Penalty clauses: look at their nature before the numbers

The first thing companies ask when they bring us a contract to review is usually the amount: isn't a penalty of twice the contract price too much, or conversely, isn't the penalty we would receive too small? But there is something to look at before the amount: what legal nature that money has.

A penalty is presumed to be liquidated damages

Article 398(4) of the Civil Act presumes that an agreement on a penalty is a predetermination of damages (손해배상액의 예정), i.e. liquidated damages. Liquidated damages are a device that allows you to claim the agreed amount when a dispute arises without proving how much the actual loss was. This is convenient for the receiving side, but it comes with a limitation: even if the actual loss exceeds the predetermined amount, it is in principle hard to receive more than that.

If the predetermined amount is unreasonably high, the court may reduce it appropriately (paragraph 2 of the same article). So for the paying side, the amount written in the contract is not the end of the story. There remains room to seek a reduction based on the size of the transaction, how the breach happened and the loss that could actually arise.

Having liquidated damages also does not take away the right to demand performance or to rescind the contract (paragraph 3 of the same article). You can choose separately whether to end the deal while receiving the penalty or to keep demanding performance. Delay penalties (지체상금) charged per day when delivery or construction runs late raise the same issue. Without a cap, they can exceed the contract price as the delay drags on, and then too, whether to reduce them becomes an issue.

What changes if you write ‘contractual penalty’

If the contract clearly states that the penalty is a contractual penalty (위약벌), things may be different. A contractual penalty is money received as a sanction for breach, so it is generally considered claimable separately from damages, and the reduction provision in Article 398(2) may not apply as is. However, an excessively heavy contractual penalty may be partly void as contrary to public order.

Even with the same figure, the size of the company's liability differs depending on whether it is liquidated damages or a contractual penalty, and whether actual losses can be claimed separately. If this is left blank, any dispute will start with an argument over interpretation.

Is your company the receiving side or the paying side?

If you are more likely to receive the penalty, consider adding a sentence that actual losses can be claimed separately from the penalty, or stating that it is a contractual penalty. If you are more likely to pay, specify that the penalty is liquidated damages and include an overall liability cap and an exclusion of indirect damages.

When reviewing, check in turn whether the nature of the penalty is settled in the wording, whether actual losses can be claimed separately from the penalty, whether there is an overall liability cap and an exclusion of indirect damages, and whether a cure period is given to correct a breach.

Even if the other side has used the form dozens of times, these few lines are worth negotiating. Once you have signed, there is not much you can do other than hope for a reduction by the court.