Comparing liquidated damages and punitive penalties in Korea

Liquidated damages are damages where the amount is agreed in advance by the parties to a contract and are intended to compensate the non-breaching party for actual damages caused by the breach. Article 398 of the Civil Act specifically permits liquidated damages clauses to be used in contracts. It also provides that a penalty agreed upon in a contract is usually presumed to refer to liquidated damages. Notwithstanding the parties’ agreement, a court may reduce the amount of liquidated damages to a reasonable and appropriate sum if the court finds that the amount agreed in advance by the parties is unduly excessive (Article 398(2) of the Civil Act).

In contrast, a punitive penalty refers to a penalty that is payable if one party fails to perform an agreement. This penalty is separate and in addition to any compensatory damages caused by the breach. A non-breaching party may file a claim for compensatory damages apart from a punitive penalty and, unlike with liquidated damages, a punitive penalty is not subject to reduction under Article 398(2). A punitive penalty is intended to encourage performance of contracts by punishing breaches.

Recent trends in Korean courts’ decisions on punitive penalties
Generally, Korean courts will uphold the language of the Civil Act, which provides that punitive penalty amounts are different from liquidated damages and are not subject to reduction under Article 398. However, based on Article 103 of the Civil Act, some courts have recognised the possibility that a punitive penalty amount may be reduced if it goes against good morals and social orders. In such a case, some or all of the penalty can be declared to be null and void.

On January 28, 2016 the Supreme Court weighed in on the debate, clarifying the meaning of a punitive penalty and the standard by which a reduction may be recognised. Going forward this case is expected to provide a useful standard for determining whether the amount of a penalty can be reduced.

The Supreme Court ruled: A punitive penalty is one that is agreed in advance to secure the performance of obligations under the agreement and is not the same as liquidated damages. Accordingly, Article 398(2) of the Civil Act cannot apply to a punitive penalty. That Article permits reductions only in liquidated damages amounts. However, there is an exception. If the agreed punitive penalty is excessively heavy compared to the benefits to be earned by a party that performs under the contract, then the penalty goes against public order and good morals and is rendered null and void in full or in part.

The Supreme Court further stated that a reduction of a penalty amount is permitted only in exceptional cases, and courts should avoid reducing penalty amounts as much as possible. A court’s intervention into a private contract and exercise of its discretion to invalidate the amount agreed by the parties may pose a risk of materially invading the principle of private autonomy. It might also result in the protection of a person who intentionally flees from the binding effects of a contract. In line with this, courts should take a careful approach by considering relative positions of the parties — whether any one party took advantage of its superior position in executing a contract — as well as the circumstances surrounding the signing of the contract, the contract terms, motives and other factors and background relating to the punitive penalty and the details of the breach of contract. The Supreme Court warned that courts should not recklessly jump to the conclusion that the amount of a punitive penalty is invalid simply because it is seemingly excessive.

In the foregoing ruling, the Supreme Court did not allow a reduction of the agreed W500 million punitive penalty payable to the non-breaching party in connection with a real estate development project that was worth W90 billion. The court held that when judged in light of the aforementioned standard, the amount of the penalty was not excessive. Recently, however, lower courts have reduced punitive penalties to 50 percent or 60 percent of the prearranged amount, based on their interpretation of the foregoing precedent.

Negotiating a punitive penalty clause
In Korea, contracts often require a breaching party to pay a certain amount to a non-breaching party. When drafting agreements, it is important to distinguish clearly between liquidated damages and a punitive penalty. Mentioning a “penalty” alone is presumed to refer to liquidated damages (Article 398(4) of the Civil Act) and not a punitive penalty. If a “punitive penalty” is intended, there should be a phrase in the contract that the amount to be paid by a non-performing party is to be paid separately from actual damages and the non-breaching party is entitled to make a claim for compensatory damages, notwithstanding the agreed punitive penalty. Even then, bear in mind that the amount determined in advance as a punitive penalty may be reduced in accordance with the standard established by the Supreme Court.

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