Concept and Nature
Compensation is the extinguishment, to the concurrent amount, of two obligations where two persons are reciprocally creditors and debtors of each other in their own right.
It operates as a simplified payment because each party is deemed to pay what he owes by applying against it what is due from the other. It prevents the useless circuity of requiring A to pay B when B must immediately return an equivalent amount to A.
The Civil Code treats compensation as a distinct mode of extinguishment. It is not the same as actual payment, because no delivery need occur; it is not confusion or merger, because there remain two obligations between two persons; and it is not merely a procedural counterclaim, because legal compensation extinguishes obligations by substantive law when all requisites concur.
Compensation may be total when the reciprocal debts are equal. It is partial when one debt is larger, in which case both obligations are extinguished only up to the lesser amount and the balance remains enforceable.
Classes of Compensation
| Class | Source | Controlling idea |
|---|---|---|
| Legal compensation | Operation of law | It arises automatically when the Civil Code requisites are present. |
| Conventional or voluntary compensation | Agreement of the parties | The parties may compensate obligations even if some legal requisites, such as maturity, are absent, provided no law or third-party right is violated. |
| Facultative compensation | Option of the party protected by law | One party may invoke or waive compensation because the impediment exists for his protection. |
| Judicial compensation | Court adjudication | The court allows set-off after establishing a claim that was not previously liquidated or demandable for purposes of legal compensation. |
Legal Compensation
Legal compensation is the principal form of compensation. Under Article 1290, when all requisites for legal compensation are present, compensation takes effect by operation of law and extinguishes both debts to their concurrent amount even though the parties do not know that compensation has occurred.
The court's later declaration does not create legal compensation; it recognizes an extinguishment that already arose when the statutory requisites first concurred. For this reason, interest, penalties, and other accessories stop running on the compensated amount from that point, unless a valid stipulation or special rule produces a different result.
Requisites
- Each party must be bound principally and must at the same time be a principal creditor of the other. The parties must be mutually creditors and debtors in the same capacity, and each debt must be his own obligation or credit.
- Both debts must consist in money, or in consumable things of the same kind and quality if quality was stated. The performances must be homogeneous so that one can truly replace the other.
- Both debts must be due. The period must have arrived, or the condition that suspends demandability must have happened.
- Both debts must be liquidated and demandable. The amount or quantity must be determined, or determinable by mere computation, and the claim must be enforceable without defeating defenses.
- No retention or controversy commenced by a third person must exist over either debt, after due notice to the debtor. The law avoids extinguishing a credit that has already become subject to a third person's asserted right.
All requisites must concur at the same time. If one debt becomes due today and the other becomes due later, legal compensation starts only when the later debt also becomes due, assuming all other requisites are then present.
Reciprocity and Same Capacity
Compensation requires true reciprocity. A person who owes in his personal capacity cannot compensate that debt with a credit belonging to him as trustee, administrator, agent, guardian, corporate officer, or representative of another estate or juridical entity.
The phrase in their own right prevents the mixing of separate patrimonies. A stockholder cannot use a corporate receivable to extinguish his personal debt, and a corporation cannot use a stockholder's personal credit as if it were corporate property.
The requirement that each party be principally bound excludes a mere guarantor from automatic legal compensation because the guarantor is only subsidiarily liable. However, the Civil Code expressly allows a guarantor to set up compensation as regards what the creditor owes the principal debtor, because the guaranty is accessory and the guarantor may rely on defenses that reduce or extinguish the principal debt.
In solidary obligations, compensation depends on the capacity in which the credit is held. A solidary debtor sued by the creditor may invoke his own due and liquidated credit against the creditor, and he may also invoke defenses arising from the nature of the obligation; credits belonging purely to another solidary debtor affect only the share to which they properly relate.
Homogeneity of the Debts
Money debts are naturally susceptible of compensation because they are measured by amount. Obligations to deliver consumable things may also be compensated if the things are of the same kind and, when quality is part of the undertaking, of the same quality.
Compensation does not require that the debts arise from the same source. A loan may be compensated with a price due from a sale, or a liquidated contractual debt may be compensated with another matured contractual debt, provided the legal requisites are present.
Obligations to deliver determinate things, to render personal services, or to perform acts are generally not susceptible of legal compensation because the prestation of one cannot be treated as the equivalent payment of the other.
Due, Liquidated, and Demandable Debts
A debt is due when the time for performance has arrived. A debt subject to a suspensive period is not due until the period expires, and a debt subject to a suspensive condition is not due until the condition happens.
A debt is demandable when the creditor may presently enforce it. A claim affected by a valid defense, an unresolved condition, a pending rescission that defeats enforceability, or a legal prohibition against collection is not demandable for legal compensation.
A debt is liquidated when its amount is already fixed or can be fixed by simple arithmetic based on established data. Unliquidated damages, disputed accounting items, and claims requiring proof of liability and amount do not support legal compensation until they are established.
Prescription matters because a prescribed civil action is no longer demandable in the legal sense. If legal compensation had already taken place before prescription became relevant, the later lapse of time does not revive an obligation already extinguished.
Third-Party Retention or Controversy
Legal compensation is barred when a third person has commenced retention or controversy over the credit and the debtor has been notified in due time. Typical situations include garnishment, attachment, adverse claims, or litigation that places the credit under a third person's asserted right.
The notice must come in time to protect the third person before the debtor can safely rely on compensation. Once legal compensation has already taken effect, a later third-party claim cannot revive the extinguished credit.
Effects of Legal Compensation
The main effect is extinguishment of both debts to the concurrent amount. If the debts are equal, both obligations and their accessories are extinguished in full; if unequal, the smaller obligation is extinguished and the larger survives for the balance.
Accessories follow the principal debt. Interest, penalties, guaranties, pledges, mortgages, and other accessory obligations are discharged to the extent that the principal obligation is extinguished by compensation.
Legal compensation may occur even if the debts are payable at different places. The party benefited by the offset must indemnify the proper expenses of exchange or transportation required by the difference in place of payment.
Because compensation operates by law, actual tender, demand, acceptance, receipt, or accounting entry is not essential to its existence. In litigation, however, a party who relies on compensation must properly allege and prove the facts showing the concurrence of the requisites when the matter is not apparent from the record.
Compensation may be waived because it is generally a benefit affecting private rights. Waiver may be express, as in a stipulation against set-off, or implied, as when a debtor consents to an assignment of credit without reserving compensation that he could have asserted against the assignor.
Conventional Compensation
The parties may agree to compensate debts that are not yet due. This recognizes freedom of contract because the requirement of maturity is primarily for the benefit of the debtor, who may waive the period when the waiver is lawful.
Conventional compensation may also settle uncertain accounts, cross-claims, or obligations that would not automatically satisfy every requirement of legal compensation. The agreement must still comply with the rules on consent, object, and cause, and it cannot impair vested rights of third persons.
Parties may also exclude or restrict compensation by stipulation. A valid no set-off clause prevents a party from invoking compensation contrary to the agreed allocation of payment risk, subject to mandatory law and public policy.
Judicial Compensation
Judicial compensation arises when a court, in resolving a dispute, allows one party's claim to be offset against the other's claim after determining the existence and amount of the first claim.
The Civil Code allows a party to a suit over an obligation to set off a claim for damages against the other party by proving both the right to damages and their amount. This is not legal compensation at the beginning of the case because the damages are not yet liquidated; it becomes effective through judicial determination.
A counterclaim may be the procedural vehicle for judicial compensation, but the counterclaim itself is not the extinguishing cause. The extinguishment results from the judgment recognizing that the adjudicated claims should be balanced against each other.
Facultative Compensation and Protected Claims
Facultative compensation exists where compensation is unavailable to one party but may be invoked by the party for whose protection the prohibition exists. The protected party may refuse the offset, while the unprotected party cannot force it.
The clearest illustration is the guarantor's statutory right to set up what the creditor owes the principal debtor. The guarantor is not a principal debtor for ordinary legal compensation, but the law gives him the option to use compensation to reduce or defeat the creditor's action.
Protected claims involving deposit, commodatum, and gratuitous support also show the reason for facultative treatment. The law prevents the obligor from withholding return, use, or support by unilaterally setting off a separate claim, but the protected creditor may waive the protection when the claim has become legally disposable.
Debts Not Properly Subject to Compensation
| Debt or claim | Reason for restriction | Effect |
|---|---|---|
| Depositum | The depositary must return the thing deposited and may not retain it as payment for a separate claim. | The depositary cannot defeat return by invoking compensation. |
| Obligation of a bailee in commodatum | Commodatum is based on trust and gratuitous use, and the bailee must return the thing loaned. | The bailee cannot keep the thing or its value by setting up an independent credit. |
| Support due by gratuitous title | Support is intended for subsistence and is protected against ordinary patrimonial set-off. | The support obligor cannot compensate current support with what the recipient owes him; support in arrears may be treated differently when the law allows disposition. |
| Civil liability arising from a penal offense | The law protects reparation due to the offended party and prevents the offender from neutralizing it through an unrelated credit. | Compensation is not proper when one debt consists of such civil liability. |
| Taxes and public charges | They are governed by public law and are not ordinary private debts subject to unilateral set-off. | Set-off is allowed only when a statute or valid governmental procedure authorizes it. |
The exception for depositum refers to civil deposit, not every transaction popularly called a deposit. Ordinary bank deposits are generally treated as debtor-creditor relations, subject to banking law, contract, and the requisites of compensation.
Assignment of Credits
Assignment affects compensation because the debtor may have a credit against the original creditor but not against the assignee. The Civil Code rules allocate the risk according to the debtor's consent, notice, or ignorance of the assignment.
| Situation | Rule on compensation |
|---|---|
| Debtor consents to the assignment | He generally cannot set up against the assignee the compensation he could have asserted against the assignor, unless he reserved that right when he consented. |
| Assignment is communicated to the debtor, but he does not consent | He may set up compensation for debts existing before the assignment, but not for debts arising afterward. |
| Assignment is made without the debtor's knowledge | He may set up compensation for credits that arose before the assignment and for later credits that arose before he learned of it. |
These rules protect commercial certainty. Consent favors the assignee, notice fixes the cut-off point, and ignorance preserves the debtor's reliance on his apparent right to offset against the assignor.
Rescissible and Voidable Obligations
Rescissible or voidable obligations may be compensated before they are judicially rescinded or annulled. Until the court sets them aside, they produce legal effects and may supply the credit necessary for compensation.
If rescission or annulment is later decreed, the judgment may require restitution or adjustment because the basis of the supposed credit has been legally undone. The availability of compensation before judgment does not prevent the court from enforcing the consequences of rescission or annulment.
Several Debts Susceptible of Compensation
When a person has several debts susceptible of compensation, the rules on application of payments determine which debts are extinguished first. The debtor's valid choice controls when made at the proper time; otherwise, the debt most onerous to him is applied first, and if the debts are equally onerous, application is made proportionately.
This rule matters when reciprocal accounts contain debts with different interest rates, securities, penalties, maturities, or burdens. Compensation should not arbitrarily extinguish a less burdensome debt while leaving a more burdensome one outstanding if the rules on application of payments point to a different result.
Practical Legal Consequences
A party asserting compensation must identify the reciprocal debts, their amounts, their maturity, their enforceability, and the absence of a legal impediment. The burden is especially important when the alleged compensating credit is based on damages, accounting, reimbursement, or a claim held in a representative capacity.
Payment made after legal compensation has already extinguished the debt may be recoverable if it was made without intending to waive compensation. A party who knowingly pays despite an available set-off may be treated as having waived the benefit, depending on the facts and the governing agreement.
Compensation cannot prejudice third persons who acquired rights before the requisites of compensation were complete. Once the requisites are complete, however, later assignments, garnishments, or adverse claims generally attach only to whatever balance remains.
The controlling inquiry is always whether, at the relevant time, the two parties stood as reciprocal principal creditors and debtors of due, demandable, liquidated, and homogeneous obligations free from legal prohibition or superior third-party claim.