Rehabilitation proceedings and the non-impairment clause

Can a rehabilitation court compel a lender to accept a 50% reduction in the borrower’s principal obligation?  Would that violate the non-impairment of contracts clause of the Constitution?

In Pacific Wide Realty and Development Corporation vs. Puerto Azul Land, Inc./Pacific Wide Realty and Development Corporation Vs. Puerto Azul Land, Inc.G.R. No. 178768/G.R. No. 180893, November 25, 2009, the borrower, Puerto Azul Land, Inc. (PALI) is the owner and developer of the Puerto Azul Complex situated in Ternate, Cavite. Its business involves the development of Puerto Azul into a satellite city with residential areas, resort, tourism and retail commercial centers with recreational areas. In order to finance its operations, it obtained loans from various banks, the principal amount of which amounted to aroundPhP640 million.

Because of financial difficulties, PALI subsequently filed a petition for rehabilitation. After trial, the rehabilitation court issued a decision which reads, in part:

The rehabilitation of the petitioner, therefore, shall proceed as follows. . .

2.      Creditors who will not opt for dacion shall be paid in accordance with the restructuring of the obligations as recommended by the Receiver as follows:

a)      The obligations to secured creditors will be subject to a 50% haircut of the principal, and repayment shall be semi-annually over a period of 10 years, with 3-year grace period. Accrued interests and penalties shall be condoned. Interest shall be paid at the rate of 2% p.a. for the first 5 years and 5% p.a. thereafter until the obligations are fully paid. The petitioner shall allot 50% of its cash flow available for debt service for secured creditors. Upon completion of payments to government and employee accounts, the petitioner’s cash flow available for debt service shall be used until the obligations are fully paid.

b)      One half (1/2) of the principal of the petitioner’s unsecured loan obligations to other creditors shall be settled through non-cash offsetting arrangements, with the balance payable semi-annually over a period of 10 years, with 3-year grace period, with interest at the rate of 2% p.a. for the first 5 years and 5% p.a. from the 6th year onwards until the obligations are settled in full. Accrued interest and penalties shall be condoned.  (underscoring supplied)

One of the lenders, Export and Industry Bank (EIB), filed with the Court of Appeals (CA) a petition for review under Rule 42 of the Rules of Court. The CA affirmed the decision of the rehabilitation court.

In its petition before the Supreme Court, EIB argues that the rehabilitation plan was unreasonable and in violation of the non-impairment clause. The Supreme Court disagreed. The court first explained the nature of rehabilitation proceedings:

Rehabilitation contemplates a continuance of corporate life and activities in an effort to restore and reinstate the corporation to its former position of successful operation and solvency. The purpose of rehabilitation proceedings is to enable the company to gain a new lease on life and thereby allow creditors to be paid their claims from its earnings. The rehabilitation of a financially distressed corporation benefits its employees, creditors, stockholders and, in a larger sense, the general public.

Under the Rules of Procedure on Corporate Rehabilitation, “rehabilitation” is defined as the restoration of the debtor to a position of successful operation and solvency, if it is shown that its continuance of operation is economically feasible and its creditors can recover by way of the present value of payments projected in the plan, more if the corporation continues as a going concern than if it is immediately liquidated.

An indispensable requirement in the rehabilitation of a distressed corporation is the rehabilitation plan . . .

On EIB’s argument that the rehabilitation plan violates the non-impairment clause, the court ruled:

In G.R. No. 180893, the rehabilitation plan is contested on the ground that the same is unreasonable and results in the impairment of the obligations of contract.PWRDC contests the following stipulations in PALI’s rehabilitation plan: fifty percent (50%) reduction of the principal obligation; condonation of the accrued and substantial interests and penalty charges; repayment over a period of ten years, with minimal interest of two percent (2%) for the first five years and five percent (5%) for the next five years until fully paid, and only upon availability of cash flow for debt service.

We find nothing onerous in the terms of PALI’s rehabilitation plan. The Interim Rules on Corporate Rehabilitation provides for means of execution of the rehabilitation plan, which may include, among others, the conversion of the debts or any portion thereof to equity, restructuring of the debts, dacion en pago, or sale of assets or of the controlling interest.

The restructuring of the debts of PALI is part and parcel of its rehabilitation. Moreover, per findings of fact of the RTC and as affirmed by the CA, the restructuring of the debts of PALI would not be prejudicial to the interest of PWRDC as a secured creditor. Enlightening is the observation of the CA in this regard,viz.:

There is nothing unreasonable or onerous about the 50% reduction of the principal amount when, as found by the court a quo, a Special Purpose Vehicle (SPV) acquired the credits of PALI from its creditors at deep discounts of as much as 85%. Meaning, PALI’s creditors accepted only 15% of their credit’s value. Stated otherwise, if PALI’s creditors are in a position to accept 15% of their credit’s value, with more reason that they should be able to accept 50% thereof as full settlement by their debtor. x x x.

We also find no merit in PWRDC’s contention that there is a violation of the impairment clause. Section 10, Article III of the Constitution mandates that no law impairing the obligations of contract shall be passed. This case does not involve a law or an executive issuance declaring the modification of the contract among debtorPALI, its creditors and its accommodation mortgagors. Thus, the non-impairment clause may not be invoked. Furthermore, as held in Oposa v. Factoran, Jr. even assuming that the same may be invoked, the non-impairment clause must yield to the police power of the State. Property rights and contractual rights are not absolute. The constitutional guaranty of non-impairment of obligations is limited by the exercise of the police power of the State for the common good of the general public.

Successful rehabilitation of a distressed corporation will benefit its debtors, creditors, employees, and the economy in general. The court may approve a rehabilitation plan even over the opposition of creditors holding a majority of the total liabilities of the debtor if, in its judgment, the rehabilitation of the debtor is feasible and the opposition of the creditors is manifestly unreasonable. The rehabilitation plan, once approved, is binding upon the debtor and all persons who may be affected by it, including the creditors, whether or not such persons have participated in the proceedings or have opposed the plan or whether or not their claims have been scheduled.”