COASTAL PACIFIC TRADING, INC., vs. SOUTHERN ROLLING MILLS, CO., INC.

(now known as Visayan

G.R. No. 118692; July 28, 2006

PANGANIBAN, C.J:

FACTS

Respondent Southern Rolling Mills Co., was organized for the purpose of engaging in a steel
processing business, later renamed as Visayan Integrated Steel Corporation (VISCO). VISCO obtained a
loan from DBP and was secured by a recorded real estate mortgage over VISCO’s three (3) parcels of
land, including all the machineries and equipment found therein. Subsequently, VISCO entered into a
Loan Agreement with several banks (Consortium) to finance its importation of various raw materials and
as a security, executed a second mortgage over the same land, machineries and equipment in favor of
respondent banks (Consortium). This second mortgage remained unrecorded.

VISCO defaulted in the performance of its obligation. Negotiations were made for the
conversion of the unpaid loan into equity in the corporation. As a result of the reorganized corporate
structure of VISCO, respondent banks acquired more than 90 percent of its equity. Nine (9) out of ten
(10) directors of corporation were all officials of the Consortium which may thus be said to have
effectively controlled the board. Notwithstanding this conversion, it remained indebted to the
Consortium.

Meanwhile, VISCO entered into a processing agreement with Petitioner Coastal Pacific Trading,
Inc. wherein tons of hot rolled steel coils are to be processed into block iron sheets. VISCO failed to fully
comply. Proposal for compromise was made but eventually failed. Petitioner then filed a complaint for
Recovery of Property and Damages with Preliminary Injunction and Attachment against VISCO.
Petitioner alleged that VISCO had fraudulently misapplied or converted the finished steel sheets
entrusted to it. A Writ of Preliminary Attachment over VISCO’s assets was issued. Sheriff attempted to
garnish the account of VISCO in FEBT, which denied holding said account because what it had was a
deposit in the name of Board of Trustees-Consortium of Banks. While Petitioner’s case was pending,
VISCO’s vice-president and director made a cash advance from FEBTC for the settlement of its liability
with DBP. Also, VISCO, through a resolution issued by its board of directors, started to sell its assets to
pay its liabilities with DBP. However, on even date, DBP executed a Deed of Assignment of Mortgage
Rights Interest and Participation in favor of Respondent Consortium of Banks. Subsequently,
Consortium, filed a Petition for Extra Judicial Foreclosure with the Office of the Provincial Sheriff of
Bohol.
Auction sale of VISCO’s mortgaged properties ensued and the Consortium emerged as the highest
bidder. On the same day, Consortium sold the foreclosed real and personal properties of VISCO to the
NSC. Petitioner Coastal thereafter filed a complaint for Annulment or Rescission of Sale, Damages with
Preliminary Injuction. Petitioner Coastal alleged that despite the Writ of Attachment issued in its favor,
Consortium had sold the properties to NSC. Further, despite the attachment of the properties, the
Consortium was allegedly able to sell and place them beyond the reach of VISCO’s other creditors. Thus
imputing bad faith to respondent banks’ actions as it was allegedly intended to defraud VISCO’s other
creditors. Moreover, Petitioner contended that the assignment in favor of the Consortium was
fraudulent, because DBO had been paid with the proceeds from the sale of the generator sets owned by
VISCO, and not with the Consortium’s own funds. Respondent Consortium countered that the minutes
would in fact readily disclosed that the intention of its members was to apply the proceeds to a partial
payment to DBP. Respondent insisted that it used its own funds to pay the bank.

Trial court held that Petitioner failed to prove its case for rescission of sale by preponderance of
evidence. The insufficiency of proof was based on the sole ground that petitioner did not file an
objection when the properties were sold on execution.

ISSUE

Should the assignment of mortgage, extrajudicial foreclosure and sale of properties of VISCO be
rescinded on the ground that they were done to defraud the latter’s creditors?

RULING

Yes, the assignment of mortgage, extrajudicial foreclosure and sale of properties of VISCO
should be rescinded on the ground that they were done to defraud the latter’s creditors.

Elementary is the principle that the validity of a contract does not preclude its rescission. Under
Articles 1380 and 1381 (3) of the Civil Code, contracts that are otherwise valid between the contracting
parties may nonetheless be subsequently rescinded by reason of injury to third persons, like creditors. In
fact, rescission implies that there is a contract that, while initially valid, produces a lesion or pecuniary
damage to someone. Thus, when the CA confined itself to the issue of the validity of these contracts, it
did not at all address the heart of petitioner’s cause of action: whether these transactions had been
undertaken by the Consortium to defraud VISCO’s other creditors. There is more than preponderance of
evidence showing the Consortium’s deliberate plan to defraud VISCO’s other creditors.

To be sure, there was undue advantage. The payment scheme devised by the Consortium
continued the efficacy of the primary lien, this time in its favor, to the detriment of the other creditors.
When one considers its knowledge that VISCO’s assets might not be enough to meet its obligations to
several creditors, the intention to defraud the other creditors is even more striking. Fraud is present
when the debtor knows that its actions would cause injury.

The assignment in favor of the Consortium was a rescissible contract for having been
undertaken in fraud of creditors. Article 1385 of the Civil Code provides for the effect of rescission, as
follows:

“Rescission creates the obligation to return the things which were the object of the contract, together
with their fruits, and the price with its interest; consequently, it can be carried out only when he who
demands rescission can return whatever he may be obligated to restore.

“Neither shall rescission take place when the things which are the object of the contract are legally in
the possession of third persons who did not act in bad faith.

“In this case, indemnity for damages may be demanded from the person causing the
loss.”

Indeed, mutual restitution is required in all cases involving rescission. But when it is no longer
possible to return the object of the contract, an indemnity for damages operates as restitution. The
important consideration is that the indemnity for damages should restore to the injured party what was
lost.

In the case at bar, it is no longer possible to order the return of VISCO’s properties. They have
already been sold to the NSC, which has not been shown to have acted in bad faith. The party alleging
bad faith must establish it by competent proof. Sans that proof, purchasers are deemed to be in good
faith, and their interest in the subject property must not be disturbed. Purchasers in good faith are
those who buy the property; and who pay the full and fair price for it at the time of the purchase, or
before they get notice of some other persons’ claim of interest in the property.