Foreign contractors and subcontractors doing business with Korean companies are often puzzled by how Korean courts deal with liquidated damages and penalty clauses in contracts. It is a generally accepted principle in many jurisdictions that unreasonably high liquidated damages intended as a punishment for non-performance are unenforceable. In these countries, liquidated damages are upheld when the actual damages resulting from a breach are difficult for the parties to estimate or difficult for the non-breaching party to prove, and the sum agreed to by the parties is reasonably connected to the harm suffered by the non-breaching party. In such jurisdictions, courts typically do not enforce penalty clauses as unconscionable or in violation of public policy. That is not to be expected of Korean courts.
Korean Jurisprudence on Liquidated Damages and Penalty Clauses
In Korea, the concept of “Liquidated Damages” is distinguishable from “Penalty”. Korean courts view liquidated damages as damages that parties have agreed on with the intent to compensate the non-breaching party for the actual damages suffered. On the other hand, a penalty clause is deemed to comprise an intent to punish the breaching party in addition to imposing the actual damages (Supreme Court decisions 92Da46905 dated Mar. 23, 1993; 2013Da63257 dated Dec. 26, 2013). According to the Korean Supreme Court, penalty clauses are valid in principle, but if the punishment being imposed is too severe, only the amount considered excessive is rendered invalid (Supreme Court decision 2014Da14511 dated Dec. 10, 2015). In this vein, Korean courts can reduce the stipulated amount in a liquidated damages clause under Article 398(2) of the Civil Code. But in practice, courts tend not to invalidate or reduce the amount in a penalty clause when the contract provides for a penalty on top of any actual damages. Indeed, in numerous cases, the Supreme Court ruled against reducing punitive penalty amount, holding that reduction of penalty is only permitted in exceptional cases (see Supreme Court decisions 2018Da248855 dated July 21, 2022; 2015Da239324 dated Jan. 28, 2016).
What to Consider when Drafting Contracts governed by Korean Law
For foreign companies contracting with Korean companies, it is important to consider the Korean jurisprudence on liquidated damages and penalty clauses. It is crucial to understand that the mere term “penalty” does not make a clause enforceable, especially if the substance resembles a liquidated damages clause. When drafting a contract governed by Korean law, the best practice is to make clear distinctions between liquidated damages and punitive penalty.
