not affect the mortgage, as the latter follows the property whoever the possessor may be.” — The Court clarifies the nature of a mortgage and the debtor’s continuing ownership, and affirms the principle of mortgage following the property.

• “[T]he fact that the plaintiff has received payments from Serna on account of Veloso's debt is of no importance, for this is, at most, a payment by a third person, which, while it may create a juridical relation between Serna and Veloso, cannot affect the relation between the latter and the plaintiff, except that the obligation thus paid is discharged.” — This explains why acceptance of payments from the third party does not effect a substitution of debtors.

• Bachrach vs. Golingco, 39 Phil. 138 — Followed. Established that courts may reduce stipulated attorney’s fees to a reasonable amount. Applied here to increase the award from P2,000 to P15,000 as reasonable under the circumstances.

• Article 1205, Civil Code — Requires the creditor’s consent for a novation that substitutes a new debtor. The absence of the plaintiff’s consent to the substitution of Serna for Veloso resulted in no novation.

• Article 1876, Civil Code — Provides that a mortgage follows the property into whosoever’s hands it may pass. The sale to Serna could not affect the plaintiff’s mortgage right.

• Article 1879, Civil Code — Empowers the creditor to demand from the third person in possession of the mortgaged property payment of the part of the debt secured by that property, in the manner and form provided by law. The Court read this in conjunction with the Mortgage Law to show that the debtor’s primary liability remains.

• Articles 135 and 136, Mortgage Law of 1889 — Provided that the creditor must first demand payment from the debtor, and upon the debtor’s failure, may proceed against the third possessor, who could abandon the property. Cited to demonstrate the legislative intent that the debtor’s personal obligation is not extinguished by transfer.

• Article 129, Mortgage Law of 1893 — Held not to alter the principle that the original debtor remains liable; the provision regarding substitution of the debtor by the third possessor applied only to procedural notice requirements when the action is directed solely against the property.

Justices Araullo, C.J., Malcolm, Johns, and Romualdez concurred. Justice Street concurred in the principal holdings but opined that a fee of not less than P20,000 would have been more appropriate. Justice Ostrand concurred except as to the reduction of the stipulated attorney’s fees, maintaining that the contract between parties dealing at arm’s length should not be disturbed without pleading and proof of unconscionability.

• Justice Johnson — Dissented on the attorney’s fees issue. The contract provided a fixed amount to cover collection expenses. If the defendant believed the amount unreasonable, that question should have been settled at the time of contracting or raised at trial; it was not properly before the Court.